🤑AP Microeconomics Unit 4 – Imperfect Competition

Key Concepts and Definitions

• Imperfect competition refers to market structures that fall between perfect competition and monopoly, where firms have some market power and can influence the price of their products
• Market power is the ability of a firm to raise prices above marginal cost without losing all its customers, and is a key characteristic of imperfect competition
• Barriers to entry, such as high startup costs, patents, or government regulations, can limit competition and give firms market power
• Product differentiation occurs when firms sell products that are similar but not identical, allowing them to charge different prices and target specific market segments
  • Can be based on quality, features, brand reputation, or other factors (location, customer service)
• Profit maximization is the goal of firms in imperfect competition, achieved by setting output where marginal revenue equals marginal cost (MR = MC)
• Allocative inefficiency arises in imperfect competition because firms produce less than the socially optimal quantity and charge prices above marginal cost
• Deadweight loss is the reduction in total economic surplus (consumer + producer surplus) due to allocative inefficiency in imperfect competition

Types of Imperfect Competition

• Monopolistic competition is a market structure with many firms selling differentiated products, relatively low barriers to entry, and some degree of market power
  • Firms in monopolistic competition engage in non-price competition through advertising, branding, and product differentiation (restaurants, clothing retailers)
• Oligopoly is a market structure characterized by a small number of interdependent firms, high barriers to entry, and significant market power
  • Firms in an oligopoly often engage in strategic behavior, such as price leadership or collusion, to maximize profits (airlines, mobile phone carriers)
• Duopoly is a special case of oligopoly with only two firms in the market, leading to intense competition or collusion depending on the nature of the products and firms (Coca-Cola and Pepsi, Boeing and Airbus)
• Monopoly is the extreme case of imperfect competition, with a single firm dominating the market and facing no direct competition due to high barriers to entry
• Natural monopolies arise when a single firm can supply the entire market at a lower cost than multiple firms due to economies of scale (utilities, railways)

Market Structures and Characteristics

• Number of firms: Perfect competition has many firms, monopolistic competition has many firms, oligopoly has few firms, and monopoly has a single firm
• Barriers to entry: Perfect competition has no barriers, monopolistic competition has low barriers, oligopoly and monopoly have high barriers
• Product differentiation: Perfect competition has homogeneous products, while imperfect competition (monopolistic competition, oligopoly, and monopoly) has differentiated products
• Price elasticity of demand: Firms in perfect competition are price takers (perfectly elastic demand), while firms in imperfect competition face downward-sloping demand curves (relatively inelastic demand)
• Excess capacity: Firms in monopolistic competition and oligopoly often operate with excess capacity in the long run, as they produce less than the minimum efficient scale to maintain market power
• Long-run profits: In perfect competition, firms earn zero economic profits in the long run due to free entry and exit; in imperfect competition, firms can earn positive economic profits in the long run due to barriers to entry

Profit Maximization in Imperfect Competition

• Firms in imperfect competition maximize profits by setting marginal revenue equal to marginal cost (MR = MC)
  • Marginal revenue is the change in total revenue from selling one more unit, while marginal cost is the change in total cost from producing one more unit
• In imperfect competition, marginal revenue is less than price (MR < P) because firms face downward-sloping demand curves and must lower prices to sell more output
• The profit-maximizing quantity (Q*) occurs where the MR and MC curves intersect, and the profit-maximizing price (P*) is determined by the demand curve at Q*
• Short-run profits are maximized when total revenue exceeds total cost by the greatest amount, which occurs at the profit-maximizing quantity and price
• Long-run profits depend on the nature of the market structure and barriers to entry
  • In monopolistic competition, firms earn zero economic profits in the long run due to free entry and exit
  • In oligopoly and monopoly, firms can earn positive economic profits in the long run due to high barriers to entry

Price and Output Decisions

• Firms in imperfect competition have some degree of price-setting power and can choose their profit-maximizing price and quantity
• The degree of price-setting power depends on the price elasticity of demand, which is influenced by factors such as the number of close substitutes and the importance of the product to consumers
• Markup pricing is a common strategy in imperfect competition, where firms set prices above marginal cost by a percentage markup (P = (1 + m) × MC, where m is the markup percentage)
  • The optimal markup depends on the price elasticity of demand and the firm's objectives (profit maximization, revenue maximization, or other goals)
• Price discrimination is another strategy used in imperfect competition, where firms charge different prices to different customers based on their willingness to pay
  • Can be based on customer characteristics (age, student status), quantity purchased (volume discounts), or time of purchase (peak vs. off-peak pricing)
• Non-price competition, such as advertising, product differentiation, and quality improvements, is also important in imperfect competition as firms seek to differentiate their products and attract customers

Efficiency and Market Power

• Imperfect competition leads to allocative inefficiency because firms produce less than the socially optimal quantity and charge prices above marginal cost
  • Results in a deadweight loss, which is the reduction in total economic surplus (consumer + producer surplus) compared to the efficient level
• Productive efficiency may also be lower in imperfect competition if firms operate with excess capacity or engage in non-price competition that increases costs
• Dynamic efficiency, or the incentive to innovate and improve products over time, may be higher in imperfect competition if firms can earn positive profits and have a greater incentive to invest in research and development
• Market power can lead to other inefficiencies, such as X-inefficiency (lack of cost minimization) and rent-seeking behavior (lobbying for regulations that limit competition)
• Government intervention, such as antitrust laws, price regulation, or subsidies, may be necessary to promote efficiency and protect consumers in imperfect competition

Real-World Examples and Applications

• Monopolistic competition: Restaurants, clothing retailers, and beauty salons are examples of industries with many firms selling differentiated products and engaging in non-price competition
• Oligopoly: Airlines, mobile phone carriers, and automobile manufacturers are examples of industries with a few large firms, high barriers to entry, and strategic behavior (price wars, collusion)
• Duopoly: Coca-Cola and Pepsi in the soft drink market, and Boeing and Airbus in the commercial aircraft market, are examples of duopolies with intense competition and product differentiation
• Monopoly: Utility companies (electricity, water), railways, and patented drugs are examples of industries with a single firm dominating the market due to high barriers to entry or government-granted monopolies
• Natural monopoly: Electricity transmission and distribution, water supply, and sewage treatment are examples of industries where a single firm can supply the entire market at a lower cost than multiple firms due to economies of scale

Comparison with Perfect Competition

• Perfect competition is an idealized market structure with many firms, homogeneous products, perfect information, and no barriers to entry or exit
  • Serves as a benchmark for evaluating the efficiency and welfare implications of other market structures
• In perfect competition, firms are price takers and face perfectly elastic demand curves, while in imperfect competition, firms have some degree of price-setting power and face downward-sloping demand curves
• Perfect competition leads to allocative and productive efficiency in the long run, as firms produce at the minimum of their average total cost curves and charge prices equal to marginal cost
  • Imperfect competition leads to allocative and productive inefficiencies, as firms produce less than the socially optimal quantity and may operate with excess capacity
• In perfect competition, firms earn zero economic profits in the long run due to free entry and exit, while in imperfect competition, firms can earn positive economic profits in the long run due to barriers to entry
• Imperfect competition is more prevalent in the real world, as most industries have some degree of product differentiation, barriers to entry, or market power, while perfect competition is rare and often used as a theoretical benchmark