Chapter 7 Monopoly, Oligopoly and Strategy

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1 Chapter 7 Monopoly, Oligopoly and Strategy After reading Chapter 7, MONOPOLY, OLIGOPOLY AND STRATEGY, you should be able to: Define the characteristics of Monopoly and Oligopoly, and explain why the are Price Searchers. Explain why a price searcher faces a downward sloping demand curve and Marginal Curve. Explain how a monopolist selects their profit-maximizing level of output and price. Describe how monopolies lead to Economic Inefficiency. Define the characteristics of Oligopoly and explain the causes and implications of Mutual Interdependence and Strategic Behavior. Explain the meaning of a Nash Equilibrium and show it can be used to determine the equilibrium outcome in a strategic game. Explain how oligopolists can coordinate their decisions through Cartels or Conscious Parallelism, and explain why such agreements are difficult to maintain. Discuss how Concentration Ratios are used to measure the degree of monopoly power in and industry and explain their drawbacks. Discuss the trends in concentration in the U.S. economy. Outline I. Monopoly and Oligopoly A) Price-searching firms such as monopolies and oligopolies face downward-sloping demand curves. The demand curve faced by a perfectly competitive firm is horizontal since they are price takers. B) A Monopoly is one seller of a good that has no close substitutes, with considerable control over price and protection from competition by barrier to entry. An Oligopolist is a price searcher who must consider the reaction of competitors. C) The Marginal Curve (MR) is the increase in revenue brought about by increasing output by one unit.

2 Chapter 7 Monopoly, Oligopoly and Strategy 71 D) The Marginal Curve for a price-searching firm lies below its demand curve and is downward-sloping. This is illustrated below. 1. For a price searcher to sell additional output, it must lower the price it charges for all its production. Therefore, the marginal revenue from selling an extra unit is less than its price. 2. When demand is elastic, marginal revenue is positive; when demand is inelastic, marginal revenue is negative. II. Profit Maximizing by a Monopoly Producer A. A monopolist maximizes its profit by producing a level of output where marginal revenue is equal to marginal cost (MR = MC). The profit maximizing price is set off the demand curve at the output level where MR = MC. This is illustrated in the figure below, where the firm produces Q and charges P. B. Note that the monopolist can maximize profits by either setting the profit maximizing price or setting the profit maximizing output. Once either price or output is set, the market determines the other.

3 72 Gregory Essentials of Economics, Sixth Edition III. Oligopoly A) An Oligopoly is an industry with a relatively small number of firms, barriers to entry, pricesearching behavior and mutual interdependence. B) Since there are only a small number of firms, each firm must take into account the reaction of their rivals: there is Mutual Interdepence. C) Oligopolists behave strategically. Strategic Behavior occurs when rivals adopt strategies to outguess other firms. When deciding on a particular course of action a firm must try to decide what his rival will do in response. D) A Nash Equilibrium is a set of strategies, one for each player, such that no player has an incentive to unilaterally change his or her action. E) A Cartel is an arrangement that allows the participating firms to coordinate their output and pricing decisions to earn the monopoly profits. 1. All members of a cartel can gain if everyone adheres to the cartel. 2. Each member can gain if it and no one else cheats on the cartel arrangement. Therefore cartels tend to break apart in the long run. F) Even if oligopolists can not form an explicit agreement to coordinate their decisions, coordination can exist through price leadership or Conscious Parallelism, which occurs when firms behave in the same way even though they have not agreed to act in a parallel manner. IV. Efficiency, Antitrust and Network Externalties A) Economic Inefficiency occurs when it is possible to rearrange production so that the benefits to gainers outweigh the costs to the losers. 1. Since a monopolist charges a price greater than marginal revenue and maximizes profits where marginal revenue is equal to marginal cost, price must be greater than marginal cost. 2. The price consumers pay is a measure of the marginal benefit to consumers. Therefore, marginal benefit is greater than marginal cost. 3. Therefore, society s welfare would increase if the monopolist would increase production. B) Additional costs imposed on society that are associated with monopolies can occur because of Monopoly Rent Seeking, which is the expenditure of resources to gain monopoly rights from the government. C) The Sherman Antitrust Act of 1890, declared monopolies and the attempt to create monopolies illegal. Antitrust laws should be applied with care since some firms can come to dominate an industry due to superior but fair competition. D) Unlike perfect competition or monopolistic competition, monopolies can earn profits in the long run since there are barriers to entry. In the very long run monopoly profits may be eroded since they may lead to the development of substitutes: for example, Linux for Windows. E) Network Externalities exist when the act of joining a network confers a benefit on all other members of the network. As more and more people come to adopt a particular standard, the costs of switching to another standard are very high. Network externalities, therefore, create a high barrier to entry and may lock in inferior products.

4 Chapter 7 Monopoly, Oligopoly and Strategy 73 V. Concentration Ratios A) The x-firm Concentration Ratio is the percentage of industry output, accounted for by the largest x domestic firms in the industry. B) The higher the concentration ratio, the greater is the presumed amount of monopoly or oligopoly power in the industry. C) Drawbacks using concentration ratios to infer monopoly power. 1. Concentration ratios only include domestic firms yet some markets (automobiles) are worldwide. 2. Concentration ratios may not reflect the degree of market power within the relevant market: the concentration ratio for the entire pharmaceutical industry is relative small, but single or a few companies can dominate the market for specific drugs. 3. Concentration ratios may not take account of the existence of close substitutes for the industry s product. 4. Concentration ratios may conceal the amount of turnover among the top firms in the industry. D) The share of manufacturing output accounted for by highly concentrated industries has hardly changed over the past fifty years. Review Questions True/False If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer. 1. All firms in an industry could benefit if they form a successful cartel. 2. If only one firm in a cartel cheats on the arrangement, that firm can increase its profits. 3. For a price-searching firm, marginal revenue exceeds price. 4. Since Kraft has a monopoly on its Parkay brand of margarine, Parkay is a good example of a pure monopoly. 5. Monopoly firms always try to set the highest possible price. 6. A price-searching firm can sell all it wants without having to lower its price. 7. Since marginal revenue is the increase in total revenue from increasing sales by one unit, MR for a price-searching firm equals the price of the product. 8. Profit-maximizing price-taking and price-searching firms produce until marginal revenue equals marginal cost.

5 74 Gregory Essentials of Economics, Sixth Edition 9. The MR curve for a price-searching firm lies below its demand curve. 10. Monopolies can create economic inefficiencies. 11. Once formed, most cartels generally persist for a very long period of time. 12. The lower the barriers to entry in an industry, the less successful will be a cartel in that industry. 13. It is easier to reach a cartel agreement when the industry s product is very heterogeneous. 14. Concentration ratios are used to measure the extent of competition in an industry. Multiple Choice Questions Circle the letter corresponding to the correct answer. 1. What type of industry structure is typified by having only one seller of a good with no close substitutes? (a) Perfect competition (b) Monopolistic competition (c) Oligopoly (d) Monopoly (e) None of the above 2. What type of industry is characterized by having only a few firms, each of which must worry about its rivals responses to its actions? (a) Perfect competition (b) Monopolistic competition (c) Oligopoly (d) Monopoly (e) None of the above 3. Which of the following industry structures do not have price-searching firms? (a) Perfect competition (b) Oligopoly (c) Monopoly (d) None of the above because all industries have price-searching firms (e) None of the above because although there is an industry that does not have price-searching firms, it is not listed above 4. For a price-searching firm, the MR curve (a) is horizontal. (b) generally is the same as its demand curve. (c) usually has a positive slope, so that MR increases as more output is sold. (d) is the same as the firm s short-run supply curve. (e) None of the above

6 Chapter 7 Monopoly, Oligopoly and Strategy Profit-maximizing price-searching firms produce where (a) MR = P. (b) P = MC. (c) P < MR. (d) MR = MC. (e) P < MC. 6. If the demand for a product is price elastic, the marginal revenue (a) is equal to zero. (b) is positive. (c) is negative. (d) may be either positive, negative or zero. (e) is not defined. 7. An important difference between a monopoly and an oligopolistic industry is (a) oligopolistic firms face horizontal (perfectly elastic) demand curves for their products. (b) MR = P for monopolies. (c) oligopolistic firms always produce a homogeneous product. (d) monopoly firms are price takers while oligopolistic firms are price searchers. (e) the barriers to entry tend to be somewhat lower in oligopolistic industries. 8. After a price-searching firm determines its profit-maximizing level of production, it will determine the price of its output by referring to (a) the demand curve for its product. (b) its marginal revenue curve. (c) its marginal cost curve. (d) its long-run average cost curve. (e) its marginal demand cost curve. 9. Economic inefficiency is created when (a) P = MR. (b) P > MC. (c) P = MC. (d) MR = MC. (e) None of the above 10. Which of the following is not a characteristic of an oligopoly? (a) A relatively small number of firms (b) Moderate to high entry barriers (c) Price searching (d) Recognized mutual interdependence (e) They are all characteristics of oligopoly.

7 76 Gregory Essentials of Economics, Sixth Edition 11. It is more difficult for firms to form a successful cartel when there are (a) high barriers to entry. (b) few sellers of the product. (c) relatively homogeneous products. (d) high rates of product innovation. (e) All of the above make it difficult to form a successful cartel. Essay Questions Write a short essay or otherwise answer each question. 1. Complete the following table about the demand curve faced by a monopoly firm: Quantity Price Total Marginal 1 $60 XXX 2 $55 3 $50 4 $45 5 $40 6 $35 7 $30 8 $25 2. Suppose the marginal cost of producing an extra unit of output is always $25. If a monopoly firm faces the demand curve in Question 1, what is the profit-maximizing level of output? What price does the firm charge? 3. Suppose the demand curve given in Question 1 was the demand curve of a perfectly competitive industry. If all the firms in this industry can produce an extra unit of output for a marginal cost of $25, how many units of output are produced? (Remember that in the long-run equilibrium, perfectly competitive industries produce so that MC = P.) What is the equilibrium price? 4. Relate your answers to Questions 2 and 3 to the harm produced to society by a monopoly. In particular, which industry structure produced more output: the monopoly or the perfectly competitive one? 5. Suppose a monopoly firm has a constant MC curve and a straight line demand curve. Draw a diagram showing the profit-maximizing level of output (label it Q) and profit-maximizing price (label it P). 6. Suppose cartels were legal. Do you think a cartel would be more likely to form in the auto industry or the wheat industry? Why?

8 Chapter 7 Monopoly, Oligopoly and Strategy Use the following data to calculate the four-firm concentration ratio of industry sales. Company Sales A $350,000 B $150,000 C $500,000 D $250,000 E $500,000 F $150,000 G $100, Say that effective competition by Company F causes its sales to climb to $350,000 while Company A s sales fall to $150,000. What now is the four-firm concentration ratio of industry sales? Answers to Review Questions True/False 1. True. If the firms agree to act as branches of a giant monopoly, the industry s total profits increase, so each firm could get more profit. (See the next question for another incentive that is at play.) 2. True. This fact accounts for the instability of cartels: each firm has an incentive to cheat because if it can do so without the other firms cheating, its profits increase. 3. False. For a price-searching firm, marginal revenue is less than price. 4. False. Parkay Margarine is not a monopoly, because it competes with different brands of margarine that are very close substitutes for Parkay. 5. False. Monopoly firms try to set the most profitable price. If the price is set as high as possible, no one will buy the product, and the firm will make no profits. (Indeed, it probably would suffer a shortrun loss.) 6. False. A price-searching firm must obey the law of demand: in order to induce demanders to buy more output, the firm must lower the price of the product. 7. False. If a price-searching firm wants to sell one more unit of output, it must lower the price it charges for all the output it sells. This loss of revenue from the lower price on the initial units sold causes the marginal revenue of the extra unit to be below the price. 8. True. The profit-maximizing rule is the same for both types of firms. A key difference, however, is that for the price-taking firm, P = MC, while for the price-searching firm, P > MC. 9. True. This is the important difference between price-searching firms and price-taking firms. 10. True. In this way monopolies can harm society. 11. False. Each firm s incentive to cheat on the cartel and thereby increase its own profits accounts for the high failure rate of most cartels.

9 78 Gregory Essentials of Economics, Sixth Edition 12. True. A successful cartel in this type of industry would attract new firms. These new firms would quickly reduce the economic profit of the cartel by undercutting the cartel s price. 13. False. The greater the differences in the product, the more costly it is to reach an agreement about the price each firm should charge. 14. True. Concentration ratios are usually the fraction of an industry s sales that are accounted for by the four largest firms. The higher the concentration ratio, the more sales are concentrated amongst these firms and so, presumably, the lower is the competition within the industry. Multiple Choice Questions 1. (d) For a firm to have a pure monopoly, there must be no close substitutes for its product. 2. (c) Oligopoly theory is difficult because the industry is sufficiently small so that each firm must try to take account of its competitors reactions to its actions. 3. (a) Perfectly competitive firms do not price search, because the demand curve they face is perfectly horizontal at the going market price. In other words, they are unable to sell their product for more than the market price and are unwilling to sell it for less, so they are price takers. 4. (e) For a price-searching firm, the MR curve lies below the demand curve and generally has a negative or inverse slope. 5. (d) This is the same rule followed by perfectly competitive, price-taking firms. The important difference is that P = MR for price-taking firms, while P > MR for price searchers. As a result, for price takers, P = MC, while for price searchers, P > MC. 6. (b) If the demand is elastic, an increase in output causes only a small reduction in price and so raises total revenue. Marginal revenue equals the change in total revenue. Since in this case total revenue increases, marginal revenue is positive. 7. (e) Monopolies have high entry barriers, and oligopolies have only medium to high barriers. The fact that entry barriers are not prohibitive is why firms can enter an oligopoly, so that there is more than one firm in the industry. 8. (a) It prices the product so that demanders are willing to buy just the quantity produced. 9. (b) If P > MC, the value of another unit of output to consumers (which equals P) exceeds the cost of producing the unit (which equals MC). 10. (e) All these are characteristics of oligopolistic industries. 11. (d) If there are high rates of innovation, any agreement concerning existing products will become obsolete quickly as new products are introduced.

10 Chapter 7 Monopoly, Oligopoly and Strategy 79 Essay Questions 1. Quantity Price Total Marginal 1 $60 $60 XX 2 $55 $110 $50 3 $50 $150 $40 4 $45 $180 $30 5 $40 $200 $20 6 $35 $210 $10 7 $30 $210 $ 0 8 $25 $200 $-10 To calculate these answers, take the row where the quantity equals 2 as an example. The total revenue equals the quantity multiplied by the price, in this case (2) ($55), or $110. Then, marginal revenue equals the change in the total revenue when one more unit is produced. Hence the marginal revenue from the second unit is the difference between the total revenue when 2 units are produced, $110, minus the total revenue when 1 unit is produced, $60. Therefore, the marginal revenue equals $50. The key points to notice from this table are that price exceeds marginal revenue and that marginal revenue can be negative. 2. The profit-maximizing level of output is 4 units, because the MR of the fifth unit ($20) falls short of the MC ($25). The firm will charge $45 because that is the price at which demanders are willing to buy 4 units. 3. The price of the product would equal $25 (which is the same as the MC) and 8 units of output would be produced. 4. Monopolies restrict output and charge higher prices. This is evident in Questions 2 and 3 where economic inefficiency is created by the restriction of output. In Question 2, the marginal cost to the monopoly (which equals the marginal cost to society) of producing an extra unit is $25; yet, consumers are willing to pay $40 for another unit. This means consumers (or, in other words, society) value an additional unit of output more than the cost of producing it.

11 80 Gregory Essentials of Economics, Sixth Edition 5. Please refer to the above figure. To maximize its profits, the monopoly produces where MR = MC. Therefore, the monopoly will produce Q. Then, to set its price, the monopoly uses the demand curve. It wants to set the highest possible price that will lead people to buy all that it has produced. This price is P. If it set a lower price, it could sell all it produces (and more, as demanders would want to buy more than Q) but the monopoly would lose profits by setting a lower price. If it set a higher price, it could not sell all that it produced. Hence, Q is the equilibrium level of output and P the equilibrium price. 6. A cartel would be more likely in the auto industry. There are virtually no barriers to entry into the wheat industry, so there are thousands of wheat farmers. The only obstacle to the formation of an auto cartel is the fact that the different brands of autos are somewhat heterogeneous. Still, this is outweighed by the observation that there are only a relative handful of auto manufacturers and the barriers to entry into the auto industry are quite high. 7. The four-firm concentration ratio is 80 percent. The four-firm concentration ratio equals the fraction of total industry sales ($2,000,000) accounted for by the four largest companies (firms C, E, A, and D, which together have sales of $1,600,000), so the concentration ratio is: $1,600,000/$2,000,000 = 80 percent. 8. The four-firm concentration ratio remains 80 percent. Total industry sales remain constant at $2,000,000 and the four largest firms (now C, E, F, and D) still have total sales of $1,600,000. This question points out an important failure of concentration ratios. They completely miss competition in which one large firm is replaced by another, similarly sized company.

12 Chapter 7 Monopoly, Oligopoly and Strategy 81 Additional Questions 1. As the only newspaper in town the Daily Record faces a daily downward sloping demand curve given in the following table: Price Quantity Demanded $ $ $ $ $ $ $ $ ,000 $ ,000 $ ,000 Total Marginal The marginal cost to produce a paper is $0.10 and there are daily fixed costs of $10,000. (a) Complete the table. (b) What price should the Daily Herald charge for its newspaper? How many copies will it sell? Explain. (c) How much profit does the Daily Herald earn each day? 2. Consider the previous problem. The city council has decided that as many people as possible should be able to read the Daily Record. Therefore, they have decided to force the Daily Record to charge a price that will ensure that the market is economically efficient. What price will they make the Daily Record charge and how many papers will be bought? What is the problem with this policy? 3. Dick Gumshoe is the only private detective in town. Not only is he the only detective in town but he also specializes in finding out whether your spouse is cheating or not. The annual demand for his services is given in the following table: Price Quantity Demanded Total Marginal $10, $9, $8, $7, $6, $5, $4, $3, $2, $1,

13 82 Gregory Essentials of Economics, Sixth Edition Dick incurs a marginal cost of $3,000 for each investigation but has no fixed costs. (a) Complete the table. (b) What price does Dick charge and how many clients will he have? (c) How much profit does Dick earn? 4. Consider the following game between Chicken King and Sally s. Each has a choice of a high price or a low price. If they both set a high price, they each earn $10,000. If they both set a low price, they each earn $5,000. If one firm sets a high price and the other firm sets a low price, the firm that sets the high price earns $2,000 and the firm that sets the low price earns $12,000. (a) Draw a diagram that shows their choices and payoffs. (b) If the two firms decide to collude, what price will each firm charge? (c) Why is the collusive solution in part (b) unstable? What is the Nash equilibrium? 5. Explain why a monopolist will always produce a level of output where demand is elastic. Answers 1. (a) Price Quality Demanded Total Marginal $ $10, $ $13, $ $16, $ $17, $ $18, $ $17, $ $16, $ $13, $ $10, $ $5, (b) The Daily Herald will maximize profits by setting output and price where marginal revenue is equal to marginal cost. Therefore, the Daily Herald will charge $0.60 per paper and sell 30,000 copies per day. (c) Profits are equal to $ ,000 $ ,000 $10,000 = $5, Economic efficiency requires that price be set equal to marginal cost. Therefore, the Daily Record should charge ten cents per paper and will sell 55,000 copies. The problem is that at this price the Daily Record has an economic loss. Although it can just cover its marginal cost it is not able to cover any of its fixed costs.

14 Chapter 7 Monopoly, Oligopoly and Strategy (a) 4. (a) Price Quantity Demanded Total Marginal $10, $500, $9, $675, $7, $8, $800, $5, $7, $875, $3, $6, $900, $1, $5, $875, $1, $4, $800, $3, $3, $675, $5, $2, $500, $7, $1, $275, $9, (b) Marginal revenue is equal to marginal cost at a quantity demanded of 125. Therefore, Dick will charge $7,000. (c) Dick s profits are equal to $500,000 ($7, , ). Chicken Sally s Strategy King s Strategy High Price Low Price High Price 10,000 2,000 10,000 12,000 Low Price 12,000 5,000 2,000 5,000 (b) If the two firms collude they will each charge the high price and earn $10,000. (c) The collusive solution is unstable since each firm has an incentive to break the agreement providing the other firm does not. For example, if Sally charges a high price, Chicken King s best response is to charge the low price since they can get $12,000 instead of $10,000. Sally s best response is also to charge the low price. Therefore, the Nash equilibrium is for both firms to charge the low price and earn $5,000 each. 5. A monopolist will maximize profits by producing a level of output where marginal revenue is equal to marginal cost. Since marginal cost is greater than zero the firm will produce where marginal revenue is positive. Marginal revenue is positive when demand is elastic.

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