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Chapter 11

Chapter 11 - Imperfect Competition & Strategic Behavior.docx

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ECON 101
Robert Gateman

11.1 Structure of Canadian Economy 12-06-2012 Industries with Many Small Firms  Two thirds – industries made up of firms that are small relative to the size of the market  Perfectly competitive model o Ex. forest and fish products, agriculture, raw materials  Individual firms lack significant market power  Theory of Monopolistic Competition – many small firms with some market power Industries with a Few Large Firms  One third – dominated by either a single firm or a few large ones o Ex. electric utilities, telephone, cable or digital TV, Internet (subject to government regulation)  Service industries – recent development of large firms  Theory of Oligopoly – small number of large firms with market power and actively compete with one another Industrial Concentration  Highly concentrated – small number of large firms  Concentration ratio – fraction of total market sales controlled by the largest four sellers/firms o Industry has power concentrated in the hands of only a few firms or dispersed over many  Low concentration – limited market power Defining the Market o Falling costs of transportation and communication  globalization of competition (most significant development in world economy) o Nature of domestic markets changed dramatically o Ex. may be large relative to Canadian market but is small in the global market (no significant market power) because of globalization 11.2 What is Imperfect Competition? 12-07-2012  Imperfectly competitive firms – choose the variety of the product and the price o Monopolistic competition – Large number of small firms o Oligopoly – Small number of large firms Firms Choose Their Products  Develop variations on existing products or whole new product with different capability  Distinctive characteristics  Differentiated product – same product but dissimilar enough that they can be sold at different prices o Similar enough to be called the same product but dissimilar enough that they do not have to have the same price  Most firms in imperfectly competitive markets sell differentiated products. In such industries, the firm itself must choose which characteristics to give the products that it will sell.  Price setter – faces a downward sloping demand curve Firms Choose Their Prices  Firms’ products are not identical, each firm must decide on the price to set  Price setters  Firm has expectations about the quantity it can sell at each price that it might set  In market structures other than perfect competition, firms set their prices and then let demand determine sales. Changes in market conditions are signaled to the firm by changes in the firm’s sales.  In markets that sell differentiated products, price change is less frequent.  Cost of changing the prices – loss of customer and retailer goodwill because of uncertainty  Respond to fluctuations in demand by changing output and holding prices constant Non-Price Competition  Firms spend large sums of money on advertising to shift the demand curves for the industry’s products  attract customers from competing firms  Offering competing standards of quality and product guarantees o Services offered along with the purchase of the product  Designed to hinder the entry of new firms  preventing the erosion of existing pure profits o Ex. Commitment to match any price offered by competitor Two Market Structures  Theory of Monopolistic Competition o Industry with large number of small firms  Theory of Oligopoly o Industry with a small number of large firms o Game theory  Key difference: amount of strategic behavior displayed by firms 11.3 Monopolistic Competition 12-07-2012  Developed to deal with the phenomenon of product differentiation  Edward Chamberlin  Similar to perfect competition – many firms; freedom of entry and exit  Sell a differentiated product  some power over setting price o Can raise price without losing all sales (monopolistic part)  Product differentiation  develop brand names  heavy advertising  some market power (restricted) o Short-run restriction – presence of similar products – very elastic demand curve o Long-run restriction – free entry – compete away profits of existing firms (competitive part) The Assumptions of Monopolistic Competition  Firm produces specific brand of the industry’s differentiated product o Negatively sloped, but highly elastic demand curve o Many close substitutes  All have access to the same technological knowledge o Same cost curves  There are so many firms that each one ignores the possible reactions of its competitors  Freedom of exit and entry o Profit = incentive to enter industry o Demand must be shared among brands Predictions of Theory  Product differentiation is the only thing that makes monopolistic competition different from perfect competition The Short-Run Decisions of the Firm  Similar to a monopoly – maximized its profits by equating marginal cost with marginal revenue The Long-Run Equilibrium of the Industry  Profits = incentive to enter industry; total demand must be shared  each firm gets a smaller share of total market  Entry shifts firm’s demand curve to the left. Entry continues until profits are eliminated.  Long run – demand curve will be tangent to the LRAC curve o Maximizing its profit here, but its profit = 0 (only normal profit) o “Tangency solution” – only possible long-run equilibrium  Other two alternatives that DON’T work: o Demand curve lies below and never touches its LRAC curve  No output at which costs are covered  Firms leave the industry o Demand curve cuts the LRAC curve  Rage of output over which positive profits could be earned  Firms enter the industry Excess Capacity Theory  Long-run equilibrium  ZERO PROFITS/normal profit only  Forces each firm into a position in which is has excess capacity  Each firm produces at an output less than that at the minimum LRAC curve o If the firm increases its output, it would reduce cost per unit. But it does not because it would reduce revenue by more than it would reduce cost.  In long-run Eq in monopolistic competition, goods are produced at a point where average total costs are not at their minimum.  Debate: industries selling differentiated products would produce them at a higher cost  “inefficient”  Does not necessarily indicate a waste of resources because some benefits accrue to consumers who can choose from a variety of products  Differences in tastes across many consumers that give rise to the social value of variety o Price of variety = higher price per unit  Society’s point of view: Trade-off: diverse tastes/variety of products vs. lower costs per unit o Consumers value variety. Benefits of variety = extra cost. Empirical Relevance of Monopolistic Competition  Distinguish between products and firms  Single-product firms are extremely rare in manufacturing industries  Useful for analyzing industries in which concentration rations are low and products are differentiated 11.4 Oligopoly and Game Theory 12-07-2012  Small number of large firms o One of which produces a significant portion of the industry’s total output  High concentration ratio  Negatively sloped demand curve  Faces only a few competitors who can respond to anything the firm does; must take these possible responses into account  Oligopolists are aware of the interdependence among the decisions made by the various firms in the industry.  Strategic behavior – take explicit account of the impact of their decisions and of their reactions  Non-strategic behavior – decisions based on their own costs and their own demand The Basic Dilemma of Oligopoly  Similar to the dilemma faced by the members of a cartel  Incentive to form an agreement to restrict total output o Incentive to cheat on agreement  Oligopolistic firms often make strategic choices; they consider how their rivals are likely to respond to their own actions.  Cooperative/collusive outcome – cooperate to maximize joint profits o Position that a single monopoly firm would reach if it owned all the firms o Worthwhile for any one firm to cut its price or to raise its output, so long as others to not do so as well o If all firms do
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