Imperfect Market Structures: Monopoly and Oligopoly

Dr. Divya Gupta

Economics I

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References

Neva Goodwin: Chapter 17 and 18

Mankiw: Chapter 17

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Precap
In our previous discussion, we saw how firms behave in a ‘perfectly
competitive’ market structure.
In this module, we discuss the imperfect market structures - that is,
those markets where there is lesser than perfect competition
(oligopoly), or no competition at all (monopoly).
Generally, the market spectrum can be visualised to be as follows:
Perfect Competition → Monopolistic competition → Oligopoly →
Monopoly
Thus, as we move from left to right, the degree of competition
decreases. In fact, it goes from infinite competition to absolutely zero
competition.
Thus, our previous discussion was about one extreme type of market
structure - perfect competition.
Now, we will start with the other extreme type of market structure -
Monopoly.
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Monopoly: Features
Single seller: There is only one firm in the market, which produces all the
output of that particular product (or a particularly dominant firm).
This is in contrast to perfect competition, where there were many sellers.
No close substitutes: Product is unique and if consumers want to buy it they
must buy from the monopolist.
In case of perfect competition, all firms were selling the exact same product
- homogeneous products.
Barriers to entry: Entry to the market is totally blocked, meaning the firm
has no immediate and potential competitors. The nature of barriers could be
natural (like possession of an important natural resource), or man-made (like
patents, copyrights, etc.).
This is in contrast to perfect competition, where there was free entry and
exit of firms.
Imperfect Information: There is information asymmetry between buyers and
sellers.
This is in contrast to perfect competition, where there is perfect information
between buyers and sellers.
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Monopoly: Outcomes
Due to the characteristics of the market in which a firm operates as a
monopoly, it becomes a ‘price-maker’, since it is the sole supplier of the
product.
This is in contrast to perfect competition, where each firm in the market is a
price-taker.
Although, a monopolist is a price-maker, it cannot charge an exorbitantly
high a price, because it still faces a downward sloping demand curve.
Thus, the monopolist will set a price which maximises its profit.
In the long-run, monopolist can earn positive economic profits (super-normal
profits) due to the existence of heavy barriers to entry.
This is in contrast to perfect competition, where in the long-run, a firm
makes zero economic profits.
The monopoly outcome will lead to a loss of efficiency in the market - we
will discuss this in detail in the upcoming slides.
This is in contrast to perfect competition where the free markets are said to
maximise efficiency - hence, no deadweight loss. This is the reason why
competitive outcome is said to be efficient outcome.
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Average Revenue and Marginal Revenue
As discussed previously, the AR curve for any firm is always the price line.
In case of perfect competition, since each firm is a price taker, the price-line
or the demand curve is a horizontal line, whereas, a monopolist firm faces a
downward sloping demand curve. Therefore, the AR curve is downward
sloping.
Further, for a monopolist firm, the MR curve is also a downward sloping
curve, below the AR curve at all points. why?
As shown in the graph below, the monopolist firm faces the following AR
and MR curves:

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Monopoly: Profit Maximisation
As always, the profit for any firm is maximised at MR = MC, therefore, even
a monopolist firm chooses that level of output at which MR = MC, as
shown in the graph below:

Notice the two-step decision by the monopolist firm:

1 First, the monopolist chooses the output as Qmax , at which MR = MC.

This is the monopoly output, i.e. QM .

2 Second, the price to be charged is given by the price on the demand

(AR) curve corresponding to Qmax , which is the ‘Monopoly Price’, i.e.

PM .
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Monopoly: Supernormal profits
At the monopoly price, PM and monopoly quantity, i.e. QM , the firm makes
positive economic profits or supernormal profits, as shown in the figure below:

This can continue in the long run because even if new firms are attracted to enter
the market, they may not be able to do so, due to barriers to entry such as:
legal barriers in the form of patents and licenses.
exclusive ownership of essential resources by the monopolist firm like a
mining company that owns the land the mineral is mined.
economies of scale i.e. if economies of scale occurs over a wide range of
output, it is possible that total market demand will be limited to a point
where only a single large firm can achieve the min ATC.
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Inefficiency in Monopoly: Deadweight loss
Summarising the discussion so far:
For a competitive firm: P = MR = MC
For a monopoly firm: P > MR = MC
As shown in the figure below, if the monopolist firm would behave like a
perfectly competitive firm, it would charge PPC and produce QPC , at which
total surplus or social welfare is maximised (recall when demand and supply
curves intersect, it is the efficient point).

However, because the monopolist firm charges PM and restricts output to

QM , it creates deadweight loss - the highlighted triangle shown in the figure.
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Natural Monopoly
Natural monopolies are those firms which face a downward sloping ATC
curve.
This is because of the huge fixed costs involved in the production of such
goods and services, such that the ATC continues to fall over large range of
output.
Recall that ATC = AFC + AVC, and AFC is always downward sloping. In
case of natural monopoly, since the fixed cost component is huge, the
downward sloping part AFC component overshadows the U-shaped AVC
component.
Examples: water and electricity distribution companies.
Such firms are said to be ‘natural’ monopolies because the barriers to entry
are natural due to economies of scale (huge fixed costs spread over large
range of output), and hence if more than one firm operates in the market to
compete, they will make losses.
Hence, society is better off (more productively efficient) with only one firm
producing this product.
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Natural Monopoly (contd.)

As shown in the diagram below, a natural monopolist firm faces a

downward sloping ATC curve and a horizontal MC curve, i.e.
constant MC, which lies below the ATC curve (why?).

The demand curve is, as usual, downward sloping.

Pricing decision, under natural monopoly is not a straightforward
decision, even if the government regulates it. Let’s see how.

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Natural Monopoly (contd.)
As shown in the figure below, if the natural monopolist firm behaves
like a typical monopoly, it would produces the monopoly output, QM
(at which MR = MC), which is too low for necessities like water and
electricity, and charge the monopoly price, PM , which is too high for
such goods and services. Although, at this price, the firm will make
profits (the highlighted blue portion), this outcome is socially
inefficient.

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Natural Monopoly (contd.)
If the firm behaves like a perfectly competitive (PC) firm, it would
produce QPC (at which MC curve intersects the demand or AR curve)
and charge price PPC . This is also called MC-pricing, i.e. when P =
MC. However, firm would not have an incentive to continue as it
would make losses (highlighted pink).
The third option, thus, is average cost-pricing of PAC , i.e. when P =
ATC, or choosing output at which demand curve intersects the ATC
curve, i.e. QAC .
This seems like a middle path, as quantity of output is lower than the
competitive one, but higher than the monopoly quantity.
Further, although there will still be a deadweight loss at this outcome,
but it will be less significant compared to the monopoly outcome.
However, at this point, there is neither a profit nor a loss. This is not
ideal as a short-run option because companies have no incentive to
enter this business/industry.
This means that the logic for private production under a natural
monopoly is weak.
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Oligopoly: Features
Next, we discuss a third type of market structure called ‘oligopoly’, which
lies between perfect competition and monopoly, but is closer to monopoly in
the entire market spectrum (see slide 3).
An oligopolic market structure has the following features:
Few sellers: A few large firms dominate the industry, each with a substantial
share of total demand. There may be few enough firms that collusion is
possible (either open or tacit).
Identical or differentiated products: Products here can be identical (eg oil) or
differentiated (e.g cars).
Significant entry barriers: Entry to the market is difficult.
Imperfect Information: There is information asymmetry.
Some examples: tires, beer, cigarettes, steel, aluminium, automobiles, and
breakfast cereals.
Due to existence of few sellers who may be selling very identical products,
pricing decisions under oligopoly are strategic decisions - taken by each firm
after considering the possible responses/reactions of all other firms - more
formally studied as ‘game theory’.
In order to understand how firms under oligopoly would take strategic
decisions, let’s first introduce the basic game of ‘prisoner’s dilemma’.
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Prisoner’s Dilemma
The Game:
2 people are arrested: Convict A and Convict B.
Police talks to them separately to implicate the other.
If you confess, but the other doesn’t, you get 1 year, other gets 10 years.
If you deny, but the other confesses, you get 10 years, other gets 1 year.
If you both confess, you get 5 years each.
If you both deny, you get 2 years each.
The punishment in terms of years of jail looks like shown in the box below.
In game theory, such a representation of different payoffs to each player,
based on each strategy is called as a ‘payoff matrix’.

Note that the payoffs in the typical prisoner’s dilemma game are negative - because they are punishments. So the aim is to
minimise the loss in this particular case. We will soon see an example of a positive payoff, in the context of oligopoly.
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Prisoner’s Dilemma: Convict A’s decision
Based on the pay-off matrix seen on previous slide, let’s see how each
convict/player will decide what to do.
Convict A will consider its decision taking into account the possible actions by
Convict B.
Thus, if Convict A thinks that B will ‘confess’, then convict A has to decide
between ‘confess’ and ‘deny’, as shown in figure I below, whereby, years of
imprisonment for A are highlighted in red. Clearly, A will choose to ‘confess’.
Whereas if convict A thinks that B will ‘deny’, then it has to decide between the
two actions, as shown in figure II below. Given the payoffs, A will choose to
‘confess’.

I. Convict B confesses II. Convict B denies

Thus, convict A will always choose ‘confess’ - their ‘dominant strategy’.

Likewise, one can find that the strategy chosen by convict B will also be ‘confess’.
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Prisoner’s Dilemma: Nash Equilibrium
Thus, we saw that if both convicts are not allowed to discuss with each
other, they would both choose to confess and each get 5 years of
imprisonment.
However, there exists a pareto superior outcome, where both get only 2
years of imprisonment each, if they both denied. This, however, is not an
equilibrium.
The outcome of (confess, confess) for both convicts is called the ‘Nash
Equilibrium’.
Nash equilibrium is a stable equilibrium because there is no incentive for any
player (or convict) to deviate (or defect/cheat) from that strategy.
If they are both allowed to discuss their options with each other, then it may
be expected that they would agree to deny, thereby leading to the “better”
or pareto superior equilibrium.
However, there is an incentive to deviate from that strategy and switch
(choosing to confess instead) as this would mean that the one who deviates
will get only 1 year instead of 2 years.
Since both have the same incentives, both will want to deviate from the
colluded strategy of (deny, deny) and ultimately reach the Nash Equilibrium.
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Equilibrium in Oligopoly
Application of Prisoner’s Dilemma

The concept of prisoner’s dilemma can also be used as an analogy to explain

how firms behave when they face oligopolistic competition.
The simplest form of oligopoly is a two-firms oligopoly, also called as
‘duopoly’.
The 2 prisoners could represent 2 firms, each of whom have 2 choices to
make: whether to set a high price or a low price.
Example: Two firms, A and B, must decide on a pricing strategy: either set
a high price or a low price.
Each firm’s profit depends on its own pricing strategy and that of its rival.
If both firms adopt a high-price strategy, each firm will earn $12 million; if
both adopt a low-price strategy, each will earn $8 million.
If one firm adopts a low-price strategy while the other adopts a high-price
strategy, the low-price firm will earn $15 million while the other firm earns
$6 million.

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Equilibrium in Oligopoly (contd.)
Application of Prisoner’s Dilemma

Based on the example described previously, the pay-off matrix for both firms
looks like this:

It is in the interest of both firms to work together and set high prices. This
will give them both the best pay-off at $12 million each.
This is called as collusion and is similar to allowing the prisoners to discuss
with each other, in the prisoners’ dilemma game.
But as we saw earlier, this is not a Nash equilibrium because if both firms
collude to set high prices, but suddenly one firm cheats and sets a low price,
the cheater firm could capture the market share and earn $15 million dollars,
leaving profits of only $6 million dollars for the other firm.
Since both firms have these incentives to cheat, both firms will arrive at the
Nash equilibrium, which is, pareto inferior to the collusive outcome.
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Collusion
Collusion is an agreement among firms in a market about what quantities to
produce or prices to charge. There are various types of collusion:
Open/Formal: The firms in a particular industry may form an official organization
through which price and output decisions are agreed upon. This is called a
CARTEL.
Cartels are illegal in most industries in most countries, due to their
anti-competitive nature.
Firms in a cartel will choose the monopoly output and price.
Due to the prisoner’s dilemma explained previously (there is always an incentive to
cheat in a collusive oligopoly), cartel arrangements are often unstable and difficult
to maintain.
Once the majority of firms have agreed to a high price and reduced output, each
individual firm has a strong incentive to either increase its output to take
advantage of the higher price in the market or decrease its price to steal market
share.
If all firms do this, the market price will fall and the cartel will fail. Examples:
OPEC, sugar cartels, etc.
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Collusion (contd.)

Other forms of cartel include:

Tacit/Informal: Since formal collusion is illegal in many countries,
oligopolistic firms have devised ways to collude informally.
The most common form of tacit collusion is Price Leadership.
Price leadership: This is when the “dominant firm” (usually the biggest firm
in an industry) sets a price and the smaller firms follow suit.
Price Wars: When tacit agreements break down, firms may engage in price
wars, in which they continually lower their prices (under cut each other) and
increase output in order to try and attract more customers than their rivals.
This can cause sudden increases in output and decreases in price,
temporarily approaching an efficient level.
Once firms realize low prices hurt everyone, price leadership is usually
restored, and prices rise once more.

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Equilibrium in Oligopoly: Summary

When firms in oligopoly collude, they can set monopoly quantities

and prices and thus earn supernormal economic profits.
When collusion breaks down, however, the market could resemble a
perfect competition (at least temporarily) when there is a price war.
When there is no collusion, firms generally set prices based on
competition. Thus, due to the possibility of losing market share,
prices in this market type are often quite sticky.
Due to the fear of a price war, most firms in a non-collusive oligopoly
market tend to compete on factors other than price.
They try to make their products more attractive to customers in other
ways. For examples: advertising and promotion, location and
distribution channels, better market segmentation, loyalty programs,
product extensions and new products, special customer services, etc.

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 ALL THE BEST!

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