Profit Maximisation under

Imperfect Competition
 Profit Maximisation under
Imperfect Competition
If ‘perfect competition’ doesn’t actually exists, then
various forms of ‘imperfect’ markets do
consider (1) Monopolistic Competition
(2) Oligopoly
(3) Duopoly
(Monopoly is an absence of competition)
 Monopolistic Competition

 Assumptions of the monopolistic competition model

 large number of firms
 independence of firms
 Small to medium market shares
 freedom of entry
 differentiated product (vital for competition)
 downward-sloping demand curve
 demand elasticity depends on type of product differentiation
 Monopolistic Competition
 Equilibrium of the firm
 short run: the usual rules apply which we have explained previously
 Profit maximising output where MC = MR
 level of supernormal profit depends on demand, i.e. the price people are
willing to pay generally
 ‘position’ (how great is) of demand curve
 elasticity of demand curve ( consumers attitude to price changes)
 Short-run equilibrium of the firm
under monopolistic competition: extra profit
£ MC

AC

Ps

ACs

AR = D

MR
O Qs Q
 Monopolistic Competition

In the long run

 firms can enter the industry
 all supernormal profits competed away
 Long-run equilibrium of the firm
under monopolistic competition
£ NOTE: LRAC= LRAR,
so ‘Normal’ profit obtained
Remember we assume ‘normal’ profit is a ‘cost’ charged by the providers of capital

LRMC

LRAC

PL

ARL = DL

MRL
O QL Q
 Long-run equilibrium of the firm
under monopolistic competition
£ Underutilisation of capacity, at this ‘equilibrium’
point. More output could be produced at lower
AC. But the price at this output is too low to
cover costs.

LRAC

PL

ARL = DL

O QL Q
Long-run equilibrium of the firm under perfect and
monopolistic competition
£ Because of the ‘idealised’ conditions in the ‘perfect’ competition
model, lower prices and greater total output is theoretically
achievable.
LRAC

P1

P2
DL under perfect
competition

DL under monopolistic
competition

O Q1 Q2 Q
 Monopolistic Competition
 Limitations of the model’s assumptions
 imperfect information

 difficulty in identifying industry demand curve (researchers life time

career!!)
 entry may not be totally free

 Indivisibilities (unlike ‘perfect’ competition, the factors are not

‘frangible’, so not perfectly mobile or adjustable)
 importance of non-price competition is a feature of the theory

 Comparing monopolistic competition with perfect competition

and monopoly
 comparison with perfect competition
 Oligopoly : a FEW producers
Key features of oligopoly
 barriers to entry
 interdependence of firms

Competition and collusion (simultaneous opposing

tendencies)
 pressures to compete: to maximise share of industry
profits
 pressures to collude: to maximise industry profits

 Collusive oligopoly: cartels

 Profit-maximising cartel
£

Industry D = AR

O Q
 Profit-maximising cartel
£
Industry profit
maximised at
Q1 and P1. Industry MC

P1

Members must
agree to restrict
total output to Q1.

Industry D = AR
Industry MR
O Q1 Q
 Oil prices (crude oil, monthly average): OPEC
130 Recovery falters
Banking turmoil and onset of
120 Actual price
recession

110 Cost in 1973 prices Continuing worries about supply;

rapid growth in demand from China
100 and India

90
Invasion
80 Revolution
$ per barrel

OPEC’s first New OPEC of Iraq

in Iran quotas
70 quotas Increase
Worldwide in output
Iraq invades Iraq invades slowdown
60 Iran Kuwait
of shale oil
Yom Kippur Recession
50 War: Arab oil in Far East
embargo Cease-fire in
40 Iran-Iraq war Worldwide Start of
OPEC refuses
recovery to cut output
global
30 First oil from recovery
OPEC/
North Sea
non-OPEC
20 agreement

10
0
1970
1970
1970
1970
1971
1971
1971
1971
1972
1972
1972
1972
Q2
1973
Q3
1973
Q4
1973
Q1
1973
Q2
1974
Q3
1974
Q4
1974
Q1
1974
Q2
Q3
1975
Q4
1975
Q1
1975
Q2
1975
1976
Q3
1976
Q4
1976
Q1
1976
Q2
1977
Q3
1977
Q4
1977
1977
Q2
1978
Q3
1978
Q4
1978
Q1
1978
Q2
1979
Q3
1979
Q4
1979
Q1
1979
Q2
Q3
1980
Q4
1980
Q1
1980
Q2
1980
1981
Q3
1981
Q4
1981
Q1
1981
Q2
1982
Q3
1982
Q4
1982
1982
Q2
1983
Q3
1983
Q4
1983
Q1
1983
Q2
1984
Q3
1984
Q4
1984
Q1
1984
Q2
Q3
1985
Q4
1985
Q1
1985
Q2
1985
1986
Q3
1986
Q4
1986
Q1
1986
Q2
1987
Q3
1987
Q4
1987
1987
Q2
1988
Q3
1988
Q4
1988
Q1
1988
Q2
1989
Q3
1989
Q4
1989
Q1
1989
Q2
Q3
1990
Q4
1990
Q1
1990
Q2
1990
1991
Q3
1991
Q4
1991
Q1
1991
Q2
1992
Q3
1992
Q4
1992
1992
Q2
1993
Q3
1993
Q4
1993
Q1
1993
Q2
1994
Q3
1994
Q4
1994
Q1
1994
Q2
Q3
1995
Q4
1995
Q1
1995
Q2
1995
1996
Q3
1996
Q4
1996
Q1
1996
Q2
1997
Q3
1997
Q4
1997
1997
Q2
1998
Q3
1998
Q4
1998
Q1
1998
Q2
1999
Q3
1999
Q4
1999
Q1
1999
Q2
Q3
2000
Q4
2000
Q1
2000
Q2
2000
2001
Q3
2001
Q4
2001
Q1
2001
Q2
2002
Q3
2002
Q4
2002
2002
Q2
2003
Q3
2003
Q4
2003
Q1
2003
Q2
2004
Q3
2004
Q4
2004
Q1
2004
Q2
Q3
2005
Q4
2005
Q1
2005
Q2
2005
2006
Q3
2006
Q4
2006
Q1
2006
Q2
2007
Q3
2007
Q4
2007
2007
Q2
2008
Q3
2008
Q4
2008
Q1
2008
Q2
2009
Q3
2009
Q4
2009
Q1
2009
Q2
Q3
2010
Q4
2010
Q1
2010
Q2
2010
2011
Q3
2011
Q4
2011
Q1
2011
Q2
2012
Q3
2012
Q4
2012
2012
Q2
2013
Q3
2013
Q4
2013
Q1
2013
Q2
2014
Q3
2014
Q4
2014
Q1
2014
Q2
Q3
2015
Q4
2015
Q1
2015
Q2
2015
Q3
2016
Q4
2016
Q1
2016
Q2
2016
Q3
2017
Q4
2071
2017
Q2
Q3
2018
Q4
Q2
2018
Q3
Q4
Q2
Q3
Q4
Q2
Sources: Nominal oil price data from World Commodity Price Data (The Pink Sheet), Commodity Markets (World Bank); Price Index from Data
Extracts (OECD).
 Oligopoly

Tacit collusion

 price leadership: dominant firm

 price leadership: barometric
 other forms of tacit collusion: rules of thumb
 average cost pricing
 price benchmarks
 Oligopoly

 Oligopoly and the consumer

 disadvantages
 less scope for economies of scale relative to monopoly
 greater use of advertising than under monopoly: costs rise
 advantages
 countervailing power
 supernormal profits may allow higher R&D
 greater choice for consumers

 Oligopoly and contestable markets

 importance of entry and exit costs
 Oligopoly
 Factors favouring collusion
 few firms
 open with each other
 similar cost structures and production methods
 similar products
 there is a dominant firm
 significant barriers to entry
 stable market conditions
 no government measures to curb collusion
 Collusion and the law
 Oligopoly

 The breakdown of collusion

 factors to consider in deciding whether to break an

agreement (common in OPEC)
 how likely are rivals to retaliate?
 who would win a price war? (Recent Rusian Saudi spat
over oil prices)
 importance of considering rivals’ reactions
 Oligopoly

 Non-collusive oligopoly: assumptions about rivals’

behaviour (cont.)
 Nash equilibrium
 when everyone makes a decision based on the alternatives rivals could
adopt
 Nash equilibrium worse for the individual firms than the collusive equilibrium
 The kinked demand curve model
 assumptions of the model
 Kinked demand for a firm under oligopoly
£

Current price
and quantity
give one point
on demand curve.
P1

O Q1 Q
 Kinked demand for a firm under oligopoly
£
Assumption 1
If the firm raises its
price, rivals will not

D Assumption 2
P1 If the firm reduces
its price, rivals will
feel forced to lower
theirs too.

D
O Q1 Q
Stable price under conditions of a kinked demand curve
£
MR is discontinuous
between a and b.
If MC is anywhere
between MC1 and MC2,
MC2 profit is maximised at Q1.

P1 MC1

a
D = AR
b

O Q1 Q
MR
 Duopoly
 Non-collusive oligopoly: assumptions about rivals’ behaviour
 Cournot model is an oligopoly model in which firms producing identical
products compete by setting their output under the assumption that its
competitors do not change their output in response. Rivals compete
through quantity offered:
 each firm aims to maximize profits, based on the expectation that its
own output decision will not have an effect on the decisions of its rivals.
Each evaluates its residual demand, and then behaves as a monopoly,
(i.e. firms chose best output for ‘remainder’ of the market)
 The Cournot model of duopoly: firm A’s demand

Costs and revenue

Firm A believes
that firm B will
produce QB1.

DA1 DM
O QB1
Quantity
 Cournot model:
firm A’s profit-maximising position

Firm A’s profit-

maximising output and
price are QA1 and PA.
Costs and revenue

MCA

PA1

MRA1 DA1 DM
O QA1 QB1
Quantity
 The Cournot model of duopoly
Firm A’s reaction
function for each
£ assumed output of B

MCA
RA A reaction curve (or best-
response curve) is a

Firm B’s output

graph which shows profit-
maximizing output of one
PA1 firm in a duopoly given
the different possible
QB1 x outputs of the other firm.
DM Put Qa1 and QB1 from
MRA1 DA1 left chart on right chart
O QA1 O QA1
QB1
Quantity Firm A’s output

(a) Firm A’s profit-maximising position (b) The firm A’s reaction function -
its output as B’s output changes
 The Cournot model of duopoly

£
Equilibrium at
RA point e, where the
MCA
two reaction

Firm B’s output

functions cross

PA1 e
QBe

QB1 x
DA1 DM RB
MRA1
O QA1 O QAe QA1
QB1
Quantity Firm A’s output

(a) Firm A’s profit-maximising position (b) The two firms’ reaction functions
 Cournot Equilibrium

A stable equilibrium occurs where competitors anticipate output

changes of the other and neither want to further change their
output.

Cournot argued that when firms choose quantities, the equilibrium

outcome involves firms pricing above marginal cost and hence
above the competitive price (they tend both to overproduce) but at
a lower price than a monopoly
 The Bertrand Duopoly Model
Bertrand argued against Cournot, that if firms chose prices rather
than quantities, then the competition will force price to equal
marginal cost.
The firm assumes the competitor keeps a fixed price, then reacts.

With at least two firms producing a undifferentiated products with

no cooperation.

Firms set prices simultaneously and consumers want to buy

everything from a firm with a lower price (the product is
homogeneous so no consumer search costs).
 The Bertrand Duopoly Model
If 2 firms charge the same price, consumers' demand is
split evenly between them.

Model assumes both firms have the same constant unit

cost of production.

Each firm reacts to the other firm’s price changes to

prevent market loss. So a reaction function can be traced.
(The reaction curves are derived from ‘isoprofit’ maps
which are convex to the axes, but that’s for a later time!!)
 Profit Maximisation under
Imperfect Competition

Game Theory
This requires a separate lecture,
but the basics are here for you to
peruse yourselves
 Game Theory

Simultaneous single-shot (single-move) games

simple ‘dominant strategy’ games
 simple 2  2 games
 best-response behaviour
 Nash equilibrium
Profits for firms X and Y at different prices
What will they do?

X’s price
£2.00 £1.80

A B
£2.00 £10m, £10m £5m, £12m

Y’s price
C D
£1.80 £12m, £5m £8m, £8m
 The prisoners’ dilemma

Amanda’s alternatives What

evidence
Not confess Confess do the
police
Not
A B Nigel gets
10 years have?
Each gets
confess Amanda gets
1 year
Nigel’s 3 months Then what
alternatives C Nigel gets more can
D
3 months Each gets your ‘mate’
Confess 3 years provide?
Amanda gets
10 years
A more complicated game: non-dominant or mixed strategy
games

X’s price
£25 £19

A B
£20 £6m, £6m £2m, £5m

Y’s price
C D
£15 £4m, £3m £4m, £4m
 Game Theory

more complex simultaneous one-shot

games
 many rivals; many possible reactions of
rivals
 how firms will best respond
 importance of information
 Nash Equilibrium

The Nash equilibrium is a concept of game theory

where the optimal outcome of a game is one where
no player has an incentive to deviate from his
chosen strategy after considering an opponent's
choice.
 Q Consider the matrix below. Which cell(s)
represent(s) the Nash equilibrium?

A. Cells A and F
B. Cell H Firm Firm B
B’s options
C. Cells F and H 1 2 3
D. Cells C and E 1 A: 3, 4 B: 1, 5 C: 2, 1

Firm A
options
Firm A’s
E. Cells B and D 2 D: 2, 5 E: 2, 1 F: 3, 6

F. Cell F 3 G: 1, 0 H: 4, 3 I: 0, 2
G. Cells C and H
H. Cell A
I. Cells G and I
 Game Theory

 Repeated simultaneous games

 infinitely repeated games
 grim trigger strategy
 In game theory, grim trigger is a trigger strategy for a repeated game. Initially,
a player using grim trigger will cooperate, but as soon as the opponent
defects, the player (using grim trigger) will defect for the remainder of the
iterated game
 Profits for firm Y in a repeated game

a b Profit stream for firm Y

12
if it charges £2.00

e f
Profit per period

10 g

c d
8

Profit stream for firm Y

if it cuts its price now

0
Now 1 2 3 4
Number of periods from now
 Game Theory

 Repeated simultaneous games

 infinitely repeated games
 tit-for-tat strategy
 finitely repeated games
 strategy in the last round of the game
 backwards induction
 Nash equilibrium
 Game Theory

 Sequential games
 importance of timing
 simple decision trees: two firms, two options
 A decision tree
Boeing –£10m
a ter Airbus –£10m
(1)
Airbus 00 s e
5
decides
B1 400
sea
ter

r
Boeing +£30m (2)

a te
se
Airbus +£50m

0
50
Boeing
decides A 40
0s Boeing +£50m
ea a ter (3)
te s e Airbus +£30m
r 500
B2 400
s eat
Airbus er
decides Boeing –£10m
Airbus –£10m
(4)
 Game Theory

 Sequential games
 importance of timing
 simple decision trees: two firms, two options
 first-mover advantage
 A decision tree
Boeing –£10m
a ter Airbus –£10m
(1)
Airbus 00 s e
5
decides
B1 400
sea
ter

r
Boeing +£30m (2)

a te
se
Airbus +£50m

0
50
Boeing
decides A 40
0s Boeing +£50m
ea a ter (3)
te s e Airbus +£30m
r 500
B2 400
s eat
Airbus er
decides Boeing –£10m
Airbus –£10m
(4)
 Game Theory

 Sequential games
 importance of timing
 simple decision trees: two firms, two options
 first-mover advantage
 more complex decision trees with multiple firms and/or multiple options
 importance of threats and promises
 are threats seen by rivals as credible?
 Game Theory

 The usefulness of game theory

 Limitations of game theory

 complex games with multiple players
 role of individuals’ morals and attitudes
 Potential for cycles of collusion and competition