homework chapter14-15

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Chapter 14 Homework Chapter 14 Oligopoly 1 Oligopoly  An oligopoly is an industry with only a small number of producers  Each firm has some market power (can change price by changing quantity supplied)  Imperfect competition – when firms compete for customers but also have market power 2 Oligopoly  Cause of oligopoly  Increasing returns to scale – larger firms have lower cost per unit than smaller ones 3 Duopoly Case  Two firms  Fixed cost only (a simplifying assumption), no variable cost, marginal cost is zero  A perfectly competitive firm would produce where MC=P, which is P=MC=0 in our example 4 Duopoly Case 5 Duopoly Case  Deciding how much to produce:  The firms could decide to collude and make production decisions as a monopolist does - at 60 million pounds (30 million each) with a revenue of $180 million each  Sellers engage in collusion when they cooperate to raise their joint profits.  A cartel is an agreement among several producers to obey output restrictions in order to increase their joint profits. 6 Duopoly Case  Cheating: (non-cooperative behavior)  The firms have an incentive to cheat on the cartel  Firm A can cheat and increase revenue by producing 10 million more pounds, dropping the price from $6 to $5  Industry revenue decreases from $360 to $350, firm B has revenue of $150 (30 * $5), firm A has revenue of $200 (40 * $5) 7 Duopoly Case  Both cheat:  Both firms face the same incentives, so both cheat and produce an extra 10 million pounds  80 million pounds are sold at $4 each, industry revenue decreases to $320  Each firm takes revenue of $160 8 Duopoly Case  Why does cheating cause profit to rise?  Recall the Price Effect (-) and Quantity Effect (+) of moving along the demand curve  The cheating duopolist receives the entire quantity effect (+) and forces the competitor to take half the price effect (-) 9 Oligopoly 10 Game Theory  The branch of economics that studies how interdependent firms make decisions is called Game Theory  Firms are interdependent when one firm’s actions affect the profits of another 11 (Original) Prisoners’ Dilemma 12 Louise = “Don’t Confess” 13 Louise = “Confess” 14 Thelma= “Don’t Confess” 15 Thelma= “Confess” 16 Prisoners’ Dilemma  Prisoners’ dilemma is a game based on two premises:  ( 1) Each player has an incentive to choose an action that benefits itself at the other player’s expense  ( 2) When both players act in this way, both are worse off than if they had acted cooperatively. 17 Game Theory  An action is a dominant strategy when it is the player’s best action regardless of the action taken by the other player.  For Thelma:  If Louise doesn’t confess, the best choice is for her to confess  If Louise does confess, the best choice is still for her to confess  So Thelma’s best (dominant) strategy is to confess 18 Game Theory  When both prisoners confess, it is the equilibrium of the game  Neither person has any reason to change their strategy when in equilibrium  This kind of equilibrium is called a Nash Equilibrium or non- cooperative equilibrium 19 Payoff Matrix 20 Payoff Matrix  Note:  This game is only played once and the simulation ends.  Firms act with self-interest (assumed under mainstream economic theory) 21 Ajinomoto = 30 million (aka “cooperate”) 22 Ajinomoto = 40 million (aka “cheat”) 23 ADM= 30 million (aka “cooperate”) 24 ADM= 40 million (aka “cheat”) 25 Game Theory  Most games aren’t that simple  In “one shot” games, individuals find it profitable to cheat  In repeated games, firms may take a different strategy  Tacit Collusion is when both firms act in their mutual best interest as the game is repeated, as if they were colluding 26 Game Theory  Same game, but now with strategic behavior (attempting to influence the actions of other firms)  Firms can choose to  Always cheat  Tit for tat  A strategy of tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period.  Leads to four possible solutions… 27 Game Theory 28 Game Theory 29 Legal Framework  Collusion is illegal in the USA and many other countries  Railroad transportation was the first oligopoly in the USA  Sherman Antitrust Act of 1890 – antitrust policy  The US Justice Department & Federal Trade Commission administer antitrust policy 30 In Practice  Tacit Collusion is difficult for oligopolists  Less concentration (low barriers to entry)  Market share is smaller, price effect is smaller  Complex products and pricing schemes  Usually firms have many products (and prices)  Differences in interests  Firms may not see 50/50 as the best conclusion  Bargaining power of buyers  Large buyers exert market power as well, driving prices lower  Price War – tacit collusion breaks and prices fall 31 Product Differentiation  When consumers think one firm’s product is different from that of another  Oligopolists often compete on differentiation rather than price/quantity when an tacit agreement is in place 32 Chapter 15 Homework Chapter 15 Principles of Microeconomics Econ 112 1 Monopolistic Competition  Characteristics of Monopolistic Competition  Many producers  Firms compete with each other, but too many for collusion  Differentiated products  Consumers can tell the difference between competitors products  Competitors products are imperfect substitutes  Leads to some market power (price setting ability)  Free entry (into) and exit (from) the industry (in the long run)  There are no barriers to entry, like there were in oligopoly 2 Monopolistic Competition  Product Differentiation  Monopolistic competitors compete with product differentiation  Types of Differentiation by…  Style or type  Location  Quality 3 Monopolistic Competition 4 Monopolistic Competition  Monopolistic Competition in the Short Run  Firms face a downward sloping demand curve, like the monopolist  Assume “U” shaped ATC (implies positive fixed cost)  Assume “swoosh” shaped MC curve  Like always, firm maximize profit by choosing the quantity where MR=MC  Profit = (Price – ATC)*Q at the profit maximizing quantity 5 Monopolistic Competition  Important: The demand curve facing the firm under monopolistic competition is NOT the market demand curve  The monopolistic competitor faces a demand curve for their specific differentiated product, yet the market is defined to include other differentiated products 6 Monopolistic Competition 7 Monopolistic Competition 8 Monopolistic Competition  Profitability:  Firms can make positive economic profit if their demand curves lie above their ATC curves  If it doesn’t, then they can’t possibly be profitable 9 Monopolistic Competition  The Long Run  Free entry and exit from the industry works just like in perfect competition  When firms make positive profits in the short run, new firms enter the industry seeking the profits  When firms make negative profits in the short run, existing firms exit the industry in the long run 10 Monopolistic Competition 11 Monopolistic Competition 12 Monopolistic Competition  Long Run Equilibrium:  In the Long Run, firms will enter or exit until profits are zero  This is known as a zero-profit equilibrium  Occurs when the firm’s demand curve is tangent to it’s ATC curve 13 Monopolistic Competition 14 Monopolistic Competition 15 Monopolistic Competition  Monopolistic Competition v. Perfect Competition:  Both firms face long run profits of zero  Perfect Competitors operate at the minimum of their ATC curves in long run equilibrium  Monopolistic Competitors operate to the left of the minimum of their ATC curves (graphically) in long run equilibrium 16 Perfect Competition 17 Monopolistic Competition 18 Monopolistic Competition  Monopolistic Competitors have excess capacity in the long run equilibrium  In other words they produce less than their ATC-minimizing output  In even other words, they are willing to sell more at the posted price  Therefore, firms would like to increase demand for their own good in the short run 19 Monopolistic Competition  Efficiency? Inefficiency?  Since firms don’t minimize total cost the way P.C. firms do, the industry seems inefficient  It seems that there should be less firms that produce more per firm, like in P.C.  But there is a tradeoff between productive efficiency and product diversity (which consumers like) 20 Monopolistic Competition  Advertising:  Firms advertise to:  1) convey information to consumers about why their product is different from other producers products  2) cause consumers to believe their product is different from other producers products (even though it may not be)  Does #2 mean consumers are irrational? 21 Monopolistic Competition  Brand Names  Can increase market power  Good: usually designates a product with consistent quality  Bad: causes consumers to prefer brand name commodities 22 Monopolistic Competition 23
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Explanation & Answer

Sending Chapter 15 shortly

OLIGOPOLY AND GAME THEORY

1

Chapter 14 Homework
a)
Price
Olive

of Quantity
demanded/gallon

Oil/gallon

Total

Marginal

Marginal

revenue

Cost

profit

P*Q

100

1000

100000

40000

60000

90

1500

135000

60000

75000

80

2000

160000

80000

80000

70

2500

175000

100000

75000

60

3000

180000

120000

60000

50

3500

175000

140000

35000

40

4000

160000

160000

0

30

4500

135000

180000

(45000)

20

5000

100000

200000

(100000)

10

5500

55000

220000

(165000)

The cartel will have to sell the Olive oil at $ 80 per gallon. The number of gallons to sold 2000
gallons in order to get a profit of $ 80,000. Since the two families share the same market share the
profits will be split 50/50 and therefore, the profit will be $40,000 each.
b) When increase the gallons of olive oil, it means the market f...


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