2.1 — Imperfect Competition

# 2.1 — Imperfect Competition

## ECON 326 • Industrial Organization • Spring 2023

### Ryan Safner Associate Professor of Economics <a href="mailto:safner@hood.edu">safner@hood.edu</a> <a href="https://github.com/ryansafner/ioS23">ryansafner/ioS23</a> <a href="https://ioS23.classes.ryansafner.com"> ioS23.classes.ryansafner.com</a>

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# Outline

### [Monopolistic Competition](#4)

### [Oligopoly](#17)

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# Reminder: Imperfect Competition

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# Monopolistic Competition

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# Monopolistic Competition

- .hi[Monopolistic competition]: **each firm has _some_ market power**, but, the industry has .hi-purple[free entry and exit] (**no barriers to entry**)
  - Each firm faces its own downward-sloping demand
  - Firms are price-searchers

- Model as a hybrid of monopoly and perfect competition models

]

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# Monopolistic Competition: Product Differentiation

- .hi[Product differentiation]: firms’ products are .hi-purple[imperfect substitutes]

- Consumers recognize **non-price differences** between sellers’ goods
  - Brand name & reputation
  - Customer service
  - Product features, shape, color, etc.
  - Marketing
  - Location, convenience
]

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# Monopolistic Competition: Residual Demand

.pull-left[
.smallest[
- Each firm faces own downward-sloping .hi-blue[“residual” demand] for each firm’s products
  - Firm faces market demand (for broad product) *leftover* from all other firms’ sales

- .hi-green[Example]: demand for *Lenovo* laptops `$\approx$` demand for *laptops* minus laptops supplied by Acer, Asus, Apple, Dell, etc.
]
]

.pull-right[
<img src="2.1-slides_files/figure-html/unnamed-chunk-17-1.png" width="504" style="display: block; margin: auto;" />
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# Monopolistic Competition Model: Short Run

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<img src="2.1-slides_files/figure-html/unnamed-chunk-18-1.png" width="504" style="display: block; margin: auto;" />
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- **Short Run**: model firm as a price-searching monopolist:
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# Monopolistic Competition Model: Short Run

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<img src="2.1-slides_files/figure-html/unnamed-chunk-19-1.png" width="504" style="display: block; margin: auto;" />
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- **Short Run**: model firm as a price-searching monopolist:

- `$q^*$`: where `$\color{purple}{MR(q)}=\color{red}{MC(q)}$`
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# Monopolistic Competition Model: Short Run

.pull-left[
<img src="2.1-slides_files/figure-html/unnamed-chunk-20-1.png" width="504" style="display: block; margin: auto;" />
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- **Short Run**: model firm as a price-searching monopolist:

- `$q^*$`: where `$\color{purple}{MR(q)}=\color{red}{MC(q)}$`
- `$p^*$`: at .blue[market demand] for `$q^*$`
]

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# Monopolistic Competition Model: Short Run

.pull-left[
<img src="2.1-slides_files/figure-html/unnamed-chunk-21-1.png" width="504" style="display: block; margin: auto;" />
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- **Short Run**: model firm as a price-searching monopolist:

- `$q^*$`: where `$\color{purple}{MR(q)}=\color{red}{MC(q)}$`
- `$p^*$`: at .blue[market demand] for `$q^*$`
- Earns `$\color{green}{\pi} = [\color{blue}{p^*}-\color{orange}{AC(q^*)}]q^*$`
]

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# Monopolistic Competition Model: Long Run

.pull-left[
<img src="2.1-slides_files/figure-html/unnamed-chunk-22-1.png" width="504" style="display: block; margin: auto;" />
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- **Long Run**: market becomes competitive (**no barriers to entry!**)

- `$\color{green}{\pi > 0}$` attracts **entry** into industry

]

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# Monopolistic Competition Model: Long Run

.pull-left[
<img src="2.1-slides_files/figure-html/unnamed-chunk-23-1.png" width="504" style="display: block; margin: auto;" />
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- **Long Run**: market becomes competitive (**no barriers to entry!**)

- `$\color{green}{\pi > 0}$` attracts **entry** into industry

- .blue[Residual demand] for each firm’s product:
  - **decreases** (more output by other firms)
  - become more **elastic** (more substitutes from new competitors)
  - until...

]

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# Monopolistic Competition Model: Long Run

.pull-left[
<img src="2.1-slides_files/figure-html/unnamed-chunk-24-1.png" width="504" style="display: block; margin: auto;" />

]

- **Long Run**: market becomes competitive (**no barriers to entry!**)

- `$\color{green}{\pi > 0}$` attracts **entry** into industry

- .blue[Residual demand] for each firm’s product:
  - **decreases** (more output by other firms)
  - become more **elastic** (more substitutes from new competitors)

- .hi-purple[Long run equilibrium]: firms earn `$\color{green}{\pi=0}$` where `$\color{blue}{p}=\color{orange}{AC(q)}$`

]

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# Monopolistic Competition vs. Perfect Competition

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- `$q_c$` where `$\color{blue}{P}=\color{red}{MC(q)}$`

- `$\color{blue}{p_c} = \color{orange}{AC(q)_{min}}$`, .hi-orange[productively efficient]
  - Production at lowest average cost

- `$\color{blue}{p_c} = \color{red}{MC(q)}$`, .hi-purple[allocatively efficient]
  - Production until .blue[MB] = .red[MC]
  - Maximum .blue[consumer surplus] (and .red[producer surplus])
  - No **DWL**

]]

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# Monopolistic Competition vs. Perfect Competition

.pull-left[
<img src="2.1-slides_files/figure-html/unnamed-chunk-26-1.png" width="504" style="display: block; margin: auto;" />

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- `$q_c > q_m$`, where `$\color{purple}{MR(q)}=\color{red}{MC(q)}$`

- `$\color{blue}{p_m} = \color{orange}{AC(q)}$`
  - but not `$\color{orange}{AC_{min}}$`, so some .hi-orange[productive .ul[inefficiency]]

- `$\color{blue}{p_m} > \color{red}{MC(q)}$`, .hi-purple[allocative .ul[inefficiency]]
  - Less .blue[Consumer Surplus]
  - Some **Deadweight loss**
  
]
]
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# Monopolistic Competition vs. Perfect Competition

.pull-left[
<img src="2.1-slides_files/figure-html/unnamed-chunk-27-1.png" width="504" style="display: block; margin: auto;" />

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- Like a monopoly, produces less `$q$` at a higher `$p$` than competition, some **DWL**

- But like perfect competition, still **no `$\pi$` in the long run**!

- Outcome is *between* perfect competition & monopoly in terms of efficiency & social welfare
]

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# Oligopoly

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# Oligopoly

- .hi[Oligopoly]: industry with a few large sellers with market power

- Other features can vary
  - May sell similar or different goods
  - May have barriers to entry

- Key: Firms make .hi-purple[strategic choices], interdependent on one another

- For modeling simplicity: 
  - .hi-purple[Duopoly]: a market with 2 sellers 
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# Oligopoly: Modeling

.pull-left[
.center[
![](../images/cokevspepsi.png)
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.footnote[.magenta[†] See Unit II of my [Game Theory course](https://gamef21.classes.ryansafner.com/schedule/) to learn more.]

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- Depends heavily on assumptions made about interactions and choice variables (FYI):.magenta[†]
 - .hi[“Bertrand competition:”] firms compete on **price**
 - .hi[“Cournot competition:”] firms **simultaneously** compete on **quantity**
 - .hi[“Stackelberg competition:”] firms **sequentially** compete on **quantity**

- One certainty: oligopoly is a .hi-purple[strategic interaction] between few firms

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# Game Theory

- .hi[Game theory]: a set of tools that model .hi-purple[strategic interactions] (.hi-purple[“games”]) between rational agents, 3 elements:
    1. **Players**
    2. **Strategies** that each player can choose from
    3. **Payoffs** to each player that are *jointly-determined* from combination of all players’ strategies

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# Game Theory vs. Decision Theory Models I

- Traditional economic models are often called .hi[“Decision theory”]:

- .hi-purple[Optimization models] **ignore all other agents** and just focus on how can **you** maximize **your** objective within **your** constraints
  - Consumers max utility; firms max profit, etc.

- **Outcome**: .hi-purple[optimum]: decision where *you* have no better alternatives

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# Game Theory vs. Decision Theory Models I

- Traditional economic models are often called .hi[“Decision theory”]:

- .hi-purple[Equilibrium models] assume that there are **so many agents** that **no agent’s decision can affect the outcome**
  - Firms are price-takers or the *only* buyer or seller
  - **Ignores all other agents’ decisions**!

- **Outcome**: .hi-purple[equilibrium]: where *nobody* has any better alternative

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# Game Theory vs. Decision Theory Models III

- .hi[Game theory models] directly confront .hi-purple[strategic interactions] between players
  - How each player would optimally respond to a strategy chosen by other player(s)
  - Lead to a stable outcome where everyone has considered and chosen mutual best responses

- **Outcome**: .hi-purple[Nash equilibrium]: where *nobody* has a better strategy **given the strategies everyone else is playing**

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# Equilibrium in Oligopoly

- What does .hi-purple[“equilibrium”] mean in an *oligopoly*?

- In competition or monopoly, a unique `$(q^*,p^*)$` for industry such that **nobody has incentives to change price**

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# Equilibrium in Oligopoly

- Oligopoly: use game-theoretic .hi-purple[Nash Equilibrium]: 
  - no player wants to change their strategy **given all other players’ strategies**
  - each player is playing a **best response** against other players’ strategies

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# As a Prisoner's Dilemma I

![:scale 100%](../images/applevsgoogle.jpg)
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- .hi-green[Example]: suppose we have a simple **duopoly** between .hi-red[Apple] and .hi-blue[Google]

- Each is planning to launch a new tablet, and choose to sell it at a **High Price** or a **Low Price**

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# As a Prisoner's Dilemma I

- Payoff matrix represents profits to each firm
  - First number in each box goes to .hi-red[Row player (Apple)]
  - Second number in each box goes to .hi-blue[Column player (Google)]
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# As a Prisoner's Dilemma II

- From .hi-red[Apple's] perspective:
  - .hi-red[Low Price] is a .hi-purple[dominant strategy] for .hi-red[Apple]

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# As a Prisoner's Dilemma II

- From .hi-blue[Google's] perspective:
  - .hi-blue[Low Price] is a .hi-purple[dominant strategy] for .hi-blue[Google]

]

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# As a Prisoner's Dilemma II

- .hi-purple[Nash equilibrium]: (.hi-red[Low Price], .hi-blue[Low Price])
  - neither player has an incentive to change price, *given the other's price*

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![](../images/pdapplegooglenash.png)

Nash equilibrium
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# As a Prisoner's Dilemma III

- .hi-purple[Nash equilibrium]: (.hi-red[Low Price], .hi-blue[Low Price])
  - neither player has an incentive to change price, *given the other's price*
  
- A possible **Pareto improvement**: (.hi-red[High Price], .hi-blue[High Price])
  - Both players are better off, nobody worse off!
  - Is it a Nash Equilibrium?

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![](../images/pdapplegooglecartel.png)

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# Cartels

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# As a Prisoner's Dilemma IV

- Google and Apple could .hi-purple[collude] with one another and agree to both raise prices

- .hi[Cartel]: group of sellers coordinate to raise prices to act like a collective monopoly and split the profits

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# Instability of Cartels

- Cartels often **unstable**:

- Incentive for each member to cheat is too strong

- Entrants (non-cartel members) can threaten lower prices

- Difficult to monitor whether firms are upholding agreement

- Cartels are illegal, must be discrete

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# Attempts to Sustain Collusion I

Archer Daniels Midland (USA), Ajinomoto (Japan), Koywa Hakko Kogyo (Japan), Sewon American Inc (South Korea) held secret meetings to fix the price of lysine, a food additive to animal feed in the 1990s.

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# Attempts to Sustain Collusion I

An internal FBI informant brought the cartel down.

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