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Monopoly © 2015 Pearson Education, Inc. 1 What is Monopoly and Why Do We Study It? Monopoly is a market structure consisting of a firm that is the only seller of a good or service that does not have a close substitute. Monopoly exists at the opposite end of the competition spectrum from perfect competition. We study monopolies for two reasons: 1. Some firms truly are monopolists, so it is important to understand how they behave. 2. Firms might collude in order to act like a monopolist, with important implications for firm behavior. © 2015 Pearson Education, Inc. 2 Is Any Firm Ever Really a Monopoly? 15.1 LEARNING OBJECTIVE Define monopoly. © 2015 Pearson Education, Inc. 3 Are There Really Monopolies? It is reasonable to ask whether monopolies truly ever exist. For example, suppose you live in a small town with only one pizzeria. Is that pizzeria a monopoly? 1. It has competition from other fast-food restaurants 2. It has competition from grocery stores that provide pizzas for you to cook at home If you consider these alternatives to be close substitutes for pizzeria pizza, then the pizza restaurant is not a monopoly. If you do not consider these alternatives to be close substitutes for pizzeria pizza, then the pizza restaurant is a monopoly. Regardless, the pizzeria’s unique position may afford it some monopoly power to raise prices, and obtain positive economic profit. © 2015 Pearson Education, Inc. 4 Where Do Monopolies Come From? 15.2 LEARNING OBJECTIVE Explain the four main reasons monopolies arise. © 2015 Pearson Education, Inc. 5 Reasons Why Monopolies Exist For a firm to exist as a monopoly, there must be barriers to entry preventing other firms coming in and competing with it. The four main reasons for these barriers to entry are: 1. Government restrictions on entry 2. Control over a key resource 3. Network externalities 4. Natural monopoly The next few slides will examine these in detail. © 2015 Pearson Education, Inc. 6 1. Government Restrictions on Entry In the U.S., governments block entry in two main ways: a. Patents, copyrights, and trademarks Newly developed products like drugs are frequently granted patents, the exclusive right to produce a product for a period of 20 years from the date the patent is filed with the government. Similarly, copyrights provide the exclusive right to produce and sell creative works like books and films. Patents and copyrights encourage innovation and creativity, since without them, firms would not be able to substantially profit from their endeavors. Trademarks, also known as brand names, work similarly. b. Public franchises A government designation that a firm is the only legal provider of a good or service is known as a public franchise. These might exist, for example, in electricity or water markets. © 2015 Pearson Education, Inc. 7 2. Control Over a Key Resource For many years, the Aluminum Company of America (Alcoa) either owned or had long-term contracts for almost all the world’s supply of bauxite, the mineral from which we obtain aluminum. Such control over a key resource served as a substantial barrier to entry for additional firms. The National Football League (NFL) acts as a monopoly in this manner too: it ensures that the majority of the world’s best football players are under contract to the NFL, and unable to be used for another potential league. © 2015 Pearson Education, Inc. 8 3. Network Externalities Economists refer to network externalities as a situation in which the usefulness of a product increases with the number of consumers who use it. Examples: HD televisions Computer operating systems (like Windows) Social networking sites (like Facebook) These network externalities can set off a virtuous cycle for a firm, allowing the value of its product to continue to increase, along with the price it can charge. But consumers may be locked into an inferior product. © 2015 Pearson Education, Inc. 9 4. Natural Monopoly A natural monopoly occurs when economies of scale are so large that one firm can supply the entire market at a lower average total cost than can two or more firms. In the market for electricity delivery, a single firm (point A) can deliver electricity at a lower cost than can two firms (point B). Figure 15.1 Average total cost curve for a natural monopoly This is often because of high fixed costs; in this example, the cost of erecting power lines and transformers, for example. © 2015 Pearson Education, Inc. 10 How Does a Monopoly Choose Price and Output? 15.3 LEARNING OBJECTIVE Explain how a monopoly chooses price and output. © 2015 Pearson Education, Inc. 11 The Return of Marginal Cost and Marginal Revenue In our study of oligopoly, we abandoned the idea of marginal cost and marginal revenue, because the strategic interaction between firms overrode these concepts. Monopolists have no competitors, and hence no concern about strategic interactions. • They seek to maximize profit by choosing a quantity to produce, just like perfect and monopolistic competitors. In fact, monopolists act very much like monopolistic competitors: they face a downward sloping demand curve. • The difference is that barriers to entry will prevent other firms from competing away their economic profit. © 2015 Pearson Education, Inc. 12 Calculating a Monopoly’s Revenue Time Warner Cable is a monopolist in the market for cable television services. The first two columns of the table show the market demand curve, which is also Time Warner’s demand curve. Total, average, and marginal revenue are all calculated in the usual manner. © 2015 Pearson Education, Inc. Figure 15.2a Calculating a monopoly’s revenue (table) 13 Calculating a Monopoly’s Revenue—continued As the monopolist seeks to expand its output, two effects occur: 1. Revenue increases from selling an additional unit of output at whatever price is necessary to convince an additional customer to purchase it. 2. Revenue decreases, because the price reduction is shared with existing customers. So marginal revenue is always below demand for a monopolist. © 2015 Pearson Education, Inc. Figure 15.2b Calculating a monopoly’s revenue (graph) 14 Profit-Maximizing Price and Output for a Monopoly Figure 15.3a Profit-maximizing price and output for a monopoly The monopolist maximizes profit by producing the quantity where the additional revenue from the last unit (marginal revenue) just equals the additional cost incurred from its production (marginal cost). MC = MR determines quantity for a monopolist. © 2015 Pearson Education, Inc. 15 Price and Output for a Monopoly—continued Figure 15.3a&b Profit-maximizing price and output for a monopoly At this quantity, • The demand curve determines price, and • The average total cost (ATC) curve determines average cost. Profit is the difference between these (P–ATC), times quantity (Q). © 2015 Pearson Education, Inc. 16 Long-Run Profits for a Monopoly Since there are barriers to entry, additional firms cannot enter the market. • So there is no distinction between the short run and long run for a monopoly. Then, unlike for monopolistic competitors, we expect monopolists to continue to earn profits in the long run. © 2015 Pearson Education, Inc. 17 Does Monopoly Reduce Economic Efficiency? 15.4 LEARNING OBJECTIVE Use a graph to illustrate how a monopoly affects economic efficiency. © 2015 Pearson Education, Inc. 18 Comparing Monopoly and Perfect Competition Suppose that a market could be characterized by either perfect competition or monopoly. Which would be better? The thought experiment here is to suppose there is some market that is perfectly competitive, such as the market for smartphones. Then a single firm buys up all of the smartphones in the country. What would happen to: • Price of smartphones? • Quantity of smartphones traded? • The net benefit for consumers (i.e. consumer surplus)? • The net benefit for producers (i.e. producer surplus)? • The net benefit for all of society (i.e. economic surplus)? © 2015 Pearson Education, Inc. 19 If a Perfect Competition Became a Monopoly… Figure 15.4 What happens if a perfectly competitive industry becomes a monopoly? The market for smartphones is initially perfectly competitive. Price is PC, quantity traded is QC. Now the market is supplied by a single firm. Since the single firm is made up of all of the smaller firms, the marginal cost curve for this new firm is identical to the old supply curve. © 2015 Pearson Education, Inc. 20 … Quantity Will Fall and Price Will Rise Figure 15.4 What happens if a perfectly competitive industry becomes a monopoly? But the new firm maximizes market profit, producing the quantity where marginal cost equals marginal revenue (MC = MR). This quantity (QM) is lower than the competitive quantity (QC)… … and the firm charges the corresponding price on the demand curve, PM. This price is higher than the competitive price, PC. © 2015 Pearson Education, Inc. 21 Measuring the Efficiency Losses from Monopoly Fewer smartphones will be traded at a higher price. • Consumer surplus will fall (with the higher price). • Producer surplus must rise, otherwise the firm would have chosen the perfectly competitive price and quantity. Could the increase in producer surplus offset the decrease in consumer surplus? • No! Perfectly competitive markets maximized the economic (total) surplus in a market; if fewer trades take place, the economic surplus must fall. © 2015 Pearson Education, Inc. 22 The Inefficiency of Monopoly With the higher monopoly price, consumer surplus decreases by the areas A+B. Producer surplus falls by C, but rises by A; an overall increase. Area A is simply a transfer of surplus: neither inherently good nor bad. But areas B and C are lost surpluses: deadweight loss. Figure 15.5 © 2015 Pearson Education, Inc. The inefficiency of monopoly 23 How Large Are the Efficiency Losses? There are relatively few monopolies, so the loss of economic efficiency due to monopolies must be relatively small. • But many firms have market power: the ability of a firm to charge a price greater than marginal cost. • In fact, the only firms that do not have market power are perfectly competitive firms; and perfect competition is rare. Economists estimate that overall, the loss of efficiency in the United States due to market power is probably less than 1% of total U.S. production—about $500 per person annually. • Why so low? Most firms face a relatively large degree of competition, resulting in prices much closer to marginal cost than we would see with monopolies. So deadweight loss due to market power is relatively small. © 2015 Pearson Education, Inc. 24 An Argument in Favor of Market Power Market power may produce some benefit for an economy; the prospect of market power (and the resulting economic profits) drives firms to innovate, creating new products and services. • This drive affects large firms—who reinvest profits in the hope of making larger future profits—and small firms—who hope to obtain profits for themselves—alike. The Austrian economist Joseph Schumpeter claimed that this drive would create a “gale of creative destruction” that would eventually benefit consumers more than increased price competition. • This helps to explain governmental ambivalence regarding large firms with market power. © 2015 Pearson Education, Inc. 25 Government Policy toward Monopoly 15.5 LEARNING OBJECTIVE Discuss government policies toward monopoly. © 2015 Pearson Education, Inc. 26 Antitrust Laws and Antitrust Enforcement In the 1870s and 1880s, several “trusts” had formed: boards of trustees that oversaw the operation of several firms in an industry, and enforced collusive agreements. This helped prompt U.S. antitrust laws, aimed at eliminating collusion and promoting competition among firms. The most important of these laws are detailed here. © 2015 Pearson Education, Inc. Law Date Enacted Purpose Sherman Act 1890 Prohibited “restraint of trade,” including price fixing and collusion. Also outlawed monopolization. Clayton Act 1914 Prohibited firms from buying stock in competitors and from having directors serve on the boards of competing firms. Federal Trade Commission Act 1914 Established the Federal Trade Commission (FTC) to help administer antitrust laws. RobinsonPatman Act 1936 Prohibited firms from charging buyers different prices if the result would reduce competition. CellarKefauver Act 1950 Toughened restrictions on mergers by prohibiting any mergers that would reduce competition. Table 15.1 Important U.S. antitrust laws 27 Mergers without Efficiency Gains The Federal government is particularly concerned about horizontal mergers: mergers between firms in the same industry, as opposed to vertical mergers between two firms at different stages of the production process. • Such mergers are likely enhance firms’ market power. The graph shows such a merger, increasing the price from the competitive price (PC) to the monopoly price (PM), and resulting in deadweight loss. © 2015 Pearson Education, Inc. Figure 15.6 A merger that makes consumers better off 28 Mergers with Efficiency Gains Firms seeking to merge typically argue that the resulting larger firm will have lower costs, and hence be able to produce more efficiently. • Then even if they charge the (new) monopoly price, the result is an improvement for consumers. However, costs may not decrease by as much as the firms claim, resulting in consumers being worse off. • Economists with the FTC and Department of Justice review potential mergers one-by-one. © 2015 Pearson Education, Inc. Figure 15.6 A merger that makes consumers better off 29 DOJ and FTC Merger Guidelines Economists and lawyers at the Department of Justice and the Federal Trade Commission developed guidelines for themselves and firms to use in evaluating whether potential merger was acceptable. These include: 1. Market definition 2. Measure of concentration 3. Merger standards © 2015 Pearson Education, Inc. 30 1. Market Definition Suppose Hershey Foods sought to merge with Mars Inc. • In what market do these firms compete? The market for candy? The market for snacks? The market for all food? The more broadly defined the market, the smaller (and more harmless) the merger appears. To determine the appropriate scope of the market, the government tries to determine which goods are close substitutes for those produced by the firms. • The “appropriate market” is defined as the smallest market containing the firms’ products for which an overall price rise within the market would result in total market profits increasing. • (If profits would decrease, there must be adequate substitutes available; hence the market is too narrowly defined.) © 2015 Pearson Education, Inc. 31 2. Measure of Concentration A market is concentrated if a relatively small number of firms have a large share of total sales in the market. To determine if a market is concentrated, the government uses the Herfindahl-Hirschman Index (HHI), created by squaring the percentage market shares of each firm, and adding up the results. Some examples are given below: Firm market shares Formula HHI 100% 1002 10,000 50%, 50% 502 + 502 5,000 30%, 30%, 20%, 20% 302 + 302 + 202 + 202 2,600 10%, 10%, …, 10% 10 x 102 1,000 © 2015 Pearson Education, Inc. 32 3. Merger Standards Based on the calculated HHI values, the DOJ and FTC apply the following standards to determine if they ought to challenge the potential merger of two or more firms: Increase in HHI Post-merger HHI < 100 100 – 200 > 200 < 1,500 Challenge unlikely Challenge unlikely Challenge unlikely 1,500 – 2,500 Challenge unlikely Challenge possible Challenge possible > 2,500 Challenge unlikely Challenge possible Challenge very likely Firms having their merger applications challenged must satisfy the DOJ and FTC that their merger would result in substantial efficiency gains. The burden of proof is on the merging firms. © 2015 Pearson Education, Inc. 33 Regulating Natural Monopolies Natural monopolies have the potential to serve customers more cheaply than multiple firms. But the usual market forces that drive prices down do not exist. Local and/or state regulatory commissions typically set prices for these natural monopolies, instead of allowing the firms to set their own price. But that raises the question: what price should the regulators choose? • A price that makes the monopoly make zero profit? • The efficient price that would maximize consumer welfare? © 2015 Pearson Education, Inc. 34 Regulating a Natural Monopoly If the natural monopoly were not subject to regulation, it would choose quantity QM and price PM. Efficiency (MC = MR) suggests a price of QE. But then the firm makes a loss. Figure 15.7 Regulating a natural monopoly The typical compromise is to allow the firm to charge a price where it can make zero economic profit: PR. The resulting quantity QR is hopefully close to the efficient level, keeping deadweight loss small. © 2015 Pearson Education, Inc. 35 Oligopoly © 2015 Pearson Education, Inc. 36 Oligopoly: A Very Different Market Structure In the previous chapters, we examined perfect and monopolistic competition. We were able to use similar logic to argue how those firms would behave: they would produce until their marginal cost was equal to marginal revenue, and the low barriers to entry would result in profit being competed away in the long run. Oligopoly, a market structure in which a small number of interdependent firms compete, will require completely different tools to analyze. Why? 1. Oligopolists are large, and know that their actions have an effect on one another. 2. Barriers to entry exist, preventing firms from competing away profits. © 2015 Pearson Education, Inc. 37 Oligopoly and Barriers to Entry 14.1 LEARNING OBJECTIVE Show how barriers to entry explain the existence of oligopolies. © 2015 Pearson Education, Inc. 38 Which Markets Are Oligopolistic? Before we analyze how oligopolists behave, it is useful to know which firms/markets we are discussing. A useful tool for identifying the type of market structure is the four-firm concentration ratio: the fraction of an industry’s sales accounted for by its four largest firms. A four-firm concentration ratio larger than 40% tends to indicate an oligopoly. Although there are limits to how useful four-firm concentration ratios can be, they are a useful tool in discussing the concentration of market power within an industry. © 2015 Pearson Education, Inc. 39 Examples of Oligopolies Retail Trade Industry Manufacturing Four-Firm Concentration Ratio Four-Firm Concentration Ratio Industry Discount department stores 97% Cigarettes 98% Warehouse clubs and supercenters 94% Beer 90% College bookstores 75% Computers 87% Hobby, toy, and game stores 72% Aircraft 81% Radio, television, and other electronic stores 70% Breakfast cereal 80% Athletic footwear stores 68% Dog and cat food 71% Pharmacies and drugstores 63% Automobiles 68% Table 14.1 © 2015 Pearson Education, Inc. Examples of oligopolies in retail trade and manufacturing 40 Why Do Oligopolies Exist? Oligopolies often exist because of barriers to entry: anything that keeps new firms from entering an industry in which firms are earning economic profits. One example of a barrier to entry is economies of scale: the situation when a firm’s long-run average costs fall as the firm increases output. • This can make it difficult for new firms to enter a market, because new firms usually have to start small, and will hence have substantially higher average costs than established firms. © 2015 Pearson Education, Inc. 41 Economies of Scale and the Extent of Competition An industry will be competitive if the minimum point on the typical firm’s long-run average cost curve (LRAC1) occurs at a level of output that is a small fraction of total industry sales, such as Q1. The industry will be an oligopoly if the minimum point comes at a level of output that is a large fraction of industry sales, such as Q2. © 2015 Pearson Education, Inc. Figure 14.1 Economies of scale help determine the extent of competition in an industry 42 Why Else Do Oligopolies Exist? Ownership of a key input • If control of a key input is held by one or a small number of firms, it will be difficult for additional firms to enter. • Examples: Alcoa—bauxite for aluminum production De Beers—diamonds Ocean Spray—cranberries Government-imposed barriers • Governments might grant exclusive rights to some industry to one or a small number of firms. • Examples: Occupational licensing for dentists and doctors Patents Tariffs and quotas imposed on foreign companies Patent: The exclusive right to a product for a period of 20 years from the date the patent is filed with the government. © 2015 Pearson Education, Inc. 43 Using Game Theory to Analyze Oligopoly 14.2 LEARNING OBJECTIVE Use game theory to analyze the strategies of oligopolistic firms. © 2015 Pearson Education, Inc. 44 Why Do We Need a Special Theory for Oligopoly? Perfect and monopolistic competitors were easily analyzed using a graph of their own costs and revenues. But remember that each of these firms were small relative to the market, so their actions were essentially insignificant to other firms. This is not true for oligopolies. Oligopolists are large relative to the market, and the actions of one oligopolist make large differences in the profits of another. Oligopolies are best analyzed using a specialized field of study called game theory. Game theory: The study of how people make decisions in situations in which attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of a firm depend on its interactions with other firms. © 2015 Pearson Education, Inc. 45 Game Theory Game theory was developed during the 1940s and advanced by mathematicians and social scientists like economists. All “games” share certain characteristics: 1. Rules that determine what actions are allowable 2. Strategies that players employ to attain their objectives in the game 3. Payoffs that are the results of the interactions among the players’ strategies For example, we can model firm production as a “game”: • Rules: the production functions and market demand curve • Strategies: Firms’ production decisions • Payoffs: Firms’ profits © 2015 Pearson Education, Inc. 46 A Duopoly Game: Price Competition Between Two Firms In this payoff matrix, Sony’s profits are in blue, and Microsoft’s profits are in red. Sony and Microsoft would each make profits of $10 million per month on sales of video game consoles if they Figure 14.2 A duopoly game both charged $499. If one charges $499 and the other charges $399, the one with a low price earns $15 million per month, while the other earns only $5 million per month. If both firms charge $399, they would each make a profit of only $7.5 million per month. How would you “play” this duopoly game? Duopoly: An oligopoly with two firms © 2015 Pearson Education, Inc. 47 A Dominant Strategy for Sony Suppose you are Sony in this duopoly game. • If Microsoft charges $499, you earn more profit by charging $399. • If Microsoft charges $399, you earn more profit by charging $399. Figure 14.2 A duopoly game Either way, charging $399 seems makes the most profit. It is a dominant strategy for Sony. Dominant strategy: A strategy that is the best for a firm, no matter what strategies other firms use. © 2015 Pearson Education, Inc. 48 A Dominant Strategy for Microsoft Also Now suppose you are Microsoft: • If Sony charges $499, you earn more profit by charging $399. • If Sony charges $399, you earn more profit by charging $399. Figure 14.2 A duopoly game Either way, charging $399 seems makes the most profit. It is a dominant strategy for Microsoft to charge $399 also! Each firm charging $399 is a Nash equilibrium: a situation in which each firm chooses the best strategy, given the strategies chosen by the other firms. © 2015 Pearson Education, Inc. 49 Could the Firms Do Better? Notice that this outcome is not good for Sony or Microsoft; if they could cooperate somehow, they could each earn more profit. Figure 14.2 A duopoly game This is the benefit of collusion: an agreement among firms to charge the same price or otherwise not to compete. Collusion is against the law in the United States, but you can see why firms might be tempted to collude: their profits could be substantially higher. © 2015 Pearson Education, Inc. 50 Prisoner’s Dilemma Economists and other social scientists refer the situation with Sony and Microsoft as a prisoner’s dilemma: a game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off. The name comes from a problem faced by two suspects the police arrest for a crime. • The police offer each suspect a suspended prison sentence in exchange for confessing to the crime and testifying against the other suspect. • Each suspect has a dominant strategy to confess; but if both confess, they both go to jail for a long time, while they both could have gone to jail for a minimal length if they had both remained silent. © 2015 Pearson Education, Inc. 51 Can Firms Escape the Prisoner’s Dilemma? Suppose Domino’s and Pizza Hut are deciding how to price a pizza: $12 or $10. • This game gets played not once, but every day. A clever way to avoid the lowprofit Nash equilibrium is to advertise a price-match guarantee. Then if either firm cuts prices, the other has guaranteed to do so as well. • Now neither firm will have an incentive to cut prices. • Price-match guarantees aren’t as good for consumers as they appear. © 2015 Pearson Education, Inc. Figure 14.3 Changing the payoff matrix in a repeated game 52 Other Methods for Avoiding Price Competition A price-match guarantee is an enforcement mechanism, making automatic the decision about whether to punish a competing firm for charging a low price. Another method is price leadership, a form of implicit collusion in which one firm in an oligopoly announces a price change and the other firms in the industry match the change. • Example: In the 1970s, General Motors would announce a price change at the beginning of a model year, and Ford and Chrysler would match GM’s price change. Such forms of implicit collusion are desirable for firms, because explicit collusion is illegal, resulting in government fines and penalties, along with a possible public backlash. © 2015 Pearson Education, Inc. 53 Cartels: The Case of OPEC A cartel is a group of firms that collude by agreeing to restrict output to increase prices and profits. This form of explicit collusion is illegal in the United States; but not in some Figure 14.4 Oil prices, 1972 to mid-2013 other locations. The most well-known cartel is OPEC, the Organization of the Petroleum Exporting Countries. • OPEC members colluded to restrict output and raise prices in the 1970s and 1980s. • But collusion has proved difficult to maintain over time. © 2015 Pearson Education, Inc. 54 Analyzing the OPEC Cartel with Game Theory Because Saudi Arabia can produce much more oil than Nigeria, its output decisions have a much larger effect on the price of oil. • Saudi Arabia has a dominant strategy to cooperate and Figure 14.5 The OPEC cartel with produce a low unequal members output. Nigeria, however, has a dominant strategy not to cooperate and instead produce a high output. • In order to punish Nigeria for defecting, Saudi Arabia would have to hurt itself substantially. Would it be worth it to you? © 2015 Pearson Education, Inc. 55 Sequential Games and Business Strategy 14.3 LEARNING OBJECTIVE Use sequential games to analyze business strategies. © 2015 Pearson Education, Inc. 56 Simultaneous vs. Sequential Games The game theory models we have analyzed so far have been simultaneous: the players have made their decisions at the same time. But some games are sequential in nature: one firm makes a decision, and the other makes its decision having observed the first firm’s decision. • We analyze such games using a decision tree, indicating who gets to make a decision at what point, and what the consequences of their decision will be. © 2015 Pearson Education, Inc. 57 The Decision Tree for an Entry Game In this game, Apple decides whether to charge $1000 or $800 for its new ultra light laptop; then Dell decides whether or not to Figure 14.6 enter the market. The decision tree for an entry game Apple “looks ahead”, and realizes that if it charges the high price, Dell will enter and compete with Apple. If Apple charges the low price, Dell’s rate of return will not be sufficient to warrant entry. So Apple can deter Dell from entering the market by preemptively charging the low price. © 2015 Pearson Education, Inc. 58 The Decision Tree for a Bargaining Game Dell is deciding whether to offer $20 or $30 per copy for TruImage’s software. Then TruImage will have the opportunity to accept or reject Figure 14.7 the offer. The decision tree for a bargaining game Dell will look ahead, and realize that TruImage is better off accepting Dell’s offer, no matter what price Dell offers. Therefore Dell should offer the low price, anticipating that TruImage will accept the offer. © 2015 Pearson Education, Inc. 59 Can TruImage Threaten Not to Accept the Offer? Notice that TruImage would like to threaten to reject an offer of $20. If Dell believed the threat, its best action would be to offer $30. Figure 14.7 The decision tree for a bargaining game But Dell shouldn’t believe the threat; it is not credible, since it would involve TruImage hurting itself with no opportunity for redemption. Only the original outcome is a subgame-perfect equilibrium: a Nash equilibrium in which no player can improve their outcome by changing their decision at any decision node. © 2015 Pearson Education, Inc. 60 The Five Competitive Forces Model 14.4 LEARNING OBJECTIVE Use the five competitive forces model to analyze competition in an industry. © 2015 Pearson Education, Inc. 61 The Five Competitive Forces Model Michael Porter of Harvard Business School identifies five separate competitive forces that determine the overall level of competition in an industry: 1. Existing firms Example: Educational Testing Service administers the SAT ($51) and GRE ($150) tests. The SAT has competition from the ACT, helping keep its price low. The GRE has no similar competitor. 2. Threat from new entrants Example: In the previous section, Apple charged a low price to deter Dell from entering its market. © 2015 Pearson Education, Inc. 62 The Five Competitive Forces Model—continued 3. Competition from substitutes Example: Printed encyclopedia sets used to cost well over $1000, but parents would buy them because there were no good substitutes. But the advent of cheap computer-based encyclopedias helped drive printed encyclopedia producers out of business. 4. Bargaining power of buyers Example: Large companies like Wal-Mart can threaten to buy goods from competitors, forcing suppliers to keep their prices low. 5. Bargaining power of suppliers Example: As a start-up, Microsoft couldn’t force IBM to pay a high price for its operating system. But as Microsoft became the dominant player in operating systems, it could charge much more to computer manufacturers. © 2015 Pearson Education, Inc. 63