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11: Imperfect competition

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    Chapter 11: Imperfect competition

    In this chapter we will explore:

    11.1

    The principle ideas

    11.2

    Imperfect competitors

    11.3

    Imperfect competitors: measures of structure and market power

    11.4

    Imperfect competition: monopolistic competition

    11.5

    Imperfect competition: economies of scope and platforms

    11.6

    Strategic behaviour: oligopoly and games

    11.7

    Strategic behaviour: duopoly and Cournot games

    11.8

    Strategic behaviour: entry, exit and potential competition

    11.9

    Matching markets: design

    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.

    Imperfectly competitive firms face a downward-sloping demand curve, and their output price reflects the quantity sold.

    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.

    Oligopoly defines a market with a small number of suppliers.

    Monopolistic competition defines a market with many sellers of products that have similar characteristics. Monopolistically competitive firms can exert only a small influence on the whole market.

    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.

    Duopoly defines a market or sector with just two firms.

    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
    img372.png
    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.

    The N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.

    Table 11.1 Concentration in Canadian food processing 2011
    Sector % of shipments
    Sugar 98
    Breakfast cereal 96
    Canning 60
    Meat processing 23
    Source: "Four Firm Concentration Ratios (CR4s) for selected food processing sectors," adapted from Statistics Canada publication Measuring industry concentration in Canada's food processing sectors, Agriculture and Rural Working Paper series no. 70, Catalogue 21-601, http://www.statcan.gc.ca/pub/21-601-m/21-601-m2004070-eng.pdf.

    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.

    A differentiated product is one that differs slightly from other products in the same market.

    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 img373.png.

    Figure 11.2 Equilibrium for a monopolistic competitor
    img374.png
    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=PE 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 img375.png, 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.

    The monopolistically competitive equilibrium in the long run requires the firm's demand curve to be tangent to the ATC curve at the output where MR=MC.

    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 img376.png, leading to a price img377.png and a quantity img378.png. Each unit of the good yields a profit margin of img379.png.

    Figure 11.3 Summa's ride hailing service
    img380.png
    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 DA to DI. 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 img381.png. 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 img382.png.

    The new profit maximizing equilibrium occurs at img383.png 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.

    Collusion is an explicit or implicit agreement to avoid 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.

    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.

    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.

    A strategy is a game plan describing how a player acts, or moves, in each possible situation.

    Equilibrium outcomes

    How do we arrive at an equilibrium in these games? Let us begin by defining a commonly used concept of equilibrium. A Nash equilibrium is one in which each player chooses the best strategy, given the strategies chosen by the other players, and there is no incentive to move or change choice.

    A Nash equilibrium is one in which each player chooses the best strategy, given the strategies chosen by the other player, and there is no incentive for any player to move.

    In such an equilibrium, no player wants to change strategy, since the other players' strategies were already figured into determining each player's own best strategy. This concept and theory are attributable to the Princeton mathematician John Nash, who was popularized by the Hollywood movie version of his life, A Beautiful Mind.

    In most games, each player's best strategy depends on the strategies chosen by their opponents. Occasionally, a player's best strategy is independent of those chosen by rivals. Such a strategy is called a dominant strategy.

    A dominant strategy is a player's best strategy, independent of the strategies adopted by rivals.

    We now illustrate these concepts with the help of two different games. These games differ in their outcomes and strategies. Table 11.2 contains the domestic happiness game1. Will and Kate are attempting to live in harmony, and their happiness depends upon each of them carrying out domestic chores such as shopping, cleaning and cooking. The first element in each pair defines Will's outcome, the second Kate's outcome. If both contribute to domestic life they each receive a happiness or utility level of 5 units. If one contributes and the other does not the happiness levels are 2 for the contributor and 6 for the non-contributor, or 'free-rider'. If neither contributes happiness levels are 3 each. When each follows the same strategy the payoffs are on the diagonal, when they follow different strategies the payoffs are on the off-diagonal. Since the elements of the table define the payoffs resulting from various choices, this type of matrix is called a payoff matrix.

    A payoff matrix defines the rewards to each player resulting from particular choices.

    So how is the game likely to unfold? In response to Will's choice of a contribute strategy, Kate's utility maximizing choice involves lazing: She gets 6 units by not contributing as opposed to 5 by contributing. Instead, if Will decides to be lazy what is in Kate's best interest? Clearly it is to be lazy also because that strategy yields 3 units of happiness compared to 2 units if she contributes. In sum, Kate's best strategy is to be lazy, regardless of Will's behaviour. So the strategy of not contributing is a dominant strategy, in this particular game.

    Will also has a dominant strategy – identical to Kate's. This is not surprising since the payoffs are symmetric in the table. Hence, since each has a dominant strategy of not contributing the Nash equilibrium is in the bottom right cell, where each receives a payoff of 3 units. Interestingly, this equilibrium is not the one that yields maximum combined happiness.

    Table 11.2 A game with dominant strategies
    Kate's choice
    Contribute Laze
    Will's choice Contribute 5,5 2,6
    Laze 6,2 3,3
    The first element in each cell denotes the payoff or utility to Will; the second element the utility to Kate.

    The reason that the equilibrium yields less utility for each player in this game is that the game is competitive: Each player tends to their own interest and seeks the best outcome conditional on the choice of the other player. This is evident from the (5,5) combination. From this position Kate would do better to defect to the Laze strategy, because her utility would increase2.

    To summarize: This game has a unique equilibrium and each player has a dominant strategy. But let us change the payoffs just slightly to the values in Table 11.3. The off-diagonal elements have changed. The contributor now gets no utility as a result of his or her contributions: Even though the household is a better place, he or she may be so annoyed with the other person that no utility flows to the contributor.

    Table 11.3 A game without dominant strategies
    Kate's choice
    Contribute Laze
    Will's choice Contribute 5,5 0,4
    Laze 4,0 3,3
    The first element in each cell denotes the payoff or utility to Will; the second element the utility to Kate.

    What are the optimal choices here? Starting again from Will choosing to contribute, what is Kate's best strategy? It is to contribute: She gets 5 units from contributing and 4 from lazing, hence she is better contributing. But what is her best strategy if Will decides to laze? It is to laze, because that yields her 3 units as opposed to 0 by contributing. This set of payoffs therefore contains no dominant strategy for either player.

    As a result of there being no dominant strategy, there arises the possibility of more than one equilibrium outcome. In fact there are two equilibria in this game now: If the players find themselves both contributing and obtaining a utility level of (5,5) it would not be sensible for either one to defect to a laze option. For example, if Kate decided to laze she would obtain a payoff of 4 utils rather than the 5 she enjoys at the (5,5) equilibrium. By the same reasoning, if they find themselves at the (laze, laze) combination there is no incentive to move to a contribute strategy.

    Once again, it is to be emphasized that the twin equilibria emerge in a competitive environment. If this game involved cooperation or collusion the players should be able to reach the (5,5) equilibrium rather than the (3,3) equilibrium. But in the competitive environment we cannot say ex ante which equilibrium will be attained.

    Repeated games

    This game illustrates the tension between collusion and competition. While we have developed the game in the context of the household, it can equally be interpreted in the context of a profit maximizing game between two market competitors. Suppose the numbers define profit levels rather than utility as in Table 11.4. The 'contribute' option can be interpreted as 'cooperate' or 'collude', as we described for a cartel in the previous chapter. They collude by agreeing to restrict output, sell that restricted output at a higher price, and in turn make a greater total profit which they split between themselves. The combined best profit outcome (5,5) arises when each firm restricts its output.

    Table 11.4 Collusion possibilities
    Firm K's profit
    Low output High output
    Firm W's profit Low output 5,5 2,6
    High output 6,2 3,3
    The first element in each cell denotes the profit to Firm W; the second element the profit to Firm K.

    But again there arises an incentive to defect: If Firm W agrees to maintain a high price and restrict output, then Firm K has an incentive to renege and increase output, hoping to improve its profit through the willingness of Firm W to restrict output. Since the game is symmetric, each firm has an incentive to renege. Each firm has a dominant strategy – high output, and there is a unique equilibrium (3,3).

    Obviously there arises the question of whether these firms can find an operating mechanism that would ensure they each generate a profit of 5 units rather than 3 units, while remaining purely self-interested. This question brings us to the realm of repeated games. For example, suppose that firms make strategic choices each quarter of the year. If firm K had 'cheated' on the collusive strategy it had agreed with firm W in the previous quarter, what would happen in the following quarter? Would firms devise a strategy so that cheating would not be in the interest of either one, or would the competitive game just disintegrate into an unpredictable pattern? These are interesting questions and have provoked a great deal of thought among game theorists. But they are beyond our scope at the present time.

    A repeated game is one that is repeated in successive time periods and where the knowledge that the game will be repeated influences the choices and outcomes in earlier periods.

    We now examine what might happen in one-shot games of the type we have been examining, but in the context of many possible choices. In particular, instead of assuming that each firm can choose a high or low output, how would the outcome of the game be determined if each firm can choose an output that can lie anywhere between a high and low output? In terms of the demand curve for the market, this means that the firms can choose some output and price that is consistent with demand conditions: There may be an infinite number of choices. This framing of a game enables us to explore new concepts in strategic behavior.

    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.

    Cournot behaviour involves each firm reacting optimally in their choice of output to their competitors' output decisions.

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

    Reaction functions define the optimal choice of output conditional upon a rival's output 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 img384.png. 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 img384.png for A is represented on the vertical axis as the point img384.png.

    Figure 11.4 Duopoly behaviour
    img385.png
    When one firm, B, chooses a specific output, e.g. img386.png, then A's residual demand img387.png is the difference between the market demand and img386.png. A's profit is maximized at img388.png – where img389.png. 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 img386.png in Figure 11.4. This reduces the demand curve facing A correspondingly from D to img390.png, which we call A's residual demand. When subject to such a choice by B, firm A maximizes profit by producing where img391.png, where img392.png is the marginal revenue corresponding to the residual demand img390.png. The optimum for A is now img388.png, and this pair of outputs is represented by the combination img393.png in Figure 11.5.

    Figure 11.5 Reaction functions and equilibrium
    img394.png
    The reaction function for A (RA) 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 RA and RB. 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 img395.png 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 img396.png; how will A react? A's reaction function indicates that it should choose a quantity to supply less than img397.png. 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 img301.png.

    Application Box 11.1 Cournot: Fixed costs and brand

    Why do we observe so many industries on the national, and even international, stages with only a handful of firms? For example, Intel produces more than half of the world's computer chips, and AMD produces a significant part of the remainder. Why are there only two major commercial aircraft producers in world aviation – Boeing and Airbus? Why are there only a handful of major North American suppliers in pharmaceuticals, automobile tires, soda pop, internet search engines and wireless telecommunications?

    The answer lies primarily in the nature of modern product development. Product development (fixed) costs, coupled with a relatively small marginal cost of production, leads to markets where there is enough space for only a few players. The development cost for a new cell phone, or a new aircraft, or a new computer-operating system may run into billions, while the cost of producing each unit may in fact be constant. The enormous development cost associated with many products explains not only why there may be a small number of firms in the domestic market for the product, but also why the number of firms in some sectors is small worldwide.

    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.

    Unintended entry barriers

    Oligopolists tend to have substantial fixed costs, accompanied by declining average costs up to high output levels. Such a cost structure 'naturally' gives rise to a supply side with a small number of suppliers. For examples, given demand and cost structures, could Vancouver support two professional soccer teams; could Calgary support two professional hockey teams; could Montreal sustain two professional football teams? The answer to each of these questions is likely 'no'. Because given the cost structure of these markets, it would not be possible to induce twice as many spectators without reducing the price per game ticket to such a degree that revenue would be insufficient to cover costs. (We will neglect for the moment that the governing bodies of these sports also have the power to limit entry.) Fixed costs include stadium costs, staff payrolls and player payrolls. In fact most costs in these markets are relatively fixed. Market size relative to fixed and variable costs is not large enough to sustain two teams in most cities. Exceptions in reality are huge urban areas such as New York and Los Angeles.

    Accordingly, it is possible that the existing team, or teams, may earn economic profit from their present operation; but such profit does not entice further entry, because the market structure is such that the entry of an additional team could lead to each team making losses.

    Intended entry barriers

    Patent Law

    This is one form of protection for incumbent firms. Research and development is required for the development of many products in the modern era. Pharmaceuticals are an example. If innovations were not protected, firms and individuals would not be incentivized to devote their energies and resources to developing new drugs. Society would be poorer as a result. Patent protection is obviously a legal form of protection. At the same time, patent protection can be excessive. If patents provide immunity from replication or copying for an excessive period of time - for longer than required to recoup R & D costs - then social welfare declines because monopoly profits are being generated as a result of output restriction at too high a price.

    Advertising

    Advertising is a second form of entry deterrence. In this instance firms attempt to market their product as being distinctive and even enviable. For example, Coca-Cola and PepsiCo invest hundreds of millions annually to project their products in this light. They sponsor sports, artistic and cultural events. Entry into the cola business is not impossible, but brand image is so strong for these firms that potential competitors would have a very low probability of entering this sector profitably. Likewise, in the 'energy-drinks' market, Red Bull spends hundreds of millions of dollars per annum on Formula One racing, kite surfing contests, mountain biking events and other extreme sports. In doing this it it reinforcing its brand image and distinguishing its product from Pepsi or Coca-Cola. This form of advertising is one of product differentiation and enables the manufacturer to maintain a higher price for its products by convincing its buyers that there are no close substitutes.

    Predatory pricing

    This form of pricing constitutes an illegal form of entry deterrence. It involves an incumbent charging an artificially low price for its product in the event of entry of a new competitor. This is done with a view to making it impossible for the entrant to earn a profit. Given that incumbents have generally greater resources than entrants, they can survive a battle of losses for a more prolonged period, thus ultimately driving out the entrant.

    An iconic example of predatory pricing is that of Amazon deciding to take on a startup called Quidsi that operated the website diapers.com. 3 The latter was proving to be a big hit with consumers in 2009 and Amazon decided that it was eating into Amazon profits on household and baby products. Amazon reacted by cutting its own prices dramatically, to the point where it was ready to loose a huge amount of money in order to grind Quidsi into the ground. The ultimate outcome was that Quidsi capitulated and sold to Amazon.

    Whether this was a legal tactic or not we do not know, but it underlines the importance of war chests.

    Maintaining a war chest

    Many large corporations maintain a mountain of cash. This might seem like an odd thing to do when it could be paying that cash out to owners in the form of dividends. But there are at least two reasons for not doing this. First, personal taxes on dividends are frequently higher than taxes on capital gains; accordingly if a corporation can transform its cash into capital gain by making judicious investments, that strategy ultimately yields a higher post-tax return to the stock holders. A second reason is that a cash war chest serves as a credible threat to competitors of the type described involving Amazon and Quidsi above.

    Network externalities

    These externalities arise when the existing number of buyers itself influences the total demand for a product. Facebook is now a classic example. An individual contemplating joining a social network has an incentive to join one where she has many existing 'friends'. Not everyone views the Microsoft operating system (OS) as the best. Many prefer a simpler system such as Linux that also happens to be free. However, the fact that almost every new computer (that is not Apple) coming onto the market place uses Microsoft OS, there is an incentive for users to continue to use it because it is so easy to find a technician to repair a breakdown.

    Transition costs and loyalty cards

    Transition costs can be erected by firms who do not wish to lose their customer base. Cell-phone plans are a good example. Contract-termination costs are one obstacle to moving to a new supplier. Some carriers grant special low rates to users communicating with other users within the same network, or offer special rates for a block of users (perhaps within a family). Tim Hortons and other coffee chains offer loyalty cards that give one free cup of coffee for every eight purchased. These suppliers are not furnishing love to their caffeine consumers, they are providing their consumers with an incentive not to switch to a competing supplier. Air miles rewards operate on a similar principle. So too do loyalty cards for hotel chains.

    How do competitors respond to these loyalty programs? Usually by offering their own. Hilton and Marriot each compete by offering a free night after a given points threshold is reached.

    Over-investment

    An over-investment strategy means that an existing supplier generates additional production capacity through investment in new plant or capital. This is costly to the incumbent and is intended as a signal to any potential entrant that this capacity could be brought on-line immediately should a potential competitor contemplate entry. For example, a ski-resort owner may invest in a new chair-lift, even if she does not use it frequently. The existence of the additional capacity may scare potential entrants. A key component of this strategy is that the incumbent firm invests ahead of time – and inflicts a cost on itself. The incumbent does not simply say "I will build another chair-lift if you decide to develop a nearby mountain into a ski hill." That policy does not carry the same degree of credibility as actually incurring the cost of construction ahead of time. However, such a strategy may not always be feasible: It might be just too costly to pre-empt entry by putting spare capacity in place. Spare capacity is not so different from brand development through advertising; both are types of sunk cost. The threats associated with the incumbent's behaviour become a credible threat because the incumbent incurs costs up front.

    A credible threat is one that is effective in deterring specific behaviours; a competitor must believe that the threat will be implemented if the competitor behaves in a certain way.

    Lobbying

    In our chapter on monopoly we stressed the role of political/lobbying activity. Large firms invariably employ public relations firms, and maintain their own public relations departments. The role of these units is not simply to portray a positive image of the corporation to the public; it is to maintain and increase whatever market power such firms already possess. It is as much in the interest of an oligopolistic firm as a monopolist to prevent entry and preserve supernormal profits.

    In analyzing perfect competition, we saw that free entry is critical to maintaining normal profits. Lobbying is designed to obstruct entry, and it is also designed to facilitate mergers and acquisitions. The economist Thomas Philippon has written about the increasing concentration of economic power in recent decades in the hands of a small number of corporations in many sectors of the North American economy. He argues that this concentration of power contributes to making the distribution of income more favorable to corporate interests and less favorable to workers. In his recent book ("The Great Reversal: How America Gave up Free Markets" ), he shows that, contrary to traditional beliefs, Europe is now much more competitive than the US in most sectors of the economy. More broadband suppliers result in rates in Europe that are about half of US rates. Whereas in the US four airlines control 80% of the market, In Europe they control 40%. If scale economies were the prime determinant of corporate concentration we should not expect such large differences. Likewise, if globalization and technological change were the main determinants of corporate concentration, we should expect experiences in Europe and North America to be similar. But they are not. Hence, it is reasonable to conclude that entry barriers in North America are more effective, or that regulatory forces are stronger in Europe.

    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

    Imperfectly competitive firms face a downward-sloping demand curve, and their output price reflects the quantity sold.

    Oligopoly defines an industry with a small number of suppliers.

    Monopolistic competition defines a market with many sellers of products that have similar characteristics. Monopolistically competitive firms can exert only a small influence on the whole market.

    Duopoly defines a market or sector with just two firms.

    Concentration ratio: N-firm concentration ratio is the sales share of the largest N firms in that sector of the economy.

    Differentiated product is one that differs slightly from other products in the same market.

    The monopolistically competitive equilibrium in the long run requires the firm's demand curve to be tangent to the ATC curve at the output where MR=MC.

    Collusion is an explicit or implicit agreement to avoid competition with a view to increasing profit.

    Conjecture: a belief that one firm forms about the strategic reaction of another competing firm.

    Game: a situation in which contestants plan strategically to maximize their profits, taking account of rivals' behaviour.

    Strategy: a game plan describing how a player acts, or moves, in each possible situation.

    Nash equilibrium: one in which each player chooses the best strategy, given the strategies chosen by the other player, and there is no incentive for any player to move.

    Dominant strategy: a player's best strategy, whatever the strategies adopted by rivals.

    Payoff matrix: defines the rewards to each player resulting from particular choices.

    Credible threat: one that, after the fact, is still optimal to implement.

    Cournot behaviour involves each firm reacting optimally in their choice of output to their competitors' decisions.

    Reaction functions define the optimal choice of output conditional upon a rival's output choice.

    Exercises for Chapter 11

    EXERCISE 11.1

    Imagine that the biggest four firms in each of the sectors listed below produce the amounts defined in each cell. Compute the three-firm and four-firm concentration ratios for each sector, and rank the sectors by degree of industry concentration.

    Sector Firm 1 Firm 2 Firm 3 Firm 4 Total market
    Shoes 60 45 20 12 920
    Chemicals 120 80 36 24 480
    Beer 45 40 3 2 110
    Tobacco 206 84 30 5 342
    EXERCISE 11.2

    You own a company in a monopolistically competitive market. Your marginal cost of production is $12 per unit. There are no fixed costs. The demand for your own product is given by the equation P=48–(1/2)Q.

    1. Plot the demand curve, the marginal revenue curve, and the marginal cost curve.

    2. Compute the profit-maximizing output and price combination.

    3. Compute total revenue and total profit [Hint: Remember AC=MC here].

    4. In this monopolistically competitive industry, can these profits continue indefinitely?

    EXERCISE 11.3

    Two firms in a particular industry face a market demand curve given by the equation P=100–(1/3)Q. The marginal cost is $40 per unit and the marginal revenue is MR=100–(2/3)Q. The quantity intercepts for demand and MR are 300 and 150.

    1. Draw the demand curve and MR curve to scale on a diagram. Then insert the MC curve.

    2. If these firms got together to form a cartel, what output would they produce and what price would they charge?

    3. Assuming they each produce half of the total what is their individual profit?

    EXERCISE 11.4

    The classic game theory problem is the "prisoners' dilemma." In this game, two criminals are apprehended, but the police have only got circumstantial evidence to prosecute them for a small crime, without having the evidence to prosecute them for the major crime of which they are suspected. The interrogators then pose incentives to the crooks-incentives to talk. The crooks are put in separate jail cells and have the option to confess or deny. Their payoff depends upon what course of action each adopts. The payoff matrix is given below. The first element in each box is the payoff (years in jail) to the player in the left column, and the second element is the payoff to the player in the top row.

    B's strategy
    Confess Deny
    A's strategy Confess 6,6 0,10
    Deny 10,0 1,1
    1. Does a "dominant strategy" present itself for each or both of the crooks?

    2. What is the Nash equilibrium to this game?

    3. Is the Nash equilibrium unique?

    4. Was it important for the police to place the crooks in separate cells?

    EXERCISE 11.5

    Taylormade and Titlelist are considering a production strategy for their new golf drivers. If they each produce a small output, they can price the product higher and make more profit than if they each produce a large output. Their payoff/profit matrix is given below.

    Taylormade strategy
    Low output High output
    Titleist strategy Low output 50,50 20,70
    High output 70,20 40,40
    1. Does either player have a dominant strategy here?

    2. What is the Nash equilibrium to the game?

    3. Do you think that a cartel arrangement would be sustainable?

    EXERCISE 11.6

    Ronnie's Wraps is the only supplier of sandwich food and makes a healthy profit. It currently charges a high price and makes a profit of six units. However, Flash Salads is considering entering the same market. The payoff matrix below defines the profit outcomes for different possibilities. The first entry in each cell is the payoff/profit to Flash Salads and the second to Ronnie's Wraps.

    Ronnie's Wraps
    High price Low price
    Flash Salads Enter the market 2,3 -1,1
    Stay out of market 0,6 0,4
    1. If Ronnie's Wraps threatens to lower its price in response to the entry of a new competitor, should Flash Salads stay away or enter?

    2. Explain the importance of threat credibility here.

    EXERCISE 11.7

    Optional: Consider the market demand curve for appliances: P=3,200–(1/4)Q. There are no fixed production costs, and the marginal cost of each appliance is img401.png. As usual, the MR curve has a slope that is twice as great as the slope of the demand curve.

    1. Illustrate this market geometrically.

    2. Determine the output that will be produced in a 'perfectly competitive' market structure where no profits accrue in equilibrium.

    3. If this market is supplied by a monopolist, illustrate the choice of output.

    EXERCISE 11.8

    Optional: Consider the outputs you have obtained in Exercise 11.7.

    1. Can you figure out how many firms would produce at the perfectly competitive output? If not, can you think of a reason?

    2. If, in contrast, each firm in that market had to cover some fixed costs, in addition to the variable costs defined by the MC value, would that put a limit on the number of firms that could produce in this market?


    This page titled 11: Imperfect competition is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Douglas Curtis and Ian Irvine (Lyryx) via source content that was edited to the style and standards of the LibreTexts platform; a detailed edit history is available upon request.