Chapter 11 - Imperfect Competition and Strategic Behaviour: Monopolistic Competition and Oligopoly

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Chapter 11: Imperfect Competition and Strategic Behaviour

Chapter Outline and Learning Objectives

Recognize that Canadian industries typically have either a large number of small firms or a small number of large firms.
Explain why imperfectly competitive firms have differentiated products and often engage in non-price competition.
Describe the key elements of the theory of monopolistic competition.
Understand why strategic behaviour is a key feature of oligopoly.
Use game theory to explain the difference between cooperative and non-cooperative outcomes among oligopolists.

11.1 The Structure of the Canadian Economy

Industries with Many Small Firms

The perfectly competitive model does not adequately explain many industries with a large number of relatively small firms.
Monopolistic competition studies the behaviour and outcomes in industries with many small firms, each with some market power.

Industries with a Few Large Firms

Most modern industries dominated by large firms contain several firms and are not competitive markets.
The theory of oligopoly helps us understand industries with few large firms, each with market power, that compete actively with each other.

Different Market Structures

The four main market structures are summarized below:

Market Structure	Industry Characteristics
Perfect Competition	Many small firms; homogeneous products; free entry and exit; firms are price takers; zero long-run economic profit; efficient allocation of resources.
Monopolistic Competition	Many small firms; differentiated products; free entry and exit; some market power; zero long-run economic profit; excess capacity in long-run equilibrium.
Oligopoly	Few large firms; products may be homogeneous or differentiated; significant barriers to entry; interdependent decision-making; potential for collusion or competition.
Monopoly	Single firm; unique product with no close substitutes; high barriers to entry; firm is a price setter; potential for long-run economic profit.

Industrial Concentration

The concentration ratio measures economic power in an industry by showing the market shares of the largest four or eight producers.
Defining a market accurately is challenging due to varying geographic and product boundaries.
Globalization means domestic firms may compete with foreign firms operating in the same market.

Example: The concentration ratio for Canadian industries varies, with some industries (e.g., petroleum and coal) being highly concentrated, while others (e.g., fabricated metals) are less so.

11.2 What Is Imperfect Competition?

Firms Choose Their Products

A differentiated product is a group of products similar enough to be considered the same but different enough to have different prices.
Most imperfectly competitive firms sell differentiated products (e.g., laundry soaps, beer, cars, running shoes).

Firms Choose Their Prices

Firms are typically price setters, not price takers.
Prices often change slowly; firms may adjust output instead of price in response to demand shocks to avoid menu costs.

Non-Price Competition

Imperfectly competitive firms engage in behaviours absent in monopoly or perfect competition:
- Heavy spending on advertising
- Non-price competition (e.g., product differentiation, customer service)
- Creation of entry barriers to protect profits

Two Market Structures

Monopolistic competition: Many small firms, differentiated products, little strategic behaviour.
Oligopoly: Few large firms, significant strategic behaviour (analyzed using game theory), often high entry barriers.

Examples: Monopolistic Competition or Oligopoly?

Car repair: Many small firms, differentiated services, easy entry/exit. Monopolistic competition.
Soft drinks: Few large firms, brand proliferation, high advertising, strategic behaviour. Oligopoly.
Other examples: Dry cleaning, haircuts, breakfast cereals, automobiles.

11.3 Monopolistic Competition

The Assumptions of Monopolistic Competition

Each firm produces one variety of a differentiated product and faces a negatively sloped, highly elastic demand curve.
All firms have access to the same technology and cost curves.
The industry contains so many firms that each ignores competitors when making price and output decisions.
Firms are free to enter and exit the industry.

Empirical Relevance of Monopolistic Competition

Useful for analyzing industries with low concentration ratios and differentiated products, such as:
- Restaurants
- Clothing
- Hair stylists
- Mechanics

Predictions of the Theory

In the short run, a monopolistically competitive firm faces a downward sloping demand curve and maximizes profit where marginal revenue equals marginal cost:

Short-run outcomes: Firms can earn positive profits, break even, or incur losses.
Long-run equilibrium: Entry of new firms erodes profits, leading to zero economic profit and excess capacity (output is less than the level that minimizes average total cost).

Excess Capacity Theorem: In monopolistic competition, firms do not produce at the minimum of their average total cost curve in the long run, resulting in excess capacity.

Tradeoff: Product Variety vs. Cost

Excess capacity may not be wasteful if consumers value product variety.
Society faces a tradeoff between more choices and lower average costs per unit.

11.4 Oligopoly and Game Theory

Definition and Strategic Behaviour

Oligopoly: An industry with two or more firms, at least one of which produces a significant portion of total output.
Firms are interdependent and must consider rivals' actions—strategic behaviour is central.

The Basic Dilemma of Oligopoly

Firms can earn higher joint profits by cooperating (colluding), but each has an incentive to cheat for individual gain.
Game theory is used to analyze such strategic interactions.

Some Simple Game Theory

Players: Firms
Strategies: Price or output decisions
Payoffs: Profits

Example: Duopoly Game

Cooperate: Each produces 1/2 of monopoly output (low output, high price)
Compete: Each produces 2/3 of monopoly output (high output, low price)

	Firm A: One-half monopoly output	Firm A: Two-thirds monopoly output
Firm B: One-half monopoly output	20, 20 (Cooperative Outcome)	15, 22
Firm B: Two-thirds monopoly output	22, 15	17, 17 (Nash Equilibrium)

Nash Equilibrium

A Nash equilibrium is an outcome where each firm is doing the best it can, given what the other firm is doing.
In the duopoly game, both firms competing (producing more) is the Nash equilibrium, even though joint profits are not maximized.
This is an example of the prisoners' dilemma.

	Prisoner B stays silent (cooperates)	Prisoner B betrays (defects)
Prisoner A stays silent (cooperates)	Each serves 1 year	Prisoner A: 3 years Prisoner B: goes free
Prisoner A betrays (defects)	Prisoner A: goes free Prisoner B: 3 years	Each serves 2 years

Extensions in Game Theory

Game theory can also analyze:
- Firms with differentiated products and price competition
- Decisions about developing new products

11.5 Oligopoly in Practice

Types of Cooperative Behaviour

Collusion: Firms agree to restrict output and raise prices.
Explicit collusion: Formal agreements (e.g., OPEC, DeBeers).
Tacit collusion: Cooperation without explicit agreement.

Types of Competitive Behaviour

Competing for market share
Offering secret discounts
Innovation to gain long-term advantage

The Importance of Entry Barriers

Oligopolists must create entry barriers to sustain long-run profits.
Brand proliferation: Many varieties of a product make it hard for new entrants to gain market share.
Advertising: Heavy advertising increases minimum efficient scale (MES) for new entrants, deterring entry.
Predatory pricing: Incumbents may temporarily set prices below cost to drive out new entrants.

Oligopoly and the Economy

Oligopoly markets are less volatile in response to temporary demand changes than competitive markets.
Permanent demand changes lead to similar adjustments in both market structures.
Oligopolies often grow through mergers or by driving rivals into bankruptcy, increasing market concentration.
Public policy aims to keep oligopolies competitive to encourage innovation and cost reduction.

Additional Examples of Game Theory in Oligopoly

	Toyota: Small	Toyota: Large
Honda: Small	20, 20	12, 25
Honda: Large	25, 12	14, 14

Example: Firms bidding on a government contract (payoff matrix shows profits depending on bid strategies).

	Firm A bids $10,000	Firm A bids $5,000
Firm B bids $10,000	B = $3,000, A = $3,000	B = $0, A = $1,000
Firm B bids $5,000	B = $1,000, A = $0	B = $500, A = $500

Example: Chicken game (payoff matrix for strategic choices between two players).

	Player A: Swerve	Player A: Straight
Player B: Swerve	0, 0	-1, +1
Player B: Straight	+1, -1	-10, -10

Key Terms and Concepts

Imperfect competition: Market structures that fall between perfect competition and monopoly, including monopolistic competition and oligopoly.
Monopolistic competition: Many firms, differentiated products, free entry/exit, some market power.
Oligopoly: Few firms, interdependent decisions, potential for collusion or competition.
Game theory: The study of strategic decision-making among interdependent agents.
Nash equilibrium: A situation where no player can improve their payoff by unilaterally changing their strategy.
Collusion: Agreement among firms to restrict output or fix prices.
Entry barriers: Factors that make it difficult for new firms to enter a market.
Excess capacity: Firms produce less than the output that minimizes average total cost.

Formulas and Equations

Profit Maximization Condition:
- For all market structures:
Concentration Ratio:

Summary Table: Comparison of Market Structures

Feature	Perfect Competition	Monopolistic Competition	Oligopoly	Monopoly
Number of Firms	Many	Many	Few	One
Product Type	Homogeneous	Differentiated	Homogeneous or Differentiated	Unique
Entry Barriers	None	Low	High	Very High
Market Power	None	Some	Significant	Complete
Long-Run Profit	Zero	Zero	Possible	Possible

Additional info: This summary expands on the provided slides by including definitions, formulas, and additional examples for clarity and completeness.