Unit 4

Imperfect Competition: the one-page sheet

4.1 Introduction to Imperfectly Competitive Markets

Firms with market power are price makers: they face a downward-sloping demand curve, so they sell more only by cutting the price on every unit, and their marginal revenue curve lies below demand. They produce where MR = MC and read the price from demand, above marginal cost. Barriers to entry (legal rights, key resources, economies of scale) protect their profit from entry. Monopoly, oligopoly and monopolistic competition differ in the number of sellers, how different their products are and how hard entry is.

Market power: the ability to raise the price without losing every customer. A firm with it is a price maker and faces a downward-sloping demand curve.
Barriers to entry (patents and licenses, control of a key resource, economies of scale) keep rivals out, so economic profit can last.
The structures, from most sellers to fewest: perfect competition, monopolistic competition (many sellers, differentiated products), oligopoly (a few interdependent sellers), monopoly (one seller).
A price maker's marginal revenue curve lies below demand: selling one more unit means cutting the price on all units. It still produces where MR = MC, then reads its price from demand.

it faces a downward-sloping demand curve marginal revenue is less than the price, so the MR curve lies below demand its price is above marginal cost economic profit can last into the long run

market power: The ability of a firm to raise its price without losing all of its customers. A firm with market power is a price maker and faces a downward-sloping demand curve.
barriers to entry: Anything that keeps new firms from entering a market, such as a patent or license, control of a key resource, or economies of scale that give a large firm a lower average total cost.
monopoly: A market with a single seller of a good with no close substitutes, protected by barriers to entry. The monopolist faces the whole downward-sloping market demand curve.
marginal revenue curve: For a firm with a downward-sloping demand curve, marginal revenue is less than the price after the first unit, because the price is cut on every unit sold; its MR curve lies below the demand curve (twice as steep when demand is a straight line).
monopolistic competition: A market with many firms selling differentiated products (product differentiation: each version is a little different) and easy entry and exit. Each firm faces a downward-sloping demand curve.
oligopoly: A market with a few large firms, often protected by barriers to entry. Each firm's best choice depends on what its rivals do (interdependence).

4.2 Monopoly

A monopolist produces where MR = MC and charges the price on the demand curve above that quantity. Its profit is (P minus ATC) times Q; it can last because barriers block entry. It produces less and charges more than a competitive industry would, on the elastic part of demand, leaving a deadweight loss between D and MC from its quantity to the efficient one. A natural monopoly, whose ATC falls over the whole range of demand, can be regulated at P = MC (efficient but a loss) or at the fair-return price P = ATC (zero economic profit). A lump-sum tax changes ATC and profit but not price or quantity.

Find Q where MR = MC, then go up to demand for P. Profit (or loss) is $(P - \text{ATC}) \times Q$ at that Q.
A monopolist produces on the elastic part of demand (MR > 0). Total revenue is largest where MR = 0, the unit-elastic point.
Monopoly deadweight loss: the triangle between D and MC from QM to where D meets MC. Consumer surplus is under D and above PM, out to QM.
Natural monopoly: ATC falls over the whole range of demand. Socially optimal price P = MC (efficient, but a loss); fair-return price P = ATC (zero economic profit). A lump-sum tax raises ATC only: P and Q stay put.

its MR curve lies below demand its quantity (QM) is smaller than the quantity where demand meets MC the price is above marginal cost there is a deadweight loss, the triangle between D and MC from QM to the efficient quantity

monopoly deadweight loss: The surplus lost because a monopolist produces where MR = MC instead of where demand meets MC: the triangle between the demand curve and MC, from the monopoly quantity to the efficient quantity.
natural monopoly: A market where one firm can supply the whole demand at a lower average total cost than two or more firms could, because ATC falls over the whole range of demand. Regulators may set the socially optimal price (P = MC, which leaves a loss) or the fair-return price (P = ATC, zero economic profit).

4.3 Price Discrimination

Price discrimination is charging different buyers different prices for the same good when costs do not differ. It needs market power, a way to sort buyers and a way to stop resale, and it charges the higher price to the less elastic group. It raises the firm's profit and usually its output. With perfect price discrimination, each buyer pays the most they will pay, so the MR curve is the demand curve and the firm produces where demand meets MC: the efficient quantity, with no deadweight loss and no consumer surplus.

Price discrimination: selling the same good at different prices to different buyers, for reasons other than cost.
Three conditions: market power, a way to sort buyers by elasticity, and a way to stop resale.
The less elastic group pays the higher price; the more elastic group pays less.
Perfect price discrimination: each buyer pays the most they will pay. MR = D, so Q is where D = MC: no deadweight loss, no consumer surplus, all surplus is profit.

it can charge different groups different prices it captures more of buyers' willingness to pay, so profit rises MR equals the price, so the MR curve is the demand curve output is the efficient quantity: deadweight loss is zero, consumer surplus is zero, and all surplus is profit

price discrimination: Selling the same good to different buyers at different prices, for reasons other than differences in cost. It needs market power, a way to sort buyers and a way to stop resale. With perfect price discrimination each buyer pays the most they are willing to pay, so MR equals demand and output is where demand meets MC.

4.4 Monopolistic Competition

In monopolistic competition, many firms sell differentiated products and entry is easy. Each firm faces a downward-sloping demand curve, produces where MR = MC and reads its price from demand, so in the short run it can earn a profit or make a loss. Profit draws entry and losses cause exit, shifting each firm's demand until it is tangent to ATC: zero economic profit. At that point price is above marginal cost and output is below the minimum of ATC (excess capacity), the cost of the variety buyers enjoy.

Monopolistic competition: many firms, differentiated products, easy entry and exit. Each firm faces a downward-sloping demand curve with MR below it.
Short run: produce where MR = MC, price from demand; profit or loss is $(P - \text{ATC}) \times Q$ , as for a monopolist.
Long run: entry (or exit) shifts each firm's demand until it is tangent to ATC: P = ATC, zero economic profit.
At the tangency P > MC (not allocatively efficient) and output is below minimum ATC: excess capacity (not productively efficient). The trade: more variety.

new firms with similar products enter (entry is easy) each firm's demand (and MR) shifts left and becomes more elastic it becomes tangent to ATC, where P = ATC entry stops; the firm produces where ATC is still falling, with excess capacity and P > MC

excess capacity: The gap between the output at the minimum of ATC and the smaller output a monopolistically competitive firm produces in long-run equilibrium, where its demand curve is tangent to the falling part of ATC.

4.5 Oligopoly and Game Theory

In an oligopoly a few interdependent firms must consider each other's choices, which a payoff matrix shows. A best response is the strategy that pays a player most with the rival's choice held fixed. A dominant strategy is the best response to every choice of the rival, proved with both comparisons. A Nash equilibrium is a cell where each player is making its best response, so neither gains by switching alone; a game can have one, several or none. In a prisoner's dilemma, dominant strategies lead to a Nash equilibrium that is worse for both than the joint-profit cell, which is why collusion and cartels tend to break down. A tax, subsidy or cost change alters payoffs and can change the equilibrium.

Oligopoly: a few interdependent firms, barriers to entry. Game theory studies their choices with a payoff matrix: the row player's payoff is listed first.
Best response: hold the rival's choice fixed and compare only your own payoffs. Do this for each of the rival's choices.
Dominant strategy: best whatever the rival does. Prove it (or that there is none) with both comparisons, with numbers.
Nash equilibrium: each player's choice is a best response to the other's. There may be one, several or none: check every cell. The largest combined payoff is not, by itself, a Nash equilibrium.

each firm's best choice depends on what its rivals choose it finds its best response to each of the rival's choices it is a dominant strategy (proved with both comparisons) the cell is a Nash equilibrium: neither gains by switching alone collusion would pay the group, but each firm gains by cheating, so cartels are unstable

payoff matrix: A table of the payoffs (profits or other gains) each player gets from every combination of the two players' strategies. By convention the row player's payoff is listed first in each cell.
best response: The strategy that gives a player the largest payoff when the other player's choice is held fixed.
dominant strategy: A strategy that gives a player a higher payoff than its other strategies whatever the other player does; proved with one comparison for each of the other player's choices. A dominated strategy is one that another strategy always beats.
Nash equilibrium: An outcome in which each player's strategy is its best response to the other's, so neither player can gain by changing its strategy alone. A game can have one, several or no Nash equilibria (Nash equilibria) in pure strategies.
collusion: An agreement among rival firms to limit output or raise prices to increase their joint profit. A formal group that does this is a cartel; each member gains by cheating, so cartels tend to be unstable (and are illegal in many countries).
game theory: The study of choices when each player's payoff depends on the other players' choices (strategic interaction), used to model firms in an oligopoly.
prisoner's dilemma: A game in which each player's dominant strategy leads to a Nash equilibrium that leaves both players worse off than if both had chosen differently (the prisoners' dilemma of two firms that both cut prices).