Unit 4 Overview: Imperfect Competition

Unit 4 Overview: Imperfect Competition

Image from Pixabay

Unit 4 is hard. 

Unit 4 is confusing. 

Unit 4 earns 5s. 

-a Micro Haiku

Do not push into Unit 4 until you are comfortable with Unit 3, especially 3.7. Don't be afraid to go back and review Perfect Competition graphs and concepts before proceeding into Imperfect Competition. Make sure you have memorized Unit 3 cost calculations and graphs in the short-run and long run. Plan to take your time in Unit 4. It's well worth your time and effort to get this right because this section WILL appear on the SAQs. Remember to click on the section hyperlinks for a more detailed explanation of the topics. 

Unit 3 covered perfectly competitive markets. However, unit 4 turns that on its head by removing some of the assumptions of perfect competition. What happens when there aren't many firms? What happens when barriers to entry exist? What happens when there are differentiated products? Different answers to these questions will give rise to our main market structures in this unit:

1. Monopolies / Natural Monopolies / Price-Discriminating Monopolies

2. Monopolistic Competition

3. Oligopolies

4.1 Introduction to Imperfectly Competitive Markets 

4.1 reminds you of your friendly, perfect competition market structures, and then it breaks it. While the perfect competition market structure allows everyone to play on the playground, imperfect competition market structures put up fences and charge for admission with Barriers to Entry (geography, common use, government, and economies of scale). 

There's a legitimate reason why you can open up a competing waste disposal company to compete against the municipal company, but it means you won't make that sweet profit either. 4.1 is going to give you the characteristics of market structures. In general, firms can sometimes make a long-run economic profit if there is less competition because firms get to be "price makers" and can utilize non-price competition tactics (such as advertising). 

The big takeaway is that all of the imperfect market structures are inefficient. There will always be deadweight loss with one big exception (4.3). 

Graphs Learned: 

None...yet. 

 

4.2 Monopolies

And here we go… A monopoly is a market structure where there is only one firm producing a product. The firm IS the Industry! They keep the competition out with super high barriers to entry and can earn economic profit in the long run. In some cases, a monopoly is the result of a government decision. You don't want a ton of power plants producing because that will impact the environment. Thus, the government may award a company a natural monopoly to keep costs low. We'll be revisiting this idea in Unit 6. Sometimes, the government can create a monopoly by awarding an individual or company a patent, and they become the sole producer of a unique product. 

Image from Pixabay

What keeps a monopolist from charging outrageous prices? For example, Luxottica has a monopoly on eyeglasses frames and is the price maker, yet most people can still afford glasses. The price-makers set the prices higher than they could be (glasses are expensive!), but not so expensive that most people can't have them. Because at the end of the day, the monopolist still needs you to buy their product, which means the MR line will not equal the Demand curve. 

MR. DARP has been chopped in two! We now have MR and DARP. If glasses become too expensive, consumers will find substitutes or go without, so the monopolist produces just enough to maximize profit (MR=MC), BUT they raise the price from the profit maximization point to the Demand curve! This means a regular monopoly will be both productively inefficient AND allocatively inefficient.  

Graphs Learned: 

Monopoly (take your time on this!) 

Natural Monopoly (revisited in Unit 6)

4.3 Price Discrimination

When we go to buy something, we typically have a price range in mind. When you go to a food truck to buy a taco, you know that the taco could be as low as $2 and as high as$10. If you see the price is $12.95, you'll walk away from the truck and leave them a lousy review on Yelp! What if the monopolist could see into your mind and know the upper limits of what you are willing to pay and adjust the price before you arrived? You walk up to the truck and see the taco will cost you$10. You aren't happy about it, but you get the taco, and the monopolists receive the profit. 

The price discrimination described happens in specific industries because everyone pays a different price for the same good. Pretty cool trick, right? To pull it off, the monopolist must keep a few rules. 

1. Go to have a monopoly- otherwise, people can easily go to your competitor.
2. You have to be able to segregate your market (i.e., make purchase negotiations private). No one knows the price the other person paid.
3. The item can't be resold.

Price will equal D, which means no deadweight loss. The big loss is the consumer surplus. A price discriminating monopoly will not have any consumer surplus!   

Graphs Learned: 

Price discriminating monopoly

4.4 Monopolistic Competition

While the name would suggest monopoly, this market structure functions closer to perfect competition than the other imperfect market structures. These industries are still inefficient price makers, yet they have lower barriers to entry, differentiated products and will break even in the long run. They have aspects of both perfect competition AND monopolies. Think fast-food burgers, for example. 

It is relatively affordable to open a fast-food franchise compared to opening a nuclear power plant; everyone may sell the same products, BUT they are not identical. Each company has its own spin on burgers, fries, and drinks. Some make their burger patties square, some make giant stacks of meat and cheese on them, some do a different direction and make the burger out of chicken or plant-based materials. How do you compete when your products differ? Advertise (AKA non-price competition) 

"I'm lovin' it!" 

"Where's the beef?" 

"Pizza, Pizza!"

"Eat Mor Chikin" 

Advertising jingles will be lodged in your head much longer than economics, but at least they will help you understand how this market structure functions. 

Graphs Learned: 

Monopolistic Competition 

4.5 Oligopoly and Game Theory 

An oligopoly's graph is so confusing that AP doesn't require you to know it. An oligopoly functions like a monopoly, but it's a small group (less than 10) of companies that make the price. It's usually a group of less than ten, and they are frenemies. They are competing against each other yet also work together in some ways to keep others out. Think of the airline industry in the USA. 

There are maybe 5 to 6 airlines that all own major hubs and dominate the market. They can't directly work together to control the price. That's called collusion and is illegal in most nations. We see collusion in other markets, like the illegal drug market, where cartels work together to control prices. The oligopolies we will be studying, however, are non-colliding oligopolies. 

Non-colluding oligopolies can't directly work together to control prices, but they can make educated guesses about what the other companies will do and plan to react. This decision-making process is called Game Theory. In-game theory, we are looking to see if any of the companies have a dominant strategy. It can be tricky at first, but most micro students consider this their strongest aspect of Unit 4. 

  

Graphs Learned: 

Game Theory Matrix + Nash Equilibrium + Dominant Strategies