Frank & Bernanke

Chapters 9 & 10
Imperfect competition

Outline
2

Monopoly
Monopoly power
Barriers to entry
Natural monopoly
Profit maximization by a monopolist
Efficiency of imperfect competition

Other forms of imperfect competition

Oligopoly and monopolistic competition
Game theory
Oligopoly models

The kinked demand curve model

Cartels and collusion

Price Taker v. Price Setter

3

Perfectly Competitive Firm

A firm that must take the price in the market

A price taker

Imperfectly Competitive Firm

A firm with at least some latitude to set its own price

A price setter

Forms of Imperfect Competition

4

Pure monopoly

A firm thats the only supplier of a unique product with

no close substitutes

Oligopoly

A market with a handful of firms (2-12) producing a

product for which only rival firms produce close
substitutes

Monopolistic competition

A market with a large number of firms that produce

slightly differentiated products that are reasonably close
substitutes for one another.

Competition v. imperfect competition

5

A perfectly competitive firm faces a perfectly

elastic demand curve for its product

Firms take the price in the market, where supply and

demand curves intersect
Charging a higher price or a lower price does not help
increase profits
An imperfectly competitive firm faces a downward

sloping demand curve

Charging a price different from competitors may be

advantageous

Pure Monopoly
6

Very rare on a global scale (DeBeers?)

Not as rare:

Local/regional monopoly
Firms with a lot of market power

Market Power
7

Monopoly Power (Market Power)

A firms ability to raise the price of a good without losing all its
sales
It does not mean that a firm can sell any quantity at any price it
wishes (if firms raise price, quantity demanded falls).

i.e. they must remember the law of demand

Sources of Market Power

8

Market power arises from factors that limit

competition = barriers to entry

Something prevents other firms from entering the market

Barriers to Entry
9

Economic barriers
Exclusive control over inputs (DeBeers, ALCOA)
Economies of scale (lower average costs)

Natural monopoly

Legal barriers
Patents

Grant exclusive rights for a specified time period

Promote monopoly but encourage innovation

Government licenses or franchises

Technological barriers
Tech superiority
Tech may give rise to natural monopoly

Economies of Scale & Natural Monopoly

10

With Economies of scale (a.k.a. increasing returns

to scale)

Average cost of production falls as output increases

High start-up (fixed) costs followed by low marginal costs
Suggests larger firms will be more efficient than smaller firms
When we see firms merge, we can assume that they are
achieving economies of scale (lower average costs and higher
per unit profit) by doing so
When is IRTS likely to happen?

What are some examples of goods or services where firms have

merged?

Total and Average Costs for a Production Process with

Economies of Scale
11

Natural Monopoly
12

In some markets, it makes more sense (is more

efficient) to only have a single provider of the good.

Economies of scale are so great that the good or
service can be provided at the lowest cost if only
one firm provides it.
E.g. Utilities
How many sets of phone lines, water pipes, cable wires,
electric lines do we need?
Since monopoly power is dangerous (to consumers) what
must we do with natural monopolies?

Returns to Scale
13

Increasing returns to scale

When all inputs are changed by a given proportion and output

changes by a higher proportion
Also know as Economies of Scale

Constant returns to scale

When all inputs are changed by a given proportion and output

changes by the same proportion

Decreasing returns to scale

When all inputs are changed by a given proportion and output

changes by a lower proportion
Firm is too big

Returns to scale
14

Reasons for IRTS

Increased ability for division of labor (specialization)

More output may justify the use of high-tech capital
Inputs can be purchased in bulk
By-product can be reused/resold

Reasons for DRTS

Thick corporate hierarchy slows decision-making

Less oversight may result in more shirking/disconnect from
labor

Profit maximization by a monopolist

15

Monopolists general strategy:

Restrict output
Stimulate demand

Monopolist must determine both Q* & P*

Monopolists Marginal Revenue

16

Marginal Revenue

The change in a firms total revenue that results from a oneunit change in output

For a monopolist

marginal revenue from selling an additional unit is less than

the market price

Note that a monopolist can only sell an additional unit if it cuts

prices on all units it sells (i.e. the seller does not engage in price
discrimination)

Aside: Price Discrimination

17

Price Discrimination
The practice of charging different buyers different prices for
essentially the same good or service

Discounts to senior citizens, children

Discounts on air travel depending on days of travel
Rebates or coupons on retail merchandise
Novel sales

Effective when the good or service cannot be resold

Types of Price Discrimination

18

Perfect price discrimination

A firm that charges each buyer exactly his or her reservation
price (rare)
Hurdle method of price discrimination
The practice by which a seller offers a discount to all buyers
who overcome some obstacle

A rebate that takes time and effort to mail in

Time spent waiting
Staying over a weekend on air travel

Benefits of Price Discrimination

19

The number of trades increase

Brings output closer to the socially efficient level

Reduces efficiency loss associated with market power and
increases total economic surplus

The Demand Curves Facing Perfectly and Imperfectly

Competitive Firms
20

The Monopolists Benefit from Selling an Additional Unit

21

Marginal Revenue in Graphical Form

22

Profit Maximization
23

Goal of all firms: Maximize profits

Rule

Expand output when MR > MC

Decrease output when MC > MR
Sell the quantity of output where marginal revenue equals
marginal cost, MR = MC

The Profit-Maximizing Output Level for a Perfectly

Competitive Melon Farmer
24

Profit-Maximizing Rule
25

Firm with market power must set quantity and price

Profit is maximized at the level of output for which

MR = MC
A monopolist sets the price off of the demand curve
at its profit-maximizing output

The Monopolists Profit-Maximizing Output Level

26

Monopoly and Efficiency

27

Recall, the market efficient level of output is where

MB = MC

The monopolist produces less than socially efficient level of

output

Monopolists are not efficient

Inefficiency is measured by deadweight loss

Monopoly may be socially inefficient, but the

alternatives, like legislation, are not perfect either

The Deadweight Loss from Monopoly

28

Chapter 10:
Thinking Strategically

29

Oligopoly
30

A handful of big firms selling a product with some quality

differentiation

Rule of thumb: if 4 biggest players together have 40% or more of

total market share

Chips
Soda
Beer
Airlines
Insurance
Cell phone providers
Automobiles
Cigarettes
Athletic shoes
Online travel booking sites

Profit in oligopoly?
31

Do these firms make economic profit > 0?

Do these profits persist into the long-run?
What must be true?

The kinked demand curve model of Oligopoly

32

Observation: prices in oligopoly markets tend to

change very slowly.

Why?

Assume no cooperation or collusion among firms

Considering the relationship between price

changes, elasticity of demand and revenue changes

helps explain this observation.

Individual firms are basically afraid to change price because

of what other firms might do.

Kinked Demand Curve

33

Assume that we have 3 firms: A, B, & C

Products are similar
The shape of the demand curve for As product

tells us how much QD changes when there is a

price change (elasticity) this depends on the
pricing behavior and similarity of the substitutes B
and C.

Kinked Demand Curve

34
Consider what might happen if firm A changes price:
1. If firm A lowers price then B and C can follow the price change or ignore it.
If B and C follow then they also lower price because they are afraid of losing their market

share to firm A.

If B and C ignore the price change by A, then they maintain the higher price because they

dont believe that people will switch.

2. If firm A raises price then B and C can follow the price change or ignore it.
If B and C follow then they also raise price because they dont believe that people will

switch, so they can increase profits by also charging more.

If B and C ignore the price change by A, then they maintain the lower price because they

believe that people will switch, and they can capture some of firm As market share by
having a lower price.

Kinked Demand Curve

35

If competitors B and C consider their product to be a reasonable substitute

for As product, they are likely to ignore (not follow) a price increase and
follow a price decrease:
If A raises price and B and C do not follow:
consumers are more likely to substitute toward B and C
increase in the Price of A => big decrease in QD for A
If the other firms do not follow the price increase then the demand for
As product will be relatively ELASTIC (flat slope) at prices above the
current price.
If A lowers price and B and C do follow:
consumers are less likely to substitute toward B and C
decrease in the Price of A => small increase in QD for A
If the other firms do follow the price decrease, then the demand for As
product is going to be relatively INELASTIC (steep slope) at prices below
the current price.

Kinked Demand Curve

36

When firms believe that their product is a close

substitute for their competitors product, they do

not have much incentive to change price:

A price decrease will be matched, so they have nothing to

gain by lowering price.
A price increase will not be matched, so they have a lot to
lose by raising price.

Theory of Games
37

The payoff of many actions depends

upon the actions of others

For

example, an imperfectly competitive

firm must weigh the responses of rivals
when deciding whether to cut their prices
The decisions of competing firms are often
interdependent

Game theory
38

A mathematical technique for analyzing the

decisions of interdependent oligopolistic firms in

uncertain situations.

History:

Cournot (1838) 1st observations on oligopoly behavior

Darwin (1878) competition and evolutionary bio
Von Nuemann (1928) minimax strategy
Dresher and Flood (1950) The prisoners dilemma
Nash (1950-1953, 1994) Bargaining theory and Nash equilibria

Game Theory
39

A game is simply a competitive situation

where two or more firms or individuals

pursue their interests and no person can
dictate the final outcome or payoff.

Players choose their strategy without certain

knowledge of the other players strategies,

but may eventually learn which way the
opposition is leaning.

Elements of a Game
40

Basic elements
The players
The strategies
The payoffs
Payoff matrix
The fundamental tool of game theory.
This is simply a way of organizing the potential outcomes
of a given game in a table that describes the payoffs in a
game for each possible combination of strategies

Strategies
41

Dominant strategy

A strategy that yields a higher payoff no matter what the other

players in a game choose

Dominated strategy

Any other strategy available to a player who has a dominant strategy

Nash Equilibrium

Any combination of strategies in which each players strategy is his

best choice, given the other players strategies.
IOW: Nash equilibrium is achieved when all players are playing
their best strategy given what the other players are doing.
Nash equilibrium does not necessarily mean the best payoff for all
the players a better payoff may be achieved through collusion.

A simple game and payoff matrix

42

Duopoly situation each of the two firms A and B must

decide whether to mount an expensive advertising

campaign.
If each firm decides not to advertise, each will earn a profit
of $50,000.
If one firm advertises and the other does not, the firm that
does will increase its profits by 50% to $75,000, and drive
the competition into a loss.
If both firms advertise, they will earn $10,000 each
because the advertising expense forced by competition
wipes out large profits

Example continued
43

If firms could agree to collude, the optimal strategy

would obviously be to not advertise maximize

joint profits = $100,000

Lets assume they cannot collude, and therefore do not

know what the competition is doing.

A Dominant Strategy is the one that is best no

matter what the opposition does.

The Payoff Matrix

44

Firm B
Dont Advertise
Dont
Advertise

Advertise

A profit = $50

A loss = $25

B profit = $50

B profit = $75

A profit = $75

A profit = $10

B loss = $25

B profit = $10

Firm A
Advertise

New Game: The Prisoners Dilemma

45
You and your friend Bugsy are the prime suspects for knocking over a liquor store.

The cops pick you up, and immediately after your arrest you and Bugsy are
separated and questioned individually by the DA. Without a confession, the DA
has insufficient evidence for a conviction. During your interrogation, you are told
the following:

The police do have sufficient evidence to convict you and Bugsy of a lesser crime.
If you and Bugsy both confess to the liquor store heist, you will each get a 5 year

sentence.
If neither of you confesses, you will each be charged with the lesser crime, and sent
up the river for 1 year.
If Bugsy confesses (turns states evidence) and you do not, Bugsy will go free while
you will be convicted of the liquor store robbery and get sent to the big house for 7
years.
Bugsy is told the exact same information.
What will you do?

The Payoff Matrix

46

You
Dont Confess
Dont
Confess

Bugsy
Confess

Confess

Bugsy = 1 year

Bugsy =7 years

You = 1 year

You = Free

Bugsy = Free

Bugsy =5 years

You = 7 years

You = 5 years

Prisoners Dilemma
47

Prisoners Dilemma

Each player has a dominant strategy

It results in payoffs that are smaller than if each had played a
dominated strategy

Produces conflict between narrow self-interest of

individuals and the broader interest of larger

communities

Naturalist applications of prisoners dilemma

48

Why do people shout at parties?

Why does everyone stand up at concerts?

There are some games where one player does not have a dominant
strategy but the outcome is predictable
49

A
Left
Top

B
Bottom

Right

B: +100

B: +100

A: 0

A: +100

B : -100

B: +200

A:0

A: +100

As behavior is predictable in this case.

One more
50

Left

Top

Right

B: +100

B: + 100

A: 0

A: +100

B: -10,000

B: + 200

A: 0

A: + 100

B
Bottom

Here, As behavior is again predictable choose Right is the

dominant strategy but now B stands to lose a great deal if by
chance A chooses left instead

Cartels
51

Cartel

A group of firms who sell a similar product who have

joined together in an agreement to act as a monopoly
restrict output and raise price
Normally cartels involve several firms

Make retaliation against a dissenter difficult

Agreements are not legally enforceable and are hence

inherently unstable

Reasons for collusion among firms

52

To reduce the uncertainty of a noncooperative

situation competition over market share makes
firms unsure of what to do with regard to pricing
decisions theyre afraid to change prices so to
avoid the possibility of a price war, firms might
try to cooperate.

To increase profits this need for profit can turn

out to be the downfall of most cartels GREED

Collusion
53
Overt collusion is illegal in the US.
Most cartels fail. This is because 3 things are needed for a cartel to be successful, and

theyre tough to accomplish

1st, the firms must come to an agreement as to what the price and quantity should be

tough to do because different firms will have different cost structures and different
assessments of market demand, so what is the profit-maximizing price and quantity for
one firm is not likely to be the profit-maximizing combination for another firm.
2nd, the cartel members must adhere to the agreed upon price and production levels no

cheating. But each firm knows that if it cheats and the others do not, that they can have
higher profits.
3rd, there must be the potential for monopoly power the market demand curve must be

relatively inelastic so that there are potential gains from increasing price it has to be a
good with few substitutes.

Is the NCAA a cartel?

54

Where do the big profits come from at large state schools?

sports
Is it a competitive market?
many schools but the large profits suggest that there is some
monopoly power.
The NCAA creates this market power and profit by

restricting output limit the number of games per season,

limit the number of teams per division, strict eligibility
guidelines for schools
Up until 1984 the NCAA restricted the number of games on
TV and charged very high prices compared to today but
the supreme court called it illegal collusion and as a result
we have much more games on TV today than 20 years ago.
Can we say the same things can be said for professional
sports?

Example: collusion
55

2 firms sell bottled water with MC = 0

The firms agree to act as a monopolist and set

price in order to maximize joint profits (P*).

Each will produce of the output.
No enforcement mechanism.
Cheating by 1 firm = selling the water at < P* =>
that firm gains entire market.

The Market Demand for Mineral Water

Q* = 1000, P* = 1.00 = > profits = $500 each
56

Temptation to Violate the Cartel Agreement

if 1 firm cheats => profits = $990 & 0
57

Practice
58

Create the payoff matrix for this game:

Firms 1 & 2
Options: collude (price = $1.00) or cheat (price =
0.90)
Is there a dominant strategy for each firm?
Is there an incentive to cut prices even more?

Exam 2
59

Thursday August 4, 6:00-9:00

Same format as exam 1:

25 short answer
2 essays (with options)