Principles of Economics, Case and Fair,8e

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(No Transcript)
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Overview

• Monopolistic Competition
• Product Differentiation
• Price and Output Determination in Monopolistic
  Competition
  
• Economic Efficiency and Resource Allocation
• Oligopoly
• Oligopoly Models
• Game Theory
• Repeated Games
• Oligopoly and Economic Performance
• The Role of Government
• Regulation of Mergers

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MONOPOLISTIC COMPETITION

• monopolistic competition
• A form of industry (market) structure,
  characterized by a large number of firms.
  
• Each firm is small relative to the market.
• Some degree of market power is achieved by firms
  producing differentiated products.
  
• No barriers to entry and exit.

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MONOPOLISTIC COMPETITION

• product differentiation
• A strategy that firms use to achieve market
  power.
  
• Accomplished by giving products certain
  characteristics that distinguish them from
  competitors products.
  
• Firms make their products characteristics known
  to the public by way of advertising.
  
• Is product differentiation good?

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MONOPOLISTIC COMPETITION

• The Case for Product Differentiation and
  Advertising
  
• Advocates claim
• Increases the variety of products available to
  accommodate consumers different preferences
  
• Advertising provides consumers with valuable and
  meaningful information on product availability,
  quality, and price that they need to make
  efficient choices in the marketplace.

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MONOPOLISTIC COMPETITION

• The Case against Product Differentiation and
  Advertising
  
• Critics claim
• Product differentiation and advertising waste
  societys scarce resources
  
• Enormous sums of money are spent to create
  minute, meaningless differences among products.
  
• These increased expenditures on advertising only
  serve to increase the price that consumers pay
  

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MONOPOLISTIC COMPETITION

• No Right Answer
• Empirical evidence yields to conflicting
  conclusions.
  
• Some studies show that advertising leads higher
  profits, and others, that advertising improves
  the functioning of the market.
  

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MONOPOLISTIC COMPETITION

• A monopolistic competitor has a monopoly of its
  own unique product but there are many close
  substitutes for the good.
  
• Although the demand curve faced by a monopolistic
  competitor is likely to be less elastic than the
  demand curve faced by a perfectly competitive
  firm, it is likely to be more elastic than the
  demand curve faced by a monopoly because of the
  availability of substitutes.

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MONOPOLISTIC COMPETITION
Product Differentiation and Demand Elasticity
FIGURE 14.2 Product Differentiation Reduces the
Elasticity of Demand Facing a Firm
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MONOPOLISTIC COMPETITION

• Price/Output Determination in the Short Run
• Like all other firms, a monopolistic competitor
  will profit maximize by producing the quantity
  where MRMC.
  
• Since the Demand curve is downward sloping, MR is
  below price.

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MONOPOLISTIC COMPETITION
Price/Output Determination in the Short Run
FIGURE 14.3 Monopolistic Competition in the
Short Run
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MONOPOLISTIC COMPETITION

• In the short run, the firm will shutdown if the
  profit maximizing price is below AVC and it will
  exit in the long run as long as the profit
  maximizing price is below ATC.

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MONOPOLISTIC COMPETITION

• In the long run, because there are no barriers to
  entry or exit, if firms are making positive
  economic profits, there will be entry of new
  types of products which are close substitutes.
• This makes the demand curve for a particular
  firms product more elastic (flatter).
  
• Entry will occur until zero profits are being
  earned. In other words in a long run equilibrium,
  the profit maximizing price will have to equal
  ATC.

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MONOPOLISTIC COMPETITION
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MONOPOLISTIC COMPETITION
Price/Output Determination in the Long Run
FIGURE 14.4 Monopolistically Competitive Firm at
Long-Run Equilibrium
The firms demand curve must end up tangent to
its average total cost curve for profits to equal
zero. This is the condition for long-run
equilibrium in a monopolistically competitive
industry.
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MONOPOLISTIC COMPETITION

• ECONOMIC EFFICIENCY AND RESOURCE ALLOCATION
• Even though there are zero economic profits in
  the long run, the final outcome is not
  efficient.
  
• First, the profit-maximizing strategy is to
  restrict production relative to the perfectly
  competitive case, and to charge a price above
  marginal cost. So it does not produce the
  efficient amount of output.
• Second, final equilibrium in a monopolistically
  competitive firm is necessarily to the left of
  the low point on its average total cost curve.
  

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OLIGOPOLY
oligopoly A form of industry (market) structure
characterized by a few dominant firms.
Products may be homogenous or differentiated.
The behavior of any one firm in an oligopoly
depends to a great extent on the behavior of
others.
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OLIGOPOLY
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OLIGOPOLY

• OLIGOPOLY MODELS
• Because many different types of oligopolies
  exist, a number of different oligopoly models
  have been developed.
  
• All kinds of oligopoly have one thing in common
• The behavior of any given oligopolistic firm
  depends on the behavior of the other firms in the
  industry comprising the oligopoly.

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OLIGOPOLY

• Oligopoly Models that we will study
• Collusion/Cartel
• Game Theory
• One shot Game
• Repeated Interaction

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OLIGOPOLY Collusion Model

• The Collusion Model (also know as the
  Monopoly/Cartel Model)
  
• cartel A group of firms that gets together and
  makes joint price and output decisions to
  maximize joint profits
  
• The different firms get together and act like
  they are a monopolist (one firm) and decide what
  is the total output that will be produced, and
  what will each firm produce, and what will be the
  price charged by each firm.

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OLIGOPOLY Collusion Model Ex 14.1

• Example Suppose there are 2 identical firms in
  the industry.
  
• The firms decide to form a cartel and maximize
  industry profits, and will each produce an equal
  share of output.
  
• To find what individual firms do, first see what
  a monopolist would do.
  
• Given the following market demand and MC curve
  (next slide), find what each firm will produce
  and charge. Also, what are each firms profits?
  

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OLIGOPOLY Collusion Model Ex 14.1

A monopolist would produce 400 units of output
and charge a price of 10. Profits would be (P-
ATC)Q (10-5)4002000.
P()
10
9
MCATC
5
MR
D
Q
400
500
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OLIGOPOLY Collusion Model Ex 14.1

• A monopolist would produce 400 units of output
  and charge a price of 10. Profits would be
  (10-5)4002000.
  
• Each firm in the cartel will produce 200 units,
  charge the same price of 10, and will each have
  an equal share of profits of 1000 each.
  

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OLIGOPOLY Collusion Model Ex 14.1

• The problem with the collusion/cartel model is
  that each firm has an incentive to cheat and
  produce a little bit more than its competitors.
  
• By doing so, it could increase its own profits at
  the expense of the other firms in the market.
  
• To see this consider what would happen if firm 1,
  cheats and makes 300 units of output, but the
  other firm sticks to the agreement and makes 200
  each.
• Total output in the industry will now be
  300200500 which means a new market price will
  prevail.

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OLIGOPOLY Collusion Model Ex 14.1

Total output in the industry will now be 500
which means a new market price will prevail equal
to 9.
P()
10
9
8
MCATC
5
MR
D
Q
400
500
600
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OLIGOPOLY Collusion Model Ex 14.1

• What are each firms profits now?
• Firm 1 makes 300 units and charges a price of 9
• Profits for firm1(9-5)3001500, so Firm 1s
  profits increased.
  
• The other firm makes 200 and also sells at a
  price of 9 per unit.
  
• Its profits (9-5)200800, so its profits
  decrease.
  
• The cheating firm gains at the faithful firms
  expense.
  

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OLIGOPOLY Collusion Model

• Since each firm has an incentive to cheat on the
  cartel, it is very hard to keep cartel contracts
  working.
  
• If all firms cheat on the contract, all of them
  will be worse off then under the cartel. (They
  will each make a profit of 900)
  
• To see when cartels will or will not work, we use
  Game Theory.

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OLIGOPOLY Game Theory

• GAME THEORY
• Mathematical technique used to study choices in
  situations when the outcomes of your choices
  depend on the choices of everyone else.
  
• In game theory, firms are assumed to anticipate
  rival reactions.
  
• Example Suppose there is a duopoly (only two
  firms in the industry). Should one firm form a
  cartel, collude, stay faithful to the cartel? The
  answer (and profits) depend on what other firms
  do and how they might react.

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OLIGOPOLY Game Theory

• Elements of a Game
• Players (individual decision makers, firms in
  previous example)
  
• Strategies (all possible choices that can be made
  by the players)
  
• Payoffs (all possible outcomes given what all
  players choose. This will be profits when talking
  about firm behavior.)

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OLIGOPOLY Game Theory

• Assumptions
• Players act independently and dont know what the
  other player will choose.
  
• Game is played just once (one-shot game)
• (Later we will consider when the game is played
  repeatedly. This will allow players to punish
  each other for cheating- and this will be what is
  needed to get cartels to work)

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OLIGOPOLY Game Theory

• Normal Form Representation of a game

2s payoff
2s payoff
1s payoff
1s payoff
2s payoff
2s payoff
1s payoff
1s payoff
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OLIGOPOLY Game Theory

• The first game we look at is what is known as the
  prisoners dilemma.
  
• prisoners dilemma
• Players Ginger and Rocky, two prisoners accused
  of shoplifting.
  
• Strategies The police give them a choice of two
  alternatives (Confess, Dont confess)
  
• Payoffs
• If neither confesses, they each get exactly one
  year.
  
• If only one confesses, the confessor goes free,
  and the silent one gets 7 years.
  
• If both confess, each will get 5 years.

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OLIGOPOLY Game Theory
What is the best strategy?
FIGURE 14.7 The Prisoners Dilemma
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OLIGOPOLY Game Theory

• dominant strategy
• In game theory, a strategy that is best no matter
  what the opposition does.
  
• In the above example, no matter what the other
  player does, both prisoners choose confess. This
  is their dominant strategy.
  

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OLIGOPOLY Game Theory

• What will be the outcome?
• We look for an equilibrium where no player has an
  incentive to change behavior given what the other
  is doing. This concept is called a Nash
  equilibrium.
• Nash equilibrium In game theory, the result of
  all players playing their best strategy given
  what their competitors are doing.
  

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OLIGOPOLY Game Theory

• Finding a Nash Equilibrium
• To find a Nash equilibrium, consider what each
  player would choose given the action of the other
  player (circle the payoff for player 1 of this
  strategy).
• Then consider what the other player would do
  given the actions of the other player (circle the
  payoff for player 2 of this strategy).
  
• If there is a grid with both payoffs circled,
  then this is a Nash Equilibrium.
  
• (Note there may more than one or no Nash
  equilibrium)
  

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OLIGOPOLY Game Theory
Find the Nash Equilibrium
FIGURE 14.7 The Prisoners Dilemma
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OLIGOPOLY Game Theory

• In the prisoners dilemma, the players are
  prevented from cooperating and each has a
  dominant strategy that leaves them both worse off
  than if they could cooperate.
• The only strategy in which neither has an
  incentive to change his or her behavior, given
  what the other is doing is to (confess,
  confess).
• Confess, Confess is the Nash equilibrium of this
  game. Any game that leads to a similarly
  inefficient outcome where players do not find it
  optimal to cooperate is considered a prisoners
  dilemma game.

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OLIGOPOLY Game Theory

• Example 14.1 Continued.
• We could consider the example of whether a cartel
  will hold or not as a type of prisoners dilemma
  game.
  
• If the game is only played once, the Nash
  equilibrium is where both firms cheat, and both
  are worse off than they would be under the cartel.

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OLIGOPOLY Game Theory
Example 14.1 Continued. The Nash Equilibrium is
(Cheat, Cheat)
1000
1200
1000
800
800
900
900
1200
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OLIGOPOLY Game Theory-Repeated Interaction

• So how is it that cartels like OPEC are able to
  get their members to not cheat and stay faithful
  to the collusion contract?
  
• KEY Need repeated interaction (that the game is
  repeatedly played time after time). If you have
  this additional dimension, then firms are able to
  punish cheaters in future periods.

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OLIGOPOLY Game Theory-Repeated Interaction

• Two types of strategies could be used to punish
  cheaters
  
• Grim Trigger Strategy
• One firm says I will not cheat as long as you
  dont. If you ever cheat, I will cheat forever
  after.
  
• This strategy now decreases the gains from
  cheating. Even if cheats the first year, (and
  gets higher profits), will be worse off in future
  years because he knows the other firm will not be
  faithful to the agreement.
• Tit for Tat
• One firm says Whatever you do, I will do next
  period
  

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OLIGOPOLY Game Theory-Repeated Interaction

• These strategies may be implicit rather than
  explicit agreements.
  
• Since in the US, tacit collusion is strictly
  illegal, some firms try to imply that they are
  willing to cooperate and collude rather than
  expressly agree.
• For example, consider what the Nash Equilibrium
  would be for the two airlines Lufthansa and
  British Airways competing in flights between New
  York and London.

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OLIGOPOLY
Payoffs are Weekly Profits What is the Nash Equil
ibrium of a one-shot game? How might the tit for
tat strategy work here?
FIGURE 14.9 Payoff Matrix for Airline Game
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OLIGOPOLY and Economic Performance

• Oligopolistic, or concentrated, industries are
  likely to be inefficient.
  
• First, profit-maximizing oligopolists are likely
  to price above marginal cost. When price is above
  marginal cost, there is underproduction from
  societys point of view.
• Second, to the extent that oligopolies
  differentiate their products and advertise, there
  is the promise of new and exciting products. At
  the same time, however, there remains a real
  danger of waste and inefficiency.

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Market Structure Summary Chart
FIGURE 14.1 Characteristics of Different Market
Organizations