CH-13-15 Monopoly – Modern Principles: Microeconomics : Chapter Notes

This Document Contains Chapters 13 to 15 Chapter 13 Monopoly Learning Objectives After completing this chapter, students should: > understand how a monopolist’s marginal revenue curve is derived from either the demand curve or a table of prices and quantities demanded by the monopolist. > be able to determine the monopolist’s profit-maximizing quantity and price along with the deadweight loss, given the monopolist’s demand and marginal cost curves. > be able to determine the monopolist’s profit, also given an average cost curve. > understand why the markup of price over marginal cost increases as the demand curve becomes more inelastic. > understand that having a market served by a monopoly is not always bad, but it entails trade-offs, such as the ones between deadweight loss and innovation, between deadweight loss and economies of scale, and in some cases between price and quality. > understand the various sources of market power (or barriers to entry): patents, laws preventing entry, economies of scale, network effects, innovation, and control over a key input. Chapter Outline Market Power How a Firm Uses Market Power to Maximize Profit The Elasticity of Demand and the Monopoly Markup The Costs of Monopoly: Deadweight Loss The Costs of Monopoly: Corruption and Inefficiency The Benefits of Monopoly: Incentives for Research and Development Patent Buyouts—A Potential Solution? Sources of Market Power Regulating Monopoly I Want My MTV Electric Shock California’s Perfect Storm Antitrust Law and Merger Policy Takeaway Chapter Narrative Markets for electricity, cable TV, and a few other products are considered throughout the chapter. The market for Combivir, also casually referred to as the AIDS cocktail, receives recurring attention. Combivir helped reduce deaths from AIDS in the United States by 50 percent between 1995 and 1997. It sells for approximately $12.50 per pill (about $10,000 per year’s prescription) but costs only about 50 cents to manufacture. This chapter considers three main reasons why competition has not pushed price down to marginal cost: > Monopoly power > The “you can’t take it with you” effect > The “other people’s money” effect Market Power GlaxoSmithKline owns the patent on Combivir. The patent prevents potential competitors from entering the market for Combivir and allows GlaxoSmithKline to be the exclusive supplier of this drug. This monopoly status gives GlaxoSmithKline the power to raise price above marginal cost without fear that other firms will enter the market and drive prices down. The ability to raise prices above marginal costs without fear of competition is known as market power. India does not recognize GlaxoSmithKline’s patent. Competition in India pushes the price of equivalent drugs down to just 50 cents. The first few minutes of the MRU video Maximizing Profit under Monopoly provide a nice introduction to the discussion of monopoly power and a brief discussion of the different barriers to entry that allow firms to maintain its monopoly power. How a Firm Uses Market Power to Maximize Profit Teaching Tip: This is the most important section of the chapter. It is important to emphasize the similarities between profit maximization by competitive firms, which students have already learned, and profit maximization by monopolists. The key difference between the two results from the fact that price and marginal revenue are not the same for a monopolist, which makes the graphs look different. Otherwise, the same principles of profit maximization are at work. Monopolies maximize profits just like competitive firms—by setting marginal revenue (MR) equal to marginal cost (MC)—but there is one important difference. For a competitive firm, marginal revenue equals price because the competitive firm is small enough that it cannot affect the prevailing market price no matter how much it produces. Monopolies, however, must lower their price to sell more output. For monopolies, then, marginal revenue is less than market price. Teaching Tip: Figure 13.1 in the text shows how to calculate MR and construct the MR curve for a monopolist. It is useful to work through this type of calculation the first time to demonstrate to students how MR is obtained and how the MR curve compares to the demand curve. Figure 13.2 in the text provides a shortcut for drawing MR curves. It illustrates that straight-line demand curves provide a straight-line MR curve that starts at the same point on the vertical axis as the demand curve, but with twice the slope (so it will intersect the horizontal axis halfway between the origin and the intersection with the demand curve). The calculus illustrating this is in endnote 6. If you have a more mathematically inclined class, it might be quicker to teach by using the calculus, but most students will probably be best served by learning the shortcut. Figure 13.3 in the text adds a marginal cost and average cost curve to the graph. At this point, students have everything they need to solve the monopolist’s profit-maximization problem. Apply the familiar MR = MC rule for profit maximization as follows: > The profit-maximizing quantity is determined by finding the point where the MR and MC curves intersect and tracing down to the horizontal axis. > The profit-maximizing price is determined by finding the point where the MR and MC curves intersect and tracing up to the demand curve and then over to the vertical axis. > The profit-maximizing profit is determined by finding the vertical distance between price and average cost at the profit-maximizing quantity and shading the rectangular area over to the vertical axis. It is important to give the students several examples of finding the profit-maximizing quantity, price, and profit. You can change the graph by drawing a higher average cost curve so that the monopolist earns a loss rather than a profit. This is an opportunity to emphasize that monopolists are not guaranteed profits. If demand is too low or costs are too high, the monopolist will incur a loss. Emphasize that monopolists cannot charge any price they wish. The price they charge is ultimately determined by the demand curve. The MRU video Maximizing Profit under Monopoly provide a detailed discussion (starting at 3:30 in the video) of how a monopolist chooses quantity and price to maximize profits, with illustrations using Figures 13.1, 13.2, and 13.3 in the text. The Elasticity of Demand and the Monopoly Markup This section explains factors that make demand less elastic and lead to a higher monopoly price. The authors explain that the “can’t take it with you” effect causes people with life-threatening diseases to be very price-inelastic for lifesaving (or life-prolonging) pharmaceuticals. The authors explain that the “other people’s money” effect makes people more price-inelastic when they have third-party payers such as health insurance. Both of these factors are then related to the demand for Combivir. Figure 13.4 graphically illustrates the monopoly markup on a relatively inelastic demand and a relatively elastic demand. Figure 13.4 The More Inelastic the Demand Curve,
the More the Monopolist Raises Price Above Marginal Cost Many students will be able to relate to the airline example used in this section. The authors explain that the availability of substitutes affects the price elasticity of demand and use an example from recent airline rates. American Airlines charges more for a flight from Washington, D.C., to Dallas than it does for a longer flight from Washington to San Francisco via Dallas. Yet the Washington-to-Dallas segment is the same flight. Why? Dallas is an American Airlines hub, and 84% of flights into Dallas are on American. There are not many substitutes for passengers wanting to fly from Washington to Dallas, but there are many substitute routes through different airline hubs to fly to San Francisco. Teaching Tip: Another fun example that students can relate to is the market for diamonds. Start by explaining that most of the world’s diamonds come from a single supplier (DeBeers), resulting in the very high price for the gemstones. You can add that diamonds are also the most plentiful gemstone in the world because it is simply compressed carbon. Now discuss with the students other things that diamond sellers do to increase their market. Specifically, ask what diamond sellers do to make the demand curve for their gemstones more inelastic. The primary answer is, of course, advertising campaigns which lead to the expectations regarding the type and cost of gem used in an engagement ring and the connection of love and diamonds. The MRU video The Monopoly Markup illustrates how the elasticity of demand determines the size of a monopolist’s markup using Figure 13.4 in the text. The Costs of Monopoly: Deadweight Loss This section covers the standard deadweight loss from a monopolist restricting output. In the chapter, consumer surplus is explained, and then Figure 13.5 is used to illustrate how a change from a competitive market to monopoly converts some of the consumer surplus to producer surplus and some of it into a deadweight loss. Teaching Tip: To help explain this point, recall for the students that a demand curve for the firm’s output in a perfectly competitive market is perfectly elastic because there are many firms providing identical output (availability of substitutes impacts elasticity). Furthermore, in the long run we know there is zero economic profit, so this horizontal demand curve intersects the average cost and marginal cost curves at the same point. In a typical monopoly graph, the minimum of the average cost curve is also the point where the market demand curve crosses the average cost curve. You can now show students the evolution of a perfectly competitive market. Starting from a monopoly position (brand-new product), the existence of economic profits attracts new firms producing the same good, causing the original firm’s demand curve to become more elastic. This continues until one reaches the point of zero economic profit (minimum of the average cost curve) and a horizontal firm demand curve. Highlight that this point (where demand crosses the minimum of the average total cost curve) is where the perfectly competitive market would be. Barriers to entry, however, keep this entry from occurring, meaning the original firm’s demand curve never becomes more elastic (no substitutes are produced), keeping the market from ever reaching the perfectly competitive point. Therefore, we have the deadweight loss created by the monopoly being a result of the loss of gains from trade that never happen because the new firms never enter. This also helps to highlight why monopolies are “bad.” Potential Pitfall: Many students think that monopoly is bad because it raises prices for consumers. It is worth stressing that producer surplus counts just as much as consumer surplus for economic efficiency. The economic argument about the undesirability of monopoly is not that producers rather than consumers get some of the surplus; monopoly is bad because some of the gains from trade are not realized (specifically when consumers value the product more than it costs the producer to make it, measured by height of the demand curve), and neither the producer nor the consumer gets the surplus. The Costs of Monopoly: Corruption and Inefficiency This section argues that many government-granted monopolies are granted not for the beneficial purpose of spurring innovation but instead as a result of corruption. Businesses that desire monopoly profits can lobby government officials to give them grants of monopoly privilege. One of the main lessons of economics is that good institutions channel self-interest toward benefits for society, but poor institutions channel self-interest toward social destruction and economic stagnation. Businesspeople will seek profits both through the market and through favors bestowed by the government. Unfortunately, when government is not prevented from bestowing favors, this self-interested activity leads to inefficient monopoly. Going Beyond the Text: For instructors with an interest in public choice, this section gives you the perfect opportunity to demonstrate how the deadweight losses from monopoly are even greater when government bestows grants of monopoly privilege than when monopolies arise naturally on the market. Politically granted monopolies generate deadweight losses in addition to the lost gains from trade that traditional monopolies generate. Businesses compete with each other to gain favor from politicians, but the resources they expend to secure grants of monopoly privilege do not benefit society. The resources spent to gain the monopoly are also deadweight losses. Much of the profit rectangle that is usually assumed to be a transfer from consumer surplus to producer surplus could end up being a deadweight loss. The classic reference is Tullock, “The Welfare Costs of Tariffs, Monopolies, and Theft,” Western Economic Journal [now known as Economic Inquiry] 5 (1967), pp. 224–232. Teaching Tip: You can also use a popular movie franchise to highlight this idea of government granted monopolies. Ask the students how many have seen the any of the Pirates of the Caribbean movies. Ask the students why the main character (and others like him) are “pirates.” The answer, of course, is that the East India Trading Company had a government-granted monopoly to transport goods from the Caribbean to Europe and that these “pirates” were simply ship captains who were bypassing the monopoly. This is also why the British Navy was so set on stopping these pirates, because otherwise the value of the monopoly to the East India Trading Company would be smaller, meaning the British crown could demand less for the granting of the monopoly. The first half of the MRU video The Costs and Benefits of Monopoly summarizes the costs of monopoly, including both deadweight loss and corruption and inefficiency. The Benefits of Monopoly: Incentives for Research and Development This section of the chapter is about what might not be wrong with monopoly. It focuses on how monopoly profits can encourage firms to undertake investments in research that would not be recouped if competitors could easily enter the market and drive down price after the initial innovation was made. The average new drug in the United States costs nearly $1 billion to research, develop, and test. It is precisely the expectation of monopoly profits that encourages firms to make the investment to develop new drugs. If they could not earn monopoly profits, they might choose not to develop many of the drugs at all, and consumers could be much worse off than if they just had the standard deadweight loss from monopoly. Teaching Tip: There is a discussion of video games, DVDs, and CDs in this section. Copyright law is often a hot topic that students have strong feelings about. An in-class discussion about innovation and monopoly profits in this area often gets students interested. Patent Buyouts—A Potential Solution? This very brief section discusses Michael Kremer’s idea to have the government offer to buy patents from monopolists in order to tear up the patents and allow open competition. The virtue of the idea is that it preserves the incentive to innovate while avoiding the deadweight losses associated with monopoly. Critics suggest that it may not work in practice because of potential problems with corruption. The second half of the MRU video The Costs and Benefits of Monopoly summarizes the benefits of monopoly, including the patent buyout solution. Sources of Monopoly Power This section discusses the various sources of monopoly power other than laws and patents. These include economies of scale, brands and trademarks, network effects, and innovation. These are different types of barriers to entry. It is important to emphasize to students that some barrier to entry must exist for a monopoly to maintain its monopoly status in a market. Table 13.1 in the text provides a summary list of the different barriers to entry along with some examples. The text devotes a considerable amount of attention to the case of a natural monopoly. A natural monopoly exists when economies of scale enable a single (large) firm to serve a market at a lower average cost than multiple (smaller) firms. A natural monopoly restricts output to raise price, but competitive firms would also produce less than optimal output because they could not take advantage of economies of scale. Figure 13.6 in the text illustrates that if the economies of scale are large enough, a monopolist produces more output than a competitive market. The key point to emphasize to students is that small firms have different average cost curves from that of a monopoly. The textbook example of the subway offers a very good description for students to understand a natural monopoly. Ask the students if it makes financial sense to have parallel subway lines or to even have the subway split up into different firms where passengers must disembark from one company’s train to board the other company’s train to continue on their way. Another source of monopoly power comes from network effects. The textbook discusses network goods in more detail in Chapter 15; however, the text uses the example of the TI-84 calculator that many students in high school are still required to purchase. Part of the reason is that this is the calculator their teachers were taught to use and, therefore, is the calculator the teachers use to teach them. It is not that it is necessary superior or more cost effective, but it is simply what everyone else uses. Another example would be the QWERTY keyboard. Innovation is another example of market power. This too is discussed in some detail in Chapter 15 but can be mentioned here as a source of market power. In this case a firm gains market power simply by being the first one to come up with an idea. Examples other than that used in the text of the iPhone include mp3 players. Generally this market is dominated by the iPod, not because the iPod is superior but because it was the first into the market, and thus it become what people related to when thinking about an mp3 player. Figure 13.6 A Monopoly with Large Economies of Scale
Can Have a Lower Price than Competitive Firms Regulating Monopoly The textbook suggests the obvious and simple solution to natural monopoly. If the government sets a price control where the marginal cost curve intersects the demand curve, then the new marginal revenue curve for the firm is a straight line intersecting that same point (as shown in Figure 13.7 in the text). The natural monopoly would produce the efficient quantity. As in Figure 13.7, however, a monopoly would incur losses at this price and would choose to exit the industry. The next obvious alternative is to regulate to the point where price equals average cost. As the next section makes clear, though, this solution is not as easy to obtain in the real world as it is in the textbook. Figure 13.7 A Price Control on a Monopoly Can Increase Output I Want My MTV When prices are regulated, the incentive for innovation and quality improvements is limited. Congress regulated cable rates through the 1970s, and even though technology permitted more channels to be offered, cable providers had no incentive to provide them because they could not increase prices. Congress lifted caps on pay TV rates in 1979 and on all cable TV in 1984. The results were as theory would predict: prices rose, but so did quality. The number of stations and the quality of their programming increased dramatically. The fact that more people signed up for cable despite the higher prices is strong evidence that consumers benefited even though prices rose. Electric Shock About two-thirds of electric utilities in the United States are government-owned, and the remainder are heavily regulated. Over time, the firms became less efficient and construction of new plants had major cost overruns. Generation, long-distance transmission, and local distribution of electricity have historically been bundled together. Since the 1970s, however, new technologies have reduced the costs of generating electricity on smaller scales, so generation is no longer a natural monopoly. Deregulation of electricity has been structured to attempt to unbundle generation from transmission and distribution, hence to instill more competition in the electricity generation market while leaving transmission and distribution regulated. The following section explains California’s unsuccessful attempt at partial deregulation. California’s Perfect Storm California deregulated wholesale electricity prices in 1998. A number of factors caused both demand and supply to shift in California to cause the perfect storm. Deregulation increased demand caused by > rising incomes (up 9.5% in 2000). > a hot summer. Supply response was limited by > lack of capacity from other states available for import. > low snowfall, which limited the available supply of hydropower. > facilities taken off the grid for maintenance and upgrades. These forces combined to increase the price of electricity from $26 per megawatt hour (MWh) in April of 2000 to $317 per MWh by December of 2000. California’s poorly designed partial deregulation was responsible for making these supply and demand changes trigger such high prices. Wholesale electricity companies had market power because price controls made consumer demand inelastic. Generators were already operating near capacity, so when firms took some of their generators off the grid for repairs, the decreased supply coupled with the inelastic demand to generate higher profits for the firms. Suspiciously, far more generators were taken off the grid for maintenance and repair during the crisis in 2000 and 2001 than were repaired in 1999. The market power resulted in an even greater supply shift than would have occurred in a competitive market. Potential Pitfall: Many students can easily fall into believing that deregulation is undesirable because of California’s experience. It is important to emphasize that a myriad of interventions in the electricity industry (including retail price controls and restrictions on new plant construction) still prevent normal market forces from functioning. California’s experience illustrates the difficulties with partial deregulation. You can also use this example to highlight another idea put forth in the book with regard to lack of innovation and poor quality within regulated natural monopolies. In electricity markets, for example, why have companies not moved more quickly to “smart grids” if there are so many advantages to such a grid system? Likewise, why have so many cable and telecommunication companies avoided upgrading their infrastructure to fiber optic cables when those cables would allow significantly faster Internet speeds and increases in content and quality of that content? Point out to the students that most homes in India, for example, have fiber to the home (FTTH) Internet connections, whereas almost all homes in the United States still access the Internet via copper cables (DSL or coaxial cable). (Fiber cables would not only increase Internet access speeds but also allow for increased competition within a given market.) Antitrust Law and Merger Policy Antitrust laws give the federal government legal authority to prosecute monopolies or attempts to monopolize. It is important to clarify that monopolies are not illegal in the U.S., but it is illegal to attempt to monopolize by illegal means. Illegal means could include various acts to reduce competition, such as collusion, predatory pricing, or exclusive dealing. Such acts can be difficult to prove in a court of law, but if proven the law gives the federal government the right to break up monopolies. One particular area in which antitrust law applies is the case of a merger between two competing firms. Courts must decide whether the merger will reduce competition and give the resulting larger firm substantial monopoly power. The decision on whether to allow a merger must also balance the increase in prices resulting from more monopoly power against any potential cost savings that might result from the increased efficiency of the larger firm. The text discusses in some detail the proposed merger of Staples and Office Depot, with arguments against and in favor of the merger. This merger was ultimately blocked as the government successfully argued in court that it would increase market power and increase prices too much to be justified. Another example not covered in the text which had a very different outcome would be the merger of Sirius and XM satellite radio. In this case it was decided that the merger would not limit choices given the large variety of existing in-car entertainment options for consumers. Takeaway Students should now understand how markets with monopolies differ from more competitive markets. They should be able to illustrate graphically how the monopolist sets quantity and price to maximize profits. They should understand and be able to illustrate graphically the deadweight loss that results from monopoly power. They should also know that monopolies can encourage innovation and be efficient when they have economies of scale. Finally, they should know how governments often grant monopoly privilege. In- and Out-of-Class Activities A simple in-class exercise can allow students to experience the deadweight losses from a monopoly. The instructor plays the role of the monopolist and offers to sell an inexpensive consumer product (e.g., a Coke, candy, doughnut hole) to the students. Ask students to fill out a demand schedule in the lecture prior to your monopoly lecture. Be sure to emphasize that their offers are real offers that you can choose to satisfy, and they will have to pay you. Between the two lectures, calculate the class’s demand curve and use your cost of acquiring the product to set a maximum monopoly profit for yourself. In your next lecture, bring in the appropriate amount of the product and make the transactions with the students. Use these data to illustrate their demand curve, what the quantity traded under the competitive outcome would have been, and the deadweight loss that occurred because of your monopoly power. The deadweight loss can be emphasized by calling out the students’ names with offers between your profit-maximizing price and the competitive price and pointing out that they did not receive the goods they wanted to buy even though your cost was less than their willingness to pay. This is adapted from John Brock, “Experimental Derivation of a Demand Curve,” Classroom Expernomics 1, no. 2 (fall 1992). For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction:
For Problems in the Section: Watch the MRU video:
Monopoly Power Maximizing Profit under Monopoly (first part of video)
How a Firm Uses Market Power to Maximize Profits Maximizing Profit under Monopoly (starting at 3:30)
The Costs of Monopoly: Deadweight Loss and Corruption and Inefficiency The Costs and Benefits of Monopoly (first half)
The Benefits of Monopoly: Incentive for Research and Development The Costs and Benefits of Monoply (second half)
Chapter 14 Price Discrimination and Pricing Strategy Learning Objectives After completing this chapter, students should: > understand that price discrimination maximizes profit for firms when they face different demand curves for their product. > know that firms should set higher prices in less elastic markets to maximize profits. > understand that arbitrage makes price discrimination difficult. > understand what perfect price discrimination is and how it increases efficiency. > know that tying and bundling are forms of price discrimination and can also increase efficiency. Chapter Outline Price Discrimination Preventing Arbitrage Price Discrimination Is Common Universities and Perfect Price Discrimination Is Price Discrimination Bad? Why Misery Loves Company and How Price Discrimination Helps to Cover Fixed Costs Tying and Bundling Tying Bundling Bundling and Cable TV Takeaway Chapter Narrative The chapter begins with a narrative about a drug-smuggling syndicate operating out of Belgium. It smuggles Combivir, the HIV treatment discussed in the previous chapter, from Kenya, Uganda, and Tanzania into Europe. GlaxoSmithKline, the manufacturer of Combivir, was selling the drug for $12.50 per pill in Europe but for only about 50 cents in Africa. The story of Combivir is used throughout much of the chapter to illustrate how price discrimination can maximize profit, lead to increased efficiency, and force companies to try to limit arbitrage opportunities. Universities, computer software, cable television, and computer printers are other markets discussed in the chapter. Price Discrimination By building on what students learned about monopoly in the last chapter, you can easily demonstrate how price discrimination can lead to increased profits. Students already know that GlaxoSmithKline has a monopoly on Combivir. Start by asking them if they think Africa and Europe have the same demand curves for Combivir. Ask which will be more price-sensitive. This might be a good time to remind them that the larger the total portion of a person’s income a good consumes, the more price-sensitive the person is going to be. After they tell you that Africa probably has a more elastic demand for Combivir, draw a graph like Figure 14.1 in the text. It is easy to illustrate that the profit-maximizing price is much higher in Europe than in Africa. You can then show that a world price that would sell some drugs in both markets would lead to a lower-than-profit-maximizing price in Europe and a higher-than-profit-maximizing price in Africa. This leads to what the text refers to as the first principle of price discrimination: 1a. If the demand curves are different, it is more profitable to set different prices in different markets than a single price that covers all markets. 1b. To maximize profit, the monopolist should set a higher price in markets with more inelastic demand. As mentioned at the start of the chapter, however, selling Combivir at different prices in different markets encourages other people to smuggle the pills out of the low-priced market and resell them in the high-priced market. Buying low and selling high is arbitrage, and smuggling is just a special instance of arbitrage. When smuggled pills are resold in the high-priced market, it cuts into GlaxoSmithKline’s profits. This leads to what the text calls the second principle of price discrimination: 2. Arbitrage makes it difficult for a firm to set different prices in different markets, thereby reducing the profit from price discrimination. Preventing Arbitrage To protect their profits, firms that discriminate on price try to prevent arbitrage. GlaxoSmithKline sells white pills in Europe and red pills in Africa. When its detectives find red pills in Europe, they use the bar codes on the package to find out which distributor’s pills made it back into Europe and then attempt to have the appropriate people arrested. Figure 14.1 Price discrimination can increase profits DVDs cost less in India than in the United States. To prevent arbitrage, producers put region codes on the DVDs that prevent Indian DVDs from being played in U.S. DVD players. It is not only geographical differences that lead to price discrimination. Rohm and Haas produces a plastic, methyl methacrylate, that is used for industrial purposes and to make dentures. There are few substitutes for their plastic in dentures but many substitutes for the other industrial uses. Because the demand curve is less elastic in the market for dentures, methyl methacrylate costs about $22 per pound for dental uses but only about 85 cents per pound for industrial uses. Entrepreneurs began buying the cheap industrial plastic and reselling it for dental use. To prevent this arbitrage, Rohm and Haas considered lacing all of its industrial plastic with the poison arsenic. Arsenic would not reduce the value of the plastic in industrial uses, but it would eliminate people’s ability to resell the industrial plastic for dental work. Ultimately, Rohm and Haas’s legal department rejected the idea, but the rumor that the industrial plastic was laced with arsenic was enough to limit arbitrage. The U.S. government does use poison to limit arbitrage. The government subsidizes ethanol production but taxes alcohol. To prevent people from turning ethanol into alcohol, the government requires ethanol to be poisoned. Some goods are easier to arbitrage than others, and in general, services are difficult to arbitrage. The first part of the MRU video Introduction to Price Discrimination introduces price discrimination and illustrates using Figure 14.1 in the text. Arbitrage and attempts to prevent arbitrage are also discussed. Price Discrimination Is Common Teaching Tip: Because the word discrimination has negative connotations, it is particularly important to emphasize that price discrimination simply means selling at different prices to different buyers and that the practice is quite common. The text mentions a few examples of price discrimination: > Movie theaters often charge seniors less than younger people. > STATA (an econometric software package) sells to students for $145 but to businesses for $1,295. > Publishers sell hardcover copies of new books for significantly more than the softcover books released a year later (enough more that it cannot be explained by production cost differences) because they know that the hardcore fans will have relatively inelastic demand, while those with more elastic demand will be willing to wait a year. > IBM sells two versions of the same printer for different prices. The only difference between the two versions is that one has an extra chip in it to slow it down from 10 ppm to 5 ppm. Airlines are a particularly interesting example. They try to sell seats on the same flight for higher prices to business travelers than to people going on vacation. Because they do not know who is a business traveler and who is not, airlines guess by observing when the ticket is purchased. Much business travel is last-minute, whereas most vacation travel is purchased far ahead of time. So airlines give discounts to those who purchase early but charge much higher prices for last-minute purchases. In-Class Exercise: People do not like it when they know they paid more than someone else for the same good or service. So businesses have to control consumer resentment when they price-discriminate, or they risk losing future business. Ask students how businesses control resentment. Things like student and senior discounts generally seem fair to most people. Most people also seem to think that hardcover books are more valuable than softcover, even though production of a hardback costs only a dollar or two more. The last part (starting at 6:00) of the MRU video Introduction to Price Discrimination discusses some common examples of price discrimination. Universities and Perfect Price Discrimination If a firm knew exactly where each consumer was on the demand curve for the firm’s good, it would charge each person the maximum he or she was willing to pay. In the process, the firm would capture all of the gains from trade so that there would be no consumer surplus remaining. You can use a graph like Figure 14.4 in the text to illustrate that what would normally be consumer surplus (in a single-price scenario) becomes producer surplus with perfect price discrimination. A perfectly price-discriminating (PPD) monopolist follows the same profit-maximizing rule as a regular monopolist: produce until marginal revenue equals marginal cost. The important difference between them is that a single-price monopolist must lower the price to all buyers to sell additional units. Because a PPD monopolist charges each buyer at his or her maximum willingness to pay, marginal revenue is always equal to the height of the demand curve for each unit (in other words, the marginal revenue is the same as the market demand curve). This leads a PPD monopolist to produce right up to the point where price equals marginal cost. Total gains from trade are maximized, and the same output is traded as in a perfectly competitive market. PPD monopolists maximize efficiency, taking all of the gains from trade for themselves in the process. In practice, consumers’ maximum willingness to pay is not tattooed on their forehead, so firms have difficulty achieving perfect price discrimination. The more they can learn about a consumer, however, the more accurate is their price discrimination. Figure 14.4 A Perfect Price Discriminator Marches Down the Demand Curve
Charging Each Customer Their Maximum Willingness to Pay Ask your students, “How many of you get some sort of financial aid?” Ask why they think the university gives aid to them. You’ll likely hear “need” and “merit.” Surely some aid is given for reasons other than price discrimination, but much of what students think of as aid is just a form of price discrimination. Universities gain lots of information about students’ ability to pay by requiring financial aid forms to disclose information about income, assets, and debt. Universities then use this information to charge different students different prices according to their ability to pay. The text uses the example of Williams College, where the official tuition was $32,470, but some students paid as little as $1,683. Table 14.1 in the text illustrates the average range charged to families in different income groups at Williams College. The price discrimination is even more detailed than the table reveals because individual students within these different groups are charged different prices. Table 14.1 Price Discrimination at Williams College, 2001–2002
Income Family Net Price After
Quintile Income Range Financial Aid
Low $0–$23,593 $1,683
Lower Middle $23,594–$40,931 $5,186
Middle $40,932–$61,397 $7,199
Upper Middle $61,398–$91,043 $13,764
High $91,044– $22,013
Note: Students who did not apply for financial aid paid $32,470. Source: Catherine B. Hill and Gordon C. Winston, Access: Net Prices, Affordability, and Equity at a Highly Selective College. Williams College, 2001. DP-62.
It makes sense for colleges to charge lower prices to buyers with a lower ability to pay, as long as the university can cover the increase in the marginal cost from the extra student attending. At a university, the marginal costs of an extra student are often low. If Econ 101 is going to be taught anyway, what is the extra cost of having one more student in the room? When people are buying high-priced goods like a college education, ability to pay is often an important factor in determining where they are on a demand curve. Cars are another good example. Teaching Tip: The textbook mentions that used car salesmen are often very friendly because they are trying to find out information about where you are on the demand curve for their product. Like universities, they also try to find out your ability to pay. Often, a car salesman will suggest filling out the paperwork so that the finance department can work on getting you a loan approval while you go out for a test drive. The salesman can then use the information you provided on your loan application to better price-discriminate. It can be fun to discuss this topic with students and suggest ways to avoid helping the salesman price-discriminate. The MRU video The Social Welfare of Price Discrimination illustrates the welfare effects of price discrimination and discusses the example of universities discussed in the text. Is Price Discrimination Bad? Students are naturally inclined to think that price discrimination is bad. This may be because of negative connotations of the word discrimination, but it may also stem from a natural tendency to sympathize with consumers more than producers. It is important to point out that economics is neutral with regard to how the gains from trade are split between producers and consumers and is instead concerned with maximizing the total gains from trade. This leads us to examine the total quantity traded. The textbook claims that price discrimination is bad when total output decreases but that if output increases, total surplus will increase and price discrimination is good. The textbook examines the case of Combivir. If there was a single world price (as in Figure 14.1) instead of region-by-region price discrimination, Europeans would benefit from the lower price and would consume more Combivir, but Africans would face higher prices and consume less. Whether price discrimination was on net beneficial would depend on whether the gains to Europeans more than offset the losses to Africans. If it was not allowed to price-discriminate, it is unlikely that GlaxoSmithKline would lower its price by much. Two-thirds of the 630 million people in Africa live on less than a dollar a day. Even when GlaxoSmithKline sells Combivir near cost at 50 cents, most Africans cannot afford it, so GlaxoSmithKline cannot make up for its low price by selling a higher volume. If forced to sell at a single price, it would likely abandon the African market altogether and just sell at the higher European price. Why Misery Loves Company and How Price Discrimination Helps
to Cover Fixed Costs The textbook asks students to consider whether they would rather have a rare or common disease (assuming they were equally harmful). It is much better to have a common disease because the fixed costs of developing a new drug are high. The more common the disease, the larger the market a firm can spread its fixed costs over. There is more incentive to develop drugs for common diseases because there are more potential customers. In fact, patients diagnosed with a rare disease are 45 percent more likely to die before age 55 than patients diagnosed with a more common disease. The relevance of this story is that price discrimination allows firms to sell more total units. So in industries with high fixed costs, even people charged a high price might benefit from price discrimination. In the case of pharmaceuticals, when price discrimination is allowed, Europeans benefit from the existence of an African market because it increases the profit from producing new drugs, giving companies a stronger incentive to research and develop new drugs that will benefit Europeans. When airlines price-discriminate by charging lower prices to people going on vacation, they increase total industry revenues. This encourages them to operate more flights to more places at more times. Business travelers also benefit from more frequent service because airlines are able to increase total revenue. Tying and Bundling Tying Hewlett-Packard inkjet printers cost as little as $69, but ink for the printer costs $44. Similarly, Xbox consoles are relatively cheap, while their games are expensive. Tying is a form of price discrimination in which a base good is tied to a second good, called the variable good, that is sold only by the same firm. In the case of HP, the printer is the base good and the ink the variable good. HP is selling the capacity to print color photos. To acquire this good, consumers must buy both the printer and the ink. HP works on the assumption that, compared to people who are only going to print a few photos, people who will print lots of photos have a higher willingness to pay. By pricing printers low and ink high, HP is able to price-discriminate and charge more to those who print lots of photos than to those who print only a few. This particular form of price discrimination is effective because it charges consumers a different price depending on how many photos they print. The high price of ink encourages other manufacturers to make ink cartridges. To control this, HP includes a crucial patented component of the printer head on each ink cartridge. As a result, there are no alternative ink cartridges for HP printers, but there is a market in refilling old HP ink cartridges. HP’s process of tying encourages innovation by allowing it to spread the fixed costs of research and development over more users. Teaching Tip: Another example that students can relate to is the cell phone industry, and this example highlights how changes in the industry can cause product tying to break down. Cell phone carriers tend to tie together the high-cost phone hardware with the relatively low-cost air time. If a consumer is willing to sign a multiyear contract with the provider, the provider usually sells the phone at a steep discount. As the ability to take your phone with you when you change providers and the practice of providers offering cash bonuses when one switches from a competitor (generally to offset early termination penalties) has increased, cell providers are moving away from discounted sales of phones and either leasing the phone to the consumer (thus keeping them from taking it with them) or selling the phone at retail price. The MRU video Tying discusses how tying one good to another is a subtle form of price discrimination and provides some examples. Bundling Bundling is requiring that products be purchased together. Bundling is another form of price discrimination. The textbook examines why Microsoft bundles Word and Excel with other programs and sells the package as Microsoft Office. The textbook considers two consumers with a maximum willingness to pay as laid out in Table 14.3 in the text. Table 14.3 Maximum Willingness to Pay for Office
Amanda Yvonne
Word $100 $40
Excel $20 $90
Office = Word + Excel $120 $130
Assuming the marginal costs are zero (approximately true for software), the profit-maximizing price is $100 for Word and $90 for Excel, with one of each being sold if the firm sells each product separately. However, if they bundle them, they can sell two units of Office for $120 each and make a total profit of $240, $50 more than when the products are sold separately. Bundling, like tying, can increase total gains from trade when fixed costs are high relative to marginal costs. In this example, total surplus is $250 when the goods are bundled but only $190 when Word and Excel are sold separately. Also, like tying, bundling increases the incentive of firms to innovate because fixed costs can be spread across more units. Bundling and Cable TV Cable TV operators sell their television channels in a bundle rather than letting consumers choose and pay for each channel individually. Ask your students how many of them subscribe to cable or satellite TV (or whether their parents did when they lived at home). Then ask 5 to 10 students what their favorite channel is. Even though they are in the same demographic group, you are likely to get significant variation. You can then ask some of them whether they would be willing to purchase some of the other students’ favorite channels if they had to buy them individually. (Try asking someone who chose ESPN if they want Lifetime or Oxygen.) You will probably be able to illustrate that while they all valued the bundle of cable channels enough to purchase it, there is significant variation in their opinion of what is a high-value and a low-value station within that bundle. You might also ask how many of the channels in the bundle they watch on a regular basis. Since the demand for the bundle of cable stations is more similar across customers than the demand for individual channels, and since there is very low marginal cost to offering additional channels to each customer, it makes sense for cable companies to sell all channels to all consumers. Like developing computer software, cable TV has high fixed costs but low marginal costs. Teaching Tip: You can also use cable TV as a means of explaining other types of price discrimination. Specifically, point to the different bundles that cable companies tend to offer and in what bundles different channels show up. For example, most networks featuring children’s programing can only be found in the more expensive bundles, whereas channels that feature older programs or news and weather-related content tend to be focused in the lower-priced bundles. Ask the students what might be different about the people likely to watch these types of channels and what their relative elasticities might be for that content. The MRU video Bundling discusses how selling two or more goods together as a bundle is a subtle form of price discrimination and provides some examples. Takeaway Students should now understand that price discrimination is common in many markets. Firms maximize profit by selling at higher prices in less elastic markets and at lower prices in more elastic markets. However, firms must prevent consumers who are charged a low price from reselling to those charged a high price. Students should also know that price discrimination requires firms to know a lot about their consumers’ demand. If they know where everyone is on the demand curve for their product, a firm can price-discriminate perfectly and capture all of the gains from trade as producer surplus. A PPD monopolist produces the same quantity as would be produced in a competitive industry. Students should understand that tying and bundling are particular forms of price discrimination that are common in industries with high fixed costs but low marginal costs. Tying or bundling products can lead to increased incentives for innovation and development. Students should understand that firms want to price-discriminate because it increases their profits but that price discrimination can also increase total surplus to society by increasing output. In- and Out-of-Class Activities Ask students to find their own examples of price discrimination along with an analysis of how the firm limits arbitrage, prevents customer resentment, and determines customers’ willingness to pay. In the case of bundling or tying, have students consider whether their example fits the general pattern of high fixed cost but low marginal cost of production. For students having trouble in the following sections of this chapter, MRU videos are available for additional outside-of-class instruction:
For Problems in the Section: Watch the MRU video:
Price Discrimination Introduction to Price Discrimination
Price Discrimination Is Common The Social Welfare of Price Discrimination
Tying and Bundling Tying
Tying and Bundling Bundling
Chapter 15 Oligopoly and Game Theory Learning Objectives After completing this chapter, students should: > know that cartels attempt to limit production to the quantity a monopoly would produce and share in the profits. > know that in a free market, cartels are unstable. They often break down because of cheating, market entry, and government prosecution. > understand that cartels are most likely to form when few firms have exclusive access to an input or when a government enforces the cartel. > understand the prisoner’s dilemma and how to solve for its equilibrium. > explain how firms in an oligopoly restrict output and raise price to increase profits. Chapter Outline Cartels The Incentive to Cheat No One Wins the Cheating Game The Prisoner’s Dilemma The Prisoner’s Dilemma and Repeated Interaction The Prisoner’s Dilemma Has Many Applications Oligopolies When Are Cartels and Oligopolies Most Successful? Control over a Key Resource or Input Economies of Scale Network Effects Government Barriers Government Policy Toward Cartels and Oligopolies Government-Supported Cartels Business Strategy and Changing the Game The Danger of Price Matching Guarantees The High Price of Loyalty Other Ways of Changing the Game Takeaway Appendix: Nash Equilibrium Chapter Narrative Much of this chapter examines the economics of cartels by analyzing OPEC, the oil cartel. Other cartels, including professional sports leagues and the government-supported milk cartel, are also discussed. Game theory—the study of strategic decision making—is introduced to explain cartel behavior. Cartels A cartel is a group of producers that tries to act as if they were a monopolist. A cartel attempts to restrict the equilibrium quantity and share the monopoly profits among all of the members in the cartel. Few cartels behave exactly like a monopoly, but some approach the monopoly quantity at least temporarily. Few cartels are able to control prices for long unless they have government support. Cartel members essentially promise each other that each will raise the price and reduce production. However, cartels tend to collapse for three reasons: Cheating by cartel members New entrants and demand response Government prosecution and regulation In the 1970s, OPEC was successful in cutting back oil production and raising prices. However, by 1985 oil had fallen from its previous high of $75 per barrel to around $20 per barrel. (The historical movement of oil prices is shown in Figure 15.1 in the text.) A closer look at cheating among cartel members helps to explain this outcome. The Incentive to Cheat When other cartel members keep their agreement, it is profitable for a single firm to cheat. It is profitable to cheat when other firms are cheating, too. A monopolist that expands production hurts itself. A cartel member that expands production increases its own profits and hurts the profits of other cartel members. The key is that a single cartel member does not have much monopoly power, so increasing its own production does not lower the price enough to offset the gain in revenue from its increased sales. The more successful the cartel is in raising prices, the greater the incentive for firms to cheat. Once cheating breaks a cartel down, firms are hard pressed to put it back together again because each firm correctly expects the others to cheat. No One Wins the Cheating Game The text illustrates a cartel member’s incentive to cheat in Figure 15.4 by showing payoffs in a cheating dilemma. Figure 15.4 The Cheating Dilemma Regardless of what Russia does, Saudi Arabia always receives more money by cheating. The same is true for Russia, regardless of what Saudi Arabia does. As a result, both countries will cheat and earn $300. A strategy that always provides a higher payoff regardless of what the other player does is called a dominant strategy. Because cheating has a higher payoff than cooperating, the dominant strategy in the cheating dilemma is always to cheat. Teaching Tip: This is the first example of game theory for your students. It will be helpful to carefully work through the individual strategies for each country in Figure 15.4. Demonstrate that each country will choose to cheat regardless of what the other country chooses to do. Have students look at Saudi Arabia’s choice, focusing on one column at a time to show that Saudi Arabia is better off cheating no matter what Russia does. Likewise, Russia’s choice can be analyzed, focusing on one row at a time. If a country is better off choosing the same strategy regardless of which choice the other country makes, it has a dominant strategy. This approach will give students a method for solving other games they will encounter in this chapter. The Prisoner’s Dilemma The textbook describes the prisoner’s dilemma as a situation in which the pursuit of the individual interest leads to a group outcome that is in the interest of no one. The game in Figure 15.4 is an example of a prisoner’s dilemma because both countries would be better off by cooperating (with each earning $400 instead of $300), yet they both choose to cheat to promote their individual interests. Teaching Tip: The core of the prisoner’s dilemma problem is that individual incentives are not in line with group incentives. To highlight this idea and the difficulty of gaining cooperation (and to highlight most of the “solutions” for the prisoner’s dilemma), you might consider engaging the students in a quick thought experiment with no reference to game theory. For example, ask the students to consider the hypothetical case where you, the instructor, offer the students a deal. Specifically, if everyone in the class were to score below a certain level (such as 25%) on the next exam, then everyone’s grade will be changed to a 100%. If, however, even one student scores above a 25%, everyone gets the grade they earned. At first students might be receptive to the idea; however, eventually they will start to realize that someone in the room will have an incentive to “cheat,” or in this case, do well on the exam. Now ask the students how their responses might change under difference cases such as the following: all students are part of the same fraternity or sorority; all the students always take the same classes together (a cohort case); if the class was bigger or smaller; and other examples you or they might think of to change the likelihood of the offer working. You can then lead into the Bonnie and Clyde example and the actual game theory format of solving this problem. Teaching Tip: While the text discusses the prisoner’s dilemma generally, it does not explain why we call such games a prisoner’s dilemma. It may be worthwhile to describe the classic prisoner’s dilemma to your students. The classic prisoner’s dilemma involves two partners in crime, say Bonnie and Clyde. Authorities suspect them of committing several offenses, but without a confession have little or no evidence to convict either of them. The two are interrogated separately by authorities and asked for a confession. The deal offered to the two in terms of jail time (in years) is shown in the following game table.
Clyde’s Strategy
Not confess Confess
Bonnie’s Strategy Not confess (1, 1) (5, 0)
Confess (0, 5) (3, 3)
In this game, both suspects would be better off if neither confesses and each receives a sentence of 1 year, but the dominant strategy is for both to confess and be sentenced to 3 years each. The objective for each player in this game is to minimize jail time. The text provides another example of a basic prisoner’s dilemma in which Figure 15.4 is altered to refer to the payoffs between two fishing firms. The possible strategies are to produce less fish (cooperate) or to overfish (cheat). Although both firms and society as a whole would be better off if both firms cooperated and limited their catch, the dominant strategy, however, is for both to overfish and risk depleting the stock of fish entirely. The Prisoner’s Dilemma and Repeated Interaction The basic lesson of the prisoner’s dilemma is that cooperation is difficult to maintain when the players in a game meet and play just once. However, if the players in a game meet and play repeatedly, they are more likely to cooperate by finding rules or norms (such as reputation) that limit the incentive to cheat. As an example, the text discusses the asphalt industry, which is notorious for cartel-like behavior. This example is interesting because even after the government prosecuted more than 600 cases of bid rigging, the cartel-like behavior did not disappear. Repeated interaction among the firms in the asphalt industry led to behavior that limited competition between firms even without explicit agreements or communication—tacit collusion. The Prisoner’s Dilemma Has Many Applications The text concludes the discussion of prisoner’s dilemma games by demonstrating its applicability to many types of problems. Four examples are mentioned in Figure 15.5 in the text: the arms race between the superpowers to develop nuclear weapons, tall trees vying for sunlight, the decision to stand for a better view at concerts, and the advertising war between Coke and Pepsi. Oligopolies The same incentive that drives cartel members to cheat by increasing production above their individual quota applies to firms in an oligopoly that fail to form a cartel. This means that firms in an oligopoly are likely to increase production beyond the monopoly level and observe prices below the monopoly price. But how low will price go in an oligopoly? In contrast to a competitive industry, none of whose firms has an incentive to restrict output (because it would not affect price), a firm in an oligopoly can raise the price and move from a zero-profit outcome to a positive-profit outcome. Therefore, prices in an oligopoly are likely to be higher than under perfect competition. The more firms in an oligopoly, the greater the incentive to increase output beyond the monopoly level and the smaller the incentive to restrict output from the competitive level; therefore, the more firms in an oligopoly, the closer the price is to the competitive price. Beyond this general result, it is difficult to be more precise about pricing in an oligopolistic market. While there are many models of oligopoly in economics (Bertrand, Cournot and Nash, Stackelberg), exactly which one is correct depends on the specific industry. The right model for the auto industry may not be the right model for the soft-drink industry. When Are Cartels and Oligopolies Most Successful? As with monopolies, cartels and oligopolies are most successful when there are significant barriers to entry. Barriers to entry are factors that make it difficult, costly, or illegal for new firms to enter an industry. The text discusses four barriers to entry that tend to make cartels or oligopolies successful: > Control over a key resource or input, such as in the oil and diamond industries > Economies of scale, such as in the automobile industry > Network effects, such as social networking and online auction websites > Government barriers (See the next section for more discussion.) Government Policy Toward Cartels and Oligopolies The Sherman Antitrust Act of 1890 made most cartels illegal in the United States, so the government can fine or imprison anyone who attempts to form a cartel in the United States. Teaching Tip: Explain to students that the word trust is an old word for monopoly stemming from early banks trying to collude by forming trusts, so antitrust laws are antimonopoly laws. Also, many countries do not have antitrust laws, so cartels are legal in some other countries. In the early 1990s, four firms controlled 95 percent of the market for lysine, an amino acid that contributes to the growth of pigs, chickens, and cattle. Archer Daniels Midland (ADM) and three foreign firms secretly held meetings around the world and agreed to reduce quantities and raise prices. One ADM official taped the meetings and informed the FBI, and three ADM officials were fined and imprisoned. You can point the students to the book and movie The Informant! (the latter staring Matt Damon), which is based on this case. Other famous antitrust cases include the government’s breakup of AT&T into eight independent companies (discussed in the text) and the case against Microsoft for monopolizing the market for computer operating systems and software. Government-Supported Cartels Most successful cartels operate with government backing. Governments are the most effective cartel enforcers because they can penalize cheaters. In the United States, government-controlled milk cartels combine with subsidies and quotas to raise the price of milk. Any farmer who cheats on this cartel is fined or sent to prison. The U.S. government has supported cartels in mining, agriculture, and other industries in the past. Government-sponsored cartels are particularly problematic in poorer countries. Government-supported cartels usually result in lower quality of service and less innovation, as well as higher prices. The possibility of getting government support also encourages people to spend their energies trying to gain these privileges from the government rather than innovating to better serve consumers. Business Strategy and Changing the Game The last section of the chapter discusses two strategies whereby firms can change the game in an attempt to gain market power. Each of these strategies may be less beneficial to consumers in terms of promoting competition than is commonly perceived. The Danger of Price Matching Guarantees Price matching guarantees may seem like a win-win situation for consumers, but game theory suggests otherwise. Figure 15.7 in the text shows a prisoner’s dilemma between Lowes and Home Depot in a price war over refrigerator sales. The dominant strategy is for both firms to charge a low price. However, with a price match guarantee, the game changes as shown in Figure 15.8, so that the dominant strategy for both firms is to charge a high price. The High Price of Loyalty Loyalty programs seem like another way for customers to get more for their money, but a closer look proves otherwise. The trick is to recognize that loyal customers are customers that are to some extent locked in to buying from a certain seller. This means that a loyal customer will stick with a seller even if it raises prices up to a point. In other words, loyalty programs increase monopoly power and reduce the incentive to lower prices. As a result, firms can offer loyalty programs to avoid competition that would otherwise drive prices down. Other Ways of Changing the Game Another way firms try to wrestle monopoly power from their competitors is by innovating and differentiating their products. Differentiated products have fewer substitutes, which translates to more inelastic demand, higher prices, and more profits for the seller. Less competition is certainly good for firms, but innovation and product differentiation are usually good for consumers, as well. The role of monopoly power in promoting innovation and product differentiation is discussed further in Chapters 16 and 17. Takeaway Students should recognize an oligopoly as a market dominated by a small number of firms. Price and quantity supplied in an oligopoly are somewhere between those in a competitive market and in a pure monopoly. Profits in an oligopoly also exceed those in a competitive industry. A cartel is an oligopoly that is able to maximize joint profits by limiting competition and producing the monopoly quantity. Students should understand that most cartels are not stable; they break down because businesses cheat on their agreements or new competitors enter the market. Although governments occasionally break up cartels, they are also responsible for supporting many inefficient cartels. Students should understand what the prisoner’s dilemma problem is, how to solve for its equilibrium, and how it can be used to examine the behavior of firms in a cartel, oligopolistic market, or other cases where individual and group incentives do not align. In- and Out-of-Class Activities You can play a simple game with your students to illustrate how the powerful incentive to cheat in a cartel causes agreements to break down. This game can be effectively played either before you teach the material in the chapter or afterward. Announce to your class that they are going to play a game to earn extra credit points on their next exam. Tell them that you are going to give all of them a proposition, and they will have to write their answer on a piece of paper that they will fold up and give to you. Only you will know what each person wrote down. Now tell them that they have to choose whether to collude with their classmates or to defect. If everyone in the class chooses to collude, you will reward them all by giving each of them 10 bonus points on their next exam. However, if one person defects, that one person will get 50 bonus points (they can get more than 100 points on the exam) and no one else will get any extra points. If more than one person chooses to defect, no one earns any points. For fun, you might also tell them that if everyone defects except one person, the one person who chose to collude will be penalized a point on the exam. You may want to give them a few minutes to discuss their strategy to see if they can cooperate. After a few minutes, have them individually write their choice on their piece of paper and turn it in to you. Without revealing identities, flip through and show how many chose to defect. You can then draw a prisoner’s dilemma box on the board, as illustrated at the end of the chapter, to show them what the dominant strategy was. Instructor Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766