Principles of Economics Chapter 11 The World of Imperfect Competition

Chapter 11 The World of Imperfect Competition Start Up eBay Needs Google , Google Needs eBay , and Neither Trusts the Other The Internet auction site eBay has had a close and cooperative relationship with Google , the giant search engine . eBay has relied heavily on Google to advertise its products . Google relies heavily on the advertising revenue it gets from eBay . The greater the success of eBay , the greater the revenue Google will have from eBay advertising . The greater the success of Google as a search engine , the greater will be the impact of eBay advertising . To paraphrase Rick line from Casablanca , This could be a beautiful It is not . The two Internet giants simply do not get along . Consider what happened in 2007 . A Google spokesman said the firm was hosting a Freedom Party to announce the inauguration of a new payments service that would compete directly with , the online payment service owned by eBay . eBay was quick to retaliate . It pulled all of its advertising from Google later on the same day Google made its announcement . Two days later , Google backed down . It canceled its party and the payment service the party was to kick Murphy Barrett , Reading Your Mind , Forbes Online , October 29 , 2007 , 180 Issue , 50 . In 2003 , eBay had commissioned an analysis of whether Google represented a threat to its operations . The study concluded that Google was unlikely to enter into and was not a potential rival to eBay . That sanguine conclusion started to unravel in 2005 . Google began recruiting eBay engineers . In October , Google started testing Google Base , a free classified advertising service that threatened eBay auction service . Executives at eBay took the threat seriously . In private meetings , they divided into two teams . A green team represented eBay interests a red team tried to emulate Google strategy . The red team concluded that Google represented a serious threat , and eBay executives began exploratory talks with and Yahoo to see if some collaborative effort could ward off the Google threat . eBay spokesman Chris describes the firm dilemma of dealing with a firm that has been a valuable ally but at the same time could be a competitive threat . Given how really fast the Internet changes , it comes as no surprise that the line between competition and cooperation is sometimes By the late spring of 2006 , eBay management was still in a quandary about what to do about Google . Some executives , fearful of losing the advantages of continuing to work with Google , want to maintain eBay ties to the firm . Others worried that continuing a close relationship with Google was akin to putting the fox in the proverbial henhouse . They want to move quickly to establish a relationship with Yahoo or with that would compete with and Robert , eBay Talks to , Yahoo About a Common Foe Google , The Wall Street Journal Online , April 21 , 2006 , 366

Chapter 11 The World of Imperfect Competition 367 The tension between eBay and Google hardly suggests the aloof world of perfect competition where consumers are indifferent about which firm has produced a particular product , where each firm knows it can sell all it wants at the going market price , where firms must settle for zero economic profit in the long run . Nor is it the world of monopoly , where a single firm maximizes its profits , believing that barriers to entry will keep out competitors , at least for a while . This is the world of imperfect competition , one that lies between the idealized extremes of perfect competition and monopoly . It is a world in which firms battle over market shares , in which economic profits may persist , in which rivals try to outguess each other with pricing , advertising , and development strategies . Unlike the chapters on perfect competition and monopoly , this chapter does not provide a single model to explain firms behavior . There are too many variations on an uncertain theme for one model to explain the complexities of imperfect competition . Rather , the chapter provides an overview of some of the many different models and explanations advanced by economists for the behavior of firms in the imperfectly competitive markets . The analytical tools you have acquired in the course of studying the models of competitive and monopoly markets will be very much in evidence in this discussion . The spectrum of business enterprise ranges from perfectly competitive firms to monopoly . Between these extremes lies the business landscape in which the vast majority of in the world of imperfect operate . Imperfect competition is a market structure with more than one firm in an industry in which at least one firm is a price setter . An imperfectly competitive firm has a degree of monopoly power , either based on product differentiation that leads to a demand curve or resulting from the interaction of rival firms in an industry with only a few firms . There are two broad categories of imperfectly competitive markets . The first is one in which many firms compete , each offering a slightly different product . The second is one in which the industry is dominated by a few firms . Important features of both kinds of markets are advertising and price discrimination , which we examine later in this chapter .

Monopolistic Competition Competition Among Many Learning Objectives . Explain the main characteristics of a monopolistically competitive industry , describing both its similarities and differences from the models of perfect competition and monopoly . Explain and illustrate both equilibrium and equilibrium for a monopolistically competitive firm . Explain what it means to say that a firm operating under monopolistic competition has excess capacity in the long run and discuss the implications of this conclusion . The first model of an imperfectly competitive industry that we shall investigate has conditions quite similar to those of perfect competition . The model of monopolistic competition assumes a large number of firms . It also assumes easy entry and exit . This model differs from the model of perfect competition in one key respect it assumes that the goods and services produced by firms are differentiated . This differentiation may occur by virtue of advertising , convenience of location , product quality , reputation of the seller , or other factors . Product differentiation gives firms producing a particular product some degree of or monopoly power . However , because of the availability of close substitutes , the power of monopolistically competitive firms is quite limited . Monopolistic competition is a model characterized by many firms producing similar but differentiated products in a market with easy entry and exit . Restaurants are a monopolistically competitive sector in most areas there are many firms , each is different , and entry and exit are very easy . Each restaurant has many close may include other restaurants , outlets , and the deli and sections at local supermarkets . Other industries that engage in monopolistic competition include retail stores , barber and beauty shops , shops , service stations , banks , and law and accounting firms . Maximization Suppose a restaurant raises its prices slightly above those of similar restaurants with which it competes . Will it have any customers ?

Probably . Because the restaurant is different from other restaurants , some people will continue to patronize it . Within limits , then , the restaurant can set its own prices it does not take the market prices as given . In fact , differentiated markets imply that the notion of a single market price is meaningless . Because products in a monopolistically competitive industry are differentiated , firms face demand curves . Whenever a firm faces a demand curve , the graphical framework for monopoly can be used . In the short run , the model of monopolistic competition looks exactly like the model of monopoly . An important distinction between monopoly and monopolistic competition , however , emerges from 368

Monopolistic Competition Competition Among Many 369 the assumption of easy entry and exit . In monopolistic competition , entry will eliminate any economic profits in the long run . We begin with an analysis of the short run . The Short Run Because a monopolistically competitive firm faces a demand curve , its marginal revenue curve is a line that lies below the demand curve , as in the monopoly model . We can thus use the model of monopoly that we have already developed to analyze the choices of a monopsony in the short run . Figure Equilibrium in Monopolistic Competition shows the demand , marginal revenue , marginal cost , and average total cost curves facing a monopolistically competitive firm , Mama Pizza . Mama competes with several other similar firms in a market in which entry and exit are relatively easy . Mama demand curve is even if Mama raises its prices above those of its competitors , it will still have some customers . Given the demand curve , Mama marginal revenue curve lies below demand . To sell more pizzas , Mama must lower its price , and that means its marginal revenue from additional pizzas will be less than price . Figure Equilibrium in Monopolistic Competition 25 20 A , and ATC Quantity per week Looking at the intersection of the marginal revenue curve and the marginal cost curve , we see that the quantity is units per week . Reading up to the average total cost curve ATC , we see that the cost per unit equals . Price , given on the demand curve , is , so the profit per unit is . Total profit per week equals times , or it is shown by the shaded rectangle . Given the marginal revenue curve and marginal cost curve , Mama will maximize profits by selling pizzas per week . Mama demand curve tells us that it can sell that quantity at a price of . Looking at the average total cost curve ATC , we see that the firm cost per unit is . Its economic profit per unit is thus . Total economic profit , shown by the shaded rectangle , is per week .

370 Principles of Economics The Long Run We see in Figure Equilibrium in Monopolistic Competition that Mama Pizza is earning an economic profit . If Mama experience is typical , then other firms in the market are also earning returns that exceed what their owners could be earning in some related activity . Positive economic profits will encourage new firms to enter Mama market . As new firms enter , the availability of substitutes for Mama pizzas will increase , which will reduce the demand facing Mama Pizza and make the demand curve for Mama Pizza more elastic . Its demand curve will shift to the left . Any shift in a demand curve shifts the marginal revenue curve as well . New firms will continue to enter , shifting the demand curves for existing firms to the left , until pizza firms such as Mama no longer make an economic profit . The solution occurs where Mama demand curve is tangent to its average total cost point A in Figure Monopolistic Competition in the Long Run . Mama price will fall to 10 per pizza and its output will fall to pizzas per week . Mama will just cover its opportunity costs , and thus earn zero economic profit . At any other price , the firm cost per unit would be greater than the price at which a pizza could be sold , and the firm would sustain an economic loss . Thus , the firm and the industry are in equilibrium . There is no incentive for firms to either enter or leave the industry . Figure Competition in the Lung Run 10 , and ATC 4567 Quantity per week The existence of economic profits in a monopolistically competitive industry will induce entry in the long run . As new firms enter , the demand curve and marginal revenue curve facing a typical firm will shift Lhe left , to and . Eventually , this shift produces a solution at zero economic profit , where is tangent to the average total cost curve ATC ( point A ) The equilibrium solution here is an output of units per week at a price of 10 per unit . Had Mama Pizza and other similar restaurants been incurring economic losses , the process of moving to run equilibrium would work in reverse . Some firms would exit . With fewer substitutes available , the demand curve faced by each remaining firm would shift to the right . Price and output at each restaurant would rise . Exit would continue until the industry was in equilibrium , with the typical firm earning zero economic profit . Such comings and goings are typical of monopolistic competition . Because entry and exit are easy , favorable

Monopolistic Competition Competition Among Many 371 economic conditions in the industry encourage . New firms hope that they can differentiate their products enough to make a go of it . Some will others will not . Competitors to Mama may try to improve the ambience , play different music , offer pizzas of different sizes and types . It might take a while for other restaurants to come up with just the right product to pull customers and profits away from Mama . But as long as Mama continues to earn economic profits , there will be incentives for other firms to try . Heads Up ! The term monopolistic competition is easy to confuse with the term Remember , however , that the two models are characterized by quite different market conditions . A monopoly is a single firm with high barriers to entry . Monopolistic competition implies an industry with many firms , differentiated products , and easy entry and exit . Why is the term monopolistic competition used to describe this type of market structure ?

The reason is that it bears some similarities to both perfect competition and to monopoly . Monopolistic competition is similar to perfect competition in that in both of these market structures many firms make up the industry and entry and exit are fairly easy . Monopolistic competition is similar to monopoly in that , like monopoly firms , monopolistically competitive firms have at least some discretion when it comes to setting prices . However , because monopolistically competitive firms produce goods that are close substitutes for those of rival firms , the degree of monopoly power that monopolistically competitive firms possess is very low . Excess Capacity The Price of Variety The equilibrium solution in monopolistic competition always produces zero economic profit at a point to the left of the minimum of the average total cost curve . That is because the zero profit solution occurs at tie point where the demand curve is tangent to the average total cost curve , and thus the average total cost curve is itself . By expanding output , the firm could lower average total cost . The firm thus produces less than the output at which it would minimize average total cost . A firm that operates to the le of the lowest point on its average total cost curve has excess capacity . Because monopolistically competitive firms charge prices that exceed marginal cost , monopolistic competition is inefficient . The marginal benefit consumers receive from an additional unit of the good is given by i price . Since the benefit of an additional unit of output is greater than the marginal cost , consumers would be better off if output were expanded . Furthermore , an expansion of output would reduce average total cost . But monopolistically competitive firms will not voluntarily increase output , since for them , the marginal revenue would be less han the marginal cost . One can thus criticize a monopolistically competitive industry for falling short of the efficiency of perfect competition . But monopolistic competition is inefficient because of product differentiation . Think about a monopolistically competitive activity in your area . Would consumers be better off if all the firms in this industry produced identical products so that they could match the assumptions of perfect competition ?

If identical products were impossible , would consumers be better off if some of the firms were ordered to shut down on grounds the model predicts there will be too many firms ?

The inefficiency of monopolistic competition may be a small price to pay for a wide range of product choices . Furthermore , remember that perfect competition is merely a model . It is not a goal toward which an economy might strive as an alternative to monopolistic competition .

372 Principles of Economics Key Takeaways A monopolistically competitive industry features some of the same characteristics as perfect competition a large number of firms and easy entry and exit . The characteristic that distinguishes monopolistic competition from perfect competition is differentiated products each firm is a price setter and thus faces a demand curve . equilibrium for a monopolistically competitive firm is identical to that of a monopoly firm . The firm produces an output at which marginal revenue equals marginal cost and sets its price according to its demand curve . In the long run in monopolistic competition any economic profits or losses will be eliminated by entry or by exit , leaving firms with zero economic profit . A monopolistically competitive industry will have some excess capacity this may be viewed as the cost of the product diversity that this market structure produces . Suppose the monopolistically competitive restaurant industry in your town is in equilibrium , when difficulties in hiring cause restaurants to offer higher wages to cooks , servers , and dishwashers . Using graphs similar to Figure Equilibrium in Monopolistic Competition and Figure Monopolistic Competition in the Long Run , explain the effect of the wage increase on the industry in the short run and in the long run . Be sure to include in your answer an explanation of what happens to price , output , and economic profit . Case in Point Craft Brewers The Rebirth of a Monopolistically Competitive Industry Figure

Monopolistic Competition Competition Among Many 373 brewery . In the early , there were about local beer breweries across America . Prohibition in the squashed the industry after the repeal of Prohibition , economies of scale eliminated smaller breweries . By the early only about 40 remained in existence . But the American desire for more variety has led to the rebirth of the nearly defunct industry . To be sure , large , national beer companies dominated the overall ale market in 1980 and they still do today , with 43 large national and regional breweries sharing about 85 of the market for beer . But their emphasis on similarly tasting , light lagers ( at least , until they felt threatened enough by the new craft brewers to come up with their own specialty brands ) left many niches to be filled . One niche was filled by , accounting for about 12 of the market . That leaves to of the national market for the domestic specialty or craft brewers . The new craft brewers , which include contract brewers , regional specialty brewers , and , offer choice . As Neal Leathers at Big Sky Brewing Company in , Montana put it , We sort of convert people . If you haven had very many choices , and all of a sudden you get if those choices involve a lot of flavor and hard to go Aided by the recent legalization in most states of , establishments where beers are manufactured and on the same premises , the number of grew substantially over the last 25 years . A recent telephone book in Colorado Springs , a city with a population of about a half million and the home of the authors of your textbook , listed nine and more exist , but prefer to be listed as restaurants . To what extent does this industry conform to the model of monopolistic competition ?

Clearly , the sell differentiated products , giving them some degree of power . A sample of four in the downtown area of Colorado Springs revealed that the price of a house beer ranged from 13 to 22 cents per ounce . Entry into the industry seems fairly easy , judging from the phenomenal growth of the industry . After more than a decade of explosive growth and then a period of leveling off , the number of craft breweries , as they are referred to by the Association of Brewers , stood at in 2007 . The cost ranges from to , according to Kevin Head , the owner of the Rhino Bar , also in . The competitive model also predicts that while firms can earn positive economic profits in the short run , entry of new firms will shift the demand curve facing each firm to the left and economic profits will fall toward

374 Principles of Economics zero . Some firms will exit as competitors win customers away from them . In the combined and of the craft beer industry in 2007 , for example , there were 94 openings and 51 closings . Sources Jim , The Art of the Latest Thing are Tapping into the New Specialty Beer Market , November 29 , 1996 ) Brewers Association , 2007 Craft Beer Industry Statistics , April 17 , 2008 , Answer to Try It ! Problem As shown in Panel ( a ) higher wages would cause both and ATC to increase . The upward shift in from to would cause the level of output ( number of meals served per week , in this case ) to fall from to and price to increase from to . The increase in ATC from to would mean that some restaurants would be earning negative economic profits , as shown by the shaded area . As shown in Panel ( in the long run , as some restaurants close down , the demand curve faced by the typical remaining restaurant would shift to the right from to . The demand curve shift leads to a corresponding shift in marginal revenue from to . Price would increase further from to , and output would increase to ( 13 , above . In the new equilibrium , restaurants would again be earning zero economic profit . Figure

Monopolistic Competition Competition Among Many 375 , ATC , and , ATC , and Panel ( a ) Meals served per week Panel ( Meals served per week Competition Among the Few Learning Objectives Explain the main characteristics of an oligopoly , differentiating it from other types of market structures . Explain the measures that are used to determine the degree of concentration in an industry . Explain and illustrate the collusion model of oligopoly . Discuss how game theory can be used to understand the behavior of firms in an oligopoly . In July , 2005 , General Motors Corporation ( offered employee discount pricing to virtually all customers , not just employees and their relatives . This new marketing strategy introduced by obviously affected Ford , Chrysler , and other automobile and truck manufacturers Ford matched discount plan by offering up to to its own employees who convinced friends to purchase its cars and trucks . Ford also offered its customers the same prices paid by its employees . By , Chrysler indicated that it was looking at many alternatives , but was waiting for to make its next move . Ultimately , Chrysler also offered employee discount pricing . had to respond . It quickly developed a new marketing strategy of its own , which included lowering the prices of its cars and offering new financing terms . The responses of Ford , Chrysler , and to pricing strategy obviously affected the outcome of that strategy . Similarly , a decision by Gamble to lower the price of Crest toothpaste may elicit a response from , and that response will affect the sales of Crest . In an oligopoly , the fourth and final market structure that we will study , the market is dominated by a few firms , each of which recognizes that its own actions will produce a response from its rivals and that those responses will affect it . The firms that dominate an oligopoly recognize that they are interdependent What one firm does affects each of the others . This interdependence stands in sharp contrast to the models of perfect competition and monopolistic competition , where we assume that each firm is so small that it assumes the rest of the market will , in effect , ignore what it does . A perfectly competitive firm responds to the market , not to the actions of any other firm . A monopolistically competitive firm responds to its own demand , not to the actions of specific rivals . These greatly simplify the analysis of perfect competition and monopolistic competition . We do not have that luxury in oligopoly , where the interdependence of firms is the defining characteristic of the market . Some oligopoly industries make standardized products steel , aluminum , wire , and industrial tools . Others make differentiated products cigarettes , automobiles , computers , breakfast cereal , and soft drinks . 376

Oligopoly Competition Among the Few 377 Measuring Concentration in Oligopoly Oligopoly means that a few firms dominate an industry . But how many is a few , and how large a share of industry output does it take to dominate the industry ?

Compare , for example , the breakfast cereal industry and the ice cream industry . The cereal market is dominated by two firms , and General Mills , which together hold more than half the cereal market . This oligopoly operates in a highly concentrated market . The market for ice cream , where the four largest firms account for just less than a third of output , is much less concentrated . One way to measure the degree to which output in an industry is concentrated among a few firms is to use a concentration ratio , which reports the percentage of output accounted for by the largest firms in an industry . The higher the concentration ratio , the more the firms in the industry take account of their rivals behavior . The lower the concentration ratio , the more the industry the characteristics of monopolistic competition or perfect competition . The Census Bureau , based on surveys it conducts of manufacturing firms every five years , reports concentration ratios . These surveys show concentration ratios for the largest , 20 , and 50 firms in each industry category . Some concentration ratios from the 2002 survey , the latest available , are reported in Table Concentration Ratios and Indexes . Notice that the concentration ratio for breakfast cereals is 78 for ice cream it is 48 . Table Concentration Ratios and Indexes Industry Largest firms Largest firms Largest 20 firms Largest 50 firms Ice cream 48 64 82 93 736 Breakfast cereals 78 91 99 100 2521 Cigarettes 95 99 100 Men and boys shirts 38 53 73 89 481 Women and girls blouses and shirts 21 32 49 70 186 Automobiles 76 94 99 100 1911 Sporting and athletic goods 23 32 46 62 182 Dental laboratories 13 18 23 30 54 , data withheld by the government to avoid revealing information about specific firms . Two measures of industry concentration are reported by the Census Bureau concentration ratios and the Index ( Source Selected statistics from Sector 31 Manufacturing Subject Ratios Share of Value of Shipments Accounted for by the , 20 , and 50 Largest Companies for Industries 2002 at . An alternative measure of concentration is found by squaring the percentage share ( stated as a whole number ) of

378 Principles of Economics each firm in an industry , then summing these squared market shares to derive a Index ( The largest possible is the case of monopoly , where one firm has 100 of the market the index is 1002 , or . An industry with two firms , each with 50 of total output , has an of ( 502 502 ) In an industry with firms that have of the market each , the is . Indexes reported by the Census Bureau are also given in Table Concentration Ratios and Indexes . Notice that the is for breakfast cereals and only 736 for ice cream , suggesting that the ice cream industry is more competitive than the breakfast cereal industry . In some cases , the census data understate the degree to which a few firms dominate the market . One problem is that industry categories may be too broad to capture significant cases of industry dominance . The sporting goods industry , for example , appears to be highly competitive if we look just at measures of concentration , but markets for individual goods , such as golf clubs , running shoes , and tennis rackets , tend to be dominated by a few firms . Further , the data reflect shares of the national market . A tendency for regional domination does not show up . For example , the concrete industry appears to be highly competitive . But concrete is produced in local is too expensive to ship it very many of these local markets are dominated by a handful of firms . The census data can also overstate the degree of actual concentration . The automobiles category , for example , has a concentration ratio that suggests the industry is strongly dominated by four large firms ( in fact , production is dominated by three General Motors , Ford , and Chrysler ) Those firms hardly account for all car sales in the United States , however , as other foreign producers have captured a large portion of the domestic market . Including those foreign competitors suggests a far less concentrated industry than the census data imply . The Collusion Model There is no single model of oligopoly behavior that corresponds to economists models of perfect competition , monopoly , and monopolistic competition . Uncertainty about the interaction of rival firms makes specification of a single model of oligopoly impossible . Instead , economists have devised a variety of models that deal with the uncertain nature of rivals responses in different ways . In this section we review one type of oligopoly model , the collusion model . After examining this traditional approach to the analysis of oligopoly behavior , we shall turn to another method of examining oligopolistic interaction game theory . Firms in any industry could achieve the maximum profit attainable if they all agreed to select the monopoly price and output and to share the profits . One approach to the analysis of oligopoly is to assume that firms in the industry collude , selecting the monopoly solution . Suppose an industry is a duopoly , an industry with two firms . Figure Monopoly Through Collusion shows a case in which the two firms are identical . They sell identical products and face identical demand and cost conditions . To simplify the analysis , we will assume that each has a horizontal marginal cost curve , The demand and marginal revenue curves are the same for both firms . We find the combined demand curve for the two firms , by adding the individual demand curves together . Because one firm demand curve , represents of market demand , it is the same as the combined marginal revenue curve for the two firms . If these two firms act as a monopoly , together they produce and charge a price . This result is achieved if each firm selects its output , which equals . This solution is inefficient the efficient solution

Competition Among the Few 379 is price and output , found where the combined market demand curve and the marginal cost curve intersect . Figure Monopoly Through Collusion , and Quantity per month Two identical firms have the same horizontal marginal cost curve . Their demand curves Drinn and marginal revenue curves ( are also identical . The combined demand curve is the combined marginal revenue curve is The profits of the two firms are maximized if each produces Om at point A . Industry output at point is thus and the price is . At point , the efficient solution output would be Or , and the price would equal . In the simplest form of collusion , overt collusion , firms openly agree on price , output , and other decisions aimed at achieving monopoly profits . Firms that coordinate their activities through overt collusion and by forming collusive coordinating mechanisms make up a cartel . Firms form a cartel to gain monopoly power . A successful cartel can earn large profits , but there are several problems with forming and maintaining one . First , in many countries , including the United States , cartels are generally . They are banned , because their purpose is to raise prices and restrict output . Second , the cartel may not succeed in inducing all firms in the industry to join . Firms that remain outside the cartel can compete by lowering price , and thus they prevent the cartel from achieving the monopoly solution . Third , there is always an incentive for individual members to cheat on cartel agreements . Suppose the members of a cartel have agreed to impose the monopoly price in their market and to limit their output accordingly . Any one firm might calculate that it could charge slightly less than the cartel price and thus capture a larger share of the market for itself . Cheating firms expand output and drive prices down below the level originally chosen . The Organization of Petroleum Exporting Countries ( perhaps the cartel , is made up of 13 countries . In the , successfully acted like a monopoly by restricting output and raising

380 Principles of Economics prices . By the , however , the monopoly power of the cartel had been weakened by expansion of output by nonmember producers such as Mexico and Norway and by cheating among the cartel members . An alternative to overt collusion is tacit collusion , an unwritten , unspoken understanding through which firms agree to limit their competition . Firms may , for example , begin following the price leadership of a particular firm , raising or lowering their prices when the leader makes such a change . The price leader may be the largest firm in the industry , or it may be a firm that has been particularly good at assessing changes in demand or cost . At various times , tacit collusion has been alleged to occur in a wide range of industries , including steel , cars , and breakfast cereals . It is difficult to know how common tacit collusion is . The fact that one firm changes its price shortly after another one does can not prove that a tacit conspiracy exists . After all , we expect to see the prices of all firms in a perfectly competitive industry moving together in response to changes in demand or production costs . Game Theory and Oligopoly Behavior Oligopoly presents a problem in which decision makers must select strategies by taking into account the responses of their rivals , which they can not know for sure in advance . The Start Up feature at the beginning of this chapter suggested the uncertainty eBay faces as it considers the possibility of competition from Google . A choice based on the recognition that the actions of others will affect the outcome of the choice and that takes these possible actions into account is called a strategic choice . Game theory is an analytical approach through which strategic choices can be assessed . Among the strategic choices available to an oligopoly firm are pricing choices , marketing strategies , and development efforts . An airline decision to raise or lower its to leave them a strategic choice . The other airlines decision to match or ignore their rival price decision is also a strategic choice . IBM boosted its share in the highly competitive personal computer market in large part because a strategic development strategy accelerated the firm introduction of new products . Once a firm implements a strategic decision , there will be an outcome . The outcome of a strategic decision is called a payoff . In general , the payoff in an oligopoly game is the change in economic profit to each firm . The firm payoff depends partly on the strategic choice it makes and partly on the strategic choices of its rivals . Some firms in the airline industry , for example , raised their fares in 2005 , expecting to enjoy increased profits as a result . They changed their strategic choices when other airlines chose to slash their fares , and all firms ended up with a payoff of lower went into bankruptcy . We shall use two applications to examine the basic concepts of game theory . The first examines a classic game theory problem called the prisoners dilemma . The second deals with strategic choices by two firms in a duopoly .

Competition Among the Few 381 The Prisoners Dilemma Suppose a local district attorney ( DA ) is certain that two individuals , Frankie and Johnny , have committed a burglary , but she has no evidence that would be admissible in court . The DA arrests the two . On being searched , each is discovered to have a small amount of cocaine . The DA now has a sure conviction on a possession of cocaine charge , but she will get a conviction on the burglary charge only if at least one of the prisoners confesses and implicates the other . The DA decides on a strategy designed to elicit confessions . She separates the two prisoners and then offers each the following deal If you confess and your partner doesn , you will get the minimum sentence of one year in jail on the possession and burglary charges . If you both confess , your sentence will be three years in jail . If your partner confesses and you do not , the plea bargain is off and you will get six years in prison . If neither of you confesses , you will each get two years in prison on the drug The two prisoners each face a dilemma they can choose to confess or not confess . Because the prisoners are separated , they can not plot a joint strategy . Each must make a strategic choice in isolation . The outcomes of these strategic choices , as outlined by the DA , depend on the strategic choice made by the other prisoner . The payoff matrix for this game is given in Figure Payoff Matrix for the Prisoners Dilemma . The two rows represent Frankie strategic choices she may confess or not confess . The two columns represent Johnny strategic choices he may confess or not confess . There are four possible outcomes Frankie and Johnny both confess ( cell A ) Frankie confesses but Johnny does not ( cell ) Frankie does not confess but Johnny does ( cell ) and neither Frankie nor Johnny confesses ( cell ) The portion at the lower left in each cell shows Frankie payoff the shaded portion at the upper right shows Johnny payoff . Figure Payoff Matrix for the Prisoners Dilemma

382 Principles of Economics Johnny Strategies Confess Do confess A Johnny Johnny years years Confess Frankie Frankie ! years year Johnny Johnny year years I Confess Frankie Frankie years years The four cells represent each of the possible outcomes of the prisoners game . If Johnny confesses , Frankie best choice is to will get a sentence rather than the year sentence she would get if she did not confess . If Johnny does not confess , Frankie best strategy is still to will get a rather than a sentence . In this game , Frankie best strategy is to confess , regardless of what Johnny does . When a player best strategy is the same regardless of the action of the other player , that strategy is said to be a dominant strategy . Frankie dominant strategy is to confess to the burglary . For Johnny , the best strategy to follow , if Frankie confesses , is to confess . The best strategy to follow if Frankie does not confess is also to confess . Confessing is a dominant strategy for Johnny as well . A game in which there is a dominant strategy for each player is called a dominant strategy equilibrium . Here , the dominant strategy equilibrium is for both prisoners to confess the payoff will be given by cell A in the payoff matrix . From the point of View of the two prisoners together , a payoff in cell would have been preferable . Had they both denied participation in the robbery , their combined sentence would have been four years in years each . Indeed , cell offers the lowest combined prison time of any of the outcomes in the payoff matrix . But because the prisoners can not communicate , each is likely to make a strategic choice that results in a more costly outcome . Of course , the outcome of the game depends on the way the payoff matrix is structured .

Oligopoly Competition Among the Few 383 Repeated Oligopoly Games The prisoners dilemma was played once , by two players . The players were given a payoff matrix each could make one choice , and the game ended after the first round of choices . The real world of oligopoly has as many players as there are firms in the industry . They play round after round a firm raises its price , another firm introduces a new product , the first firm cuts its price , a third firm introduces a new marketing strategy , and so on . An oligopoly game is a bit like a baseball game with an unlimited number of firm may come out ahead after one round , but another will emerge on top another day . In the computer industry game , the introduction of personal computers changed the rules . IBM , which had won the mainframe game quite handily , struggles to keep up in a world in which rivals continue to slash prices and improve quality . Oligopoly games may have more than two players , so the games are more complex , but this does not change their basic structure . The fact that the games are repeated introduces new strategic considerations . A player must consider not just the ways in which its choices will affect its rivals now , but how its choices will affect them in the future as well . We will keep the game simple , however , and consider a duopoly game . The two firms have colluded , either tacitly or overtly , to create a monopoly solution . As long as each player upholds the agreement , the two firms will earn the maximum economic profit possible in the enterprise . There will , however , be a powerful incentive for each firm to cheat . The monopoly solution may generate the maximum economic profit possible for the two firms combined , but what if one firm captures some of the other firm profit ?

Suppose , for example , that two equipment rental firms , Quick Rent and Speedy Rent , operate in a community . Given the economies of scale in the business and the size of the community , it is not likely that another firm will enter . Each firm has about half the market , and they have agreed to charge the prices that would be chosen if the two combined as a single firm . Each earns economic profits of per month . Quick and Speedy could cheat on their arrangement in several ways . One of the firms could slash prices , introduce a new line of rental products , or launch an advertising blitz . This approach would not be likely to increase the total profitability of the two firms , but if one firm could take the other by surprise , it might profit at the expense of its rival , at least for a while . We will focus on the strategy of cutting prices , which we will call a strategy of cheating on the duopoly agreement . The alternative is not to cheat on the agreement . Cheating increases a firm profits if its rival does not respond . Figure To Cheat or Not to Cheat Game Theory in Oligopoly shows the payoff matrix facing the two firms at a particular time . As in the prisoners dilemma matrix , the four cells list the payoffs for the two firms . If neither firm cheats ( cell ) profits remain unchanged . Figure To Cheat or Not to Cheat Game Theory in Oligopoly

384 Principles of Economics Speedy Strategies Cheat Do cheat Speedy Speedy Cheat Quick Quick Speedy Speedy Quick Strategies Dont Cheat Quick Quick Two rental firms , Quick Rent and Speedy Rent , operate in a duopoly market . They have colluded in the past , achieving a monopoly solution . Cutting prices means cheating on the arrangement not cheating means maintaining current prices . The payoffs are changes in monthly profits , in thousands of dollars . If neither firm cheats , then neither firm profits will change . In this game , cheating is a dominant strategy equilibrium . This game has a dominant strategy equilibrium . Quick preferred strategy , regardless of what Speedy does , is to cheat . Speedy best strategy , regardless of what Quick does , is to cheat . The result is that the two firms will select a strategy that lowers their combined profits ! Quick Rent and Speedy Rent face an unpleasant dilemma . They want to maximize profit , yet each is likely to choose a strategy inconsistent with that goal . If they continue the game as it now exists , each will continue to cut prices , eventually driving prices down to the point where price equals average total cost ( presumably , the cutting will stop there ) But that would leave the two firms with zero economic profits . Both firms have an interest in maintaining the status quo of their collusive agreement . Overt collusion is one device through which the monopoly outcome may be maintained , but that is illegal . One way for the firms to encourage each other not to cheat is to use a strategy . In a strategy a firm responds to cheating by cheating , and it responds to cooperative behavior by cooperating . As each firm learns that its rival will respond to cheating by cheating , and to cooperation by cooperating , cheating on agreements becomes less and less likely . Still another way firms may seek to force rivals to behave rather than competitively is to use a

Competition Among the Few 385 trigger strategy , in which a firm makes clear that it is willing and able to respond to cheating by permanently revoking an agreement . A firm might , for example , make a credible threat to cut prices down to the level of average total leave them response to any by a rival . A trigger strategy is calculated to impose huge costs on any firm that on the firm that threatens to invoke the trigger . A firm might threaten to invoke a trigger in hopes that the threat will forestall any cheating by its rivals . Game theory has proved to be an enormously fruitful approach to the analysis of a wide range of problems . Corporations use it to map out strategies and to anticipate rivals responses . Governments use it in developing strategies . Military leaders play war games on computers using the basic ideas of game theory . Any situation in which rivals make strategic choices to which competitors will respond can be assessed using game theory analysis . One rather chilly application of game theory analysis can be found in the period of the Cold War when the United States and the former Soviet Union maintained a nuclear weapons policy that was described by the acronym MAD , which stood for mutually assured destruction . Both countries had enough nuclear weapons to destroy the other several times over , and each threatened to launch sufficient nuclear weapons to destroy the other country if the other country launched a nuclear attack against it or any of its allies . On its face , the MAD doctrine seems , well , mad . It was , after all , a commitment by each nation to respond to any nuclear attack with a counterattack that many scientists expected would end human life on earth . As crazy as it seemed , however , it worked . For 40 years , the two nations did not go to war . While the collapse of the Soviet Union in 1991 ended the need for a MAD doctrine , during the time that the two countries were rivals , MAD was a very effective trigger indeed . Of course , the ending of the Cold War has not produced the ending of a nuclear threat . Several nations now have nuclear weapons . The threat that Iran will introduce nuclear weapons , given its stated commitment to destroy the state of Israel , suggests that the possibility of nuclear war still haunts the world community . Key Takeaways The key characteristics of oligopoly are a recognition that the actions of one firm will produce a response from rivals and that these responses will affect it . Each firm is uncertain what its rivals responses might be . The degree to which a few firms dominate an industry can be measured using a concentration ratio or a Index . One way to avoid the uncertainty firms face in oligopoly is through collusion . Collusion may be overt , as in the case of a cartel , or tacit , as in the case of price leadership . Game theory is a tool that can be used to understand strategic choices by firms . Firms can use and trigger strategies to encourage cooperative behavior by rivals . Which model of oligopoly would seem to be most appropriate for analyzing firms behavior in each of the situations given below ?

386 Principles of Economics . When South Airlines lowers its fare between Miami and New York City , North Airlines lowers its fare between the two cities . When South Airlines raises its fare , North Airlines does too . Whenever Bank A raises interest rates on car loans , other banks in the area do too . In 1986 , Saudi Arabia intentionally the market with oil in order to punish fellow members for cheating on their production quotas . In July 1998 , Saudi Arabia a proposal in which a group of eight or nine major countries ( including members and some , such as Mexico ) would manage world oil prices by adjusting their production . Case in Point Memory Chip Makers Caught in Global Scheme Figure

Oligopoly Competition Among the Few 387 Chips array . It may have been the remark by . Chang , vice president of the memory chip manufacturer that sparked the investigation by the US . Department of Justice Antitrust Division . Chang was quoted in Commercial Times in May 2002 as admitting to meetings held in Asia among the major producers of DRAM , or dynamic random access memory . DRAM is the most common main memory format for storage and retrieval of information that is used in personal computers , mobile phones , digital cameras , music players , and other electronics products . At those meetings , as well as through emails and telephone conferences , the main manufacturers of DRAM decided not only what prices to charge and how much to make available , but also exchanged information on DRAM sales for the purpose of monitoring and enforcing adherence to the agreed prices . The collusion lasted for three 1999 to 2002 . In December 2001 , DRAM prices were less than . By May of 2002 , price had risen to the to range .

388 Principles of Economics The companies that were directly injured by the higher chip prices included Dell , Compaq , Apple , IBM , and Gateway . In the end , though , the purchasers of their products paid in the form of higher prices or less memory . In December 2003 , a Micron Technology sales manager pled guilty to obstruction of justice and served six months of home detention . The first to plead guilty a year later was Technologies , which was fined 160 million . As of September 2007 , five companies , being the largest , had been charged fines of more than 732 million , and over days of jail time had been meted out to eighteen corporate executives . The sharp reduction in the number of DRAM makers in the late undoubtedly made it easier to collude . The industry is still quite concentrated with holding of the market and . The price , however , has fallen quite sharply in recent years . Sources Department of Justice , Sixth Executive Agrees to Plead Guilty to Participating in DRAM Fixing Cartel , Press Release April 19 , 2007 Stephen , To Pay a Fine in the Fixing of Chip Prices , The New York Times , September 16 , 2004 George Leopold and David , DRAMs Under Gun in Antitrust Probe , Electronic Engineering Times , 1124 ( June 24 , 2002 ) 102 Lee , Cements DRAM Leadership , Korea Herald , online , March 31 , 2008 . Answers to Try It ! Problems . North Airlines seems to be practicing a price strategy known in game theory as . The banks could be engaged in tacit collusion , with Bank A as the price leader . Saudi Arabia appears to have used a trigger strategy , another aspect of game theory . In general , of course , participants hope they will never have to pull the trigger , because doing so harms all participants . After years of cheating by other members , Saudi Arabia did undertake a policy that hurt all members of , including itself has never since regained the prominent role it played in oil markets . Saudi Arabia seems to be trying to create another oil cartel , a form of overt collusion . legal cartel is the , which many economists regard as a successful device through which member firms ( colleges and universities ) collude on a wide range of rules through which they produce sports .

Extensions of Imperfect Competition Advertising and Price Discrimination Learning Objectives . Discuss the possible effects of advertising on competition , price , and output . Define price discrimination , list the conditions that make it possible , and explain the relationship between the price charged and price elasticity of demand . The models of monopoly and of imperfectly competitive markets allow us to explain two commonly observed features of many markets advertising and price discrimination . Firms in markets that are not perfectly competitive try to influence the positions of the demand curves they face , and hence profits , through advertising . Profits may also be enhanced by charging different customers different prices . In this section we will discuss these aspects of the behavior of firms in markets that are not perfectly competitive . Advertising Firms in monopoly , monopolistic competition , and oligopoly use advertising when they expect it to increase their profits . We see the results of these expenditures in a daily barrage of advertising on television , radio , newspapers , magazines , billboards , passing buses , park benches , the mail , home telephones , and the ubiquitous advertisements on our virtually every medium imaginable . Is all this advertising good for the economy ?

We have already seen that a perfectly competitive economy with fully defined and easily transferable property rights will achieve an efficient allocation of resources . There is no role for advertising in such an economy , because everyone knows that firms in each industry produce identical products . Furthermore , buyers already have complete information about the alternatives available to them in the market . But perfect competition contrasts sharply with imperfect competition . Imperfect competition can lead to a price greater than marginal cost and thus generate an inefficient allocation of resources . Firms in an imperfectly competitive market may advertise heavily . Does advertising cause inefficiency , or is it part of the solution ?

Does advertising insulate imperfectly competitive firms from competition and allow them to raise their prices even higher , or does it encourage greater competition and push prices down ?

There are two ways in which advertising could lead to higher prices for consumers . First , the advertising itself is costly in 2007 , firms in the United States spent about 149 billion on advertising . By pushing up production costs , advertising may push up prices . If the advertising serves no socially useful purpose , these costs represent a 389

390 Principles of Economics waste of resources in the economy . Second , firms may be able to use advertising to manipulate demand and create barriers to entry . If a few firms in a particular market have developed intense brand loyalty , it may be difficult for new firms to advertising creates a kind of barrier to entry . By maintaining barriers to entry , firms may be able to sustain high prices . But advertising has its defenders . They argue that advertising provides consumers with useful information and encourages price competition . Without advertising , these defenders argue , it would be impossible for new firms to enter an industry . Advertising , they say , promotes competition , lowers prices , and encourages a greater range of choice for consumers . Advertising , like all other economic phenomena , has benefits as well as costs . To assess those benefits and costs , let us examine the impact of advertising on the economy . Advertising and Information Advertising does inform us about products and their prices . Even critics of advertising generally agree that when advertising advises consumers about the availability of new products , or when it provides price information , it serves a useful function . But much of the information provided by advertising appears to be of limited value . Hearing that Pepsi is the right one , baby or Tide gets your clothes whiter than white may not be among the most edifying lessons consumers could learn . Some economists argue , however , that even advertising that seems to tell us nothing may provide useful information . They note that a consumer is unlikely to make a repeat purchase of a product that turns out to be a dud . Advertising an inferior product is likely to have little payoff people who do try it are not likely to try it again . It is not likely a firm could profit by going to great expense to launch a product that produced only unhappy consumers . Thus , if a product is heavily advertised , its producer is likely to be confident that many consumers will be satisfied with it and make repeat purchases . If this is the case , then the fact that the product is advertised , regardless of the content of that advertising , signals consumers that at least its producer is confident that the product will satisfy them . Advertising and Competition If advertising creates consumer loyalty to a particular brand , then that loyalty may serve as a barrier to entry to other firms . Some brands of household products , such as laundry detergents , are so well established they may make it difficult for other firms to enter the market . In general , there is a positive relationship between the degree of concentration of market power and the fraction of total costs devoted to advertising . This relationship , critics argue , is a causal one the high expenditures on advertising are the cause of the concentration . To the extent that advertising increases industry concentration , it is likely to result in higher prices to consumers and lower levels of output . The higher prices associated with advertising are not simply the result of passing on the cost of the advertising itself to consumers higher prices also derive from the monopoly power the advertising creates .

Extensions of Imperfect Competition Advertising and Price Discrimination 391 But advertising may encourage competition as well . By providing information to consumers about prices , for example , it may encourage price competition . Suppose a firm in a world of no advertising wants to increase its sales . One way to do that is to lower price . But without advertising , it is extremely difficult to inform potential customers of this new policy . The likely result is that there would be little response , and the price experiment would probably fail . Price competition would thus be discouraged in a world without advertising . Empirical studies of markets in which advertising is not allowed have confirmed that advertising encourages price competition . One of the most famous studies of the effects of advertising looked at pricing for prescription eyeglasses . In the early , about half the states in the United States banned advertising by firms making prescription eyeglasses the other half allowed it . A comparison of prices in the two groups of states by economist Lee showed that the cost of prescription eyeglasses was far lower in states that allowed advertising than in states that banned it ( 1972 ) research proved quite all states have since revoked their bans on such advertising . Similarly , a study of the cigarette industry revealed that before the 1970 ban on radio and television advertising market shares of the leading cigarette manufacturers had been declining , while after the ban market shares and profit margins increased ( 1991 ) Advertising may also allow more entry by new firms . When Kia , a South Korean automobile manufacturer , entered the compact car market in 1994 , it the airwaves with advertising . Suppose such advertising had not been possible . Could Kia have entered the market in the United States ?

It seems highly unlikely that any new product could be launched without advertising . The absence of advertising would thus be a barrier to entry that would increase the degree of monopoly power in the economy . A greater degree of monopoly power would , over time , translate into higher prices and reduced output . Advertising is thus a sword . On the one hand , the existence of established and heavily advertised rivals may make it difficult for a new firm to enter a market . On the other hand , entry into most industries would be virtually impossible without advertising . Economists do not agree on whether advertising helps or hurts competition in particular markets , but one general observation can safely be world with advertising is more competitive than a world without advertising would be . The important policy question is more more difficult to answer Would a world with less advertising be more competitive than a world with more ?

Price Discrimination Throughout the text up to this point , we have assumed that firms sold all units of output at the same price . In some cases , however , firms can charge different prices to different consumers . If such an opportunity exists , the firm can increase profits further . When a firm charges different prices for the same good or service to different consumers , even though there is no difference in the cost to the firm of supplying these consumers , the firm is engaging in price discrimination . Except for a few situations of price discrimination that have been declared illegal , such as manufacturers selling their goods to distributors at different prices when there are no differences in cost , price discrimination is generally legal .

392 Principles of Economics The potential for price discrimination exists in all market structures except perfect competition . As long as a firm faces a demand curve and thus has some degree of monopoly power , it may be able to engage in price discrimination . But monopoly power alone is not enough to allow a firm to price discriminate . Monopoly power is one of three conditions that must be met . A Firm The firm must have some degree of monopoly must be a price setter . A firm can only take the market price as is not in a position to make price choices of any kind . Thus , firms in perfectly competitive markets will not engage in price discrimination . Firms in monopoly , monopolistically competitive , or oligopolistic markets may engage in price discrimination . Distinguishable Customers The market must be capable of being fairly easily so that customers with different of demand can be identified and treated differently . Prevention of Resale The various market segments must be isolated in some way from one another to prevent customers who are offered a lower price from selling to customers who are charged a higher price . If consumers can easily resell a product , then discrimination is unlikely to be successful . Resale may be particularly difficult for certain services , such as dental checkups . Examples of price discrimination abound . Senior citizens and students are often offered discount fares on city buses . Children receive discount prices for movie theater tickets and entrance fees at zoos and theme parks . Faculty and staff at colleges and universities might receive discounts at the campus bookstore . Airlines give discount prices to customers who are willing to stay over a Saturday night . Physicians might charge wealthy patients more than poor ones . People who save coupons are able to get discounts on many items . In all these cases a firm charges different prices to different customers for what is essentially the same product . Not every instance of firms charging different prices to different customers constitutes price discrimination . Differences in prices may reflect different costs associated with providing the product . One buyer might require special billing practices , another might require delivery on a particular day of the week , and yet another might require special packaging . Price differentials based on differences in production costs are not examples of price discrimination . Why would a firm charge different prices to different consumers ?

The answer can be found in the marginal decision rule and in the relationship between marginal revenue and elasticity . Suppose an airline has found that its solution for a flight between and Cleveland , when it charges the same price to all passengers , is to carry 300 passengers at 200 per ticket . The airline has a degree of monopoly power , so it faces a demand curve . The airline has noticed that there are essentially two groups of customers on each flight people who are traveling for business reasons and people who are traveling for personal reasons ( visiting family or friends or taking a vacation ) We will call this latter group Of the 300 passengers , 200 are business travelers and 100 are tourists . The airline revenue from business travelers is therefore currently ( 200 times 200 business travelers ) and from tourists is currently ( 200 times 100 tourists ) It seems likely that the price of demand of these two groups for a particular will differ . Tourists may have a wide range of substitutes They could take their trips at a different time , they could vacation in

Extensions of Imperfect Competition Advertising and Price Discrimination 393 a different area , or they could easily choose not to go at all . Business travelers , however , might be attending meetings or conferences at a particular time and in a particular city . They have options , of course , but the range of options is likely to be more limited than the range of options facing tourists . Given all this , tourists are likely to have relatively more price elastic demand than business travelers for a particular . The difference in price suggests the airline could increase its profit by adjusting its pricing . To simplify , suppose that at a price of about 200 per ticket , demand by tourists is relatively price elastic and by business travelers is relatively less price elastic . It is plausible that the marginal cost of additional passengers is likely to be quite low , since the number of crewmembers will not vary and no food is served on short . Thus , if the airline can increase its revenue , its profits will increase . Suppose the airline lowers the price for tourists to 190 . Suppose that the lower price encourages 10 more tourists to take the flight . Of course , the airline can not charge different prices to different tourists rather it charges 190 to all , now 110 , tourists . Still , the airline revenue from tourist passengers increases from to ( 190 times 110 tourists ) Suppose it charges 250 to its business travelers . As a result , only 195 business travelers take the flight . The airline revenue from business travelers still rises from to ( 250 times 195 business travelers ) The airline will continue to change the mix of passengers , and increase the number of passengers , so long as doing so increases its profit . Because tourist demand is relatively price elastic , relatively small reductions in price will attract relatively large numbers of additional tourists . Because business demand is relatively less elastic , relatively large increases in price will discourage relatively small numbers of business travelers from making the trip . The airline will continue to reduce its price to tourists and raise its price to business travelers as long as it gains profit from doing so . Of course , the airline can impose a discriminatory fare structure only if it can distinguish tourists from business travelers . Airlines typically do this by looking at the travel plans of their customers . Trips that involve a stay over a weekend , for example , are more likely to be tourist related , whereas trips that begin and end during the are likely to be business trips . Thus , airlines charge much lower fares for trips that extend through a weekend than for trips that begin and end on weekdays . In general , strategies are based on differences in price elasticity of demand among groups of customers and the differences in marginal revenue that result . A firm will seek a price structure that offers customers with more elastic demand a lower price and offers customers with relatively less elastic demand a higher price . It is always in the interest of a firm to discriminate . Yet most of the goods and services that we buy are not offered on a discriminatory basis . A grocery store does not charge a higher price for vegetables to vegetarians , whose demand is likely to be less elastic than that of its omnivorous customers . An audio store does not charge a different price for Pearl Jam compact disks to collectors seeking a complete collection than it charges to casual fans who could easily substitute a disk from another performer . In these cases , firms lack a mechanism for knowing the different demands of their customers and for preventing resale . Key Ta If advertising reduces competition , it tends to raise prices and reduce quantities produced . If it enhances competition , it tends to lower prices and increase quantities produced .

394 Principles of Economics In order to engage in price discrimination , a firm must be a price setter , must be able to identify consumers whose differ , and must be able to prevent resale of the good or service among consumers . The firm will adjust its prices so that customers with more elastic demand pay lower prices than customers with less elastic demand . Try It ! Explain why price discrimination is often found in each of the following settings . Does it make sense in terms of price elasticity of demand ?

Senior citizen discounts for travel . Food sold cheaper if the customer has a coupon for the item . College scholarships to students with the best academic records or to students with special athletic , musical , or other skills Case in Point Pricing Costa National Parks Figure Volcano National Park , BY . Costa boasts some of the most beautiful national parks in the world . An analysis by Francisco , an economist with University in Sweden and , a tropical research institute in Costa , suggests that Costa should increase the degree to which it engages in price discrimination in pricing its national parks .

Extensions of Imperfect Competition Advertising and Price Discrimination 395 The country has experimented with a wide range of prices for its national parks , the price varying between and 15 for a daily visit . With data on the resultant number of visitors at each price , Professor was able to estimate the demand curve , compute the price elasticity of demand , and develop a recommendation for pricing the country national parks . Presumably , foreign visitors have a relatively less elastic demand for visiting the parks than do local citizens . Local citizens have better knowledge of substitutes for the other areas in Costa . And , of course , once foreign travelers are in the country , they have already committed the expense of getting there , and are less likely to be willing to pass up a visit to national parks based on pricing considerations . Costa already discriminates to a large degree . Foreigners are charged per day to visit the parks locals are charged . Professor proposes increasing the degree of discrimination . He estimates that the price elasticity of foreign demand for visits to Costa national parks is . That , of course , suggests inelastic demand . Costa could increase its revenue from foreign visitors by increasing the fee . Professor proposes increasing the fee for foreigners to 10 . He proposes that the price charged to Costa Ricans remain at price that he calculates equals the marginal cost of an additional visit . Professor calculates a fee of 10 per visit by a foreigner would more than pay the country fixed cost of maintaining its extensive park system , which utilizes 24 of the country land . The higher price would thus allow the government to meet the major costs of operating the national parks . Charging a fee to locals would satisfy the efficiency requirement that price equal marginal cost for local visitors the 10 fee to foreigners would permit the country to exploit its monopoly power in permitting people to visit the parks . The Costa Rican government has asked Professor to design three pilot projects aimed at incorporating his proposal to raise park fees to foreign visitors . Source Francisco , The Pricing of Protected Areas in Tourism A Local Prospective , Ecological Economics , 56 ( February 2006 ) 294307 and personal correspondence with Professor . Answers to Try It ! Problems . Senior citizens are ( usually ! easy to identify , and for travel , preventing resale is usually quite easy as well . For example , a picture ID is required to board an airplane . Airlines might be expected to oppose implementing the rule since it is costly for them . The fact that they support the rule can be explained by how it aids them in practicing price discrimination , by preventing the resale of discount tickets , which now can easily be matched to the purchasing customers . The demand for air travel by senior citizens is likely to be more elastic than it is for other passengers , especially business travelers , since the purpose of their travel is largely discretionary ( often touristic in nature ) and since their time is likely to be less costly , making them more willing to seek out information on travel alternatives than the rest of the population . Since the customer must present the coupon at the point of sale , identification is easy . Willingness to search for and cut out coupons suggests a high degree of price consciousness and thus a greater price elasticity of demand . Such students are likely to have more choices of where to attend college . As we learned in an earlier chapter on elasticity , demand is likely to be more elastic when substitutes are available for it . Enrollment procedures make identification and prevention of resale very easy . References , The Effect of Advertising on the Price of Eyeglasses , Journal and Economics 15 ( 1972 )

396 Principles of Economics , Competition and the Cigarette Advertising Ban , Economic Inquiry 29 ( January 1991 ) Review and Practice Summary This chapter examined the world of imperfect competition that exists between the idealized extremes of perfect competition and monopoly . Imperfectly competitive markets exist whenever there is more than one seller in a market and at least one seller has some degree of control over price . We discussed two general types of imperfectly competitive markets monopolistic competition and oligopoly . Monopolistic competition is characterized by many firms producing similar but differentiated goods and services in a market with easy entry and exit . Oligopoly is characterized by relatively few firms producing either standardized or differentiated products . There may be substantial barriers to entry and exit . In the short run , a monopolistically competitive firm pricing and output decisions are the same as those of a monopoly . In the long run , economic profits will be whittled away by the entry of new firms and new products that increase the number of close substitutes . An industry dominated by a few firms is an oligopoly . Each is aware of its interdependence with other firms in the industry and is constantly aware of the behavior of its rivals . engage in strategic decision making in order to determine their best output and pricing strategies as well as the best forms of competition . Advertising in imperfectly competitive markets can increase the degree of competitiveness by encouraging price competition and promoting entry . It can also decrease competition by establishing brand loyalty and thus creating barriers to entry . Where conditions permit , a firm can increase its profits by price discrimination , charging different prices to customers with different of demand . To practice price discrimination , a firm must be able to segment customers that have different of demand and must be able to prevent resale among its customers . Concept Problems . What are the major distinctions between a monopolistically competitive industry and an oligopolistic industry ?

What is the difference between a price taker and a price setter ?

Which do you think a firm would prefer to be ?

Why ?

In the model of monopolistic competition , we say that there is product differentiation . What does this mean , and how does it differ from the assumption of homogeneous goods in perfect competition ?

In the following list of goods and services , determine whether the item is produced under conditions of monopolistic competition or of oligopoly . soft drinks exercise drinks office supply stores massage therapists 397 398 Principles of Economics 10 . 11 . 12 . 13 . 14 . 15 . accountants colleges and universities Suppose a city experiences substantial population growth . What is likely to happen to profits in the short run and in the long run in the market for haircuts , a monopolistically competitive market ?

Some professors grade students on the basis of an absolute percentage of the highest score earned on each test given during the semester . All students who get within a certain percentage of the highest score earned get an A . Why do these professors not worry that the students will get together and collude in such a way as to keep the high score in the class equal to a very low total ?

Your parents probably told you to avoid behavior . Why does it make sense for firms to do it ?

What model of oligopoly behavior were the DRAM producers discussed in the Case in Point following ?

How might the DRAM producers have achieved their goal and still stayed within the law ?

Explain why a price increase for foreigners would increase Costa total revenue and profits from operating its national park system . Restaurants typically charge much higher prices for dinner than for lunch , despite the fact that the cost of serving these meals is about the same . Why do you think this is the case ?

Hint Think about the primary consumers of these meals and their respective . What effect do you think advertising to discourage cigarette smoking will have on teens ?

On adults ?

What changes might occur in the cigarette market as a result ?

Many manufacturers of clothing and other consumer goods open stores in outlet malls where they charge much lower prices than they charge in their own stores located within cities . Outlet malls are typically located a considerable distance from major metropolitan areas , and stores in them typically charge much lower prices than do stores located within cities . Given that both sets of stores are often owned by the same , explain this price discrimination based on likely differences in the price elasticity of demand between consumers in the two types of stores . Suppose a particular state were to ban the advertising of prices charged by firms that provide laser eye surgery . What effect do you think that would have on the price of this service ?

The Case in Point on noted that a large number of such breweries open every year . Yet , the model of monopolistic competition predicts that the long run equilibrium solution in such markets is one of zero economic profits . Why do enter such industries ?

Many lawyers advertise their services . Do you think this raises or lowers the price of legal services ?

Explain your answer carefully . Numerical Problems Suppose the monopolistically competitive barber shop industry in a community is in equilibrium , and that the typical price is 20 per haircut . Moreover , the population is rising . Illustrate the effects of a change on the price and output of a typical firm in the market . Show what happens in the long run . Will the final price be higher than 20 ?

Equal 20 ?

Be less than 20 ?

Assume that nothing happens to the cost of producing haircuts . Suppose that , initially , the price of a typical children haircut is 10 . Do you think this represents price discrimination ?

Why or why not ?

Review and Practice 399 . Consider the same industry as in Problem . Suppose the market is in equilibrium and that an annual license fee is imposed on barber shops . Illustrate the effects of the change on the price and output of haircuts for a typical firm in the community . New show what happens to price and output for a typical firm in the long run . Who pays the fee in the long run ?

How does this compare to the conclusions of the model of perfect competition ?

Industry A consists of four firms , each of which has an equal share of the market . Compute the index for the industry . Industry consists of 10 firms , each of which has an equal share of the market . Compare the Indexes for the two industries . Now suppose that there are 100 firms in the industry , each with equal shares . What is the index for this industry ?

State the general relationship between the competitiveness of an industry and its index . Given the payoff matrix ( shown below ) for a duopoly , consisting of Firm A and Firm , in which each firm is considering an expanded advertising campaign , answer the following questions ( all figures in the payoff matrix give changes in annual profits in millions of dollars ) Does Firm A have a dominant strategy ?

Does Firm have a dominant strategy ?

Figure is there a dominant strategy equilibrium ?

Explain .

400 Principles of Economics . Explain what this means . 60 ( where is quantity sold per week . The firm marginal cost curve is given by 60 . What price will it charge ?

How much will the firm produce in the short run ?

Firm Expand No change advertising in advertising A Firm Firm Expand advertising Firm A Firm A i Firm Firm No change in advertising Firm Firm . Suppose that two industries each have a concentration ratio of 75 . Suppose that the of the first industry is 425 , and that the of the second is 260 . Which would you say is the more competitive ?

Why ?

Suppose that a typical firm in a monopolistically competitive industry faces a demand curve given by . Draw the demand , marginal revenue , and marginal cost curves . Does this solution represent a equilibrium ?

Why or why not ?