Chapter 11

1. Chapter 11 Market Power, Collusion, and Oligopoly

2. I. Collusion – an agreement in which price and outputs are set by firms in an industry

3. I. Collusion – an agreement in which price and outputs are set by firms in an industry A. cartel – group of firms engaged in collusion 1. What will these firms agree to do? a. reduce industry output (each firms produces less) b. increase price

4. 2. Why would they do this? a. When these firms act as a monopoly by colluding, their profits are higher. ex: Suppose there are 2 firms in an industry and they form a cartel. How much will they produce and what price will they charge?

5. Suppose market demand is: P = 100 – 2Q , and marginal cost is constant at $12. → they will act as a monopoly and set MR = MC for the industry

6. Suppose market demand is: P = 100 – 2Q , and marginal cost is constant at $12. → they will act as a monopoly and set MR = MC for the industry industry MR = 100 – 4Q (has twice the slope of the demand curve) Set: MR = MC

7. The 2 firms will each produce half of this market quantity: q1 = q2 = 11

8. The 2 firms will each produce half of this market quantity: q1 = q2 = 11 Calculate the price they will charge using the market demand curve: Graph this situation:

9. 3. Problem: Each firm has an incentive to “cheat”. a. cheat → produce more output and lower the price b. The cheating firm will gain customers from the other firm(s) in the cartel → more profit for this firm

10. 4. So what will happen? Let’s look at a collusive “game” played by 2 firms:

11. Each firm’s decision to cheat or not depends on what it thinks its rival will do: What will Firm A do? What will Firm B do?

12. Outcome: Both firms will cheat, although they would have been better off if neither of them had cheated.

13. B. This outcome is called a “prisoners’ dilemma”. ex: Two suspects have been arrested for a crime. Each is interrogated separately, and told that if neither confesses, they will each go to jail for 2 years for a lesser charge. If one confesses and the other doesn’t, the first will have only 1 year in jail while the other has 10 years in jail. But if they both confess, they’ll each have 5 years in jail.

14. We can represent this situation with the following game:

15. Outcome: Both suspects will confess and get 5 years in jail, although they would have been better off if neither of them had confessed.

16. C. Why are cartels rare? 1. There is an incentive for each firm involved to cheat. 2. They are illegal in the U.S.

17. D. What if the prisoners’ dilemma is repeated and has a definite ending date? 1. Suppose the collusive game above will be repeated for 3 time periods. Will this encourage the firms in the cartel to not cheat because they each want to develop a reputation for reliability?

18. 2. Let’s work backward from the last time period: a. at T = 3, the game is over so each firm will cheat

19. 2. Let’s work backward from the last time period: a. at T = 3, the game is over so each firm will cheat b. at T = 2, each firm knows the other firm will cheat at T = 3, so they both cheat

20. 2. Let’s work backward from the last time period: a. at T = 3, the game is over so each firm will cheat b. at T = 2, each firm knows the other firm will cheat at T = 3, so they both cheat c. at T = 1, each firms knows the other will cheat at T = 2 and T = 3, so they both cheat 3. So the prisoners’ dilemma is not resolved.

21. E. What if the prisoners’ dilemma is repeated and does not have a definite ending date? 1. The situation is more complicated.

22. E. What if the prisoners’ dilemma is repeated and does not have a definite ending date? 1. The situation is more complicated. 2. Through experiments, economists have found that the “Tit-for-Tat” strategy is the best for each firm in the cartel. 3. According to Tit-for-Tat, a firm won’t cheat, unless the opponent firm cheats and then the first firm will punish the opponent by cheating once and then go back to not cheating.

23. II. Oligopoly – an industry in which the number of firms is sufficiently small that any one firm’s actions can affect market conditions

24. III. Oligopoly – an industry in which the number of firms is sufficiently small that any one firm’s actions can affect market conditions A. Contestable Market – a market in which firms can enter and exit costlessly 1. This means that the number of firms in the industry is not fixed.

25. 2. If the firms in a contestable market have positive profits, new firms will enter this industry

26. 2. If the firms in a contestable market have positive profits, new firms will enter this industry → the firms in this industry will set their price at the competitive price and earn zero profit in the first place (since they would earn this in the LR anyway)

27. B. Oligopoly with a Fixed Number of Firms 1. Cartel (discussed above)

28. 2. Cournot Model – an oligopoly model in which firms take their rivals’ output as given

29. 2. Cournot Model – an oligopoly model in which firms take their rivals’ output as given a. example: Demand in an industry is given by: P = 100 – Q There are 2 firms in the industry, producing q1 and q2, and both charge price, P. → demand is: P = 100 – (q1 + q2) Suppose marginal cost is constant at: MC = $10

30. b. How much will Firm 1 produce?

31. c. So how much will Firm 2 produce?

32. d. Now back to Firm 1’s quantity: plug in q2 from above:

33. e. What will be the price charged in the market? use demand curve:

34. f. How does this compare to the price and output if this industry were a monopoly?

35. g. How does it compare to the price and output if this were perfect competition?

36. h. graph:

37. 3. Bertrand Model – an oligopoly model in which firms take their rivals’ prices as given

38. 3. Bertrand Model – an oligopoly model in which firms take their rivals’ prices as given a. As long as price is greater than marginal cost, a firm will undercut its rivals by charging a slightly lower price → all customers will buy from this firm b. What will happen? Firms will keep lowering their prices until they get down to marginal cost. (below MC, profit becomes negative)

39. c. So price and output will be the same as in a perfectly competitive industry. d. graph:

40. C. Criticism of Cournot and Bertrand Models 1. In both models, a firm makes a decision based on its rivals’ choices, but then assumes that the rivals’ choices aren’t affected by its own choice. 2. Game Theory is becoming a more popular way to model oligopolies (more on this in Chapter 12).

41. IV. Monopolistic Competition – an industry in which there are many firms who produce similar, but differentiated, products

42. III. Monopolistic Competition – an industry in which there are many firms who produce similar, but differentiated, products A. product differentiation → a firm has a slightly downward-sloping demand curve

43. B. in LR, positive profits → new firms will enter this industry 1. Therefore, the demand curve for an existing firm decreases. 2. As it decreases, the price for that firm’s product falls until profit is zero. 3. graph of this situation:

44. C. Welfare Consequences of Monopolistic Competition 1. P > MC → inefficient (too little output is produced) a. However, since the demand curve is quite elastic (flat), the reduction in output as compared to perfect competition is fairly small (not much inefficiency)

45. C. Welfare Consequences of Monopolistic Competition 1. P > MC → inefficient (too little output is produced) a. However, since the demand curve is quite elastic (flat), the reduction in output as compared to perfect competition is fairly small (not much inefficiency) 2. Not at minimum point on average cost curve → not producing at lowest possible cost

46. 3. A lot of money is spent on advertising in this type of industry to point out product differences, but nothing valuable is created with this money (expect that maybe consumers gain information about the products).

47. 3. A lot of money is spent on advertising in this type of industry to point out product differences, but nothing valuable is created with this money (expect that maybe consumers gain information about the products). 4. Consumers like having choices and not always consuming the same thing. a. Due to diminishing marginal utility, total utility is higher with a variety of products.

48. 3. A lot of money is spent on advertising in this type of industry to point out product differences, but nothing valuable is created with this money (expect that maybe consumers gain information about the products). 4. Consumers like having choices and not always consuming the same thing. a. Due to diminishing marginal utility, total utility is higher with a variety of products. 5. There is no consensus on whether the pro’s or con’s of monopolistic competition are higher.