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Costs, Competition &
Organization of the
Business Firm
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Utility
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Utility
• Utility
• Satisfaction or pleasure derived from
consuming a good or service.
• Law of Diminishing Utility
• Added satisfaction declines as
additional units are used or consumed
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Substitution Effect
• Effect of a change in price on the
relative utility of a product and the
quantity demanded.
• MUA/PA = MUB/PB
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Prospect Theory
• Behavioral analysis of negative
occurrences.
• Factors
• Status quo
• Loss Aversion
• Market applications
• Package sizing
• Framing
• Anchoring
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Types of Business
Structures
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Three Types of Business Firms
• Proprietorship:
• owned by a single individual
• make up 72% of the firms in the market, but
account for only 4% of total business revenue
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Three Types of Business Firms
• Partnership:
• owned by two or more persons
• 8% of the firms; 12% of business
revenues
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Three Types of Business Firms
• Corporation:
• owned by stockholders
• In contrast to the unlimited liability of
proprietorships and partnerships, the
owners’ liability is limited to their
explicit investment.
• 20% of the firms; 84% of business
revenue
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The Economic Way
of Thinking about Costs
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Implicit & Explicit Costs
• Explicit
• Monetary Payments
• Accounting Profits
• Implicit
• Opportunity Costs
• Economic Profits
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Sunk Costs
• Sunk Costs are historical costs associated
with past decisions that can’t be changed.
• Sunk costs may provide information, but are
not relevant to current choices.
• Current choices should be made on current
and expected future costs and benefits.
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Economies of Scale
• As output (plant size) is increased, per-unit
costs will follow one of three possibilities:
• Economies of Scale:
Reductions in per unit costs as output
expands. This can occur for three reasons:
• mass production
• specialization
• improvements in production
as a result of experience
• Diseconomies of Scale:
increases in per unit costs as output expands
• Constant Returns to Scale:
unit costs are constant as output expands
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Short-Run and Long-Run
Time Periods
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The Short Run
• The short run is a period of time so short
that the firm’s level of plant and heavy
equipment (capital) is fixed.
• In the short run, output can only be altered
by changing the usage of variable resources
such as labor and raw materials.
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The Long Run
• The long run is a period of time sufficient
for the firm to alter all factors of production.
• In the long run, firms can freely enter and
exit the industry.
• The time duration of the short run and the
long run will differ across industries.
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Categories of Cost
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Fixed & Variable Costs
• Fixed Costs :
costs that remain unchanged regardless
on the amount produced.
• EG – Rent or the purchase of
machinery.
• Variable Costs:
Fixed costs depend on the amount
produced.
• EG – Electricity to run a machine or
inputs for production
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Total and Average Fixed Costs
• Total Fixed Costs (TFC):
costs that remain unchanged in the short run
when output is altered
• Examples:
• insurance premiums
• property taxes
• the opportunity cost of fixed assets
• Average Fixed Costs (AFC):
Fixed costs per unit (i.e. FC / output).
• decline as output expands
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Total and Average Variable Costs
• Total Variable Costs (TVC):
sum of costs that increase as output expands
• Examples:
• cost of labor
• raw materials
• Average Variable Costs (AVC):
variable costs per unit (i.e. TVC / output)
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Total Cost
• Total Costs (TC):
Total Fixed Cost + Total Variable Cost
• TC=FC+VC
• Average Total Costs (ATC):
Average Fixed Cost + Average Variable Cost
• ATC=AVC+AFC
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Marginal Cost
• Marginal Cost (MC):
the increase in Total Cost associated with
a one-unit increase in production
• Typically, MC will decline initially,
reach a minimum, and then rise.
• MC = (Change in TC)/(Change in Q)
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Revenues
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Revenues
• TR = Total Revenue
• AR = Average Revenue
• AR = TR / Q
• Marginal Revenue is the added revenue
associated with an increase of one unit of
output
• MR = TRN – TRN-1
• MR = ∆TR / ∆Q
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Profits & Equilibrium
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Profits & Equilibrium
• Profits
• Π = TR – TC
• Π = (P – ATC) * Q
• Equilibrium Pricing
• MC = MR
• Shut-down price
• P < AVCMIN
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Cost and Supply
• When making output decisions in the short
run, it is the firm’s marginal costs that are
most important.
• Additional units will not be supplied if they
do not generate additional revenues that are
sufficient to cover their marginal costs.
• For long-run output decisions, it is the firm’s
average total costs that are most important.
• Firms will not continue to supply output in
the long run if revenues are insufficient to
cover their average total costs.
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Short-Run Cost Curves
P
• Marginal Costs:
rise sharply as the plant’s
production capacity (q) is
approached.
MC
q Q
P
ATC
• Average Total Costs:
will be a U-shaped curve since
AFC will be high for small rates
of output and MC will be high
as the plant’s production
capacity (q) is approached.
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q Q
Output and Costs
In the Short Run
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Total Cost Schedule
•
•
•
•
•
•
•
•
•
•
•
•
Output
0
1
2
3
4
5
6
7
8
9
10
TFC
50
50
50
50
50
50
50
50
50
50
50
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TVC
0
15
25
34
42
52
64
79
98
122
152
TC
50
65
75
84
92
102
114
129
148
172
202
Short Run Total Cost Curves
• Note that total fixed costs are flat
Total
– they are constant at all output levels.
costs
• Note that total variable costs increase as
more variable inputs are utilized.
200
• As total costs are the combination of
TVC and TFC, they are everywhere
positive and increase sharply with output
TC
TVC
150
Output
per day
0
2
4
6
8
10
TFC + TVC = TC
50
50
50
50
50
50
0
25
42
64
98
152
50
75
92
114
148
202
100
TFC
50
2
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4
6
8
10
Output
Average Cost Schedule
•
•
•
•
•
•
•
•
•
•
•
•
Output
AFC
=(TFC/Output)
1
2
3
4
5
6
7
8
9
10
50
25
16.7
12.5
10
8.3
7.1
6.25
5.6
5
AVC
=(TVC/Output)
15
12.5
11.3
10.5
10.4
10.7
11.3
12.25
13.6
15.2
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ATC
=(TC/Output)
65
37.5
28
23
20.4
19
18.4
18.5
19.2
20.2
Short Run Cost Curves
• The average variable cost curve (AVC)
is the total variable cost (TVC) divided
Cost
by the output level. It is higher either
per unit
for a few or a lot of units and has some
minimal point between the two where,
when graphed later, marginal costs (MC) 60
will cross.
TVC
0
15
25
42
64
98
152
/
Output
per day
0
1
2
4
6
8
10
= AVC
---$ 15.00
$ 12.50
$ 10.50
$ 10.67
$ 12.25
$ 15.20
40
AVC
20
AFC
Output
2
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4
6
8
10
Marginal Cost Schedule
•
•
•
•
•
•
•
•
•
•
•
•
Output
0
1
2
3
4
5
6
7
8
9
10
VC
0
15
25
34
42
52
64
79
98
122
152
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∆VC=MC
=15-0
=25-15
=34-25
=42-34
=52-42
=64-52
=79-64
=98-79
=122-98
=152-122
15
10
9
8
10
12
15
19
24
30
Short Run Cost Curves
Short-Run
• To calculate the marginal cost curve
(MC) we take the change in TC (TC)
and divide that by the change in output.
Note: our increments for increasing
output here are 1 (
1).
• Note that MC starts low and increases
as output increases. It also crosses AVC
at its minimum point.
TC
50
65
75
84
92
102
114
129
148
172
202
TC  Output MC
=
/
15
10
1
1
Cost
per unit
60
MC
Note: MC always crosses
AVC at its minimum point.
40
$ 15.00
$ 10.00
AVC
20
8
1
$ 8.00
12
1
$ 12.00
AFC
19
1
$ 19.00
Output
30
1
$ 30.00
2
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4
6
8
10
Short Run Cost Curves
• The average total cost curve (ATC)
is simply TC divided by the output.
• When output is low, ATC is high
because AFC is high. Also, ATC is
high when output is large as MC
grows large when output is high.
• These two relationships explain the
distinct U–shape of the ATC curve.
TC
50
65
75
92
114
148
202
/
Output
per day
0
1
2
4
6
8
10
= ATC
---$ 65.00
$ 37.50
$ 23.00
$ 19.00
$ 18.50
$ 20.20
Cost
per unit
60
MC
Note: MC always crosses
ATC at its minimum point.
40
ATC
20
AVC
AFC
Output
2
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4
6
8
10
Marginal Revenue
• Marginal Revenue is the change in total
revenue divided by the change in output.
Marginal
Revenue (MR)
=
Change in Revenue TRi-TR(i-1)
• In a perfectly competitive market, marginal
revenue (MR) = market price, because all
units are sold at the same price (market
price).
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Profit Maximization when
the Firm is a Price Taker
• In the short run, the price taker
will expand output until the
marginal revenue (MR) is just
equal to marginal cost (MC).
• This will maximize the firm’s
profits (rectangle PBAC).
• When P > MC, production of the
unit adds more to revenues than
costs. In order for the firm to
maximize its profits it will expand
output until MC = P.
• When P < MC, the unit adds more
to costs than revenues. A profit
maximizing firm will not produce
in this output range. It will reduce
output until MC = P.
MC
Price
P = MC
Profit
B
P
ATC
d (P = MR)
C
A
P > MC
P < MC
increase q
decrease q
q
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Output
MR / MC Approach
• At low output levels MR > MC.
• After some point, additional units cost more than the
MR realized from selling them.
• Profit is maximized where P = MR = MC.
Marginal Marginal
Profit
Price and
Revenue Cost
(MC) (TR - TC) cost per Unit
Output (MR)
0
2.
..
8
10
12
14
15
16
18
20
---5.
..
5
5
5
5
5
5
5
5
---$ 3.95
..
.
$ 1.50
$ 1.00
$ 1.75
$ 3.50
$ 4.75
$ 6.00
$ 8.25
$ 13.00
- 25.00
- 23.75
..
.
- 8.00
- .25
6.75
10.75
11.00
10.00
4.50
- 8.00
9
7
MC
Profit Maximum
P = MR = MC
MR
5
3
1
Output
2
4
6
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8 10 12 14 16 18 20
MC=MR
•
•
•
•
•
•
•
•
•
•
•
•
Output
0
1
2
3
4
5
6
7
8
9
10
MC
MR
15
10
9
8
10
12
15
19
24
30
10
10
10
10
10
10
10
10
10
10
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MC=MR
Profits (π)
•
•
•
•
•
•
•
•
•
•
•
•
Output
0
1
2
3
4
5
6
7
8
9
10
TR=Q*P
TC
π=TR-TC
10
20
30
40
50
60
70
80
90
100
65
75
84
92
102
114
129
148
172
202
(55)
(55)
(54)
(52)
(52) Max. π
(54)
(59)
(68)
(82)
(102)
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• If MC = MR at a fractional point,
always choose the last level of output
where MR > MC.
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Output and Costs
In the Long Run
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Short-Run & Long-Run
Cost Curves
• Each potential plant has a cost curve (SRAC).
• The choices of each plant’s short-run curves
combine to create a long-run curve (LRAC).
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Market Structures
1 – Perfectly Competitive Markets
2 – Monopolies
3 – Monopolistic Competition
4 – Oligopolies
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1 – Perfectly Competitive
Markets
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Perfectly Competitive
Markets
• Perfect Competition
• Many buyers & sellers
• No single buyer or seller exerts
influence on the market
• Informed buyers
• Identical products
• Easy market entry & exit
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Demand from Seller’s
Perspective
• Perfectly elastic
• P = MR = AR = D
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Firm vs. Industry in
Perfect Competition
P
MC
P
ΣMC
P
D=MR=AR=P
D
QFirm
Q
Single Firm
QIndustry
Industry
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Q
Short-Run in Perfectly
Competitive Markets
• MC = MR
• Provided MR > Minimum AVC
• Loss Minization
• MR > AVC but MR < ATC
• Operation reduces losses
• Shut-down Situation
• If MR < AVCmin, operating
increases losses
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Long-Run in Perfectly
Competitive Markets
• If there are profits
• New companies enter market b/c no
barriers to entry
• Drives profits towards zero
• Eventually, ATC = Price (zero profits)
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Long-Run effects on π
Perfect Competition
Π adds new entrants
Increasing supply to ΣMC2
Π @ P1
P
P
MC
ΣMC1
ΣMC2
ATC
P1
P2
D
D
QFirm2
QFirm1
Single Firm
Q
Drives Q↑ & P↓
Eliminates Π
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QIndustry2 QIndustry1
Q
Industry
2 – Monopolies
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Monopolies
• Price maker
• Single seller
• No close substitutes
• Difficult market entry
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Monopolies – Entry Barriers
• A few examples of factors that may
serve as ‘barriers’ to free entry into a
market:
• economies of scale
• government licensing
• patents
• control over an essential resource
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Demand & MR
• Demand is downward
sloping
• MR is lower than demand
P
• NB to lower price the
Monopoly must lower price
on all units sold therefore
MR associated with
increased sales reduces
revenues on a per unit basis.
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MR
D
Q
Demand, MR & TR
P
MR
D
Q
P
Elastic
Inelastic
TR
Q
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Price and Output Under Monopoly
• The monopolist will reduce price
and expand output as long as
MR > MC.
• The monopolist will raise price
and reduce output whenever
MR < MC.
• Output level q will result … and
price P (along the demand curve)
will be charged.
• At output q the average total cost
is C.
• As P > C (price > ATC) the firm
is making economic profits equal
to the area PABC.
Price
MC
Economic
profits
ATC
A
P
B
C
d
MR < MC
MR > MC
MR
q
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Quantity/time
Efficiency &
Monopolies
P
MC=MR @ point b
result is point a for P & Q
MC = S
∆abc represents
efficiency loss
PM
a
c
PE
Monopolies lead to
higher Price & lower Q
b
MR
QM
QE
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D
Q
Price Discrimination
• Conditions
• Monopoly Power
• Market Segregation
• No Resale
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Price Regulation
Monopoly Price
P
Fair-return Price
Socially-optimal Price
PM
ATC
PF
MC
PS
D
MR
QM
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QF Q
S
Q
Effects of Monopolies
• Market Inefficiency
• Higher Prices
• Monopolies P > MR = MC
• Perfect Competition P = MR = MC
• Lower Quantities
• Income Transfer
• From Buyers to Seller
• X-inefficiency
• Higher costs due to outdated
plants/equipment
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Market Regulation
• American history & big business
• Anti-trust legislation
• Modern application:
• Was Microsoft a monopoly?
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3 – Monopolistic Competition
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Monopolistic Competition
Major differences from perfectly Competitive
Market
• Products not identical (variation)
• Non price competition
• Profits
• Short-term economic profits
• Long-term normal or accounting profits
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Price and Output
• A profit-maximizing price searcher will
expand output as long as marginal revenue
exceeds marginal cost.
• Price will be lowered and output expanded
until MR = MC.
• The price charged by a price searcher will be
greater than its marginal cost.
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Price and Output: Short-Run Profit
MC
Price
• A competitive market maximizes
profits by producing where MR =
MC, at output level q …
and charges a price P along the
demand curve for that output level.
• At q the average total cost is C.
• Because the price is greater than the
average total cost per unit (P > C)
the firm is making economic profits
equal to the area ( [ P - C ] x q )
• What impact will economic profits
have if this is a typical firm?
Economic
Profits
ATC
P
C
d
MR
q
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Quantity/time
Long-Run
• Similar to perfect Competition
• Economic efficiency
• P (MR) = MC = ATC
• Efficiency
• Productive Efficiency
• Relationship between price & costs
• P = ATCmin
• Allocative Efficiency
• Supply & Demand
• MC = D
• Is monopolistic competition efficient?
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Price and Output – Long Run in a
Competitive Markets
MC
Price
• Because entry and exit are free,
competition will eventually drive
prices down to the level of ATC.
• When profits (losses) are present,
the demand curve will shift inward
(outward) until the zero profit
C=P
equilibrium is restored.
• The companies establishes
its output level where MC = MR.
• At q the average total cost is equal
to the market price. Zero economic
profit is present. No incentive for
firms to either enter or exit the
market is present.
ATC
d
MR
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q
Quantity/time
Excess Capacity
P
Allocative
Efficiency
MC = D
Productive
Efficiency
P = ATCmin
MC
ATC
P1
Excess
Capacity
Productive
inefficiency
MR
D
Q1
Qe
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Q
Differentiation
• Location
• Advertising
• Brand Loyalty
• Service
• Quality
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4 – Oligopoly
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Oligopolies
•
•
•
•
Few large companies
Identical or similar products
Difficult market entry
Non price compitetion
• Price leadership
• Collusion (cartels) vs. price war
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Terms
• Collusion
• Tacit Collusion
• Cartel
• Prisoner’s Dilemma
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Prisoner’s Dilemma
Don’t Cheat
Profit $180M
Profit $180M
Profit $150M,
then $160M
Profit $200M,
then $160M
Cheat
Profit $200M,
then $160M
Don’t Cheat
Profit $150M,
then $160M
Profit $160M
Cheat
Profit $160M
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Price & Output
Under Oligopoly
• No general theory exists for price and output
under oligopoly.
• If the firms operated independently, they
would drive down the price to the per-unit
cost of production.
• If the firms colluded perfectly, the price
would rise to the monopoly price.
• The outcome is usually between these two
extremes.
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Product Differentiation
• Price searchers produce differentiated
products – products that differ in design,
dependability, location, ease of purchase, etc.
• Rival firms produce similar products (good
substitutes) and therefore each firm confronts
a highly elastic demand curve.
• Result is attempt to compete on non-price
factors.
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Incentive to Collude
Prisoner’s Dilemma
• Oligopolists have a strong incentive to
collude and raise their prices.
• However, each firm also has an incentive to
cheat by lowering price because the demand
curve facing each firm is more elastic than
the market demand curve.
• This conflict makes collusive agreements that
are difficult to maintain.
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Gaining from Cheating
• Using industry demand Di and marginal revenue MRi,
oligopolists maximize their joint profit where MRi = MC
– at output Qi and price Pi .
• The demand facing each firm df (where no other firms cheat)
would be much more elastic than the industry demand Di .
• The firm maximizes its profit where MRf = MC by
expanding output to qf and lowering its price to Pf from Pi .
Price
Industry
Pi
Price
Individual firms have
an incentive to cheat
by cutting price to
expand output
Firm
Pi
Pf
MC
MC
MRi
Qi
MRf
Di
Quantity/time
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qf
df
Quantity/time
Kinked-Demand Curve
P
Price Decreases
Competition matches price
Price increase
Competition does not match
P1
D2
MR2
D1
Q1
MR1
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Q
Kinked-Demand Curve
P
Incentives to
- lower prices
- collusion
P1
Dmp
Q1
MRmp
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Q
Monopolistic Competition
vs. Oligopilies
• MP (many firms) vs. Oligopilies (a few firms)
• 2 measures
• 4 firm concentration ratio
• (output of 4 largest)/Total output
• Low (MP) to high (Oligopoly)
• Herfindahl index
• Σ(market shares for each firm)2
• Low (MP) to high (Oligopoly)
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