11: Imperfect competition

11.1 The principle ideas

The preceding chapters have explored extreme forms of supply: The monopolist is the sole supplier and possesses as much market power as possible. In contrast, the perfect competitor is small and has no market power whatsoever. He simply accepts the price for his product that is determined in the market by the forces of supply and demand. These are very useful paradigms to explore, but the real world for the most part lies between these extremes. We observe that there are a handful of dominant brewers in Canada who supply more than three quarters of the market, and they are accompanied by numerous micro brewers that form the fringe of the brewing business. We have a small number of air carriers and one of them controls half of the national market. The communications market has just three major suppliers; the Canadian Football League has nine teams and there are just a handful of major hardware/builders' suppliers stores nationally. At the other end of the spectrum we have countless restaurants and fitness centres, but they do not supply exactly the same product to the marketplaces for 'food' or 'health', and so these markets are not perfectly competitive, despite the enormous number of participants.

In this chapter we will explore three broad topics: First is the relationship between firm behaviour and firm size relative to the whole sector. This comes broadly under the heading of imperfect competition and covers a variety of market forms. Second, we will explore the principle modern ideas in strategic behavior. In a sense all decisions in microeconomics have an element of strategy to them - economic agents aim to attain certain goals and they adopt specific maximizing strategies to attain them. But in this chapter we explore a more specific concept of strategic behavior - one that focuses upon direct interactions between a small number of players in the market place. Third, we explore the principle characteristics of what are termed matching' markets. These are markets where transactions take place without money and involve matching heterogeneous suppliers with heterogeneous buyers.

11.2 Imperfect competitors

Imperfect competitors can be defined by the number of firms in their sector, or the share of total sales going to a small number of suppliers. They can also be defined in terms of the characteristics of the demand curves they all face. A perfect competitor faces a perfectly elastic demand at the existing market price, and this is the only market structure to have this characteristic. In all other market structures suppliers effectively face a downward-sloping demand. This means that they have some influence on the price of the good, and also that if they change the price they charge, they can expect demand to reflect this in a predictable manner. So, in theory, we can classify all market structures apart from perfect competition as being imperfectly competitive. In practice we use the term to denote firms that fall between the extremes of perfect competition and monopoly.

The demand curve for the firm and industry coincide for the monopolist, but not for other imperfectly competitive firms. It is convenient to categorize the producing sectors of the economy as either having a relatively small number of participants, or having a large number. The former market structures are called oligopolistic, and the latter are called monopolistically competitive. The word oligopoly comes from the Greek word oligos meaning few, and polein meaning to sell.

The home appliance industry is an oligopoly. The prices of KitchenAid appliances depend not only on their own output and sales, but also on the prices of Whirlpool, Maytag and Bosch. If a firm has just two main producers it is called a duopoly. Canadian National and Canadian Pacific are the only two major rail freight carriers in Canada; they thus form a duopoly. In contrast, the local Italian restaurant is a monopolistic competitor. Its output is a package of distinctive menu choices, personal service, and convenience for local customers. It can charge a different price than the out-of-neighbourhood restaurant, but if its prices are too high local diners may travel elsewhere for their food experience, or switch to a different cuisine locally. Many markets are defined by producers who supply similar but not identical products. Canada's universities all provide degrees, but they differ one from another in their programs, their balance of in-class and on-line courses, their student activities, whether they are science based or liberal arts based, whether they have cooperative programs or not, and so forth. While universities are not in the business of making profit, they certainly wish to attract students, and one way of doing this is to differentiate themselves from other institutions. The profit-oriented world of commerce likewise seeks to increase its market share by distinguishing its product line.

These distinctions are not completely airtight. For example, if a sole domestic producer is subject to international competition it cannot act in the way we described in the previous chapter – it has potential, or actual, competition. Bombardier may be Canada's sole rail car manufacturer, but it is not a monopolist, even in Canada. It could best be described as being part of an international oligopoly in rail-car manufacture. Likewise, it is frequently difficult to delineate the boundary of a given market. For example, is Canada Post a monopoly in mail delivery, or an oligopolist in hard-copy communication? We can never fully remove these ambiguities.

The role of cost structures

A critical determinant of market structure is the way in which demand and cost interact to determine the likely number of market participants in a given sector or market. Structure also evolves over the long run: Time is required for entry and exit.

Figure 11.1 shows the demand curve D for the output of an industry in the long run. Suppose, initially, that all firms and potential entrants face the long-run average cost curve LATC₁. At the price P₁, free entry and exit means that each firm produces q₁. With the demand curve D, industry output is Q₁. The number of firms in the industry is N₁ (=Q₁/q₁). If q₁, the minimum average cost output on LATC₁, is small relative to D, then N₁ is large. This outcome might be perfect competition (N virtually infinite), or monopolistic competition (N large) with slightly differentiated products produced by each firm.

Figure 11.1 Demand, costs and market structure

With a cost structure defined by LATC₁ this market has space for many firms – perfect or monopolistic competition, each producing approximately q₁. If costs correspond to LATC₂, where scale economies are substantial, there may be space for just one producer. The intermediate case, LATC₃, can give rise to oligopoly, with each firm producing more than q₁ but less than a monopolist. These curves encounter their MES at very different output levels.

Instead, suppose that the production structure in the industry is such that the long-run average cost curve is LATC₂. Here, scale economies are vast, relative to the market size. At the lowest point on this cost curve, output is large relative to the demand curve D. If this one firm were to act like a monopolist it would produce an output where MR=MC in the long run and set a price such that the chosen output is sold. Given the scale economies, there may be no scope for another firm to enter this market, because such a firm would have to produce a very high output to compete with the existing producer. This situation is what we previously called a "natural" monopolist.

Finally, the cost structure might involve curves of the type LATC₃, which would give rise to the possibility of several producers, rather than one or very many. This results in oligopoly.

It is clear that one crucial determinant of market structure is minimum efficient scale relative to the size of the total market as shown by the demand curve. The larger the minimum efficient scale relative to market size, the smaller is the number of producers in the industry.

11.3 Imperfect competitors: measures of structure and market power

Sectors of the economy do not fit neatly into the limited number of categories described above. The best we can say in most cases is that they resemble more closely one type of market than another. Consider the example of Canada's brewing sector: It has two large brewers in Molson-Coors and Labatt, a couple of intermediate sized firms such as Sleeman, and an uncountable number of small boutique brew pubs. While such a large number of brewers satisfy one requirement for perfect competition, it would not be true to say that the biggest brewers wield no market power; and this is the most critical element in defining market structure.

By the same token, we could not define this market as a duopoly: Even though there are just two major participants, there are countless others who, together, are important.

One way of defining what a particular structure most closely resembles is to examine the percentage of sales in the market that is attributable to a small number of firms. For example: What share is attributable to the largest three or four firms? The larger the share, the more concentrated the market power. Such a statistic is called a concentration ratio. The N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.

Table 11.1 contains information on the 4-firm concentration ratio for several sectors of the Canadian economy. It indicates that, at one extreme, sectors such as breakfast cereals and sugars have a high degree of concentration, whereas meat processing has much less. A high degree of concentration suggests market power, and possibly economies of scale.

11.4 Imperfect competition: monopolistic competition

Monopolistic competition presumes a large number of quite small producers or suppliers, each of whom may have a slightly differentiated product. The competition element of this name signifies that there are many participants, while the monopoly component signifies that each supplier faces a downward-sloping demand. In concrete terms, your local coffee shop that serves "fair trade" coffee has a product that differs slightly from that of neighbouring shops that sell the traditional product. They coexist in the same sector, and probably charge different prices: The fair trade supplier likely charges a higher price, but knows nonetheless that too large a difference between her price and the prices of her competitors will see some of her clientele migrate to those lower-priced establishments. That is to say, she faces a downward-sloping demand curve.

The competition part of the name also indicates that there is free entry and exit. There are no barriers to entry. As a consequence, we know at the outset that only normal profits will exist in a long-run equilibrium. Economic profits will be competed away by entry, just as losses will erode due to exit.

As a general rule then, each firm can influence its market share to some extent by changing its price. Its demand curve is not horizontal because different firms' products are only limited substitutes. A lower price level may draw some new customers away from competitors, but convenience or taste will prevent most patrons from deserting their local businesses. In concrete terms: A pasta special at the local Italian restaurant that reduces the price below the corresponding price at the competing local Thai restaurant will indeed draw clients away from the latter, but the foods are sufficiently different that only some customers will leave the Thai restaurant. The differentiated menus mean that many customers will continue to pay the higher price.

Given that there are very many firms, the theory also envisages limits to scale economies. Firms are small and, with many competitors, individual firms do not compete strategically with particular rivals. Because the various products offered are slightly differentiated, we avoid graphics with a market demand, because this would imply that a uniform product is being considered. At the same time the market is a well-defined concept—it might be composed of all those restaurants within a reasonable distance, for example, even though each one is slightly different from the others. The market share of each firm depends on the price that it charges and on the number of competing firms. For a given number of suppliers, a shift in industry demand also shifts the demand facing each firm. Likewise, the presence of more firms in the industry reduces the demand facing each one.

Equilibrium is illustrated in Figure 11.2. Here D₀ is the initial demand facing a representative firm, and MR₀ is the corresponding marginal revenue curve. Profit is maximized where MC=MR, and the price P₀ is obtained from the demand curve corresponding to the output q₀. Total profit is the product of output times the difference between price and average cost, which equals .

Figure 11.2 Equilibrium for a monopolistic competitor

Profits exist at the initial equilibrium (q₀,P₀). Hence, new firms enter and reduce the share of the total market faced by each firm, thereby shifting back their demand curve. A final equilibrium is reached where economic profits are eliminated: At AC=P_E and MR=MC.

With free entry, such profits attract new firms. The increased number of firms reduces the share of the market that any one firm can claim. That is, the firm's demand curve shifts inwards when entry occurs. As long as (economic) profits exist, this process continues. For entry to cease, average cost must equal price. A final equilibrium is illustrated by the combination , where the demand has shifted inward to D.

At this long-run equilibrium, two conditions must hold: First, the optimal pricing rule must be satisfied—that is MC=MR; second it must be the case that only normal profits are made at the final equilibrium. Economic profits are competed away as a result of free entry. Graphically this implies that ATC must equal price at the output where MC=MR. In turn this implies that the ATC is tangent to the demand curve where P=ATC. While this could be proven mathematically, it is easy to intuit why this tangency must exist: If ATC merely intersected the demand curve at the output where MC=MR, we could find some other output where the demand price would be above ATC, suggesting that profits could be made at such an output. Clearly that could not represent an equilibrium.

11.5 Imperfect competition: economies of scope and platforms

The communications revolution has impacted market structure in modern economies profoundly: it has facilitated economies of scope, meaning that firms may yield more collective profit if merged than if operating independently.

Economies of Scope

Imagine an aspiring entrepreneur who envisages a revolution of the traditional taxi sector of the economy. He decides to develop a smartphone application that will match independent income-seeking vehicle owners (drivers) with individuals seeking transport (passengers) from point A to point B. We know how this adventure evolves. In one case it takes the form of the corporation Uber, in another the corporation Lyft, and others worldwide.

These corporations have grown in leaps and bounds and have taken business from the conventional taxi corporations. As of 2019 they cannot turn a profit, yet the stock market continues to bet upon future success: investors believe that when these corporations evolve into fully integrated multi-product suppliers, both costs will decline and demand will increase for each component of the business. In the case of transportation companies, they aim to become a 'one-stop-shop' for mobility services. Uber is not only a ride-hailing service, it also transports meals through its Uber-eats platform, and is developing the electric scooter and electric bike markets in addition. In some local markets it is linked to public transport services. All of this is being achieved through a single smartphone application. The objective is to simplify movement for persons, by providing multiple options on a variety of transport modes, accessed through a single portal.

This phenomenon is described in Figure 11.3. The subscripts A and I represent market conditions when the service supplier is operating Alone or in an Integrated corporation. The initial equilibrium is defined by the A demand and cost conditions. The profit maximizing output occurs when , leading to a price and a quantity . Each unit of the good yields a profit margin of .

Figure 11.3 Summa's ride hailing service

Demand for a particular product increases when the autonomous supplier (A) merges with another firm to become an integrated firm (I), because customers switch to firms that offer several different services from the same platform: the demand curve shifts outward, from D_A to D_I. With integration, the fixed costs fall and average costs fall, even with marginal costs constant. Output and profit increase, and concentration in the marketplace rises.

This firm now merges with another transportation corporation - perhaps a food delivery service, perhaps an electric bike service. Since each firm has a similar type of fixed cost, these costs can be reduced by the merger. In technical terms, the merged firms, or merged operations, share a common hardware-cum-software platform. Each firm will therefore incur lower average costs, even if marginal costs remain unchanged: the AC curve declines to . In addition to the decline in average costs, each firm sees an increase in its customer base, because transportation service buyers find it preferable to choose their mode of transport through a single portal rather than through several different modes of access. This is represented by an outward shift in the demand curve for vehicle rides to .

The new profit maximizing equilibrium occurs at Total profit necessarily increases both because average costs have fallen and the number of buyers willing to buy at any price has risen. The analytics in this figure also describe the benefits accruing to the other firm or firms in the merger.

A platform describes a technology that is common to more than one product in a multi-product organization.

We conclude from this analysis that, if scope economies are substantial, it may be difficult for stand-alone firms specializing in just one component of the transportation services sector to remain profitable. It may also be impossible to define a conventional equilibrium in this kind of marketplace. This is because some conglomerate firms may have different component producers in their suite of firms. For example, Lyft may not have a food delivery service, but it may have a limousine or bus service. What is critical for an equilibrium is that firms of a particular type, whether they are part of a conglomerate or not, be able to compete with corresponding firms. This means that their cost structure must be similar.

As a further example: Amazon initially was primarily an on-line book seller. But it expanded to include the sale of other products. And once it became a 'market for everything' the demand side of the market exploded in parallel with the product line, because it becomes easy to shop for 'anything' or even different objects on a single site. Only Walmart, in North America, comes close to being able to compete with Amazon.

11.6 Strategic behaviour: Oligopoly and games

Under perfect competition or monopolistic competition, there are so many firms in the industry that each one can ignore the immediate effect of its own actions on particular rivals. However, in an oligopolistic industry each firm must consider how its actions affect the decisions of its relatively few competitors. Each firm must guess how its rivals will react. Before discussing what constitutes an intelligent guess, we investigate whether they are likely to collude or compete. Collusion is a means of reducing competition with a view to increasing profit.

A particular form of collusion occurs when firms co-operate to form a cartel, as we saw in the last chapter. Collusion is more difficult if there are many firms in the industry, if the product is not standardized, or if demand and cost conditions are changing rapidly. In the absence of collusion, each firm's demand curve depends upon how competitors react: If Air Canada contemplates offering customers a seat sale on a particular route, how will West Jet react? Will it, too, make the same offer to buyers? If Air Canada thinks about West Jet's likely reaction, will it go ahead with the contemplated promotion? A conjecture is a belief that one firm forms about the strategic reaction of another competing firm.

Good poker players will attempt to anticipate their opponents' moves or reactions. Oligopolists are like poker players, in that they try to anticipate their rivals' moves. To study interdependent decision making, we use game theory. A game is a situation in which contestants plan strategically to maximize their payoffs, taking account of rivals' behaviour.

The players in the game try to maximize their own payoffs. In an oligopoly, the firms are the players and their payoffs are their profits. Each player must choose a strategy, which is a plan describing how a player moves or acts in different situations.

11.7 Strategic behaviour: Duopoly and Cournot games

The duopoly model that we frequently use in economics to analyze competition between a small number of competitors is fashioned after the ideas of French economist Augustin Cournot. Consequently it has come to be known as the Cournot duopoly model. While the maximizing behaviour that is incorporated in this model can apply to a situation with several firms rather than two, we will develop the model with two firms. This differs slightly from the preceding section, where each firm has simply a choice between a high or low output.

The critical element of the Cournot approach is that the firms each determine their optimal strategy – one that maximizes profit – by reacting optimally to their opponent's strategy, which in this case involves their choice of output.

A central element here is the reaction function of each firm, which defines the optimal output choice conditional upon their opponent's choice.

We can develop an optimal strategy with the help of Figure 11.4. D is the market demand, and two firms supply this market. If B supplies a zero output, then A would face the whole demand, and would maximize profit where MC=MR. Let this output be defined by . We transfer this output combination to Figure 11.5, where the output of each firm is on one of the axes—A on the vertical axis and B on the horizontal. This particular combination of zero output for B and for A is represented on the vertical axis as the point .

Figure 11.4 Duopoly behaviour

When one firm, B, chooses a specific output, e.g. , then A's residual demand is the difference between the market demand and . A's profit is maximized at – where . This is an optimal reaction by A to B's choice. For all possible choices by B, A can form a similar optimal response. The combination of these responses forms A's reaction function.

Instead, suppose that B produces a quantity in Figure 11.4. This reduces the demand curve facing A correspondingly from D to , which we call A's residual demand. When subject to such a choice by B, firm A maximizes profit by producing where , where is the marginal revenue corresponding to the residual demand . The optimum for A is now , and this pair of outputs is represented by the combination in Figure 11.5.

Figure 11.5 Reaction functions and equilibrium

The reaction function for A (R_A) defines the optimal output response for A to any output choice by B. The reaction function for B is defined similarly. The equilibrium occurs at the intersection of R_A and R_B. Any other combination will induce one firm to change its output, and therefore could not be an equilibrium.

Firm A forms a similar optimal response for every possible output level that B could choose, and these responses define A's reaction function. The reaction function illustrated for A in Figure 11.5 is thus the locus of all optimal response outputs on the part of A. The downward-sloping function makes sense: The more B produces, the smaller is the residual market for A, and therefore the less A will produce.

But A is just one of the players in the game. If B acts in the same optimizing fashion, B too can formulate a series of optimal reactions to A's output choices. The combination of such choices would yield a reaction function for B. This is plotted as in Figure 11.5.

An equilibrium is defined by the intersection of the two reaction functions, in this case by the point E. At this output level each firm is making an optimal decision, conditional upon the choice of its opponent. Consequently, neither firm has an incentive to change its output; therefore it can be called the Nash equilibrium.

Any other combination of outputs on either reaction function would lead one of the players to change its output choice, and therefore could not constitute an equilibrium. To see this, suppose that B produces an output greater than ; how will A react? A's reaction function indicates that it should choose a quantity to supply less than . If so, how will B respond in turn to that optimal choice? It responds with a quantity read from its reaction function, and this will be less than the amount chosen at the previous stage. By tracing out such a sequence of reactions it is clear that the output of each firm will move to the equilibrium .

The Cournot model yields an outcome that lies between monopoly (or collusion/cartel) and competitive market models. It does not necessarily assume that the firms are identical in terms of their cost structure, although the lower-cost producer will end up with a larger share of the market.

The next question that arises is whether this duopoly market will be sustained as a duopoly, or if entry may take place. In particular, if economic profits accrue to the participants will such profits be competed away by the arrival of new producers, or might there be barriers of either a 'natural' or 'constructed' type that operate against new entrants?

11.8 Strategic behaviour: Entry, exit & potential competition

At this point we inquire about the potential entry and impact of new firms – firms who might enter the industry if conditions were sufficiently enticing, meaning the presence of economic profits. One way of examining entry in this oligopolistic world is to envisage potential entry barriers as being either intended or unintended, though the difference between the two can be blurred. Broadly, an unintended or 'natural' barrier is one related to scale economies and the size of the market. An intended barrier involves a strategic decision on the part of the firm to prevent entry.

11.9 Matching markets: design

Markets are institutions that facilitate the exchange of goods and services. They act as clearing houses. The normal medium of exchange is money in some form. But many markets deal in exchanges that do not involve money and frequently involve matching: Graduating medical students are normally matched with hospitals in order that graduates complete their residency requirement; in many jurisdictions in the US applicants for places in public schools that form a pool within a given school-board must go through an application process that sorts the applicants into the different schools within the board; patients in need of a new kidney must be matched with kidney donors.

These markets are clearinghouses and have characteristics that distinguish them from traditional currency-based markets that we have considered to this point.

• The good or service being traded is generally heterogeneous. For example, patients in search of a kidney donor must be medically compatible with the eventual donor if the organ transplant is not to be rejected. Hospitals may seek residents in particular areas of health, and they must find residents who are, likewise, seeking such placements. Students applying to public schools may be facing a choice between schools that focus upon science or upon the arts. Variety is key.

• Frequently the idea of a market that is mediated by money is repugnant. For example, the only economy in the world that permits the sale of human organs is Iran. Elsewhere the idea of a monetary payment for a kidney is unacceptable. A market in which potential suppliers of kidneys registered their reservation prices and demanders registered their willingness to pay is incompatible with our social mores. Consequently, potential living donors or actual deceased donors must be directly matched with a patient in need. While some individuals believe that a market in kidneys would do more good than harm, because a monetary payment might incentivize the availability of many more organs and therefore save many more lives, virtually every society considers the downside to such a trading system to outweigh the benefits.

• Modern matching markets are more frequently electronically mediated, and the communications revolution has led to an increase in the efficiency of these markets.

The Economics prize in memory of Alfred Nobel was awarded to Alvin Roth and Lloyd Shapley in 2011 in recognition of their contributions to designing markets that function efficiently in the matching of demanders and suppliers of the goods and services. What do we mean by an efficient mechanism? One way is to define it is similar to how we described the market for apartments in Chapter 5: following an equilibrium in the market, is it possible to improve the wellbeing of one participant without reducing the wellbeing of another? We showed in that example that the market performed efficiently: a different set of renters getting the apartments would reduce total surplus in the system.

Consider a system in which medical graduates are matched with hospitals, and the decision process results in the potential for improvement: Christina obtains a residency in the local University Hospital while Ulrich obtains a residency at the Childrens' Hospital. But Christina would have preferred the Childrens' and Ulrich would have preferred the University. The matching algorithm here was not efficient because, at the end of the allocation process, there is scope for gains for each individual. Alvin Roth devised a matching mechanism that surmounts this type of inefficiency. He called it the deferred acceptance algorithm.

Roth also worked on the matching of kidney donors to individuals in need of a kidney. The fundamental challenge in this area is that a patient in need of a kidney may have a family member, say a sibling, who is willing to donate a kidney, but the siblings are not genetically compatible. The patient's immune system may attack the implantation of a 'foreign' organ. One solution to this incompatibility is to find matching pairs of donors that come from a wider choice set. Two families in each of which there is patient and a donor may be able to cross-donate: donor in Family A can donate to patient in Family B, and donor in Family B can donate to patient in Family A, in the sense that the donor organs will not be rejected by recipients' immune systems. Hence if many patient-donor families register in a clearinghouse, a computer algorithm can search for matching pairs. Surgical operations may be performed simultaneously in order to prevent one donor from backing out following his sibling's receipt of a kidney.

A more recent development concerns 'chains'. In this case a good Samaritan ('unaligned donor') offers a kidney while seeking nothing in return. The algorithm then seeks a match for the good Samaritan's kidney among all of the recipient-donor couples registered in the data bank. Having found (at least) one, the algorithm seeks a recipient for the kidney that will come from the first recipient's donor partner. And so on. It turns out that an algorithm which seeks to maximize the potential number of participating pairs is fraught with technical and ethical challenges: should a young patient, who could benefit from the organ for a whole lifetime, get priority over an older patient, who will benefit for fewer years of life, even if the older patient is in greater danger of dying in the absence of a transplant? This is an ethical problem.

Examples where these algorithms have achieved more than a dozen linked transplants are easy to find on an internet search - they are called chains, for the obvious reason.

Consider the following efficiency aspect of the exchange. Suppose a patient has two siblings, each of whom is willing to donate (though only one of the two actually will); should such a patient get priority in the computer algorithm over a patient who has just a single sibling willing to donate? The answer may be yes; the dual donor patient should get priority because if his two siblings have different blood types, this greater variety on the supply side increases the chances for matching in the system as a whole and is therefore beneficial. If a higher priority were not given to the dual-donor patient, there would be an incentive for him to name just one potential donor, and that would impact the efficiency of the whole matching algorithm.

It is not always recognized that the discipline of Economics explores social problems of the nature we have described here, despite the fact that the discipline has developed the analytical tools to address them.

Conclusion

Monopoly and perfect competition are interesting paradigms; but few markets resemble them in the real world. In this chapter we addressed some of the complexities that define the economy we inhabit: It is characterized by strategic planning, entry deterrence, differentiated products and so forth.

Entry and exit are critical to competitive markets. Frequently entry is blocked because of scale economies – an example of a natural or unintended entry barrier. In addition, incumbents can formulate numerous strategies to limit entry.

Firms act strategically – particularly when there are just a few participants in the market. Before acting, firms make conjectures about how their competitors will react, and incorporate such reactions into their own planning. Competition between suppliers can frequently be analyzed in terms of a game, and such games usually have an equilibrium outcome. The Cournot duopoly model that we developed is a game between two competitors in which an equilibrium market output is determined from a pair of reaction functions.

Scale economies are critical. Large development costs or setup costs may mean that the market can generally support just a limited number of producers. In turn this implies that potential new (small-scale) firms cannot benefit from the scale economies and will not survive competition from large-scale suppliers.

Product differentiation is critical. If small differences exist between products produced in markets where there is free entry we get a monopolistically competitive structure. In these markets long-run profits are 'normal' and firms operate with some excess capacity. It is not possible to act strategically in this kind of market.

The modern economy also has sectors that have successfully erected barriers. These barriers lead to fewer competitors than could efficiently supply the market. Ultimately the owners of capital are the beneficiaries of these barriers and consumers suffer from higher prices.

Key Terms

Exercises for Chapter 11