IMPERFECT
COMPETITION
Units in this chapter
8.1 Monopolistic competition
8.2 Oligopoly
Chapter objectives
Imperfect competition is the label attached to the wide variety of market structures
between the extremes of perfect competition and pure monopoly. A great many
theoretical models of imperfect competition have been devised, each model pertaining to a
precisely defined market structure and a set of assumptions about how the member firms
behave. In this chapter just three of the possible market structures will be examined:
1. monopolistic competition, in which it is assumed that firms act independently of
each other.
2. competitive oligopoly, an example of a market structure in which
interdependent firms must take account of the reactions of one another when
forming a market strategy.
3. collusive oligopoly, which occurs when firms attempt to overcome the uncer-
tainty associated with guessing how competitors will react by colluding together
and forming a cartel.
8.1 M ON OP OL ISTIC COM P ET IT ION
A FURTHER LOOK AT PROFIT - MAXIMISATIO N
As in the theories of perfect competition and monopoly, the profit-maximising
assumption is fundamental to the models of imperfect competition considered in this
chapter. If you refer back to the introduction to Chapter 7, you will see how managerial and
behavioural theories of the firm attack the assumption of profit-maximizing behaviour as
being an unrealistic objective for large modern business corporations.
Even if imperfectly competitive and monopolistic firms aim to maximise profits, they
may simply not possess the accurate information about their market situation needed to
equate marginal cost and marginal revenue. For this reason, imperfectly competitive firms
are often modelled as price-searchers, seeking by trial and error the price which will
maximise profits. In some circumstances, firms may produce a wide variety of
differentiated products and services, for which the marginal cost of producing each
particular good or service is different. In these conditions, imperfectly competitive firms
commonly resort to rule of thumb pricing, without ever consciously setting MC equal to
MR. Businessmen may ask their accountants to estimate the cost of one unit of output
when producing at near to full capacity. This estimate is called a standard cost and is used
for price setting. On the basis of this standard cost, firms may adopt cost-plus or mark-up
pricing, by adding a profit margin to the standard cost. The choice of the profit margin may
itself be based on rule of thumb, or historical experience, or what a firm thinks it can
charge without falling foul of a government monopoly investigation.
Nevertheless, many economists argue that the gap between the MC=MR rule and actual
business pricing behaviour can be bridged. When cost-plus pricing gets businessmen too far
out of line with what they would achieve with profit-maximising pricing, they will modify
their pricing. Firms which stray too far from the profit-maximising path will experience low
profits and falling share prices. While such firms are unlikely to be competed out of
business in a highly imperfect market, they may become vulnerable to discipline by the
capital market. This means that firms which perform badly are vulnerable to takeover by
managers who believe that they can manage the firms’ assets more successfully.
THE THEORY OF MONOPOLISTIC COMPETITION
The theory of monopolistic competition was introduced by Edward Chamberlin in 1933
as an early attempt to model the characteristics of imperfect competition. As the name
implies, monopolistic competition resembles both perfect competition and monopoly in
some respects. Each firm's product is assumed to be a little different from those of its
competitors; if it raises its price slightly, it will not lose all its customers. Thus a firm faces a
downward-sloping demand curve, rather than the horizontal or infinitely elastic demand
curve of perfect competition. Nevertheless, the absence of barriers to entry allows market
forces, through the entry of new firms, to shift the demand curve and to compete away
abnormal profits in the long run.
The short-run equilibrium in monopolistic competition is little different from the
monopoly equilibrium illustrated in Fig. 7.4, except that the demand or average revenue
curve is likely to be rather more elastic. Fig. 8.1 shows the long-run equilibrium, achieved
after the entry of new firms has eliminated abnormal profits. As in the case of monopoly,
monopolistic competition involves both productive inefficiency (the lowest-cost output is
not produced) and allocative inefficiency (P > MC). However, the consumer is presented
with a considerable choice between differentiated goods. There may be circumstances in
which consumers prefer a wider choice at the expense of an improvement in productive
efficiency.
Quantity
Fig. 8.1 Long-run equilibrium of a firm in monopolistic competition
Nevertheless, it is also possible that firms are using advertising and brand-imaging to
present the consumer with a false choice between essentially similar goods, in which case
advertising is an unnecessary cost and a waste of resources. Advertising may manipulate
consumer wants by persuading people to buy products through the association of the
product with other desirable properties such as social success. Many economists
distinguish between informative advertising, which helps the consumer to make a more
rational choice between products, and persuasive advertising, which distorts the choice.
8.2 OL IGOP OLY
COMPETITIVE OLIGOPOLY
Monopolistic competition shares with perfect competition and monopoly the characteristic
that member-firms choose their market strategy in a way which is completely independent
of the likely reactions of other firms. However, this may not be very realistic, particularly
when there are only a few large firms competing within an industry. An oligopoly is
sometimes defined in terms of an industrial concentration ratio: for example, a four-firm
concentration ratio of 70% means that the four largest firms account for 709b of sales.
Alternatively, an oligopoly can be defined in relation to the behaviour or market strategy of
the member-firms. Oligopolists are mutually interdependent since each firm is concerned
about the reactions of its competitors. There are a great many separate theories of
oligopoly, each modelling a different set of assumptions about how the rivals react. Many
of these theories are examples of game theory, in which each oligopolist is regarded as a
player in a game, choosing a best strategy subject to retaliations.
REASONS FOR THE EXISTENCE OF OLIGOPOLY
In many industries there are economies of large-scale production, but diseconomies of
scale begin to set in while output is still well below the total market size. The result is a
natural oligopoly in which a few firms can produce the total industry output and
simultaneously benefit from full economies of scale. In other circumstances, countervailing
power may explain the existence of an oligopoly: large duopolists such as Unilever and
Proctor & Gamble may each possess sufficient market power in the detergent industry to
prevent the other emerging as a sole monopolist. Government monopoly legislation may
also deter the creation of an outright monopoly.
PRICE STABILITY AND THE KINKED DEMAND CURV E
Although oligopolistic markets are characterised by competitive behaviour, the competition
often takes the form of non-price competition such as:
1. advertising competition, packaging, brand-imaging and product
differentiation;
2. marketing competition, including the attempt to obtain ‘exclusive outlets’
through which to sell the product;
3. quality competition, including the provision of after-sales servicing.
Fig. 8.2 illustrates the theory of the kinked demand curve, a theory originally proposed in
1939 by Paul Sweezy as an explanation of supposed price rigidity and the absence of price
wars in conditions of oligopoly. Suppose that an oligopolist, for whatever reason, produces
an output Q0 at a price P0, determined at point X on the diagram. He perceives that
demand will be relatively elastic in response to an increase in price, because he expects his
rivals to react to the price rise by keeping their prices stable, thereby gaining customers at
his expense. Conversely, he expects his rivals to react to a decrease in price by cutting their
prices by an equivalent amount; he therefore expects demand to be relatively inelastic in
response to a price fall, since he cannot hope to lure many customers away from his rivals.
In other words, the oligopolist’s initial position is at the junction of two demand curves of
different relative elasticity, each reflecting a different assumption about how the rivals are
expected to react to a change in price. Indeed, if demand is inelastic (and marginal revenue
negative) when the oligopolist reduces his price, the best policy may be to leave the price
unchanged.
Fig. 8.2 The ‘kinked’ demand theory of oligopoly
A second explanation of price rigidity is also suggested by Fig. 8.2. In mathematical
terms, a discontinuity exists along a vertical line above output Q0, between the marginal
revenue curves associated with the relatively elastic and inelastic demand (or average
revenue) curves. Costs can rise or fall within a certain range without causing a profit-
maximising oligopolist to change either price or output. At output Q0 and price P0, MC = MR
as long as the MC curve is between an upper limit of MC 2, and a lower limit of MC1.
Although the kinked demand curve theory provides a neat and apparently plausible
explanation of price rigidity, it has been subject to many attacks. It is an incomplete theory
because it does not explain how and why an oligopolist chooses to be at point X in the first
place. Empirical evidence casts great doubt on whether oligopolists respond to price
changes in the manner assumed. Oligopolistic markets often display evidence of price
leadership, which provides an alternative explanation of orderly price behaviour. Firms
come to the conclusion that price-cutting is self- defeating and decide that it may be
advantageous to follow the firm which takes the first step in raising the price. If all firms
follow, the price rise will be sustained to the benefit of all the firms.
Collusive oligopoly
The theory of the kinked demand curve illustrates an important characteristic of
competitive oligopoly: the existence of uncertainty. An oligopolist can never be sure how
his rivals will respond, yet he must take their expected reactions into account when
determining his own market strategy. An incentive may exist for oligopolists to collude
together in order to reduce uncertainty. Also, by acting collectively the firms may achieve
an outcome which is better for all of them than if they had remained a competitive
oligopoly. This can be shown by the principle of joint profit maximisation, which is
illustrated in Fig. 8.3. We shall assume that there are three firms with similar cost curves in
an industry. The cost curves of one of the firms are drawn in the left-hand panel of Fig. 8.3.
Suppose the firms now decide together and act as a single monopolist, yet at the same time
maintaining their separate identities. The monopoly MC curve, which is illustrated in the
right-hand part of the diagram, is obtained by adding up the identical MC curves of the
three separate firms. Monopoly output of 750 units is determined where MC = MR, and
each firm charges a price of £10. You should notice that the monopoly output is well below
1000 units, which would be the output if the industry was perfectly competitive. The
shaded area in the right-hand panel represents the efficiency loss which is caused by the
cartel raising the price to £10 and restricting the industry output to 750 units.
Fig. 8.3 Joint profit maximisation by a three-firm cartel in which the market is shared equally by the three firms
If the firms decide to split the output of 750 units equally between themselves, each firm
will be allocated a quota of 250 units to produce. In this situation, the shaded area in the left-
hand part of the diagram shows the abnormal profits made by an individual firm. Other forms
of market-sharing, based for example on geography or historical tradition, are of course
possible.
It is important to stress that the formation of a cartel does not completely eliminate
uncertainty. Each member of the cartel has an incentive to cheat on the other members: this is
because the marginal cost of producing the 250th unit is only £5, yet the marginal revenue
received, which equals the price, is £10. A firm can increase its total profit at the expense of
the other members of the cartel by secretly selling an output over and above its quota at a
price which is less than £10 but greater than the marginal cost incurred. This is an example of a
divergency between collective and individual interest. The firms’ collective interest is to
maintain the cartel so as to keep sales down and the price up. Nevertheless, an individual firm
can benefit if, while the other members maintain the cartel, it secretly undercuts the
agreement by selling more than its allotted market share.
The possibility of price discrimination
Monopolies, and other firms in highly imperfect markets, regularly charge a number of
different prices to different groups of customers. Sometimes more than one product is
involved, as in the case of first- and second-class rail travel; in other instances the prices may
reflect the different transport and handling costs which are incurred in delivering the good or
service to the customer. You must not confuse these examples of differentiated prices with
the concept of monopoly or oligopoly price discrimination. Price discrimination occurs when a
firm is able to charge different prices for an identical product, with the same costs of
production and supply. Price discrimination will benefit a firm if it increases the firm’s total
profits. The necessary conditions for successful price discrimination are:
1. It must be possible to identify different groups of customers or markets for the
product.
2. There must be a different elasticity of demand at each price in each market.
3. Total profits will be increased by selling at a higher price in the market where
demand at each price is less elastic. (Demand will never be inelastic, since this
would imply that marginal revenue is negative.) The markets must be
separated to prevent seepage, which occurs when customers buy at the lower
price in one market in order to resell in the other market at a price which
undercuts the monopolist.
Fig. 8.4 illustrates the simplest case of price discrimination, when a firm's MC curve is assumed
to be constant and there are two groups of customers, each with a different demand curve.
Profits are maximised by equating MR to the constant MC curve in each market.
Output Q1 is sold at a price of P1 in the industrial market, while household customers
buy Q2 at price P2. Marginal revenue is the same in each market at these outputs. If this was
not the case, the firm would be able to increase profits by reallocating its output between the
markets.
Fig. 8.4 Price discrimination
Although price discrimination can benefit the producer in terms of higher profits, there
may be circumstances in which it is also in the interest of consumers. The classic case
concerns the demand for the services of a doctor in an isolated small town. If all the
townspeople are charged the same price for health care, the town's doctor is unable to
make a sufficient income to cover his opportunity cost: it is in his interest to move to a
larger city, thus leaving the townspeople without any medical care. If, however, the doctor
is permitted to charge a higher price to the few rich citizens who can afford to pay, he may
be able to earn sufficient income to make it worth his while to treat the poorer people at a
lower price. Everybody ends up by getting some benefit from the introduction of price
discrimination - though, as the next chapter explains, collective provision of a merit good
such as health care outside the market may be judged more desirable than private provision
through the market.
Chapter roundup
This chapter has followed on from Chapter 7 in extending the coverage of market
structures to include the main forms of imperfect competition. Certain aspects of the
behaviour or conduct of large firms which have been examined in some depth in this
chapter are equally applicable to the case of pure monopoly. Chapter 10, on privatisation
and related policies, describes and analyses government policies towards the behaviour of
firms in imperfectly competitive markets.