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Lecture 4: Wee
Imperfect Competition & Game Theory Qian
Hui

IMPERFECT COMPETITION
Imperfectly competitive firms have some ability to set their own price: they are price
setters

• Long-run economic profits possible

• Reduce economic surplus

3 TYPES
Has only one seller, no close substitutes

Monopolies exist for economic reasons

1. Monopoly
• Patents, copyrights, and innovation
• Economies of scale
• Network economies
Has many firms producing slightly differentiated products that are
close substitutes
2. Monopolistic
Competition E.g., Restaurants
• Restaurants compete on quality of food as much as price.
Product differentiation is a key element of the business.
Small number of large firms producing products that are identical
or close substitutes

3. Oligopoly E.g., Banking & Petrol industry.

• Shell & Caltex may not be exactly the same
• Banks can make profits in the long run as it is not easy to
enter the industry

COMPARISON
Monopolistic
Oligopoly Perfect Competition
Competition
Number of Few firms,
Many firms Many firms
Firms each large
Price Limited flexibility Some flexibility Price taker
Entry and
Free Difficult Free
Exit
Differentiated or
Product Differentiated Standardized
standardized
Economic
Zero in long run Possible Zero in long run
Profits
P, Q, product P, Q, differentiation,
Decisions Q only
differentiation advertising
MARKET POWER
• Market power is the firm's ability to raise its price without losing all its sales
o But the price must be an amount that consumers are willing to pay. The
higher price you charge, the lesser you can sell.
o Pick the best price and quantity on the demand curve
• Any firm facing a downward sloping demand curve
o Firm picks P and Q on the demand curve
• Market power comes from factors that limit competition

FIVE SOURCES OF MARKET POWER

1. Exclusive control over inputs
• Only one firm can produce the product – give rise to monopoly

2. Patents and copyrights

• You have the exclusive right to produce the product. No one can produce
without your approval.

3. Government licenses or franchises

• If the government only issue one license or one exclusive franchise, only
one producer can exist. (most common reason to monopoly)

4. Economies of scale (natural monopolies)

• More you produce, lower the average cost. You become more efficient
when you produce more output.
• E.g., the power & utility industry.

5. Network economies
• Network economies occur when the value of the product increases as the
number of users increases
• Occurs when more people use your product. Efficiency of production by
one producer.
• E.g., Telephone. When more people use telephones, communication
becomes more efficient.
 ECONOMIES OF SCALE

Returns to scale refers to the percentage change in output from a given percentage change in
ALL inputs (long-run idea)

Constant returns to scale doubling all inputs doubles output

Increasing returns to scale output increases by a greater percentage than the increase in
inputs
the firm becomes more efficient as it scales up production. Consequently,
• Average costs decrease as output increases
• Natural monopoly: a monopoly that results from
economies of scale Best outcome as the company become the most efficient
Decreasing returns to scale doubling all inputs less than doubles output

Economic of Scale & Start-Up Costs:

• New products can have a large, fixed development cost

• Variable cost: sum of payments made to the variable factors, such as labor
o 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 (𝑀𝐶) × 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
o Producing one more unit of the product can lower the variable cost
• Fixed cost: sum of payments made to the fixed factors, such as capital
o 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 (𝑇𝐹𝐶) = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 (𝐹𝐶) + 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 (𝑉𝐶)
𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 (𝐹𝐶)
o 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 (𝐴𝐹𝐶) = 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦

o Start-up costs can be thought of as a fixed cost (extremely high)

o Natural monopoly can occur if FC is extremely high, and VC/MC is very low
• Average total cost (ATC): total cost divided by output
o 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 (𝐴𝑇𝐶) = 𝐴𝐹𝐶 + 𝑀𝐶
o Lowered if there is more output
• A good whose production has a large start-up cost and low variable cost is subject
to economies of scale
o ATC declines sharply as output increases

Economies of Scale in a Graph

ATC curve explains why it is best for

just one big company produce the
whole market

If a lot of firms, the ATC will be at

the higher side of the curve
FIXED COST & MARGINAL COST
• Firms that have high fixed cost and low marginal cost may have tendency to
become monopolist
o High fixed cost creates entry barriers and need high output to average out
the cost
o With low marginal cost, as output increases, average total cost decreases
over a large range of output
• The firm becomes more efficient as production increases  Monopolize the
market
• Eventually, you can set a lower price and kick out competitor in the market.
Resulting in monopoly.

PROFIT MAXIMISATION FOR THE MONOPOLIST

• Like all other firms, a monopolist:
o Maximizes profits
o Applies the Cost-Benefit Principle:
▪ Increase output if marginal benefit > marginal cost
▪ Decrease output is marginal benefit < marginal cost
• Marginal benefit is called marginal revenue:
o Change in total revenue from a one-unit change in output
o Equal to price for the perfectly competitive firm
o Less than price for the monopolist
o MR is always lower than the price for monopoly

MONOPOLIST’S MARGINAL REVENUE

Price Qty TR MR
$6 2 $12
$5 3 $15 3
$4 4 $16 1
$3 5 $15 -1

MONOPOLY DEMAND & MARGINAL REVENUE

• The monopolist's marginal revenue curve:

o Same intercept as the straight-line demand curve
o Has twice the slope of the demand curve
▪ X intercept is half for MR as compared to D
o Lies below the demand curve
o Demand is unique elastic Demand Curve: P = 15 – 2Q

MR Curve: MR = 15 – 4Q
DECIDING QUANTITY

• Optimal Output: MR=MC (Profit Maximised)

o At Q = 8, MC = MR = 2
o At any output below 8, MC < MR
• Price is always given by demand curve
o Best price is $4

MC = Q

MONOPOLY PROFIT
Calculations are the same as Chapter 3:

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 − 𝑇𝐶
𝑇𝐶 = 𝐴𝑇𝐶 × 𝑄
𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑃 × 𝑄) − (𝐴𝑇𝐶 × 𝑄)
𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑃 − 𝐴𝑇𝐶) × 𝑄

• If P > ATC then the firm earns a profit

• If P < ATC then the firm suffers a loss

MONOPOLY LOSSES & PROFITS

All depends whether P is higher or lower than ATC at the optimal output

Loss Profit

The Invisible Hand Fails:

• Invisible Hand only for competitive

market.
• A monopolised market is inefficient
because it creates deadweight loss
MONOPOLY & PERFECT COMPETITION

Monopoly Perfect Competition

MC=MR MC=MR
P>MR P=MR
P>MC P=MC
Deadweight Loss No Deadweight Loss

PRICE DISCRIMINATION
Case Background:

• Consider Clara as the only editor in a university that edits student’s assignment
before submission - Monopoly
• Editing each assignment takes up her time with an opportunity cost of $29
• She can edit the maximum 7 student’s assignments
• She can charge the same price to each student or practice price discrimination.
• Different student has different reservation price for assignment editing

SOCIAL OPTIMUM

Student Reservation Price Total Revenue Social optimal occurs when P = MC

A $40 $40 Maximize social welfare
B 38 $76
C 36 $108 Edit 6 papers, charge $30 each
D 34 $136 Economic profit = $180 – 6($29) = $6
E 32 $160
F 30 $180 All the previous customers must also be
G 28 $196 subjected to the lowered price.

PROFIT MAXIMIZATION

Reservation Total Profit maximization occurs when MR = MC

Student MR
Price Revenue
A $40 $40 $40 Edit 3 papers, charge $36 each
B 38 $76 $36 Economic profit of $108 – 3($29) = $21
C 36 $108 $32
Not the best profit unless you practice
D 34 $136 $28
E 32 $160 $24 price discrimination.
F 30 $180 $20
G 28 $196 $16
PERFECT PRICE DISCRIMINATOR

Reservation Total Marginal Edit 6 papers, charge different price

Student
Price Revenue Revenue for each paper, earns an economic
A $40 $40 $40 profit of $210 – 6($29) = $36
B 38 $78 $38
C 36 $114 $36 Can serve up to customer F
D 34 $148 $34 As long as MR/P>ATC / MC
E 32 $180 $32
F 30 $210 $30
G 28 $238 $28

HURDLE METHOD

• The hurdle method of price discrimination is the practice of offering a discount to

all buyers who overcome some obstacle.
• Assume two groups of consumers, one more price sensitive than the other.

Reservation Total Marginal If reservation price < $36, student will mail
Student
Price Revenue Revenue in rebate
A $40 $40 $40
B 38 76 36 Tier 1 = charge $36, serve 3 customers
C 36 108 32 Tier 2 = charge $32, serve 2 customers
Discounted Price with rebate $4
D $34 $34 $34
E 32 64 30 Economic profit =3($36) + 2($32) – 5($29)
F 30 90 26 = $27

Lower than perfect price discrimination, but more realistic

MONOPOLY & PUBLIC POLICY

• Monopolists tend to create deadweight loss and reduce total economic surplus
• Policy options: (how to prevent monopoly)
o Government ownership and operation
o Regulation
o Competitive bids for natural monopoly services
o Break up monopolist
• Anti-trust laws that enhances competition attempt to limit deadweight loss
o Limiting monopoly has costs (the following are benefits of monopoly)
▪ Patents encourage innovation
▪ Economies of scale minimize ATC
▪ Network economies increase benefits
STATE-OWNED NATURAL MONOPOLY
• Marginal cost is always less than average cost
o Marginal cost pricing produces losses
• Options (to cover losses)
o Fund losses from tax revenues
o Fixed monthly fee & usage fee (helps cover losses)
• Limited incentives to innovate and cut costs
• Commonly used for water, Post Office, and power (electricity)
• If you earn or lose money, it goes to government
• You at most earn salary as manager

REGULATED MONOPOLIES
• Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs
• Used for electricity, telephone, and cable
• Disadvantages
o High administrative cost
o Reduced incentive for cost-saving innovation
o Price is greater than marginal cost (you set a price with a markup that is inefficient)

EXCLUSIVE CONTRACTING FOR NATURAL MONOPOLIES

• Government awards contract to low bidder for natural monopoly services
o Garbage collection, fire protection, road construction, Department of Defense
• Could achieve marginal cost pricing IF government pays the resulting losses
• Administration is complex

BREAK UP MONOPOLIST
• Two objections to monopolies
o Restrict output, decrease total surplus
o Raise price, earn economic profits and exploit consumers
• Policy
o Break up monopolist to introduce competition (e.g. singtel, starhub and M1)
o May undermine economies of scale if there is natural monopoly and discourage
innovation

GAME THEORY
• Basic elements of a game:
o The players (the 2 producers)
o Their available strategies, actions, or decisions
o The payoff to each player for each possible action
• A dominant strategy is one that yields a higher payoff no matter what the other player
does
o A dominated strategy is any other strategy available to a player who has a
dominant strategy
 NASH EQUILIBRIUM

A Nash equilibrium is any combination of strategies in which each player’s strategy is her or his
best choice, given the other player’s strategies

• Equilibrium occurs when each player follows his dominant strategy, if it exists
• Equilibrium does not require a dominant strategy
• Sometimes more than one Nash equilibrium may occur

Thai Airways Options

Singapore Airlines Options Raise Spending No Raise

Singapore: $5,500 Dominant Singapore: $8,000

Raise Spending
Strategy
Thai: $5,500 Thai: $2,000

No Raise Singapore: $2,000 Singapore: $6,000

Thai: $8,000 Thai: $6,000

• Payoff matrix: a table that describes the payoffs in a game for each possible
combination of strategies
• Payoff is symmetric
• Dominant strategy is raised advertising spending (for both companies)
o Both companies are worse off

PRISONER’S DILEMMA

The prisoner’s dilemma is a game in which each player has a dominant strategy, and when
each plays it, the resulting payoffs are smaller than if each had played a dominated strategy

Thai Airways Options

Singapore Airlines Options Raise Spending No Raise

Raise Spending Singapore: $3,000 Singapore: $8,000

Thai: $4,000 Thai: $3,000
Nash
No Raise Singapore: $4,000 Singapore: $5,000
Equilibrium
Thai: $5,000 Thai: $2,000

• Payoff is non-symmetric
• Thailand raises spending. Singapore anticipates Thailand action; does not raise.

Kakuzu’s Options
Hidan’s Options Confess Don’t Confess

Hidan: 5 Years Dominant Hidan: 0 Years

Confess
Strategy
Kakuzu: 5 Years Kakuzu: 20 Years
Don’t Confess
Hidan: 20 Years Hidan: 1 Year Optimal
Strategy
Kakuzu: 0 Years Kakuzu: 1 Year
 Repeated Prisoner’s Dilemma

• In a repeated prisoner’s dilemma, the same players repeatedly face the same
prisoner’s dilemma
• Both players discover benefit from collaboration
o Tit-for-tat strategy limits defections
• A tit-for-tat strategy says my move in this round is whatever your move was in the
last round
o If you defect, I defect. (if you hurt me, I will hurt you)
• Tit-for-tat is rarely observed in the market
o This strategy breaks down with more than two players or potential players

SIMULTANEOUS DECISIONS

Sony Xperia Options

Samsung Galaxy Options Quad Core No Quad Core

Quad Core Samsung: $60M Samsung: $80M Nash

Equilibrium
Sony: $60M Sony: $70M
Nash
No Quad Core Samsung: $70M Samsung: $50M
Equilibrium
Sony: $80M Sony: $50M

• Profits are higher when each company offers a different type of smartphone
• Suppose Sony Moves First (Multistage Method)

• Sony best outcome: ABE

• Samsung best outcome: ABF
• Whoever moves first, whoever will earn $80 mil
THREATS, PROMISES & COMMITMENTS
• A credible threat is a threat to take an action that is in the threatener's best
interest to carry out
• A credible promise is a promise to take an action that is in the promiser's best
interest to carry out
• A commitment problem arises from an inability to make credible threats or
promises
o A commitment device changes incentives to make threats or promises
credible

STRATEGIC ROLE OF PREFERENCES

• Game theory assumes that the goal of the players is to maximize their own
outcome
o In most games, players do not attain the best outcomes
• Altering psychological incentives may improve the outcome of a game

SELF-INTEREST & PREFERENCES

• Exceptions to outcomes based on self-interest
o Revenge
o Passing on "unfair" opportunities
• Preferences are given
o Affect choices through
▪ Sympathy
▪ Generosity
▪ Honesty
• If preferences can be known to the other party, the commitment problem is
reduced