Chapter 11: The World of Imperfect Competition

Start Up: eBay Needs Google, Google Needs eBay, and Neither Trusts the Other

The Internet auction site eBay has had a close and cooperative relationship with Google, the giant search engine. eBay has relied heavily on Google to advertise its products. Google relies heavily on the advertising revenue it gets from eBay. The greater the success of eBay, the greater the revenue Google will have from eBay’s advertising. The greater the success of Google as a search engine, the greater will be the impact of eBay’s advertising. To paraphrase Rick’s line from Casablanca, “This could be a beautiful relationship.” It is not. The two Internet giants simply do not get along.

Consider what happened in 2007. A Google spokesman said the firm was hosting a “Freedom Party” to announce the inauguration of a new payments service that would compete directly with PayPal, the online payment service owned by eBay. eBay was quick to retaliate. It pulled all of its advertising from Google later on the same day Google made its announcement. Two days later, Google backed down. It canceled its party and the payment service the party was to kick off.Victoria Murphy Barrett, “Reading Your Mind,” Forbes Online, October 29, 2007, 180 Issue 9, p. 50.

In 2003, eBay had commissioned an analysis of whether Google represented a threat to its operations. The study concluded that Google was unlikely to enter into e-commerce and was not a potential rival to eBay. That sanguine conclusion started to unravel in 2005. Google began recruiting eBay engineers. In October, Google started testing Google Base, a free classified advertising service that threatened eBay’s auction service.

Executives at eBay took the threat seriously. In private meetings, they divided into two teams. A green team represented eBay’s interests; a red team tried to emulate Google’s strategy. The red team concluded that Google represented a serious threat, and eBay executives began exploratory talks with Microsoft and Yahoo to see if some collaborative effort could ward off the Google threat.

eBay spokesman Chris Donlay describes the firm’s dilemma of dealing with a firm that has been a valuable ally but at the same time could be a competitive threat. “Given how really fast the Internet changes, it comes as no surprise that the line between competition and cooperation is sometimes blurry.”

By the late spring of 2006, eBay’s management was still in a quandary about what to do about Google. Some executives, fearful of losing the advantages of continuing to work with Google, want to maintain eBay’s ties to the firm. Others worried that continuing a close relationship with Google was akin to putting the fox in the proverbial henhouse. They want to move quickly to establish a relationship with Yahoo or with Microsoft that would compete with Google.Mylene Mangalindan and Robert A. Guth, “eBay Talks to Microsoft, Yahoo About a Common Foe: Google,” The Wall Street Journal Online, April 21, 2006, p. A1.

The tension between eBay and Google hardly suggests the aloof world of perfect competition where consumers are indifferent about which firm has produced a particular product, where each firm knows it can sell all it wants at the going market price, where firms must settle for zero economic profit in the long run. Nor is it the world of monopoly, where a single firm maximizes its profits, believing that barriers to entry will keep out would-be competitors, at least for a while. This is the world of imperfect competition, one that lies between the idealized extremes of perfect competition and monopoly. It is a world in which firms battle over market shares, in which economic profits may persist, in which rivals try to outguess each other with pricing, advertising, and product-development strategies.

Unlike the chapters on perfect competition and monopoly, this chapter does not provide a single model to explain firms’ behavior. There are too many variations on an uncertain theme for one model to explain the complexities of imperfect competition. Rather, the chapter provides an overview of some of the many different models and explanations advanced by economists for the behavior of firms in the imperfectly competitive markets. The analytical tools you have acquired in the course of studying the models of competitive and monopoly markets will be very much in evidence in this discussion.

The spectrum of business enterprise ranges from perfectly competitive firms to monopoly. Between these extremes lies the business landscape in which the vast majority of firms—those in the world of imperfect competition—actually operate. Imperfect competition is a market structure with more than one firm in an industry in which at least one firm is a price setter. An imperfectly competitive firm has a degree of monopoly power, either based on product differentiation that leads to a downward-sloping demand curve or resulting from the interaction of rival firms in an industry with only a few firms.

There are two broad categories of imperfectly competitive markets. The first is one in which many firms compete, each offering a slightly different product. The second is one in which the industry is dominated by a few firms. Important features of both kinds of markets are advertising and price discrimination, which we examine later in this chapter.

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