Market Structure

Haripriya Gundimeda

Introduction: A Scenario
Four years after graduating, you run your own
business.
You have to decide how much to produce, what price
to charge, how many workers to hire, etc.
What factors should affect these decisions?
Your costs
How much competition you face
We begin by studying the behavior of firms in
perfectly competitive markets.

Competition and the Market Structure

Price Control and the Market Structure

Least control over price

Most control over price

Very
Many

Agric. products
Fishery

Some

Fair
Amount

Extensive
Fair amount

with

differentiated

Extensive

oligopolies

Cable TV
Water

Characteristics of Perfect Competition

1. Many buyers and many sellers
2. The goods offered for sale are largely the same

(homogeneous products).
3. Firms can freely enter or exit the market.

Because of 1 & 2, each buyer and seller is a

price taker takes the price as given.

The Meaning of Competition

As a result of its characteristics, the
perfectly competitive market has the
following outcomes:
The actions of any single buyer or seller in the
market have a negligible impact on the market
price.
Each buyer and seller takes the market price
as given.

Why Monopolies Arise

The main cause of monopolies is barriers

to entry other firms cannot enter the
market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the worlds
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws

Monopoly
A monopoly is a firm that is the sole seller
of a product without close substitutes.
The key difference:
A monopoly firm has market power, the
ability to influence the market price of the
product it sells. A competitive firm has no
market power.

Why Monopolies Arise

3. Natural monopoly: a single firm can produce
the entire market Q at lower ATC than could
several firms.
Example: 1000 homes
need electricity.
ATC is lower if
one firm services
all 1000 homes
than if two firms
each service
500 homes.

Cost

Electricity
Economies of
scale due to
huge FC

$80

$50

ATC
500

1000

Demand curve for a Perfectly competitive

firm

D
Q

Industry Output

Firm output

The firms demand curve looks infinitely elastic.

A perfect competitor has such a small fraction of the market
that it can sell all it wants at the market price

Monopoly vs. Competition: Demand Curves

A monopolist is the only
seller, so it faces the
market demand curve.
To sell a larger Q,
the firm must reduce P.

A monopolists
demand curve

Thus, MR P.

The Revenue of a Competitive Firm

Total revenue (TR)

Average revenue (AR)

Marginal Revenue
(MR):
The change in TR from
selling one more unit.

TR = P x Q

TR
=P
AR =
Q
TR
MR =
Q

MR = P for a Competitive Firm

A competitive firm can keep increasing its
output without affecting the market price.
So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.
MR = P is only true for
firms in competitive markets.

PROFIT MAXIMIZATION AND THE

COMPETITIVE FIRMS SUPPLY CURVE
The goal of a competitive firm is to maximize
profit.
This means that the firm will want to produce
the quantity that maximizes the difference
between total revenue and total cost.

Profit Maximization
What Q maximizes the firms profit?
To find the answer,
Think at the margin.
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
If MR > MC, then increase Q to raise profit.
If MR < MC, then reduce Q to raise profit.

Profit
Maximization
(continued from earlier exercise)
At any Q with
MR > MC,
increasing Q
raises profit.
At any Q with
MR < MC,
reducing Q
raises profit.

Profi M
Q TR TC
t
R
0

1 10

2 20 15

3 30 23

4 40 33

5 50 45

M Profit =
C MR MC

10

10

10

10 10

10 12

MC and the Firms Supply Decision

Rule: MR = MC at the profit-maximizing Q.

At Qa, MC < MR.

So, increase Q
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit.
At Q1, MC = MR.
Changing Q
would lower
profit.

Costs
MC

MR

P1

Q a Q 1 Qb

MC and the Firms Supply Decision

Costs
If price rises to P2,
then the profitmaximizing quantity P2
rises to Q2.

The MC curve
determines the
firms Q at any
price.

MC

MR2
MR

P1

Hence, the MC curve is the

firms supply curve.

Q1

Q2

Figure 1 Profit Maximization for a Competitive Firm

Costs
and
Revenue

The firm maximizes

profit by producing
the quantity at which
marginal cost equals
marginal revenue.

Suppose the market price is P.

MC
If the firm produces
Q2, marginal cost is
MC2.
ATC

MC2

P = MR1 = MR2

P = AR = MR
AVC

If the firm
produces Q1,
marginal cost is
MC1.

MC1

Q1

QMAX

Q2

Quantity

Marginal Cost is the Competitive Firms Supply

Curve
Price

P2

So, this section of the

firms MC curve is
also the firms supply
curve.

As P increases, the firm will

select its level of output
along the MC curve.

MC

ATC

P1
AVC

Q1

Q2

Quantity

A Monopoly Does Not Have an S Curve

A competitive firm
takes P as given
has a supply curve that shows how its Q
depends on P

A monopoly firm
is a price-maker, not a price-taker
Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.

So there is no supply curve for monopoly.

Profit-Maximization
Like a competitive firm, a monopolist
maximizes profit by producing the quantity
where MR = MC.
Once the monopolist identifies this
quantity, it sets the highest price
consumers are willing to pay for that
quantity.
It finds this price from the D curve.

Profit-Maximization
1. The profitmaximizing Q
is where
MR = MC.

Costs and
Revenue

MC

2. Find P from
the demand
curve at this Q.

MR

Quantity

Profit-maximizing output

The Monopolists Profit

Costs and
Revenue

As with a
competitive firm,
the monopolists
profit equals

MC

ATC

ATC
D

(P ATC) x Q

MR

Quantity

Understanding the Monopolists MR

Increasing Q has two effects on revenue:
The output effect:
More output is sold, which raises revenue
The price effect:
The price falls, which lowers revenue
To sell a larger Q, the monopolist must reduce the
price on all the units it sells.
Hence, MR < P
MR could even be negative if the price effect
exceeds the output effect

Case Study: Monopoly vs. Generic Drugs

Patents on new drugs
Price
give a temporary
monopoly to the seller.

The market for

a typical drug

PM
When the
patent expires,
PC = MC
the market
becomes competitive,
generics appear.

MR

QM

Quantity

QC

Shutdown vs. Exit

Shutdown:
A short-run decision not to produce anything
because of market conditions.
Exit:
A long-run decision to leave the market.
A firm that shuts down temporarily must still
pay its fixed costs. A firm that exits the
market does not have to pay any costs at all,
fixed or variable.

A Firms Short-run Decision to Shut

Down
If firm shuts down temporarily,
revenue falls by TR
costs fall by VC

So, the firm should shut down if TR < VC.

Divide both sides by Q: TR/Q < VC/Q
So we can write the firms decision as:
Shut down if P < AVC

A Competitive Firms SR Supply

Curve

The firms SR
supply curve
is the portion
of
its MC curve
above AVC.

If P > AVC, then

firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).

Costs
MC

ATC
AVC

The Irrelevance of Sunk Costs

Sunk cost: a cost that has already been
committed and cannot be recovered
Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed
costs whether it produces or shuts down.
So, FC should not matter in the decision to
shut down.

A Firms Long-Run Decision to Exit

If firm exits the market,
revenue falls by TR
costs fall by TC

So, the firm should exit if TR < TC.

Divide both sides by Q to rewrite the
firms decision as:
Exit if P < ATC

A New Firms Decision to Enter Market

In the long run, a new firm will enter the
market if it is profitable to do so: if TR >
TC.
Divide both sides by Q to express the
firms entry decision as:
Enter if P > ATC

The Competitive Firms Supply Curve

The firms
LR supply
curve is the
portion of
its MC curve
above
LRATC.

Costs
MC
LRATC

Identifying a firms profit

A competitive firm
Costs, P

Determine
this firms
total profit.
Identify the
area on the
graph that
represents
the firms
profit.

MC
MR
ATC

P = $10
$6

50

35

Answers
A competitive firm
Costs, P

profit per unit

= P ATC
= $10 6
= $4

MC
MR
ATC

P = $10

profit
$6

Total profit
= (P ATC) x Q
= $4 x 50
= $200

50

36

Identifying a firms loss

A competitive firm
Costs, P

Determine
this firms
total loss.
Identify the
area on the
graph that
represents
the firms
loss.

MC
ATC

$5

MR

P = $3

30

37

Answers
A competitive firm
Costs, P

MC

Total loss
= (ATC P) x Q
= $2 x 30
= $60

ATC

$5
P = $3

loss

loss per unit = $2

MR

30

38

Market Supply: Assumptions

1) All existing firms and potential entrants have
identical costs.
2) Each firms costs do not change as other firms enter
or exit the market.

3) The number of firms in the market is

fixed in the short run
(due to fixed costs)
variable in the long run
(due to free entry and exit)

The SR Market Supply Curve

As long as P AVC, each firm will
produce its profit-maximizing quantity,
where MR = MC.
At each price, the market quantity supplied
is the sum of quantity supplied by each
firm.

The SR Market Supply Curve

Example: 1000 identical firms.
At each P, market Qs = 1000 x (one firms Qs)
P

One firm
MC

P3

P3

P2

P2

AVC

P1

Market
S

P1
10 20 30

Q
(firm)

Q
(market)
10,000

20,000 30,000

Entry & Exit in the Long Run

In the LR, the number of firms can change
due to entry & exit.
If existing firms earn positive economic
profit,
New firms enter.
SR market supply curve shifts right.
P falls, reducing firms profits.
Entry stops when firms economic profits have
been driven to zero.

Entry & Exit in the Long Run

In the LR, the number of firms can change
due to entry & exit.
If existing firms incur losses,
Some will exit the market.
SR market supply curve shifts left.
P rises, reducing remaining firms losses.
Exit stops when firms economic losses have
been driven to zero.

The Zero-Profit Condition

Long-run equilibrium:
The process of entry or exit is complete
remaining firms earn zero economic profit.

Zero economic profit occurs when P = ATC.

Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
Recall that MC intersects ATC at minimum
ATC.
Hence, in the long run, P = minimum ATC.

The LR Market Supply Curve

The LR market supply
curve is horizontal at
P = minimum ATC.

In the long run,

the typical firm
earns zero profit.
P

One firm
MC

Market

LRATC
P=
min.
ATC

long-run
supply

Q
(firm)

Q
(market)

Why Do Firms Stay in Business if Profit = 0?

Recall, economic profit is revenue minus all
costs including implicit costs, like the
opportunity cost of the owners time and
money.
In the zero-profit equilibrium, firms earn
enough revenue to cover these costs.

SR & LR Effects of an Increase in Demand

A firm begins in longbut then an increase in
run eqm
demand raises P,
leading to SR profits driving profits to zero
for the firm.
and restoring long-run eqm.

One firm

Over time, profits induc

entry,
shifting S to the right,
reducing P

Market

S1

MC
Profit

S2

ATC
P2

P2
P1

P1

Q
(firm)

B
A

long-run
supply
D1

Q1 Q2

Q3

D2

Q
(market)

Why the LR Supply Curve Might Slope Upward

The LR market supply curve is horizontal if

1) all firms have identical costs, and

2) costs do not change as other firms enter or exit the
market.

For example,
Production of many commodities example textiles
can be expanded by merely duplicating factors of
production
In this case the long run supply curve is horizontal
2) If either of these assumptions is not true, then LR supply
curve slopes upward.

1) Firms Have Different Costs

As P rises, firms with lower costs enter the
market before those with higher costs.
Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
Hence, LR market supply curve slopes
upward.
At any P,
For the marginal firm,
P = minimum ATC and profit = 0.

For lower-cost firms, profit > 0.

2) Costs Rise as Firms Enter the Market

In some industries, the supply of a key input is limited
(e.g., theres a fixed amount of land suitable for
farming).
The entry of new firms increases demand for this
input, causing its price to rise.
This increases all firms costs.
Hence, an increase in P is required to increase the
market quantity supplied, so the supply curve is
upward-sloping.
Supply curve can be vertical if inputs are fixed (e.g.
Monalisa, Land).

CONCLUSION: The Efficiency of a

Competitive Market
Profit-maximization:

MC = MR

Perfect competition:

P = MR

So, in the competitive eqm:

P = MC
Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
So, the competitive eqm is efficient, maximizes total
surplus.
In the next chapter, monopoly: pricing & production
decisions, deadweight loss, regulation.

CHAPTER SUMMARY

For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.
If P > AVC, a firm maximizes profit by producing the
quantity where MR = MC. If P < AVC, a firm will
shut down in the short run.
If P < ATC, a firm will exit in the long run.
In the short run, entry is not possible, and an increase
in demand increases firms profits.

With free entry and exit, profits = 0 in the long run,

and P = minimum ATC.

In this chapter, look for the answers to these

questions:
Why do monopolies arise?

Why is MR < P for a monopolist?

How do monopolies choose their P and Q?
How do monopolies affect societys well-being?
What can the government do about monopolies?
What is price discrimination?

CHAPTER 15
MONOPOLY

The Welfare Cost of Monopoly

Recall: In a competitive market

equilibrium,
P = MC and total surplus is maximized.
In the monopoly eqm, P > MR = MC

The value to buyers of an additional unit (P)

exceeds the cost of the resources needed to
produce that unit (MC).
The monopoly Q is too low
could increase total surplus with a larger Q.
Thus, monopoly results in a deadweight loss.

The Welfare Cost of Monopoly

Competitive eqm:
quantity = QE
P = MC
total surplus is
maximized

Monopoly eqm:
quantity = QM
P > MC
deadweight loss

Price

Deadweight
MC
loss

P
P = MC

MC
D

MR

QM Q E

Quantity

Public Policy Toward Monopolies

Increasing competition with antitrust laws
Examples: Monopolies restrictive Trade
Practices Act
Antitrust laws ban certain anticompetitive
practices, allow govt to break up monopolies.
Regulation
Govt agencies set the monopolists price
For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
If so, regulators might subsidize the monopolist or
set P = ATC for zero economic profit.

Public Policy Toward Monopolies

Public ownership
Example: Indian Posts
Problem: Public ownership is usually less
efficient since no profit motive to minimize
costs
Doing nothing
The foregoing policies all have drawbacks,
so the best policy may be no policy.

Price Discrimination
Discrimination is the practice of treating people
differently based on some characteristic, such as
race or gender.
Price discrimination is the business practice of
selling the same good at different prices to different
buyers.
The characteristic used in price discrimination
is willingness to pay (WTP):
A firm can increase profit by charging a higher
price to buyers with higher WTP.

Perfect Price Discrimination vs.

Single Price Monopoly
Here, the monopolist
charges the same
price (PM) to all
buyers.
A deadweight loss
results.

Price

Monopoly
profit

Consumer
surplus
Deadweight
loss

PM
MC

D
MR

QM

Quantity

Perfect Price Discrimination vs.

Single Price Monopoly
Here, the monopolist
produces the
competitive quantity,
but charges each
buyer his or her WTP.
This is called perfect
price discrimination.
The monopolist
captures all CS
as profit.
But theres no DWL.

Price

Monopoly
profit

MC
D
MR
Quantity

Price Discrimination in the Real World

In the real world, perfect price

discrimination is not possible:
no firm knows every buyers WTP
buyers do not announce it to sellers

So, firms divide customers into groups

based on some observable trait
that is likely related to WTP, such as age.

Examples of Price
Discrimination
Movie tickets
Discounts for seniors, students, and people
who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help
distinguish business travelers, who usually have
higher WTP, from more price-sensitive leisure
travelers.

Examples of Price
Discrimination
Discount coupons
People who have time to clip and organize
coupons are more likely to have lower
income and lower WTP than others.
Need-based financial aid
Low income families have lower WTP for
their childrens college education.
Schools price-discriminate by offering
need-based aid to low income families.

Examples of Price
Discrimination
Quantity discounts
A buyers WTP often declines with
additional units, so firms charge less per
unit for large quantities than small ones.
Example: Charging rs 40 for small pop
corn and 60 for large popcorn as big

CONCLUSION: The Prevalence of Monopoly

In the real world, pure monopoly is rare.

Yet, many firms have market power, due
to
selling a unique variety of a product
having a large market share and few
significant competitors

In many such cases, most of the results

from this chapter apply, including
markup of price over marginal cost
CHAPTER 15
deadweight loss
MONOPOLY

CHAPTER SUMMARY
A monopoly firm is the sole seller in its market.
Monopolies arise due to barriers to entry,
including: government-granted monopolies, the
control of a key resource, or economies of scale
over the entire range of output.
A monopoly firm faces a downward-sloping
demand curve for its product. As a result, it must
reduce price to sell a larger quantity, which causes
marginal revenue to fall below price.

CHAPTER SUMMARY
Monopoly firms maximize profits by producing the
quantity where marginal revenue equals marginal
cost. But since marginal revenue is less than
price, the monopoly price will be greater than
marginal cost, leading to a deadweight loss.
Policymakers may respond by regulating
monopolies, using antitrust laws to promote
competition, or by taking over the monopoly and
running it. Due to problems with each of these
options, the best option may be to take no action.

CHAPTER SUMMARY
Monopoly firms (and others with market power) try
to raise their profits by charging higher prices to
consumers with higher willingness to pay. This
practice is called price discrimination.

Comparing Perfect & Monop. Competition

perfect
competition

monopolistic
competition

number of sellers

many

many

free entry/exit

yes

yes

long-run econ. profits

zero

zero

the products firms sell

identical

differentiated

firm has market power? none, price-taker

yes

D curve facing firm

downwardsloping

horizontal

Comparing Monopoly & Monop. Competition

monopoly

monopolistic
competition

number of sellers

one

many

free entry/exit

no

yes

long-run econ. profits

positive

zero

firm has market power?

yes

yes

D curve facing firm

downwarddownwardsloping
sloping
(market demand)

close substitutes

none

many

Comparing Oligopoly & Monop. Competition

oligopoly

number of sellers

few

monopolistic
competition

many

importance of strategic
high
interactions between firms

low

likelihood of fierce
competition

high

low

A Monopolistically Competitive Firm Earning

Profits in the Short Run
The firm faces a
downward-sloping
D curve.

Price
profit

At each Q, MR < P.
To maximize profit,
firm produces Q
where MR = MC.

MC
ATC

P
ATC

The firm uses the

D curve to set P.

MR
Q

Quantity

A Monopolistically Competitive Firm

With Losses in the Short Run
For this firm,
P < ATC
at the output where
MR = MC.

Price

The best this firm

can do is to
minimize its losses.

ATC

MC
losses

ATC

D
MR
Q

Quantity

Monopolistic Competition and Monopoly

Short run: Under monopolistic competition,
firm behavior is very similar to monopoly.
Long run: In monopolistic competition,
entry and exit drive economic profit to zero.
If profits in the short run:
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
If losses in the short run:
Some firms exit the market,
remaining firms enjoy higher demand and
prices.

A Monopolistic Competitor in the Long Run

Entry and exit
occurs until
P = ATC and
profit = zero.
Notice that the
firm charges a
markup of price
over marginal
cost, and does
not produce at
minimum ATC.

Price
MC
ATC
P = ATC
markup

D
MC

MR

Quantity

Why Monopolistic Competition Is

Less Efficient than Perfect Competition

1. Excess capacity
The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing
output.
Under perfect competition, firms produce the
quantity that minimizes ATC.

2. Markup over marginal cost

Under monopolistic competition, P > MC.
Under perfect competition, P = MC.

Monopolistic Competition and Welfare

Monopolistically competitive markets do not
have all the desirable welfare properties of
perfectly competitive markets.
Because P > MC, the market quantity is below
the socially efficient quantity.
Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
to reduce prices.

Monopolistic Competition and Welfare

Number of firms in the market may not be optimal,

due to external effects from the entry of new firms:
the product-variety externality:
surplus consumers get from the introduction
of new products
the business-stealing externality:
losses incurred by existing firms
when new firms enter market
The inefficiencies of monopolistic competition are
subtle and hard to measure. No easy way for
policymakers to improve the market outcome.

Advertising
In monopolistically competitive industries,
product differentiation and markup pricing
lead naturally to the use of advertising.
In general, the more differentiated the
products,
the more advertising firms buy.
Economists disagree about the social
value of advertising.

The Critique of Advertising

Critics of advertising believe:
Society is wasting the resources it devotes to
advertising.

Firms advertise to manipulate peoples tastes.

Advertising impedes competition
it creates the perception that products are
more differentiated than they really are,
allowing higher markups.

The Defense of Advertising

Defenders of advertising believe:

It provides useful information to buyers.

Informed buyers can more easily find and
exploit price differences.
Thus, advertising promotes competition and
reduces market power.
Results of a prominent study:
Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers
than in states that did not restrict such advertising.

Advertising as a Signal of Quality

A firms willingness to spend huge amounts

on advertising may signal the quality of its product
to consumers, regardless of the content of ads.

Ads may convince buyers to try a product once,

but the product must be of high quality for people
to become repeat buyers.
The most expensive ads are not worthwhile
unless they lead to repeat buyers.
When consumers see expensive ads,
they think the product must be good if the
company
is willing to spend so much on advertising.

Brand Names
In many markets, brand name products coexist
with generic ones.
Firms with brand names usually spend more on
advertising, charge higher prices for the products.
As with advertising, there is disagreement about
the economics of brand names

The Critique of Brand Names

Critics of brand names believe:
Brand names cause consumers to perceive
differences that do not really exist.
Consumers willingness to pay more for brand
names is irrational, fostered by advertising.
Eliminating govt protection of trademarks
would reduce influence of brand names,
result in lower prices.

The Defense of Brand Names

Defenders of brand names believe:
Brand names provide information about
quality to consumers.
Companies with brand names have incentive
to maintain quality, to protect the reputation of
their brand names.

CONCLUSION
Differentiated products are everywhere;
examples of monopolistic competition
abound.
The theory of monopolistic competition
describes many markets in the economy,
yet offers little guidance to policymakers
looking to improve the markets allocation
of resources.

CHAPTER SUMMARY
A monopolistically competitive market has
many firms, differentiated products, and free entry.
Each firm in a monopolistically competitive market
has excess capacity produces less than the
quantity that minimizes ATC. Each firm charges a
price above marginal cost.

CHAPTER SUMMARY
Monopolistic competition does not have all of the
desirable welfare properties of perfect competition.
There is a deadweight loss caused by the markup
of price over marginal cost. Also, the number of
firms (and thus varieties) can be too large or too
small. There is no clear way for policymakers to
improve the market outcome.

CHAPTER SUMMARY
Product differentiation and markup pricing lead to
the use of advertising and brand names. Critics of
advertising and brand names argue that firms use
them to reduce competition and take advantage of
consumer irrationality. Defenders argue that firms
use them to inform consumers and to compete
more vigorously on price and product quality.

Introduction:
Between Monopoly and Competition
Two extremes
Competitive markets: many firms, identical
products
Monopoly: one firm

In between these extremes

Oligopoly: only a few sellers offer similar or
identical products.
Monopolistic competition: many firms sell
similar but not identical products.

Measuring Market
Concentration
Concentration ratio: the percentage of
the markets total output supplied by its
four largest firms.
The higher the concentration ratio,
the less competition.
This chapter focuses on oligopoly,
a market structure with high concentration
ratios.

Concentration Ratios in Selected U.S. Industries

Industry

Video game consoles

Tennis balls
Credit cards
Batteries
Soft drinks
Web search engines
Breakfast cereal
Cigarettes
Greeting cards
Beer
Cell phone service
Autos

Concentration ratio

100%
100%
99%
94%
93%
92%
92%
89%
88%
85%
82%
79%

EXAMPLE: Cell Phone Duopoly in Smalltown

Smalltown has 140 residents

$0

140

130

10

120

15

110

20

100

25

90

30

80

(duopoly: an oligopoly with two firms)

35

70

Each firms costs: FC = $0, MC = $10

40

60

45

50

CHAPTER 16
OLIGOPOLY

The good:
cell phone service with unlimited
anytime minutes and free phone

Smalltowns demand schedule

Two firms: Cingular, Verizon

EXAMPLE: Cell Phone Duopoly in Smalltown

P

$0

140

130

650

1,300

650

10

120

1,200

1,200

15

110

1,650

1,100

550

20

100

2,000

1,000

1,000

25

90

2,250

900

1,350

30

80

2,400

800

1,600

35

70

2,450

700

1,750

40

60

2,400

600

1,800

45

50

2,250

500

1,750

CHAPTER 16
OLIGOPOLY

Revenue

Cost

Profit

$0 $1,400 1,400

Competitive
outcome:
P = MC = $10
Q = 120
Profit = $0

Monopoly
outcome:
P = $40
Q = 60
Profit = $1,800

EXAMPLE: Cell Phone Duopoly in Smalltown

One possible duopoly outcome: collusion

Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
Cingular and Verizon could agree to each produce
half of the monopoly output:
For each firm: Q = 30, P = $40, profits = $900
Cartel: a group of firms acting in unison,
e.g., Cingular and Verizon in the outcome with
collusion

CHAPTER 16
OLIGOPOLY

1:
Collusion vs. self-interest
ACTIVE LEARNING

$0

140

130

10

120

15

110

20

100

25

90

30

80

35

70

40

60

45

50

Duopoly outcome with collusion:

Each firm agrees to produce Q = 30,
earns profit = $900.
If Cingular reneges on the agreement and
produces Q = 40, what happens to the
market price? Cingulars profits?
Is it in Cingulars interest to renege on the
agreement?

If both firms renege and produce Q = 40,

determine each firms profits.
96

ACTIVE LEARNING

1:

Answers
P

$0

140

130

10

120

15

110

20

100

25

90

30

80

35

70

40

60

45

50

If both firms stick to agreement,

each firms profit = $900
If Cingular reneges on agreement and
produces Q = 40:
Market quantity = 70, P = $35
Cingulars profit = 40 x ($35 10) = $1000

Cingulars profits are higher if it reneges.

Verizon will conclude the same, so
both firms renege, each produces Q = 40:
Market quantity = 80, P = $30
Each firms profit = 40 x ($30 10) = $800

Collusion vs. Self-Interest

Both firms would be better off if both stick
to the cartel agreement.
But each firm has incentive to renege on
the agreement.
Lesson:
It is difficult for oligopoly firms to form
cartels and honor their agreements.

2:
The oligopoly equilibrium
ACTIVE LEARNING

$0

140

130

10

120

15

110

20

100

25

90

30

80

35

70

40

60

45

50

If each firm produces Q = 40,

market quantity = 80
P = $30
each firms profit = $800

Is it in Cingulars interest to increase its

output further, to Q = 50?
Is it in Verizons interest to increase its
output to Q = 50?

99

ACTIVE LEARNING

2:

Answers
P

$0

140

130

10

120

15

110

20

100

25

90

30

80

35

70

40

60

45

50

If each firm produces Q = 40,

then each firms profit = $800.

If Cingular increases output to Q = 50:

Market quantity = 90, P = $25
Cingulars profit = 50 x ($25 10) = $750
Cingulars profits are higher at Q = 40
than at Q = 50.
The same is true for Verizon.

100

The Equilibrium for an Oligopoly

Nash equilibrium: a situation in which

economic participants interacting with one another
each choose their best strategy given the strategies
that all the others have chosen
Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.

Given that Verizon produces Q = 40,

Cingulars best move is to produce Q = 40.
Given that Cingular produces Q = 40,
Verizons best move is to produce Q = 40.
CHAPTER 16
OLIGOPOLY

A Comparison of Market
Outcomes
When firms in an oligopoly individually
choose production to maximize profit,
Q is greater than monopoly Q
but smaller than competitive market Q

P is greater than competitive market P

but less than monopoly P

CHAPTER 16
OLIGOPOLY

The Output & Price Effects

Increasing output has two effects on a firms profits:
output effect:
If P > MC, selling more output raises profits.
price effect:
Raising production increases market quantity,
which reduces market price and reduces profit
on all units sold.
If output effect > price effect,
the firm increases production.
If price effect > output effect,
the firm reduces production.
CHAPTER 16
OLIGOPOLY

The Size of the Oligopoly

As the number of firms in the market increases,

the price effect becomes smaller
the oligopoly looks more and more like a
competitive market
P approaches MC
the market quantity approaches the socially
efficient quantity

Another benefit of international trade:

Trade increases the number of firms competing,
increases Q, keeps P closer to marginal cost
CHAPTER 16
OLIGOPOLY

Game Theory
Game theory: the study of how people
behave in strategic situations
Dominant strategy: a strategy that is
best
for a player in a game regardless of the
strategies chosen by the other players
Prisoners dilemma: a game between
two captured criminals that illustrates
why cooperation is difficult even when it is
CHAPTER 16
mutually beneficial
OLIGOPOLY

Prisoners Dilemma Example

The police have caught Bonnie and Clyde,

two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
The police question each in separate rooms,
offer each the following deal:
If you confess and implicate your partner,
you go free.
If you do not confess but your partner implicates
you, you get 20 years in prison.
If you both confess, each gets 8 years in prison.

CHAPTER 16
OLIGOPOLY

Prisoners Dilemma Example

Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnies decision
both confess
Confess

Confess

Clydes
decision

Bonnie gets
8 years

Clyde
gets 8 years
Bonnie goes
free

Remain
silent Clyde
gets 20 years
CHAPTER 16
OLIGOPOLY

Remain silent
Bonnie gets
20 years
Clyde
goes free
Bonnie gets
1 year

Clyde
gets 1 year

Prisoners Dilemma Example

Outcome: Bonnie and Clyde both
confess,
each gets 8 years in prison.
Both would have been better off if both
remained silent.
But even if Bonnie and Clyde had agreed
before being caught to remain silent, the
logic of self-interest takes over and leads
them to confess.
CHAPTER 16
OLIGOPOLY

Oligopolies as a Prisoners Dilemma

When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners dilemma.
Our earlier example:
Cingular and Verizon are duopolists in
Smalltown.
The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
Here is the payoff matrix for this example

Cingular & Verizon in the Prisoners Dilemma

Each firms dominant strategy: renege on agreement,
produce Q = 40.
Cingular

Q = 30

Q = 30
Verizon
Q = 40

CHAPTER 16
OLIGOPOLY

Cingulars
profit = $900

Verizons
profit = $900
Cingulars
profit = $750
Verizons profit
= $1000

Q = 40
Cingulars
profit = $1000
Verizons
profit = $750

Cingulars
profit = $800
Verizons
profit = $800

ACTIVE LEARNING

3:

The fare wars game

The players: American Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone.
If both airlines cut fares,
each airlines profit = $400 million
If neither airline cuts fares,
each airlines profit = $600 million
If only one airline cuts its fares,
its profit = $800 million
the other airlines profits = $200 million
Draw the payoff matrix, find the Nash equilibrium.
111

ACTIVE LEARNING

3:

Answers
Nash equilibrium:
both firms cut fares

American Airlines
Cut fares
$400 million

Dont cut fares

$200 million

Cut fares
United
Airlines

$400 million
$800 million

$800 million
$600 million

Dont cut
fares
$200 million

$600 million
112

Other Examples of the Prisoners Dilemma

Ad Wars
Two firms spend millions on TV ads to steal
business from each other. Each firms ad
cancels out the effects of the other,
and both firms profits fall by the cost of the ads.

Organization of Petroleum Exporting Countries

Member countries try to act like a cartel, agree to
limit oil production to boost prices & profits.
But agreements sometimes break down
when individual countries renege.

Other Examples of the Prisoners Dilemma

Arms race between military superpowers
Each country would be better off if both disarm,
but each has a dominant strategy of arming.
Common resources
All would be better off if everyone conserved
common resources, but each persons dominant
strategy is overusing the resources.

Prisoners Dilemma and Societys Welfare

The noncooperative oligopoly equilibrium
bad for oligopoly firms:
prevents them from achieving monopoly
profits
good for society:
Q is closer to the socially efficient output
P is closer to MC
In other prisoners dilemmas, the inability to
cooperate may reduce social welfare.
e.g., arms race, overuse of common
resources

Why People Sometimes

Cooperate
When the game is repeated many times,
cooperation may be possible.
Strategies which may lead to cooperation:
If your rival reneges in one round,
you renege in all subsequent rounds.
Tit-for-tat
Whatever your rival does in one round
(whether renege or cooperate),
you do in the following round.

Public Policy Toward

Oligopolies
Recall one of the Ten Principles from Chap.1:
Governments can sometimes
improve market outcomes.
In oligopolies, production is too low and prices are too
high, relative to the social optimum.
Role for policymakers:
promote competition, prevent cooperation
to move the oligopoly outcome closer to
the efficient outcome.

Restraint of Trade and Antitrust Laws

Sherman Antitrust Act (1890):

forbids collusion between competitors
Clayton Antitrust Act (1914):
strengthened rights of individuals
damaged by anticompetitive arrangements
between firms

Controversies Over Antitrust

Policy
Most people agree that price-fixing
agreements among competitors should be
illegal.
Some economists are concerned that
policymakers go too far when using
antitrust laws to stifle business practices
that are not necessarily harmful, and may
have legitimate objectives.
We consider three such practices

1. Resale Price Maintenance (Fair Trade)

Occurs when a manufacturer imposes lower limits
on the prices retailers can charge.
Is often opposed because it appears to reduce
competition at the retail level.
Yet, any market power the manufacturer has
is at the wholesale level; manufacturers do not
gain from restricting competition at the retail level.
The practice has a legitimate objective:
preventing discount retailers from free-riding
on the services provided by full-service retailers.

2. Predatory Pricing
Occurs when a firm cuts prices to prevent entry
or drive a competitor out of the market,
so that it can charge monopoly prices later.
Illegal under antitrust laws, but hard for the courts
to determine when a price cut is predatory and
when it is competitive & beneficial to consumers.
Many economists doubt that predatory pricing is a
rational strategy:
It involves selling at a loss, which is extremely
costly for the firm.
It can backfire.

3. Tying
Occurs when a manufacturer bundles two products
together and sells them for one price (e.g., Microsoft
including a browser with its operating system)
Critics argue that tying gives firms more market
power by connecting weak products to strong ones.
Others counter that tying cannot change market
power: Buyers are not willing to pay more for two
goods together than for the goods separately.
Firms may use tying for price discrimination,
which is not illegal, and which sometimes
increases economic efficiency.

CONCLUSION
Oligopolies can end up looking like
monopolies or like competitive markets,
depending on the number of firms and
how cooperative they are.
The prisoners dilemma shows how
difficult it is for firms to maintain
cooperation, even when doing so is in their
best interest.
Policymakers use the antitrust laws to
CHAPTER 16
regulate oligopolists behavior. The proper
OLIGOPOLY

CHAPTER SUMMARY
Oligopolists can maximize profits if they form a
cartel and act like a monopolist.
Yet, self-interest leads each oligopolist to a higher
quantity and lower price than under the monopoly
outcome.
The larger the number of firms, the closer will be
the quantity and price to the levels that would
prevail under competition.

CHAPTER SUMMARY
The prisoners dilemma shows that self-interest
can prevent people from cooperating, even when
cooperation is in their mutual interest. The logic of
the prisoners dilemma applies in many situations.
Policymakers use the antitrust laws to prevent
oligopolies from engaging in anticompetitive
behavior such as price-fixing. But the application
of these laws is sometimes controversial.

CHAPTER 16
OLIGOPOLY