CH-15-17 Oligopoly and Game Theory – Modern Principles: Microeconomics : Book Guide

This Document Contains Chapters 15 to 17 CHAPTER 15 Modern Principles of Economics: Oligopoly and Game Theory Facts and Tools 1. Let’s start off by working out a few examples to illustrate the lure of the cartel. To keep it simple on the supply side, we’ll assume that fixed costs are zero so marginal cost equals average cost. We’ll compare the competitive outcome (P = MC) to what you’d get if the firms all agreed to act “as if” they were a monopoly. In all cases, we’ll use terms from the following diagram: a. First, let’s see where the profits are. Comparing this figure with Figure 15.2, shade the rectangle that corresponds to monopoly profit. b. What is the formula for this rectangle in terms of price, cost, and quantity? c. Let’s look at the market for one kind of apple: Gala. Assume that there are 300 produc¬ers of Gala apples and that MC = AC = $0.40 per pound. In a competitive market, price will be driven down to marginal cost. Let’s assume that when P = MC, each apple grower produces 2 million pounds of apples for a total market production of 600 million pounds. Now imagine that the apple growers form a cartel and each agrees to cut production to 1 million pounds, which drives the price up to $0.70 per pound. Calculate profit per pound and total industry profit if the apple growers behave “as if” they were a monopoly and are able to produce according to the following table. d. If a single apple grower broke from the cartel and produced an extra million pounds of apples, how much additional profit (approximately) would this apple grower make? Solution 1. a. b. (PMonopoly − AC) × QMonopoly c. d. At a price of $0.70 per pound each pound of apples earns $0.30 in profit. If a single apple grower were to increase his output by 1 million pounds, this would increase profit by approximately $300,000, a doubling of profit! Note that the increase in profit is approximate because the increase in apple output will push the price down a little bit—ignore the latter complication because the increase in output is only 1/300th of total output. To do an exact calculation, try the demand curve P = $1 − 0.000000001 × Q. 2. Take a look at the reasons presented in the chapter for why cartels collapse. For each of the following pairs, choose the case in which the cartel is more likely to stick together. a. An industry where it’s easy for new firms to enter vs. an industry where the same firms stick around for decades. b. When the government makes it legal for all the firms to agree on prices vs. when the government makes it illegal for all firms in an industry to agree on prices. (Note: The Sherman Antitrust Act made the latter generally illegal in 1890, but President Franklin Roosevelt’s National Industrial Recovery Act tem¬porarily legalized price-setting cartels during the Great Depression.) c. Cartels in which all the industry leaders went to the same schools and live in the same neighborhood vs. cartels where the industry leaders don’t really know or trust each other. (Hint: As Adam Smith said in the Wealth of Nations, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” d. An industry in which it’s easy for a firm to sell a little extra product without any¬one knowing (e.g., music downloads) vs. an industry where all sales are public and visible (e.g., concert tickets). Solution 2. a. When firms stick around, the cartel is better off. New entrants make it harder to stick together. b. Of course, if government sponsors the cartel, it’s likely to succeed. c. A cartel is more likely to succeed when all industry leaders in a cartel are from same trade or school and all know each other. d. When sales are visible and public: It’s harder to cheat then. 3. The prisoner’s dilemma game is one of the most important models in all of social science: Most games of trust can be thought of as some kind of prisoner’s dilemma. Here’s the classic game: Two men rob a bank and are quickly arrested. The police do not have an airtight case; they have just enough evidence to put each man in prison for one year, a slap on the wrist for a serious crime. If the police had more evidence, they could put the men away for longer. To get more evidence, they put the men in separate interrogation rooms and offer each man the same deal: If you testify against your accomplice, we will drop all the charges against you (and convict the other guy of the full penalty of 10 years of prison time). Of course, if both prisoners take the deal the police will have enough evidence to put both prisoners away and they will each get 6 years each. And, as noted, if neither testifies both will get just one year of prison time. What’s the best thing for each man to do? In each cell in the following table, the first number is the number of years Butch will spend in prison, and the second is the number that Sundance will spend in prison given the strategies chosen by Butch and Sundance. If years in prison are minuses, then we can write it like this:
Sundance
Keep quiet Testify
Butch Keep quiet (−1, −1) (−10, 0)
Testify (0, −10) (−6, −6)
a. If Sundance keeps quiet, what’s the best choice (highest payoff) for Butch, keep quiet or testify? b. If Sundance chooses to testify, what’s the best choice for Butch, keep quiet or testify? c. What’s the best choice for Butch? What’s the best choice for Sundance? d. Using the definition in the chapter, does Butch have a “dominant strategy”? If so, what is it? e. What is your prediction about what will happen? f. How does this help explain why the police never put two suspects in the same interrogation room? (Note the similarity between this question and the earlier Adam Smith quote.) Solution 3. a. If Sundance chooses to keep quiet, Butch’s choice is between one year in prison or going free: Going free is better, which means that testify is better. b. If Sundance chooses testify, Butch’s choice is between 10 years in prison and 6 years in prison: 6 years is better, so testify is again better. c. The best choice for Butch either way is testify. The same is true for Sundance. d. Butch has a dominant strategy: testify. So does Sundance. e. (Testify, Testify) is a good prediction. Notice that that is collectively the worst outcome for the prisoners (12 total years in prison, versus 11 total years or 2 total years). f. If they were in the same room, they could both agree to keep their mouths shut, because if either man opened his mouth, the other could quickly testify at the same time. In other words, they are better able to enforce their “cartel” if they are close together. This is similar to Smith’s quote because if the two suspects are together, they can easily form a “conspiracy against the public” and spend little time in jail. 4. Your professor probably grades on a curve, implicitly if not explicitly. This means that you and your classmates could each agree to study half as much, and you would all earn the same grade you would have earned without the agreement. What do you think would happen if you tried to enact this agreement? Why? Which model in this chapter is most similar to this conspiracy? Solution 4. The agreement would fall apart because of cheating, because it is difficult to verify how much your classmates are studying, especially if you have a large number of classmates. This is similar to a prisoner’s dilemma and is also similar to the cartel-cheating example. 5. In many college towns, rumors abound that the gas stations in town collude to keep prices high. If this were true, where would you expect this conspiracy against the public to work best? Why? a. In towns with dozens of gas stations or in towns with fewer than 10? b. In towns where the city council has many environmental and zoning regulations, making it difficult to open a new gas station, or in towns where there is a lot of open land for development? c. In towns where all the gas stations are about equally busy or in towns where half the gas stations are always busy and half tend to be empty? Solution 5. a. In towns with fewer than 10 gas stations. It’s easier to hold the cartel together when there are fewer members to monitor. b. When entry is hard due to many environmental and zoning regulations regarding opening new gas stations, it’s easier to hold cartels together. c. If some stations are half empty, then those stations will be tempted to win cus¬tomers by charging a little less—cheating is more tempting for them. If all the gas stations are equally busy, there won’t be a core group that is looking to cheat. 6. Suppose you have a suit that needs altering, and you take it to three different tailors in the same mall to get an estimate of the cost of the alterations. All three tailors give you the exact same estimate of $25. What are two different explanations for the simi¬larity of the price quotes? (Hint: One is consistent with competition and one is not.) Solution 6. The explanation that is consistent with competition is that $25 is the marginal cost of the alteration, so all three tailors are quoting a price equal to marginal cost due to a high degree of competition. The other explanation is that the three tailors have colluded (whether explicitly or implicitly) to keep prices above marginal cost. In this case, $25 is greater than the marginal cost, but the tailors have decided not to compete with one another on price. Now, if a tailor in another mall across town quoted a price of $25, that could be evidence that $25 is the marginal cost and the market is competitive, especially if it were unlikely that the distant tailor has col¬luded with the tailors in question. Thinking and Problem Solving 7. Usually, we think of cheating as a bad thing. But in this chapter, cheating turns out to be a very good thing in some important cases. a. Who gets the benefit when a cartel collapses through cheating: consumers or producers? b. Does this benefit usually show up in a lower price, a higher quantity, or both? c. Does cheating increase consumer surplus, producer surplus, or both? d. So, is cheating good for the cheaters or good for other people? Solution 7. a. Consumers get the price benefit through cheating by producers. b. Lower price and higher quantity. c. It increases consumer surplus. d. Cheating is good for consumers, but in the end it is bad for the cheaters (though you could argue it’s good for the cheaters in the short term; it’s why they cheat in the first place!). 8. Firms in a cartel each have an incentive individually to lower the prices they charge. a. Suppose there were a government regulation that set minimum prices. Would this regulation tend to strengthen cartels, weaken them, or have no effect? b. Another way that one firm can cheat on a cartel is to offer a higher-quality product to consumers. Suppose there were a government regulation that stan¬dardized the quality of a good. Would this regulation tend to strengthen cartels, weaken them, or have no effect? Solution 8. a. This regulation would strengthen cartels since it reduces the ability to cheat by lowering the price and reduces the incentive to raise the quality of the products. b. This regulation would also strengthen cartels. The government can make it easier to coordinate. 9. In the late fifteenth century, Europe consumed about 2 million pounds of pepper per year. At this time, Venice (ruled by a small, tightly knit group of merchants) was the major player in the pepper trade. But after Portuguese explorer Vasco da Gama blazed a path around Africa into the Indian Ocean in 1498, Venice found itself competing with Portugal’s trade route. By the mid-sixteenth century, Europeans consumed 6 to 7 million pounds, much of it through Lisbon. After da Gama’s success, the price of pepper fell. a. During the fifteenth century, was it likely that a cartel was restricting pepper imports? Why or why not? b. If the price of pepper before 1498 had been lower, would da Gama have been more willing or less willing to sail around South Africa’s Cape of Good Hope? Why? c. What happened in 1498 that turned a successful cartel into a less successful cartel? d. The ruling merchants of Venice had no political power in other parts of Europe. Why is that important in understanding how European pepper consumption more than tripled in just over half a century? Solution 9. a. The Venetians were a small group with control over a lot of the market: That’s a perfect situation for forming a cartel. The fact that the price fell after da Gama found his route to India is further, weaker evidence (he could have just increased the supply of pepper). b. He would be less interested in discovering a route because, with the price of pepper lower, the incentives are not as strong (less “demand response”). c. Venice faced a new entrant in the pepper market: Portugal. d. Venice had no way to force other European merchants to join its pepper cartel. 10. In 1890, Senator Sherman (of the Sherman Antitrust Act mentioned earlier) pushed through the legislation that bears his name that gave the government signifi¬cant power to “bust-up” cartels, presumably in order to increase output. More than a century later, economist Thomas J. DiLorenzo examined the industries commonly accused of being cartels and found those industries increased output by an average of 175% from 1880 to 1890—seven times the growth rate of the economy at the time. Suppose the industries were conspiring. Indeed, let’s suppose that these cartels grew ever stronger in the decade before the Sherman Act became law. If that were true, would we expect output in these industries to grow by so much? In other words, is DiLorenzo’s evidence consistent with the standard story of the Sherman Antitrust Act? Solution 10. Cartels exist to restrict output (and increase price), not expand output. We would expect output to grow slowly or maybe even shrink if the cartels really were getting stronger. Moreover, as we saw in the chapter, it’s difficult to maintain a cartel when an industry is growing rapidly. Thus, DiLorenzo’s evidence is inconsistent with the standard story of the act. DiLorenzo also points out that Sherman was a big sup¬porter of tariffs, which raise prices, reduce output, and also make cartels easier to maintain! The important lesson here is that you should take claims about what a law is in-tended to do or claims about what a law does do with a grain of salt. For more on the history of antitrust, see DiLorenzo, Thomas J. 1985. The origins of antitrust: An interest-group perspective. International Review of Law and Economics 5(6): 73–90. And for a recent review of antitrust effectiveness, see Crandall, Robert W. and Clifford, Winston. 2003. Does antitrust policy improve consumer welfare? Assessing the evidence. Journal of Economic Perspectives 17(4): 3–26. 11. In 2005, economist Thomas Schelling won the Nobel prize in economics, in part for his development of the concept of the “focal point” in game theory. Focal points are a way to solve a coordination game. If two people both benefit by choosing the same option but cannot communicate, they will choose the most obvious option, called the focal point. Of course, what’s obvious will vary from culture to culture. Whether to wear business attire or just shorts and a T-shirt, whether to use Apple or Microsoft products, whether to arrive at meetings on time or late. In all these cases, having a group agree on one focal point is more important than which particular focal point you all agree on. Therefore, people will look for cultural clues so that they can find the focal point. (Note: Schelling wrote two highly readable books that won him the Nobel, Micromotives and Macrobehavior and Strategy and Conflict.) a. Suppose you are playing a game in which you and another player have to choose one of three boxes. You can’t communicate with the other player until the game is over. One box is blue and the other two are red. If the two of you choose the same box you win $50; otherwise, you get nothing. Which box do you choose: The blue box or one of the red boxes? Why? b. Suppose that you and another player have to write down on a slip of paper any price in dollars and cents between $90.01 and $109.83. If you both write down the same price, you’ll each win that amount of money. If your numbers don’t match, you get nothing. Again, you can’t communicate with the other player until the game is over. What number will both of you probably choose? c. Many “slippery slope” arguments are really stories about focal points. In the United States during debates over banning guns or restricting speech, people will argue that any limitation follows a “slippery slope.” What do they mean by that? (Hint: Attor¬neys often worry about “gray areas” and they prefer “bright line tests.”) d. Schelling used the idea of the focal point to explain implicit agreements on the limits to war. Poison gas, for example, was not used in World War II and the agreement was largely implicit. Since focal points have to be obvious, explain why there was no implicit agreement that “some” poison gas would be allowed, but “a lot” of poison gas would not be allowed. Solution 11. a. You choose the blue box, because it is obvious and will be obvious to the other player. b. $100.00. That’s a nice round number that most people would focus on. Alterna¬tively, you could claim it is $109.83, the most you could write down and thus the most you could receive. c. They mean that once you’ve banned one or two guns, it’s easy to ban one or two hundred. There’s no natural place to stop banning unpopular ideas or unpopular guns. “Slippery slope” implies a bit more than “focal point,” since on a slippery slope you keep going in the same direction, but a focal point story says that if you lose the focal point, you could just stop at banning 59 or 72 political ideas: It’s not a claim that you’ll ban all offensive ideas. d. “Some” versus “a lot” is just in the eye of the beholder. Once you’ve sent over “some” gas, the other side might decide that was “a lot.” “Zero use” is a much stronger focal point. 12. Suppose the five landscapers in your neighborhood form a cartel and decide to restrict output to 16 lawns each per week (for a total of 80 lawns in the entire market) in order to keep prices high. The weekly demand curve for lawn-mowing services is shown in the following chart. Assume that the marginal cost of mowing a lawn is a constant $10 per lawn. a. What is the market price under the cartel’s arrangement? How much profit is each landscaper earning per week under this arrangement? b. Suppose one untrustworthy landscaper decides to cheat and increase her own output by an additional 10 lawns. For this landscaper, what is the total increase in revenue from such behavior? What is the marginal revenue per lawn from cheating? Which is higher: the marginal revenue from the extra lawns or the marginal cost? c. Is it a good idea for the untrustworthy landscaper to cheat? What considerations, other than weekly profit, might enter into the landscaper’s decision about whether to cheat? Solution 12. a. According to the demand curve, the price will be $40. Each landscaper is earning 16 × ($40 − $10) = $480 in profit per week. b. The increase in output will reduce the market price to $30 per lawn. So the untrustworthy landscaper’s revenue will increase from 16 × $40 = $640 to 26 × $30 = $780. The marginal revenue per lawn from cheating is therefore ($780 − $640) ÷ 10 = $14. This marginal revenue from each extra lawn is greater than the marginal cost of $10. c. From a simple comparison of marginal cost and marginal revenue, it is definitely a good idea for this landscaper to cheat. However, there may be more for the land¬scaper to consider. For example, if the cartel will break down and the other firms will increase output, this one act of cheating may cause the firm to experience perma¬nently lower future profits. Also, we should realize that the untrustworthy landscaper may indeed be worried that the other landscapers might rough her up or sabotage her lawns, which would reduce her business. Local cartels often work this way. 13. Looking for dominant strategies is a great way to find an equilibrium in many games. However, there are also a lot of games in which this won’t work because not all players have dominant strategies. If one player has a dominant strategy but the other doesn’t, game theorists remove the first player’s dominated strategies (the strategies that are always worse than some other strategy) and then continue to work toward solving the game with what’s left. Let’s take a look at an example of this. Consider the following payoff table, where the outcomes are written in the form {A’s payoff, B’s payoff}. Each player has four choices, which might make this game seem intimi¬dating, but it’s not. Start off by trying to figure out whether any player has a strategy that is never best, and then eliminate it. The first one is done for you; no matter what move A makes, B’s best response is never to play Red. Since B will never play Red, we don’t even have to consider that as part of the game. Next, figure out if there’s a move A will never make, then B, and so on. What is the equilibrium? Solution 13. The order in which strategies can be eliminated is B will never play Red, thus A will never play Red, thus B will never play Blue, thus A will never play Green, and thus B will never play Green. At this point, it is determined that B will always play Yellow, so A will play Yellow in response. The equilibrium is {Yellow, Yellow} with a payoff of (5, 1). Challenges 14. The French economist Antoine Cournot developed an interesting model of com¬petition in an oligopoly that now bears his name. In a Cournot oligopoly, all of the firms know that the total output from all firms will determine the price (based on the downward-sloping market demand curve), but they make independent and simultaneous decisions about how much output to produce. Cournot developed this model after observing how a spring water duopoly (two firms) behaved. So let’s look at a duopoly example. For each firm to decide how much to produce, it must make a guess about how much the other firm is going to produce. Also, the firms basically assume that once the other firm has decided how much to produce, it can’t really change its decision. Here’s an example. Suppose the market demand curve for gallons of fresh spring water looks like the one below and, to keep things simple, the marginal cost of spring water is zero. If Firm X believes that Firm Y is going to produce 100 gallons of spring water, for example, then Firm X knows that if it produces 0 gallons, the price will be $2.75; if it produces 100 gallons, the price will be $2.50, and so on. Basically, Firm X will face its own demand curve where all of the quantities are lower by 100. Based on the demand schedule above, calculate the demand schedule that Firm X would face if it suspected Firm Y was going to produce 0, 200, 400, or 600 gallons of spring water. Then, figure out the profit-maximizing amount of spring water for Firm X to produce in response. Fill in the table below. What you have just constructed is what economists would call Firm X’s reaction function. Even though Firm X thought about the different choices Firm Y could make, Firm Y is not actually going to choose just any random level of output. In fact, Firm Y has its own reaction function, where it considers how best to respond to what it thinks Firm X is doing. Because both firms have the same zero marginal cost, the two reaction functions are symmetrical. (Thus, Firm Y’s reaction function looks the same, only with “X” and “Y” switched.) Graph the two reaction functions. Do you notice any points that stand out? Describe why this point represents an equilibrium for both firms. Solution 14. The filled-in table should look like this: The graph should look like this: The two reaction functions intersect at a quantity of 400 gallons of spring water on each axis. Both firms will produce 400 gallons. This is an equilibrium because both firms are producing exactly the right quantity in response to the quantity produced by the other firm. 15. The following diagram shows the monthly demand for hot dogs in a large city. The marginal cost (and average cost) is a constant $2 per hot dog. a. If the market for hot dogs is perfectly competitive, how many hot dogs will be sold per month, and at what price? Suppose there are 100 identical firms in this perfectly competitive market. How many hot dogs is each firm selling, and what are the profits for each firm? b. Suppose the market was almost perfectly competitive, so that each firm has some very limited ability to change the price. What would happen if one of the firms in this market reduced its output by one half, and no other firm changed its output. What would happen to the price of a hot dog? How much profit would the firm earn as a result? c. Discuss the ability of one firm to reduce output and raise the market price if the market for hot dogs was instead an oligopoly made up of four firms, each ini¬tially producing 25,000 hot dogs per month. If only one firm reduced its output by a half, what would happen to the price of a hot dog? How much profit could this firm potentially earn? d. Compare your answers for parts b and c. What does this tell you about the ability to earn profits in perfect competition vs. oligopoly? Solution 15. a. If the market is perfectly competitive, the price will equal marginal cost, $2. So there will be 100,000 sold in a month. If there are 100 firms, they are each producing 1,000 hot dogs and earning zero profit. b. If one firm reduced its output by one-half, it would go from producing 1,000 hot dogs to producing 500 hot dogs. To calculate how much this would change price, we need to calculate an elasticity. Using the mid-point method we have that ε_d=((80-100)/90)/((4-2)/3)=-(20/90)/(2/3)=-1/3 That means that every 1% change in the quantity results in a 3% change in price over this range. A decline of 500 hot dogs is a .5% decline in quantity so price would increase by 1.5% or 3 cents. The firm that did this would now be earning 500 × ($2.03 − $2.00) = $15 in profit. Not very much—and remember this only works if every other firm continues to produce the same quantity. c. If one firm in this situation reduced its output by one-half, that would be 12,500 hot dogs or a decline of 12.5% which would raise price by 37.5% or 70 cents. The firm who reduced its output would now be earning 12,500 × ($2.70 − $2.00) = $8,750. Not bad. Again, this would only work if every other firm maintains quantity, but maybe an agreement among four firms could be made to share the profits. d. Reducing output to increase price and earn profits is more likely to be effective in an oligopoly than in competition. Firms in oligopoly will recognize this and will take advantage of it. Firms in competition also realize this fact and will not be as inspired to try such a course of action. 16. In our chapter on Competition and the Invisible Hand, we quoted the Austrian economist Joseph Schumpeter who said that in the textbooks the most important fact about competition was that price was pushed down to marginal cost. However, Schumpeter goes on to say: . . . in capitalist reality as distinguished from its textbook picture, it is not this competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization…competition which commands a decisive cost or quality advantage and which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is more effective than the other as a bombardment is in comparison with forcing a door, and so much more important that it becomes a matter of comparative indifference whether competition in the ordinary sense functions more or less promptly... a. Relate Schumpeter’s statement to the models of monopoly and oligopoly discussed in this and earlier chapters. In what ways are these market forms inefficient? In what ways might they be efficient or beneficial? b. The terms static efficiency and dynamic efficiency are sometimes used in economics. Is there a trade-off between the two types of efficiency? How might we evaluate this tradeoff? Solution 16. a. In the standard textbook models, monopoly and oligopoly are inefficient because price is not pushed all the way down to marginal cos; thus the quantity produced is below the efficient quantity. Schumpeter is arguing, however, that pushing price down to marginal cost is a fairly small benefit of competition. More important in his estimation is that free markets create incentives to innovate and produce entirely new products and new forms of production. In Schumpeter’s view, it could be better to have a series of new products, like new cell phones, each better than the last, even if each cell phone is sold at a price above marginal cost, as compared to a situation in which cell phones are very cheap but improve more slowly. b. A big reason to innovate is to price above marginal cost and earn monopoly profits. Thus, there could be a trade-off between static efficiency (price = marginal cost) and dynamic efficiency (new products and processes over time). Patents are one way that we recognize this trade-off. The patent system is an attempt to create more dynamic efficiency, even at the expense of static efficiency. Evaluating trade-offs like this is very difficult, however, and economists don’t have good ways of optimizing this trade-off or even of measuring and comparing the benefits. Antitrust law often involves a debate between those who see monopoly, oligopoly, and product differentiation as a necessary part of dynamic efficiency, and those who see these features of an economy as simply generating static inefficiencies that need to be corrected. Appendix 1. Cat and mouse is a simple game in which each player can choose either Right or Left. If the cat and mouse both choose Right or both choose Left, however, that is very bad for the mouse but good for the cat. If the cat and mouse choose different strategies that is good for the mouse but not good for the cat. Can you find a Nash equilibrium in this game? Solution 1. No. In the cat and mouse game, we cannot find a Nash equilibrium since in a Nash equi¬librium no player in the game would take a different action as long as every other player remains the same. Nash equilibrium is self-enforcing; when players are at a Nash equilibrium they have no desire to move because they will be worse off. Here, Cat and Mouse must choose either right or left. The cat wants her side just like the mouse, while the mouse wants its side to be different than the cat’s. As shown below, we could not find any combination where both players have “no desire” to move. Note: (Mouse, Cat) ➔ 1 denotes the benefit and 0 denotes the loss. As shown above, Cat or Mouse is not benefited by taking the same decision. In each combination either of them have a desire to move. So, we can conclude that we cannot find Nash equilibrium in this game. 2. Bob and Al are prestigious rival magicians who have developed a new trick that is very popular. If both magicians perform five times a week, each will earn a profit of $6,000. If one magician does a single show while the other does five shows, the former gets a profit of $1,000 and the latter gets a profit of $15,000. If both magicians perform only one show a week, each will earn $10,000. a. Use this information to complete the table. (Hint: It’ll look a lot like Figure 15.4.) b. Suppose Al does one show. What is Bob’s preferred strategy? c. Suppose Al does five shows. What is Bob’s preferred strategy? d. What is Bob’s dominant strategy? e. Suppose Bob does one show. What is Al’s preferred strategy? f. Suppose Bob does five shows. What is Al’s preferred strategy? g. What is Al’s dominant strategy? h. What is the Nash equilibrium? i. Magicians are famously hesitant to reveal the secrets behind their magic, even to other magicians. Based on what you’ve learned in this question, why do they act like this? Is letting other magicians in on your secrets an optimal strategy? Solution 2. a. b. Do five shows, because $15,000 > $10,000 c. Do five shows, because $6,000 > $1,000 d. Do five shows. e. Do five shows, because $15,000 > $10,000 f. Do five shows, because $6,000 > $1,000 g. Do five shows. h. Five shows, five shows i. Since colluding is difficult, revealing their secrets means facing more competition, which drives down profits. 3. Imagine that two players are competing over a valuable resource. Each player has two options. He or she can either be aggressive and demand the entire resource, or the player can offer to split the resource equally. The literature uses the word “Hawk” to describe the aggressive behavior and the word “Dove” to describe the sharing behavior. If two Hawks meet, then both will demand the resource, neither will give in, and there will be a fight. If a Hawk meets a Dove, the Hawk will take the resource and the Dove will get nothing. If two Doves meet, the resource will be shared equally. Assume that the value of the resource is 60, the cost of losing a fight is 100, and if two Hawks fight, each of them has a 50% chance of losing. Here’s the payoff matrix: a. Oops! The payoffs are missing. You’ll have to fill them in. Remember, if there’s a fight, there is a 50% chance of winning 60 but also a 50% of losing the fight, which has payoff –100. What’s the expected outcome? If both players choose Dove, assume that they peacefully split the resource. If one is a Hawk and the other is the Dove, the Hawk gets the resource, and the Dove receives nothing... b. Explain why {Hawk, Dove} and {Dove, Hawk} are both Nash equilibriums. c. The Hawk-Dove game is often used to discuss international relations. Can you explain why a country might like to be perceived as a Hawk? What are the dangers of being a Hawk? What are the dangers of being a Dove? d. Biologists also use game theory to understand animal behavior, but they inter¬pret the strategies a little differently. Instead of allowing an animal to choose a strategy, they assume that x percent of animals in a population will always play Hawk and 100 – x percent of animals in a population will always play Dove, and they also assume that animals will meet randomly. Biologists argue that if Hawk has an expected higher payoff than Dove, then Hawks will outcompete Doves so that over time, evolution will increase the percentage of animals playing Hawk. Similarly, if Dove has a higher payoff, then over time, evolution will increase the percentage of animals playing Dove. Can you find a strategy that is evolutionarily stable; that is, can you find a strategy where the percentages of animals playing Hawk and Dove are stable over time? Here are two hints: Let x be the percentage of animals playing Hawk. If 0% of animals play Hawk (x = 0%) and thus all play Dove, is that evolutionarily stable? If all animals play Hawk (x = 100%), is that evolutionarily stable? Solution 3. a. The payoff matrix should look like the one above. b. In both cases {Hawk, Dove} and {Dove, Hawk}, no player would have done better if he or she made a different choice. Consider {Hawk, Dove}. If Player A had chosen Dove instead, A’s payoff would have decreased from 60 to 30. If Player B had chosen Hawk instead, B’s payoff would have decreased from 0 to –20. This confirms {Hawk, Dove} to be an equilibrium, and the same argument can be made for {Dove, Hawk}. c. No one benefits by getting into a conflict with a Hawk. Doves lose right away, of course, but so do other Hawks. Thus, a player perceived to be a Hawk can intimidate its rivals and claim resources from other players at low cost. We know some (unpleasant) people who act like Hawks all the time. Some countries may also like to be seen as Hawks for similar reasons. Saddam Hussein, for example, didn’t have weapons of mass destruction in the early twenty-first century, but many of his actions suggested that he did. Hussein hoped to be seen as a Hawk to avoid a conflict and intimidate rivals. The dan¬ger, however, is that when two Hawks meet, there will be a costly fight. It’s not good to be perceived as a Dove because other people or countries may take advantage of your Dove status. Thus, players want to be seen as Hawks but sometimes act like Doves. Of course, a player who acts like a Dove will probably be perceived as a Dove, which is what makes international relations so tricky. d. If all animals but one were Doves, then a Hawk would always win every conflict and never face any cost of losing. Thus, if all but one were Doves, Hawks would have a higher payoff and increase as a percentage of the population. Therefore, “all Dove” cannot be evolutionarily stable. What about “all Hawk”? If all animals were Hawks, then every meeting would result in a conflict with an expected negative payoff. Even though a Dove in this system would never win a fight, the payoff from running away (0) is better than the payoff from fighting in an all-Hawk world (220). Thus, “all Hawk” cannot be an evolutionarily stable equilibrium. Knowing this, can we find an evolutionarily stable equilibrium somewhere in the middle? If animals meet randomly and if x percent are Hawks, then the probability of meeting a Hawk is x/100. Thus, the expected payoff for each type of strategy will be calculated as (x/100) times the payoff if Animal B is a Hawk plus (1 − x/100) times the payoff if Animal B is a Dove: Expected value of a Hawk = (x/100)(−20) + (1 − x/100)(60) Expected value of a Dove = (x/100)(0) + (1 − x/100)(30) In an evolutionarily stable equilibrium, the payoff to the two strategies must be equal, so setting the payoffs equal to each other gives (x/100)(−20) + (1 − x/100)(60) = (x/100)(0) + (1 − x/100)(30) −0.2x + 6 0 − 0.6x = 30 − 0.3x−0.8x + 60 = 30 − 0.3x 60 = 30 + 0.5x 30 = 0.5x x = 60 Thus, if Hawks are 60% of the population and Doves are 40% of the population, then this is an evolutionarily stable equilibrium. CHAPTER 16 Modern Principles of Economics: Competing for Monopoly: The Economics of Network Goods Facts and Tools 1. Antitrust laws make certain “anticompetitive” practices illegal because these prac¬tices raise prices and reduce output, which reduces the total amount of consumer surplus. Explain why antitrust action may not be helpful or necessary in markets that are: a. Characterized by network goods b. Highly contestable Solution 1. a. Network goods provide more value to consumers the greater the total number of consumers that use the good. For this reason, forcing “competi¬tion” between multiple products would actually reduce the value of the products to the consumers. b. In markets that are highly contestable, firms may behave as though they face competition even if that competition is only potential competition. In this case, the behavior of firms does not differ from the behavior of competitive firms, even if the market appears to be dominated by one firm or a few. 2. Explain the difference between competition “in the market” and competition “for the market.” What impact does each kind of competition have on prices and output in a market? Is one better than the other? How does the distinction make the application of antitrust laws more complicated? Solution 2. For network goods, there will be one standard, so firms compete to be the standard—this is competition for the market. For goods where a standard is not needed, firms compete in the market for customers. A firm that success¬fully competes “for the market” may have some market power; however, the potential for other firms to compete further for the market may keep prices low and output high. The book uses Facebook—which is free—as an example of this. Competition in the market is the standard sort of competition covered in previous chapters; it reduces price and increases output. One is not necessarily better than the other; the type of good determines which kind of competition will apply. Competition for the market makes the application of antitrust laws complicated because for goods where there exists a standard, it may be difficult to observe the positive impact of competition from firms that have lost standard wars on the market; it may appear as though competition does not exist where, in fact, it does. 3. LinkedIn is an online professional networking site, much like Facebook or MySpace, except that it’s for connecting with classmates and colleagues to create networks that may be helpful in, among other things, finding job opportunities. The site boasts approximately half a billion members and claims to be the “world’s largest professional network on the Internet.” What made LinkedIn the largest professional network site? Since it is already the largest, does that mean LinkedIn will always be the largest? Why or why not? Solution 3. It is impossible to say with certainty what has made LinkedIn the largest professional network site, but it was probably a combination of LinkedIn providing valuable services and what the textbook calls accidents of history. Just because it is currently the largest, there is no guarantee that LinkedIn will always be the largest. Standards can change quickly, as the book points out—especially for something like a networking site. LinkedIn still faces competition and must not become lazy just because it is the current standard. 4. For each of the following pairs, determine which business is more likely to operate in a contestable market, and explain why. a. The only clothing store in a small town vs. the only natural gas provider in a small town b. The only clothing store in a small town vs. the only cable TV provider in a small town (What recent technologies make part b different from part a?) c. De Beers diamond mining vs. H&R Block tax preparation services Solution 4. a. Clothing stores have low fixed costs so a competitor could easily enter the market. Laying pipe for natural gas, on the other hand, is very expensive. Thus, the clothing market is contestable, while the natural gas market is not. As a result, even though the clothing store and the natural gas company may both serve 100% of the market, we are more concerned about natural gas monopolies than clothing monopolies. b. The clothing store likely operates in a more contestable market. Cable TV seems a lot like natural gas in that it is expensive to lay cable. But in recent years, two new technologies have made cable TV a much more contestable market than it previously was: satellite TV and the Internet (Hulu, Netflix, and other services of¬fering digital downloads of television shows as well as movies). Thus, a market can become more contestable over time with the introduction of new technologies. c. De Beers and H&R Block both serve a large share of their respective markets but De Beers has a unique, hard-to-replicate resource and H&R Block does not, so the diamond industry is less contestable. 5. In the following three games, is each a coordination game or a prisoner’s dilemma? The best way to check is to see if there is exactly one Nash equilibrium; another way is to see if there is a dominant strategy for each player. To keep it a little challenging, we won’t give the actions obvious labels that might give away the answer. Higher numbers are always better: a. b. c. Solution 5. a. Pure coordination: Down/Left is one Nash; Up/Right is the other. b. Prisoner’s dilemma: Up dominates Down, and Left dominates Right. c. Pure coordination: Up/Left is one Nash, but Down/Right is the better “payoff dominant” Nash. 6. The mantra of Amazon.com CEO Jeff Bezos is “Get big fast.” As we saw in Chapter 13, one reason to “get big fast” is because in some industries the firm’s average cost will plum¬met as the firm expands—so size helps on the supply side. In this chapter, network effects illustrated how size helps on the demand side. With this in mind, explain the following real world drives to get big fast: Do you think it’s mostly about increasing returns or mostly about network effects? Explain why: a. Second Life, an online virtual world, lets people use many of its features for free. To use the best features, you have to pay. b. Likewise, Match.com, the online dating set, lets people post profiles, look at other people’s profiles, and even get mail from other members for free. To send an e-mail to a member, you have to pay. c. Adobe Acrobat Reader is free, but the software to create sophisticated Adobe documents is not. d. King Gillette (real name) gave away his first disposable razor blades in 1885. They came free with the purchase of a box of Cuban cigars. e. Amazon itself. Solution 6. a. Network effects: The many free customers make the experience better for the paying customers. b. Same story. Network effects: The many free customers make the experience better for the paying customers. c. Again, network effects: Adobe gives away the low-end software so that power users will buy the high-end software that creates better low-end documents. d. Increasing returns. It’s hard to imagine that men would choose a razor primarily because other men use the same brand. How common is it for men to worry about another man’s razor brand, especially in 1885? It’s probable that King wanted to get his company big so he could cut the average cost per blade. e. Amazon is probably a case of increasing returns. They need to run a massive supply network that holds huge amounts of inventory. Yes, there’s some benefit to being able to look at your friends’ Amazon wish lists, but as of today it still seems like Amazon’s model is based on “low average cost” not “the website that all your friends use to buy books.” Thinking and Problem Solving 7. If you get a crack in your windshield, you can take your car to an auto-glass repair shop where they will gladly try to repair your windshield, so you can avoid having to replace it. They guarantee their work, too; if the repair is not successful, they will allow you to apply the money you already paid for the unsuccessful repair toward the purchase of a new windshield. Sounds terrific, but how does this strategy relate to the material in the chapter? If all auto-glass repair shops employ this strategy, what impact do you think this has on the price of a new windshield? Solution 7. This strategy is a way of trying to impose switching costs. Once you pick a particular place to repair your windshield, you are more likely to choose that same place to install the replacement windshield because switching at that point would mean giving up the money you have already invested in the windshield repair. If all shops employ this strategy, then they can raise new windshield prices. 8. Every so often, rumors float around Facebook claiming that the social networking site is going to begin charging its users a small monthly fee. So far, those rumors have always turned out to be false. a. Do you use Facebook? If so, how much would you be willing to pay per month for access to Facebook? (If you don’t use Facebook—as unlikely as that is nowadays—how much do you imagine the typical user would be willing to pay to use it?) b. Besides the price itself, what else would determine whether it was worth it to you to pay for Facebook? Is your response independent of others’ responses? c. Do you think Facebook ever will charge users a fee? What are some reasons Facebook might do this? What are some arguments against this idea? Solution 8. a. Student answers for this may vary. Most who use the service would probably be willing to pay a nominal monthly fee for it, though since they’d rather not, they may report that they will not. b. Besides the price, the willingness of any single user to pay for Facebook depends on how many other users are also willing to pay for the service. It may be worth $5 per month if all of one’s friends are on Facebook, but not if they all choose not to remain there. c. Student answers will vary. The biggest pro: 500 million users X almost any price = tons of money. The biggest con: Many people will opt out of paying, which makes Facebook not worth as much to the remaining users and, most important, its advertisers. Many people might pay at first, but then as the value falls because users leave, they will cease using Facebook. The market is reason¬ably contestable so free alternatives, such as MySpace, might become more popular. 9. Deciding which side of the road to drive on is a kind of coordination game. In some countries, people drive on the right side of the road, and in other countries (notably the United Kingdom and some of its former colonies), they drive on the left. These customs developed hundreds of years ago. If there were a single world standard, car companies could save some money by not having to produce both left and right types, and cars would be a little bit cheaper. Why do you think it is that these customs persist? In other words, what keeps the world “locked in” to two separate kinds of cars? Solution 9. Switching is expensive, and there are many reasons why. For one thing, it would be difficult to switch the cars all at once, so in the meantime many people would be driving left-side cars on right-side roads, which could cause crashes. People would also have to relearn all of their driving intuition—where the gear shifter is for a manual transmission, which way to look to see the rearview mirror—and so this could also cause crashes. You’d also have to change all of the signs, the freeway on-ramps, just about everything. Nevertheless, Sweden did switch from driving on the left to driving on the right on Sunday, September 3, 1967. 10. Consider the shipping container (the large box that stacks on cargo ships and attaches to trucks). If all containers are the same size and design, then the container can pass seamlessly between ships, trains, trucks, and cranes along the way. Today, the standard dimensions are 8 feet wide, 8.5 feet tall, and 40 feet long. (The recent book The Box tells the surprisingly gripping tale of how this size came to be the standard, and how it has cut the cost of shipping worldwide.) Let’s see how this standard dimension illustrates the meaning of “Nash equilibrium.” a. Suppose an inventor created a new shipping container that was slightly cheaper to make, as well as stronger, but it had to be 41 feet long. Keeping the idea of standardization in mind, would this inventor be successful? Why or why not? b. Suppose a container manufacturer reduced the strength of the end walls of his containers (saving him $100 per container made). While this makes no difference to containers on a ship, containers on a train are at risk as the container bumps against the flatcar when the train hits the brakes. Who would tend to oppose these weaker, cheaper containers: the company whose products are stored in the container, the train companies who transport the goods, or both? c. Why does Federal Express, the overnight delivery company, require everyone to use FedEx packaging for most shipments? Solution 10. a. He would not be successful since adopting the container would drastically reduce its synergy—its usefulness—with the ships, trains, trucks, and cranes that were built for a slightly smaller container. b. Both. The train company doesn’t want to look bad and handing over damaged goods makes them look bad. The company shipping the goods doesn’t want damaged stuff either—though the lower container price could make it worth it at some point. But the train company’s reputation is probably the biggest driver for standardization. c. FedEx standardizes the packaging so that they can move everything efficiently. If they had to handle hundreds of different shapes of envelopes (like the U.S. Postal Service), it would be more expensive to monitor and handle each and every item. 11. It’s more efficient to go shopping when everyone else is shopping: This is one explanation for the rise of Christmas as a shopping season. Even many people who don’t celebrate Christmas do a lot of shopping and gift giving during this season. At the other extreme, a “dead mall” is one of the dreariest sights of modern consumer capitalism. Let’s see how a pleasant shopping experience is a network good. a. Part of the pleasure of walking through a mall is the pleasure of seeing and being seen. When will you see more people at the mall: In the months before Christmas or at other times? So if you like seeing people, when will you tend to go to the mall? (This is an example of the “multiplier effects” so common in economics.) b. When you were in high school (or perhaps middle school), you may have spent time hanging out at a mall. How was the mall like Facebook, MySpace, or other social networking Web sites? c. Malls will spend more money on decorations and entertainment when they can spread this cost over a large number of consumers. Again, when will you expect to see more of these extra expenses: In the months before Christmas or at other times? d. If Christmas is so great for malls, why don’t they have Christmas every month, spending money on decorations and singers all the time? Of course, they try to do this with Easter and back-to-school and Valentine’s Day, and so forth, but why do these fail so miserably compared with the big success of Christmas? Answer in the language of network goods. (Hint: Once there’s a big chunk of the popu¬lation committed to using Facebook, what’s the benefit to setting up another, pseudo-Facebook?) Solution 11. a. You’ll see more people during the months before Christmas. That makes you more willing to go to the mall, which in turn makes others more likely to go. The process feeds on itself, making the network good more and more valuable. b. Teenagers do the same things on Facebook that they do at malls: They gossip, they make friends, they tell stories. Since a mall is a network good, you’d expect some malls to succeed dramatically and others to fail miserably, just like social networking sites. There’s little room for a middle ground. c. They’ll offer more features during the busy times, which will in turn attract more customers. So they get yet another “social multiplier” effect. d. There’s a built-in customer base for Christmas, so all of the other shoppers are drawn in by the network effect of that core base of Christmas shoppers. It’s hard for other holidays to find that core base to start off with. 12. Suppose a friend is taking an economics course at another college or university and his professor uses a different textbook. Your friend, after learning about monopolies and the lost gains from trade that result from monopolies, becomes very agitated about firms with market power, and he makes this statement: “It should be strictly forbidden for any company, in any market, to have more than 50% market share—market power like this always leads to higher prices, deadweight loss and inefficiency!” After you calm him down, how would you respond to this statement? Is your friend right? Solution 12. No, your friend is not entirely right. In many cases it works just as he says: Market power leads to higher prices and deadweight loss. But there are some cases for which it is not this simple. Two such cases are presented in this chapter. First, you might want to explain to your friend that with many network goods, the establishment of one stan¬dard (which often involves one firm with a dominant market share) leads to increased efficiency. Secondly, contestable markets, even in non-network goods, do not always result in inefficiently high prices. In many markets, the mere threat of competition, if it is credible, is enough to force firms to behave as though they are in a competitive mar¬ket, even with a dominant market share. Finally, in a dynamic economy, a firm might have a high market share because it is outcompeting all the other firms! In 2011, Apple had an 81% market share in the market for tablets because Apple pioneered the category. Apple’s share has declined as other firms have caught on to their innovations. Challenges 13. Why doesn’t everyone just switch to one language? Solution 13. Switching costs are too high. Language is an example of a coordination game played by billions, where people in the same regions of the planet tend to choose the same language. This is similar to the side-of-the-road problem, except for the fact that the world really could become substantially richer if we all spoke the same language. The literature on “ethnolinguistic fractionalization” in economic development gives some evidence that countries in which people speak many languages are more likely to have wars, more likely to stay poor. Economist William Easterly, author of the ex¬cellent, compulsively readable book The Elusive Quest for Growth, is the best-known advocate of this view. His evidence is still disputed, but no one argues that it would be very convenient and would lower a lot of costs if we all spoke the same language. 14. Nobel Laureate Paul Krugman once asked “Who would enter a demolition derby without the incentive of a prize?” (Source: Krugman, Paul. 1998. Soft microeco¬nomics: The squishy case against you-know-who, Slate www.slate.com/id/1933/. Posted April 24, 1998.) a. The “demolition derby” he was talking about was the battle over Internet browsers: Many enter the battle, but only one (or two) survive. But let’s take his story literally: If there were two cars in a demolition derby, and each car costs $20,000 to build, and one car will be totally destroyed, how big will the prize probably have to be to get two people to enter if there’s a 50–50 chance of losing all your investment? b. What if we want a really good demolition derby: one where 10 of these cars compete but only one survives. About how big will the prize have to be now? c. Let’s draw the lesson for network goods: Since competition in network-good markets is competition “for the market,” then it’s like winning a prize in a demolition derby. If there’s a fixed price of starting up a new social networking Web site (you need so many computers, so many nerds, so many advertisers), then when would you see a lot of firms competing for the prize: when the prize is large or when the prize is small? Thus, if we want a lot of competition for the market, do we necessarily want to restrict the profits of the winner? Solution 14. a. You’ll need a prize at least twice the cost of each car: A $40,000 prize (or more if drivers are risk averse) will be needed. b. Then you’ll need at least 10 times the cost of a car: a $200,000 prize (or more). c. The larger the prize, the more firms will compete “for the market.” Restricting the profits of the prizewinner, such as by antitrust regulation, may feel good at the time but it means that fewer firms will enter the initial competition. Some¬what paradoxically, the net result of reducing the power of a monopolist may be less competition. 15. The market for college textbooks is an interesting one. One thing that makes it unique is that the person who chooses the textbook (the professor) is not the person who purchases the textbook (the student). Therefore, much of a text¬book publishing company’s marketing is geared toward college professors. Most publishers of economics textbooks have developed (or have partnered with other companies to provide) online homework-management systems. This textbook has one, as you may already know if your professor is using it. Explain how a homework-management system might benefit a professor. What impact might a homework-management system have on switching costs? Solution 15. Homework-management systems make things easier for professors because such systems make it easy to write, deliver, grade, and track homework assignments. However, once professors have created homework assignments and organized their courses within a homework-management system, the costs of switching to another publisher (or textbook) can be high. With these online systems, publishers can impose switching costs on professors, so that the publishers can achieve market power, raise prices, and earn more profit. Online grading is also great for students, but it’s useful to understand everyone’s incentives. CHAPTER 17 Modern Principles of Economics: Monopolistic Competition and Advertising Facts and Tools 1. Though its name can sometimes cause confusion for students, the market structure we call “monopolistic competition” is so named because it has some features of monopoly and some features of competition. a. In what ways is a monopolistically competitive market like a monopoly? In what ways is it like competition? b. Which of the outcomes of monopolistically competitive markets is a direct result of its monopoly-like features? Which outcome is a result of its competitive features? Can you summarize these results, so that they can be applied to product markets in general? Solution 1. a. Monopolistic competition is like a monopoly in that each firm is selling a unique, or differentiated, product, so each firm faces a downward-sloping demand curve. It is like competition in that there are a lot of firms in the market as a result of a lack of barriers to entry. b. Just like a monopoly, a firm in monopolistic competition charges a price that is greater than marginal cost because the demand curve is downward sloping. Just like a firm in perfect competition, a firm in monopolistic competition will earn zero profit in the long run. This is because new entrants will compete away any short-run profits. Generally speaking, we can conclude that differentiated prod¬ucts will be sold at prices higher than marginal cost, but easy entry into markets will drive profits toward zero. 2. In a city like New York, the market for stand-up comedians is likely to be mo¬nopolistically competitive. Explain why this is. If the market is monopolistically competitive, then what can be said about prices, output, and profits in this market? Solution 2. Monopolistic competition is a good description of the market for stand-up co¬medians in a city like New York because there are very many of them, the bar¬riers to entry are very low, and they are all a little different—each has their own style and, hopefully, their own material. Because of this, we would expect the results we normally get in monopolistic competition: Prices will be higher than marginal cost (what’s the marginal cost of letting one more person watch a stand-up routine?), each comedian (or comedy club, depending on the student’s take on the question) will have excess capacity, and profits will be equal to zero in the long run. 3. Fill in the blanks with “=,” “” as appropriate to describe the long-run outcome in a monopolistically competitive market. a. MC ____ AC b. P ____ AC c. MR ____ MC d. P ____ MC Solution 3. a. MC MC 4. For each of the following items, describe how the market that these sellers par¬ticipate in resembles monopolistic competition. For bonus points (if your profes¬sor agrees), describe briefly the strategies that sellers in the market use in order to differentiate their products. a. New car dealerships b. Real estate agents c. Landscapers Solution 4. a. There are often a lot of new car dealerships in most metropolitan areas, and each has a unique location, sells a unique set of vehicles from specific manufacturers or brands, and offers a unique shopping experience. Dealerships try to differen¬tiate themselves primarily through their service departments, their hours, their customer service philosophy, or their shopping experience. Shopping experience is a big one; it’s becoming more and more common now to find coffee shops, salons, or child care services inside a car dealership! b. There are lots of real estate agents in any market, and they are always clamor¬ing for more customers. They differ from one another in their (geographic or demographic) areas of expertise, the company or broker they work for, the relationships they have with other related vendors, and the extra services they provide. Real estate agents work hard trying to steal and retain customers—they send birthday cards, newsletters, and other communications frequently to try to establish a long-term relationship with a homeowner. c. There are lots of landscapers in any market, and they are always clamoring for more customers. They differ from one another in their areas of expertise, the equipment they use, the relationships they have with other related vendors, and the extra services they provide. Landscapers rely a lot on word of mouth and reputation and may advertise which of your neighbors are already using their services, as a way of implying a recommendation from your neighbor. Thinking and Problem Solving 5. As you read in the chapter, the requirements for an industry to be considered monopolistically competitive are that there are many firms and those firms are pro¬ducing unique, or differentiated, products. One industry in which we find differen¬tiated products is the recording industry. Not only are there many genres of music (iTunes lists almost 50), but within each genre there are countless artists, as well. Over the past few decades, technology has reduced the fixed costs of recording and the marginal costs of distributing music. In 1979, for example, the average studio bill for an album was over $30,000 ($170,000 in today’s dollars). Nowadays, with digital recording technology, an artist or band can record an entire album for a few thousand dollars and the album can be distributed at low cost as MP3s on the Internet, with no record store involved. a. What do you expect to happen to the music industry due to the evolution of much cheaper recording technology? What do you expect to happen to the number of recording artists? b. Suppose there are initially only two recording artists in all of the record industry: the Decemberists (an indie rock band) and Yo-Yo Ma (a famous cellist). How many MP3s will they each be able to sell? Who would buy MP3s from the Decemberists? What about from Yo-Yo Ma? Will anybody buy MP3s from both? c. Now suppose that another artist joins the industry: Isobel Campbell (an indie rock cellist!). What will happen to the demand curves for MP3s that the Decemberists and Yo-Yo Ma face? Will they keep all of their fans? Will they keep any of their fans? What do you think will happen to the total number of MP3s sold in the industry? d. Generally speaking, as technology makes it cheaper and cheaper to produce MP3s, and as more and more bands join the music industry, what will happen to the total number of MP3s downloaded by music fans? What will happen to the MP3s sold by each individual band? What will happen to the profits of each band? Solution 5. a. As recording technology becomes cheaper, more bands should enter the market, and profits should fall. b. Because there are so few bands, anyone who likes music at all will have to buy MP3s from either the Decemberists or Yo-Yo Ma, so they will each sell a lot of MP3s. Anyone who likes rock at all will have to buy from the Decemberists; anyone who likes classical music at all will have to buy from Yo-Yo Ma. Some people (in fact, many people) may buy both, because they like different genres of music. c. Isobel Campbell may draw some but not all fans away from the Decemberists and from Yo-Yo Ma. Some people would rather buy Isobel Campbell MP3s than the Decemberists or Yo-Yo Ma MP3s, so they will switch. Others will welcome the opportunity to listen to more music, so they will add Isobel Campbell MP3s to the MP3s they were already going to purchase. Each band will sell fewer after she joins the market, but the total sold in the market should go up. d. As more bands enter the market, the number of MP3s downloaded by music fans will increase, even though the number downloaded from each individual band will decrease. Reduced costs of distributing music will let people ex¬periment with different genres at lower costs. MP3 singles rather than albums become the norm. Profits, as well, will decrease as each band has less “market power” and faces less and less demand for its MP3s. 6. In a famous article on advertising, Gary Becker and Kevin Murphy wrote about advertisements that run during television programs: “One can say either that adver¬tising pays for the programming—the usual interpretation—or that programming compensates for the advertising, which is our preferred interpretation.” Viewing ads during a television program (or hearing them during a radio broadcast) makes consumers worse off, so they must be compensated (with programming) for having experienced the ads. On the other hand, print ads in newspapers and magazines can be avoided by consumers, so these ads must make consumers better off; otherwise, no one would ever read them. Use this theory to answer the following questions: a. Think about the different types of advertisements discussed in the chapter (informative, signaling, part of the product). Which type is more likely to appear on TV? Which type is more likely to appear in a newspaper or magazine? Often you’ll see television com¬mercials, especially for pharmaceuticals, that say: “See our ad in such-and-such magazine.” What does this say about the difference between television and print ads? b. Becker and Murphy wrote their article before TiVo and other DVR systems became popular. Nowadays, ads on television are avoidable (to a degree), just like ads in a newspaper. What impact do you think this new technology has on the types of ads you see on TV? Solution 6. a. Television advertisements tend to be less informative than newspaper or magazine advertisements. Print ads often include lots of information. Those uninformative ads, if Becker and Murphy are right, must make consumers worse off. But, as the textbook points out, these kinds of ads might actually increase the value of the good they advertise—even if the ads themselves make consumers worse off. The “see our ad” technique is employed to take advantage of the different advertising media. For example, a pharmaceutical company may want to convey lots of complicated information, but a television ad may not be the right place for this kind of information; rather, in a television spot, the pharmaceutical company wants to accomplish the task of increasing the value of the product—not necessarily creating value from the ad itself. b. If TV ads become avoidable because of DVR technology, then they will have to become ads that make consumers better off, not worse off. This can be done if TV ads contain more information (like newspaper ads), but TV ads have potential that newspaper ads don’t have: They can become as entertaining (sometimes more entertaining) than the TV programs during which they air. If advertisers start making commercials that are really funny, for example, people will want to watch them, despite their ability to fast forward, just to be entertained. New technologies such as DVRs, therefore, should cause firms to invest more in making ads entertaining. Most important, with DVRs, ads will become incorporated into the television show itself so they cannot be skipped. Did you see the ad in the American Idol photo? 7. Why do you think chain restaurants like Chili’s, Applebee’s, and TGI Fridays are always changing their menus—introducing new appetizers, new entrees, and new cocktails? Are they all just trying to find the perfect menu, or is there something else going on? Solution 7. Something else is going on—these restaurants are trying constantly to differentiate themselves from one another and from other restaurants in a given market. If any of these restaurants were to “settle” on a menu and leave it unchanged, then over time any number of competitors would be able to replicate the menu and offer the same set of menu items and amenities. The constant menu rotation is a (potentially costly) way of preserving product differentiation and market power. 8. Wrigley’s spends around $30 million per year on intense, over-the-top commercials that claim to showcase what it feels like to chew 5® Gum—Wrigley’s second most popular gum brand. Despite claiming, in a tongue-in-cheek way, to provide infor¬mation about the gum to viewers, it is obvious that very little information is em¬bedded in the high-concept, visually stimulating commercials. So what is the point of the advertising? How would an economist view this type of advertising? How do you view it? Would it be better to have a perfectly competitive market in gum? Solution 8. The point of this advertising is to differentiate this product (even if only in the minds of television viewers) from the other gums on the market. No one view of this kind of ad¬vertising is universal among economists. However, some views may be more common. If this advertising doesn’t help consumers make better choices—and it is costly—then some economists might view it as a waste, particularly because it creates market power, which leads to lost gains from trade (deadweight loss). On the other hand, a competi¬tive gum market would have more efficiency, but it would result in fairly standardized gum, with many producers all producing essentially the same product. Some economists identify the trade-off between the positive outcome of greater variety and the negative outcome of less efficiency as an important one worthy of careful consideration. 9. Many restaurants are not 100% full all day long, especially in the late morning and during the afternoon. Economists call this “excess capacity” and it is a characteristic result of monopolistic competition. What would restaurants have to do in order to be closer to 100% full all of the time? Why won’t they do this? Solution 9. If restaurants lowered their prices, they could attract more customers. They do, after all, face downward-sloping demand curves. Restaurants don’t do this, however, because they would lose money. First, having to reduce menu prices means that you are reducing the price even for the customers that are already choosing to eat at the restaurant; because a profit-maximizing restaurant already has prices as low as they can be, lowering prices any further would cause the restaurant’s profits to fall, because the ad¬ditional revenue brought in (adjusted for the lost revenue of cheaper meals to extant customers) would not be enough to offset the additional cost of providing the meals. Secondly, consider the fact that the restaurant faces significant competition—this is what has driven the price down to its current level. Even though restaurants charge a markup on marginal cost (i.e., they charge you more for the food than the ingredients and labor cost them to buy), the price of the food is, in the long run, exactly equal to the average cost (including overhead and capital) of producing it. There simply is no room for the price to fall any lower. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766