10.8

• Imperfect Competition: Most industries in reality fall under imperfect competition, where firms have some market power and face downward-sloping demand curves. The main types include:

  • Monopolistic competition: Many firms, differentiated products.
  • Oligopoly: Few firms, interdependence between them.
  • Monopoly: One firm dominates the market.
• Game Theory: This was introduced to analyze strategic decisions made by firms when they are interdependent. Game theory allows economists to predict outcomes based on the strategies chosen by firms.
• 1. Commitment, Credibility, and Deterrence: Strategic behaviors such as making credible threats or commitments (like pre-committing to high production capacity) help incumbents protect their market position from potential entrants.
• Market Structure and Behavior of Firms:

  • Market structure determines how firms behave. Traditionally, economists started by analyzing the structure of the market (like monopoly, oligopoly, or perfect competition) and then predicted firm behavior based on that.
  • Now, the focus is more on strategic behaviors of firms, such as how they prevent entry or sustain their market dominance through tactics like price wars, advertising, or excess capacity.
• Potential Competition:

  • Firms must consider not only existing competitors but also the threat of new entrants. Even if there is no immediate competitor, the fear of potential competition can influence firm behavior.
  • Incumbent firms may act to deter entry through strategic behavior, even if the threat of entry is small.
• 1. Strategic Business Practices:

  • Many common business practices—such as price wars, excessive advertising, and research and development—are not just profit-maximizing but also act as strategic tools to prevent competition.
  • These strategies are only effective if they are credible. For instance, threatening a price war only works if the potential entrant believes the incumbent will follow through with that strategy.
• Imperfect Competition: In most real-world industries, firms face imperfect competition. They have some market power, meaning they can influence prices and don’t face perfectly elastic demand.
• Monopoly: Sometimes pure monopoly exists, often due to regulation or barriers to entry. Monopolies can ignore competitive threats if their market is well protected.
• Contestable Markets: In other cases, entry and exit may be free and easy. This forces incumbents to behave more like firms in a perfectly competitive market to avoid being flooded by new entrants.
• • Monopolistic Competition: Firms in this structure face free entry and exit but produce differentiated products. Each firm has some market power because of its brand or product variety, leading to higher prices than in perfect competition.
• Oligopoly: Oligopolists face competition between each other, balancing between collusion (to maximize joint profits) and competition (to gain market share). Without credible threats of punishment, collusive agreements tend to break down.
• • Game Theory: Game theory is vital to understanding how firms make strategic decisions. For example, in the Prisoner’s Dilemma game, each firm faces the temptation to cheat on a collusive agreement because it could gain more short-term profits by undercutting the other firm.