3.

10301

FOUNDATION
ECONOMICS

TOPIC 7 :
FIRM BEHAVIOR:
IMPERFECT COMPETITION

Objectives
At the end of this unit, you should be able to:
define imperfect competition, monopoly,
monopolistic competition, and oligopoly.
determine the profit maximizing level of output
and price for the pure monopolist given
demand and cost data.
describe output and price for a monopolistic
firm in the short run and long run.
describe using graphs, price and output
determination under the various oligopoly
models.

Introduction
In Unit 6 we discussed pure competition. In this unit we
begin our explanation of the price and output decisions
of firms under the opposite extreme of the market
structure spectrum; monopoly.
A monopoly arises when there is only a single in the
industry. A monopolist output and price decisions are
analysed using the method of analysis used in Unit 6.
A monopolist faces a downward sloping market demand
curve because it is able to sell more by lowering price.
Therefore the monopolistic firm has market power.
In between pure competition and monopoly are the other
types of market structure such as monopolistic
competition and oligopoly

Introduction
Monopolistic competition exhibit elements of both
pure competition and monopoly, where firms
possess some degree of market power
(monopoly element) and a high degree of
competition (pure competition element).
A monopolistically competitive firm possess
some degree of market power because it is able
to sell differentiated products.
An oligopolistic industry is characterized by
relatively few firms which dominate the market.
This tends to be the case in many economies.

Monopoly
A monopolistic firm is the only supplier in the
industry. A monopoly is characterized by the
following:
One seller,
There are no close substitutes,
Price setter since the monopolist faces a
downward sloping demand curve, and
There are no barriers to entry may be because
of government policy preventing competition or
firms preventing competition to remain the sole
suppliers

Monopoly

Fig 1

Fig 2

Because the monopolist

provides all the output, any
increase in output would have
to be matched by falling prices
to enable the monopolist to sell
the additional output. In other
words, in order to sell the
increased output the
monopolist will charge a lower
price.
Therefore the monopolist faces
a downward sloping demand
curve (Figure 1). As output
increases and price falls, total
revenue (TR) will increase less
than proportionately with
output (Figure 2)

Monopoly

Fig 3

A perfectly competitive firm

maximizes profits by producing
an output level where MC
equals MR and MR also
equals price.
Likewise, a monopolist also
maximizes profits by producing
a level of output where MC
equals MR but in this case MR
is lower than price.
Notice that in Figure 3, the
monopolist is making a profit
because where MR equals
MC, price exceeds AC.

Illustration: South Pacific Brewery

Table 1

Cartons
(thousands)

Price

Total

Marginal
Revenu
es
(K000)

Revenu
es
(K000)

Total Costs
(K000)

Marginal
Cost
(K000)

K 100

K 100

K 90

K 180

K 80

K 170

K 20

K 85

K 80

K 240

K 60

K 200

K 30

K 67

K 70

K 280

K 40

K 240

K 40

K 60

K 60

K 300

K 20

K 290

K 50

K 58

K 50

K 300

K 350

K 60

K 58

K 150

Average costs
(K000)

K 150

Table 1 gives the demand curve facing SP Brewery which has a monopoly
on the production of beer in PNG. The table shows that each level of price
the company will charge a particular price. The company will sell more as
it lowers its price. For simplicity, we will assume that SP beer is sold in 24
bottle cartons at a price of K100 each to retailers

Illustration: South Pacific Brewery

Table 1

Cartons
(thousands)

Price

Total

Marginal
Revenu
es
(K000)

Revenu
es
(K000)

Total Costs
(K000)

Marginal
Cost
(K000)

K 100

K 100

K 90

K 180

K 80

K 170

K 20

K 85

K 80

K 240

K 60

K 200

K 30

K 67

K 70

K 280

K 40

K 240

K 40

K 60

K 60

K 300

K 20

K 290

K 50

K 58

K 50

K 300

K 350

K 60

K 58

K 150

Average costs
(K000)

K 150

It is clear from Table 1 and that where MR equals MC, price per carton of
beer (K70) exceeds average costs (or cost per carton of beer) (K60) by
K10 per carton of beer. SP Brewery will maximize profits by selling 4,000
cartons at K70 per carton at a unit costs of K60 thereby generate K10 per
carton of beer profit. Monopoly profits are equal to K40,000 (= (K70
K60)*4,000 cartons of beer). Therefore the monopolists objective is to
maximize profits by setting MR equal to MC so price exceeds MC and AC .

Monopoly
Fig 4

Monopolist also engage is price discrimination to

increase profits. This practice is demonstrated in Figure
4. Supposing SP Brewery also sells its product in Fiji and
recognizes that the demand curve it faces in both
countries is different. Given the same marginal cost, SP
Brewery will charge a higher price in Fiji than in PNG.

Price & Output under monopolistic

competition
Monopolistic competition refers to the market
organization in which there are many firms selling closely
related but not identical commodities.
An example of this is given by the many cigarette
brands available (e.g., Kool, B & H, Cambridge, etc).
Another example is given by the many different
detergents on the market (e.g., Dazzle, Kuat Harimau,
Tide, etc).
Because of this product differentiation, the seller has
some degree of control over the price he or she charges
and thus faces a negatively sloped demand curve.
However, the existence of many close substitutes
severely limits the sellers monopoly power and results
in a highly elastic demand curve.

Short-run equilibrium under

monopolistic competition

Fig 5

Since a firm in a monopolistically competitive industry faces a highly

elastic but negatively sloped demand curve for the differentiated
product its sells, its MR curve will lie below its demand curve. The
short-run equilibrium level of output for the firm is given by the point
where its SMC curve intersects its MR curve from below (provided
that at this output level p > AVC). ( Figure 5).

Long-run equilibrium under

monopolistic competition

Fig 6

If the firms in a
monopolistically competitive
industry received economic
profits in the short run, firms
will enter the industry in the
long run. This shifts each
firms demand curve down
(since each firm now has a
smaller share of the market)
until all profits are squeezed
out. The opposite occurs if
firms suffered losses in the
short run. (see Figure 6).

Price and output under oligopoly

Oligopoly is the market organization in which
there are few sellers of a commodity. So, the
actions of each seller will affect the other sellers.
As a result, unless we make some specific
assumptions about the actions of other firms to
the actions of the firm under study, we cannot
construct the demand curve for that oligopolist,
and we will have an indeterminate solution.
For each specific behavioural assumption we
make, we get a different solution. Thus, we have
no general theory of oligopoly. All we have are
many different models, most of which are more
or less satisfactory.

The Cournot and Bertrand model

In the Cournot model, we begin by assuming (with Cournot) that

there are two firms selling spring water under conditions of zero
costs of production. Therefore, the profit-maximizing level of sales
of each firm occurs at the midpoint of its negatively sloped straightline demand curve, where elasticity equals 1 and TR is maximum.
The basic behavioural assumption made by Cournot is that each
firm, in attempting to maximize its total profits or TR, assumes that
the other firm will hold its output constant. Faced with this
assumption, there will be a number of converging moves and
countermove by the two firms until each of them sells exactly 1/3 of
the total amount of spring water that would be sold if the market had
been perfectly competitive. (See Figure 16.2 in Stiglitz chapter 16, p.
437).
If, in determining its best level of output, each firm assumes that the
other holds its price (rather than its output) constant, we have a
Bertrand model . (See Figure 16.3 in Stiglitz chapter 16, p. 438).

The kinked demand curve model

As a further development toward more realistic models,
we have the kinked demand curve, or Sweezy model.
This tries to explain the price rigidity often observed in
oligopolistic markets. Sweezy postulates that if an
oligopolist firm increases its price, others in the industry
will not raise theirs and so the firm would lose most of its
customers.
On the other hand, an oligopolistic firm cannot increase it
share of the market by lowering its price since the other
oligopolies in the industry will match the price cut.
Thus there is a strong compulsion for the oligopolist not
to change the prevailing price but rather to compete for a
greater share of the market on the basis of quality,
product design, advertisement and service. (See Figure
16.4 in Stiglitz chapter 16, p. 440).

Other oligopolistic models

Other models not covered in this course
include, the Edgeworth model,
Chamberlain model, Centralised Cartel
model, Market-Sharing Cartel model, and
the Price Leadership model.

References
Joseph Stiglitz, 1993, Principles of Micro
Economics, WW Norton & Company, New
York, USA.
H.G.Mannur, Foundation Economics,
1995, Economics Department, University
of Papua N