This Document Contains Chapters 13 to 14 Chapter 13: Monopoly What’s New in the Fifth Edition? Chapter Objectives • Explain the significance of monopoly. • Explain how a monopolist determines its profit-maximizing output and price. • Discuss the difference between monopoly and perfect competition in terms of the effect on society’s welfare. • Discuss how policy makers address the problems posed by monopoly. • Define price discrimination and explain why it is so prevalent when producers have market power. Teaching Tips Types of Market Structure Creating Student Interest • Ask students if they have ever played the game Monopoly. Most of them probably have. Ask them to tell you the object of the game and the best strategy for winning. Chances are several different strategies will be defended as the “best” (“buy the yellow properties,” “buy the railroads or utilities”). Use this discussion to point out that the object of the game is to become the only seller—a monopolist. Ask students what happens to the rent of a property when one owner owns all the properties of the same color. Someone will probably know that the rent on a property doubles when the owner has a monopoly for that color block. Point out that prices increase when there is a monopoly on one color property. Students generally become interested when you bring up the game Monopoly—use this to create interest in how the market structure model is similar to the game. Presenting the Material • Use Handout 13-1 to help students identify different market types. • Use the chart in text Figure 13-1 to illustrate the differences between the types of market structure. Give specific examples of industries that fit each classification. Monopoly (pharmaceutical companies with drugs under patent) Oligopoly (autos, airlines, photographic film, colas) Monopolistic competition (fast food, retail clothing stores, sports clubs) Perfect competition (wheat, corn, soybeans, stock market) The Meaning of Monopoly Creating Student Interest • Draw a downward-sloping demand curve on the board. Ask students if this is a market or a firm demand curve. Students should remember that the market and firm demand curves were different in perfect competition. You will probably get a difference of opinion, with students calling out both “market” and “firm” as the answer. If you wait quietly for a little bit, you will likely see the class come to a consensus, figuring out that it is both. Since the monopoly is the only firm, it has the entire market demand. • Ask students whether the college bookstore has a monopoly on textbooks. Tell them about how the bookstore worked for previous generations. (Was your bookstore a monopoly?) What changes in recent years have affected the market power of the college bookstore in the market for textbooks? (Online sources, laws that require bookstores to release textbook requirements before the start of the semester.) Presenting the Material • For a monopoly to remain a monopoly there must be something preventing firms from entering the industry. If a monopoly were losing money in the long run, it would exit the industry (just like any other firm). If a monopoly exits, the industry disappears (the Pet Rock industry). We have seen in the perfect competition model that if a firm is earning profits, it will signal other firms to enter the industry. If there is only one firm and the firm is earning a profit, then there must be something keeping new firms from being able to enter. Barriers to entry allow a monopoly to remain a monopoly. Present the five principles of barriers to entry. • Explain that the government takes actions to both create and prevent monopolization of industries. It may seem strange to students that the government does both. Explain why the government would want a monopoly in certain cases and why, in general, the government tries to prevent monopolization. Here you can go back to the discussion of the “spectrum” of market structures and the idea of the monopoly model having drawbacks that will be discussed later. Use the websites listed at the end of the chapter to present examples of government behavior to both promote and prevent monopoly. How a Monopolist Maximizes Profit Creating Student Interest • Ask students to recall the profit-maximizing rule for a perfectly competitive firm (MC = MR). Then ask them the profit-maximizing rule for a monopolistic firm (MC = MR). Emphasize that profit maximization occurs at MC = MR any time, any industry, any market structure. Presenting the Material • Use Handout 13-2 to show profit maximization occurs where MC = MR. Monopoly and Public Policy Creating Student Interest • Remind students that antitrust laws in the United States were designed to prevent the formation of monopoly. Ask students why the government would want to prevent monopolies? By now they should say because the monopolist will produce less and charge a higher price. Now ask them if that is really fair given that the monopoly firm is able to earn higher profits. Do we really want to have a law that sets a limit on how much profit a firm can earn? This should generate some lively discussion and will lead nicely to a comparison of total surplus under monopoly and perfect competition. • Use Handout 13-3 to help students think through regulation of monopolies. Presenting the Material • Start with a review of consumer and producer surplus and market efficiency. Next, illustrate what happens to producer surplus, consumer surplus, and total surplus when the entire market output is supplied by one firm. Point out that the real problem with monopoly is the inefficiency it creates in terms of the deadweight loss. Text Figure 13-9 illustrates what happens to total surplus under monopoly using a constant marginal cost curve. • Use the example of a natural gas company as a natural monopoly. If it is able to serve the entire market, it can spread the high fixed costs of the pipelines over more customers and enjoy economies of scale. If two or more firms serve the market, customers will not enjoy low prices. A regulated price is set to cover the firm’s unit costs. Price Discrimination Creating Student Interest • Ask students how much it costs to see a movie at a theater. The question should prompt some discussion of the market price. Students will also bring up the fact that different customers pay different prices (seniors, children, students) and the price is different for movies shown on different days and/or times (matinees, weekends). You can illustrate this by showing the prices charged at your local theater. Presenting the Material • Use Handout 13-4 to have students consider price discrimination. • Many students become very interested in examples of price discrimination and the fact that it is illegal. They will often start asking you about specific examples. Make sure you emphasize that price discrimination is charging different prices to different customers for the same product. Many of the examples they bring up appear to be price discrimination, but in fact are not, because the product is actually different. For example, phone calls and airline flights are different products when they occur at different times or on different days. A dinner buffet for a child and an adult are different products. Examples of actual price discrimination include charging men and women different prices for dry cleaning the same type of shirt, or charging men and women different prices for the same drink. There are some examples of price discrimination that are allowed. (Sometimes firms discriminate in favor of senior citizens, military personnel, or students.) There are also some examples of price discrimination that are illegal but are not prosecuted. This can make dealing with student “But what about . . .” questions tricky and potentially entangling and time consuming. Try to harness student interest in the topic without becoming swamped by the complexity of the real world! • Use the example of airline travel by business and vacation travelers. The price elasticity of demand for business travelers is calculated to be .54, or very inelastic. The price elasticity of demand for vacation travelers is 2.33, or very elastic. Airlines have a clear opportunity to practice price discrimination by raising prices on business travelers and charging a lower price for vacation travelers. • Use text Figure 13-11 to illustrate the profits from two different groups of customers. Show that the firm will earn the highest profit if it charges one price to the business travelers and one price to the vacation travelers. Common Student Pitfalls • Finding the monopoly price. Students need to be reminded often that to find the monopoly price you must go up from the profit-maximizing quantity to the demand curve. It is very tempting, especially under the stress of an exam, to indicate the monopoly price by drawing a line over to the vertical axis from the MC = MR point—after all, there is a great big point already there! Every time you show the monopoly price, emphasize that you have to go up from the MC = MR point to the demand curve. • Is there a monopoly supply curve? Since the monopolist has control over price, there is no given market price to use to identify a monopoly supply curve. There is no supply curve for a monopoly. • Monopoly versus monopolistic. Students may confuse monopoly with monopolistic competition because of the similarities in names. Carefully explain the possibility of confusion if students use the term “monopolistic.” If a firm is “monopolistic,” does that mean it is a monopoly or it is monopolistically competitive? It is important to be clear. Explain that the term monopolistic is used in “monopolistic competition” to indicate that firms in the industry, of which there are many, try to convince consumers that they are the only brand with a particular unique feature. • How much can a monopoly charge? Students often think that a monopolist can “charge whatever price it wants to.” Explain that the downward-sloping demand curve for the industry’s product means that if the monopoly charges too high a price, it will have no customers. Therefore, because the firm is the industry, the industry demand curve is downward sloping. Chapter Outline Opening Example: De Beers, the world’s main supplier of diamonds, is a successful monopolist that limits the quantity of diamonds supplied to the market. By so doing, De Beers drives up the price of diamonds. I. Types of Market Structure A. There are four principal models of market structure: perfect competition, monopoly, oligopoly, and monopolistic competition. B. Economists use these four models of market structure to develop principles and make predictions about markets and how producers will behave in them. C. Market structure is based on two dimensions: the number of producers in the market (one, few, or many) and whether the goods offered are identical or differentiated. 1. In perfect competition, many producers sell an identical product. 2. In monopoly, a single producer sells a single, undifferentiated product. 3. In oligopoly, a few producers—more than one but not a large number—sell products that may be identical or may be differentiated. 4. In monopolistic competition, many producers each sell a differentiated product. II. The Meaning of Monopoly A. A monopolist is a firm that is the only producer of a good that has no close substitutes. When an industry is controlled by a monopolist, it is known as a monopoly. B. Monopoly: Our first departure from perfect competition 1. True monopolies are hard to find in the economy because of legal obstacles: Antitrust laws help to prevent monopolies from emerging. 2. Monopolies play an important role in some sectors of the economy, such as pharmaceutical markets. C. What monopolists do 1. Monopolies raise price above the perfectly competitive price and restrict output. 2. Under perfect competition, economic profits normally vanish in the long run. This is not the case for monopolists. D. Why do monopolies exist? 1. To earn monopoly profits, a monopolist must be protected by a barrier to entry, something that prevents other firms from entering the industry. 2. The five principal types of barriers to entry are: a. Control of a scarce resource or input. b. Increasing returns to scale: Large firms with lower unit costs drive out smaller firms, sometimes creating a natural monopoly. c. Technological superiority: A firm that produces a better product because it has a technological advantage over other firms can become a monopolist, at least in the short run. d. Network externality: The firm with the largest network of customers using its product can become a monopolist, even if they do not produce the highest-quality product (e.g. Microsoft’s Windows operating system.) e. Government-created barriers, such as patents and copyrights. III. How a Monopolist Maximizes Profit A. The monopolist’s demand curve and marginal revenue 1. The demand curve for a monopolist is downward sloping, whereas the demand curve for a perfectly competitive firm is horizontal. 2. For a monopolist, the demand curve is the market demand curve. 3. The additional revenue a monopolist earns from increasing output by one unit is less than the price at which the unit is sold. 4. For a monopolist, an increase in production has two opposing effects on revenue. a. The quantity effect: As one more unit is sold, it increases total revenue by the price at which the unit is sold. b. The price effect: In order to sell the last unit, the monopolist must cut the price on all units sold. c. At low levels of output, the quantity effect is larger than the price effect; at higher output levels, the price effect is stronger than the quantity effect. 5. For a firm with market power, the marginal revenue curve always lies below its demand curve. This is illustrated in text Figure 13-5, shown here. B. C. The monopolist’s profit-maximizing output and price 1. A monopolist maximizes profit at an output level where MR = MC. 2. The price a monopolist charges is what consumers are willing to pay for that output level. This price is found on a graph by going vertically up from the optimal output level to the demand curve and then left to the price axis, as illustrated in text Figure 13-6, which is shown here. C. Monopoly versus perfect competition 1. For a perfectly competitive firm, P = MC at the profit-maximizing quantity of output. 2. P > MR = MC for a monopolist at the profit-maximizing quantity of output. 3. Compared to a firm in perfect competition, a monopolist produces a smaller quantity, charges a higher price, and earns a positive profit. D. Monopoly: The general picture 1. Generally, a monopolist will have an upward-sloping marginal cost curve. 2. The total profit for a monopolist = (PM × QM) – (ATCM × QM) = (PM – ATCM) × QM. 3. Monopolies can earn profits in the short run and the long run. The monopolist’s profit is illustrated in text Figure 13-7, shown here. IV. Monopoly and Public Policy A. Welfare effects of monopoly 1. There are welfare losses from monopoly; the loss to consumers is greater than the gain in profits for the monopoly. 2. Total surplus is less under monopoly than under perfect competition. B. Preventing monopoly 1. If the monopoly is not a natural monopoly, it is best to prevent its existence or break it up. 2. Antitrust laws prevent or eliminate monopolies. C. Dealing with natural monopoly 1. There are two major public policies toward natural monopolies: public ownership or regulation. a. Price regulation of natural monopolies gives the monopoly firm an incentive to expand output as long as price is above marginal cost and the monopolist at least breaks even. 2. A monopsony exists when there is only one buyer of a good. A monopsonist is a firm that is the sole buyer in a market. a. There are not many real-world examples of monopsony. b. When Time Warner Cable wanted to merge with Comcast there was an objection because this would make the resulting company both a monopolist and a monopsonist in some markets. V. Price Discrimination A. A single-price monopolist offers its product to all consumers at the same price. B. Sellers engage in price discrimination when they charge different prices to different consumers for the same good. C. The logic of price discrimination 1. When a single firm sells the same good to two or more different types of customers, it can earn more profit if it is able to charge different prices to each of the different types of customers. 2. Most monopolists can increase their profits by engaging in price discrimination. This is illustrated in text Figure 13-12, shown here. VI. Price Discrimination and Elasticity A. If a firm can identify two separate customer groups that have differing price elasticities of demand, it can engage in price discrimination. 1. A firm with market power will raise the price on customers who have inelastic demand and lower the price on customers who have elastic demand. B. Perfect price discrimination 1. Perfect price discrimination takes place when a monopolist charges each consumer his or her willingness to pay—the maximum that the consumer is willing to pay. 2. The greater the number of prices the monopolist charges, the lower the lowest price; that is, some consumers will pay prices that approach marginal cost. 3. The greater the number of prices the monopolist charges, the more money it can extract from consumers. 4. Monopolies try to achieve perfect price discrimination by: a. advance purchase restrictions. b. volume discounts. c. two-part tariffs. Case Studies in the Text Economics in Action The Monopoly That Wasn’t: China and the Market for Rare Earths—This EIA discussed the effects of an export quota by China for rare earths and the subsequent, though short-lived, spike in prices. Ask the students the following questions: 1. Why was the panic over the price of rare earths short-lived? (China only controlled about 33 percent of the world supply of the rare earth. Other firms began to produce as soon as the price went up.) 2. Was China a monopolist in rare earths? (No, they merely possessed low-cost means of production.) Shocked by the High Price of Electricity—This EIA discusses deregulation in the distribution and generation of electricity. Ask students the following questions: 1. Why was there a move toward deregulation of electric utilities in the 1990s? (It was believed that competition would result in lower prices.) 2. Why is there a move toward reregulation of electric utilities? (The generation of power entails large up-front costs so smaller generators will have higher production costs; since competition did not emerge, producers were able to drive up prices.) The (R)Evolution of the American High-Speed Internet Market—This EIA discusses the high price of cable and broadband access in the United States relative to other countries in the world. Ask students the following questions: 1. Why is the provision of cable service a natural monopoly? (There are large fixed costs associated with running cables to each individual house.) 2. What percentage of broadband access is provided by cable companies in the United States? (About two-thirds.) 3. Why is broadband access cheaper in other countries? (Regulators in other countries imposed a common carriage rule whereby cable companies must rent their cable capacity to internet service providers who then compete to provide service to consumers.) Sales, Factory Outlets, and Ghost Cities—This EIA presents examples of subtle forms of price discrimination employed by oligopolists and monopolistic competitors. Ask students the following questions: 1. Why do stores put goods on sale? (To increase revenues by appealing to their customers who have high price elasticity of demand.) 2. What two different types of customers is the store catering to? (Customers who will shop regardless of price and customers who will buy only if the item is on sale.) 3. Why are outlet stores on the outskirts of towns? (These appeal to customers who are willing to take the time to drive to enjoy lower prices; the time spent driving is an opportunity cost. These customers also have high price elasticity of demand.) Global Comparison The Price We Pay—This Global Comparison compares the price of Nexium in seven different countries. Business Case Amazon and Hachette Go to War—This business case discusses pricing agreements between Hachette, the fourth-largest book publisher, and Amazon.com. Web Resources The U.S. Patent and Trademark office provides information on patents in the United States: http://www.uspto.gov/. The Federal Trade Commission’s “Promoting Competition, Protecting Consumers: A Plain English Guide to Antitrust Laws” is available at https://www.ftc.gov/tips-advice/competition-guidance/guide-antitrust-laws. Handout 13-1 Date_________ Name____________________________ Class________ Professor________________ Classifying Markets Classify the following products as being in monopoly, oligopoly, monopolistically competitive, or perfectly competitive industries. What is the source of their market power? Microsoft’s Windows operating system Kodak’s 35-mm film Burroughs Welcome’s drug for AIDS patients McDonald’s Big Mac A regional electric company Answers Microsoft’s Windows operating system (near monopoly, patents) Kodak’s 35-mm film (oligopoly, patents, and copyrights) Burroughs Welcome’s drug for AIDS patients (oligopoly, patents) McDonald’s Big Mac (monopolistic competition, brand loyalty) A regional electric company (monopoly, economies of scale, government license) Handout 13-2 Date_________ Name____________________________ Class________ Professor________________ Monopoly Profit Maximization (1) Quantity of diamonds (2) Price of diamonds (3) Total revenue (4) Marginal revenue (5) Total cost (6) Marginal cost (7) Profit 0 $200 $100 1 180 110 2 160 140 3 140 200 4 120 300 5 100 450 1. Which two columns depict the demand for this monopolist? 2. Calculate Total Revenue, Marginal Revenue, and Marginal Cost for this firm. 3. What quantity of output will yield maximum profits for this firm? At what price must they sell? 4. Calculate the profits at each possible level of output for the firm. Does this profit confirm the profit maximizing price and quantity in 3? Answers (1) Quantity of diamonds (2) Price of diamonds (3) Total revenue (4) Marginal revenue (5) Total cost (6) Marginal cost (7) Profit 0 $200 $0 $100 –$100 1 180 180 $180 110 $10 70 2 160 320 140 140 30 180 3 140 420 100 200 60 220 4 120 480 60 300 100 180 5 100 500 20 450 150 50 1. Which two columns depict the demand for this monopolist? (1) and (2) 2. Calculate Total Revenue, Marginal Revenue, and Marginal Cost for this firm. See table. 3. What quantity of output will yield maximum profits for this firm? At what price must they sell? Q = 3, P = $140 4. Calculate the profits at each possible level of output for the firm. Does this profit confirm the profit maximizing price and quantity in 3? Yes. Handout 13-3 Date_________ Name____________________________ Class________ Professor________________ Regulate It? Are the following companies natural monopolies? Would price regulation give enough incentive to the firm to innovate? Would price regulation protect consumers? Your local electricity company Monopoly? Would price regulation give incentive for the firm to innovate? Would price regulation protect consumers? Your local cable TV company Monopoly? Would price regulation give incentive for the firm to innovate? Would price regulation protect consumers? The theme park in your area Monopoly? Would price regulation give incentive for the firm to innovate? Would price regulation protect consumers? Your trash pickup company Monopoly? Would price regulation give incentive for the firm to innovate? Would price regulation protect consumers? Handout 13-4 Date_________ Name____________________________ Class________ Professor________________ Price Discrimination on Campus Imagine that you represent the student government on campus. Can you engage in profitable price discrimination on the following services? Why or why not? Parking spaces Theater productions Sports events Chapter 14: Oligopoly What’s New in the Fifth Edition? • Updated Opening Example • Updated cases Chapter Objectives • Define oligopoly and discuss its prevalence. • Explain how oligopoly firms can benefit from collusion, and why they have an incentive to act in ways that reduce their combined profit. • Define game theory and use the prisoner’s dilemma to understand oligopoly behavior. • Explain how repeated interactions between oligopoly firms can help them achieve tacit collusion. • Discuss antitrust policy and explain how oligopoly works in practice. Teaching Tips The Prevalence of Oligopoly Creating Student Interest • To introduce the basic characteristics of oligopoly (a few sellers selling either a homogeneous or differentiated good in a market with some barriers to entry), pose the following scenario to students. A friend who enjoys cooking and chemistry has been experimenting in his kitchen and has come up with a recipe for a cola drink. He has let many of his friends try his cola drink, and he has put it in a blind taste test against the two major cola brands. His friends all say his cola drink is better than either of the two major brands. Is it possible your friend could market his cola drink and compete with the major brands? The general consensus should be that although it would be relatively easy for your friend to produce and bottle his cola drink, trying to get it distributed and marketed would prove to be very challenging. Presenting the Material • Oligopoly is defined as a market with only a “few” sellers but “few” is not well-defined. Present the Herfindahl-Hirschman Index as one method of determining whether an industry is an oligopoly. The second method is to look at the market share of the four largest firms. If the four largest firms control a sizeable percentage of the market, then the industry is more likely to be an oligopoly. Some examples of industries to discuss would be soft drinks, chocolate, package delivery, and automobile production. In addition, any relatively isolated town with only two or three firms in the industry can behave as an oligopoly. Understanding Oligopoly Creating Student Interest • Ask students what they know about OPEC. Almost every student should have heard of OPEC and should have some idea of its purpose. The current member countries are Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela. Ask students why they think it is in these countries’ best interest to cooperate and act together to control production? Most will surely say it gives each country an opportunity to earn more profit. Now get them to speculate on whether any one country has an incentive to cheat on the agreement. There is an abundance of online information about OPEC, and current estimates have OPEC countries controlling about 80% of proven oil reserves. Presenting the Material • Use Handout 14-1 to help your students understand oligopoly behavior. Games Oligopolists Play Creating Student Interest • Tell students that you are going to give them a pop quiz. The only question on the quiz is, “What grade would you like to receive on this quiz?” The two permitted answers are “A” or “C” (though those are not the only possible grades they may receive). Then explain that the grade they will actually receive on the quiz depends on their answer and the answer of another student in the class. (Each student will be randomly paired with another student. If there is an odd number of students in the class, the remaining student will be paired with the instructor.) Tell the students that the grade assigned for the quiz will be determined by the following payoff matrix: Have students write their name and their choice (A or C) on a small slip of paper and collect all the decisions and put them in a hat. Draw two names at a time and inform the students what grade they receive, based on the payoff matrix. After assigning all the grades, ask the students what they think. You will likely get comments like “It’s not fair!” You can also repeat the exercise and/or change the payoffs. Presenting the Material • Use Handout 14-2 to present game theory. Oligopoly in Practice Creating Student Interest • Ask students if they know of any cases where the Department of Justice has sued a company for violating antitrust laws, or if they know of any cases where two companies wanted to merge and the Department of Justice had to decide if the merger should be allowed. You can find several examples at http://www.wsj.com if you enter either “collusion” or “price fixing” into the search box. Some notable examples are Microsoft, the merger of Whole Foods and Wild Oats, and the proposed merger of AT&T and T-Mobile. Other examples are price fixing of detergent in France, e-Book pricing, and the pricing of optical disk drives by Hitachi-LG Data Storage Inc. Presenting the Material • Review the welfare effects of monopoly to help students understand why antitrust laws exist. Given that explicit collusion is illegal and tacit collusion can be challenging, companies have an incentive to differentiate their products so that they have more pricing power. Present the reasons why it can be challenging for an industry to tacitly collude and set high prices, and then brainstorm on strategies for product differentiation. • Do the experiment Tit for Tat? (30–45 minutes) Organize students into teams of three, with each team representing a specific oligopoly industry. Each student represents a specific company within the oligopoly. Make this clear by standing by one team and indicating that one student may play the role of Kellogg’s, the second Quaker Oats, and the third student General Mills. The goal of each company is to maximize profits for their corporation. Explain that during this experiment, each firm must decide whether to choose a high price for their product (H = $8) or a low price (L = $6). (In this game, oligopolists are competing on price alone, not on quantities.) If a student is operating as the price leader, he or she will signal a high price by thumbs up and a low price by thumbs down. Use Handout 14-3 to record pricing and profits. Tell students that any verbal discussion on pricing strategy during the game will be punished under antitrust laws: a team can be thrown out into the hall. Optional: Remind students that the most profitable strategy for the industry as a whole is to collude. To start the experiment, ask each team to choose a price leader for the first round; the student taking this role changes each round. Ask the price leader to choose a high or low price and signal to the team his or her choice. Then have the two other students choose their prices and secretly record them on the firm’s profit sheet, covering their prices with their hands. Now it is time for them to reveal their pricing decisions to the industry. The oligopoly determines the outcome: HHH, HHL, HLL, LLL, etc. Then each firm records its individual profit or loss for this first round. Teams continue this process until they have played all 15 rounds: The new price leader shows the choice of his or her firm’s price, and the two other firms secretly respond. The two firms show their choice, the oligopoly determines the outcome, and individual firms record their profit or loss for that round. Observe the teams during the game to see if any are able to achieve tacit collusion and agree on a high price. Because leading with a high price risks rivals undercutting the price, the least risky strategy is to lead with a low price. Students tend to use a tit-for-tat strategy in this game. Common Student Pitfalls • Playing fair in the prisoners’ dilemma. Students may find it difficult to assume that players in the prisoners’ dilemma will care only about the length of their sentences, and not at all about other players. Liken the prisoners to firms maximizing profits and students may be better able to see how the dilemma works. • Rivalry versus competition. When students think of a few firms operating in the same market, they often think of the firms as competitive. This use of the term competitive can cause confusion with the competitive model studied previously. Using the term rivalry and describing the firms as “rivals” can help to eliminate the confusion that may result from the use of the term competitive. • Illegal behaviors. Students may think that the marketplace is a “free-for-all” in which there are no rules of the game. Explain that U.S. antitrust laws lay out rules for the game, and that certain practices are illegal, such as predatory pricing and price setting. Chapter Outline Opening Example: The opening example deals with collusion Bridgestone and 25 other companies, which pled guilty to price fixing in the market for rubber automotive parts. Collusion is illegal in the United States, and these companies were caught red-handed. This example is used throughout the chapter. I. The Prevalence of Oligopoly A. An oligopoly is an industry with only a small number of producers. 1. The number of firms determines whether a specific market is an oligopoly, not the size of each firm. 2. Each oligopolist has some market power. B. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition. C. The most important source of oligopoly is the existence of increasing returns to scale, which gives bigger producers a cost advantage over smaller ones. II. Understanding Oligopoly A. A duopoly example 1. An oligopoly consisting of only two firms is a duopoly. 2. Sellers engage in collusion when they cooperate to raise each other’s profits. A cartel is an agreement by several producers that increases their combined profits by telling each one how much to produce. 3. OPEC is the most famous of the world’s cartels. 4. Cartels among firms are illegal in the United States and many other jurisdictions. 5. Individual firms in a cartel have an incentive to cheat. B. Collusion and competition 1. In a duopoly, firms choose a level of output and sell that output at the market price. 2. Individual firms have an incentive to produce more than the quantity that maximizes their joint profits because neither firm has as strong an incentive to limit its output as a true monopolist would. 3. Producing more output creates a positive quantity effect and a negative price effect. An individual firm in an oligopoly faces a smaller price effect than a monopolist because the firm only considers its own output and not that of the other firms. It seems profitable for one company to increase production. 4. When firms ignore the effects of their actions on each other’s profits, they engage in noncooperative behavior. 5. When there are only a small number of firms, collusion is possible. However, it is hard to determine whether collusion will actually materialize. III. Games Oligopolists Play A. When the decisions of two or more firms significantly affect each other’s profits, they are in a situation of interdependence. B. The study of behavior in situations of interdependence is known as game theory. C. The prisoners’ dilemma 1. The reward received by a player in a game, such as the profits earned by an oligopolist, is that player’s payoff. 2. A payoff matrix shows how the payoff to each of the participants in a two-player game depends on the actions of both. Such a matrix helps us analyze situations of interdependence. This is illustrated in text Figure 14-2, shown next. a. Prisoners’ dilemma is a game based on two premises: (1) Each player has an incentive to choose an action that benefits themselves at the other player’s expense, and (2) when both players act in this way, both are worse off than if they had acted cooperatively. b. An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. c. A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of the other players, ignoring the effects of that action on the payoffs received by those other players. D. Overcoming the prisoners’ dilemma: repeated interaction and tacit collusion 1. Oligopolists in the real world play repeated games. 2. A firm engages in strategic behavior when it attempts to influence the future behavior of other firms. 3. A strategy of tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period. Doing this, a firm can punish another firm for cheating. 4. When firms limit production and raise prices in a way that raises each other’s profits, even though they have not made any formal agreement, they are engaged in tacit collusion. 5. When oligopolists expect to compete with each other over an extended period, each individual firm will often find it in its own best interest to help other firms in the industry, and so there will be tacit collusion. IV. Oligopoly in Practice A. The legal framework 1. Before 1890 in the United States, cartels were legal but legally unenforceable. 2. The Sherman Antitrust Act was passed in 1890; its goal was to prevent the creation of monopolies and to break up existing ones. a. One of the first actions taken under the Sherman Antitrust Act was the breakup of Standard Oil. B. Tacit collusion and price wars 1. Oligopolists do succeed in keeping prices above their noncooperative level. 2. Tacit collusion is a normal state for an oligopoly. 3. However, four major factors make it hard for an industry to coordinate on high prices. a. Less concentration: The more firms in an oligopoly, the less incentive for firms to behave cooperatively. b. Complex products and pricing schemes: In the real world, oligopolists produce many products, which makes it difficult for a firm to track what its competitors are doing. c. Differences in interests: Firms differ in what they perceive as fair and what strategies are in their real interests. d. Bargaining power of buyers: Often, oligopolists sell to large buyers who can bargain for lower prices. 4. A price war occurs when tacit collusion breaks down and prices collapse. C. Product differentiation and price leadership 1. Product differentiation lessens the competitiveness between firms in an oligopoly. 2. In price leadership, one firm sets the price and the other firms follow. 3. Firms that have a tacit understanding not to compete on price often engage in intense nonprice competition, using advertising and other means to try to increase their sales. D. How important is oligopoly? 1. Important parts of the economy are fairly well described by perfect competition. 2. Even in oligopolies, the limits to cooperation keep prices fairly close to marginal costs. 3. Predictions from supply and demand analysis are often accurate for oligopolies. 4. While it is difficult to model oligopolies, most economists take a pragmatic approach and know that there are important issues—from antitrust to price wars—that need to be analyzed and understood. Case Studies in the Text Economics in Action Is It a Beer-opoly or Not?—This EIA presents the Herfindahl-Hirschman index for determining market power. Ask students the following questions: 1. What is the formula for calculating the HHI? What does the HHI equal for a monopoly? (∑[market share]2; for monopoly, that is [100][100] = 10,000.) 2. What does the HHI equal if an industry has four firms and their market shares are 10%, 20%, 20%, and 50%? (HHI = 100 + 400 + 400 + 2,500, which equals 3,400.) The Case Against Chocolate Producers Melts—This EIA discusses potential price fixing in the chocolate industry. Ask students the following questions: 1. What percentage of the chocolate market do the four largest firms control? (76%.) 2. By what percentage did chocolate candy prices increase from 2008 to 2010? (17%.) 3. How do chocolate producers explain the increase in the price of candy? (Producers claim costs have risen.) The Demise of OPEC—This EIA presents the Organization of Petroleum Exporting Countries as an example of a real-world cartel. Ask students the following questions: 1. How successful was OPEC as a cartel in the 1970s, 1980s, and 1990s? (In 1974 and 1978, OPEC was successful as a cartel. In the mid-1980s, a glut of oil and cheating by cartel members reduced cooperation. In the late 1990s, OPEC’s clout increased when Mexico, a nonmember, agreed to follow output reductions.) 2. Does OPEC meet in public? (Yes, the cartel meets frequently outside the United States.) 3. How has OPEC’s ability to control price been affected by the 2007–2009 recession, political instability in the Middle East, and the expansion of shale oil production in North America? (Demand for oil fell during the recession so it was difficult to maintain a high price, political instability gives a country an incentive to cheat, and rising shale oil production has reduced North America’s dependence on imported oil.) The Price Wars of Christmas—This EIA uses the toy industry to show how price wars break out when the opportunity for collusion through repeated interaction diminishes. Ask students the following questions: 1. What changes in the retail toy market have led to the price wars described in the EIA? (The future payoff from collusion is shrinking because the industry is in a state of decline and there are new entrants.) 2. Explain what this EIA means by “creeping Christmas.” (Price wars are beginning earlier and earlier each year as firms try to expand sales.) For Inquiring Minds Prisoners of the Arms Race and the Resurgent Cold War—This FIM looks at the arms race between World War II and the late 1980s and the current flare-up as an example of the application of game theory. Global Comparison Contrasting Approaches to Antitrust Regulation—This Global Comparison describes the methods used by the European Union and the United States to enforce antitrust regulations. Business Case Virgin Atlantic Blows the Whistle . . . or Blows It?—This business case discusses the rivalry between Virgin Atlantic and British Airways, and the potential conspiracy between the two companies to fix surcharges imposed to cover the rising cost of fuel. Web Resources A prisoners’ dilemma game and information about prisoners’ dilemma can be found at these two websites: http://serendip.brynmawr.edu/playground/pdref.html http://serendip.brynmawr.edu/playground/pd.html The Department of Justice website contains information about ongoing antitrust cases. From the main page click on Agencies, then Antitrust Division: http://www.justice.gov Handout 14-1 Date_________ Name____________________________ Class________ Professor________________ Oligopoly Strategy Price (per pound) Quantity Total revenue Marginal revenue $10 0 9 20 8 40 7 60 6 80 5 100 4 120 3 140 2 160 1 180 0 200 1. Calculate Total Revenue and Marginal Revenue in the table above. 2. What would be a monopoly firm’s optimal output? Price? 3. If two firms supply this market, and they agree to split the market evenly, what is the optimal output per firm? Price? 4. Suppose one of the two firms decides to break the agreement and increase production by 20 from the answer in number 3. What will be the price effect and the quantity effect for that firm? What happens to the other firm? 5. What will firm 2 do to react to firm 1’s violation of the agreement? 6. What result occurs as the firms react to each other’s changes? Answers Price (per pound) Quantity Total revenue Marginal revenue $10 0 9 20 180 180 8 40 320 140 7 60 420 100 6 80 480 60 5 100 500 20 4 120 480 -20 3 140 420 -60 2 160 320 -100 1 180 180 -140 0 200 0 -180 1. Calculate Total Revenue and Marginal Revenue. (See table.) 2. What would be a monopoly firm’s optimal output if the marginal cost of production is 0? Price? 100 units at $5. 3. If two firms supply this market, and they agree to split the market evenly, what is the optimal output per firm? Price? If there are two firms, the optimal outcome is for them to behave together as a monopolist, with both selling 50 units at a price of $5. 4. Suppose one of the two firms decides to break the agreement and increase production by 20 from the answer in number 3. What will be the price effect and the quantity effect for that firm? What happens to the other firm? If the firm increases output by 20 to 70, the total quantity in the market goes to 120, so the price drops to $4. The quantity effect is +$80 ($4 x 20) and the price effect is 1 from the drop in price, spread over the original 50 units, or $50 ($1 x 50). The net effect is an increase in profit of $30, so the firm will make the change. The other firm will lose $50, making the net result a loss of $20 in the industry. 5. What will firm 2 do to react to firm 1’s violation of the agreement? Firm 2 will also increase output. 6. What result occurs as the firms react to each other’s changes? The industry approaches perfect competition. Handout 14-2 Date_________ Name____________________________ Class________ Professor________________ Game Theory In this game, there are two airlines, Sky World and Bay City Airlines, and they have the choice of pricing high or low. Each company’s profit depends on how the other company responds to its pricing strategy. 1. What pricing strategy will Sky World choose if it assumes Bay City will choose a high pricing strategy? 2. What pricing strategy will Sky World choose if it assumes Bay City will choose a low pricing strategy? 3. Does Sky World have a dominant strategy? 4. What pricing strategy will Bay City choose if it assumes Sky World will choose a high pricing strategy? 5. What pricing strategy will Bay City choose if it assumes Sky World will choose a low pricing strategy? 6. Does Bay City have a dominant strategy? 7. What pricing strategies will be chosen if there is no collusion? 8. Can the firms improve the outcome if they collude? If so, how would they collude? 9. Would the collusion work in a one-shot game? Answers: 1. What pricing strategy will Sky World choose if it assumes Bay City will choose a high pricing strategy? Low price. 2. What pricing strategy will Sky World choose if it assumes Bay City will choose a low pricing strategy? Low price. 3. Does Sky World have a dominant strategy? Yes, low price. 4. What pricing strategy will Bay City choose if it assumes Sky World will choose a high pricing strategy? Low price. 5. What pricing strategy will Bay City choose if it assumes Sky World will choose a low pricing strategy? Low price. 6. Does Bay City have a dominant strategy? Low price. 7. What pricing strategies will be chosen if there is no collusion? What will be the firms’ profits? Both firms will choose low price. Profits for each firm will be $10. 8. Can the firms improve the outcome if they collude? Why? If so, how would they collude? Yes, if they collude and both offer high prices, profits will increase to $30. 9. Would the collusion work in a one-shot game? Why? No, the firms will have the incentive to cheat and offer a lower price, which would increase profits to $50. Handout 14-3 Date_________ Name____________________________ Class________ Professor________________ Tit for Tat Prices (possible outcomes of each round) Total sales in the market Price Firm’s sales (quantity) Total cost Total revenue (P Q) ($110 fixed and $2 variable) Profit HHH 60, 60, 60 180 H = $8 HHL 20, 20, 160 200 H = $8 L = $6 HLL 10, 100, 100 210 H = $8 L = $6 LLL 72, 72, 72 216 L = $6 During the game, track your pricing and profits with the form below: Profit or loss statement form (extend this form to show 15 rounds): Round Industry situation (HHH, HHL, HLL, LLL) Your firm’s price (H or L) Profit Loss 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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