Chapter 3:

Imperfect Competition
Advanced Public Economics 1

1. Welfare
Consider an economy with only one good. The inverse demand
function is p(y ), with p 0 (y ) < 0.
To emphasize the impact of imperfect competition on welfare, we
will envision 2 extreme cases:
1. Competitive economy (efficient)
2. Monopoly
Competitive Economy
Each firm max its profit, taking the price p as given:
max py cy = (pc)y in a competitive equilibrium: p (y ) = c .
y 0

p( y ) + p' ( y ) y

p( y )
Consumers
surplus

p( y m )

Supply

y
Figure 1.1

ym

y
Figure 1.2

 Monopoly
The monopoly does not take the price as given, and takes into
account the effect of its supply on the the price:
max p(y )y cy
y 0

, F.O.C.: p (y m ) + p 0 (y m ) y m = c
{z
}
|
marginal revenue
p (y m ) + p 0 (y m ) y m = p (y ) p (y m ) > p (y ) = c
, The monopoly sets price above marginal cost (inefficient!!!)
Deadweight Loss of Monopoly

Consumers
surplus

Deadweight loss

p( y m )
Monopolys
profit

ym
Figure 2

2. Oligopolistic Competition and Entry

Suppose now that there are n > 1 firms, indexed by i = 1, . . . , n.
Let yi be firm is production, and let Y be the aggregate
production:
n
X
Y =
yi
i=1

For simplicity, assume that p(Y ) = 1 Y = 1

Marginal cost of production: 0 < c < 1.

Pn

i=1 yi .

, the profit of firm j is therefore

j (y1 , . . . , yn ) =

n
X

!
yi

yj cyj

i=1

, Firm j chooses the production level yj that solves

max 1 yj
yj

n
X

yi yj cyj

i6=j

, j, the F.O.C. yields:

!
n
n
X
X
yj + 1
yi c = 0 yj = 1
yi c = 1 Y c
i=1

i=1

 The equilibrium is symmetric: yj = y for all j = 1, . . . , n.

Using the F.O.C., we obtain:
y = 1 ny c y =

1c
.
n+1

, The equilibrium price is

p = p (ny ) = 1 ny =

1
n
+
c
n+1 n+1

One can check that p > c [Yes?] and that the equilibrium profit is
= (p c) y > 0 .

Proposition: The equilibrium price and profit, p and , are

strictly deceasing in n. Furthermore,
lim p = c , and lim = 0

[Yes?]

, As the number of firms becomes arbitrarily large, the

oligopolistic equilibrium becomes arbitrarily close to the
competitive equilibrium.
, EFFICIENCY!!!

3. Regulation
, See Exercise 4 in the Problem Set.

Further Reading:
This chapter mainly relies on Chapter 8 in Hindriks & Myles 2006
(Intermediate Public Economics, MIT Press).