Imperfect competition

In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market, resulting in market failure. [1]

The structure of a market can significantly impact the financial performance and conduct of the firms competing within it. The degree of market power refers to the firms' ability to affect the price of a good and thus, raise the market price of the good or service above marginal cost (MC). Moreover, market structure can range from perfect competition to a pure monopoly. Perfect competition is a market situation and competitive outcome that economists use as a benchmark for economic welfare analysis and efficiency. [2]

Conditions of imperfect competition

If ONE of the following conditions are satisfied within an economic market, the market is considered "imperfect":

  • The market's goods and services are Heterogenous or Differentiated. This means that firms can charge higher prices as their goods and services are perceived as better;
  • The market contains ONE or few sellers;
  • There are barriers to market entry and exit. If there are barriers to market entry and exit, there may be special costs to a firm that may prevent or make it difficult for a firm to enter or exit an industry market. Additionally, if prices are different, buyers may not have the ability to easily switch suppliers and thus, suppliers cannot easily exit or enter the market; and
  • Market firms are NOT price takers and hence, have some control over the pricing of their goods and services. [2]

Range of market structures

There are FOUR broad market structures that result in Imperfect Competition. The table below provides an overview of the characteristics of each of these market structures.

Characteristics of "Imperfect" Market Structures
Market StructureNumber of buyers and sellersDegree of product differentiationDegree of control over price
Monopolistic CompetitionMany buyers and sellersSomeSome
OligopolyFew sellers and many buyersSomeSome
DuopolyTwo sellers and many buyersCompleteComplete
MonopolyOne seller and many buyersCompleteComplete

Monopolistic competition

A situation in which many firms with slightly different products compete. Moreover, firms compete by selling differentiated products that are highly substitutable, but are not perfect substitutes. Therefore, the level of market power under monopolistic competition is contingent on the degree of product differentiation.

There are two types of product differentiation:

  • Vertical differentiation: a product is unambiguously better or worse than a competing product (e.g. products that differ in efficiency or effectiveness); and
  • Horizontal differentiation: a product that only some consumers prefer to competing products (e.g. Mercedes Benz and BMW). [3]

Furthermore, each firm shares a small percentage of the total monopolistic market and hence, has limited control over the prevailing market price. Thus, each firms' demand curve (unlike perfect competition) is downward sloping, rather than flat. Additionally, cross-price elasticities of demand are large (but not infinite). Production costs are above what may be achieved by perfectly competitive firms, but society benefits from the product differentiation. [4]


Oligopoly

In an oligopoly market structure, the market is supplied by a small number of firms (more than 2). Moreover, there are so few firms that the actions of one firm can influence the actions of the other firms. Under this market structure, the differentiation of products may or may not exist.[5] The product they sell may or may not be differentiated and there are barriers to entry: natural, cost, market size,... or dissuasive strategies.

In an oligopoly, barriers to market entry and exit are high. The major barriers are:

If two firms collude, they form a cartel to reduce output and increase their firms' profitability. Oil companies, grocery stores and some telecommunication companies are examples of oligopolies.[6]

Duopoly

A special type of Oligopoly, where two firms have exclusive power and control in a market. It is a particular case of oligopoly, so it can be said that it is an intermediate situation between monopoly and perfect competition economy. Hence, it is the most basic form of oligopoly. [2]


Monopoly

In a monopoly market, there is only one offerer and there is a plurality of buyers; it is a firm with no competitors in its industry. The monopolist has market power, that is, it can influence the price of the good. Moreover, a monopoly is the sole provider of a good or service and thus, faces no competition in the output market. Hence, there are significant barriers to market entry, such as, patents, market size, control of some raw material. Examples of monopolies include public utilities (water, electricity) and Australia Post. [7] A monopolist faces a downward sloping demand curve. Thus, as the monopolist raises its price, it sells fewer units.

Hence, a monopolist's:

Another feature of monopolies is rent seeking, whereby monopoly firms engage in spending money to maintain and exercise its monopoly power. This is undertaken through advertising, lobbying and building excess capacity to deter competitors from entering the market.

A firm is a monopsonist if it faces small levels, or no competition in ONE of its output markets. A natural monopoly occurs when it is cheaper for a single firm to provide all of the market's output.[8]

Intensity of price competition

The intensity of price competition is another good measure of how much control a firm within a market structure has over price. The Herfindahl Index provides a measure of firm concentration within a market and is the sum of the squared market shares of all the firms in the market (Herfindahl Index = (Si)2, where Si = market share of firm i) . The value of the index ranges from 1/N to 1 (where N is the number of firms in the market). Thus, the more concentrated the market is, the larger the value of the Herfindahl Index will be. [2] The table below provides an overview of price competition and intensity in the four main classes of market structure.

Price Competition Intensity in Four Classes of Market Structure
Market StructureRange of HerfindahlsIntensity of Price Competition
Perfect CompetitionBelow 0.20Fierce
Monopolistic CompetitionBelow 0.20Depending on product differentiation, intensity may be light or fierce
Oligopoly0.20 to 0.60Depending on interfere rivalry, intensity may be light or fierce
MonopolyAbove 0.60Light or nil

[2]

See also

References
  1. O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 153. ISBN 0-13-063085-3.CS1 maint: location (link)
  2. Kifle, T. (2020). Lecture 5: Competitors and Competition (Part I) [PowerPoint Slides] . Unpublished Manuscript, ECON2410, University of Queensland, St Lucia, Australia.
  3. Kifle, T. (2020). Lecture 6: Competitors and Competition (Part II) [PowerPoint Slides] . Unpublished Manuscript, ECON2410, University of Queensland, St Lucia, Australia.
  4. "Monopolistic competition". Economics online. Retrieved 25 April 2020.
  5. "3 Different Forms of Imperfect Competition". Economics discussion. Saqib Shaikh. Retrieved 1 April 2020.
  6. "Perfect vs. Imperfect Competition: What's the Difference?". Investopedia. GREG DEPERSIO. Retrieved 5 April 2020.
  7. Robert Pindyck and Daniel Rubinfeld. (2013). Microeconomics. United States: PEARSON INDIA; Edición: 8th (2017)
  8. Economics of the Public Sector (Third ed.). New York, USA: Joseph E. Stiglitz. p. 78. ISBN 0-393-96651-8.
  • Massimiliano Vatiero (2009), "An Institutionalist Explanation of Market Dominances". World Competition. Law and Economics Review, 32(2):221-6.
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