Profit maximisation under imperfect competition

Welcome to the World of the "Middle Ground"!

In your studies so far, you’ve likely looked at Perfect Competition (where everyone is tiny and sells the same thing) and Monopoly (where one giant rules the market). But look around you—most businesses, like your favorite coffee shop or your smartphone provider, sit somewhere in the middle. This is Imperfect Competition.

In this chapter, we will explore how these "real-world" firms decide how much to produce and what price to charge to make the most money possible. Don’t worry if this seems tricky at first; we’ll break it down step-by-step!

1. The Golden Rule: Profit Maximisation

Before we dive into specific market types, remember the "Golden Rule" for almost any firm in Business Economics: Profit is maximised where Marginal Revenue (MR) equals Marginal Cost (MC).

Equation: \( MR = MC \)

Quick Review:
• Marginal Revenue (MR): The extra money earned from selling one more unit.
• Marginal Cost (MC): The extra cost of producing one more unit.
• If \( MR > MC \), the firm should produce more because they are adding more to revenue than to costs.
• If \( MC > MR \), the firm is losing money on that last unit and should scale back.

2. Monopolistic Competition: The "Coffee Shop" Model

Monopolistic Competition occurs when there are many firms selling products that are similar but not identical (product differentiation).

Key Characteristics:
• Many buyers and sellers: No single firm controls the whole market.
• Low barriers to entry: It’s relatively easy for new shops to open.
• Differentiated products: Firms use branding, quality, or location to make their product seem unique (e.g., Starbucks vs. a local artisan café).

How they Maximise Profit

Because their products are unique, these firms have a downward-sloping demand curve. If they raise their price, they won't lose all their customers (some are loyal), but they will lose some.

Short Run: In the short run, a firm can make supernormal profits (where price is higher than average cost). They simply find the point where \( MR = MC \), go up to the demand curve, and set that price.

Long Run: This is the "catch." Because it's easy to enter the market, other entrepreneurs will see those supernormal profits and open their own shops. This shifts the original firm's demand curve to the left until only normal profits (breaking even) are made.
Memory Aid: In the long run, competition "eats" the extra profit!

Key Takeaway: In Monopolistic Competition, firms make supernormal profits in the short run, but only normal profits in the long run due to freedom of entry.

3. Oligopoly: The "Battle of the Giants"

An Oligopoly exists when a few large firms dominate the industry (e.g., supermarkets or mobile network providers). The most important feature here is interdependence.

Interdependence and Strategy

In an oligopoly, what Firm A does (like cutting prices) directly affects Firm B. This leads to two main behaviors:
1. Collusion: Firms act together (explicitly in a cartel or tacitly) to act like a monopoly, restrict total industry output, and keep prices high.
2. Competition: Firms fight for market share through price wars or non-price competition (e.g., advertising, customer service).

The Kinked Demand Curve

Have you ever noticed that prices in some industries stay the same for a long time, even when costs change? Economists explain this using the Kinked Demand Curve.

The Logic:
• If I raise my price: My competitors won't follow me. I will lose a lot of customers (Elastic demand).
• If I lower my price: My competitors will follow me to avoid losing their customers. I won't gain many new sales (Inelastic demand).
• Result: There is a "kink" in the demand curve at the current price. This makes the MR curve have a vertical gap (discontinuity). As long as the Marginal Cost (MC) shifts within that gap, the profit-maximising price and output remain completely unchanged!

Game Theory: Explaining Strategic Decisions

Because oligopolists are interdependent, economists model their strategic choices using Game Theory, most famously the Prisoner's Dilemma.

Imagine two rival firms deciding whether to charge a High Price (collude) or a Low Price (compete):
• If both collude and charge a High Price, both earn high supernormal profits.
• If Firm A cheats and cuts its price while Firm B keeps prices high, Firm A captures most of the market and earns maximum profit, leaving Firm B with heavy losses.
• If both cut their prices, both earn low profits.

Dominant Strategy and Nash Equilibrium: Regardless of what Firm B does, Firm A’s best individual response is to cut prices to protect itself or grab market share. The same applies to Firm B. Choosing the low price is the dominant strategy for both firms. The outcome where both cut prices is a Nash equilibrium: neither firm can unilaterally improve its payoff, even though mutual collusion would have made both firms better off!

Why Collusion Breaks Down: Game theory explains why cartels and tacit collusion are inherently unstable—every member faces an overwhelming incentive to cheat by secretly lowering prices or offering discounts.

4. Oligopoly and the Consumer Interest

How does the behaviour of oligopolists affect consumers and society? The impact is mixed:

Potential Harms to Consumers:
• Collusive behaviour: If firms successfully collude, consumers face higher prices, restricted output, and allocative inefficiency (\( P > MC \)), similar to a monopoly.
• Heavy advertising: Substantial non-price competition can lead to wasteful expenditure on persuasive advertising, creating barriers to entry rather than providing real consumer value.
• Productive inefficiency: Firms may operate with excess capacity and fail to produce at the minimum efficient scale.

Potential Benefits to Consumers:
• Dynamic efficiency: Sustained supernormal profits can be reinvested into substantial Research & Development (R&D), resulting in superior technology and product innovation.
• Economies of scale: Large oligopolistic firms can exploit large-scale production, potentially passing on lower average costs to consumers.
• Price wars and non-price benefits: When collusion breaks down, fierce price competition leads to low consumer prices, while non-price competition can offer enhanced product variety and quality service.

5. Summary Quick-Check

1. Where is profit maximised?
Always where \( MR = MC \).

2. Why do Monopolistic Competitors only make normal profit in the long run?
Because low barriers to entry allow new entrants to join, shifting existing firms' demand curves leftward until \( AR = AC \).

3. What does the Kinked Demand Curve explain?
Price rigidity or "stickiness" in an oligopoly when costs fluctuate within the vertical gap of the MR curve.

4. How does Game Theory explain the instability of cartels?
Each firm has a dominant strategy to cheat on the agreement to capture extra profit, leading to an equilibrium with lower joint profits.

5. Does oligopoly serve the consumer interest?
It depends: collusive oligopolies exploit consumers with high prices, but competitive oligopolies can deliver lower prices, scale economies, and innovation.