Micro Questions

I need a 100% on this, there is a graph involved, please only ask to do if you are very good with economics

PART 2 and 3 of Final Exam—54 POINTS

INSTRUCTIONS FOR TABLE 1 and Two Graphs-21 points

A) 1) Calculate the Total Cost (TC) for each level of output. (3 points)

2) Calculate the Average Fixed Cost (AFC) for each level of output. (3 points)

3) Calculate the Average Variable Cost (AVC) for each level of output. (3 points)

4) Calculate the Average Total Cost (ATC) for each level of output. (3 points)

5) Calculate the Marginal Cost (MC) for each level of output. (3 points)

B) Using the data from Table 1 draw two graphs:

1) Draw a graph showing the Total Fixed Cost, Total Variable Cost, and Total Cost curves. (3 points)

2) Draw a graph showing the Average Fixed Cost, Average Variable Cost, and Average Total Cost curves and Marginal Cost curve. (3 points)

TABLE 1

(1) (2) (3) (4) (5) (6)

(7) (8)

Total Total Total Total Average Average Average Marginal

Product Fixed Variable Cost Fixed Variable Total Cost

Cost Cost Cost Cost Cost

(Q) (TFC) (TVC) (TC) (AFC) (AVC) (ATC) (MC)

$100 0 $______ ______

1 100 90 ______ ______ ______ ______ ______

2 100 170 ______ ______ ______ ______ ______

3 100 240 ______ ______ ______ ______ ______

4 100 300 ______ ______ ______ ______ ______

5 100 370 ______ ______ ______ ______ ______

6 100 450 ______ ______ ______ ______ ______

7 100 540 ______ ______ ______ ______ ______

8 100 650 ______ ______ ______ ______ ______

9 100 780 ______ ______ ______ ______ ______

10 100 930 ______ ______ ______ ______ ______

INSTRUCTIONS FOR TABLE 2 and One Graph-11 points

A) 1) Calculate the Average Total Cost (TC) for each level of output. (2 points)

2) Enter the Marginal Cost data from Table 1

3) Calculate the Profit (+) or Loss (-) and enter the data in column

(2 points)

4) Indicate the level of output at which Profit will be maximized ______________. (2 points)

5) Calculate the Total Revenue and Total Cost at this level of output. (2 points)

Total Revenue $_________________ Total Cost $____________________

6) Draw a graph with the Marginal Cost Curve, Marginal Revenue Curve, Average Total Cost Curve and

Average Variable Cost Curve on the graph paper. (3 points)

TABLE 2

(1) (2) (3) (4) (5) (6) (7)

Total Average Average Average Marginal Price= Total Economic

Product Fixed Variable Total Cost Marginal Profit (+)

Cost Cost Cost Revenue or Loss (-)

(Q) (AFC) (AVC) (ATC) (MC)

1 $100.00 $90.00 ______ ______ $131 ______

2 50.00 8

00 ______ ______ $131 ______

3 3

33 80.00 ______ ______ $131 ______

4 25.00 75.00 ______ ______ $131 ______

20.

00 7

00 ______ ______ $131 ______

6 1

67 75.00 ______ ______ $131 ______

14.

29 77.14 ______ ______ $131 ______

8 1

50 81.25 ______ ______ $131 ______

11.

11 86.67 ______ ______ $131 ______

10.

00 93.00 ______ ______ $131 ______

PART 3 OF FINAL EXAM—22 POINTS

TABLE ON ORGANIZATION AND FINANCING OF BUSINESS (22 points)
In the fill-in-the-blank boxes below you must put in the correct answers based upon the table that is in the lecture notes. Please DO NOT be creative. Please DO NOT use your own words. Use the exact language that is in the lecture notes. If there are problems, I will review answers. MAKE SURE THAT YOU FOLLOW THE NUMERICAL SEQUENCE OF THE ANSWERS, OTHERWISE YOUR ANSWERS WILL BE MARKED WRONG.

TYPE OF          FINANCING         LENGTH OF           LIABILITY         WHO GETS        WHO MAKES
BUSINESS                                      LIFE                                         PROFITS?          DECISIONS?
PROPRIE-             1, 2                      3                     4                      5                     6
TORSHIP
PARTNER-            7-9                        10                     11                       12 13
SHIP
CORPO-               14-18                     19                     20 21                     22
RATION

PROPRIETORSHIP FINANCING

PROPRIETORSHIP–LENGTH OF LIFE (one word)

PROPRIETORSHIP–LIABILITY (one word)

PROPRIETORSHIP-WHO GETS PROFITS? (one word)

PROPRIETORSHIP–WHO MAKES DECISIONS?

PARTNERSHIP–FINANCING

PARTNERSHIP–LENGTH OF LIFE

10.

PARTNERSHIP–LIABILITY

11.

PARTNERSHIP–WHO GETS PROFITS?

12.

PARTNERSHIP–WHO MAKES DECISIONS?

13.

CORPORATION–FINANCING

14.

15.

16.

17.

18.

CORPORATION–LENGTH OF LIFE

19.

CORPORATION–LIABILITY (one word)

20.

CORPORATION–WHO GETS PROFITS (six words)

21.

CORPORATION–WHO MAKES DECISIONS? (two words)

22.

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Production and Costs
Survey of ECON
Robert L. Sexton
Chapter 6
© ISIFA/GETTY IMAGES
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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*

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Chapter 6 Sections
– Firms and Profits: Total Revenues Minus Total Costs
– Production in the Short Run
– Costs in the Short Run
– The Shape of the Short-Run Cost Curves
– Cost Curves: Short-Run versus Long-Run

Firms and Profits: Total Revenues Minus Total Costs

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Section 1
SECTION 1 QUESTIONS

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A firm’s costs are a key determinant in pricing and production decisions.
But what exactly makes up a firm’s cost of production?
Let’s begin by looking at the two distinct components of a firm’s total cost: explicit costs and implicit costs.
Firms and Profits

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Explicit costs are input costs that require a monetary payment.
They are out-of-pocket expenses, such as wages, which are relatively easy to measure by the money spent on the resources used.
Explicit Costs

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Implicit Costs
Implicit costs do not represent an explicit outlay of money, but they are still real, representing the implicit opportunity costs of alternatives that must be forgone.
© ERLEND KVALSVIK/ISTOCKPHOTO.COM

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Implicit Costs: Example
Example: A typical farmer or small business owner may perform work without receiving formal wages, but the value of the alternative earnings forgone represents an implicit opportunity cost to the individual.

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Whenever we talk about costs explicit or implicitwe are talking about opportunity costs.
Implicit Costs

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Profits
Economists generally assume that
the ultimate goal of every firm is to maximize profits.
In other words, firms try to maximize the difference between what they receive for their goods and services— their total revenue—and what they give up for their inputs—their total costs (explicit and implicit).

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Accounting Profits and Economic Profits
ACCOUNTING PROFITS
total revenues minus total explicit costs.
ECONOMIC PROFITS
total revenues minus all explicit and implicit costs.

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Exhibit 6.1: Accounting Profits versus Economic Profits

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A Zero Economic Profit is
a Normal Profit
Economists consider a zero economic profit a normal profit because it means that the firm is covering both implicit and explicit costs—the total opportunity cost of its resources.
This is clearly different from making a zero accounting profit, when revenues would not cover the implicit costs.

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Sunk Costs
SUNK COSTS
costs that have already been incurred and cannot be recovered.

Sunk costs are irrelevant for any future action.

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Section 1

Production in the Short Run

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Section 2
SECTION 2 QUESTIONS

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Since it takes more time to vary some inputs than others, we must distinguish between the short run and the long run.
The Short Run Versus the Long Run

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The Short Run versus the Long Run
The short run is defined as a period too brief for some inputs to be varied.
In the short run, the inputs that do not change with output are called fixed inputs.

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The long run is a period of time in which the firm can adjust all inputs. In the long run, all inputs to the firm are variable and will change as output changes.
The long run can vary considerably in length from industry to industry.
The Short Run versus the Long Run

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Production in the Short Run
Production function is the relationship between the quantity of inputs and the quantity of outputs.
Total output (Q) is the total amount of output of a good produced by the firm.

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Total output will start at a low level and increase—perhaps rapidly at first, and then more slowly—as the amount of the variable input increases.
It will continue to increase until the quantity of the variable input becomes so large in relation to the quantity of others that further increases in output become more and more difficult or even impossible.
Production in the Short Run

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Exhibit 6.2: Moe’s Production Function with One Variable, Labor

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Rising Marginal Product
The marginal product (MP) of any single input is defined as the change in total product resulting from a small change in the amount of that input used.
Marginal product first rises as the result of more effective use of fixed inputs, and then falls.

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Exhibit 6.3: Total Output and Marginal Product

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As the amount of a variable input is increased, the amount of other (fixed) inputs being held constant, a point ultimately will be reached beyond which marginal product will decline.
Diminishing marginal product stems from the crowding of the fixed input with more and more of the variable input.
Diminishing Marginal Product

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A firm never knowingly allows itself to reach the point at which the marginal product becomes negative, the situation in which the use of additional variable input units actually reduces total output.
In such a situation, there are so many units of the variable input (inputs with positive opportunity costs) that efficient use of the fixed input units is impaired.
Diminishing Marginal Product

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Section 2

Costs in the Short Run

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Section 3
SECTION 3 QUESTIONS

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The short-run total costs of a business fall into two distinct categories:
Fixed costs
Variable costs
Costs in the Short Run

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Fixed Costs, Variable Costs,
and Total Costs
Fixed costs are costs that do not vary with the level of output.
Examples: the rent on buildings or equipment that is fixed for some period of time, as well as insurance premiums and property taxes.
Fixed costs have to be paid even if no output is produced.
In the short run, fixed costs cannot be avoided.

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The sum of the firm’s fixed costs is called its total fixed cost (TFC).
Costs that are not fixed are called variable costs. Variable costs vary with the level of output.
Examples: the expenditures on wages and raw materials
Fixed Costs, Variable Costs,
and Total Costs

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The sum of the firm’s variable costs is called its total variable cost (TVC).
The sum of the firm’s total fixed costs and total variable costs is called its total cost (TC).
Fixed Costs, Variable Costs,
and Total Costs

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Average Total Costs
Sometimes we find it convenient to discuss costs on a per-unit-of-output, or average, basis.
AVERAGE TOTAL COST (ATC)
a per-unit cost of operation; total cost divided by output

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Average fixed cost (AFC) equals total fixed cost divided by the level of output produced.
Average variable cost (AVC) equals total variable cost divided by the level of output produced.
Average Fixed Cost and Average Total Cost

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Marginal Cost
The most important single cost concept is marginal cost.
Marginal cost (MC) shows the change in total costs associated with a change in output by one unit, or the costs of producing one more unit of output.

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Marginal costs are really just a very useful way to view variable costs (costs that vary as output varies).
Marginal costs are the additional, or incremental, costs associated with the “last” unit of output produced.
Marginal Cost

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How Are These Costs Related?
Exhibit 6.4 summarizes the definitions of the seven different short-run cost concepts.
Exhibit 6.5 presents the costs incurred by Pizza Shack at various levels of output.

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Exhibit 6.4: A Summary of the Short-Run Cost Concept

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Exhibit 6.5: Cost Calculations for Pizza Shack Company

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The various cost concepts are illustrated graphically.
A total fixed cost (TFC) curve is always a horizontal line because fixed costs are the same at all output levels.
The total cost (TC) curve is the summation of the total variable cost (TVC) and total fixed cost (TFC) curves.
How Are These Costs Related?

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Because the total fixed cost curve is horizontal, the total cost curve lies above the total variable cost curve by a fixed (vertical) amount.
How Are These Costs Related?

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Exhibit 6.6: Total and Fixed Costs

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The average fixed cost (AFC) curve constantly declines, approaching—but never reaching—zero.
The marginal cost (MC) curve crosses the average variable cost (AVC) and average total cost (ATC) curves at those curves’ lowest points.
How Are These Costs Related?

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At higher output levels, high marginal costs pull up the average variable cost and average total cost curves, while at low output levels, low marginal costs pull the curves down.
How Are These Costs Related?

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Exhibit 6.7: Average and Marginal Costs

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Section 3

The Shape of the Short-Run Cost Curves

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Section 4
SECTION 4 QUESTIONS

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Marginal Costs and Marginal Product
The behavior of marginal costs bears a definite relationship to marginal product (MP).
For example, the variable input is labor. Initially, as the firm adds more workers, the marginal product of labor tends to rise.
© AGE FOOTSTOCK/SUPERSTOCK

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When the marginal product of labor is rising, marginal costs are falling, because each additional worker adds more to the total product than the previous worker.
Thus, the increase in total cost resulting from the production of another unit of output—marginal costs—falls.
Marginal Costs and Marginal Product

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Exhibit 6.8: Marginal Product and Marginal Costs

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The Relationship Between Marginal and Average Amounts
The relationship between the marginal and the average is simply a matter of arithmetic.
When a number (the marginal cost) being added into a series is smaller than the previous average, the new average will be lower than the previous one.

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When a number (the marginal cost) being added into a series is larger than the previous average, the new average will be higher.
The Relationship Between Marginal and Average Amounts

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The average total cost (ATC) curve
is usually U‑shaped.
The average cost per unit declines
as output expands, but then starts increasing again as output expands still further beyond a certain point.
The U-Shaped Average Total
Cost Curve

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The reason for high average total costs when the firm is producing a very small amount of output is the high average fixed costs.
It is the declining AFC that is primarily responsible for the falling ATC.
The U-Shaped Average Total
Cost Curve

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The average total cost curve rises at high levels of output because of diminishing marginal product.
Diminishing marginal product sets in at the very bottom of the marginal cost curve.
The U-Shaped Average Total
Cost Curve

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Diminishing marginal product causes MC to increase, eventually causing the AVC and ATC curves to rise.
At very large levels of output, where the plant approaches full capacity, the fixed plant is overutilized, and this leads to a high MC that causes a high ATC.
The U-Shaped Average Total
Cost Curve

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Exhibit 6.9: U-Shaped Average Total Cost Curve

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Marginal Costs, Average Variable Costs, and Average Total Costs
When AVC is falling, MC must be less than AVC.
When AVC is rising, MC must be greater than AVC.

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MC is equal to AVC at the lowest point on the AVC curve.
The same is true for the ATC curveMC is equal to ATC at the lowest point on the ATC curve.
Marginal Costs, Average Variable Costs, and Average Total Costs

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Exhibit 6.10: Marginal Cost and Average Variable Cost

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Exhibit 6.11: Marginal Cost and Average Total Cost

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Section 4

Cost Curves: Short-Run versus Long-Run

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Section 5
SECTION 5 QUESTIONS

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Cost Curves: Short Run versus Long Run
Over long enough time periods, firms can vary all of their productive inputs.
However, in the short run a firm cannot alter its plant size and equipment, so the firm can only expand output by employing more variable inputs (e.g., workers and raw materials).

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Why Are Long-Run Cost Curves Different From Short-Run Cost Curves?
If a company has to pay many workers overtime wages in order to expand output in the short run, over the long run firms may opt to invest in new equipment to conserve on expensive labor.
In the long run, the firm can expand its factories, build new ones, or shut down unproductive ones.

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The time it takes for a firm to get to the long run varies from firm to firm.
In Exhibit 6.12, we see that the long-run average total cost (LRATC) curve lies equal to or below the short-run average total cost (SRATC) curves.
It presents three short-run average total cost curves, representing small, medium, and large plant sizes.
Long-Run Cost Curves versus Short-Run Cost Curves

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Exhibit 6.12: Short- and Long-Run Average Total Costs

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It also shows the long-run average total cost curve. In the short run, the firm is restricted to the current plant size, but in the long run it can choose the short-run cost curve for the level of production it is planning on producing.
Long-Run Cost Curves versus Short-Run Cost Curves

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As we move along the LRATC, the factory size changes with the quantity of output.
The reason for the difference between the firm’s long-run total cost curve and the short-run total cost curve is that in the long run, costs are lower because firms have greater flexibility in changing inputs that are fixed in the short run.
Long-Run Cost Curves versus Short-Run Cost Curves

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Economies of Scale
ECONOMIES OF SCALE
occur in an output range where LRATC falls as output increases
MINIMUM EFFICIENT SCALE
the output level where economies of scale are exhausted and constant returns to scale begin

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Economies of Scale (cont.)
DISECONOMIES OF SCALE
occur in an output range where LRATC rises as output expands
CONSTANT RETURNS TO SCALE
occur in an output range where LRATC does not change as output varies

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Economies of scale may exist because a firm can use mass production techniques or capture gains from further labor specialization not possible at lower levels of output.
Diseconomies of scale may occur as a firm finds it increasingly difficult to handle the complexities of large-scale management.
Why Do Economies and Diseconomies of Scale Occur?

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Section 5

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Firms in Competitive Markets
Survey of ECON
Robert L. Sexton
Chapter 7
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
© SCOTT OLSON/GETTY IMAGES

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Chapter 7 Sections
– A Perfectly Competitive Market
– An Individual Price Taker’s Demand Curve
– Profit Maximization
– Short-Run Profits and Losses
– Long-Run Equilibrium
– Long-Run Supply

A Perfectly Competitive Market

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Section 1
SECTION 1 QUESTIONS

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A Perfectly Competitive Market
© MARIE-FRANCE BÉLANGER/ISTOCKPHOTO.COM

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Many Buyers and Sellers
In a perfectly competitive market, there are many buyers and sellers.
Because each firm is so small in relation to the industry, its production decisions have no impact on the market.
For this reason, perfectly competitive firms are called price takers.

Consumers believe that all firms in perfectly competitive markets sell identical or homogeneous products.
For example, in the wheat market we are assuming that it is not possible to determine any significant and consistent qualitative differences in the wheat produced by different farmers.
Identical (Homogeneous) Products

Product markets characterized by perfect competition have no significant barriers to entry or exit.
This means that it is fairly easy for entrepreneurs to become suppliers of the product or, if they are already producers, to stop supplying the product.
Easy Entry and Exit

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Barriers to entry are modest, so large numbers of firms can enter the business if they so desire.
Because of easy market entry and exit, perfectly competitive markets generally consist of a large number of small suppliers.
Easy Entry and Exit

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Highly organized markets for securities and agricultural commodities are the best examples of perfectly competitive markets.
Perfectly Competitive Markets: Examples

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While the assumptions for perfect competition may seem a bit unrealistic, the model is useful.
Many markets resemble perfect competition: firms face very elastic demand curves and relatively easy entry and exit.
It gives us a standard of comparison.
Easy Entry and Exit

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Section 1

An Individual Price Taker’s Demand Curve

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Section 2
SECTION 2 QUESTIONS

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An Individual Price Taker’s Demand Curve
Perfectly competitive firms are price takers, selling at the market-determined price.
An individual seller cannot sell at any price higher than the current market price because buyers could purchase the same good from someone else at the market price.
A seller would not charge a lower price when he could sell all he wants at the market price.

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An Individual Firm’s
Demand Curve
In a perfectly competitive market, an individual seller can change his output and it will not alter the market price.
Each producer provides such a small fraction of the total supply that a change in the amount he or she offers does not have a noticeable effect on market price.

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In a perfectly competitive market, then, an individual firm can sell as much as it wishes to place on the market at the prevailing price.
The demand, as seen by the seller, is perfectly elastic at the market price.
An Individual Firm’s
Demand Curve

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A perfectly competitive seller won’t charge more than the market price because no one will buy at higher prices, and will not charge less because the seller can sell all she wants at the market price.
Thus, the demand curve is horizontal at the market price over the entire range of output that she could possibly produce.
An Individual Firm’s
Demand Curve

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Exhibit 7.1: Market and Individual Firm Demand Curves in a Perfectly Competitive Market

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The position or height of each firm’s demand curve varies with every change in the market price.
Sellers are provided with current information about market demand and supply conditions as a result of price changes.
A Change in Market Price and the Firm’s Demand Curve

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The perfectly competitive model does not assume any knowledge on the part of individual buyers and sellers about market demand and supplythey only have to know the price of the good they sell.
A Change in Market Price and the Firm’s Demand Curve

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Exhibit 7.2: Market Prices and the Position of a Firm’s Demand Curve

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Section 2

Profit Maximization

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Section 3
SECTION 3 QUESTIONS

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Profit Maximization
The firm’s objective is to maximize profits.
It wants to produce the amount that maximizes the difference between its total revenues and total costs.

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Total revenue for a perfectly competitive firm equals the market price of the good (P) times the quantity (q) of units sold.
Total Revenue
TR = P × q
TOTAL REVENUE (TR)
the product price times the quantity sold

Average Revenue and Marginal Revenue
AVERAGE REVENUE (AR)
the total revenue divided by the number of units sold
MR = ΔTR ÷ Δq
MARGINAL REVENUE (MR)
the increase in total revenue resulting from a one-unit increase in sales
AR = TR ÷ q
= (P × q) ÷ q

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In a perfectly competitive market, additional units of output can be sold without reducing the market price.
Therefore, marginal revenue is constant and equal to the market price, which is also the average revenue.
Average Revenue and Marginal Revenue

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In perfect competition, marginal revenue, average revenue, and price are all equal:
P = MR = AR
Average Revenue, Marginal Revenue, and Price

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Exhibit 7.3: Revenues for a Perfectly Competitive Firm

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In all types of market environments, the firm will maximize its profits at the level of output that maximizes the difference between total revenue and total cost, which is at the same output level at which marginal revenue equals marginal cost.
How Do Firms Maximize Profits?

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Equating Marginal Revenue and Marginal Cost
The importance of equating marginal revenue and marginal costs for maximizing profits is straightforward.

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As long as the marginal revenue derived from expanded output exceeds the marginal cost of that output, the expansion of output creates additional profits.
However, expansion of output when the marginal cost of production exceeds marginal revenue will lead to losses on the additional output, decreasing profits.
Equating Marginal Revenue and Marginal Cost

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The profit-maximizing output rule says a firm should always produce where its
MR = MC.
The Profit-Maximizing Level of Output

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Exhibit 7.4: Finding the Profit-Maximizing Level of Output

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As long as marginal revenue exceeds marginal cost, producing and selling those units add more to revenues than to costs; in other words, they add to profits.
However, once the production is expanded beyond four units of output, the costs are less than the marginal revenues, and profits begin to fall.
The Profit-Maximizing Level of Output

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Exhibit 7.5: Cost and Revenue Calculations for a Perfectly Competitive Firm

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Section 3

Short-Run Profits and Losses

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Section 4
SECTION 4 QUESTIONS

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Short-Run Profits and Losses
Producing at the profit-maximizing output level does not mean that a firm is actually generating profits.
It merely means that a firm is maximizing its profit opportunity at a given price level.
A firm could be:
Earning profits
Generating losses
Breaking even

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Three easy steps to determine economic profits, economic losses, or zero economic profits:
Where MR equals MC proceed down to horizontal axis to find q*, the profit-maximizing output level.
At q*, go straight up to demand curve, then to price axis to find the market price, P*. Now you can find TR at the profit-maximizing output level because TR = P x q.
The Three-Step Method

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The last step is to find total costs. Go straight up from q* to the short-run average total cost (SRATC) curve; this will give you the average cost per unit. If we multiply average total costs by the output level, we can find the total costs TC = ATC x q.
The Three-Step Method

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If TR > TC at the profit-maximizing output level, the firm is generating economic profits.
If TR < TC, the firm is generating economic losses. If TR = TC, the firm is earning zero economic profits, Covering both implicit and explicit costs, economists sometimes call zero economic profit a normal rate of return. The Three-Step Method ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 7.6: Short-Run Profits, Losses, and Zero Economic Profits ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Alternatively, to find total economic profits we can take the product price at P* and subtract the ATC at q*. This will give us per-unit profit. If we multiply this by output, we will arrive at total economic profit. Or (P* - ATC) × q* = total economic profit. Economists sometimes call the zero economic profit a normal rate of return. That is, the owners are doing as well as they could elsewhere, in that they are getting the normal rate of return on the resources they invested in the firm. The Three-Step Method ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * A firm generating an economic loss faces a tough choice. Should it continue to produce or shut down its operation? To make this decision, we need to consider average variable costs. Evaluating Economic Losses in the Short Run ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * If a firm cannot generate enough revenues to cover its variable costs, then it will have larger losses if it operates than if it shuts down (losses in that case = fixed costs). Thus, a firm will not produce at all unless the price is greater than its average variable costs. Evaluating Economic Losses in the Short Run ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * At price levels greater than or equal to average variable costs, a firm may continue to operate in the short run even if average total costs—variable and fixed costs—are not completely covered. Because fixed costs continue whether the firm produces or not, it is better to earn enough to cover a portion of these costs than to earn nothing at all. Operating at a Loss ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * When price is less than average total costs but more than average variable costs, the firm produces in the short run, but at a loss. To shut down would make this firm worse off because it can cover at least some of its fixed costs with the excess of revenue over its variable costs. Operating at a Loss ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 7.7: Short-Run Losses: Price above AVC but below ATC ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * When the price a firm is able to obtain for its product is below its average variable costs at all ranges of output, it is unable to cover even its variable costs in the short run. Since it is losing even more than the fixed costs it would lose if it shut down, it is more logical for the firm to cease operations. The Decision to Shut Down © BEAU LARK/PHOTOLIBRARY ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 7.8: Short-Run Losses: Price below AVC ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * At all prices above minimum AVC, a firm produces in the short run, even if ATC is not completely covered. At all prices below the minimum AVC, the firm shuts down. Therefore, the short-run supply curve of an individual competitive seller is identical to that portion of the MC curve that lies above the minimum of the AVC curve. The Short-Run Supply Curve ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * As a cost relation, the MC curve above minimum AVC shows the marginal cost of producing any given output. As a supply curve, the MC curve above minimum AVC shows the equilibrium output that the firm will supply at various prices in the short run. The Short-Run Supply Curve ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Beyond the point of lowest AVC, the MC of successively larger outputs are progressively greater, so the firm will supply larger amounts only at higher prices. The Short-Run Supply Curve ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 7.9: The Firm’s Short-Run Supply Curve ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * The short-run market supply curve is the summation of all the individual firms’ supply curves (that is, the portion of the firms’ MC above AVC) in the market. Because the short run is too brief for new firms to enter the market, the market supply curve is the summation of existing firms. Deriving the Short-Run Market Supply Curve ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 7.10: Deriving the Short-Run Market Supply Curve ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 4 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Long-Run Equilibrium ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 5 SECTION 5 QUESTIONS ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Long-Run Equilibrium If perfectly competitive producers make economic profits: Resources devoted to that lucrative business increase. More firms enter the industry and existing firms expand, shifting the market supply curve to the right over time. The impact of increasing supply, other things equal, is to reduce the equilibrium price. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * As entry into the profitable industry pushes down the market price, producers will move from making a profit (P > ATC) to zero economic profits (P = ATC).
In long‑run equilibrium, perfectly competitive firms make zero economic profits, earning a normal return on the use of their capital.
Long-Run Equilibrium

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Zero economic profits is an equilibrium or stable situation because any positive economic (above‑normal) profits signal resources into the industry, beating down prices and thus revenues to the firm.
Long-Run Equilibrium

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Economic losses signal resources to leave the industry, causing supply reductions that lead to increased prices and higher firm revenues to the remaining firms.
Only at zero economic profits is there no tendency for firms to either enter or leave the business.
Long-Run Equilibrium

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Exhibit 7.11: Profits Disappear with Entry

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Exhibit 7.12: Losses Disappear with Exit

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The long‑run competitive equilibrium for a perfectly competitive firm can be graphically illustrated.
Where MC = MR, short-run and long-run average total costs are also equal.
The ATC curves touch the MC and MR (demand) curves at the equilibrium output point.
The Long‑Run Equilibrium for the Competitive Firm

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Because the MR curve is also the AR curve, average revenues and average total costs are equal at the equilibrium point.
The Long‑Run Equilibrium for the Competitive Firm

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The long-run equilibrium output in perfect competition occurs at the lowest point on the ATC curve, so the equilibrium condition in the long run in perfect competition is for firms to produce at that output that minimizes per-unit total costs.
The Long‑Run Equilibrium for the Competitive Firm

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Exhibit 7.13: The Long-Run Competitive Equilibrium

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Section 5

Long-Run Supply

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Section 6
SECTION 6 QUESTIONS

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Long-Run Supply
When the output of an entire industry changes, the likelihood is greater that changes in costs will occur.
The three possible types of industries seen when considering long-run supply are:
Constant-costs
Increasing-costs
Decreasing-cost
The shape of the long-run supply curve depends on the extent to which input costs change when there is entry or exit of firms in the industry.

*
In a constant-cost industry, the prices of inputs do not change as output is expanded. The industry does not use inputs in sufficient quantities to affect input prices.
A Constant-Cost Industry
© WENDELL FRANKS/ISTOCKPHOTO.COM

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Because the industry is one of constant costs, industry expansion does not alter firms’ cost curves, and the industry long-run supply curve is horizontal.
A Constant-Cost Industry

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The short-run higher profits from an increase in demand attracts entry until long-run equilibrium is again reached.
The long‑run equilibrium price is at the same level that prevailed before demand increased.
The only long‑run effect of the increase in demand is an increase in industry output.
A Constant-Cost Industry

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Exhibit 7.14: Demand Increase in a Constant-Cost Industry

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In an increasing-cost industry, the cost curves of the individual firms rise as the total output of the industry increases.
An Increasing-Cost Industry

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When an industry utilizes a large portion of an input, input prices will rise when the industry uses more of that input as it expands output, which will shift firms’ cost curves upward.
An Increasing-Cost Industry

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For example, if a construction boom occurs in a fully employed economy, would it be more costly to obtain additional resources such as workers and raw materials?
Yes, as an increasing-cost industry, the industry can only produce more output if it gets a higher price, because the firm’s costs of production rise as output expands.
An Increasing-Cost Industry: Example

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As new firms enter and output expands, the increase in demand for inputs causes the price of inputs to rise—the cost curves of all construction firms shift upward as the industry expands.
The industry can produce more output, but only at a higher price, enough to compensate the firm for the higher input costs.
In an increasing-cost industry, the long-run supply curve is upward sloping.
An Increasing-Cost Industry

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A firm experiences lower cost as an industry expands. The new long-run market equilibrium has more output at a lower price—that is, the long-run supply curve for a decreasing-cost industry is downward sloping.
This situation might occur in the computer industry.
A Decreasing-Cost Industry

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The firms in the industry may be able to acquire computer chips at a lower price as the industry’s demand for computer chips rises.
The marginal and average costs of the firm fall as input prices fall because of expanded output in the industry.
In this case, the LRS curve would be negatively sloped.
A Decreasing-Cost Industry

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PRODUCTIVE EFFICIENCY
requires that firms produce goods and services in the least costly way
This is where P = minimum ATC.
The output that results from equilibrium conditions of market demand and supply in perfectly competitive markets is economically efficient.
Perfect Competition and
Economic Efficiency

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Once the competitive equilibrium is reached, the buyers’ marginal benefit equals the sellers’ marginal cost.
That is, in a competitive market, producers efficiently use their scarce resources (labor, machinery, and other inputs) to produce what consumers want.
Perfect Competition and
Economic Efficiency

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In this sense, perfect competition achieves allocative efficiency.
Allocative efficiency is where P = MC and production will be allocated to reflect consumer preferences.
Perfect Competition and
Economic Efficiency

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Exhibit 7.15: Allocative Efficiency and Perfect Competition

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Section 6

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Monopoly
Survey of ECON
Robert L. Sexton
Chapter 8
©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
© HULTON ARCHIVE/GETTY IMAGES

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*

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Chapter 8 Sections
– Monopoly: The Price Maker
– Demand and Marginal Revenue in Monopoly
– The Monopolist’s Equilibrium
– Monopoly and Welfare Loss
– Monopoly Policy
– Price Discrimination

Monopoly:
The Price Maker

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Section 1
SECTION 1 QUESTIONS

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Monopoly
A true or pure monopoly exists when there is only one seller of a product for which no close substitute is available.
The firm and “the industry” are one and the same.

*
Because a monopoly firm faces the industry demand curve, it can pick the most profitable point on that demand curve.
Monopolists are price makers (rather than takers) that try to pick the price that will maximize their profits.
Monopoly: Price Makers

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Pure Monopoly is a Rarity
Pure monopolies are a rarity because few goods and services truly have only one producer.
Near-monopoly conditions may exist, such as many public utilities, but absolute total monopoly is rather unusual.
However, the number of situations in which monopoly conditions are fairly closely approximated are numerous enough to make the study of monopoly useful.

*
Barriers to Entry
For a monopoly to persist, it must be virtually impossible for other firms to overcome barriers to entry.
Barriers to entry
legal barriers
economies of scale
control of important inputs

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Legal Barriers
Legal barriers include franchising (the postal service), licensing to ensure quality (trade industries), and patents.

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The situation in which one large firm can provide the output of the market at a lower cost than two or more smaller firms is called a natural monopoly. With a natural monopoly, it is more efficient to have one firm produce the good. The reason for the cost advantage is economies of scale throughout the relevant output range.
Economies of Scale

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Exhibit 8.1: Economies of Scale

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Another barrier to entry is control over an important input.
Alcoa’s control over aluminum in the 1940s
De Beers’ control over much of the world’s output of diamonds
Control of Important Inputs

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Section 1

Demand and Marginal Revenue in Monopoly

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Section 2
SECTION 2 QUESTIONS

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Demand and Marginal Revenue in Monopoly
In monopoly, the market demand curve may be regarded as the demand curve for the firm’s product because the monopoly firm is the market for that particular product.
Unlike in perfect competition, monopolists (and all other firms that are price makers) face a downward-sloping demand curve.
If the monopolist raises its price, it will lose some, but not all of its customers.

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Exhibit 8.2: Comparing Demand Curves: Perfect Competition versus Monopoly

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Exhibit 8.3: Total, Marginal, and Average Revenue

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Because a monopolist’s marginal revenue is always less than the price, the marginal revenue curve will always lie below the demand curve.
If the seller wants to expand output, it will have to lower the price on all units.
Demand and Marginal Revenue in Monopoly

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The monopolist receives additional revenue from the new unit sold (the output effect), but will receive less revenue on all the units it was previously selling (the price effect).
So when the monopolist cuts prices to attract new customers, the old customers benefit.
Demand and Marginal Revenue in Monopoly

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Exhibit 8.4: Demand and Marginal Revenue for the Monopolist

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In Exhibit 8.5, we can compare marginal revenue for the competing firm with the marginal revenue for the monopolist.
Marginal Revenue: The Competing Firm and the Monopolist

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Exhibit 8.5: Marginal Revenue—Competitive Firm versus Monopolist

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The Monopolist’s Price in the
Elastic Portion of the Demand Curve
The relationship between the elasticity of demand and marginal and total revenue are shown in Exhibit 8.6.
In the elastic portion of the curve, when the price falls, total revenue rises, so that marginal revenue is positive.
In the inelastic portion of the curve, when the price falls, total revenue falls, so that marginal revenue is negative.

*
Exhibit 8.6: The Relationship between the Elasticity of Demand and Total and Marginal Revenue

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A monopolist will never knowingly operate in the inelastic portion of its demand curve.
Increased output will lead to lower total revenue and higher total cost in that region.
The Monopolist’s Price in the
Elastic Portion of the Demand Curve

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Beyond the Book: The Cable Car
Cable cars in San Francisco are one of the main tourist attractions. Consider a cable car company that decided to increase prices from $3 to $5. Consequently, the number of users would fall, as locals would substitute into buses and other forms of transportation. The demand by tourists for cable car rides, however, would be relatively inelastic. So as cable car fares rose, so would total revenue; so the firm must have been operating in the inelastic portion of its demand curve.

*
Of course, as we just learned, this is clearly not the profit-maximizing part of the demand curve; monopolists can improve their profits by operating on the elastic portion of their demand curve.
However, one might argue that there are positive externalities from keeping cable car fares low. Lower fares could attract more visitors and help local businesses.
Beyond the Book: The Cable Car

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Section 2

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*

The Monopolist’s Equilibrium

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Section 3
SECTION 3 QUESTIONS

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The Monopolist‘s Equilibrium
The monopolist, like the perfect competitor, will maximize profits at that output where MR = MC. Profits continue to grow until that output is reached.
Therefore, the equilibrium output is where MR = MC.

*
Exhibit 8.7: Equilibrium Output and Price for a Monopolist

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Three-Step Method for Monopolists
The three-step method for determining economic profits, economic losses, or zero economic profits:
Find where MR equals MC, which is the profit-maximizing output level.
Go straight up to the demand curve, then left to find the corresponding market price.
Find TC as ATC times the quantity produced.
TC = ATC  Q

*
If TR > TC (the price exceeds average total cost), the monopolist is generating economic profits.
If TR < TC (the price is less than average total cost), the monopolist is generating economic losses. Profits for a Monopolist ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 8.8: A Monopolist’s Profits ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * In perfect competition, profits in an economic sense will persist only in the short run because in the long run, new firms will enter the industry, increasing industry supply, and thus driving down the price of the good. Thus, profits are eliminated. Profits for a Monopolist ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * In monopoly, profits are not eliminated because barriers to entry exist. Other firms cannot enter, so economic profits can persist in the long run. Profits for a Monopolist ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Being a sole supplier does not guarantee that consumers will demand your product. A monopolist will incur a loss if there is insufficient demand to cover average total costs at any price and output combination along the demand curve. Losses for the Monopolist ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 8.9: A Monopolist’s Losses ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Patents Patents and copyrights examples of monopoly power designed to provide an incentive to develop new products The fall in the price of a patented good when the patent expires illustrates the effect of introducing competition. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 8.10: Impact of Patent Protection on Equilibrium Price and Quantity ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 3 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * * Monopoly and Welfare Loss ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 4 SECTION 4 QUESTIONS ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Does Monopoly Promote Inefficiency? The major objections to monopoly: Not “fair” for monopoly owners to have persistent economic profits Monopoly leads to lower output and higher prices than would exist under perfect competition ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Does Monopoly Promote Inefficiency? Efficiency objection: monopolists charge higher prices and produce less output. monopolist produces an output where the price is greater than its cost, so that the value to society from the last unit produced is greater than its cost, so the monopoly is not producing enough of the good from society’s perspective, creating a welfare loss. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 8.11: Perfect Competition versus Monopoly ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * The actual amount of the welfare loss in monopoly is of considerable debate among economists. Estimates vary from 0.1 percent to 6 percent of national income. Welfare Loss in Monopoly ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Does Monopoly Retard Innovation? Some argue that a lack of competition retards technological advance. Already reaping monopolistic profits, firms do not work at: product improvement technical advances designed to promote efficiency Notion that monopoly retards innovation can be disputed. Many near‑monopolists are important innovators. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Indeed, innovation helps firms initially obtain a degree of monopoly status. Even monopolists want more profits, and any innovation that lowers costs or expands revenues creates profits for a monopolist. Therefore, the incentive to innovate may well exist in monopolistic market structures. Does Monopoly Retard Innovation? ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 4 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Monopoly Policy ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 5 SECTION 5 QUESTIONS ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Monopoly Policy Two major approaches to dealing with the monopoly problem: antitrust policies regulation ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Antitrust Policies By imposing monetary and nonmonetary costs on monopolists, antitrust policies reduce the profitability of monopoly. The fear of lawsuits Jail sentences ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Antitrust Laws The first important law regulating monopoly was the Sherman Antitrust Act. The Sherman Act prohibited “restraint of trade”—price fixing and collusion—but narrow court interpretation of the legislation led to a number of large mergers, such as U.S. Steel. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Antitrust efforts were strengthened by subsequent legislation, the most important of which was the Clayton Act in 1914. Additional legislation in the same year created the Federal Trade Commission (FTC), which became the second government agency concerned with antitrust actions. Antitrust Acts Strengthened ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * The Clayton Act made it illegal to engage in predatory pricing—setting prices to drive out competitors or deter potential entrants in order to ensure higher prices in the future. The Clayton Act also prohibited mergers if it led to weakened competition. The Clayton Act ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Not all of the later legislation actually served to enhance competition. The Robinson-Patman Act of 1936 (forbade most forms of price discrimination) The Cellar-Kefauver Act in 1950, (toughened restrictions on mergers that reduced competition) Further Antitrust Legislation ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Many professional associations restrict the promotion of price competition by prohibiting advertising among their members. Both the FTC and the Justice Department successfully attacked these types of restrictions on the grounds that they violate the antitrust laws. Promoting More Price Competition ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Have Antitrust Policies Been Successful? The success of antitrust policies can be debated. It is very likely that at least some anticompetitive practices have been prevented simply by the very existence of laws prohibiting monopoly‑like practices. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Although the laws were probably enforced in an imperfect fashion, on balance they impeded monopoly influences to at least some degree. Have Antitrust Policies Been Successful? ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Government Regulation Government regulation is an alternative approach to dealing with monopolies. The goal is to achieve the efficiency of large-scale production without permitting the high monopoly prices and low output that can promote allocative inefficiency. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Regulators often face a basic policy dilemma. Without regulation, profit-maximizing monopolists will produce where MR = MC. At that output, the price exceeds average total cost, so economic profits exist. Government Regulation ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * The monopolist is producing relatively little output charging a relatively high price producing at a point where price is above marginal cost Government Regulation ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 8.12: Marginal Cost Pricing versus Average Cost Pricing ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Socially allocative efficiency where P = MC With natural monopoly, where P = MC, the ATC > P
The optimal output, then, is an output that produces losses for the producer.
Allocative Efficiency

*
Any regulated business that produced for long at this “optimal” output would go bankrupt; it would be impossible to attract new capital to the industry.
Therefore, the “optimal” output from a welfare perspective really is not viable.
Allocative Efficiency

*
A compromise between unregulated monopoly and marginal cost pricing is average cost pricing, where price equals average total cost.
The monopolist is permitted to price the product where economic profits are zero, meaning that a normal return is being permitted, like firms experience in perfect competition in the long run.
Average Cost Pricing

*
Difficulties in Average Cost Pricing
The actual implementation of a rate (price) that permits a “fair and reasonable” return is more difficult than the graphical analysis suggests.
The calculations of costs and values is very difficult, often forcing regulatory agencies to use profits as a guide instead.

*
Another problem is that average cost pricing gives the monopolist no incentive to reduce costs (which regulators have tackled by letting the firm keep some of the profits that come from lower costs).
Difficulties in Average Cost Pricing

*
Exhibit 8.13: Changes in Average Costs

*
Also, consumer groups are constantly battling for lower rates, while the utilities themselves are lobbying for higher rates so that they can achieve some monopoly profits.
The temptation is great for the commissioners to be generous to the utilities.
On the other hand, there may be a tendency for regulators to bow to pressure from consumer groups.
Difficulties in Average Cost Pricing

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Section 5

Price Discrimination

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Section 6
SECTION 6 QUESTIONS

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Price Discrimination

Under certain conditions, the monopolist finds it profitable to discriminate among various buyers, charging higher prices to those that are more willing to pay and lower prices to those less willing to pay.

PRICE DISCRIMINATION
the practice of charging different consumers different prices for the same good or service

*
Conditions for Price Discrimination

Three conditions are necessary for the monopolist to practice price discrimination:
Monopoly Power
Market Segregation
No Resale

*
Monopoly Power
Price discrimination is possible only with monopoly or where members of a small group of firms follow identical pricing policies.
When there are a number of competing firms, discrimination is less likely because competitors tend to undercut higher prices charged by the firms engaging in price discrimination.

*
Price discrimination can only occur if the demand curve for markets, groups, or individuals are different. If the demand curves are not different, a profit-maximizing monopolist would charge the same price in both markets.
In short, price discrimination requires the ability to separate customers according to their willingness to pay.
Market Segregation

*
For price discrimination to work, the purchaser buying the product at a discount must have difficulty in reselling the product to customers being charged more. Otherwise, consumers would buy extra product at the discounted price and sell it at a profit to others, reducing the number of customers paying the higher price.
No Resale

*
Why Does Price Discrimination Exist?
Price discrimination results from the profit-maximization motive.
Different groups of people have different demand curves and therefore react differently to price changes.
A producer can make more money by charging these different buyers different prices.

*
Exhibit 8.14: Price Discrimination in Movie Ticket Prices

*
Price Discrimination Examples: Airline Tickets
Seats on airlines usually go for different prices.
The airlines can discriminate against business travelers who usually have little advance warning and often travel on weekdays—preferring to be home on the weekends.
Because the business traveler has a high willingness to pay (a relatively inelastic demand curve) the airlines can charge them a higher price.

*
The coupon cutter, who spends an hour looking through the Sunday paper for coupons, will probably have a relatively more elastic demand curve than, say, a busy and wealthy physician or executive.
Consequently, firms charge a lower price to customers with a lower willingness to pay (more elastic demand)—the coupon cutter—and a higher price to those who don’t use coupons (less elastic demand).
Price Discrimination Examples: Coupons

Students who are well off financially tend to pay more for their education than do students who are less well off because of different financial aid packages.
Price Discrimination Examples: College and University Tuition

*
The seller charges a higher price for the first unit than for later units, allowing the producer to extract some consumer surplus.
A six-pack of soda might be less expensive than buying each separately. Or you might be able to buy a baker’s dozen of donuts—13 for the price of 12.
With this type of price discrimination, you are charging more for the first units than, say, for the 20th unit.
Price Discrimination Examples: Quantity Discounts

*
Section 6

*
Monopolistic Competition and Oligopoly
Survey of ECON
Robert L. Sexton
Chapter 9
ied or duplicated, or posted to a publicly accessible website, in whole or in part.

*
*

Chapter 9 Sections
– Monopolistic Competition
– Price and Output Determination in Monopolistic Competition
– Monopolistic Competition versus Perfect Competition
– Oligopoly
– Collusion and Cartels
– Game Theory and Strategic Behavior
*

Monopolistic Competition

*
Section 1
SECTION 1 QUESTIONS

*
Monopolistic Competition
MONOPOLISTIC COMPETITION
a market structure with many firms selling differentiated products

*
Monopolistic competition has features in common with both monopoly and perfect competition.
Like monopoly, individual sellers believe that they have some market power.
Monopolistic Competition

*
Monopolistic competition is similar to perfect competition.
Relatively free entry of new firms
Long-run price and output behavior
Zero long-run economic profits
However, the monopolistically competitive firm produces a differentiated product, which leads to some degree of monopoly power.
Monopolistic Competition:
Characteristics

*
In a sense, each seller in a market of monopolistic competition may be regarded as a “monopolist” of its own particular brand of the commodity.
Unlike a firm in the monopoly model, there is competition by many firms selling similar (but not identical) brands.
Monopolistic Competition

*
The Three Basic Characteristics of
Monopolistic Competition

*
Product differentiation is the accentuation of unique product qualities, real or perceived, to develop a specific product identity.
With differentiation, buyers believe that the products of the various sellers are not the same, whether the products are actually different or not.
Product Differentiation

*
Product differentiation leads to preferences among buyers to deal with particular sellers or to purchase the products of particular sellers.
Sources of differentiation:
Physical differences
Prestige considerations
Location
Service considerations
Product Differentiation

*
When many firms compete for the same customers, any particular firm has little control over or interest in what other firms do.
Impact of Many Sellers

*
Entry in monopolistic competition is relatively unrestricted.
New firms may easily start the production of close substitutes for existing products.
Economic profits tend to be eliminated in the long run, as is the case in perfect competition.
Significance of Free Entry

*
Section 1

Price and Output Determination in Monopolistic Competition

*
Section 2
SECTION 2 QUESTIONS

*
Monopolistically competitive sellers are price makers rather than price takers, they do not regard price as a given by market conditions like perfectly competitive firms.
The cost and revenue curves of a typical seller are shown in Exhibit 9.1.
Determining Short-Run Equilibrium

*
Exhibit 9.1: Short-Run Equilibrium in Monopolistic Competition

*
The intersection of the marginal revenue and marginal cost curves indicates that the short-run profit-maximizing output will be q*.
By observing how much will be demanded at that output level, we find our profit-maximizing price, P*.
That is, at the equilibrium quantity, q*, we go vertically to the demand curve and read the corresponding price on the vertical axis, P*.
Determining Short-Run Equilibrium

*
1. Find where MR = MC and proceed straight down to the horizontal quantity axis to find q*, the profit-maximizing output level.
2. Go up to the demand curve then to the left to find the market price. Once P* and q* are identified, total revenue can be found, TR = P × q.
3. To find total costs, go straight up from q* to the ATC curve, then left to the vertical axis to compute the ATC per unit. (TC = ATC × q).
If TR > TC at q*, the firm is generating total economic profits.
If TR < TC at q*, the firm is generating total economic losses. Three-Step Method for Monopolistic Competition ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * If we take the product price at P* and subtract the average cost at q*, this will give us per-unit profit. If we multiply this by output, we will arrive at total economic profit, that is, (P* − ATC) × q* = total profit. The cost curves include implicit and explicit costs—that is, even at zero economic profits the firm is covering the total opportunity costs of its resources and earning a normal profit or rate of return. Three-Step Method for Monopolistic Competition ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Short-Run Profits and Losses in Monopolistic Competition In Exhibit 9.1(a), the total revenue is greater than total cost so the firm has a total economic profit. In Exhibit 9.1(b), price is below average total cost, so the firm is minimizing its economic loss. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Determining Long-Run Equilibrium The short-run equilibrium situation, whether involving profits or losses, will probably not last long, because there is entry and exit in the long run. If market entry and exit are sufficiently free: New firms will enter when there are economic profits. Some firms will exit when there are economic losses. © MARCUS LINDSTRÖM/ISTOCKPHOTO.COM ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Determining Long-Run Equilibrium If existing firms are earning economic profits, new firms enter to take advantage of the economic profits. The demand curves for each of the existing firms will fall and become more elastic due to increasing substitutes. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Long‑run equilibrium will occur when demand is equal to average total cost for each firm at a level of output at which each firm’s demand curve is just tangent to its ATC curve. Achieving Long-Run Equilibrium ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * The point of tangency will always occur at the same level of output as where MR = MC. At this equilibrium point, there are: Zero economic profits No incentives for firms to either enter or exit the industry Achieving Long-Run Equilibrium ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Exhibit 9.2: Long-Run Equilibrium for a Monopolistically Competitive Firm ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 2 ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Monopolistic Competition versus Perfect Competition ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Section 3 SECTION 3 QUESTIONS ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Monopolistic Competition versus Perfect Competition Both monopolistic competition and perfect competition have many buyers and sellers and relatively free entry. However, product differentiation allows a monopolistic competitor the ability to have some influence over price. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * A monopolistic competitive firm has a downward-sloping demand curve, but it tends to be more elastic than the demand curve for a monopolist because of the large number of good substitutes for its product. Monopolistic Competition versus Perfect Competition ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * The Significance of Excess Capacity Because of the downward slope of the demand curve, its point of tangency with ATC will not and cannot be at the lowest level of average cost. Therefore, even when long-run adjustments are complete, firms will not be operating at a level that permits the lowest average cost of productionthe efficient scale of the firm. ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * The existing plant, even though optimal for the equilibrium volume of output, will not be used to capacity. The Significance of Excess Capacity EXCESS CAPACITY occurs when the firm produces below the level at which average total cost is minimized ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Unlike a perfectly competitive firm, a monopolistically competitive firm could increase output and lower its average total costs. However, increasing output to attain lower average costs would be unprofitable. The price reduction necessary to sell the greater output would cause MR to fall below MC of the increased output. The Significance of Excess Capacity ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Consequently, in monopolistic competition, there is a tendency toward too many firms in the industry, each producing a volume of output less than that which would allow lowest cost. Economists call this tendency a failure to reach productive efficiency. The Significance of Excess Capacity ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. * Failing to Meet Allocative Efficiency, Too In monopolistic competition, firms are not operating where P = MC. At the intersection of MC and MR, curves (q*), P > MC .
This means that society is willing to pay more for the product (the price, P*) than it costs society to produce it (MC at q*).
The firm is not allocatively efficient, (where P = MC).
Too many firms are producing at output levels that are less than full capacity.

*
Perfectly competitive firms reach
Productive efficiency (P = ATC at the minimum point on the ATC curve).
Allocative efficiency (P = MC).
Failing to Meet Allocative
Efficiency, Too

*
In monopolistic competition, the higher average costs and the slightly higher price and lower output may just be the price we pay for differentiated productsvariety.
Just because we have not met the conditions of productive and allocative efficiencies, it is not obvious that society is better off.
Failing to Meet Allocative
Efficiency, Too

*
Exhibit 9.3: Comparing Long-Run Perfect Competition and Monopolistic Competition

*
What are the Real Costs of Monopolistic Competition?
Perfect competition meets the test of allocative and productive efficiency and monopolistic competition does not.
A remedy for a monopolistically competitive firm to look more like an efficient, perfectly competitive firm might entail using government regulation, as in the case of a natural monopoly.

*
However, this process would be costly because a monopolistically competitive firm makes no economic profits in the long run.
Therefore, asking monopolistically competitive firms to equate price and marginal cost would lead to economic losses, because long-run ATC would be greater than price at P = MC.
Consequently, the government would have to subsidize the firm.
What are the Real Costs of Monopolistic Competition?

*
The monopolistically competitive firm does not operate at the minimum point of the ATC curve, whereas the perfectly competitive firm does.
The excess capacity that exists in monopolistic competition is the price we pay for product differentiation.
In short, the inefficiency of monopolistic competition is a result of product differentiation.
What are the Real Costs of Monopolistic Competition?

*
Because consumers value variety—the ability to choose from competing products and brands—the loss in efficiency must be weighed against the gain in increased product variety.
The gains from product diversity can be large and may easily outweigh the inefficiency associated with a downward-sloping demand curve.
Firms differentiate their products to meet consumers’ demand.
What are the Real Costs of Monopolistic Competition?

*
Section 3

Oligopoly

*
Section 4
SECTION 4 QUESTIONS

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Oligopoly
The products may be homogeneous or differentiated, but the barriers to entry are often very high, which makes it very difficult for firms to enter into the industry. Firms in the industry may earn long-run economic profits.

OLIGOPOLY
a market structure in which relatively few firms control all or most of the production and sale of a product

*
Mutual Interdependence
Oligopolists must strategize, much like good chess or bridge players, constantly observing and anticipating the moves of their rivals.

MUTUAL INTERDEPENDENCE
when a firm shapes its policy with an eye to the policies of competing firms

*
Oligopoly occurs when the number of firms in an industry is so small that any change in output or price by one firm appreciably impacts the sales of competing firms, so competitors respond directly to these actions in determining their own policy.
Mutual Interdependence

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Why Do Oligopolies Exist?
Primarily, oligopoly is a result of the relationship between technological conditions of production and potential sales volumes.
For many products, a reasonably low cost of production cannot be obtained unless a firm is producing a large fraction of the market output.
In other words, substantial economies of scale are present.

*
Measuring Industry Concentration
Oligopolies exist, by definition, when relatively few firms control most of the production and sale of a given product or class of products.
A way of measuring the extent of oligopoly power in various industries is by using concentration ratios.

*
A concentration ratio indicates the proportion of total industry shipments (sales) of goods that a specified number of the largest firms in the industry produced, or the proportion of total industry assets held by those largest firms.
Measuring Industry Concentration

*
The extent of oligopoly power is indicated by the four-firm concentration ratio for the U.S. (Exhibit 9.4).
Concentration ratios of 70 to 100 percent are common in oligopolies.
That is, a high concentration ratio means that a few sellers dominate the market.
Measuring Industry Concentration

*
Exhibit 9.4: Four-Firm Concentration Ratios, U.S. Manufacturing
SOURCE: U.S. Census Bureau, 2002 Economic Census, Concentration Ratios, 2002.
Washington, D.C. (Issued May, 2006). Available at http://www.census.gov/epcd/
www/concentration.html, (accessed April, 16, 2010).

SOURCE: U.S. Census Bureau, 2002 Economic Census, Concentration Ratios, 2002. Washington, D.C. (Issued May, 2006). Available at http://www.census.gov/epcd/www/concentration.html, (accessed April, 16, 2010).

*
However, concentration ratios are not a perfect guide to industry concentration.
One problem is that they do not take into consideration foreign competition.
Measuring Industry Concentration

*
Economies of Scale as a
Barrier to Entry
Economies of large‑scale production make operation on a small scale during a new firm’s early years extremely unprofitable.
A firm cannot build up a large market overnight; in the interim, ATC is so high that losses are heavy. Recognition of this fact discourages new firms from entering the market.

*
Exhibit 9.5: Economies of Scale as a Barrier to Entry

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Equilibrium Price and Quantity in Oligopoly
With mutual interdependence, an oligopolist generally faces considerable uncertainty as to the shape of its demand and marginal revenue curves. In order to know anything about its demand curve, a firm must know how other firms will react to its prices and other policies.

*
Thus, in the absence of additional assumptions, equating marginal revenue and marginal cost is relegated to guesswork.
Thus, it is difficult for an oligopolist to determine its profit-maximizing price and output.
Equilibrium Price and Quantity in Oligopoly

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Section 4

Collusion and Cartels

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Section 5
SECTION 5 QUESTIONS

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Collusion and Cartels
The uncertainties of pricing decisions are substantial in oligopoly, so the implications of misjudging the behavior of competitors could prove to be disastrous.
Because of this uncertainty, some believe that oligopolists change their prices less frequently than perfect competitors, whose prices may change almost continuously.

*
The empirical evidence, however, does not clearly indicate that prices are in fact always slow to change in oligopoly situations.
Collusion and Cartels

*
Collusion
Because the actions and profits of oligopolists are so dominated by mutual interdependence, the temptation is great for firms to colludeto get together and agree to act jointly in pricing and other matters.

*
If firms believe they can increase their prices by coordinating their actions, they will be tempted to collude.
Collusion reduces uncertainty and increases the potential for monopoly profits.

Collusion

*
From society’s point of view, collusion has the same disadvantages as monopoly.
Goods are overpriced.
Goods are under-produced.
Consumers lose out from a misallocation of resources.
Collusion

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Joint Profit Maximization
Agreements between firms on sale, pricing, and other decisions are usually called cartel agreements.
A cartel is a collection of firms making an agreement.
Cartels may lead to joint profit maximization, which requires the determination of price based on the marginal revenue function derived from the total (or market) demand schedule for the product and the marginal cost schedules of the various firms.

*
Exhibit 9.6: Collusion in Oligopoly

*
With outright agreements—necessarily secret because of antitrust laws—firms that make up the market will attempt to estimate demand and cost schedules, and will set optimum price and output levels accordingly.
Joint Profit Maximization

*
Equilibrium quantity and price for a collusive oligopoly, like those of a monopoly, are determined according to the intersection of the marginal revenue curve derived from the market demand curve and the horizontal sum of the short-run marginal cost curves for the oligopolists.
Joint Profit Maximization

*
Collusion facilitates joint profit maximization for an oligopoly.
Like monopoly, if the oligopoly is maintained in the long run:
It charges a higher price.
It produces less output.
It fails to maximize social welfare relative to perfect competition.
Joint Profit Maximization

*
The manner in which total profits are shared among firms in the industry depends in part upon the relative costs and sales of the various firms.
Joint Profit Maximization

*
Firms with low costs and large supply capability will obtain the largest profits because they have great bargaining power. With outright collusion, firms may agree upon market shares and the division of profits.
Joint Profit Maximization

*
Division of total profits depends on:
Relative bargaining strength of the firms
Relative financial strength
Ability to inflict damage (through price wars) on other firms
Ability to withstand similar action on the part of other firms
Relative costs
Consumer preferences
Bargaining skills
Joint Profit Maximization

*
Why are Most Collusive Oligopolies Short Lived?
Fortunately, most strong collusive oligopolies are rather short lived for two reasons.
First, in the United States and in some other nations, collusive oligopolies are strictly illegal under antitrust laws.
Second, for collusion to work, firms must agree to restrict output to a level that will support the profit-maximizing price.

*
At profit-maximizing prices, firms can earn positive economic profits.
Yet a great temptation exists for firms to cheat on the agreement of the collusive oligopoly.
And because collusive agreements are illegal, the other parties have no way to punish the offender.
Why are Most Collusive Oligopolies Short Lived?

*
Why do oligopolists have a strong incentive to cheat?
Any individual firm could lower its price slightly and increase sales and profits, as long as it is undetected.
Undetected price cuts could bring in new customers, including rivals’ customers.
In addition, there are non-price forms of spurring defection.
Why are Most Collusive Oligopolies Short Lived?

*
Price Leadership
Over time, an implied understanding may develop in an oligopoly market that a large firm is the price leader.
Competitors that go along with the pricing decisions of the price leader are called price followers.

*
What Happens in the Long Run if Entry is Easy?
Mutual interdependence in itself is no guarantee of economic profits, even if the firms in the industry succeed in maximizing joint profits.
The extent to which economic profits disappear depends on the ease with which new firms can enter the industry.

*
When entry is easy, excess profits attract newcomers.
New firms may break down existing price agreements by cutting prices in an attempt to establish themselves in the industry.
Older firms may reduce prices to avoid excessive sales losses.
As a result, the general level of prices will begin to approach average total cost.
What Happens in the Long Run if Entry is Easy?

*
How Do Oligopolists Deter Market Entry?
The profit-maximizing level of profits in oligopoly could be quite high, which would encourage entry.
But oligopolists often initiate pricing policies that reduce the entry incentive for new firms, holding prices below the maximum‑profit point.
This lower-than-profit-maximizing price may discourage newcomers from entering.

*
Because new firms would likely have higher costs than existing firms, the lower price may not be high enough to cover their costs.
However, once the threat of entry subsides, the market price may return to the profit-maximizing price.
How Do Oligopolists Deter Market Entry?

*
Exhibit 9.7: Long-Run Equilibrium and Deterring Entry

Antitrust and Mergers
The Justice Department and the Federal Trade Commission use the Herfindahl-Hirshman Index (HHI) to determine if a potential merger would result in an oligopoly.

Antitrust and Mergers:
Three Types of Mergers

*
If the price is deliberately kept low (below AVC) to drive a competitor out of the market, it is called predatory pricing.
It is difficult to distinguish predatory pricing from vigorous competition.
Predatory Pricing

*
Section 5

Game Theory and Strategic Behavior

*
Section 6
SECTION 6 QUESTIONS

*
Game Theory and Strategic Behavior
Noncollusive oligopoly resembles a military campaign or a poker game.
Firms take certain actions not because they are necessarily advantageous in themselves but because they improve the position of the oligopolist relative to its competitors and may ultimately improve its financial position.

*
A firm may deliberately cut prices, sacrificing profits either to drive competitors out of business or to discourage them from undertaking actions contrary to the interests of the other firms.
Game Theory and Strategic Behavior

*
What is Game Theory?
Some economists have suggested that the entire approach to oligopoly equilibrium price and output should be recast. They replace the analysis that assumes that firms attempt to maximize profits with one that examines firm behavior in terms of a strategic game.

GAME THEORY
firms attempt to maximize profits by acting in ways that minimize damage from competitors

*
With the game theory approach, there is a set of alternative actions, and the action that would be taken in a particular case depends on the specific policies followed by each firm.
The firm may try to figure out its competitors’ most likely countermoves to its own policies and then formulate alternative defense measures.
What is Game Theory?

*
Cooperative and Noncooperative Games
Interactions can either be cooperative or noncooperative.
A cooperative game would be two firms that decide to collude in order to improve their profit maximization position.
Consequently, most games are noncooperative games, in which each firm sets its own price without consulting other firms.

*
The primary difference between cooperative and noncooperative games is the contract.
Players in a cooperative game can talk and set binding contracts.
Those in noncooperative games are assumed to act independently, with no communication and no binding contracts.
Cooperative and Noncooperative Games

*
Because antitrust laws forbid firms to collude, we will assume that most strategic behavior in the marketplace is noncooperative.
Cooperative and Noncooperative Games

*
The Prisoners’ Dilemma
A firm’s decision makers must map out a pricing strategy based on a wide range of information.
They also must decide whether their strategy will be effective only under certain conditions regarding the actions of competitors or if the strategy will work regardless of the competitors’ actions.

*
Dominant Strategy
DOMINANT STRATEGY
strategy that will be optimal regardless of opponents’ actions

*
The prisoners’ dilemma is a famous game that has a dominant strategy and demonstrates the basic problem confronting noncolluding oligopolists.
Two bank robbery suspects are caught.
The suspects are placed in separate jail cells and are not allowed to talk with each other.
The Prisoners’ Dilemma

*
There are four possible results in this situation:
Both prisoners confess.
Neither confesses.
Prisoner A confesses but Prisoner B doesn’t.
Prisoner B confesses but Prisoner A doesn’t.
The Prisoners’ Dilemma

*
The payoff matrix summarizes these possibilities.
If each prisoner confesses, they will each serve two years in jail.
If neither confesses, each prisoner may only get one year because of insufficient evidence.
If one prisoner confesses and the other does not, the confessor gets six months and the other prisoner gets six years.
The Prisoners’ Dilemma:
The Payoff Matrix

*
Exhibit 9.8: The Prisoners’ Dilemma Payoff Matrix

*
Looking at the payoff matrix, if one prisoner confesses, it is in the best interest of the other prisoner to confess.
Since both know the temptation of the other to confess, the dominant strategy is to confess.
That is, the prisoners know that confessing is the way to make the best of a bad situation.
The Prisoners’ Dilemma

*
Firms in oligopoly often behave like the prisoners in the prisoners’ dilemma, carefully anticipating the moves of their rivals in an uncertain environment.
The Prisoners’ Dilemma

*
Profits Under Different
Pricing Strategies
To demonstrate how the prisoners’ dilemma can shed light on oligopoly theory, let us consider the pricing strategy of two firms.
In Exhibit 9.9, we present the payoff matrix—the possible profits that each firm would earn under different pricing strategies.

*
Exhibit 9.9: The Profit Payoff Matrix

*
At a Nash equilibrium, each firm is doing as well as it can, given the actions of its competitor. Each will make the choice that minimizes the risk of the worst scenario.
The Nash equilibrium is also the dominant strategy.
Nash Equilibrium

*
The Nash equilibrium takes on particular importance because it is a self-enforcing equilibrium.
Once this equilibrium is established, there is no incentive for either firm to move.
Nash Equilibrium

*
If two firms were to collude, it would be in their best interest.
However, each firm has a strong incentive to lower its price if this pricing strategy goes undetected by its competitor.
Profits under Different
Pricing Strategies

*
However, if both firms defect by lowering their prices from the joint profit-maximization level, both will be worse off than if they had colluded, but at least each will have minimized its potential loss if it cannot trust its competitor.
This situation is the oligopolist’s dilemma.
Profits under Different
Pricing Strategies

*
Advertising: Prisoners’ Dilemma Example
Advertising can lead to a situation like the prisoners’ dilemma.
Perhaps the decision makers of a large firm are deciding whether or not to launch an advertising campaign against a rival firm.

*
According to the payoff matrix in Exhibit 9.10, if neither company advertises, the two companies split the market, each making $100 million in profits.
Advertising

*
Exhibit 9.10: The Advertising Payoff Matrix

*
They also split the market if they both advertise, but their net profits are smaller ($75 million) because they would both incur advertising costs that are greater than any gains in additional revenues from advertising.
Advertising

*
However, if one advertises and the other does not, the company that advertises takes customers away from the rival.
The dominant strategy—the optimal strategy regardless of the rival’s actions—is to advertise.
Advertising

*
Arms Race: Prisoners’ Dilemma Example
The arms race provides a classic example of prisoner’s dilemma.
For each country, the dominant strategy is to build arms.
Self interest drives each participant into a noncooperative game that is worse for both.

*
Exhibit 9.11: The Arms Race Payoff Matrix

*
Repeated Games
TIT-FOR-TAT STRATEGY
used in repeated games, the strategy in which one player follows the other player’s move in the previous round; leads to greater cooperation

*
Exhibit 9.12: Characteristics of the Four Major Market Structures

*
Section 6

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