4.5 — Imperfect Competition

# 4.5 — Imperfect Competition
## ECON 306 · Microeconomic Analysis · Fall 2020
### Ryan Safner Assistant Professor of Economics <a href="mailto:safner@hood.edu">safner@hood.edu</a> <a href="https://github.com/ryansafner/microF20">ryansafner/microF20</a> <a href="https://microF20.classes.ryansafner.com"> microF20.classes.ryansafner.com</a>

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# Outline

### [Monopolistic Competition](#4)

### [Oligopoly](#17)

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# Reminder: Imperfect Competition

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# Monopolistic Competition

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# Monopolistic Competition

- .hi[Monopolistic competition]: hybrid of monopoly and competition, where **each firm has _some_ market power**
  - Each firm faces own downward-sloping demand
  - Firms are price-searchers

- But, the industry has .hi-purple[free entry and exit] (no barriers)

]

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# Monopolistic Competition: Product Differentiation

- .hi[Product differentiation]: firms’ products are .hi-purple[imperfect substitutes]

- Consumers recognize non-price differences between sellers’ goods
  - Brand name & reputation
  - Customer service
  - Product features, shape, color, etc.
  - Marketing
  - Location, convenience
]

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# Monopolistic Competition: Product Differentiation

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- Each firm faces a downward-sloping demand curve
  - Implies some market power

- A .hi-blue[“residual” demand] for each firm’s products
  - Firm faces market demand (for broad product) *leftover* from all other firms’ sales

- .hi-green[Example]: demand for *Lenovo* laptops `$\approx$` demand for *laptops* `$-$` laptops supplied by Acer, Asus, Apple, Dell, etc.
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# Monopolistic Competition Model: Short Run

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- **Short Run**: model firm as a price-searching monopolist:
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# Monopolistic Competition Model: Short Run

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- **Short Run**: model firm as a price-searching monopolist:

- `$q^*$`: where `$MR(q)=MC(q)$`
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# Monopolistic Competition Model: Short Run

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- **Short Run**: model firm as a price-searching monopolist:

- `$q^*$`: where `$MR(q)=MC(q)$`
- `$p^*$`: at market demand for `$q^*$`
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# Monopolistic Competition Model: Short Run

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- **Short Run**: model firm as a price-searching monopolist:

- `$q^*$`: where `$MR(q)=MC(q)$`
- `$p^*$`: at market demand for `$q^*$`
- Earns `$\pi = [p^*-AC(q^*)]q^*$`
]

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# Monopolistic Competition Model: Long Run

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- **Long Run**: market becomes competitive (*no barriers to entry!*)

- `$\pi > 0$` attracts entry into industry

- Residual demand for each firm’s product will:
  - *decrease* (more production by other firms)
  - become more *elastic* (more substitutes)
until...

]

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# Monopolistic Competition Model: Long Run

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- **Long Run**: market becomes competitive (*no barriers to entry!*)

- `$\pi > 0$` attracts entry into industry

- Residual demand for each firm’s product will:
  - *decrease* (more production by other firms)
  - become more *elastic* (more substitutes)
until...

- .hi-purple[Long run equilibrium]: firms earn `$\pi=0$` where `$p=AC(q)$`.magenta[†]

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# Monopolistic Competition vs. Perfect Competition

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- `$q_c$` where `$P=MC(q)$`

- `$p_c = AC(q)_{min}$`, .hi-orange[productively efficient]

- `$p_c = MC(q)$`, .hi-purple[allocatively efficient]
  - Maximum .blue[consumer surplus]
  - No **DWL**

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# Monopolistic Competition vs. Perfect Competition

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- `$q_m < q_c$`, where `$MR(q)=MC(q)$`

- `$p_m = AC(q)$`
  - but not `$AC_{min}$`, .hi-orange[productive inefficiency]

- `$p_m > MC(q)$`, .hi-purple[allocative inefficiency]
  - Less .blue[Consumer Surplus]
  - **Deadweight loss**
  
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# Monopolistic Competition vs. Perfect Competition

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- Like a monopolist, produces less `$q$` at a higher `$p$` than competition

- But like perfect competition, still no `$\pi$` in the long run!
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# Oligopoly

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# Oligopoly

- .hi[Oligopoly]: industry with a few large sellers with market power

- Other features can vary
  - May sell similar or different goods
  - May have barriers to entry

- Key: Firms make .hi-purple[strategic choices], interdependent on one another

- For modeling simplicity: 
  - .hi-purple[Duopoly]: a market with 2 sellers 
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# Oligopoly: Modeling

- Unlike PC or monopoly, no single “theory of oligopoly”

- Depends heavily on assumptions made about interactions and choice variables

- One certainty: oligopoly is a .hi-purple[strategic interaction] between few firms

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# Game Theory

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- .hi[Game theory]: a set of tools that model .hi-purple[trategic interactions] (.hi-purple[“games”]) between rational agents, 3 elements:
    1. **Players**
    2. **Strategies** that each player can choose from
    3. **Payoffs** to each player that are *jointly-determined* from combination of all players’ strategies

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# Game Theory vs. Decision Theory Models I

- Traditional economic models are often called .hi[“Decision theory”]:

- .hi-purple[Optimization models] **ignore all other agents** and just focus on how can **you** maximize **your** objective within **your** constraints
  - Consumers max utility; firms max profit, etc.

- **Outcome**: .hi-purple[optimum]: decision where *you* have no better alternatives

]

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# Game Theory vs. Decision Theory Models I

- Traditional economic models are often called .hi[“Decision theory”]:

- .hi-purple[Equilibrium models] assume that there are **so many agents** that **no agent’s decision can affect the outcome**
  - Firms are price-takers or the *only* buyer or seller
  - **Ignores all other agents’ decisions**!

- **Outcome**: .hi-purple[equilibrium]: where *nobody* has no better alternatives

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# Game Theory vs. Decision Theory Models III

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- .hi[Game theory models] directly confront .hi-purple[strategic interactions] between players
  - How each player would optimally respond to a strategy chosen by other player(s)
  - Lead to a stable outcome where everyone has considered and chosen mutual best responses

- **Outcome**: .hi-purple[Nash equilibrium]: where *nobody* has a better strategy *given the strategies everyone else is playing*

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# Equilibrium in Oligopoly

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- What does .hi-purple[“equilibrium”] mean in an *oligopoly*?

- In competition or monopoly, a unique `$(q^*,p^*)$` for industry such that **nobody has incentives to change price**

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# Equilibrium in Oligopoly

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- Oligopoly: use game-theoretic .hi-purple[Nash Equilibrium]: 
  - no player wants to change their strategy **given all other players’ strategies**
  - each player is playing a **best response** against other players’ strategies

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# As a Prisoner's Dilemma I

![:scale 100%](https://www.dropbox.com/s/uj1jxo2s1dr8yeb/applevsgoogle.jpg?raw=1)
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- Suppose we have a simple **duopoly** between .hi-red[Apple] and .hi-blue[Google]

- Each is planning to launch a new tablet, and choose to sell it at a **High Price** or a **Low Price**

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# As a Prisoner's Dilemma I

- Payoff matrix represents profits to each firm
  - First number in each box goes to .hi-red[Row player (Apple)]
  - Second number in each box goes to .hi-blue[Column player (Google)]
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# As a Prisoner's Dilemma II

- From .hi-red[Apple]'s perspective:
  - .hi-red[Low Price] is a .hi-purple[dominant strategy] for .hi-red[Apple]

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# As a Prisoner's Dilemma II

- From Google's perspective:
  - .hi-blue[Low Price] is a .hi-purple[dominant strategy] for .hi-blue[Google]

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# As a Prisoner's Dilemma II

- .hi[Nash equilibrium]: (.hi-red[Low Price], .hi-blue[Low Price])
  - neither player has an incentive to change price, *given the other's price*

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![](https://www.dropbox.com/s/9xram8ppumhfuoq/pdapplegooglenash.png?raw=1)

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# As a Prisoner's Dilemma III

- .hi[Nash equilibrium]: (.hi-red[Low Price], .hi-blue[Low Price])
  - neither player has an incentive to change price, *given the other's price*
  
- A possible **Pareto improvement**: (.hi-red[High Price], .hi-blue[High Price])
  - Both players are better off, nobody worse off!
  - Is it a Nash Equilibrium?

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![](https://www.dropbox.com/s/y2903cwtikr31e4/pdapplegooglecartel.png?raw=1)

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# Cartels

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# As a Prisoner's Dilemma IV

- Google and Apple could .hi-purple[collude] with one another and agree to both raise prices

- .hi[Cartel]: group of sellers coordinate to raise prices to act like a collective monopoly and split the profits

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# Instability of Cartels

- Cartels often **unstable**:

- Incentive for each member to cheat is too strong

- Entrants (non-cartel members) can threaten lower prices

- Difficult to monitor whether firms are upholding agreement

- Cartels are illegal, must be discrete

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# Attempts to Sustain Collusion I

Archer Daniels Midland (USA), Ajinomoto (Japan), Koywa Hakko Kogyo (Japan), Sewon American Inc (South Korea) held secret meetings to fix the price of lysine, a food additive to animal feed in the 1990s.

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# Attempts to Sustain Collusion I

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An internal FBI informant brought the cartel down.

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