Imperfect Markets

Sarika Rachuri
Monopoly
A monopoly is a market structure in which there
is a single supplier of a product.
The product has no close substitutes
Monopoly firm hence makes up the entire
industry
Monopolies exist because of barriers to entry into
a market that prevent competition
- Natural barriers, the most common being
economies of scale
Actions by firms to keep other firms out
Government (legal) barriers
Monopoly
Examples of Monopoly : Indian Railways ,
SEB,Local utility Companies
Economies of Scale
In some industries, the larger the scale of
production, the lower the costs of
production.
Entrants are not usually able to enter the
market assured of or capable of a very
large volume of production and sales.
This gives incumbent firms a significant
advantage.
Case Study – De beers

Historically owned 85% share of the diamond

market
•Owns both mines and main distribution
system, Central Selling Organization
–Mine and trading companies owned by
subsidiaries with generic names
•Known for influencing supply and demand
to control prices
Case Study – De beers
Majority of diamonds from mines sold to De Beers
De Beers has sole power to determine how many
diamonds to sell and at what price
–Vast amounts of research done
Can only accept or reject boxes
–Not allowed to negotiate
–Not allowed to sell to retailers who will lower prices
–Must give De Beers information about market and
inventory
–De Beers has the right to come and audit them
Case Study – De beers
Highly effective advertising to control demand
–Over 70% of American women own at least
one diamond
•“A Diamond is Forever”
–Campaign used to convince people not to sell
or buy used diamond
Case Study – De beers
Ifprice of diamonds are falling, De Beers will:
–Hoard inventory by selling less
•Accumulated $2B in diamonds in 1984 after
allowing prices to rise too much and a sudden
sell off in the market and $5B in 1990s

If new suppliers emerge, it will:

–Flood the market with similar diamonds at below
market prices
Case Study – De beers

Stopped trying to control market and instead

focus on using its marketing and bran
 In 2004 Partnered with Louis Vuitton to
open retail outlets
Transited from monopoly to oligopoly
markets
Demand Curve under Monopoly
Unlike Perfect competition where firm
chooses an o/p, Monopoly firm has to choose
price/op combination that yields maximum
profits .
Each quantity change will bring about a
change in price at which product can be sold.
Demand Curve under Monopoly
Unlike Perfect competition where firm
chooses an o/p, Monopoly firm has to choose
price/op combination that yields maximum
profits .
Each quantity change will bring about a
change in price at which product can be sold.
Demand Curve under Monopoly
The monopolist AR curve is the price a
monopolist receives per unit of o/p.
The AR curve is the Demand Curve and is
downward sloping
A monopoly firm can either control price or
output but not both
If it controls the price it has to take the
output demanded
Demand Curve under Monopoly
A downward sloping demand curve implies
price/AR> MR Price Quantity TR MR AR

6 0 0

Price- Rs 5 1 5 5 5
per unit of
O/P 6
4 2 8 3 4

AR curve
3 3 9 1 3

MR
curve 2 4 8 -1 2

1 5 5 -3 1

3 6
Output
Demand Curve under Monopoly
 Hence MR will be less than AR/Price
We know that
MR= AR(e-1)/e
MR=P(e-1)/e
P=MR e/(e-1)
The extent to which MR lies below AR will
depend on (e-1)/(e)
Equilibrium Condition under monopoly
The MR = MC condition determines the
quantity a monopolist produces.
Since MR= P(e-1)/e
MC= P(e-1)/(e)
P=MC[(e)/(e-1)]
Brain teaser
Find the profit maximizing price
Given MC=12 and e=4
P= 12*[(4)/(4-1)]
P=16
So if e<1 MR will be negative and a
monopolist will not operate at that level of
output .
Demand Curve of A monopoly firm
e>1

E= 1
AR curve

e<1

MR
curv
e
The Price a Monopolist Will Charge
The MR = MC condition determines the
quantity a monopolist produces.
Since MR= P(e-1)/e
MC= P(e-1)/(e)
P=MC[(e)/(e-1)]
 Profit Maximizing Level of Output

• The profit-maximizing condition of a monopolistic

firm is:
MR = MC
• For a monopolistic firm, MR < P
• A monopolistic firm maximizes total profit, not profit
per unit
if MR > MC,
• The monopoly can increase profit by
increasing output
If MR < MC,
The monopoly can increase profit by decreasing its output

15-19
Profits and Monopoly
The monopolist will make a profit if price
exceeds average total cost.
The monopolist will make a normal return if
price equal average total cost.
The monopolist will incur a loss if price is
less than average total cost.
Determining the Monopolist’s Price and
Output
Price MC
Monopoli
$36 st price
30
24
18
12
6 D
0
6 1 2 3 4 5 6 7 8 9 10
12 MR
A Monopolist Making a Profit
Price MC

ATC
PM A
Profit
CM B

MR D
0 QM Quantity
A Monopolist making Normal Profits
Price MC
ATC

PM

MR D
0 QM Quantity
A Monopolist Making a Loss
Price MC ATC

CM B
Loss A
PM

MR D
0 QM Quantity
Profit Maximization
The monopoly firm will not set the price
arbitrarily high, the profit-maximizing price
still corresponds to the point where MR=MC.

The monopoly firm’s market power will

allow the firm to achieve above-normal
profits.
Profit Maximization
The Price-Discriminating Monopolist
Price discrimination is the ability to charge
different prices to different individuals or
groups of individuals.
The Price-Discriminating Monopolist*
In order to price discriminate, a monopolist
must be able to:
 Identify groups of customers who have
different elasticities of demand;
 Separate them in some way; and

 Limit their ability to resell its product

between groups.
The Early Bird Gets a Lower Price
Early Bird Specials—
Restaurants charge
special, lower prices
for early diners.
Matinees—Theaters
charge less for
earlier shows.
Air Fares—Airlines
charge less for flyers
willing to fly “off
peak,” i.e. early
morning and late
night.
PD possible and Profitable
Nature of Commodity
Long Distance tariff barriers
Prejudices of buyers
Ignorance/laziness
PD profitable
Difference in elasticity of demand in different
markets
Brain Teaser
Market A
Market B
Ea =2 Eb = 5
AR =15
AR = 15

MR in market B
MR in market A

= ARa (ea-1)/ea ARb (eb-1)/eb

=15(5-1/5)

=15(2-1)/2 = 12
Monopolist transfers units from relatively
less elastic markets to more elastic markets
Loss in revenue= Rs7.5
Gain in Revenue = Rs 12
Net gain 12-7.5= Rs 4.5 per unit
Conditions of Equilibrium under PD
Equilibrium under PD
1. AMR= MC
2. MR1=MR2= MC
3. Aggregate Output determined at AMR= MC
Aggregate output will be distributed in such a
way that MR in both markets is equal
 P1
P2
AR
price

E
AR2
AMR
AR1 MR2
MR1
O M2 O M
O M1
Outpu Output Output
t
Price Discrimination in Action
Monopolistic Competition
Features
Many Sellers
Product Variation
Selling Costs
Freedom of Entry and Exit
Concept of A group
Monopolistic Competition
 Markets of monopolistic
competition are those that
have features of both
competition and monopoly.
 It is the most common type of
market structure.
Characteristics of Monopolistic
Competition

 Many sellers
 Differentiated

products
 Free entry and exit
 Many Sellers
 There are many firms
competing for the same group
of customers.
 Examples: CDs, movies,
restaurants, furniture, etc.
Differentiated Products
Each firm produces a product
that is at least slightly different
from those of other firms.
Rather than being a price
taker, the firm can change its
output and consequently
influence the price of the
product.
Free Entry or Exit

 Firms can enter or exit the

market without restriction.
 It is the striking difference

from the monopolistic market

which has high barriers to
entry and exit.
Demand Curves
A Perfectly A Monopolistically
Competitive Firm Competitive Firm
Price Price

D=P=AR=MR

D=P=AR

0 Quantity of 0 Quantity of
Output Output
Profit Maximization for Monopolistic
Competitors

Price
MC
ATC

Price
Average
total cost
Profits D
MR

0 Profit-maximizing
Quantity
quantity
Loss Minimization for Monopolistic
Competitors

Price ATC
MC

ATC
Price
Losses
D
MR

0 Loss-minimizing
Quantity
quantity
The Long-Run Equilibrium
Firms will enter and exit
until the firms are making
exactly
zero economic profits.
A Monopolistic Competitor
in the Long Run
Price
MC
ATC

P=ATC

Demand
MR
0 Profit-maximizing Quantity
quantity
Economic Profits and Monopolistic
Competition
Economic profits encourage new
firms to
enter the market. The entry will:
Increase the number of products
offered.
Reduce demand faced by firms already
in the market.
Shift the demand curve to the left.
Decrease economic profit to zero in the
long run.
 Long Run Equilibrium of Monopolistic Firm

E MC
AC
Price

O M M1
Output
EXCESS CAPACITY
Oligopoly
Definition:
“Competition among few “
Types
- Pure
- Differentiated Oligopoly
Examples
Automobile industry, Crude Oil
Oligopoly
Features
Interdependence
Importance of Selling Costs
Group Behavior
Profit maximizing behavior may not be valid
Interdeminate Demand Curve
Conjectural variations decide shape of
demand curve
No single solution of equilibrium of price and
output.
Different models of Oligopoly
Ignoring Interdependence
Cournot / Bertrand
Predicting Reaction Patterns of competitors
- Kinked Demand Curve
Collusive Oligopoly
- Price Leader/Cartel
-Non Cooperative Equilibrium
 Oligopoly Models
Oligopoly

Collusiv
Non
e
collusive

Price Cournot
Cartel
leadership Dominant

Low Cost Bertrand

Barometr
Chamberli
ic
n

Paul Sweezy kink

Motivations for
Collusion
a) Decrease competition, achieve monopoly-like behavior
b) Decrease uncertainty
c) Decrease ease of entry

Case of the centralized

cartel...
(perfect collusion)
 Collusion
Decision making is carried on by the central organization. It sets price
and output. (The ideal case is illegal in the U.S. and seldom reached,
probably, elsewhere.)

Firm A Firm B Industry

$ $ $
MCa MC
ACa
MCb
ACb

MR D
0 Qa X 0 Qb X 0 Qc X
Objective: Minimize industry costs for any given
output. Allocate quotas to members so the MC of each
producing firm at its quota output is equal to MC of
Theory of Cartels
The key to a very high price is the
inelasticity of demand.
The cartel’s inelastic demand depends
upon:
 world Ed for the product
 E of supply of competing non-cartel
producers
A successfully high price starts all these factors gradually working
 the
against thecartel’s
cartel. The share of the
world searches for world
substitute,market
non-cartel
producers to try to increase supplies and decrease the cartel’s
market share.
Motivation for
Independent Action
If a single firm can successfully break away from the cartel, and gain
more customers by lowering price and increasing sales beyond its
former quota, it increases profits. If everybody breaks, the old pre-
cartel problems reappear.

Firm A Firm B Industry

$ $ $
MCa MC
ACa
MCb
D ACb

MR
MR D
0 Qa Qa X 0 Qb X 0 Qc X
Collusive Oligopoly
Cartel As A cooperative model
Firms Jointly fix a price through agreements
Outputs allocated to firms that minimize
costs and keep MC equal
Theory of Cartels
The key to a very high price is the
inelasticity of demand.
The cartel’s inelastic demand depends
upon:
 world Ed for the product
 E of supply of competing non-cartel
producers
A successfully high price starts all these factors gradually working
 the
against thecartel’s
cartel. The share of the
world searches for world
substitute,market
non-cartel
producers to try to increase supplies and decrease the cartel’s
market share.
Motivation for
Independent Action
If a single firm can successfully break away from the cartel, and gain
more customers by lowering price and increasing sales beyond its
former quota, it increases profits. If everybody breaks, the old pre-
cartel problems reappear.

Firm A Firm B Industry

$ $ $
MCa MC
ACa
MCb
D ACb

MR
MR D
0 Qa Qa X 0 Qb X 0 Qc X
Collusive Oligopoly
Cartel Sharing Arrangements
 Non price Competition
 Uniform Price
Competition on no price basis
Cartels break Down due to strong incentive to
cheat
Cost differences among firms make Cartels
unstable
Cartels: bad and ubiquitous
“People of the same trade
seldom meet together, even for
merriment and diversion, but
the conversation ends in a
conspiracy against the public,
or some contrivance to raise
prices.”
— Adam Smith

61
Why cartels form
firms form a cartel so that they can raise profits
they earn greater profit by coordinating their
activities rather than acting independently

62
Why cartels can raise profits
if a firm is maximizing its profit, why should joining a
cartel increase its profit?
a firm is already choosing output (or price) to
maximize its profit
however, it ignores effect that changing its output level
has on other firms’ profits
cartel takes into account how changes in one firm's
output affect cartel profits

63
So the firms have an incentive to cheat and
produce higher output, if all firms follow the
suit Cartel might collapse
Increased
Profits
when firm PRICE
cheat
r
p
h
t

Q O Qm
q1
Output
OPEC A case study of Cartel

Formed In 1973
Opec countries Share more than 50% of
world output
Non member countries cannot increase their
supply in short run
Demand for oil in short run inelastic
OPEC by cutting outputs maintained higher
crude prce regimes through out seventies
A case study of Cartel OPEC
Substantial increase in wealth of non Opec
countries
In seventies prices climbed from $4 to $10, to
$12to over $30per barrel
End of seventies saw breaking of Cartel,
higher prices drove non OPEC countries to
produce more which drove down prices
Decline of OPEC oil exports dropped from27
million tons a day in 1973 to 15million by
1985
Price leadership Under Dominant Firm
 A firm having large market Share
Small firms are followers
Dominant firm fully aware of its competitors
supply position
Superior due to low cost technology,
entrepreneur ability
Fringe firms price takers
The Dominant Firm Model (1)
P Sf

0 Q
The Dominant Firm Model (2)

P MC=Sf

MC L

DL

MR L D

0 Q
The Dominant Firm Model (3)

P MC=Sf

MC L

P* DL

MR L D

0 Qf QL Q
Cournot Duopoly
Framework
Two Identical mineral springs
Zero marginal cost
Homogeneous product
Duopoly fully aware of market demand
“ Conjecture
“Regardless of his action the rival firm will
keep his o/p constant.”
Cournot Duopoly
Framework
Two Identical mineral springs
Zero marginal cost
Homogeneous product
Duopoly fully aware of market demand
“ Conjecture
“Regardless of his action the rival firm will
keep his o/p constant.”
Here’s the intuition behind what the dominant
firm is doing in setting its price.
In this context, the dominant firm is choosing not
to produce as much output as it is capable of, in
order to avoid driving down the market price.
In doing so, however, the dominant firm is ceding
some market share to the competitive (price‐
taking) fringe supplier.
 While the dominant firm could drive that fringe
(or most of it) out of the market entirely, this is
not a profit‐maximizing strategy because the
dominant firm would have to lower its price too
much for all the units it already sells.
Cournot Duopoly
M

K
P
P’
P” G L

MR D

O MR A
T
N b
Cournot Duopoly

MD = DD curve
ON= ND ie half of dd curve
Firm A enters and sets profit maximizing op AT
ON
(Mra = MC)
Profits = ONPK
Price =OP
 Firm B enters business only KD demand curve is
available
Sets o/p assuming firm A will continue to produce
ON=1/2 OD
 B produces NH=1/2(ND)
Total o/p= ON+NH=OH
Output Increases and price falls
 New price OP”
New profits OP”HL
Firm A profits= ONGP”
Firm B= NLGH
 A will reconsider by assuming B output level at NH
A will produce ½(OD-NH) which is less than ON
Consequent fall in output will increase price
 B will reconsider and again change1/2(od- ouput of A)
After readjustments and adjustments
Market equilibrium will be 2/3 OD\
Each firm producing 1/3
 If this was monopoly output at ON
Price at OP” and profits much higher
With duopoly profits are lower
Price is lower
Output is higher
 Sweezy’s kinked demand curve
model of oligopoly
Assumptions:
1. If a firm raises prices, other firms won’t
follow and the firm loses a lot of business.
So demand is very responsive or elastic to
price increases.
2. If a firm lowers prices, other firms follow
and the firm doesn’t gain much business.
So demand is fairly unresponsive or
inelastic to price decreases.
The Kinked Demand Curve
$

P*

D
quantity
Q
*
The Kinked Demand Curve
$

P*

D
quantity
Q
*
MR Curve
for the top part of the Demand Curve
$
D
P*
MR

quantity
Q
*
Drawing MR Curve
for the bottom part of the Demand Curve
$

P*
MR

D
quantity
Q*
MR Curve
for the bottom part of the Demand Curve
$

P*
MR

D
Q* quanti
ty
The Kinked Demand Curve
and the MR Curve
$

P*
MR

D
Q* quanti
ty
The MC curve intersects the MR curve
in the vertical segment.
$
MC
P*
MR

D
quantity
Q*
If costs shift up slightly, but MC still intersects
MR in the vertical segment, there will be no
change in price.
$ MC This price
’ rigidity is seen
MC in real world
P* oligopoly
markets.

D
quantity
Q* MR
The ATC curve can be added to the graph.
To show positive profits, part of ATC curve
must lie under part of the demand curve.

$
MC ATC
P*

D
Q* MR quantity
Theory of Games
The payoff of many actions depends
upon the actions of others
For example, an imperfectly
competitive firm must weigh the
responses of rivals when deciding
whether to cut their prices
The decisions of competing firms
are often interdependent

88
Game theory
A mathematical technique for analyzing
the decisions of interdependent
oligopolistic firms in uncertain situations.
A “game” is simply a competitive situation
where two or more firms or individuals
pursue their interests and no person can
dictate the final outcome or “payoff”.
Players choose their strategy without
certain knowledge of the other players
strategies, but may eventually learn which
way the opposition is leaning.

89
Elements of a Game
Basic elements
The players
The strategies
The payoffs
Payoff matrix
The fundamental tool of game theory.
This is simply a way of organizing the
potential outcomes of a given game in a
table that describes the payoffs in a game
for each possible combination of
strategies

90
Strategies
Dominant strategy
 A strategy that yields a higher payoff no matter
what the other players in a game choose
Dominated strategy
 Any other strategy available to a player who has a
dominant strategy
Nash Equilibrium
 Any combination of strategies in which each
player’s strategy is his best choice, given the other
players’ strategies
 IOW: Nash equilibrium is achieved when all
players are playing their best strategy given what
the other players are doing.

91
A simple game and payoff matrix
Duopoly situation – each of the two firms A
and B must decide whether to mount an
expensive advertising campaign.
If each firm decides not to advertise, each
will earn a profit of $50,000.
If one firm advertises and the other does
not, the firm that does will increase its
profits by 50% to $75,000, and drive the
competition into a loss.
If both firms advertise, they will earn
$10,000 each because the advertising
expense forced by competition wipes out
large profits

92
Example continued…
If firms could agree to collude, the
optimal strategy would obviously be to not
advertise – maximize joint profits =
$100,000
Let’s assume they cannot collude, and
therefore do not know what the competition is
doing.

A “Dominant Strategy” is the one that is

best no matter what the opposition does.
93
The Payoff Matrix
Firm B
Don’t Advertise Advertise

Don’t A profit = $50 A loss = $25

Advertise
Firm A B profit = $50 B profit = $75

Advertise
A profit = $75 A profit = $10

B loss = $25 B profit = $10

94
New Game: “The Prisoner’s Dilemma”
 You and your friend Deepak are the prime suspects for
knocking over a liquor store. The cops pick you up, and
immediately after your arrest you and Deepak y are
separated and questioned individually by the police .
Without a confession, the police has insufficient evidence
for a conviction. During your interrogation, you are told
the following:

 The police do have sufficient evidence to convict you and

Bugsy of a lesser crime.
 If you and Deepak both confess to the liquor store heist,
you will each get a 5 year sentence.
 If neither of you confesses, you will each be charged with
the lesser crime, and sent up the river for 1 year.
 If Deepak confesses (turns state’s evidence) and you do
not, Deepak will go free while you will be convicted of
the liquor store robbery and get sent to the big house for
7 years.
 Deepak is told the exact same information.
 What will you do?

95
The Payoff Matrix
You
Don’t Confess Confess

Don’t Deepak = 1 Deepak =7

year years
Confess
Deepak You = 1 year You = Free

ConfessDeepak = Deepak =5
Free years

You = 7 years You = 5 years

96
Prisoner’s Dilemma
Prisoner’s Dilemma
Each player has a dominant strategy
It results in payoffs that are smaller than if
each had played a dominated strategy
Produces conflict between narrow self-
interest of individuals and the broader
interest of larger communities

97