4.1 Introduction

Even with a common goal of profit-maximization, market structure constrains and influences prices, output, and efficiency. Imperfectly competitive markets include monopoly, oligopoly, and monopolistic competition in product markets and monopsony in factor markets.

In imperfectly competitive output markets and assuming all else is constant, a firm must lower price to sell additional units.

In imperfectly competitive markets, consumers and producers respond to prices that are above the marginal costs of production and/or marginal benefits of consumption (i.e., price is greater than marginal cost in an inefficient market).

Incentives to enter an industry may be mitigated by barriers to entry. Barriers to entry — such as high fixed/start-up costs, legal barriers to entry, and exclusive ownership of key resources — can sustain imperfectly competitive market structures.

According to the Wikipedia, in economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfill at the necessary conditions of a perfectly competitive market, resulting in market failure.

If one of the following conditions are satisfied within an economic market, the market is considered “imperfect”:

• The market’s goods and services are heterogenous or differentiated.
• The market contains ONE or few sellers
• Barriers to make entry or exit.
• Firms are NOT price takers
• Fewer, large firms in the industry
• Firms earn long-run profits (except monopolistic competition, which break even in the long-run)

4.2 Monopolies

One large (e.g., Standard Oil and Electronic Company) firm in the market and the firm is the market.

A monopoly exists because of high barriers to entry.

Monoplies are “price makers”

In a monopoly, equilibrium (profit-maximizing) quantity is determined by equating marginal revenue (MR) to marginal cost (MC). The price charged is greater than the marginal cost.

In a monopoly graph, the demand curve is located above the marginal revenue cost curve. This is because they have to lower their price in order to sell each additional unit. Their profit-maximizing profit output is where MR=MC. The price is determined by going from where MR=MC, up to the demand curve.

Let’s check out the monopoly graph.

library(DT)
P = seq(from = 14, to = 2, by = -2)
Q = seq(0, 6, 1)
TR = P*Q # elementwise multiplication
MR = c(0,diff(TR))
df = as.data.frame(cbind(P,Q,TR,MR))
datatable(df, rownames = FALSE)

library(ggplot2)
df[2:nrow(df),]%>%
  ggplot(., aes(x=Q)) +
  geom_line(aes(y=P), col='blue') +
  geom_line(aes(y=MR), col='red') +
  geom_line(aes(y=TR), col='orange') +
  geom_vline(xintercept = 4)+
  #geom_smooth(aes(y=TR), col='orange', method = 'lm', formula = y ~ poly(x, 2), se = FALSE) +
  theme_bw()

4.3 Price discrimination

In a competitive market, price discrimination occurs when identical goods and services are sold at different prices by the same provider.

A firm with market power can engage in price discrimination to increase its profits or capture additional consumer surplus under certain conditions.

There are three conditions that need to be present in order for a monopoly to practice price discrimination:

• The firm must have monopoly power
• The firm must be able to segregate the market
• Consumers cannot easily re-sell the product in the market
  • No facebook market, ebay, carrot market

When a monopoly price discriminates, it becomes allocatively efficient. A pure monopoly always produces less than a perfectly competitive market, meaning its level of output is not allocatively efficient. When a monopoly price discriminates, it earns a higher marginal revenue (MR), so it will increase its output and produce at the allocatively efficient level of output.

By price discriminating, a monopolistic firm will increase its economic profits. A pure monopoly charges a single price, where a price discriminator will charge each consumer at different prices. This eliminates consumer surplus and turns that into revenue, which in turn increases the economic profits that are earned by the firm.

Examples of various situations where monopolies are price discriminating include:

• Travel industry: airlines and other travel companies use price discrimination regularly in order to generate commerce. Prices vary according to seat selection, time of day, day of the week, time of year, and how close a purchase is made to the date of travel.
• Coupons: coupons are used in commerce to distinguish consumers by their reserve price. A manufacturer can charge a higher price for a product which most consumers will pay. Coupons attract sensitive consumers to the same product by offering a discount. By using price discrimination, the seller makes more revenue, even off of the price sensitive consumers.
• A university charging out of state tuition vs in state tuition.
• Gender/Age based prices: uses price discrimination based on gender and age. For example, bars that have Ladies Nights are price discriminating based on gender. A movie theater charging different prices for tickets based on a consumers age.
• A sports team charging different prices for seats in the same section of a stadium.

With perfect price discrimination, a monopolist produces the quantity where price equals marginal cost (just as a competitive market would) but extracts all economic surplus associated with its product and eliminates all deadweight loss.

4.4 Monopolistic competition

In a market with monopolistic competition, firms producing differentiated products may earn positive, negative, or zero economic profit in the short run. Firms typically use advertising as a means of differentiating their product. Free entry and exit drive profits to zero in the long run. The output level, however, is smaller than the output level needed to minimize average total costs, creating excess capacity. The price is greater than marginal cost, creating allocative inefficiency.

Monopolistic competition is an imperfect market structure where many, various sized firms compete for market demand shares. This type of market structure has some characteristics that are the same or similar to perfect competition, as well as some characteristics that are the same or similar to monopolies. Some examples of monopolistic competition include restaurants, clothing companies, jewelers, hair salons, and furniture stores.

Monopolistic competitors can earn positive, negative, or zero economic profit in the short run, and they will break even in the long run (i.e. earn a normal profit) because of low barriers to entry/exit. The graph for a monopolistically competitive firm is very similar to a monopoly, and many people think they look almost identical. The main difference in the elasticity of the demand curve. The demand curve is more elastic in monopolistic competition than it is in a monopoly mainly because there are many more firms in monopolistic competition.

You can see in the graph below that both the demand (D) and marginal revenue (MR) curves are more elastic. We still identify profit-maximizing output and price the same way in monopolistic competition as we do in a monopoly. We identify output where MR=MC, and then go up to the demand curve and over to find the price.

4.5 Oligopoly and game theory

An oligopoly is an imperfect market structure where the industry is dominated by a few, large firms. Some good examples of the types of industries that fall in this type of market structure are the cereal industry, oil industry, and automobile industry.

An oligopoly is an inefficient market structure with high barriers to entry, where there are few firms acting interdependently.

Firms in an oligopoly have an incentive to collude and form cartels.

There are two types of oligopolies that can exist:

• Colluding oligopolies, othewise known as cartels
• Non-colluding oligopolies that practice what we refer to as price leadership