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Monopolistic Competition and Oligopoly
Monopolistic Competition and Oligopoly 11
Lecture 11 Imperfect Competition
Business 5017 Managerial Economics
The Stackelberg Leadership Model
Public Interest Theory
Economic Theory of Regulation
Market for Corporate Control
Are Hostile Takeovers Ecient?
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 2 / 29Introduction
Monopolistic Competition and Oligopoly
We have so far studied two extreme forms of market structure.
In perfect competition, no single rm has the market power to
uence the market price. In the long run rms make no economic
A monopolist which sells a product with no close substitute enjoy
great market power and makes economic prots in the long run.
Most market structures in our economy are something in between.
In monopolistic competition, each rm sells a dierentiated product
with its market niche. The rms enjoy some market power and face
their own downward sloping demand curves.
In an oligopoly, price, quantity, and therefore prots depend on the
interactions of the rm. The form of competition and market
outcome are indeterminate.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 3 / 29Monopolistic Competition
The market power of a monopolistic competitive rm depends on a
number of factors:
Number of competitors
Production capacity of competitors
Ease of new rms entering the market
Degree of product dierentiation
Brand name recognition and loyalty
Price dierence awareness of consumers
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 4 / 29Monopolistic Competition
A typical rm faces a
downward sloping demand
curve, with a steeper
marginal revenue curve.
Prot maximization is
achieved by setting MC =
The rm produces Q and
charges P on the demand
compared with the perfectly
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 5 / 29Monopolistic Competition
As long as the rms are making economic prots, new rms will enter
The demand and MR curves of a typical rm shift down because of
increased competitive. Demand also becomes more elastic.
This continues until all economic prots have eroded, with price P
and quantity Q on the LRAC curve.
Note that in the long run the rm is not producing at the minimum
eciency scale, meaning economic ineciency.
This occurs as long as the demand curve facing an individual rm is
not perfectly elastic.
Firms in monopolistic competitive often engage in non-price
competitive such as advertisement and customer relationships.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 6 / 29Monopolistic Competition
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 7 / 29Oligopoly Modelling Reality
Just a Handful of Sellers
Typically just a few sellers in a market with not much product
dierentiation. Barriers to entry are high.
Demands are more inelastic than that in a monopolistic competition.
Therefore the oligopolists have more market power.
Consequently if an oligopolist behaves like a monopolist, the
dead-weight loss is larger than that of a monopolistic competitive
However, this is not always the case. Pricing decisions of oligopolists
are mutually interdependent. There is a wide variety of economic
models on their behaviours.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 8 / 29Oligopoly Modelling Reality
Oligopolist as a Monopolist
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 9 / 29Oligopoly The Stackelberg Leadership Model
One Market Leader
The market is dominated by one big producer with cost advantage
(advanced technology, patents, big brand name, etc.).
The rest of the rms are followers with no market power.
The total supply curve of the followers is the sum of their MC curves.
Without the leader, this supply curve MC meets the market demand
curve D at price P and quantity Q .
m 1 2
Excess demand exists at any price below P , these excess demands
become the demand curve D for the dominant producer, with
corresponding marginal revenue MR .
The dominant producer maximizes prot by setting MC = MR with
the price-quantity combination (P ;Q ).
The followers are price takers, now face market price P . The excess
demand between the consumers and the followers is Q Q , which
is equal to Q .
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 10 / 29Oligopoly The Stackelberg Leadership Model
Price Leader and Followers
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 11 / 29Oligopoly Collusion
How Cartels are Formed
If product dierentiation is weak, consumers are more price sensitive.
Pricing becomes the main tool in competition among the oligopolists.
There are strong incentives for the rm to form a cartel and behave
collectively like a monopoly.
The cartel chooses the monopoly price-quantity combination to
maximize prot, which is shared by its members.
With the high monopoly price, however, each individual rm in the
cartel has an incentive to cheat, making even more prot by
To avoid collapse, the cartel must have a mechanism in place to
punish the cheaters.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 12 / 29Oligopoly Collusion
An Example of Duopoly
Two identical rms with
constant returns to scale
They form a cartel to maximize
joint prot with (P ;Q ). This
means each rm produces at a
level Q =Q =2.
After the collusion agreement,
each rm has the incentive to
lower price a little to P and
capture almost the whole
But total prot goes down if
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 13 / 29Oligopoly Collusion
Back to Game Theory
The above colluding duopoly can be described by a Prisoner's
Assume that the two rms, A and B, have two choices, high price or
low price. Their incentive can be analyzed with the payo matrix.
For Firm A, no matter what Firm B chooses, its best strategy is to
choose low price. The same is true for Firm B.
Therefore the dominant strategy is low price for both rms, resulting
in the inecient outcome (500; 500).
This outcome is also a Nash equilibrium, which consists of the best
strategy for every player given the action of all the other players. In
other words, no player has the incentive to change his/her choice.
Therefore in a one-shot game the collusion will fail. In a repeated
game setting, the behaviours are more complicated.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 14 / 29Oligopoly Collusion
Payo Matrix of a Duopoly
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 15 / 29Oligopoly Collusion
Cartels with Lagged Demand
Recall that when a product exhibits lagged demand due to network
eect or rational addiction, a rm has the incentive to lower price
now so that demand will be higher in the future.
This applies to a cartel as well. But individual rm has the incentive
to free-ride the other rms.
Since the game is inherently dynamic, actual behaviours depends on
the mechanism design of the cartel.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 16 / 29Oligopoly Collusion
In a lot of cases the transaction costs of maintaining a cartel
(negotiating, monitoring, and enforcing the agreement) is higher than
the benets of collusion.
The problem may be resolved with a third party doing the monitoring
and enforcement task.
A good candidate for this third party is the government. With
legislative and executive power, the government can be very ecient
in maintaining a cartel.
This is why some industries lobby for government regulations or
oppose deregulation. The eects of regulations can suppress
Examples: airline regulations, liquor licence, banning Sunday
shopping, professional licensing, etc.
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 17 / 29Oligopoly Regulating Monopoly
When the long-run average cost is declining within the range of
market demand, it is cost eective to have a single producer.
The natural monopoly is socially inecient, however, if it exploits
consumers with its market power. The government usually steps in to
regulate the monopoly.
Instead of the monopolist's prot maximizing (P ;Q ), the
government can impose a price ceiling at P , where the LRAC meets
the market demand curve.
This may occur naturally without government intervention in a
contestable market. Even though there is a high xed cost, some
well-nanced rms may see the monopoly prot as a sign to enter the
The threat of a price war with a new competitor keeps the natural
monopolist in check and charge a price close to the socially ecient
level at P .
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 18 / 29Oligopoly Regulating Monopoly
A Natural Monopolist
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 19 / 29Business Regulation Public Interest Theory
\The Government is the Problem"
Many sectors in the economy are subject to various degree of
In Canada the most heavily regulated sectors are health care,
education, transportation, telecommunication, agriculture, and
Common reasons for regulation are social insurance, monopoly power,
public safety, market stability, preservation of culture and languages,
Some economists think that excessive government regulation hinders
the operation of the free markets and creates ineciency.
Others try to explain regulation from an institutional economics
Kam Yu (LU) Lecture 11 Imperfect Competition Fall 2013 20 / 29