Imperfect Competition

Imperfect Competition Definition

Here is the definition of imperfect competition.

Figure 1 below shows the different kinds of market structures on a spectrum. They range from the most competitive to the least competitive from left to right. In perfect competition, there are many firms selling the same product; in monopolistic competition, there are many firms competing with differentiated products; an oligopoly has only a couple or a few firms; and in a monopoly, there's only one firm serving the entire market.

Fig. 1 - The spectrum of market structures

Imperfect Competition Characteristics

Imperfect competition has some peculiar characteristics which make it different from perfect competition. Let's consider some of them!

Imperfect Competition: Marginal Revenue Below Demand

A hallmark of an imperfectly competitive market is that the marginal revenue (MR) curve facing the firms lies below the demand curve, as Figure 2 shows below. There is a smaller number of competing firms under imperfect competition - in the case of monopolistic competition, there are many firms, but they are not perfect competitors due to product differentiation. Firms in these markets have some influence over the demand for their products, and they can charge a price that is higher than the marginal cost of production. In order to sell more units of the product, the firm must lower the price on all units - this is why the MR curve is below the demand curve.

Fig. 2 - Marginal revenue curve in imperfect competition

On the other hand, there are many firms selling homogeneous products in a perfectly competitive market. These firms have no influence over the demand they face and have to take the market price as given. Any individual firm that operates in such a perfectly competitive market faces a flat demand curve because if it charges a higher price, it will lose all its demand to competitors. For an individual firm under perfect competition, its marginal revenue (MR) curve is the demand curve, as shown in Figure 3. The demand curve is also the firm's average revenue (AR) curve because it can only charge the same market price no matter the quantity.

Fig. 3 - An individual firm in a perfectly competitive market

Imperfect Competition: Economic Profits in the Long Run

One important implication of imperfect competition has to do with firms' ability to make economic profits. Recall that in the case of a perfectly competitive market, firms have to take the market price as given. Firms in perfect competition do not have a choice because as soon as they charge a higher price, they will lose all their customers to their competitors. The market price in perfectly competitive markets is equal to the marginal cost of production. As a result, firms in perfectly competitive markets are only able to break even in the long run, after all costs (including opportunity costs) are taken into account.

On the other hand, firms in imperfectly competitive markets have at least some power in setting their prices. The nature of imperfectly competitive markets means that consumers can't find perfect substitutes for these firms' products. This allows these firms to charge a price that is higher than the marginal cost and to turn a profit.

Imperfect Competition: Market Failure

Imperfect competition leads to market failures. Why is that? This actually has to do with the marginal revenue (MR) curve being below the demand curve. In order to maximize profit or minimize loss, all firms produce to the point where marginal cost equals marginal revenue. From a societal perspective, the optimal output is the point where marginal cost equals demand. Since the MR curve is always below the demand curve in imperfectly competitive markets, the output is always lower than the socially optimal level.

In Figure 4 below, we have an example of an imperfectly competitive market. The imperfect competitor faces a marginal revenue curve that is below the demand curve. It produces up to the point where marginal revenue equals marginal cost, at point A. This corresponds to point B on the demand curve, so the imperfect competitor charges consumers at a price of Pi. In this market, the consumer surplus is area 2, and area 1 is the profit that goes to the firm.

Contrast this situation to a perfectly competitive market. The market price is equal to the marginal cost at Pc. All the firms in this perfectly competitive market will take this price as given and jointly produce a quantity of Qc at point C, where the market demand curve for the entire industry intersects with the marginal cost curve. The consumer surplus under perfect competition would be the combination of areas 1, 2, and 3. So, the imperfectly competitive market leads to a deadweight loss of the size of area 3 - this is the inefficiency caused by imperfect competition.

Fig. 4 - Imperfect competition with inefficiency

Imperfectly Competitive Market Types

There are three types of imperfectly competitive market structures:

• monopolistic competition
• oligopoly
• monopoly

Let's go through these, one by one.

Imperfect Competition Examples: Monopolistic Competition

You may have noticed that the term "monopolistic competition" has both the words "monopoly" and "competition" in it. This is because this market structure has some characteristics of a perfectly competitive market and also some characteristics of a monopoly. Like in a perfectly competitive market, there are many firms because the barriers to entry are low. But unlike in perfect competition, the firms in monopolistic competition are not selling identical products. Instead, they sell somewhat differentiated products, which gives the firms some degree of monopoly power over the consumers.

All these fast-food restaurants sell essentially the same thing: sandwiches and other usual American fast-food items. But also not exactly the same. The burgers at McDonald's are not the same as the ones sold at Wendy's, and Dairy Queen has ice creams that you can't find from the other brands. Why? Because these businesses deliberately make their products a little bit different - that's product differentiation. It's certainly not a monopoly because you have way more than one choice, but when you are craving that specific kind of burger or ice cream, you have to go to that one specific brand. Because of this, the restaurant brand has the power to charge you a little more than in a perfectly competitive market.

Imperfect Competition Examples: Oligopoly

In an oligopoly, there are only a few firms selling to the market because of high barriers to entry. When there are only two firms in the market, it's a special case of oligopoly called duopoly. In an oligopoly, firms do compete with one another, but the competition is different from the cases of perfect competition and monopolistic competition. Because there are only a small number of firms in the market, what one firm does affects the other firms. In other words, there is an interdependent relationship between the firms in an oligopoly.

Imagine that there are only two firms selling the same potato chips at the same price on the market. It's a duopoly of chips. Naturally, each firm would want to capture more of the market so that they can earn more profits. One firm can try to take customers from the other firm by lowering the price of its potato chips. Once the first firm does this, the second firm would have to lower its price further to try to take back the customers that it has lost. Then the first firm would have to lower its price again... all this back and forth until the price reaches the marginal cost. They can't lower the price further at this point without losing money.

You see, if oligopolists are to compete without cooperation, they might reach a point where they operate just like firms in perfect competition - selling with a price equal to the marginal cost and making zero profits. They don't want to make zero profits, so there is a strong incentive for oligopolists to cooperate with each other. But in the U.S. and many other countries, it is illegal for firms to cooperate with each other and fix prices. This is done to ensure that there's healthy competition and to protect consumers.

Imperfect Competition Examples: Monopoly

On the very far end of the market competitiveness spectrum lies a monopoly.

A monopoly exists because it's very difficult for other firms to enter such a market. In other words, high barriers to entry exist in this market. There are a number of reasons for a monopoly to exist in a market. It can be the case that a firm controls the resource that is required to make the product; governments in many countries often grant permission for only one state-owned firm to operate in a market; intellectual property protections give firms a monopoly right as a reward for their innovation. Besides these reasons, sometimes, it is "natural" that there's only one firm operating in the market.

Imperfect Competition and Game Theory

The interaction between oligopolistic firms is like playing a game. When you are playing a game with other players, how well you do in that game depends not only on what you do but also on what the other players do. One of the uses of game theory for Economists is to help understand the interactions between firms in oligopolies.

Economists often use a payoff matrix to show how players' actions lead to different outcomes. Let's use the example of the potato chips duopoly. There are two firms selling the same potato chips at the same price on the market. The firms face a decision of whether to keep their prices at the same level or to lower the price in order to try and take customers from the other firm. Table 1 below is the payoff matrix for these two firms.

Table 1. Game theory payoff matrix of the potato chips duopoly example - StudySmarter

If both firms decide to keep their prices as they are, the outcome is the top left quadrant: both firms make the same profits as before. If either firm drops the price, the other will follow suit to try to recapture the market share that they lose. This will continue until they reach a point where they can't drop the price any lower. The outcome is the bottom right quadrant: both firms still split the market but make less profit than before - in this case, zero profit.

In the potato chips duopoly example, there is a tendency for both firms to lower their prices in an attempt to capture the entire market in the absence of an enforceable agreement between the two duopolists. The likely outcome is the one shown in the bottom right quadrant of the payoff matrix. Both players are worse off than if they have just kept their prices as they were. This kind of situation where players tend to make a choice that leads to a worse outcome for all the players involved is called the prisoners' dilemma.

Imperfectly Competitive Factor Markets: Monopsony

The markets that we usually talk about are product markets: the markets for goods and services that consumers buy. But let's not forget there's also imperfect competition in the factor markets as well. Factor markets are markets for the factors of production: land, labor, and capital.

There is one form of imperfectly competitive factor market: Monopsony.

A classic example of a monopsony is a large employer in a small town. Since people can't seek work elsewhere, the employer has market power over the local labor market. Similar to an imperfectly competitive product market where firms have to lower prices in order to sell more units, the employer in this case has to raise the wage to hire more workers. Since the employer has to raise the wage for every worker, it faces a marginal factor cost (MFC) curve that is above the labor supply curve, as shown in Figure 7. This results in the firm hiring a fewer number of workers Qm at a lower wage Wm than in a competitive labor market, where the number of workers hired would be Qc, and the wage would be Wc.

Fig. 7 - A monopsony in a labor market