e201: principles of microeconomics - lecture 10 - market

Overview Perfect Competition Monopoly Monopolistic Competition Oligopoly

e201: Principles of MicroeconomicsLecture 10 - Market Structure

Justin R. Cress

University of Kentucky

Justin R. Cress e201: Principles of Microeconomics


What does market structure mean?

After studying the optimizaiton process of firms and consumers, weunderstand the underpinnings of the market system

The diversity of firms and consumers (in the form if differingtechnologies, preferences, et cetera) implies a variety of differentinteractions between consumers and firms

Then, we can imagine a number of market structures displayingdifferent emergent characteristics

By this, we mean different sorts of firms and consumers may interactin different ways



The Competitive Environment

Firms do not operate in a vacuum, they are influenced by thecompetitive environment in which they operate, meaning theconditions the firm is exposed to in the markets for their factors ofproduction and final goods.

This competitive environment will determine

Productive decisions, via the cost of productive resourcesMarketing and price strategies, determined by the market for finalgoods

Understanding how firms actually act requires understanding thecompetitive environment in which they operate



Perfect Competition: Defined

Perfect competition exists in an industry where

Many firms sell identical products to many buyers.There are no restrictions to entry into the industry.Established firms have no advantages over new ones.Sellers and buyers are well informed about prices.

Although few markets in the real world meet all of theserequirements, understanding perfect competition informs ourunderstanding of market dynamics

Also, we’ll be able to understand divergences from perfectcompetition via contrast



Perfect Competition: Conditions

Many firms sell identical products to many buyers.

Numerous buyers and sellers create price competition, more sellers enterthe market to underbid and new buyers outbid buyers allowing marketmechanisms (shortages and surpluses) to function

Goods must be homogenous, simply, the same, in order for a market tobe competitive.Homogenous goods include many commodities, wheat, gold, et cetera

There are no restrictions to entry into the industry.

Government imposes no restrictions on producers which hinder marketentry (including licensing requirements, regulatory compliance costs )



Perfect Competition: Conditions

Established firms have no advantages over new ones.

Firms are unable to constrain competition via brand loyalty

Factors of production are easily accessible by new comers

The minimum efficient scale is small enough to allow room for competitors

Sellers and buyers are well informed about prices.

Perfect competition requires informed bids from buyers and sellers,without which markets are distorted in one direction

This condition applies to present prices and future prices, accurate pricesrequire symmetrical predictions.



Economic Profit & Revenue

Given perfect competition, firmsare price takers, firms cannotinfluence the price of a good orservice.

Demand for each firm’s output isperfectly elastic.Thus, if one firm increases itsprice, buyers shift awayAt lower prices, firms areforegoing profit

Total revenue = P ×Q, pricetimes quantity sold

So, as quantity sold increases,total revenue increases.



Economic Profit & Revenue

And, because the firm is a pricetaker, goods are homogenous,thus the demand for any one firmsgood is perfectly elastic

In perfect competition, marginalrevenue is constant.

Notice, market demand is notperfectly elastic, and may even beinelastic, depending upon thegood



Profit maximization

The Objective

A perfectly competitive firm faces two constraints

A market constraint summarized by the market price and the firm’srevenue curves.

A technology constraint summarized by firm’s product curves andcost curves.

The goal of the firm is to make maximum economic profit, given theconstraints it faces.



Profit maximization

Choice

Short Run Decision Making

Whether to produce or to shut down temporarily.

If the decision is to produce, what quantity to produce.

Remember, we’re assuming the firm can increase production byincreasing labor

Long Run Decision Making

Whether to increase or decrease its plant size.

Whether to stay in the industry or leave it.



Profit maximization

The Criteria

Maximizing Economic Profit

Recall, economic profit is total revenue (TR) - total cost (TC)

Many firms use lots of information to estimate the TR and TCcurves,

However, smaller firms find obtaining information difficult and costly

Do firms maximize economic profit, even if they don’t know preciselyhow to do it?



Profit maximization

Economic Profit Maximization

At low output levels, firms incur economicloss, unable to cover fixed costs

Above that level, the firm makeseconomic profit



Profit maximization

Economic Profit Maximization

At high output levels, the firm againincurs an economic loss

now the firm faces steeply rising costsbecause of diminishing returns.



Profit maximization

Marginal Analysis

If MR > MC, economic profitincreases if output increases.

If MR < MC, economic profitdecreases if output increases.

If MR = MC, economic profitdecreases if output changes ineither direction, so economicprofit is maximized.



Profit maximization

Short Run Outcomes

Break Even

In the short run, firms may breakeven, incurring neither economicprofit nor economic loss

This occurs when ATC = MC =MR

At this level, the firm is stillprofitable because it is still makingits normal profit



Profit maximization

Short Run Outcomes

If ATC is lower than MarginalRevenue and Marginal Cost, thefirm experiences an economicprofit



Profit maximization

Short Run Outcomes

If ATC exceeds MR and MC, thefirm experiences an economic loss



Short-run Supply Curve


A perfectly competitive firm’s short run supply curve shows how thefirm’s profit-maximizing output varies as the market price varies.

Firms produce output where MR = MC,

Since MR = Price, the firm’s supply curve is determined by itsmarginal cost curve

However, there is a price below which a firm will produce nothing




Temporary Shutdown

If price is lower than the lowest average variable cost, the firm wouldlose money on each unit of output

the firm shuts down temporarily to confine losses only to fixed costs

The firm must incur fixed costs either way, but by shutting downtemporarily, the firm can avoid paying variable costs




Temporary Shutdown

At the point T, the firm isindifferent between operating andshutting down

At T, MR = 17 and MC = 17

Any price below 17, the firm mustshut down temporarily




Firm Supply Curve

Comparing changing marginal revenuecurves (different prices) allow us to backout the firm supply curve

At all points where MR = MC we candetermine how much a firm is willing toproduce, and how much supply the firmbrings to market

If the price is $25, the firm produces 9sweaters a day, the quantity at which P =MC

If the price is $31, the firm produces 10sweaters a day, the quantity at which P =MC



Short-Run Equilibrium

Industry Supply

The short-run industry supply curveshows the quantity supplied by theindustry at each price when the plant sizeof each firm and the number of firmsremain constant.

Imagine any number of firms which facesimilar marginal cost curves, the industrysupply curve is the summation of all ofthe quantities supplied by these firms at agiven price




Market Equilibrium

Short-run industry supply andindustry demand determine themarket price and output.

Each firm takes the market priceas a given, and produces theamount where MR = MC




Market Equilibrium

Increasing market price, changesin demand influence the marginalrevenue faced by firms

Changing the point at which MR= MC (the intersection of supplyand demand)

So, the amount of demandinfluences market supply via theprice mechanism



Long Run Adjustment

Short run outcomes, long run incentives

In the short run, firms may garner economic profit or loss, or couldbreak even

Each of these outcomes in the short run influences long run decisionmaking for firms in any given industry

If firms in an industry are experiencing an economic profit, MRexceeds MC, thus, the industry will increase supply

New firms will enter the market,existing firms will expand output

On the contrary, if firms in the industry are experiencing aneconomic loss, MR is lower MC, the industry will decrease supply

Firms will leave the market,firms which stay may decrease output



Long Run Adjustment

Industry Entry

Attracted by the allure of bigbucks, economic profit encouragesfirms to enter an industry

If capital can garner economicprofit in an industry, that is profitabove and beyond its next bestalternative

New firms entering the marketcause the supply curve to shiftright, decreasing prices andincreasing quantity

Because price is decreasing, theMR of existing firms falls,decreasing their economic profit



Long Run Adjustment

Industry Exit

If firms in an industry experiencean economic loss, capital can bemore efficiently used in otherindustries

Thus, firms exit the industry,shifting the supply curve left

because price in creases, the MRof remaining firms increases,decreasing their economic losses



Long Run Adjustment

Plant Size

Recall, one of the ways firmsmimize costs is by optimizing theirproductive capacity

If current productive capacityexceeds the minimum of the longrun average cost curve, the firmcan increase its profit byincreasing productive capacity



Long Run Adjustment

Plant Size

However, if each firm faces thesame competitive environment,they will all increase theirproductive capacity.

In the long run, this increase insupply industry wide will decreaseprice

Decreasing marginal revenue, andevaporating economic profit



Long Run Adjustment

Long Run Industry Equilibrium

In the long run then,

Economic profit is zero, preventing entry and exitLong run average cost is at its minimum, making the cost-minimzingplant size static

Thus, economic profit is fleeting and temporary in a competitiveenvironment

In most industries a stable long run equilibrium is rare,

Technological advances often cause cost decreases

Changing tastes and preferences shift demand for certain products

industries are constantly adjusting to changing long run forecasts



Long Run Dynamics

Permanent shifts in demand

So, imagine a permanent changein preferences which decreasesdemand for a good

People recognize cigarettesaren’t super cool, andprobably cause heartproblemsTape players lose their lustercompared to CDs

This decrease in demand leads toa decrease in price



Long Run Dynamics


Now consider the impact thisdecrease in demand has on firmsin that industry,

The decrease in marginal revenueerodes profit, causing an economicloss

Firms are forced to scale back(downsize) their production

some firms exit the market alltogether



Long Run Dynamics


This response from firms results ina decrease in industry supply

Notice, in the long run, the pricerises again to the originalequilibrium, but at a lowerquantity



Long Run Dynamics


Each remaining firm is then ableto increase its production back tothe maximizing rule MR = MC

Thus, for remaining firms,quantity produced does notchange in the long run



Long Run Dynamics

Industrial Economies of Scale

Thus, changes in demand only result in a change in the number offirms in an industry

the long run equilibrium price of any given industry is static, relativeto demand

However, there are factors which influence the long run price of agood via changing the long run supply of a good in any given market

External economies are factors beyond the control of an individualfirm that lower the firms costs as the industry output increases.

External diseconomies are factors beyond the control of a firmthat raise the firms costs as industry output increases.



Long Run Dynamics

Constant cost

If the cost structure of an industryis unaffected by scale, chagnes inquantity do not change price

Changes in demand influence firmexit & entry which change thenumber of firms, but not theequilibrium price

LS is horozontal



Long Run Dynamics

Increasing cost

Some industries face increasingcosts as output increases

Industries which rely on finiteresources which do not have closesubstitutes

Airlines, real estate, et cetera

in these cases, increases indemand lead to increases in price



Long Run Dynamics

Decreasing cost

Other industries benefit fromeconomies of scale which decreaseaverage costs as prices increase

Supply lines for raw materialsbecome entrenched

The labor force is tailored toincrease specializaiton

in these cases, expanding industryoutput decreases prices



Monopoly

Market Power

Market power is the ability to influence the market, and inparticular the market price, by influencing the total quantity offeredfor sale.

Perfectly competitive firms have no market power, attempts toinfluence price are undercut by

a large number of competitors offering perfectly substitutable goodslow barriers to entry attracting new capital, eroding any economicprofit

Market power provides firms the ability to increase the price byrestricting supply, such that MR > MC



Monopoly

Def: Monopoly

A monopoly is an industry that produces a good or service forwhich no close substitute exists and in which there is one supplierthat is protected from competition by a barrier preventing the entryof new firms.

Characteristics:

A single firm dominates the supply of a goodThe good can not easily be substituted away fromThe firm is protected from competition by steep barriers to entry

The monopolist is the consolodation of all market power into asingle firm



Lack of Close Substitutes

Necessities

Some goods lack substitutes because they are necessary goods

e.g. utilities

Innovation

Some goods lack substitues because they haven’t been developed,innovative goods meet a very specific need

Hence, many firms closely guard trade secrets, such as the codebehind Microsoft’s Windows



Barriers to Entry

Legal

Legal barriers to entry create legal monopolies (when thegovernment sees fit to grant them...)

Public charters / franchises grant de-jure monopolies for the supplyof a good (the postal service)Licensing requirements restrict entry into the production of a good.Think doctors, lawyers, liquor salesPatenting provides a legal monopoly on the production of a giventechnologyIntellectual property rights are intended to provide economic profit,in order to incentivize innovation



Natural Monopolies

Legal

Natural Monopolies exist when one firm supplies the entire marketat a lower cost than two and/or many firms could

Due to economies of scale

Infrastructure intensive industries, multiple electricity providers in asinlge market would require twice or thrice as many electrical linesExcludability, if one firm can capture the means of supply, providingcompeting products is higher costconsider roads, if there’s one cheap path from city a to city b, thefirst firm to build a road would have a natural monopoly

Does the USPS have a natural monopoly?



Natural Monopolies

The long run average cost curve is alwaystrending downward

as Q increases, costs continue to fall

If a firm produces 4 million KWh, costsare 5 cents per

Divide that amongst two firms (equally)and each firm is producing 2 million, at acost of 10 cents



Single-Price Monopoly Pricing

Single-price monopoly

A Single-price monoply is a firm that must sell its product at thesame price to all customers

Since the firm controls price by controling supply, as the firmattempts to sell more of its product the price in the market falls

But, it falls for all customers, so selling an extra unit of outputdecreases the revenue gained from all units

Thus, if price decreases marginal revenue falls faster




Marginal Revenue

Consider

A firm selling 2 units at price 16

Attempts to sell a third unit, but mustreduce the price to 14

The sale of this unit increases revenue by14 (price) but,

we must adjust the total revenue by the $4 lost on the other two units

14 - 4 = 10 MR

Thus, at all prices, MR < P




Single-price monopoly

Recall our definition of elasticity, basically, some measure ofresponsivness to price

For a monopolist, elasticity matters – decreases in price will only beprofitable if the increase in quantity sold at the new price outweighsthe decrease in marginal revenue

So, decreaes in price have to increase quantity demanded, whichonly occurs in the elastic portion of the demand curve

A single-price monopoly never produces an output at which demandis inelastic.

If it did produce such an output, the firm could increase totalrevenue, decrease total cost, and increase economic profit bydecreasing output.




Total Revenue

Consider

Notice the intersection of marginalrevenue and the X axis,

At all points left of the intersection(Q < 5) demand is elastic. Decreases inprice cause increases in demand largeenough to offset falling marginal revenue

All points to the right (Q > 5) demand isnot responsive enough to price decreases,thus, the monopolist begins to decreasetotal revenue by increasing production




Total Revenue

Consider

Total revenue increases as quantityincreases, until demand is unit elastic

At the point where changes in price causeproportional changes in demand, MR = 0

At this point, total revenue is maximized.




Profit Maximization

Monopolists face constraintssimilar to perfectly competitivefirms, cost structures andfunctions are fundamentally thesame

The monopoly selects theprofit-maximizing quantity in thesame manner as a competitivefirm, where MR = MC.




Profit Maximization

So, the monopolist uses itsmarket power to set price atthe highest level which allows itto sell the profit maximizingquantity

Unlike firms in perfectlycompetitive markets, then,monopolists are able tocommand an economic profit,made durable by barriers toentry



Monopoly Vs. Competition

Price and Quantity

Remember, for perfectcompetition, MR is determinedby the intersection of Demandand MC

However, for the monopolist,the profit maximizing quantityis lower, at a higher price




Efficiency

Consider the effects ofmonopoly pricing on socialwelfare,

By restricting quantity, themonopolist creates a deadweight loss

The monopolist decreases bothconsumer and producer surplus




Efficiency

The monopolist does this inorder to expand its own surplus

The economic profit garneredby the monopolist reallocates(or extracts) from consumers tothe monopolist




Economic Rent

Unfortunately for the monopolist, being on top of an industry comeswith a cost, creating & maintaining monopoly is expensive

Buying a monopoly, or gaining monopoly status is expensive.Purchasing resources, rights, et cetera requires search costs, and theeconomic profit associated with monoply increases the cost of thesethingsThe right to run a taxi cab, or own a liquor store, et ceteraCreating a monopoly, or intentionally restricting competition is alsoexpensive. Purchasing politicians, restricting competition fromabroad, et cetera require the allocation of resources

This type of behavior is called rent seeking, in that the monopolist istrying to extract economic rent



Price Discrimination


Defined:

Price discrimination is selling a good or service at a number ofdifferent prices

price discrimination occurs due to differences in willingness to paynot differences in cost, so not all price differences are pricediscrimination

Price discrimination occurs when

Identify differing willingness to pay among classes of consumersBusiness vs Casual travelers

Sell a product without a secondary market (cannot be resold)




Efficiency

The monopolist has anincentive to charge buyers thehighest price each buyer iswilling to pay, the goal is toextract consumer surplus

By pricing each unit at thedemand curve, the monopolistno longer has lower marginalrevenue as price decreases



Defined:

What is Monopolistic Competition?

Monopolistic competition is a market with the followingcharacteristics:

A large number of firms.

Each firm produces a differentiated product.

Firms compete on product quality, price, and marketing.

Firms are free to enter and exit the industry.



Defined:

Large Number of Firms

The presence of a large number of firms in the market implies:

Each firm has only a small market share and therefore has limitedmarket power to influence the price of its product.

Each firm is sensitive to the average market price, but no firm paysattention to the actions of the other, and no one firms actionsdirectly affect the actions of other firms.

Collusion, or conspiring to fix prices, is impossible.



Defined:

Product Differentiation

Each firm makes a product that is slightly different from theproducts of competing firms

This differentiation is an attempt to create a psuedo-monopolypower over a segment of the market

Are Nike and Adidas perfect substiutes?

What about Old Navy and Abercrombie?



Defined:

Product Differentiation and Competition

Product differentiation enables firms to compete in three areas:quality, price, and marketing.

Loosley defined, quality can be understood to include design,reliability, and/or service

Each firm faces a downward sloping demand curve, price increasescause decreases in demand( The magnitude of which depends upon elasticity)hence, firms must compete on price

Firms differentiate products in quality, but most importantly have toconvince consumers that their product is superior

By spending on advertising, packaging et cetera, firms decrease theelasticity of their demand curve, hopefully making consumers thinkcompeting products are poor substitutes



Defined:

Entry and Exit

There are no barriers to entry in monopolistic competition, so firmscannot earn an economic profit in the long run.

Successful production, pricing and marketing strategies are emulated

new firms enter profitable markets

So, in the long run, economic profit is zero



Monopolistic Competition: Pricing


In the short run, the marginalrevenue curve mirrors amonopolist, as each firm is amonopolist over its product

The profit maximizing output isstill MR = MC

Price is still the intersection ofsupply and the demand curve

Thus, for some firms, the profitmaximizing output may garner aneconomic profit





Not all firms, though, will earn aneconomic profit

Many firms will capture aninsufficient share of the market tocreate a profit

In this case, ATC will be abovethe demand curve

At this level, the firm is losingmoney, profit maximization meansloss minimization




But, in the long run ...

Economic profit attracts newfirms, more capital, et cetera

As more firms enter the market,they attract market share, theytake customers from existing firms

This means that each firm faces adecreasing demand curve for itsown production

Firm entry will continue until price= ATC, where economic profit =0




Long Run

Excess Capacity

Monopolistic competition differsfrom perfect competition becausefirms will always produce belowthe efficient scale

Unlike perfectly competitive firms,monopolistically competitive firmshave downward sloping demandcurves

as price falls, marginal revenuefalls faster

So, expanding to the efficientscale would decrease price, andmarginal revenue




Long Run

Because marginal revenue is lowerthan price, firms operate with amark-up

Buyers will pay a higher price inthe long run




Long Run Efficiency

So, consumers pay higher prices in monopolistically competitivemarkets

Is this outcome efficient?

It depends. Remember, firms achieve their mark-up via productdifferentiation

So, monopolistically competitive markets increase choice andproduct variety, which people value

Given a choice between homogeneity at a low price andheterogeneity at a high price, which should society choose?



Market Strategy

Creating an economic profit

Product Development

Maintaining an economic profit requires constantly improving aproduct

Innovation decreases substitutability, increasing a firm’s market share

Incentives for innovative products increase social benefit



Market Strategy


Advertising

The goal for each firm is todecrease responsiveness to price,to create an inelastic demandcurve for its product relative tothe market demand curve

Selling costs, like advertisingexpenditures, fancy retailbuildings, etc. are fixed costs.

The advertising expenditure shiftsthe average total cost curveupward



Market Strategy


Advertising

If all firms advertise, equillibriumquantity increases, allowing morefirms to enter the market

Also, by increasing information, ifall firms are advertising, thedemand curve becomes moreelastic

Thus, advertising increases overallcosts and decreases price, whichdecreases the mark-up



Oligopoly: Defined

Oligopoly is a market structure defined by,

Natural or legal barriers that prevent entry of new firmsA small number of firms compete

Oligopolies may be

Natural, due to natural barriers to entry -or-Legal, legal barriers to entry



Oligopoly: Why Should We Care?

Interdependence

The actions of each firm in the market simultaneously influences thenature of the market, and the strategy of other firms

This introduces a level of strategic interaction which makesoligopoly complex, and unique

Collusion

A small number of firms makes collusion possible – cooperationamong firms designed to increase price

When firms cooperate to create a monopoly price they form a cartel



Oligopoly: Defined

Market Concentration

The defining characteristic of Oligopoly is that these markets have asmall number of firms

but, what is ’small’?

Market concentration is measured via the Herfindahl-HirschmanIndex (HHI) (see p. 208 in parkin)

The HHI is computed by summing the squre of market share for thetop 50 firms in a market (or all firms, if fewer than 50)

So, consider a competitive market with 100 firms, each with 1% ofthe market share,12 + 12 + ... 11 = 50 (pretty low)

Compute the HHI for a monopolist: 1002 = 10, 000

For a market with two firms, dividing the market equally:502 + 502 = 5, 000



Long Run

Market Concentration

Generally, an HHI above 1000 isconsidered an oligopoly

Notice, many oligopoly marketsare dominated by a few firms,specifically the four largest firms(shown in red)



Oligopoly: Defined

Natural Oligopoly

A natural barrier to entry, definedby the nature of the ATC curve

In this case, the market is anatural duopoly, two firms areable to supply the entire marketmost efficiently



Traditional Oligopoly Models

Kinked Demand Curve

From the perspective of one firm in an oligopoly:

The firm cannot charge more than other firms, because the otherfirms will undercut their prices and steal market share

The firm could decrease prices, but knows they could not increasemarket share by doing this, because other firms will mimick theirdiscounting

From the perspective of the manager, the demand curve is notcontinuous, it breaks at the current market price




Kinked Demand Curve

What it looks like:

The firm perceives a break at thecurrent market price

A decrease in price drasticallyreduces marginal revenue due tolost market share

keep in mind, the demand curvedisplayed here is the curve thefirm faces




Kinked Demand Curve

Compare

Compare the actual marginalrevenue curve to the hypotheticalextension of the kinked marginalrevenue curve

The break in marginal revenueresults from the broken demandcurve




Kinked Demand Curve

Compare

In this (exceptional) case, anincrease in marginal cost does notnecessarily increase price

If the increase in marginal costresults in a marginal cost belowdemand, none of the firms areable to increase price




Dominant Firm Oligopoly

The kinked demand curve model occurs when a small number offirms have similar cost structures, and thus, divide market shareequally

However, this is not always the case.

Imagine, instead, that market concentration is high because it isdominated by a large firm, with many firms supplying small portionsof the market

Consider,

Gas stationsVideo rentalsWal-Mart (in many markets)





The Firm

The dominant firm acts like amonopolist, and prices accordingly

If the dominant firm charges asingle price (there’s nodiscrimination), it faces a marginalrevenue curve similar to amonopolist





The Market

In doing so, the dominant firmsets the market price

Other firms in the market areunable to price higher than thedominant firm



Game Theory & Oligopoly

Economic Games

The defining characteristic of oligopoly is strategic interaction

Firms must position themselves in a way that capitalizes on marketconditions, which means constantly jockeying for market share

This requires adapting behavior to competitior behavior, actual andexpected

This strategic interaction is an economic game, and it is studied bygame theory, the study of strategic behavior, or, behavior takinginto account the behavior of other actors




The prisoner’s dillema

Two people are suspected of a crime for which the police havelimited evidence

The police know they are going to have to exact a confession fromone or both of the prisoners in order to convict

The prisoners are placed in seperate rooms, and are not allowed tospeak to one another

What happens?





Strategy

Strategy are the possible actions each player could take. In the caseof the prisoner’s dillema each prisoner could:

Confess

Deny





The Payoff Matrix

Given a finite number of playersand strategies, the possiblepayoffs, results, are known

The payoff matrix describes theresults each strategy for eachplaer, given the other player’sstrategy





The Payoff Matrix

Summarizing the prisoner’sdillema payoff matrix:

if both confess, they each recievethree years

if neither confess they recieve 2years

if one denies, and one confesses,one recieves the lightest treatmentwhile the other gets the harshtreatment





Equilibrium

Each player in the game choseshis strategy assuming the otherplayer will follow their dominantstrategy

In the case of the prisoner’sdillema,

Art can confess or deny,

if art confesses, Bob’s beststrategy is to confess, and theyboth get three years

if art denies, Bob’s beststrategy is still to confess, toavoid the 10 year sentence

(the payoffs are symmetrical)Justin R. Cress e201: Principles of Microeconomics




But this outcome is sub-optimal, if both prisoners were to deny theaccustions they would both get 2 years

However, because the two prisoners are unable to collude, theequilibrium is sub-optimal




Games in Oligopoly

Firms in oligopoly have an incentive to collude, in order to extractand divide monopoly profits

Although explicit collusion is illegal, it still occurs

implicitly / informallysecretly

If the two firms agree to restrict output to the single firm monoplylevel, price will increase and so will profit

Could such collusion be maintained?




Games in Oligopoly

What happens if someone cheats?

If one firm abandons the agreement and increases production,quantity supplied increases

The price falls, and the cheating firm sells more output (and gainsmarket share) at the expense of the complying firm

The complying firm, then, experiences an economic loss, becausethey’re producing on a non-profitable portion of the ATC curve





Equilibrium

So, here’s the payoff matrix

A complying / complyequilibrium is impossible. If onefirm considers complying,they’ll recognize that the otherfirm will cheat

expecting the other firm tocheat makes each firm cheat




Games in Oligopoly

Here’s the point:

In the long run, without an enforcement mechanism, cartels breakdown

When co-operation and overt collusion are costly or prohibited, thepursuit of self interest leaves both players worse off

In prisoner’s dillema type situations, utility maximizing behavioroften harms social welfare


e201: principles of microeconomics - lecture 10 - market

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