Review: Efficiency

1. Oligopoly Review: Efficiency Pareto’s Query: Given the state of affairs in question, is it possible to make one individual better off without hurting anyone else? Yes No Is the state of affairs getting the most from the economy’s resources? No. Is the state of affairs getting the most from the economy’s resources? Yes. State of affairs inefficient. State of affairs efficient.

2. Review: Efficiency and the Two Polar Cases of Market Structure Perfectly Competitive Industry Monopoly A large number of small firms One large firm A single firm’s production decision does not significantly affect the price.  Monopoly produces a quantity and charges a price that lies on the market demand curve. MR curve horizontal:MR = Price MR curve lies beneath the market demand curve: MR < Price orPrice = MR Profit Maximization orPrice > MR MR = MC Price = MR = MC Price > MR = MC  Price = MC  Price > MC  Consumers base decisions on accurate information  Consumers base decisions on misleading information  Efficient  Inefficient Perfectly Competitive Industry Oligopoly Monopoly A large number of small firms A few moderately sized firms One large firm Efficient Efficient or Inefficient?  Inefficient

3. Project: Explaining OPEC’s Vacillating Behavior in 1993 In late September, the members of OPEC negotiated quotas to restrict the quantity of oil produced. The agreement was applauded by OPEC oil ministers. Shortly thereafter, oil prices promptly rose. The increase in oil prices proved to be short lived, however. OPEC members violated their agreement within two weeks of consummating it. Within a few weeks, the price of oil fell. Conflicting Interests of an Oligopolies and Cartels: Collective versus Individual It is in the collective interests of the firms in an industry to establish a cartel to maximize their joint profits. It is in their collective interests to collude by reducing production below the competitive level; by do so they can act like a monopoly to maximize the joint profits of the entire industry by restricting production below the competitive level. On the other hand, if a cartel is established it may be in the individual interests of each firm to cheat on the cartel agreement to maximize its individual profit. If the cartel agreement is in place, it may be in the individual interests of a firm to produce more than the agreement allows thereby pushing production toward the competitive level. Strategy: Begin with a multi-plant monopoly and then “convert” it to an oligopoly.

4. A Multi-Plant Monopoly To maximize profits, two conditions must be satisfied when a firm has two plants: Marginal costs of each plant must be equal: MCA= MCB Marginal revenue must equal each plant’s marginal cost: MR = MCA = MCB MCA MCB MCB MCA 100 100 100 80 80 80 60 60 60 D 40 40 40 20 20 20 MR qA qB Q 50 100 50 100 150 200 50 100 150 200 200 qA = 50 MCA = 60 qB = 100 MCB = 60 Q = 150 MR = 60 P = 90 20 Rise As Aside: Slope of Demand Curve = =  =  .20 Run 100 Convert the Multi-Plant Monopoly into an Oligopoly Adam’s Firm Beth’s Firm Total Production qA= 50  MCA = $60 qB= 100  MCB = $60 Q = 150 P = $90

5. Scenario 1: No Retaliation – Does Adam have an incentive to cheat if Beth does not retaliate? Quantity Slope of Demand Curve = .20 Adam Beth Joint Price To clear the market the quantity demanded must increase by 1 unit. Tomorrow 51 100 151 89.80 Today 50 100 150 90.00 The price must fall by .20, from $90.00 to $89.80. Adam’s Adam’s Quantity Price Total Revenue = Price  Quantity Tomorrow: 51 89.80 89.8051 89.80(1 + 50) = 89.80 + 89.8050 Today: 50 90.00 90.0050 Adam’s Marginal Revenue = 89.80 + 89.8050  90.0050 Question: What does Adam’s marginal revenue (MRA) equal? = 89.80 + (89.80  90.00)50 = 89.80 + (.20)50  TR tends to rise by 89.80, the price, as a consequence of the additional unit sold.  TR tends to fall by 10.00, as a consequence of the lower price. MCA = $60 Does Adam have an incentive to cheat?  Output Effect  Price Effect Yes   MRA = Adam’s Marginal Revenue = 89.80  10.00 = $79.80

6. QA: 50 51 MRA = 79.80 MCA = 60.00 QB = 100P: 90.00 89.80 ProfitA = TRA TCA ProfitB = TRB TCB  79.80  19.80  60.00  20.00 No change  20.00  Lab 12.2 Remember that consumer surplus equals the net benefits consumers enjoy from the purchase and consumption of the good. Firms: Joint profit falls. Adam’s profit rises; Adam has an incentive to cheat. Conflicting Interests of an Oligopolies and Cartels: Collective versus Individual Beth’s profit falls; Beth has reason to be upset. It is in the collective interests of the firms in an industry to establish a cartel to maximize their joint profits. Consumers: Consumer Surplus rises. If a cartel is established it may be in the individual interests of each firm to cheat on the cartel agreement. The increase in consumer surplus is greater than the fall in joint profits. Society as a whole (firms and consumers together) is better off.

7. No Retaliation – Does Beth have an incentive to cheat if Adam does not retaliate? Quantity Slope of Demand Curve = .20 Adam Beth Joint Price To clear the market the quantity demanded must increase by 1 unit. Tomorrow 50 101 151 89.80 Today 50 100 150 90.00 The price must fall by .20, from $90.00 to $89.80. Beth’s Beth’s Quantity Price Total Revenue = Price  Quantity Tomorrow: 101 89.80 89.80101 89.80(1 + 100) = 89.80 + 89.80100 Today: 100 90.00 90.00100 Beth’s Marginal Revenue = 89.80 + 89.80100  90.00100 Question: What does Adam’s marginal revenue (MRA) equal? = 89.80 + (89.80  90.00)100 = 89.80 + (.20)100  TR tends to rise by 89.80, the price, as a consequence of the additional unit sold.  TR tends to fall by 20.00, as a consequence of the lower price. MCB = $60 Does Beth have an incentive to cheat?  Output Effect  Price Effect Yes   MRB = Beth’s Marginal Revenue = 89.80  20.00 = $69.80

8.  Lab 12.3 Remember that consumer surplus equals the net benefits consumers enjoy from the purchase and consumption of the good. Firms: Joint profit falls. Beth’s profit rises; Beth has an incentive to cheat. Adam’s profit falls; Adam has reason to be upset. Consumers: Consumer Surplus rises. The increase in consumer surplus is greater than the fall in joint profits. Society as a whole (firms and consumers together) is better off.

9. Summary Adam’s Marginal Revenue = 89.80 + 89.8050  90.0050 Adam: MRA  $80 MCA = $60 = 89.80 + (89.80  90.00)50 = 89.80 + (.20)50 When Adam producers 1 more unit his profit risesby approximately $20.  TR tends to rise by 89.80, the price, as a consequence of the additional unit sold.  TR tends to fall by 10.00, as a consequence of the lower price. Question: Who has the greater incentive to cheat?  Output Effect  Price Effect Adam has a greater incentive to cheat. Why?   Adam’s MR is greater. Why? MRA = 89.80  10.00 = 79.80 Adam’s price effect is smaller. Why? Beth’s Marginal Revenue = 89.80 + 89.80100  90.00100 Adam is the smaller producer. = 89.80 + (89.80  90.00)100 Conclusion: The smaller producer has a greater incentive to cheat. = 89.80 + (.20)100  TR tends to rise by 89.80, the price, as a consequence of the additional unit sold.  TR tends to fall by 20.00, as a consequence of the lower price. Beth: MRB  $70 MCB = $60 When Beth producers 1 more unit her profit rises by approximately $10.  Output Effect  Price Effect   MRB = 89.80  20.00 = 69.80

10. Scenario 3: 1-For-1 Retaliation – Adam Cheats and Beth Retaliates Quantity Slope of Demand Curve = .20 Adam Beth Joint Price To clear the market the quantity demanded must increase by 2 units. Tomorrow 51 101 152 89.60 Today 50 100 150 90.00 The price must fall by .40, from $90.00 to $89.60. Adam’s Adam’s Quantity Price Total Revenue = Price  Quantity Tomorrow: 51 89.60 89.6051 89.60(1 + 50) = 89.60 + 89.6050 Today: 50 90.00 90.0050 Adam’s Marginal Revenue = 89.60 + 89.6050  90.0050 Question: What does Adam’s marginal revenue (MRA) equal? = 89.60 + (89.60  90.00)50 = 89.60 + (.40)50  TR tends to rise by 89.60, the price, as a consequence of the additional unit sold.  TR tends to fall by 20.00, as a consequence of the lower price. MCA = $60 Does Adam have an incentive to cheat?  Output Effect  Price Effect Yes   MRA = Adam’s Marginal Revenue = 89.60  20.00 = $69.60

11.  Lab 12.4 Remember that consumer surplus equals the net benefits consumers enjoy from the purchase and consumption of the good. Firms: Joint profit falls. Adam’s profit rises; Adam has an incentive to cheat. Beth’s profit falls; Beth has reason to be upset. Consumers: Consumer Surplus rises. The increase in consumer surplus is greater than the fall in joint profits. Society as a whole (firms and consumers together) is better off.

12. Scenario 4: 3-For-1 Retaliation – Adam Cheats and Beth Retaliates Aggressively Quantity Slope of Demand Curve = .20 Adam Beth Joint Price To clear the market the quantity demanded must increase by 4 units. Tomorrow 51 103 154 89.20 Today 50 100 150 90.00 The price must fall by .80, from $90.00 to $89.20. Adam’s Adam’s Quantity Price Total Revenue = Price  Quantity Tomorrow: 51 89.20 89.2051 89.20(1 + 50) = 89.20 + 89.2050 Today: 50 90.00 90.0050 Adam’s Marginal Revenue = 89.20 + 89.2050  90.0050 Question: What does Adam’s marginal revenue (MRA) equal? = 89.20 + (89.20  90.00)50 = 89.20 + (.80)50  TR tends to rise by 89.20, the price, as a consequence of the additional unit sold.  TR tends to fall by 40.00, as a consequence of the lower price. MCA = $60 Does Adam have an incentive to cheat?  Output Effect  Price Effect No   MRA = Adam’s Marginal Revenue = 89.20  40.00 = $49.20

13.  Lab 12.5 Remember that consumer surplus equals the net benefits consumers enjoy from the purchase and consumption of the good. Firms: Joint profit falls. Adam’s profit falls; Adam has no incentive to cheat. Consumers: Consumer Surplus rises. The increase in consumer surplus is greater than the fall in joint profits. Society as a whole (firms and consumers together) is better off.

14. Summary To cheat or not to cheat? If a firm believes that the other firm(s) will not retaliate, the firm has an incentive to cheat. retaliate aggressively, the firm does not have an incentive to cheat. As cheating and retaliation occurs: The joint profits of the firms fall. That is, as firms cheat attempting to get more of the “profit pie,” the pie shrinks. Consumer surplus rises. The gain in consumer surplus exceeds the loss in joint profits. Society as a whole becomes better off.

16. Role of the Government Antitrust legislation: Broadly speaking antitrust legislation is designed to prevent • a firm from becoming a monopoly • or • an oligopoly from colluding and acting as a cartel. Regulation Airline Deregulation Act: In 1978, Congress passed and President Carter signed the Airline Deregulation Act. This act phased in the deregulation of the industry: 1981 - CAB lost authority over domestic routes 1983 - CAB lost authority over airline prices 1984 - CAB was disbanded

18.  Lab 12.2 Conflicting Interests of an Oligopolies and Cartels: Collective versus Individual It is in the collective interests of the firms in an industry to establish a cartel. It is in their collective interests to collude by reducing production below the competitive level; by do so they can act like a monopoly and maximize the joint profits of the entire industry by restricting production below the competitive level. This represents the state of affairs before the father and there was a single monopoly firm with two plants maximizing its profit. On the other hand, if a cartel is established it may be in the individual interests of each firm to cheat on the cartel agreement. If the cartel agreement is in place, it may be in the individual interests of a firm to produce more than the agreement allows thereby pushing production toward the competitive level.

19.  Lab 12.2 Remember that consumer surplus equals the net benefits consumers enjoy from the purchase and consumption of the good. Firms: Joint profit falls. Adam’s profit rises; Adam has an incentive to cheat. Beth’s profit falls; Beth has reason to be upset. Consumers: Consumer Surplus rises. The increase in consumer surplus is greater than the fall in joint profits. Society as a whole (firms and consumers together) is better off.

20. A Multi-Plant Monopoly MCA MCB MCB MCA 100 100 100 80 80 80 60 60 60 D 40 40 40 20 20 20 MR qA qB Q 50 100 50 100 150 200 50 100 150 200 200 qA = 50 MCA = 60 qB = 100 MCB = 60 Q = 150 MR = 60

21. A Multi-Plant Monopoly To maximize profits, two conditions must be satisfied when a firm has two plants: Marginal costs of each plant must be equal: MCA= MCB Marginal revenue must equal each plant’s marginal cost: MR = MCA = MCB MCA MCB MCB MCA 100 100 100 80 80 80 60 60 60 D 40 40 40 20 20 20 MR qA qB Q 50 100 50 100 150 200 50 100 150 200 200 qA = 50 MCA = 60 qB = 100 MCB = 60 Q = 150 MR = 60 P = 90 20 Rise As Aside: Slope of Demand Curve = =  =  .20 Run 100

22.  Lab 12.2 Conflicting Interests of an Oligopolies and Cartels: Collective versus Individual It is in the collective interests of the firms in an industry to establish a cartel. It is in their collective interests to collude by reducing production below the competitive level; by do so they can act like a monopoly and maximize the joint profits of the entire industry by restricting production below the competitive level. This represents the state of affairs before the father and there was a single monopoly firm with two plants maximizing its profit. On the other hand, if a cartel is established it may be in the individual interests of each firm to cheat on the cartel agreement. If the cartel agreement is in place, it may be in the individual interests of a firm to produce more than the agreement allows thereby pushing production toward the competitive level.

23.  Lab 12.2 Remember that consumer surplus equals the net benefits consumers enjoy from the purchase and consumption of the good. Firms: Joint profit falls. Adam’s profit rises; Adam has an incentive to cheat. Beth’s profit falls; Beth has reason to be upset. Consumers: Consumer Surplus rises. The increase in consumer surplus is greater than the fall in joint profits. Society as a whole (firms and consumers together) is better off.