Homework answers / question archive / Name________________________ ECON 251 Final Ingersoll Final Exam This exam is due as a submission to Canvas on the specified date

Name________________________ ECON 251 Final Ingersoll Final Exam This exam is due as a submission to Canvas on the specified date

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Name________________________ ECON 251 Final Ingersoll Final Exam This exam is due as a submission to Canvas on the specified date. You may not work with anyone else. There are 6 free response questions, some with multiple parts, worth a total of 70 points. There are multiple choice questions on Canvas worth a total of 30 points. There are 100 points total on the exam. Please provide the best answer to each question. 1) Consider the differences between the perfectly competitive and the monopolistically competitive structures on the same market: (20 points total) a) Which structure yields a higher market quantity? (3 points) b) Which has a higher market price? (3 points) c) Which maximizes total surplus? (3 points) d) How is the profit max rule different between perfect competition and monopolistic competition? (3 points) Consider a monopolistically competitive firm in general: f) Graph a standard profit maximizing monopolistically competitive firm. Include on your graph the profit maximizing price, quantity, and profits for the firm. (8 points) 2) Assume that demand for a product that is produced at zero marginal cost is reflected in the table below. (15 points total) Quantity Price 0 $60 100 $55 200 $50 300 $45 400 $40 500 $35 600 $30 700 $25 800 $20 900 $15 1000 $10 1100 $5 1200 $0 a. What is the profit-maximizing level of production for a group of oligopolistic firms that operate as a cartel? (5 points) b. What profit does each firm make if they each produce half of the quantity discussed in part (a)? (5 points) c. Assume that this market is characterized by a duopoly in which collusive agreements are illegal. What market price and quantity will be associated with the Nash equilibrium? (5 points) 3) Compare a perfectly (1st degree) price discriminating firm versus a single price monopolist by answering the following questions. (10 points total) a. What makes the pricing techniques different? (5 points) b. How is welfare (consumer, producer, total surplus) different between the two pricing methods? (5 points) 4) Suppose the airplane production market is a duopoly between Boeing and Airbus. (10 points total) a. Boeing and Airbus can make more profits if they both restrict their production from their current production levels, but they do not. Why are they stuck at this equilibrium? (5 points) b. Suppose Boeing offers to sign a legally binding contract with Airbus stating that if either firm produces above the restricted production level mentioned in (a) above, the overproducing firm must pay a fee to the firm that produced the restricted amount. If the fee was set at the correct level, could this change the expected equilibrium in the market? Why? (5 points) 5) Artie and Beth have just broken up. They shared a love for the movies, but in the end that is all they shared. This week, two new blockbuster movies, a sci-fi thriller and a drama, are coming out. Both Artie and Beth are excited about seeing both movies. However, they are not excited about seeing the movie in the same theater as each other. (10 points total) a. The following normal form game represents the situation described above. What are the Nash Equilibria of this game? Do they make sense given the above situation? Why? (5 points) Beth Artie Sci-Fi Drama Sci-Fi -5,-5 10,10 Drama 8,8 -5,-5 b) Artie sends a text to Beth, saying that he will be attending the Drama movie. Given that she receives the text, which movie do we expect Beth to go to? (5 points) 6) What was your favorite part of the course? (5 points) Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of perfect competition and monopoly. But oligopoly and monopolistic competition are quite different. Oligopoly departs from the perfectly competitive ideal of Chapter 14 because there are only a few sellers in the market. The small number of sellers makes rigorous competition less likely and strategic interactions among them vitally impor- tant. By contrast, a monopolistically competitive market has many sellers, each of which is small compared to the market. It departs from the perfectly competitive ideal because each of the sellers offers a somewhat differ- ent product. Figure 1 summarizes the four types of market structure. The first question to ask about any market is how many firms there are. If there is only one firm, the market is a monopoly. If there are only a few firms, the mar- ket is an oligopoly. If there are many firms, we need to ask another question: Do the firms sell identical or differ- entiated products? If the many firms sell identical products, the market is perfectly competitive. But if the many firms sell differentiated products, the market is monopolistically competitive. Figure 1. The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Identical products Monopoly (Chapter 15) Oligopoly (Chapter 17) Monopolistic Competition (Chapter 16) Perfect Competition (Chapter 14) • Tap water • Cable TV • Tennis balls • Cigarettes • Novels • Movies • Wheat • Milk Economists who study industrial organization divide markets into four types: monopoly, oligopoly, monopolis- tic competition, and perfect competition. Because reality is never as clear-cut as theory, at times you may find it hard to decide what structure best de- scribes a market. There is, for instance, no magic number that separates “few" from "many" when counting the number of firms. (Do the approximately dozen companies that now sell cars in the United States make this mar- ket an oligopoly, or is the market more competitive? The answer is open to debate.) Similarly, there is no sure way to determine when products are differentiated and when they are identical. (Are different brands of milk re- ally the same? Again, the answer is debatable.) When analyzing actual markets, economists have to keep in mind the lessons learned from studying all types of market structure and then apply each lesson as it seems appropriate. Now that we understand how economists define the various types of market structure, we can continue our analysis of each of them. In this chapter we examine monopolistic competition. In the next chapter we analyze oligopoly. Quick Quiz Define oligopoly and monopolistic competition and give an example of each. Competition with Differentiated Products To understand monopolistically competitive markets, we first consider the decisions facing an individual firm. We then examine what happens in the long run as firms enter and exit the industry. Next, we compare the equilibrium under monopolistic competition to the equilibrium under perfect competition that we examined in Chapter 14. Finally, we consider whether the outcome a monopolistically competitive market is desirable Competition with Differentiated Products To understand monopolistically competitive markets, we first consider the decisions facing an individual firm. We then examine what happens in the long run as firms enter and exit the industry. Next, we compare the equilibrium under monopolistic competition to the equilibrium under perfect competition that we examined in Chapter 14. Finally, we consider whether the outcome in a monopolistically competitive market is desirable from the standpoint of society as a whole. The Monopolistically Competitive Firm in the Short Run Each firm in a monopolistically competitive market is, in many ways, like a monopoly. Because its product is different from those offered by other firms, it faces a downward-sloping demand curve. (By contrast, a perfectly competitive firm faces a horizontal demand curve at the market price.) Thus, the monopolistically competitive firm follows a monopolist's rule for profit maximization: It chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price at which it can sell that quantity. Figure 2 shows the cost, demand, and marginal-revenue curves for two typical firms, each in a different mo- nopolistically competitive industry. In both panels of the figure, the profit-maximizing quantity is found at the intersection of the marginal-revenue and marginal-cost curves. The two panels show different outcomes for the firm's profit. In panel (a), price exceeds average total cost, so the firm makes a profit. In panel (b), price is below average total cost. In this case, the firm is unable to make a positive profit, so the best it can do is to minimize its losses. Figure 2. Monopolistic Competitors in the Short Run (a) Firm Makes Profit (b) Firm Makes Losses Price Price MC MC ATC ATC Losses Price Average total cost Price Average total cost Profit Demand MR MR Demand Quantity 0 Quantity Profit- maximizing quantity Loss minimizing quantity Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal rev- enue equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is greater than aver- age total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost. All this should seem familiar. A monopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar. The Long-Run Equilibrium The situations depicted in Figure 2 do not last long. When firms are profits, as in panel (a), ew firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit en- courages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms' products falls, these firms experience declining profit. Conversely, when firms are making losses, as in panel (b), firms in the market have an incentive to exit. As firms exit, customers have fewer products Tom when to choose. This decrease in the number of firms expands The Monopolistically Competitive Firm in the Short Run Each firm in a monopolistically competitive market is, in many ways, like a monopoly. Because its product is different from those offered by other firms, it faces a downward-sloping demand curve. (By contrast, a perfectly competitive firm faces a horizontal demand curve at the market price.) Thus, the monopolistically competitive firm follows a monopolist's rule for profit maximization: It chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price at which it can sell that quantity. Figure 2 shows the cost, demand, and marginal-revenue curves for two typical firms, each in a different mo- nopolistically competitive industry. In both panels of the figure, the profit-maximizing quantity is found at the intersection of the marginal-revenue and marginal-cost curves. The two panels show different outcomes for the firm's profit. In panel (a), price exceeds average total cost, so the firm makes a profit. In panel (b), price is below average total cost. In this case, the firm is unable to make a positive profit, so the best it can do is to minimize its losses. Figure 2. Monopolistic Competitors in the Short Run (a) Firm Makes Profit (b) Firm Makes Losses Price Price MC MC ATC ATC Losses Price Average total cost Price Average total cost Demand Profit MR MR Demand 0 Quantity 0 Quantity Profit- maximizing quantity Loss minimizing quantity Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal rev- enue equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is greater than aver- age total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost. All this should seem familiar. A monopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar. The Long-Run Equilibrium The situations depicted in Figure 2 do not last long. When firms are making profits, as in panel (a), new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit en- courages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms' products falls, these firms experience declining profit. Conversely, when firms are making losses, as in panel (b), firms in the market have an incentive to exit. As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. In other words, losses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms' products rises, these firms experience rising profits (that is, declining losses). This process of entry and exit continues until the firms in the market are making exactly zero economic profit. Figure 3 depicts the long-run equilibrium. Once the market reaches this equilibrium, new firms have no incen- tive to enter, and existing firms have no incentive to exit. Figure 3 A Monopolistic Competitor in the Long Run Figure 3. A Monopolistic Competitor in the Long Run Price MC ATC P- ATC Demand MR Profit-maximizing quantity Quantity In a monopolistically competitive market, if firms are making profits, new firms enter, causing the demand curves for the incumbent firms to shift to the left. Similarly, if firms are making losses, some of the firms in the market exit, causing the demand curves of the remaining firms to shift to the right. Because of these shifts in de- mand, monopolistically competitive firms eventually find themselves in the long-run equilibrium shown here. In this long-run equilibrium, price equals average total cost, and each firm earns zero profit. Notice that the demand curve in this figure just barely touches the average-total-cost curve. Mathematically, we say the two curves are tangent to each other. These two curves must be tangent once entry and exit have dri- ven profit to zero. Because profit per unit sold is the difference between price (found on the demand curve) and average total cost, the maximum profit is zero only if these two curves touch each other without crossing. Also note that this point of tangency occurs at the same quantity where marginal revenue equals marginal cost. That these two points line up is not a coincidence: It is required because this particular quantity maximizes profit and the maximum profit is exactly zero in the long run. To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market: As in a monopoly market, price exceeds marginal cost (P > MC). This conclusion arises because profit maximization requires marginal revenue to equal marginal cost (MR = MC) and because the downward-sloping demand curve makes marginal revenue less than the price (MR< P). As in a competitive market, price equals average total cost (P = ATC). This conclusion arises be- cause free entry and exit drive economic profit to zero. The second characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close substitutes, it can earn positive economic profit, even in the long run. By contrast, because there is free entry into a monopolistically competitive market, the economic profit of a firm in this type of market is driven to zero. Monopolistic versus Perfect Competition Figure 4 compares the long-run equilibrium under monopolistic competition to the long-run equilibrium under perfect competition. (Chapter 14 discussed the equilibrium with perfect competition.) There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the markup. Figure 4. Monopolistic versus Perfect Competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC MC ATC ATC Markup Excess Capacity As we have just seen, the process of entry and exit drives each firm in a monopolistically competitive market to a point of tangency between its demand and average-total-cost curves. Panel (a) of Figure 4 shows that the quantity of output at this point is smaller than the quantity that minimizes average total cost. Thus, under mo- nopolistic competition, firms produce on the downward-sloping portion of their average-total-cost curves. In this way, monopolistic competition contrasts starkly with perfect competition. As panel (b) of Figure 4 shows, free entry in competitive markets drives firms to produce at the minimum of average total cost. The quantity that minimizes average total cost is called the efficient scale of the firm. In the long run, perfect- ly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. Firms are said to have excess capacity under monopolistic competition. In other words, a monopolisti- cally competitive firm, unlike a perfectly competitive firm, could increase the quantity it produces and lower the average total cost of production. The firm forgoes this opportunity because it would need to cut its price to sell the additional output. It is more profitable for a monopolistic competitor to continue operating with excess ca- pacity. Markup Over Marginal Cost A second difference between perfect competition and monopolistic competition is the relationship between price and marginal cost. For a perfectly competitive firm, such as the one shown in panel (b) of Figure 4, price equals marginal cost. For a monopolistically competitive firm, such as the one shown in panel (a), price exceeds marginal cost because the firm always has some market power. How is this markup over marginal cost consistent with free entry and zero profit? The zero-profit condition ensures only that price equals average total cost. It does not ensure that price equals marginal cost. Indeed, in the long-run equilibrium, monopolistically competitive firms operate on the declining portion of their average- total-cost curves, so marginal cost is below average total cost. Thus, for price to equal average total cost, price must be above marginal cost. In this relationship between price and marginal cost, we see a key behavioral difference between perfect com- petitors and monopolistic competitors. Imagine that you were to ask a firm the following question: "Would you like to see another customer come through your door ready to buy from you at your current price?” A perfectly competitive firm would answer that it didn't care. Because price exactly equals marginal cost, the profit from an extra unit sold is zero. By contrast, a monopolistically competitive firm is always eager to get another customer. Because its price exceeds marginal cost, an extra unit sold at the posted price means more profit. According to an old quip, monopolistically competitive markets are those in which sellers send Christmas cards to the buyers. Trying to attract more customers makes sense only if price exceeds marginal cost. Monopolistic Competition and the Welfare of Society Is the outcome in a monopolistically competitive market desirable from the standpoint of society as a whole? Can policymakers improve on the market outcome? In previous chapters we evaluated markets from the stand- point of efficiency by asking whether society is getting the most it can out of its scarce resources. We learned that competitive markets lead to efficient outcomes, unless there are externalities, whereas monopoly markets lead to deadweight losses. Monopolistically competitive markets are more complex than either of these polar cases, so evaluating welfare in these markets is a more subtle exercise. One source of inefficiency in monopolistically competitive markets is the markup of price over marginal cost. Because of the markup, some consumers who value the good at more than the marginal cost of production (but less than the price) will be deterred from buying it. Thus, a monopolistically competitive market has the normal deadweight loss of monopoly pricing. This outcome is undesirable compared with the efficient quantity that arises when price equals marginal cost, but policymakers don't have an easy way to fix the problem. To enforce marginal-cost pricing, they would need to regulate all firms that produce differentiated products. Because such products are so common in the economy, the administrative burden of such regulation would be overwhelming. Moreover, regulating monopolistic competitors entails all the problems of regulating natural monopolies. In narticular , titore are malinczorenreftelronde irina+bom tel thoir < 3: Q TT .:) @ Markets with Only a few Sellers Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension be- tween cooperation and self-interest. The oligopolists are best off when they cooperate and act like a monopolist -producing a small quantity of output and charging a price above marginal cost. Yet because each oligopolist cares only about its own profit, there are powerful incentives at work that hinder a group of firms from main- taining the cooperative outcome. A Duopoly Example To understand the behavior of oligopolies, let's consider an oligopoly with only two members, called a du- opoly. Duopoly is the simplest type of oligopoly. Oligopolies with three or more members face the same prob- lems as duopolies, so we do not lose much by starting with the simpler case. Imagine a town in which only two residents, Jack and Jill, own wells that produce water safe for drinking. Each Saturday, Jack and Jill decide how many gallons of water to pump, bring the water to town, and sell it for whatever price the market will bear. To keep things simple, suppose that Jack and Jill can pump as much water as they want without cost. That is, the marginal cost of water equals zero. Table 1 shows the town's demand schedule for water. The first column shows the total quantity demanded, and the second column shows the price. If the two well owners sell a total of 10 gallons of water, water goes for $110 a gallon. If they sell a total of 20 gallons, the price falls to $100 a gallon. And so on. If you graphed these two columns of numbers, you would get a standard downward-sloping demand curve. 339 Table 1. The Demand Schedule for Water Quantity O gallons 10 20 30 40 Price $120 110 100 90 80 70 60 50 40 50 Total Revenue (and total profit) $ 0 1,100 2,000 2,700 3,200 3,500 3,600 3,500 3,200 2,700 2,000 1,100 0 60 70 80 90 100 110 30 20 10 O 120 The last column in Table 1 shows total revenue from the sale of water. It equals the quantity sold times the price. Because there is no cost to pumping water, the total revenue of the two producers equals their total profit. Let's now consider how the organization of the town's water industry affects the price of water and the quan- tity sold. Competition, Monopolies, and Cartels Before considering the price and ouantity of water that results from the duopoly of Jack and Jill, let's discuss How the Size of an Oligopoly Affects the Market Outcome We can use the insights from this analysis of duopoly to discuss how the size of an oligopoly is likely to affect the outcome in a market. Suppose, for instance, that John and Joan suddenly discover water sources on their property and join Jack and Jill in the water oligopoly. The demand schedule in Table i remains the same, but now more producers are available to satisfy this demand. How would an increase in the number of sellers from two to four affect the price and quantity of water in the town? If the sellers of water could form a cartel, they would once again try to maximize total profit by producing the monopoly quantity and charging the monopoly price. Just as when there were only two sellers, the members of the cartel would need to agree on production levels for each member and find some way to enforce the agree- ment. As the cartel grows larger, however, this outcome is less likely. Reaching and enforcing an agreement be- comes more difficult as the size of the group increases. If the oligopolists do not form a cartel-perhaps because the antitrust laws prohibit it-they must each decide on their own how much water to produce. To see how the increase in the number of sellers affects the outcome, consider the decision facing each seller. At any time, each well owner has the option to raise production by one gallon. In making this decision, the well owner weighs the following two effects: The output effect: Because price is above marginal cost, selling one more gallon of water at the go- ing price will raise profit. The price effect: Raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other gallons sold. If the output effect is larger than the price effect, the well owner will increase production. If the price effect is larger than the output effect, the owner will not raise production. (In fact, in this case, it is profitable to reduce production.) Each oligopolist continues to increase production until these two marginal effects exactly balance, taking the other firms' production as given. Now consider how the number of firms in the industry affects the marginal analysis of each oligopolist. The larger the number of sellers, the less each seller is concerned about her own impact on the market price. That is, as the oligopoly grows in size, the magnitude of the price effect falls. When the oligopoly grows very large, the price effect disappears altogether. In this extreme case, the production decision of an individual firm no longer affects the market price. Each firm takes the market price as given when deciding how much to produce and, therefore increases production as long as price is above marginal cost. We can now see that a large oligopoly is essentially a group of competitive firms. A competitive firm considers only the output effect when deciding how much to produce: Because a competitive firm is a price taker, the price effect is absent. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level. This analysis of oligopoly offers a new perspective on the effects of international trade. Imagine that Toyota and Honda are the only automakers in Japan, Volkswagen and BMW are the only automakers in Germany, and Ford and General Motors are the only automakers in the United States. If these nations prohibited international trade in autos, each would have an auto oligopoly with only two members, and the market outcome would likely depart substantially from the competitive ideal. With international trade, however, the car market is a world market, and the oligopoly in this example has six members. Allowing free trade increases the number of produc- ers from which each consumer can choose, and this increased competition keeps prices closer to marginal cost. Thus, the theory of oligopoly provides another reason, in addition to the theory of comparative advantage dis- cussed in Chapter 3, why countries can benefit from free trade. QuickQuiz If the members of an oligopoly could agree on a total quantity to produce, what quantity would they choose? If the oligopolists do not act together but instead make production decisions individually, do they produce a total quantity more or less than in your answer to the previous question? Why? The Equilibrium for an Oligopoly Oligopolists would like to form cartels and earn monopoly profits, but that is often impossible. Squabbling among cartel members over how to divide the profit in the market can make agreement among members diffi- cult. In addition, antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy. Even talking about pricing and production restrictions with competitors can be a criminal offense. Let's therefore con- sider what happens if Jack and Jill decide separately how much water to produce. At first, one might expect Jack and Jill to reach the monopoly outcome on their own, because this outcome maximizes their joint profit. In the absence of a binding agreement, however, the monopoly outcome is unlikely. To see why, imagine that Jack expects Jill to produce only 30 gallons (half of the monopoly quantity). Jack would reason as follows: “I could produce 30 gallons as well. In this case, a total of 60 gallons of water would be sold at a price of $60 a gallon. My profit would be $1,800 (30 gallons * $60 a gallon). Alternatively, I could produce 40 gallons. In this case, a total of 70 gallons of water would be sold at a price of $50 a gallon. My profit would be $2,000 (40 gallons * $50 a gallon). Even though total profit in the market would fall, my profit would be higher, because I would have a larger share of the market.” Of course, Jill might reason the same way. If so, Jack and Jill would each bring 40 gallons to town. Total sales would be 80 gallons, and the price would fall to $40. Thus, if the duopolists individually pursue their own self- interest when deciding how much to produce, they produce a total quantity greater than the monopoly quantity, charge a price lower than the monopoly price, and earn total profit less than the monopoly profit. Although the logic of self-interest increases the duopoly's output above the monopoly level, it does not push the duopolists all the way to the competitive allocation. Consider what happens when each duopolist produces 40 gallons. The price is $40, and each duopolist makes a profit of $1,600. In this case, Jack's self-interested logic leads to a different conclusion: "Right now, my profit is $1,600. Suppose I increase my production to 50 gallons. In this case, a total of 90 gal- lons of water would be sold, and the price would be $30 a gallon. Then my profit would be only $1,500. Rather than increasing production and driving down the price, I am better off keeping my production at 40 gallons.” The outcome in which Jack and Jill each produce 40 gallons looks like some sort of equilibrium. In fact, this outcome is called a Nash equilibrium. (It is named after Nobel Prize-winning mathematician and economic the- orist John Nash, whose life was portrayed in the book and movie A Beautiful Mind.) A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strate- gies that the others have chosen. In this case, given that Jill is producing 40 gallons, the best strategy for Jack is also to produce 40 gallons. Similarly, given that Jack is producing 40 gallons, the best strategy for Jill is also to produce 40 gallons. Once they reach this Nash equilibrium, neither Jack nor Jill has an incentive to make a dif- ferent decision. This example illustrates the tension between cooperation and self-interest. Oligopolists would be better off cooperating and reaching the monopoly outcome. Yet because they each pursue their own self-interest, they do not end up reaching the monopoly outcome and, thus, fail to maximize their joint profit. Each oligopolist is tempted to raise production and capture a larger share of the market. As each of them tries to do this, total pro- duction rises, and the price falls. At the same time, self-interest does not drive the market all the way to the competitive outcome. Like monop- olists, oligopolists are aware that increasing the amount they produce reduces the price of their product, which in turn affects profits. Therefore, they stop short of following the competitive firm's rule of producing up to the point where price equals marginal cost. In summary, when firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by perfect competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost). How the Size of an Oligopoly Affects the Market Outcome We can use the insights from this analysis of duopoly to discuss how the size of an oligopoly is likely to affect the outcome in a market. Suppose, for instance, that John and Joan suddenly discover water sources on their property and join Jack and Jill in the water oligopoly. The demand schedule in Table i remains the same, but now more producers are available to satisfy this demand. How would an increase in the number of sellers from two to four affect the price and quantity of water in the town? If the sellers of water could form a cartel, they would once again try to maximize total profit by producing the monopoly quantity and charging the monopoly price. Just as when there were only two sellers, the members of the cartel would need to agree on production levels for each member and find some way to enforce the agree- ment. As the cartel grows larger, however, this outcome is less likely. Reaching and enforcing an agreement be- comes more difficult as the size of the group increases. If the oligopolists do not form a cartel-perhaps because the antitrust laws prohibit it-they must each decide on their own how much water to produce. To see how the increase in the number of sellers affects the outcome, consider the decision facing each seller. At any time, each well owner has the option to raise production by one gallon. In making this decision, the well owner weighs the following two effects: The output effect: Because price is above marginal cost, selling one more gallon of water at the go- ing price will raise profit. The price effect: Raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other gallons sold. If the output effect is larger than the price effect, the well owner will increase production. If the price effect is larger than the output effect, the owner will not raise production. (In fact, in this case, it is profitable to reduce production.) Each oligopolist continues to increase production until these two marginal effects exactly balance, taking the other firms' production as given. Now consider how the number of firms in the industry affects the marginal analysis of each oligopolist. The larger the number of sellers, the less each seller is concerned about her own impact on the market price. That is, as the oligopoly grows in size, the magnitude of the price effect falls. When the oligopoly grows very large, the price effect disappears altogether. In this extreme case, the production decision of an individual firm no longer affects the market price. Each firm takes the market price as given when deciding how much to produce and, therefore increases production as long as price is above marginal cost. We can now see that a large oligopoly is essentially a group of competitive firms. A competitive firm considers only the output effect when deciding how much to produce: Because a competitive firm is a price taker, the price effect is absent. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level. This analysis of oligopoly offers a new perspective on the effects of international trade. Imagine that Toyota and Honda are the only automakers in Japan, Volkswagen and BMW are the only automakers in Germany, and Ford and General Motors are the only automakers in the United States. If these nations prohibited international trade in autos, each would have an auto oligopoly with only two members, and the market outcome would likely depart substantially from the competitive ideal. With international trade, however, the car market is a world market, and the oligopoly in this example has six members. Allowing free trade increases the number of produc- ers from which each consumer can choose, and this increased competition keeps prices closer to marginal cost. Thus, the theory of oligopoly provides another reason, in addition to the theory of comparative advantage dis- cussed in Chapter 3, why countries can benefit from free trade. QuickQuiz If the members of an oligopoly could agree on a total quantity to produce, what quantity would they choose? If the oligopolists do not act together but instead make production decisions individually, do they produce a total quantity more or less than in your answer to the previous question? Why? The Economics of Cooperation As we have seen, oligopolies would like to reach the monopoly outcome. Doing so, however, requires cooper- ation, which at times is difficult to establish and maintain. In this section we look more closely at the problems that arise when cooperation among actors is desirable but difficult. To analyze the economics of cooperation, we need to learn a little about game theory. In particular, we focus on a “game” called the prisoners' dilemma , which provides insight into why coop- eration is difficult. Many times in life, people fail to cooperate with one another even when cooperation would make them all better off. An oligopoly is just one example. The story of the prisoners' dilemma contains a gener- al lesson that applies to any group trying to maintain cooperation among its members. The Prisoners' Dilemma The prisoners' dilemma is a story about two criminals who have been captured by the police. Let's call them Bonnie and Clyde. The police have enough evidence to convict Bonnie and Clyde of the minor crime of carrying an unregistered gun, so that each would spend a year in jail. The police also suspect that the two criminals have committed a bank robbery together, but they lack hard evidence to convict them of this major crime. The police question Bonnie and Clyde in separate rooms and offer each of them the following deal: “Right now, we can lock you up for 1 year. If you confess to the bank robbery and implicate your partner, however, we'll give you immunity and you can go free. Your partner will get 20 years in jail. But if you both con- fess to the crime, we won't need your testimony and we can avoid the cost of a trial, so you will each get an in- termediate sentence of 8 years." If Bonnie and Clyde, heartless bank robbers that they are, care only about their own individual sentences, what would you expect them to do? Figure 1 shows their choices. Each prisoner has two strategies: confess or remain silent. The sentence each prisoner gets depends on the strategy he or she chooses and the strategy cho- sen by his or her partner in crime. Figure 1. The Prisoners' Dilemma Bonnie's Decision Confess Bonnie gets 8 years Remain Silent Bonnie gets 20 years Confess Clyde goes free Clyde's Decision Clyde gets 8 years Bonnie goes free Bonnie gets 1 year Remain Silent Clyde gets 20 years Clyde gets 1 year In this game between two criminals suspected of committing a crime, the sentence that each receives depends both on his or her decision whether to confess or remain silent and on the decision made by the other. Consider first Bonnie's decision. She reasons as follows: “I don't know what Clyde is going to do. If he remains silent, my best strategy is to confess, because then I'll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, because then I'll spend 8 years in jail rather than 20. So, regardless of what Clyde does, I am better off confessing.” In the language of game theory, a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Bonnie. She spends less time in jail if she confesses, regardless of whether Clyde confesses or remains silent. Now consider Clyde's decision. reasons in much the same way. Consider first Bonnie's decision. She reasons as follows: “I don't know what Clyde is going to do. If he remains silent, my best strategy is to confess, because then I'll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, because then I'll spend 8 years in jail rather than 20. So, regardless of what Clyde does, I am better off confessing.” In the language of game theory, a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Bonnie. She spends less time in jail if she confesses, regardless of whether Clyde confesses or remains silent. Now consider Clyde's decision. He faces the same choices as Bonnie, and he reasons in much the same way. Regardless of what Bonnie does, Clyde can reduce his jail time by confessing. In other words, confessing is also a dominant strategy for Clyde. In the end, both Bonnie and Clyde confess, and both spend 8 years in jail. This outcome is a Nash equilibri- um: Each criminal is choosing the best strategy available, given the strategy the other is following. Yet, from their standpoint, the outcome is terrible. If they had both remained silent, both of them would have been better off, spending only 1 year in jail on the gun charge. Because each pursues his or her own interests, the two pris- oners together reach an outcome that is worse for each of them. You might have thought that Bonnie and Clyde would have foreseen this situation and planned ahead. But even with advanced planning, they would still run into problems. Imagine that, before the police captured Bon- nie and Clyde, the two criminals had made a pact not to confess. Clearly, this agreement would make them both better off if they both lived up to it, because they would each spend only 1 year in jail. But would the two crimi- nals in fact remain silent, simply because they had agreed to? Once they are being questioned separately, the logic of self-interest takes over and leads them to confess. Cooperation between the two prisoners is difficult to maintain, because cooperation is individually irrational. Oligopolies as a Prisoners' Dilemma What does the prisoners' dilemma have to do with markets and imperfect competition? It turns out that the game oligopolists play in trying to reach the monopoly outcome is similar to the game that the two prisoners play in the prisoners' dilemma. Consider again the choices facing Jack and Jill. After prolonged negotiation, the two suppliers of water agree to keep production at 30 gallons so that the price will be kept high and together they will earn the maximum profit. After they agree on production levels, however, each of them must decide whether to cooperate and live up to this agreement or to ignore it and produce at a higher level. Figure 2 shows how the profits of the two produc- ers depend on the strategies they choose. Figure 2. Jack and Jill's Oligopoly Game Jack's Decision High Production: 40 Gallons Low Production: 30 Gallons Jack gets Jack gets $1,600 profit $1,500 profit High Production: 40 Gallons Jill gets $1,600 profit Jill gets $2,000 profit Jill's Decision Jack gets $2,000 profit Jack gets $1,800 profit Low Production: 30 Gallons Jill gets Jill gets $1,500 profit $1,800 profit In this game between Jack and Jill, the profit that each earns from selling water depends on both the quantity he or she chooses to sell and the quantity the other chooses to sell. Suppose you are Jack. You might reason as follows: “I could keep production at 30 gallons as we agreed, or I could raise my production and sell 40 gallons. If Jill lives up to the agreement and keeps her production at 30 gallons, then I earn a profit of $2,000 by selling 40 gallons and $1,800 by selling 30 gallons. In this case, I am bet- ter off with the higher-level production. If Jill fails to live up to the agreement and produces 40 gallons, then I earn $1,600 by selling 40 gallons and $1,500 by selling 30 gallons. Once again, I am better off with higher produc- tion. So, regardless of what Jill chooses to do, I am better off reneging on our agreement and producing at the higher level.” Producing 40 gallons is a dominant strategy for Jack. Of course, Jill reasons in exactly the same way, and so both produce at the higher level of 40 gallons. The result is the inferior outcome (from Jack and Jill's standpoint) with low profits for each of the two producers. This example illustrates why oligopolies have trouble maintaining monopoly profits. The monopoly outcome is jointly rational, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners' dilemma to confess, self-interest makes it difficult for the oligopolists to maintain the cooperative outcome with low production, high prices, and monopoly profits. Case Study OPEC and the World Oil Market Our story about the town's market for water is fictional, but if we change water to crude oil, and Jack and Jill to Iran and Iraq, the story is close to being true. Much of the world's oil is produced by a few coun- tries, mostly in the Middle East. These countries together make up an oligopoly. Their decisions about how much oil to pump are much the same as Jack and Jill's decisions about how much water to pump. The countries that produce most of the world's oil have formed a cartel, called the Organization of the Petroleum Exporting Countries (OPEC). As originally formed in 1960, OPEC included Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. By 1973, eight other nations had joined: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon. These countries control about three-fourths of the world's oil reserves. Like any cartel, OPEC tries to raise the price of its product through a coordinated re- duction in quantity produced. OPEC tries to set production levels for each of the member countries. The problem that OPEC faces is much the same as the problem that Jack and Jill face in our story. The OPEC countries would like to maintain a high price for oil. But each member of the cartel is tempted to in- crease its production to get a larger share of the total profit. OPEC members frequently agree to reduce production but then cheat on their agreements. OPEC was most successful at maintaining cooperation and high prices in the period from 1973 to 1985. The price of crude oil rose from $3 a barrel in 1972 to $11 in 1974 and then to $35 in 1981. But in the mid- 1980s, member countries began arguing about production levels, and OPEC became ineffective at main- taining cooperation. By 1986 the price of crude oil had fallen back to $13 a barrel. In recent years, the members of OPEC have continued to meet regularly, but they have been less suc- cessful at reaching and enforcing agreements. As a result, fluctuations in oil prices have been driven more by the natural forces of supply and demand than by the cartel's artificial restrictions on production. While this lack of cooperation among OPEC nations has reduced the profits of the oil-producing nations below what they might have been, it has benefited consumers around the world. Other Examples of the Prisoners' Dilemma We have seen how the prisoners' dilemma can be used to understand the problem facing oligopolies. The same logic applies to many other situations as well. Here we consider two examples in which self-interest pre- vents cooperation and leads to an inferior outcome for the parties involved. Arms Races In the decades after World War II, the world's two superpowers-the United States and the Soviet Union- were engaged in a prolonged competition over military power. This topic motivated some of the early work on game theory. The game theorists in the prisoners' dilemma. < 3: Q TT .) @ Why Monopolies Arise A firm is a monopoly if it is the sole seller of its product and if its product does not have any close substi- tutes. The fundamental cause of monopoly is barriers to entry: A monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources: 29 . Monopoly resources: A key resource required for production is owned by a single firm. Government regulation: The government gives a single firm the exclusive right to produce some good or service. The production process: A single firm can produce output at a lower cost than can a larger number of firms. Let's briefly discuss each of these. m w THE WALL STREET JOURNAL - PERMSSION, CARTOON FEATURES SYNDICATE DAVE CARPENTIER. THE WALL STREET JOURNAL - PERMISSION, CARTOON FEATURES SYNDICATE “Rather than a monopoly, we like to consider ourselves 'the only game in town.”” Monopoly Resources The simplest way for a monopoly to arise is for a single firm to own a key resource. For example, consider the market for water in a small town. If dozens of town residents have working wells, the model of competitive mar- kets discussed in the preceding chapter describes the behavior of sellers. Competition among suppliers drives the price of a gallon of water to equal the marginal cost of pumping an extra gallon. But if there is only one well in town and it is impossible to get water from anywhere else, then the owner of the well has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market. In the case of a necessity like water, the monopolist can command quite a high price, even if the marginal cost of pumping an extra gallon is low. A classic example of market power arising from the ownership of a key resource is DeBeers, the South African diamond company. Founded in 1888 by Cecil Rhodes, an English businessman (and benefactor of the Rhodes scholarship), DeBeers has at times controlled up to 80 percent of the production from the world's diamond mines. Because its market share is less than 100 percent, DeBeers is not exactly a monopoly, but the company has nonetheless exerted substantial influence over the market price of diamonds. Although exclusive ownership of a key resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason. Economies are large, and resources are owned by many people. The natural scope of many markets is worldwide, because goods are often traded internationally. There are, therefore, few examples of firms that own a resource for WHICHI mere are no tiose suosuutes. < Q TT @ Although exclusive ownership of a key resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason. Economies are large, and resources are owned by many people. The natural scope of many markets is worldwide, because goods are often traded internationally. There are, therefore, few examples of firms that own a resource for which there are no close substitutes. Government-Created Monopolies In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service. Sometimes the monopoly arises from the sheer political clout of the would-be mo- nopolist. Kings, for example, once granted exclusive business licenses to their friends and allies. At other times, the government grants a monopoly because doing so is viewed to be in the public interest. The patent and copyright laws are two important examples. When a pharmaceutical company discovers a new drug, it can apply to the government for a patent. If the government deems the drug to be truly original, it approves the patent, which gives the company the exclusive right to manufacture and sell the drug for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The copyright is a government guarantee that no one can print and sell the work without the author's permission. The copyright makes the novelist a monopolist in the sale of her novel. The effects of patent and copyright laws are easy to see. Because these laws give one producer a monopoly, they lead to higher prices than would occur under competition. But by allowing these monopoly producers to charge higher prices and earn higher profits, the laws also encourage some desirable behavior. Drug companies are allowed to be monopolists in the drugs they discover to encourage research. Authors are allowed to be mo- nopolists in the sale of their books to encourage them to write more and better books. 292 Thus, the laws governing patents and copyrights have both benefits and costs. The benefits of the patent and copyright laws are the increased incentives for creative activity. These benefits are offset, to some extent, by the costs of monopoly pricing, which we examine later in this chapter. Natural Monopolies An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output. Figure 1 shows the average total costs of a firm with economies of scale. In this case, a single firm can produce any amount of output at the lowest cost. That is, for any given amount of output, a larg- er number of firms leads to less output per firm and higher average total cost. Figure 1. Economies of Scale as a Cause of Monopoly Cost Average total cost 0 Quantity of Output When a firm's average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the lowest cost. < iii Q TT @ An example of a natural monopoly is the distribution of water. To provide water to residents of a town, a firm must build a network of pipes throughout the town. If two or more firms were to compete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average total cost of wa- ter is lowest if a single firm serves the entire market. We saw other examples of natural monopolies when we discussed public goods and common resources in Chapter 11. We noted that club goods are excludable but not rival in consumption. An example is a bridge used so infrequently that it is never congested. The bridge is excludable because a toll collector can prevent someone from using it. The bridge is not rival in consumption because use of the bridge by one person does not diminish the ability of others to use it. Because there is a large fixed cost of building the bridge and a negligible marginal cost of additional users, the average total cost of a trip across the bridge (the total cost divided by the number of trips) falls as the number of trips rises. Hence, the bridge is a natural monopoly. 293 When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. Nor- mally, a firm has trouble maintaining a monopoly position without ownership of a key resource or protection from the government. The monopolist's profit attracts entrants into the market, and these entrants make the market more competitive. By contrast, entering a market in which another firm has a natural monopoly is unat- tractive. Would-be entrants know that they cannot achieve the same low costs that the monopolist enjoys be- cause, after entry, each firm would have a smaller piece of the market. In some cases, the size of the market is one determinant of whether an industry is a natural monopoly. Again, consider a bridge across a river. When the population is small, the bridge may be a natural monopoly. A single bridge can satisfy the entire demand for trips across the river at the lowest cost. Yet as the population grows and the bridge becomes congested, satisfying the entire demand may require two or more bridges across the same river. Thus, as a market expands, a natural monopoly can evolve into a more competitive market. Quick Quiz What are the three reasons that a market might have a monopoly? Give two examples of monopolies and explain the reason for each. How Monopolies Make Production and Pricing Decisions Now that we know how monopolies arise, we can consider how a monopoly firm decides how much of its product to make and what price to charge for it. The analysis of monopoly behavior in this section is the starting point for evaluating whether monopolies are desirable and what policies the government might pursue in mo- nopoly markets. Monopoly versus Competition The key difference between a competitive firm and a monopoly is the monopoly's ability to influence the price of its output. A competitive firm is small relative to the market in which it operates and, therefore, has no power to influence the price of its output. It takes the price as given by market conditions. By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market. One way to view this difference between a competitive firm and a monopoly is to consider the demand curve that each firm faces. When we analyzed profit maximization by competitive firms in the preceding chapter, we drew the market price as a horizontal line. Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve, as in panel (a) of Figure 2. In effect, because the competitive firm sells a product with many perfect substitutes (the products of all the other firms in its mar- ket), the demand curve that any one firm faces is perfectly elastic. < E Q TT al @ Figure 2. Demand Curves for Competitive and Monopoly Firms (a) A Competitive Firm's Demand Curve (b) A Monopolist's Demand Curve Price Price Demand Demand 0 Quantity of Output 0 Quantity of Output Because competitive firms are price takers, they face horizontal demand curves, as in panel (a). Because a mo- nopoly firm is the sole producer in its market, it faces the downward-sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output. By contrast, because a monopoly is the sole producer in its market, its demand curve is the market demand curve. Thus, the monopolist's demand curve slopes downward, as in panel (b) of Figure 2. If the monopolist raises the price of its good, consumers buy less of it. Looked at another way, if the monopolist reduces the quan- tity of output it produces and sells, the price of its output increases. A 294 The market demand curve provides a constraint on a monopoly's ability to profit from its market power. monopolist would prefer, if it were possible, to charge a high price and sell a large quantity at that high price. The market demand curve makes that outcome impossible. In particular, the market demand curve describes the combinations of price and quantity that are available to a monopoly firm. By adjusting the quantity produced (or equivalently, the price charged), the monopolist can choose any point on the demand curve, but it cannot choose a point off the demand curve. What price and quantity of output will the monopolist choose? As with competitive firms, we assume that the monopolist's goal is to maximize profit. Because the firm's profit is total revenue minus total costs, our next task in explaining monopoly behavior is to examine a monopolist's revenue. A Monopoly's Revenue Consider a town with a single producer of water. Table 1 shows how the monopoly's revenue might depend on the amount of water produced. Table 1. A Monopoly's Total, Average, and Marginal Revenue (2) (3) (4) (5) (1) Quantity of Water (Q) Price (P) Total Revenue (TR = P x 2) Average Revenue CAR = TR/Q) Marginal Revenue (MR = ATR/AQ) O gallons $11 $ 0 $10 1 10 10 $10 8 9 18 9 N 6 3 8 24 00 4