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SECOND MEETING PJJ ECN3101: MICROECONOMICS SEMESTER 2, 2011/2012 Chapter 8 Perfect Competition Market Structure, Profit Maximization and Competitive Supply Topics to be Discussed Perfectly Competitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Output in the Short-Run The Competitive Firm’s Short-Run Supply Curve Short-Run Market Supply Choosing Output in the Long-Run ©2005 Pearson Education, Inc. Chapter 8 3 Perfectly Competitive Markets Basic assumptions of perfectly competitive markets Many buyers and sellers Each buys and sells only a small fraction of the total amount exchanged in the market Standardized or homogeneous product Buyers and sellers are fully informed about the price and availability of all resources and products Firms and resources are freely mobile Individual firms have no control over the price Price is determined by market supply and demand Firm is free to produce whatever quantity maximizes profit ©2005 Pearson Education, Inc. Chapter 8 4 Perfectly Competitive Markets 1.Price Taking The individual firm sells a very small share of the total market output and, therefore, cannot influence market price. Each firm takes market price as given – price taker The individual consumer buys too small a share of industry output to have any impact on market price. ©2005 Pearson Education, Inc. Chapter 8 5 Perfectly Competitive Markets 2. Product Homogeneity The products of all firms are perfect substitutes. Product quality is relatively similar as well as other product characteristics Agricultural products, oil, copper, iron, lumber 3. Free Entry and Exit There is no barriers or special costs that make it difficult for a firm to enter (or exit) an industry Buyers can easily switch from one supplier to another. Suppliers can easily enter or exit a market. ©2005 Pearson Education, Inc. Chapter 8 6 Marginal Revenue, Marginal Cost, and Profit Maximization Profit maximizing output for any firm whether perfectly competitive or not basically focuses on Profit () = Total Revenue - Total Cost Total Revenue (R) = Pq Costs of production depends on output Total Cost (C) = Cq Profit for the firm, , is difference between revenue and costs (q) R(q ) C (q) ©2005 Pearson Education, Inc. Chapter 8 7 Marginal Revenue, Marginal Cost, and Profit Maximization Total revenue curve shows that a firm can only sell more if it lowers its price Slope in total revenue curve is the marginal revenue Slope of total cost curve is marginal cost As output rises, revenue rises faster than costs leading to increasing profit Profit is maximized where MR = MC or where slopes of the R(q) and C(q) curves are equal ©2005 Pearson Education, Inc. Chapter 8 8 Profit Maximization – Short Run Cost, Revenue, Profit ($s per year) Profits are maximized where MR (slope at A) and MC (slope at B) are equal C(q) A R(q) Profits are maximized where R(q) – C(q) is maximized B 0 q0 ©2005 Pearson Education, Inc. q* Chapter 8 Output (q) 9 Marginal Revenue, Marginal Cost, and Profit Maximization Profit is maximized at the point at which an additional increment to output leaves profit unchanged R C R C 0 q q q MR MC 0 MR MC ©2005 Pearson Education, Inc. Chapter 8 10 The Competitive Firm Demand curve faced by an individual firm is a horizontal line – implies that firm’s sales have no effect on market price Price $ per bushel Firm Demand curve faced by whole market is downward sloping Price $ per bushel Industry S $4 d $4 D 100 ©2005 Pearson Education, Inc. 200 Output (bushels) Chapter 8 100 Output (millions 11 of bushels) The Competitive Firm The competitive firm’s demand Individual producer sells all units for $4 regardless of that producer’s level of output. MR = P with the horizontal demand curve For a perfectly competitive firm, profit maximizing output occurs when MC (q) MR P AR ©2005 Pearson Education, Inc. Chapter 8 12 Choosing Output: Short Run The point where MR = MC, the profit maximizing output is chosen MR=MC at quantity, q*, of 8 At a quantity less than 8, MR>MC so more profit can be gained by increasing output At a quantity greater than 8, MC>MR, increasing output will decrease profits ©2005 Pearson Education, Inc. Chapter 8 13 A Competitive Firm MC Price Lost Profit for q2>q* 50 Lost Profit for q2>q* A 40 AR=MR=P ATC AVC 30 The point where MR = MC, the profit maximizing output is chosen q*= 8 20 q1 : MR > MC q2: MC > MR q0: MC = MR 10 0 1 2 3 4 5 6 7 q1 ©2005 Pearson Education, Inc. 8 9 q* q2 Chapter 8 10 11 Output 14 A Competitive Firm – Positive Profits Price 50 40 MC Total Profit = ABCD A D AR=MR=P ATC Profit per unit = PAC(q) = A to B 30 C Profits are determined by output per unit times quantity AVC B 20 10 0 1 2 3 4 5 6 7 q1 ©2005 Pearson Education, Inc. Chapter 8 8 q* 9 q2 10 11 Output 15 A Competitive Firm – Losses MC Price q *: At MR = MC and P < ATC B C D A Losses = (P- AC) x q* or ABCD P = MR AVC q* ©2005 Pearson Education, Inc. ATC Chapter 8 Output 16 Choosing Output in the Short Run Summary of Production Decisions Profit is maximized when MC = MR If P > ATC the firm is making profits. If P < ATC the firm is making losses ©2005 Pearson Education, Inc. Chapter 8 17 Short Run Production Firm has two choices in short run Continue producing Shut down temporarily Will compare profitability of both choices When should the firm shut down? If AVC < P < ATC the firm should continue producing in the short run Can cover some of its variable costs and all of its fixed costs If AVC > P < ATC the firm should shut-down. Can not cover even its fixed costs ©2005 Pearson Education, Inc. Chapter 8 18 A Competitive Firm – Losses MC Price ATC Losses B C D P < ATC but AVC so firm will continue to produce in short run A P = MR AVC F E q* ©2005 Pearson Education, Inc. Chapter 8 Output 19 Competitive Firm – Short Run Supply Supply curve tells how much output will be produced at different prices Competitive firms determine quantity to produce where P = MC Firm shuts down when P < AVC Competitive firms supply curve is portion of the marginal cost curve above the AVC curve ©2005 Pearson Education, Inc. Chapter 8 20 A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) The firm chooses the output level where P = MR = MC, as long as P > AVC. Supply is MC above AVC MC S P2 ATC P1 AVC P = AVC q1 ©2005 Pearson Education, Inc. Chapter 8 q2 Output 21 Market Supply in the Short Run S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. $ per unit P3 P2 P1 Q 2 ©2005 Pearson Education, Inc. 4 5 7 8 10 Chapter 8 15 21 22 Choosing Output in the Long Run In short run, one or more inputs are fixed Depending on the time, it may limit the flexibility of the firm In the long run, a firm can alter all its inputs, including the size of the plant. We assume free entry and free exit. No legal restrictions or extra costs ©2005 Pearson Education, Inc. Chapter 8 23 Long-run Profit Maximization In the short run a firm faces a horizontal demand curve Take market price as given The short-run average cost curve (SAC) and short run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD) The long run average cost curve (LRAC) Economies of scale to q2 Diseconomies of scale after q2 ©2005 Pearson Education, Inc. Chapter 8 24 Output Choice in the Long Run Price LMC LAC SMC SAC $40 D A P = MR C B $30 In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. q1 ©2005 Pearson Education, Inc. Chapter 8 q2 q3 Output 25 Output Choice in the Long Run In the long run, the plant size will be increased and output increased to q3. Long-run profit, EFGD > short run profit ABCD. LMC Price LAC SMC SAC $40 D C A E P = MR B G $30 F q3 is profitmaximizin g output Output q1 q2 q3 Economies of scale Diseconomies of scale ©2005 Pearson Education, Inc. Chapter 8 26 Long-run Competitive Equilibrium Entry and Exit The long-run response to short-run profits is to increase output and profits. Profits will attract other producers. More producers increase industry supply which lowers the market price. This continues until there are no more profits to be gained in the market – zero economic profits ©2005 Pearson Education, Inc. Chapter 8 27 Long-Run Competitive Equilibrium – Profits •Profit attracts firms •Supply increases until profit = 0 $ per unit of output $ per unit of output Firm Industry S1 LMC $40 LAC P1 S2 P2 $30 D q2 ©2005 Pearson Education, Inc. Output Chapter 8 Q1 Q2 Output 28 Long-Run Competitive Equilibrium – Losses •Losses cause firms to leave •Supply decreases until profit = 0 $ per unit of output Firm LMC $ per unit of output LAC $30 Industry S2 P2 S1 P1 $20 D q2 ©2005 Pearson Education, Inc. Output Chapter 8 Q2 Q1 Output 29 Long-Run Competitive Equilibrium 1. All firms in industry are maximizing profits MR = MC 2. No firm has incentive to enter or exit industry Earning zero economic profits 3. Market is in equilibrium QD = QD ©2005 Pearson Education, Inc. Chapter 8 30 Chapter 10 Market Power: Monopoly Topics to be Discussed Characteristics Average and Marginal Revenue Monopolist’s output decision Measuring monopoly power The Social Costs of Monopoly Power Regulating monopoly ©2005 Pearson Education, Inc. Chapter 10 32 Monopoly One seller (but many buyers), one product (no substitutes), there are barriers to entry and price maker The monopolist is the supply-side of the market and has complete control over the amount offered for sale. Monopolist controls price but must consider consumer demand Profits will be maximized at the level of output where MC = MR For monopolist’s P = AR = DD Its MR curve always below the demand curve ©2005 Pearson Education, Inc. Chapter 10 33 Total, Marginal, and Average Revenue 1. Revenue is zero when price is $6 - nothing is sold 2. At lower prices, revenue increases as quantity sold increases 3. When demand is downward sloping, the price (average revenue) is greater than marginal revenue 4. For sales to increase, price must fall 5. When MR is positive, TR is increasing with quantity but when MR is negative, TR is decreasing ©2005 Pearson Education, Inc. Chapter 10 34 Average and Marginal Revenue $ per unit of output 7 Observations: 1. To increase sales the price must fall 2. MR < P 3. Compared to perfect competition MR =P 6 5 Average Revenue (Demand) 4 3 2 1 Marginal Revenue 0 1 ©2005 Pearson Education, Inc. 2 3 4 Chapter 10 5 6 7 Output 35 Monopolist’s Output Decision 1. Profits maximized at the output level where MR = MC 2. Cost functions are the same (Q) R(Q) C (Q) / Q R / Q C / Q 0 MC MR or MC MR ©2005 Pearson Education, Inc. Chapter 10 36 Monopolist’s Output Decision $ per unit of output MC MC=MR P1 1. At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). P* AC P2 Lost profit D = AR MR Q1 Q* ©2005 Pearson Education, Inc. Q2 Lost profit 2. At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) Quantity Chapter 10 37 Example of Profit Maximization C = TOTAL COST $ r' 400 R = TOTAL REVENUE 300 c’ 200 r Profits 150 When profits are maximized, slope of rr’ and cc’ are equal: MR=MC 100 50 0 c 5 ©2005 Pearson Education, Inc. 10 15 Chapter 10 20 Quantity 38 Profit Maximization $/Q 40 Profit = (P - AC) x Q = ($30 - $15)(10) = $150 MC P=30 AC Profit 20 AR AC=15 10 MR 0 5 ©2005 Pearson Education, Inc. 10 15 Chapter 10 20 Quantity 39 Monopoly Monopoly pricing compared to perfect competition pricing: Monopoly P > MC Price is larger than MC by an amount that depends inversely on the elasticity of demand Perfect Competition P = MC Demand is perfectly elastic so P=MC ©2005 Pearson Education, Inc. Chapter 10 40 Monopoly If demand is very elastic, Ed is a large negative number thus price will be close to MC – monopoly will look much like a perfectly competitive market. So there is little benefit to being a monopolist. Note also that a monopolist will never produce a quantity in the inelastic portion of demand curve (Ed < 1) In inelastic portion, can increase revenue by decreasing quantity and increasing price ©2005 Pearson Education, Inc. Chapter 10 41 Elasticity of Demand and Price Markup The more elastic is demand, the less the Markup – little monopoly power. $/Q The more inelastic is demand, the more the Markup – more monopoly power. $/Q P* MC MC P* P*-MC D P*-MC MR D MR Q* ©2005 Pearson Education, Inc. Quantity Chapter 10 Q* Quantity 42 Monopoly Power Pure monopoly is rare. However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost. Firms often product similar goods that have some differences thereby differentiating themselves from other firms ©2005 Pearson Education, Inc. Chapter 10 43 Measuring Monopoly Power How can we measure monopoly power to compare firms What are the sources of monopoly power? ©2005 Pearson Education, Inc. Chapter 10 44 Measuring Monopoly Power • An important distinction between Perfect Competition and Monopoly: PC : P = MC ; Monopoly : P > MC •To measure monopoly power – look the extent to which profit maximizing P exceeds MC •Use the markup ratio of P – MC / P as the rule of thumb for pricing •This measure of monopoly power is called as Lerner Index of Monopoly Power : L = (P-MC) / P •The Lerner Index always has a value between 0 to 1 •The larger the value of L the greater the monopoly power ©2005 Pearson Education, Inc. Chapter 10 45 The Social Costs of Monopoly Monopoly power results in higher prices and lower quantities. Perfectly competitive: produce where MC = D PC and QC Monopoly produces where MR = MC PM and QM There is a loss in consumer surplus when going from perfect competition to monopoly A deadweight loss is also created The incentive to engage in monopoly practices is determined by the profit to be gained. The larger the transfer from consumers to the firm, the larger the social cost of monopoly. ©2005 Pearson Education, Inc. Chapter 10 46 Deadweight Loss from Monopoly Power $/Q Lost Consumer Surplus Deadweight Loss Pm A MC B PC Because of the higher price, consumers lose A+B and producer gains A-C. C AR=D MR Qm ©2005 Pearson Education, Inc. QC Chapter 10 Quantity 47 Regulating Monopoly Government can regulate monopoly power through price regulation. Price regulation can eliminate deadweight loss with a monopoly. Some countries use antitrust law to prevent firms from obtaining excessive market power ©2005 Pearson Education, Inc. Chapter 10 48 Natural Monopoly A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms. Usually arises when there are large economies of scale We can show that splitting the market into two firms results in higher AC for each firm than when only one firm was producing ©2005 Pearson Education, Inc. Chapter 10 49 Regulating the Price of a Natural Monopoly $/Q Unregulated, the monopolist would produce Qm and charge Pm. Pm If the price were regulate to be Pc, the firm would lose money and go out of business. Can’t cover average costs AC Pr PC Setting the price at Pr giving profits as large as possible MC without going out of business AR MR Qm ©2005 Pearson Education, Inc. Qr Chapter 10 QC Quantity 50 Chapter 11 Pricing with Market Power (Price Discrimination by Monopoly) Introduction Pricing without market power such as in perfect competition is determined by market supply and demand. Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production. The main objective of all pricing strategies is to capture consumer surplus and transfer it to the producer ©2005 Pearson Education, Inc. 52 Price Discrimination Monopoly increases it profit by charging higher prices to those who value the product more. The practice of charging difference prices to different customers is called price discrimination Conditions: Demand curve must slope downward – the firm has some market power and control over price At least two groups of consumers for the product, each with a different price elasticity of demand Ability, at little cost, to charge each group a different price for essentially the same product Ability to prevent those who pay the lower price from reselling the product to those who pay the higher price • • • • • ©2005 Pearson Education, Inc. 53 Types of Price Discrimination First Degree Price Discrimination Charge a separate price to each customer: the maximum or reservation price they are willing to pay. Second Degree Price Discrimination In some markets, consumers purchase many units of a good over time Practice of charging different prices per unit for different quantities of the same good or service Third Degree Price Discrimination Practice of dividing consumers into 2 or more groups with separate demand curves and charging different prices to each group 1. Divides the market into two-groups. 2. Each group has its own demand function. ©2005 Pearson Education, Inc. 54 First-Degree Price Discrimination Examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product: Lawyers, doctors, accountants Car salesperson (15% profit margin) Colleges and universities (differences in financial aid) ©2005 Pearson Education, Inc. 55 First Degree Price Discrimination $/Q Pmax P1 P2 P* P3 P4 MC PC D Q1 Q2 Q* ©2005 Pearson Education, Inc. MR Q3 Q4 Qc Quantity 56 Second-Degree Price Discrimination Practice of charging different prices per unit for different quantities of the same good or service Example- water, electricity, fuel, quantity discounts Quantity discounts are an example of 2nd degree price discrimination (bulk buying) pricing – the practice of charging different prices for different quantities of ‘blocks’ of a good. Ex: electric power companies charge different prices for a consumer purchasing a set block of electricity Block ©2005 Pearson Education, Inc. 57 Second-degree Price Discrimination $/Q P1 P0 P2 AC MC P3 D MR Q1 1st Block Q0 2nd Block Q2 Q3 Quantity 3rd Block 1. Different prices are charged for different quantities or “blocks” of same good 2. Without PD: P = P0 and Q = Q0. With second-degree discrimination there are three blocks with prices P1, ©2005 Pearson Education, 58 P2, & P3. Inc. Third-Degree Price Discrimination Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group 1. Divides the market into two-groups. 2. Each group has its own demand function. Most common type of price discrimination. Examples: airlines, discounts to students and senior citizens, frozen v. canned vegetables ©2005 Pearson Education, Inc. 59 Third degree Price Discrimination 1. Suppose the consumer are sorted into 2 groups with different demand elasticities 2. Assume the firm produces at a constant LRAC and MC =$1.00 3. At a given price, price elasticity of demand (panel b, elastic-more sensitive to price) is greater than in panel a (inelastic). 4. The firm maximizes profit by finding the price in each market that equates MC=MR 5. So consumers with lower price elasticity pay $3.00 and those with higher price ©2005 Pearson Education, Inc. 60 elasticity pay $1.50 Chapter 12 Monopolistic Competition and Oligopoly Topics to be Discussed Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners’ Dilemma Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Cartels ©2005 Pearson Education, Inc. 62 Monopolistic Competition Characteristics 1. Many firms 2. Free entry and exit 3. Differentiated product The amount of monopoly power depends on the degree of differentiation. Examples of this very common market structure include: Toothpaste Soap Cold remedies ©2005 Pearson Education, Inc. 63 A Monopolistically Competitive Firm in the Short and Long Run Short-run Downward sloping demand – differentiated product Demand is relatively elastic – good substitutes MR < P Profits are maximized when MR = MC This firm is making economic profits ©2005 Pearson Education, Inc. 64 A Monopolistically Competitive Firm in the Short and Long Run Long-run Profits will attract new firms to the industry (no barriers to entry) The old firm’s demand will decrease to DLR Firm’s output and price will fall Industry output will rise No economic profit (P = AC) P > MC some monopoly power ©2005 Pearson Education, Inc. 65 A Monopolistically Competitive Firm in the Short and Long Run $/Q Short Run $/Q MC Long Run MC AC AC PSR PLR DSR DLR MRSR QSR ©2005 Pearson Education, Inc. Quantity MRLR QLR Quantity Monopolistically and Perfectly Competitive Equilibrium (LR) $/Q Monopolistic Competition Perfect Competition $/Q MC Deadweight loss AC MC AC P PC D = MR DLR MRLR QC ©2005 Pearson Education, Inc. Quantity QMC Excess capacity Quantity Monopolistic Competition & Economic Efficiency The monopoly power yields a higher price than perfect competition. If price was lowered to the point where MC = D, consumer surplus would increase by the yellow triangle – deadweight loss. With no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists. ©2005 Pearson Education, Inc. 68 Monopolistic Competition and Economic Efficiency Firm faces downward sloping demand so zero profit point is to the left of minimum average cost Excess capacity is inefficient because average cost would be lower with fewer firms Inefficiencies would make consumers worse off ©2005 Pearson Education, Inc. 69 Oligopoly – Characteristics Small number of firms Product – identical or differentiation Barriers to entry Scale economies Patents Technology Name recognition Strategic action Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment ©2005 Pearson Education, Inc. 70 Oligopoly In oligopoly the quantity sold by any one firm depends on that firm’s price and on the other firm’s prices and quantities sold So the main management challenges facing oligopoly firms are to determine The strategic actions to deter entry Threaten to decrease price against new competitors by keeping excess capacity Rival behavior Because only a few firms, each must consider how its actions will affect its rivals and in turn how their rivals will react. ©2005 Pearson Education, Inc. 71 Oligopoly – Equilibrium If one firm decides to cut their price, they must consider what the other firms in the industry will do Some might cut price , the same amount, or more than firm Could lead to price war and drastic fall in profits for all ©2005 Pearson Education, Inc. 72 Models in Oligopoly Several models were developed to explain the prices and quantities in oligopoly markets The Cournot Model Collusion Model: Cartels Stackelberg Model Bertrand Model Price Rigidity and Kinked Demand Curve Model Game Theory : The Prisoners’ Dilemma The Dominant Firm Model ©2005 Pearson Education, Inc. 73 Oligopoly – Equilibrium Defining Equilibrium Equilibrium refers to situation where firms are doing the best they can and have no incentive to change their output or price All firms assume competitors are taking rival decisions into account. Nash Equilibrium Each firm is doing the best it can given what its competitors are doing. (Each firm interact with one another choosing the best strategy given the strategies the others have chosen) ©2005 Pearson Education, Inc. 74 Oligopoly The Cournot Model Oligopoly model in which firms produce a homogeneous good, each firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce Firm will adjust its output based on what it thinks the other firm will produce ©2005 Pearson Education, Inc. 75 Firm 1’s Output Decision 1. Assuming MC is constant at MC1. 2. Firm 1’s profit-maximizing output depends on how much it thinks that Firm 2 will produce 3. If firm 1 thinks Firm 2 will produce nothing – D1(0) is the market DD curve. MR1(0) intersects Firm 1’s MC1 at Q=50 units 4. If firm 1 thinks that Firm 2 will produce 50 units, its demand curve = D1(50). Profit maximization output=25 units 5. If Firm 1 thinks that Firm 2 will produce 75, Firm 1 will produce only 12.5 units P1 D1(0) MR1(0) MC1 MR1(75) MR1(50) 12.5 25 D1(50) D1(75) 50 ©2005 Pearson Education, Inc. Q1 Firm 1 Firm 2 50 0 25 50 12.5 75 76 First Mover Advantage – The Stackelberg Model In Cournot Model it is assumed that two duopolists make their output decisions at the same time. In Stackelberg Model one firm sets its output before other firms do. Two main questions are : First, is it advantageous to go first? Second, how much will each firm produce? Assumptions One firm can set output first Firm 1 sets output first and Firm 2 then makes an output decision after seeing Firm 1 output ©2005 Pearson Education, Inc. 77 First Mover Advantage – The Stackelberg Model Conclusion Going first gives firm 1 the advantage Firm 1’s output is twice as large as firm 2’s Firm 1’s profit is twice as large as firm 2’s Going first allows firm 1 to produce a large quantity. Firm 2 must take that into account and produce less unless wants to reduce profits for everyone ©2005 Pearson Education, Inc. 78 Price Competition with Homogenous Products – The Bertrand Model Competition in an oligopolistic industry may occur with price instead of output. The Bertrand Model (developed by French economist, Joseph Bertrand, 1883) It is a model of price competition between doupoly firms which results in each charging the price that would be charged under perfect competition (known as marginal cost pricing) In which each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge ©2005 Pearson Education, Inc. 79 Price Competition – Bertrand Model The questions is , what is the Nash Equilibrium in this case? N.E. is where each firm interact with one another choosing the best strategy given the strategies the others have chosen In this case because there is an incentive to cut prices, the N.E is the competitive outcome where both firms will set P=MC Both firms earn zero profit ©2005 Pearson Education, Inc. 80 Game Theory and The Prisoners’ Dilemma Game theory examines oligopolistic behavior as a series of strategic moves and countermoves among rival firms It analyzes the behavior of decision-makers, or players, whose choices affect one another Provides a general approach that allows us to focus on each player’s incentives to cooperate or not There are 3 main features: 1. Rules 2. Strategies 3. Payoffs Payoff matrix is a table listing the rewards or penalties that each can expect based on the strategy that each pursues. The numbers in the matrix indicate the prison sentence in years for each based on the corresponding strategies ©2005 Pearson Education, Inc. 81 Example: Prisoners’ Dilemma - Payoff Matrix Suppose Art and Bob have been caught for stealing and will receive a sentence of 2 years for the crime. During investigation it is suspected that A and B were responsible for a bank robbery sometime ago. To proof this they were placed in separate room to investigate. If both confess – each will get 3 years sentence If one confess and other deny – the one who confess gets 1 year and the other one will get 10 year sentence Each of them have 2 option or strategies : confess or deny Payoffs – both confess both deny Art confess and Bob denies Bob confess and Art denies ©2005 Pearson Education, Inc. 82 Prisoners’ Dilemma Payoff Matrix Art’s Strategies Confess Confess Bob’s Strategies Deny 3 years Deny 10 years 3 years 1 year 2 years 1 year 2 years 10 years 1. The equilibrium of the game occurs when player A takes the possible action given the action of player B and the player B takes the best possible action given the action of player A 2. In the case of prisoners’ dilemma, the equilibrium occurs when Art makes his best choice given Bob’s choice and when Bob makes his choice given Art’s choice. 3. Art’s point of view – if Bob confess, Art also must confess because he gets 3 years compared to 10 years. If Bob does not confess, it still pays Art to confess because he receives 1 year rather than 2 years – so the best action for Art is to confess 4. Bob’s point of view – if Art confess, Bob must confess because he gets 3 years rather than 10 years. If Art does not confess, it still pays Bob to confess because he receives 1 years rather than 2 years – Bob’s best action is to confess 5. ©2005 ThusPearson the equilibrium of the game is to confess and each gets 3-year prison term83 Education, Inc. Price Rigidity and Kinked Demand Curve Model In other oligopoly markets, the firms are very aggressive and collusion is not possible. a. Firms are reluctant to change price because of the likely response of their competitors. b. In this case prices tend to be relatively rigid. Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change Fear lower prices will send wrong message to competitors leading to price war Higher prices may cause competitors to raise theirs ©2005 Pearson Education, Inc. 84 A Kinked Demand Curve Oligopoly Model Assumption: i. Firms believe that rivals will follow if they cut prices but not if they raise prices ii. Assume the elasticity of demand in response to an increase in price is different from the elasticity of demand in response to a price cut – which result a ‘kink’ in the demand for a single firm’s product With a kinked demand curve, marginal revenue curve is discontinuous Firm’s costs can change without resulting in a change in price ©2005 Pearson Education, Inc. 85 The Kinked Demand Curve $/Q So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MC’ P* MC D Quantity Q* ©2005 Pearson Education, Inc. 1. Above P*, demand is very elastic. 2. If P>P*, other firms will not follow 3. Below P*, demand is very inelastic. 4. If P<P*, other firms will follow suit MR 86 Price Signaling and Price Leadership Generally it is difficult to make collusion on pricing as cost and demand conditions are always changing. So firms adopt price signaling or price leadership. Price Signaling Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Price Leadership Pattern of pricing in which one firm (leader) regularly announces price changes that other firms (price followers) then match ©2005 Pearson Education, Inc. 87 Signaling and price leadership might lead to an antitrust lawsuit especially when there is a large firm which naturally emerge as a leader Price leadership also serve as a way for oligopolistic firm to deal with firms that are reluctance to change prices ( fear for being undercut). As demand and cost change, firms may find it necessary to change price ©2005 Pearson Education, Inc. 88 Cartels Producers in a cartel explicitly agree to cooperate in setting prices and output. Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels ©2005 Pearson Education, Inc. 89 Cartels Examples of successful cartels OPEC International Bauxite Association Mercurio Europeo ©2005 Pearson Education, Inc. Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa 90 A Summary of Market Structures Perfect Competition Monopolistic Competition Oligopoly Monopoly Assumptions Number of firms Very many Many Few One Output of different firms Standardized Differentiated Standardized or Differentiated - View of pricing Price taker Price setter Price setter Price setter Barriers to entry or exit No No Yes Yes strategic interdependence No No Yes No Predictions P and Q decisions MC = MR Short-run profit Long-run profit Through strategic interdependence MC = MR Positive, zero, Positive, zero, negative negative Positive, zero, negative Positive, zero, negative zero zero Positive or zero Positive or zero Almost always Maybe, if differentiated Sometimes 91 Advertising never ©2005 Pearson Education, Inc. MC = MR