Imperfect competition exists when individual firms believe they face downward-sloping demand curves. The most important forms are monopolistic competition, oligopoly and pure monopoly.
Pure monopoly status can be conferred by legislation, as when an industry is nationalized or a temporary patent is awarded. When minimum efficient scale is very large relative to the industry demand curve, this innocent entry barrier may be sufficiently high to produce a natural monopoly in which all threat of entry can be ignored.
At the opposite extreme, entry and exit may be costless. The market is contestable, and incumbent firms must mimic perfectly competitive behaviour to avoid being flooded by entrants. With an intermediate size of entry barrier, the industry may be an oligopoly.
Monopolistic competitors face free entry and exit to the industry but are individually small and make similar though not identical products. Each has limited monopoly power in its special brand. In long-run equilibrium, price equals average cost but exceeds marginal revenue and marginal cost at the tangency equilibrium.
Oligopolists face tension between collusion to maximize joint profits and competition for a larger share of smaller joint profits. Collusion may be formal, as in a cartel, or informal. Without credible threats of punishment by its partners, each firm faces a temptation to cheat.
Game theory analyses interdependent decisions in which each player chooses a strategy. In the Prisoners’ Dilemma game, each firm has a dominant strategy. With binding
commitments, both players could do better by guaranteeing not to cheat on the collusive
solution.
A reaction function shows one player’s best response to the actions of other players. In Nash equilibrium reaction functions intersect. No player then wishes to change his decision.
In Cournot behaviour each firm treats the output of its rival as given. In Bertrand behaviour each firm treats the price of its rival as given. Nash-Bertrand equilibrium entails pricing at marginal cost. Nash-Cournot equilibrium entails lower output, higher prices and profits. However, firms still fail to maximize joint profits because each neglects the fact that its output expansion hurts its rivals.
A firm with a first mover advantage acts as a Stackelberg leader. By deducing the
subsequent reaction of its rival, it produces higher output, knowing the rival will then have to
produce lower output. Moving first is a useful commitment.
Innocent entry barriers are made by nature, and arise from scale economies or absolute
cost advantages of incumbent firms. Strategic entry barriers are made in boardrooms and
arise from credible commitments to resist entry if challenged. Only in certain circumstances
is strategic entry deterrence profitable for incumbents.
