Imperfect competition

Most markets are not considered either monopolies nor perfectly competitive. Economists place markets (industries) along the continuum between these two extremes according to the structure of the industry: How many firms: the concentration ratio Product differentiation Entry barriers - sources and difficulty of overcoming Structure influences what firms do (conduct). Some outcomes are more socially desirable than others (performance).

Concentration Ratio
Measures the extent to which the industry is dominated by a small number of firms. Market share: A firm's market share is its output (or sales) as a percent of industry output (sales) The concentration ratio is the sum of the market shares of the four (8 or 20) largest firms. It equals the output of the four (8 or 20) largest firms as a percent of industry output.

Interpretation
Concentration ratios under 40 indicate competitive industries (which type depends on whether or not the product is differentiated). Concentration ratios of 40-60 indicate weak oligopoly while 80-100 indicates strong oligopoly. The concentration ratio does not distinguish between a four-firm oligoply and a monopoly. Examples

Concentration and market power

In general, high concentration ratios indicate that the firm has market pwoer. Consumers have few alternatives, so the firm can influence the price. Low concntration ratios indicate the firm has many competitors and little control over the price. Concentration ratios are imperfect indicators because they do not include the effects of import competition, inter-product competition, or the effect of regional markets.

Herfindahl Index
An alternative but more precise measure is the Herfindahl index. It is calcualted by squaring the market shares for each firm, then adding the resulting numbers. It can range from close to zero to 10000, with larger numbers representing more concentrated, less competitive industries. The government is now using this index to measure the competitiveness of industries.

Product differentiation
Products are differentiated if the product of one company is perceived as different insome way from the products of other producers. It may be based on Real physical differences in the product such as appearance, product speed or reliability, location. Differences in accompanying services: installation, repair, responsiveness of staff. Perceived differences ("image") created through advertising.

Importance of Product Differentiation
Product differentiation is very important in most consmer goods industries. Brand names are important to people, especially when it is difficut to assess quality before purchase. Product differentiation is less important for producer goods industies (steel, for example) when firms specify the product and/or purchases are made by professional buyers.

Effect of product differentiaion

If the product is differentiated, the firm has more market power, other things being equal. If the firm raises the price, only some consumers will switch to alternatives. Others like this brand enough to pay a bit more. If people think most brands are fairly similar, they would be willing to switch if the price of the alternative was (for example) 50% less. If consumers think the brands are very different, they wouldn't switch.

Entry Barriers -- Economies of scale

Economies of scale crate high barriers to entry if the minimum efficient size plant is large relative to the market and if there is a large cost difference between small and large scale operations. The minimum efficient scale is the smallest output at which long-run average costs are at their minimum level. The maximum number of firms the market can sustain is the total quantity people want to buy at a price equal to minimum average cost divided by the output of one firm at minimum efficient size. (OT/OM on graph)

Economies of scale as a barrier

It is relatively easy to build a small plant. However, such a plant is at a cost disadvantae relative to one at minimum efficient size. New firms have a difficult time finding buyers willing to pay a higher price and aren't profitable at a price as low as large firms can charge. The cost of building a minimum efficient size plant is large. Financing such a large plant is difficult and entry increases market supply so much that profits are eliminated.

Entry barriers --Cost advantages
An establish firms has an absolute cost advantage over a potential entrant if it can produce any output at a lower cost (its marginal and average cost curves are below those of a new firm). Graph. Sources of absolute cost advantages: learning by doing, patents, and control of raw materials. Firms can set a price low enough to discourage entry and still earn a profit.

Barriers to Entry --Product Differentiation

Product differentiation is the largest barrier to entry in most consumer goods industries. Most people make a habit of buying the same brand. To overcome this habit, a new entrant must spend more than an established firm on advertizing, free samples, etc. It has higher costs. These costs are independent of output (they are fixed costs); they create additional cost advantages of operating on a large scale.

Conduct

Imperfectly competitive firms also try to maximize profits. They too will follow the marginal principle: increase output so long as the marginal revenue is greater than the marginal cost. All imperfectly competitive firms are price setters rather than price takers. The degree of control over price varies. All imperfectly competitive firms can sell some a relatively high price but more at lower prices. How much more it can sell (and thus its marginal revenue) depends on the number of firms (number of substitutes), the degree of product differentiation (brand loyalty) and the reaction of other firms.

Monopolistic Competition - Demand

In monopolistic competiton, there are many firms with differentiated products. Concentration ratios are low. Each firm is only a small part of the market. Consequently, its price changes have relatively little impact on each of the other firms. Each firm will make desciions assuming others will not notice or react to what it does. The firm can raise price and still sell some of its product. It must cut the price a little to sell more and/or attract some buyers from alternatives.

Short-run profit-maximizing

Under monopolistic competition, the firm's demand curve is downward-sloping but quite elastic (many substitutes). Marginal revenue is a little less than price because only small changes in price are needed to sell the additional units due to the elasticity of demand. The firm maximizes by producing where MR=MC. The firm sells at the highest price the demand allows. It acts like a little monopoly in the short run. p > MC but the difference is small.

Interdependence

When the number of firms is small, what one does affects the others. If one firm produces a large quantity and lowers the price to sell more, other firms will notice they aren't selling as much as before and will change what they do in response. A firm can't estimate how much it can sell at various prices without knowing what other firms will charge. Strategic interdependence is a key feature of oligopoly.

Oligopolist's Strategy

The oligopolist will estimate how many it could sell at each price (and hence its profits) with different assumptions about competitiors' prices The firm then considers which price/quantity combination is best give different assumptions about competitors: If competitors charge a low price, what price maxmizes this firm's profits? If competitors charge a high price, what price maxiizes this firm's profits? Example