Section A: Strategic decision making

in imperfectly competitive markets

 Outline of sessions
 Monopoly, oligopoly and collusion
 Sustaining profitability: Rivalry and monopoly profits
 Market failures due to monopoly power and oligopoly
collusion
 Strategic decision making - Game theory
 Prisoners’ dilemma and collusion – more game theory
 Prisoners’ dilemma and trade
 Entry barriers and entry deterrence
 Credibility– more game theory
 Case studies:
 Exception to the rule: competitive balance and collusion in
sports leagues
 Industry case studies
Suggested reading
 For the theory and some business applications:
 Allen et al. 2009. Managerial Economics. Norton. Chapters 7, 10-11,
16
 Kreps, D. M. 2004. Microeconomics for Managers. Norton.
Chapters 20-23
 Frank, R. H. 2008. Microeconomics and behaviour. McGraw Hill.
Chapters 12-13
 Wall,S., Minocha, S. and Rees, B. 2010. International Business,
Pearson. Chapter 7
 Dixit, A., Reiley, D. H. and Skeath, S. 2009. Games of Strategy, 3 rd
Edition , Norton
 Rasmusen, E. 2007. Games and Information, Blackwell. Chapters 1-2,
4-5
 Carmichael, F. 2004. A Guide to Game Theory, Pearson. Chapters 1-
4, 7-8
 And for the sports application:
 Grimes, P, Register, C. and Sharp, A. 2009. Economics of Social
Issues, McGraw Hill. Chapter 9
 Plus sports economics texts of which there are many e.g: Sandy,
Sloane and Rosentraub, The Economics of Sports, Palgrave.
Chapters 1-6
Objectives: by the end of this
section you should be able to:
 Collusion, cooperation and the prisoners’ dilemma:
 Use game theory and/or one detailed example to explain why
economists predict that collusion between oligopolists is likely to
be fragile unless particular conditions are satisfied e.g. some
possibility of repetition in the longer term, and/or the specific
characteristics of the market are conducive to cooperation.
 Use the concept of the prisoners’ dilemma to make predictions
about trade wars
 Entry barriers and entry deterrence:
 Use one detailed example and/or sequential game theory to
explain what is meant by the idea of a credible threat e.g. the
threat to fight the entry of a new firm into an industry or the
threat to strike/lock-out.
 Use sequential game theory to show how an incumbent monopolist
(or oligopolistic cartel) might be able to deter entry even though
fighting entry is costly .
Monopoly, oligopoly and collusion:
Sustaining profitability
 Key to determination of profits of firms in an
oligopoly and how they can continue to
improve profits
 Porter’s 5 forces (1980) – profitability depends on:
1. Extent of rivalry among existing firms (competition)
2. Number of potential entrants (and barriers to entry)
3. Number of substitutes (and complements)
4. The bargaining power of customers
5. The bargaining power of suppliers
 Question: when is a firm more profitable in terms
of the 5 forces?
Entry deterrence and entry barriers
- Porter’s Five Forces
a firm is more profitable:
 The less intense the rivalry among existing
firms (monopoly or if oligopoly -collusion vs.
strategic competition)
 The less the danger of potential entrants and

the higher barriers to entry

 The fewer substitutes for the firm’s products

(the more firms that sell complements)

 The weaker the bargaining power of customers

 The weaker the bargaining power of suppliers

 Porter’s first force: Extent of
rivalry; Monopoly and collusion in
oligopolies

Monopoly: a market dominated by one large firm

Oligopoly: a market dominated by a small number of

large firms that have an incentive to collude in order
to make monopoly profits (i.e. aim to minimise
competition and if compete, compete strategically on
aspects other than price – kinked demand curve)
 Revision: Monopoly (zero rivalry)

MC = S

AC

D = AR

What is the profit maximising level of output under

monopoly and what are the monopolists supernormal
profits?
Revision: Monopoly

MC = S

PMONOP AC

D = AR

QMONOP

= supernormal profits
Implications
 Monopolists make supernormal profits by
restricting output in order to charge a higher
price
 Oligopolists therefore have an incentive to collude
by restricting output to the profit maximising level
under monopoly – implying limited competition on
price
 Porter’s 5 forces: Rivalry - a firm is more profitable the
less intense the rivalry among existing firms (monopoly
or if oligopoly -collusion vs. competition)
 Collusion implies restrained rivalry
 But monopoly and collusion are not in the interests
of consumers
Revision: Monopoly vs. competition

MC = S

PMONOP
AC

D = AR

QMONOP

What would price and output be if the market were

competitive (in the short-run)? i.e. PCOMP, QCOMP
Revision: Monopoly vs. competition

MC = S

PMONOP
AC
PCOMP

D = AR

QMONOP QCOMP

if the market is competitive:

Price = PCOMP and output = QCOMP
Only normal profits
 Revision: Monopoly as a market failure

MC = S

PMONOP
PCOMP

D = AR

QMONOP QCOMP

What is the DEADWEIGHT LOSS to society under

monopoly?
 Revision: Monopoly as a market failure

MC = S

PMONOP
PCOMP

D = AR

QMONOP QCOMP

The total DEADWEIGHT LOSS to society under monopoly is the total

blue shaded area.
Implications
 Restricted rivalry under monopoly and
oligopoly collusion, is inefficient from the
perspective of society as a whole but large
firms have an incentive to collude and at the
very least not compete on price
 Rationale for competition policy in the UK, anti-
trust policy in the USA; see www.competition-
commission.org.uk
 But oligopolists are likely to participation in
non-price competition: competition among the
few - strategic competition
 But what is strategic competition and does it (1)
weaken the sustainability of oligopoly collusion and
(2) sustain profits by deterring entry?
Strategic competition among the few
 Oligopolists are interdependent agents
(players) involved in strategic decision
making - taking into account each
others moves and responses
 when they make moves in secret they can
be analysed as if moving simultaneously
 To predict the outcome need to use game
theory
 Simultaneous move games and the concept of a Nash
equilibrium - collusion
 Sequential/dynamic games – entry deterrence
Exercise on monopoly
1. Explain (i) how the economic analysis of monopoly shows
that firms can gain from a monopoly position and (ii) how a
comparative analysis of monopoly and perfect competition shows
that consumers are likely to be worse off if competition in a
market is reduced? As well as using diagrammatic analysis,
illustrate aspects of your analysis with reference to (a) the FT
letter from David McConnell on BT (British Telecom) and (b)
the UK Competition Commission News Release 28 November
2007 on the Tesco sell-off.
Hints: You need to use diagrammatic analysis to contrast
monopoly and perfect competition and consider the role of
government policy.
 
BT monopoly not in interests of a competitive
telecoms market, the UK economy or users
By David McConnell
Published: October 11 2004 03:00 | Last updated: October 11 2004 03:00
From Mr David McConnell.

Sir, Ben Verwaayen, BT Group's chief executive, seems to be suggesting that the only way BT can
make an adequate return is if it remains a near-monopoly provider (Letters, October 6). This may be
an appealing idea to BT and its shareholders, but it most certainly is not in the interests of a
competitive telecommunications market, the UK economy or consumers.

A healthy UK telecoms market depends not on a single provider being profitable but on there being
sufficient competition from a number of players, each with equal access to the monopoly's assets
(assets owned not through investment and risk but paid for by taxpayers before BT was privatised 20
years ago).

A healthy market that encourages innovation from a range of network and service providers will give
consumers a wider choice of improved and keenly priced communication services. UK Competitive
Telecommunications Association members believe that the best way to achieve a genuinely
competitive market is by establishing a genuinely level playing field where all players have the same
opportunities and play by the same set of rules.

What is important is that a level playing field is achieved, an objective that even BT now seems willing
to address. Successful implementation of equivalence will deliver the benefits of breaking up BT but
without the potential attendant disruption. It will also, crucially, avoid perpetuating a market dominated
by a single company.

David McConnell, Chairman, UK Competitive Telecommunications Association, London WC1B 4HP.

Copyright The Financial Times Limited 2008
 
TESCO FACES SLOUGH SELL-OFF TO COMPETITOR
Competition Commission News Release 64/07 28 November 2007
 
The Competition Commission (CC) has decided that Tesco will be required to sell the site it acquired when it bought a former Co-op store in Slough.
 
In its final report the CC has concluded that the acquisition of the Co-op store on Uxbridge Road, which took place in 2003, reduced competition and choice in the
market for grocery retailing in Slough. This confirms the CC’s provisional findings published in September.
The CC’s preferred solution is for another grocery retailer to buy the former Co-op site and develop a large enough store to compete effectively with the other large
grocery stores in Slough, and especially with the large Tesco store at nearby Brunel Way. As a fallback, the CC would allow a retailer to move into a smaller unit—or
combination of units—on the current redevelopment if the first option, which would require planning permission, takes too long or if planning permission is not
granted.
 
Since the original acquisition, Tesco has demolished the Co-op store and started work on a new four-unit retail development on the site. In its report, the CC notes that
a competing grocery retailer would face a number of drawbacks operating from the Tesco redevelopment, which would affect its ability to compete in Slough and in
particular with Tesco’s Brunel Way store. A divestment trustee will be appointed to oversee the process and will report to the CC, who will assess bids on a number of
criteria before giving its approval. This will ensure that the sales process is carried out objectively and that Tesco is not required to accept any offer that is
unreasonable.
 
Peter Freeman, Inquiry Group Chairman and CC Chairman, said: Our aim, as the best solution to protect competition and to help consumers in Slough, is to see a large
store on the former Co-op site fully equipped to compete with Tesco’s existing store on Brunel Way. Tesco’s own internal assessments and the evidence of both stores’
performance shows that, under another owner, the Co-op store would have been the main competition to the Tesco store at Brunel Way. We are also concerned about
further delay to a situation which has dragged on for longer than anyone would wish. As such, we are also including a fallback solution which would see another
grocery retailer operating from the former Co-op site under the current redevelopment.Tesco originally bought the Co-op store nearly four years ago and so the
circumstances surrounding this case are highly unusual. Our priority is to find a practical and effective solution to this complicated situation without undue delay.
 
The Office of Fair Trading (OFT) first decided to refer the acquisition to the CC in February 2004, but suspended action while it sought to agree a remedy with Tesco
in place of the reference. This arrangement would have seen a competing grocery retailer move on to the Co-op site, once Tesco had finished work to extend its
existing store on nearby Brunel Way. When this did not prove possible, the OFT made the reference on 19 April 2007.
During the inquiry, the CC ordered Tesco to suspend work on the ongoing retail redevelop-ment on the former Co-op site. Although the planned redevelopment
includes a unit ear-marked for grocery retail, following the discussions with the OFT, concerns were expressed that it might not prove a suitable or desirable site for a
competing grocery retailer.
Exercise on monopoly: Answers

1 (i) Firms with large market share such as BT gain from their market position if they face limited
competition since this gives them a degree of monopoly power (p. 78). Figure 5 illustrates the profit
maximising position of a monopolist. In Figure 5 the profit maximising output for the monopolist is
Qm and the profit maximising price is P m. The monopolist’s profits are given by the shaded area
given by (Pm – Cm)xQm. As long as price is higher than average cost a monopolist will make
supernormal profits by restricting output to the level at which marginal revenue is equal to marginal
cost. Monopolists can only do this if there are entry barriers preventing them from facing
competition (p. 90-95). If there are no entry barriers then other firms, seeing the supernormal profits
made by the monopolist, would enter the industry, increasing supply and reducing price.

Prior to privatisation BT was a state-owned (nationalised) monopoly but its monopoly power is
gradually being eroded through competition and the regulatory power of the Office of
Communications (Ofcom, previously Oftel) i.e by dismantling entry barriers. According to the letter
in the Financial Times, BT has resisted these changes and this would be consistent with the analysis
above, since competition would be expected to erode supernormal profits.

Figure 5

P
MC

AC
Pm

Cm

MR
AR = D
Q
Qm
 (ii) Economic theory implies that it is usually in consumers’ interest for markets to be more
competitive because competition leads to higher output and lower price. The difference between
price and output in a competitive and a monopolised market is illustrated in Figure 6 (which assumes
that average costs are constant – this simplifies the analysis without affecting the results). In Figure 6
AR = D is the monopolist’s and the market demand curve. AC = MC is the market supply curve
under perfect competition. The diagram shows that under monopoly price is P m and output is Q m.
When a market is characterised by perfect competition then price is P c and quantity is Qc. This
shows that under monopoly price is higher and output lower than when a market is characterised by
perfect competition.

The Competition Commission requirement for Tesco to sell the site it acquired when it bought a
former Co-op store in Slough is consistent with this analysis. The Commission argued that if Tesco
retained ownership this would limit the amount of competition faced by Tesco in the area and that
this would be detrimental for consumers since it would give them less choice. Similarly, David
McConnell, Chairman of UK Competitive Telecommunications Association argues that BT’s
resistance to the regulatory changes introduced by Ofcom is not in consumers’ interests.

P Figure 6

Pm

Pc AC = MC

AR = D
MR
Q
Qm Qc

However, the result that consumers face higher prices under monopoly assumes that there will be no
long–run changes in a monopolised industry as a result of process innovation s. These could benefit
consumers by lowering costs and consequently prices.