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 effcient 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 to and exit from
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.
