Imperfect Competition
In monopolistic competition, firms can enter and exit the industry with ease. Goods and services are differentiated using advertising, quality, seller reputation and location among other factors. Differentiates renders notion of single market price futile. Firms enjoy lesser degree of monopoly power as a number of close substitutes are available. In the short-run, where at least one input is variable, firms profit-maximizing output is the quantity of product that equalizes MC (marginal cost) and MB (marginal benefit). MR curve lies below the demand curve and is downward sloping. In the short-run, positive and negative economic profits may exist. These, however, are eliminated in the long-run as easy entry and exit into industry facilitate industry expansion or contraction till profits or losses are absorbed. In monopolistic competition, zero economic profits prevail in the long-run. Zero economic profits point lies to the left of minimum ATC (downward-sloping) curve. Firms operating at point lying to the left of minimum ATC value have excess capacity. Consequently, monopolistic competition does not minimize MC and is economically inefficient. This inefficiency is the price paid for enjoying product alternatives. Further, firms have no incentive to charge lower prices and reduce revenue to achieve efficiency. In oligopoly, firms are fewer in number and dependent upon each other unlike monopolistic competition. A firms actions influence other firms, evoking responses from them. Firms enjoy
Figure 1 Monopolistic Competition- Short-Run Equilibrium
Figure 2 Monopolistic Competition- Long-run Behavior
considerable share of industry output, which can be measured using concentration ratio or HerfindahlHirschman Index (HHI). Concentration ratio measures output percentage accounted for by largest industry firms. It is directly related to influence of a firms decision on its rivals. HHI is the square of percentage share of largest industry firms. It has a maximum value of 10,000. Census Bureau measures industry concentration using the aforementioned methods but the same may be overstated or understated. Expanse of industry and regional domination can create mistakes in industry concentration calculation. Multiple models explain rival behavior in oligopoly. In collusion model, firms collude and form cartels to implement monopoly solution and enjoy maximum attainable profits. Collusion may be overt, wherein firms openly agree to set prices, and output at monopoly level and take decisions to sustain monopoly profits. Since cartels are generally illegal, firms may opt for tacit collusion, an unspoken and unwritten strategy to limit competition and achieve monopoly profits. Tacit behavior is difficult to identify. Colluding firms always have an incentive for cheating to increase their profits. This cheating possibility can be reduced by adopting tit-for-tat or trigger strategies. Game theory is another model that explains strategic choices, or choices taken after evaluating possible rival actions. Pricing choices, product-development and innovation efforts, and marketing strategies are strategic in nature. Outcome of a strategic decision is called payoff and generally implies variation in economic profit. In game theory, players cannot make decisions jointly and must select an optimum strategy based on plausible rival actions. When a players strategy is unaffected by the others action, the player is said to have a dominant strategy. When both or all players have dominant strategies, dominant-strategy equilibrium is attained. Oligopolies have several players and multiple rounds of strategic choices or games. Price war and prisoners dilemma are common examples of game theory usage.
Figure 3 Game Theory Analysis
Player B
Player
A Action x Action y
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PA1 PB2
PA2 PB3
PA3 PB4
PA4
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Advertising and price discrimination are common in imperfect competition. Protagonists opine that advertising is essential for entry of new firms. It promotes competition lowering prices and conveys useful information to consumers. Antagonist suggest that it increases prices by adding advertising costs to them and generating brand loyalty, thereby encouraging monopoly conditions and creating entry barriers. Empirical studies support both groups. Portion of total costs used for advertising and market power concentration share a positive casual relationship. Another common characteristic of imperfect markets is price discrimination or charging different prices for the same product from different customer groups despite no production cost difference. Different customer groups have different elasticities and marginal revenues. It can be practices in markets with downward-sloping demand curves or markets having some price-setting or monopoly power. Price variations due to location or policy restrictions that add to cost are not part of price discrimination. Distinguishable customers that facilitate easy segregation of consumers into groups, and prevention of resale, curbing reselling of lower price products, are the other conditions for price discrimination to be feasible. Though legal and beneficial to most markets, it is not commonly practiced due to insufficient knowledge of consumer demand.