Q13.2 Describe the oligopoly market structure and give some examples.

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1 MONOPOLISTIC COMPETITION AND OLIGOPOLY QUESTIONS & ANSWERS Q13.1 Describe the monopolistically competitive market structure and give some examples. Q13.1 ANSWER Monopolistic competition is a market structure quite similar to perfect competition in that vigorous price competition among a large number of firms and individuals is present. The major difference between these two market structures is that at least some degree of product differentiation is present in monopolistically competitive markets. As a result, firms have at least some discretion in setting prices. However, the presence of many close substitutes limits the price-setting ability of individual firms, and drives profits down to a normal rate of return in the long-run. As in the case of perfect competition, above-normal profits are only possible in the short-run before rivals are able to take effective counter measures. Examples of monopolistically competitive market structures include a broad range of industries producing clothing, consumer financial services, professional services, restaurants, and so on. Q13.2 Describe the oligopoly market structure and give some examples. Q13.2 ANSWER Oligopoly is a market structure where only a few large rivals are responsible for the bulk, if not all, industry output. As in the case of monopoly, high to very high barriers to entry are typical. Under oligopoly, the price/output decisions of firms are interrelated in the sense that direct reactions from leading rivals can be expected. As a result, the decision making of individual firms is based, in part, on the likely response of competitors. This "competition among the few@ involves a wide variety of price and nonprice methods of interfirm rivalry, as determined by the institutional characteristics of a particular market setting. Although fewness in the number of competitors gives rise to a potential for excess profits, above-normal rates of return are far from guaranteed. Competition among the few can sometimes be vigorous. Examples of the oligopoly market structure include such industries as: bottled and canned soft drinks, brokerage services, investment banking, long distance telephone service, pharmaceuticals, ready-to-eat cereals, tobacco, and so on

2 Q13.3 Explain the process by which economic profits are eliminated in a monopolistically competitive market as compared to a perfectly competitive market. Q13.3 ANSWER In a monopolistically competitive industry, excess profits are eliminated in the longrun through imperfect emulation of successful product design, production systems, and marketing efforts by both established and new competitors. Excess profits are eliminated in a perfectly competitive industry through expansion by established firms and entry of new firms, both of whom offer identical products that are perfect substitutes. Q13.4 Would you expect the demand curve for a firm in a monopolistically competitive industry to be more or less elastic in the long run after competitor entry has eliminated economic profits? Q13.4 ANSWER In most instances, demand will be more elastic in monopolistically competitive industries after excess profits have been eliminated. The effect of increased competition will typically be to make firm demand curves more elastic given the greater availability of close substitutes. However, it is conceivable that increased competition would simply involve a parallel leftward shift in the firm demand curve. As discussed in the chapter, monopolistically competitive equilibrium will typically involve a price-output combination between the high price-low output equilibrium reached following a parallel leftward shift in demand, and the low price-high output (perfectly competitive) equilibrium reached when the firm demand curve becomes perfectly elastic. Q13.5 AOne might expect firms in a monopolistically competitive market to experience greater swings in the price of their products over the business cycle than those in an oligopoly market. However, fluctuations in profits do not necessarily follow the same pattern.@ Discuss this statement. Q13.5 ANSWER Oligopoly prices are expected to be more stable than those in a monopolistically competitive industry. To see this, simply recall the discussion of the kinked oligopoly demand curve and the fact that marginal cost changes within limits will not affect prices, whereas similar cost changes would affect prices in a monopolistically competitive industry. But would the more stable price pattern for firms in monopolistically competitive industries produce a correspondingly more stable

3 pattern for profits? This is not entirely clear. This depends on a great many factors, including the speed of entry and exit in response to profit changes, the level of fixed versus variable costs, and so on. For example, if entry conditions in the monopolistically competitive industry allowed instantaneous entry, profits for individual firms might closely reflect required rates of return and be quite stable. In general, the quicker (slower) the return to equilibrium, the less (more) variable will be firm profits in monopolistically competitive industries. In oligopoly markets, price tends to fluctuate less than costs, and profits can be quite variable (e.g., readyto-eat cereal and tobacco industries). Q13.6 What is the essential difference between the Cournot and Stackelberg models? Q13.6 ANSWER In the Cournot model, oligopoly firms make output decisions simultaneously. In the Stackelberg model, oligopoly firms make output decisions sequentially rather than simultaneously. In the Stackelberg model, a dominant firm is the first to set output, and the remaining competitors follow that lead and make their own output decisions given the output decision of the dominant first mover. Q13.7 Which oligopoly model(s) result in long-run oligopoly market equilibrium that is identical to a competitive market price/output solution? Q13.7 ANSWER In markets where competitors produce identical products, the Bertrand model and contestable markets theory result in a long-run oligopoly market equilibrium price/output solution that is identical to that achieved in a competitive market. According to Bertrand, when products and production costs are identical all customers will purchase from the firm selling at the lowest possible price. For example, consider a duopoly where each firm has the same marginal costs of production. By slightly undercutting the price charged by a rival, the competing firm would capture the entire market. In response, the competing firm can be expected to slightly undercut the rival price, thus recapturing the entire market. Such a price war would only end when the price charged by each competitor converged on their identical marginal cost of production, P A = P B = MC, and economic profits of zero would result. While critics regard as implausible Bertrand=s prediction of a competitive-market equilibrium in oligopoly markets that offer homogenous products, contestable markets theory provides some additional useful perspective. Oligopoly firms will sometimes behave much like perfectly competitive firms if

4 Monopolistic Competition and Oligopoly potential entrants pose a credible threat and entry costs are largely fungible rather than sunk. Q13.8 Why is the four-firm concentration ratio only an imperfect measure of market power? Q13.8 ANSWER The four firm concentration ratio measures the share of domestic output produced by the top four firms in an industry. As such, it is only an imperfect measure of monopoly power. First, concentration ratios ignore the magnitude of foreign competition. Such competition limits the market power of industry leaders in automobile manufacturing, electronics, television equipment and many other industries. And second, concentration ratios compiled using national data fail to recognize regional market power due to the local character of markets such as those for the newspapers, dairy products, waste disposal, and so on. Thus, although foreign competition can sometimes cause concentration ratios to overstate true market power by ignoring the regional characteristics of many markets, concentration ratios can also understate monopoly power in some instances. Q13.9 The statement AYou get what you pay for@ reflects the common perception that high prices indicate high product quality and low prices indicate low quality. Irrespective of market structure considerations, is this statement always correct? Q13.9 ANSWER No, not necessarily. In both perfectly competitive and monopolistically competitive markets P = AC in long run equilibrium. Given efficient methods of production, it is reasonable to infer a close relation between prices and the costs of production, and hence product quality, in such markets. However, in both monopoly and oligopoly markets P > AC in long-run equilibrium. Therefore, there may only be a weak relation between prices and the costs of production (product quality) in these markets. Thus, the statement AYou get what you pay for@ may be quite descriptive of vigorously competitive markets, but is less true in instances of imperfectly competitive markets. Q13.10 AEconomic profits result whenever only a few large competitors are active in a given market.@ Discuss this statement. Q13.10 ANSWER

5 This statement is not true, and reflects a simplistic view of the link between the number of competitors and the vigor of competition. Holding buyer power constant, competition can sometimes be fierce in markets that involve only a handful of competitors. Similarly, markets involving several Acompetitors@ may have little or no effective competition. For example, despite the fact that there are relatively few providers of general aviation equipment, competition for new plane orders is often fierce and suppliers seldom earn above-normal profits. On the other hand, textile and agricultural markets involve thousands of competitors that are sometimes sheltered from import competition by trade barriers and government price support programs. To accurately assess the vigor of competition in any given market, one must carefully analyze market structure (including the number and size distribution of competitors), competitor behavior and industry performance. SELF-TEST PROBLEMS & SOLUTIONS ST13.1 Price Leadership. Over the last century, The Boeing Co. has grown from building planes in an old, red boathouse to become the largest aerospace company in the world. Boeing=s principal global competitor is Airbus, a French company jointly owned by Eads (80%) and BAE Systems (20%). Airbus was established in 1970 as a European consortium of French, German and later, Spanish and U.K companies. In 2001, thirty years after its creation, Airbus became a single integrated company. Though dominated by Boeing and Airbus, smaller firms have recently entered the commercial aircraft industry. Notable among these is Embraer, a Brazilian aircraft manufacturer. Embraer has become one of the largest aircraft manufacturers in the world by focusing on specific market segments with high growth potential. As a niche manufacturer, Embraer makes aircraft that offer excellent reliability and cost effectiveness. To illustrate the price leadership concept, assume that total and marginal cost functions for Airbus (A) and Embraer (E) aircraft are as follows: TC A = $10,000,000 + $35,000,000Q A + $250,000Q A 2 MC A = $35,000,000 + $500,000Q A TC E = $200,000,000 + $20,000,000Q E + $500,000Q E 2 MC E = $20,000,000 + $1,000,000Q E Boeing=s total and marginal cost relations are as follows:

6 Monopolistic Competition and Oligopoly TC B = $4,000,000,000 + $5,000,000Q B + $62,500Q2B MC B = ΜTC B /ΜQ B = $5,000,000 + $125,000Q B The industry demand curve for this type of jet aircraft is Q = P Assume throughout this problem that the Airbus and Embraer aircraft are perfect substitutes for Boeing=s Model , and that each total cost function includes a risk-adjusted normal rate of return on investment. A. Determine the supply curves for Airbus and Embraer aircraft, assuming that the firms operate as price takers. B. What is the demand curve faced by Boeing? C. Calculate Boeing=s profit-maximizing price and output levels. (Hint: Boeing=s total and marginal revenue relations are TR B = $50,000,000Q B - $50,000Q2B, and MR B =ΜTR B /ΜQ B = $50,000,000 - $100,000Q B.) D. Calculate profit-maximizing output levels for the Airbus and Embraer aircraft. E. Is the market for aircraft from these three firms in short-run and in long-run equilibrium? ST13.1 SOLUTION A. Because price followers take prices as given, they operate where individual marginal cost equals price. Therefore, the supply curves for Airbus and Embraer aircraft are: Airbus P A = MC A = $35,000,000 + $500,000Q A 500,000Q A = -35,000,000 + P A Q A = P A Embraer

7 P E = MC E = $20,000,000 + $1,000,000Q E 1,000,000Q E = -20,000,000 + P E Q E = P E B. As the industry price leader, Boeing=s demand equals industry demand minus following firm supply. Remember that P = P B = P M = P E because Boeing is a price leader for the industry: Q B = Q - Q A - Q E = P $ P $ P = 1, P B P B = $50,000,000 - $50,000Q B C. To find Boeing=s profit maximizing price and output level, set MR B = MC B and solve for Q: MR B = MC B $50,000,000 - $100,000Q B = $5,000,000 + $125,000Q B 45,000,000 = 225,000Q B Q B = 200 units P B = $50,000,000 - $50,000(200) = $40,000,000 D. Because Boeing is a price leader for the industry, P = P B = P A = P E = $40,000,000 Optimal supply for Airbus and Embraer aircraft are:

8 Monopolistic Competition and Oligopoly Q A = P A = (40,000,000) = 10 Q E = P E = (40,000,000) = 20 E. Yes. The industry is in short-run equilibrium if the total quantity demanded is equal to total supply. The total industry demand at a price of $40 million is: Q D = P = (40,000,000) = 230 units The total industry supply is: Q S = Q B + Q A + Q E = = 230 units Thus, the industry is in short-run equilibrium. The industry is also in long-run equilibrium provided that each manufacturer is making at least a risk-adjusted normal rate of return on investment. To check profit levels for each manufacturer, note that: π A = TR A - TC A = $40,000,000(10) -$10,000,000 -$35,000,000(10) - $250,000(10 2 )

9 = $15,000,000 π E = TR E - TC E = $40,000,000(20) -$200,000,000 -$20,000,000(20) - $500,000(20 2 ) = $0 π B = TR B - TC B = $40,000,000(200) -$4,000,000,000 - $5,000,000(200) - $62,500(200 2 ) = $500,000,000 Boeing and Airbus are both earning economic profits, whereas Embraer, the marginal entrant, is earning just a risk-adjusted normal rate of return. As such, the industry is in long-rum equilibrium and there is no incentive to change. ST13.2 Monopolistically Competitive Equilibrium. Soft Lens, Inc., has enjoyed rapid growth in sales and high operating profits on its innovative extended-wear soft contact lenses. However, the company faces potentially fierce competition from a host of new competitors as some important basic patents expire during the coming year. Unless the company is able to thwart such competition, severe downward pressure on prices and profit margins is anticipated. A. Use Soft Lens=s current price, output, and total cost data to complete the table: Monthly Total Marginal Total Marginal Average Total Price Output Revenue Revenue Cost Cost Cost Profit ($) (million) ($million) ($million) ($million) ($million) ($million) ($million) $20 0 $

10 Monopolistic Competition and Oligopoly Monthly Total Marginal Total Marginal Average Total Price Output Revenue Revenue Cost Cost Cost Profit ($) (million) ($million) ($million) ($million) ($million) ($million) ($million) (Note: Total costs include a risk-adjusted normal rate of return.) B. If cost conditions remain constant, what is the monopolistically competitive high-price/low-output long-run equilibrium in this industry? What are industry profits? C. Under these same cost conditions, what is the monopolistically competitive low-price/high-output equilibrium in this industry? What are industry profits? D. Now assume that Soft Lens is able to enter into restrictive licensing agreements with potential competitors and create an effective cartel in the industry. If demand and cost conditions remain constant, what is the cartel price/output and profit equilibrium? ST13.2 SOLUTION A. Monthly Total Marginal Total Marginal Average Total Price Output Revenue Revenue Cost Cost Cost Profit ($) (million) ($million) ($million) ($million) ($million) ($million) ($million) $20 0 $0 --- $ $ $19 12 $12 $

11 Monthly Total Marginal Total Marginal Average Total Price Output Revenue Revenue Cost Cost Cost Profit ($) (million) ($million) ($million) ($million) ($million) ($million) ($million) B. The monopolistically competitive high-price/low-output equilibrium is P = AC = $14, Q = 6(000,000), and π = TR - TC = $0. Only a risk-adjusted normal rate of return is being earned in the industry, and excess profits equal zero. Because π = $0 and MR = MC = $9, there is no incentive for either expansion or contraction. Such an equilibrium is typical of monopolistically competitive industries where each individual firm retains some pricing discretion in long-run equilibrium. C. The monopolistically competitive low-price/high-output equilibrium is P = AC = $11, Q = 9(000,000), and π = TR - TC = $0. Again, only a risk-adjusted normal rate of return is being earned in the industry, and excess profits equal zero. Because π = $0 and MR = MC = $3, there is no incentive for either expansion or contraction. This price/output combination is identical to the perfectly competitive equilibrium. (Note that average cost is rising and profits are falling for Q > 9.) D. A monopoly price/output and profit equilibrium results if Soft Lens is able to enter into restrictive licensing agreements with potential competitors and create an effective cartel in the industry. If demand and cost conditions remain constant, the cartel price/output and profit equilibrium is at P = $17, Q = 3(000,000), and π = $9(000,000). There is no incentive for the cartel to expand or contract production at this level of output because MR = MC = $15. PROBLEMS & SOLUTIONS P13.1 Market Structure Concepts. Indicate whether each of the following statements is true or false and explain why. A. Equilibrium in monopolistically competitive markets requires that firms be operating at the minimum point on the long-run average cost curve

12 Monopolistic Competition and Oligopoly B. A high ratio of distribution cost to total cost tends to increase competition by widening the geographic area over which any individual producer can compete. C. The price elasticity of demand tends to fall as new competitors introduce substitute products. D. An efficiently functioning cartel achieves a monopoly price/output combination. E. An increase in product differentiation tends to increase the slope of firm demand curves. P13.1 SOLUTION A. False. Stable equilibrium in perfectly competitive markets requires that firms must operate at the minimum point on the long-run average cost curve. In monopolistically competitive markets, however, equilibrium is achieved at a point of tangency between firm demand and average cost curves. This tangency typically occurs at an output level below the point of minimum long-run average costs. B. False. A low ratio of distribution cost to total cost tends to increase competition by widening the geographic area over which any individual producer can compete. C. False. The price elasticity of demand tends to rise as new competitors introduce substitute products. D. True. A perfectly functioning cartel achieves the monopoly price-output combination. E. True. An increase in product differentiation tends to increase the slope of individual firm demand curves. P13.2 Monopolistically Competitive Demand. Would the following factors increase or decrease the ability of domestic auto manufacturers to raise prices and profit margins? Why? A. Decreased import quotas B. Elimination of uniform emission standards

13 C. Increased automobile price advertising D. Increased import tariffs (taxes) E. A rising value of the dollar, which has the effect of lowering import car prices P13.2 SOLUTION A. Increase. As import quotas are decreased, fewer substitutes for domestic automobiles become available. This will decrease competition in the industry, and ease pressure on profit margins. B. Increase. An elimination of uniform emission standards reduces product homogeneity. As product differentiation rises, some increase in the pricing discretion of firms will result. C. Decrease. An increase in automobile price advertising increases price competition in the industry and thereby decreases the ability of firms to raise prices and profit margins. D. Increase. An increase in import tariffs (taxes) increases the price of import cars, thus making imports less attractive to car buyers. This will reduce the price pressure on domestic manufacturers, and make it easier for them to increase profit margins. E. Decrease. A rising value of the dollar that has the effect of lowering import car prices puts downward pressure on the profit margins of domestic manufacturers. P13.3 Competitive Markets v. Cartels. The City of Columbus, Ohio, is considering two proposals to privatize municipal garbage collection. First, a handful of leading waste disposal firms have offered to purchase the city's plant and equipment at an attractive price in return for exclusive franchises on residential service in various parts of the city. A second proposal would allow several individual workers and small companies to enter the business without any exclusive franchise agreements or competitive restrictions. Under this plan, individual companies would bid for the right to provide service in a given residential area. The city would then allocate business to the lowest bidder. The city has conducted a survey of Columbus residents to estimate the amount that they would be willing to pay for various frequencies of service. The city has also estimated the total cost of service per resident. Service costs are expected to be the same whether or not an exclusive franchise is granted

14 Monopolistic Competition and Oligopoly A. Complete the following table. Trash Pickups per Month Price per Pickup Total Revenue Marginal Revenue Total Cost 0 $5.00 $ Marginal Cost B. Determine price and service level if competitive bidding results in a perfectly competitive price/output combination. C. Determine price and the level of service if local regulation results in a cartel. P13.3 SOLUTION A. Trash Pickups per Month Price per Pickup Total Revenue Marginal Revenue Total Cost Marginal Cost 0 $5.00 $ $ $ $

15 Trash Pickups per Month Price per Pickup Total Revenue Marginal Revenue Total Cost Marginal Cost B. In a perfectly competitive industry, P = MR, so the optimal activity level occurs where P = MC. Here, P = MC = $3.40 at Q = 8 pickups per month. C. A monopoly cartel maximizes profits by setting MR = MC. Here, MR = MC = $3.60 at Q = 4 pickups per month and P = $4.20 per pickup. P13.4 Monopolistic Competition. Gray Computer, Inc., located in Colorado Springs, Colorado, is a privately held producer of high-speed electronic computers with immense storage capacity and computing capability. Although Gray=s market is restricted to industrial users and a few large government agencies (e.g., Department of Health, NASA, National Weather Service, etc.), the company has profitably exploited its market niche. Glen Gray, founder and research director, has recently announced his retirement, the timing of which will unfortunately coincide with the expiration of several patents covering key aspects of the Gray computer. Your company, a potential entrant into the market for supercomputers, has asked you to evaluate the short- and long-run potential of this market. Based on data gathered from your company=s engineering department, user surveys, trade associations, and other sources, the following market demand and cost information has been developed: P MR = $54 - $1.5Q, = ΜTR/ΜQ = $54 - $3Q, TC = $200 + $6Q + $0.5Q 2, MC = ΜTC/ΜQ = $6 + $1Q,

16 Monopolistic Competition and Oligopoly where P is price, Q is units measured by the number of supercomputers, MR is marginal revenue, TC is total costs including a normal rate of return, MC is marginal cost, and all figures are in millions of dollars. A. Assume that these demand and cost data are descriptive of Gray=s historical experience. Calculate output, price, and economic profits earned by Gray Computer as a monopolist. What is the point price elasticity of demand at this output level? B. Calculate the range within which a long-run equilibrium price/output combination would be found for individual firms if entry eliminated Gray=s economic profits. (Note: Assume that the cost function is unchanged and that the high-price/low-output solution results from a parallel shift in the demand curve while the low-price/high-output solution results from a competitive equilibrium.) C. Assume that the point price elasticity of demand calculated in Part A is a good estimate of the relevant arc price elasticity. What is the potential overall market size for supercomputers? D. If no other near-term entrants are anticipated, should your company enter the market for supercomputers? Why or why not? P13.4 SOLUTION A. Set MR = MC to determine the profit-maximizing activity level. MR = MC $54 - $3Q = $6 + $1Q 4Q = 48 Q = 12 and P = $54 - $1.5Q = $54 - $1.5(12)

17 = $36 million π = -$2(12 2 ) + $48(12) - $200 = $88 million From the demand curve note that: Q = P, which, at the profit-maximizing activity level, implies a point price elasticity of ε P = ΜQ/ΜP Η P/Q = Η 36/12 = -2 (Note: Profits are declining for Q > 12.) B. The high-price/low-output equilibrium point is identified by the point of tangency between the firm=s demand and average cost curves which occurs after a parallel leftward shift in demand due to competitor entry. Therefore, in equilibrium the new firm demand and average cost curves have the same slope. To determine the slope of the average cost curve note that: AC = TC/Q = 2 $200 + $6Q + $0.5Q Q = $200Q -1 + $6 + $0.5Q Slope of average cost curve Slope of new demand curve = ΜAC/ΜQ = -200Q = -1.5 (Same as for original demand curve) And in equilibrium,

18 Monopolistic Competition and Oligopoly Slope of average cost curve = Slope of new demand curve -200Q = -1.5 Q -2 = 2/200 Q 2 = 100 Q = 10 and P = AC = $200(10-1 ) + $6 + $0.5(10) = $31 million π = P Η Q - TC = $31(10) - $200 - $6(10) - $0.5(10 2 ) = $0 The low-price/high-output equilibrium point occurs where P = AC and average costs are minimized (this is also the perfectly competitive equilibrium). Set MC = AC to determine the point of minimum average costs, and solve for Q: MC = AC $6 + $1Q = $200Q -1 + $6 + $0.5Q 200Q -1 = 0.5Q 200Q -2 = 0.5 Q 2 = 200/0.5 =

19 Q = 400 = 20 and P = AC = $200(20-1 ) + $6 + $0.5(20) = $26 million π = P Η Q - TC = $26(20) - $200 - $6(20) - $0.5(20 2 ) = $0 C. If the high-price/low-output equilibrium is achieved in the long run, total industry output rises to 16.2 supercomputers because: Q2- Q E P = x P P P - P Q + Q Q = x Q ( Q2-12) -2 = -5( Q + 12) 10(Q ) = 67(Q 2-12) 10Q = 67Q Q 2 = 924 Q 2 = Conversely, if the low-price/high-output equilibrium is achieved, total industry output rises to 23.4 supercomputers because:

20 Monopolistic Competition and Oligopoly E P = Q2- Q1 P2+ P1 x P - P Q + Q Q = x Q ( Q2-12) -2 = -10( Q + 12) 20(Q ) = 62(Q 2-12) 20Q = 62Q Q 2 = 984 Q 2 = D. No. Entry into this industry is unwise. Gray currently sells 12 supercomputers per year, a substantial share of the projected long-run potential of between 16.2 and 23.4 for total industry output. Moreover, the industry does not have the potential to support more than one firm of Q = 20 size class, the minimum optimal firm size. Therefore, by virtue of its role as an industry leader of dominant proportions, Gray would have the capability to continuously undercut new rivals and make profitable entry very difficult, if not impossible. (Note: Fractional output can be completed during subsequent periods). P13.5 Cartel Equilibrium. The Hand Tool Manufacturing Industry Trade Association recently published the following estimates of demand and supply relations for hammers: Q D = 60,000-10,000P Q S = 20,000P (Demand), (Supply). A. Calculate the perfectly competitive industry equilibrium price/output combination

21 B. Now assume that the industry output is organized into a cartel. Calculate the industry price/output combination that will maximize profits for cartel members. (Hint: As a cartel, industry MR = $6 - $0.0002Q.) C. Compare your answers to parts A and B. Calculate the price/output effects of the cartel. P13.5 SOLUTION A. The industry equilibrium price is determined by setting: Q D = Q S 60,000-10,000P = 20,000P P = $2 At P = $2, the equilibrium output is 40,000 because: Q D =? Q S 60,000-10,000(2) =? 20,000(2) 40,000 =_ 40,000 B. The profit-maximizing activity level is found where MR = MC. Here it is important to recognize that the industry supply curve represents the horizontal sum of the marginal cost curves for individual producers. Therefore, when the industry is organized into a cartel and acts like a monopolist, the industry supply curve represents the relevant marginal cost curve: Q S = 20,000P (Supply) MC = P = $ Q From the demand curve: Q D = 60,000-10,000P (Demand) P = $6 - $0.0001Q

22 Monopolistic Competition and Oligopoly TR = P Η Q = ($6 - $0.0001Q)Q = $6Q - $0.0001Q 2 MR = ΜTR/ΜQ = $6 - $0.0002Q And the profit-maximizing activity level is found by setting MR = MC and solving for Q: MR = MC $6 - $0.0002Q = $ Q Q = 6 Q = 24,000 P = $6 - $0.0001(24,000) = $3.60 C. With a cartel, the level of industry output falls from 40,000 to 24,000 units and price rises from $2 to $3.60, when compared with the perfectly competitive industry. Generally speaking, monopolists offer consumers too little output at too high a price. P13.6 Cournot Equilibrium. VisiCalc, the first computer spreadsheet program, was released to the public in A year later, introduction of the DIF format made spreadsheets much more popular because they could now be imported into word processing and other software programs. By 1983, Mitch Kapor used his previous programming experience with VisiCalc to found Lotus Corp. and introduce the wildly popular Lotus spreadsheet program. Despite enormous initial success, Lotus stumbled when Microsoft Corp. introduced Excel with a much more user-friendly graphical interface in Today, Excel dominates the market for spreadsheet applications software, and Lotus represents a small part of IBM=s suite of instant messaging tools. To illustrate the competitive process in markets dominated by few firms, assume that a two-firm duopoly dominates the market for spreadsheet application software, and that the firms face a linear market demand curve

23 P = $1,250 - Q where P is price and Q is total output in the market (in thousands). Thus Q = Q A + Q B. For simplicity, also assume that both firms produce an identical product, have no fixed costs and marginal cost MC A = MC B = $50. In this circumstance, total revenue for Firm A is Marginal revenue for Firm A is TR A = $1,250Q A - Q A 2 - Q A Q B MR A = ΜTR A /ΜQ A = $1,250 - $2Q A - Q B Similar total revenue and marginal revenue curves hold for Firm B. A. Derive the output reaction curves for Firms A and B. B. Calculate the Courtnot market equilibrium price-output solutions. P13.6 SOLUTION A. Because MC A = 0, Firm A=s profit-maximizing output level is found by setting MR A = MC A = 0: MR A = MC A $1,250 - $2Q A - Q B = 50 $2Q A = $1,200 - Q B Q A = Q B Notice that the profit-maximizing level of output for Firm A depends upon the level of output produced by itself and Firm B. Similarly, the profit-maximizing level of output for Firm B depends upon the level of output produced by itself and Firm A. These relationships are each competitor=s output-reaction curve Firm A output-reaction curve: Q A = Q B

24 Monopolistic Competition and Oligopoly Firm B output-reaction curve: Q B = Q A B. The Cournot market equilibrium level of output is found by simultaneously solving the output-reaction curves for both competitors. To find the amount of output produced by Firm A, simply insert the amount of output produced by competitor Firm B into Firm A=s output-reaction curve and solve for Q A. To find the amount of output produced by Firm B, simply insert the amount of output produced by competitor Firm A into Firm B=s output-reaction curve and solve for Q B. For example, from the Firm A output-reaction curve Q A = Q B Q A = ( Q A ) Q A = Q A 0.75Q A = 300 Q A = 400 (000) units Similarly, from the Firm B output-reaction curve, the profit-maximizing level of output for Firm B is Q B = 400. With just two competitors, the market equilibrium level of output is Cournot equilibrium output = Q A + Q B = = 800 (000) units The Cournot market equilibrium price is Cournot equilibrium price = $1,250 - Q = $1,250 - $1(800) = $450 P13.7 Stackelberg Model. The Stackelberg model allows for strategic behavior by leading firms, and can be used to illustrate how leading firms maintain dominence of

25 important industries. To illustrate the concept of Stackelberg first-mover advantages, again imagine that a two-firm duopoly dominates the market for spreadsheet application software for personal computers. Also assume that the firms face a linear market demand curve P = $1,250 - Q where P is price and Q is total output in the market (in thousands). Thus Q = Q A + Q B. For simplicity, also assume that both firms produce an identical product, have no fixed costs and marginal cost MC A = MC B = $50. In this circumstance, total revenue for Firm A is Marginal revenue for Firm A is TR A = $1,250Q A - Q A 2 - Q A Q B MR A = ΜTR A /ΜQ A = $1,250 - $2Q A - Q B Similar total revenue and marginal revenue curves hold for Firm B. A. Calculate the Stackelberg market equilibrium price-output solutions. B. How do the Stackelberg equilibrium price-output solutions differ from those suggested by the Cournot model? Why? P13.7 SOLUTION A. To illustrate Stackelberg first-mover advantages, reconsider the Cournot model but now assume that Firm A, as a leading firm, correctly anticipates the output reaction of Firm B, the following firm. With prior knowledge of Firm B=s output-reaction curve, Q B = Q A, Firm A=s total revenue curve becomes TR A = $1,250Q A - Q A 2 - Q A Q B = $1,250Q A - Q A 2 - Q A ( Q A ) = $650Q A - 0.5Q A 2 With prior knowledge of Firm B=s output-reaction curve, marginal revenue for Firm A is

26 Monopolistic Competition and Oligopoly MR A = ΜTR A /ΜQ A = $650 - $1Q A Because MC A = $50, Firm A=s profit-maximizing output level with prior knowledge of Firm B=s output-reaction curve is found by setting MR A = MC A = $50: MR A = MC A $650 - $1Q A = $50 Q A = 600 After Firm A has determined its level of output, the amount produced by Firm B is calculated from Firm B=s output-reaction curve Q B = Q A = (600) = 300 With just two competitors, the Stackelberg market equilibrium level of output is Stackelberg equilibrium output = Q A + Q B = = 900 (000) units The Stackelberg market equilibrium price is Stackelberg equilibrium price = $1,250 - Q = $1,250 - $1(900) = $350 B. Notice that market output is greater in Stackelberg equilibrium than in Cournot equilibrium because the first mover, Firm A, produces more output while the follower, Firm B, produces less output. Stackelberg equilibrium also results in a lower market price than that observed in Cournot equilibrium. In this example, Firm

27 A enjoys a significant first-mover advantage. Firm A will produce twice as much output and earn twice as much profit as Firm B so long as Firm B accepts the output decisions of Firm A as given and does not initiate a price war. If Firm A and Firm B cannot agree on which firm is the leader and which firm is the follower, a price war can break out with the potential to severely undermine the profitability of both leading and following firms. If neither duopoly firm is willing to allow its competitor to exercise a market leadership position, vigorous price competition and a competitive market price/output solution can result. Obviously, participants in oligopoly markets have strong incentives to resolve the uncertainty surrounding the likely competitor response to leading-firm output decisions. P13.8 Bertrand Equilibrium. Coke and Pepsi dominate the U. S soft-drink market. Together, they account for about 75% of industry sales. Dr. Pepper/Seven Up, Cott Beverage, and Royal Crown Cola account for most of the rest. The Bertrand model can be used to show the effects of price competition in this highly differentiated market. Suppose the quantity of Coke demanded depends upon the price of Coke (P C ) and the price of Pepsi (P P ) Q C = P C P P where output (Q) is measured in millions of 24-packs per month, and price is the wholesale price of a 24-pack. For simplicity, assume average costs are constant and AC = MC = X dollars per unit. In that case, the total profit and change in profit with respect to own price functions for Coke are π C = TR C - TC C = P C Q C - xq C = (P C - X) Q C Μπ C /ΜP C = 15-5P C P P + 2.5X A. Set Μπ C /ΜP C = 0 to derive Coke=s optimal price-response curve. Interpret your answer. B. Calculate Coke=s optimal price-output combination if Pepsi charges $5 and marginal costs are $2 per 24-pack. P13.8 SOLUTION A. To derive Coke=s optimal price-response curve, set Μπ C /ΜP C =

28 Monopolistic Competition and Oligopoly 15-5P C P P +2.5X = 0 5P C = P P + 2.5X P C = $3 + $0.25P P + $0.5X Coke=s optimal price-response curve shows that Coke should increase its own price by 254 with each $1 increase in the price of Pepsi, and increase its own price by 504 with every $1 increase in the marginal cost of production. B. If Pepsi charges $5 and marginal costs are $2 per 24-pack, Coke=s optimal priceresponse curve shows that Coke should charge $5.25 per 24-pack: P C = $3 + $0.25P P + $0.5X = $3 + $0.25($5) + $0.5($2) = $5.25 P13.9 Kinked Demand Curves. Safety Service Products (SSP) faces the following segmented demand and marginal revenue curves for its new infant safety seat: 1. Over the range from 0 to 10,000 units of output, P 1 = $60 - Q, MR 1 = ΜTR 1 /ΜQ = $60 - $2Q. 2. When output exceeds 10,000 units, P 2 MR 2 = $80 - $3Q, = ΜTR 2 /ΜQ = $80 - $6Q. The company=s total and marginal cost functions are as follows: TC = $100 + $20Q + $0.5Q 2, MC = ΜTC/ΜQ = $20 + $1Q,

29 where P is price (in dollars); Q is output (in thousands); MR is marginal revenue; TC is total cost; and MC is marginal cost, all in thousands of dollars. A. Graph the demand, marginal revenue, and marginal cost curves. B. How would you describe the market structure of the industry in which SSP operates? Explain why the demand curve takes the shape indicated previously. C. Calculate price, output, and profits at the profit-maximizing activity level. D. How much could marginal costs rise before the optimal price would increase? How much could they fall before the optimal price would decrease? P13.9 SOLUTION A. Note that: MR 1 = ΜTR 1 /ΜQ = $60 - $2Q MR 2 = ΜTR 2 /ΜQ = $80 - $6Q MC = ΜTC/ΜQ = $20 + Q

30 Monopolistic Competition and Oligopoly B. The firm is in an oligopolistic industry. It faces a kinked demand curve, indicating that competitors will react to price reductions by cutting their own prices and causing the segment of the demand curve below the kink to be relatively inelastic. Price increases are not followed, causing the portion of the demand curve above the kink to be relatively elastic. C. An examination of the graph indicates that the marginal cost curve passes through the gap in the marginal revenue curve. Graphically, this indicates optimal P = $50 and Q = 10(000). Analytically, MR 1 = $60 - $2Q Q # 10,000 MR 2 = $80 - $6Q Q > 10,000 MC = $20 + $Q

31 MR 1 > MC over the range Q # 10(000), and MR 2 < MC for the range Q > 10(000). Therefore, SSP will produce 10(000) units of output and market them at a price P 1 = $60 - Q = $60 - $(10) = $50. Alternatively, P 2 = $80 - $3Q = $80 - $3(10) = $50. D. At Q = 10(000), At P = $50 and Q = 10: π = TR - TC = $50(10) - $100 - $20(10) - $0.5(10 2 ) = $150(000) or $150,000 MR 1 = $60 - $2Q MR 2 = $80 - $6Q = $60 - $2(10) = $80 - $6(10) = $40 = $20 This implies that if marginal costs at Q = 10(000) exceed $40, the optimal price would increase. Conversely, if marginal costs at Q = 10(000) fall below $20, the optimal price would decrease. So long as marginal cost at Q = 10(000) is in the range of $20 to $40, SSP will have no incentive to change in price. P13.10 Price Signaling. Louisville Communications, Inc., offers 24-hour telephone answering service for individuals and small businesses in southeastern states. Louisville is a dominant, price-leading firm in many of its markets. Recently, Memphis Answering Service, Inc., and Nashville Recording, Ltd., have begun to offer services with the same essential characteristics as Louisville=s service. Total and marginal cost functions for Memphis (M) and Nashville (N) services are as follows: TC M = $75,000 - $7Q M + $0.0025Q 2M, MC M = ΜTC M /ΜQ M = -$7 + $0.005Q M, TC N = $50,000 + $3Q N + $0.0025Q2N, MC N = ΜTC N /ΜQ N = $3 + $0.005Q N

32 Monopolistic Competition and Oligopoly Louisville=s total and marginal cost relations are as follows: TC L = $300,000 + $5Q L + $0.0002Q2L, MC L = ΜTC L /ΜQ L = $5 + $0.0004Q L. The industry demand curve for telephone answering service is Q = 500,800-19,600P. Assume throughout this problem that the Memphis and Nashville services are perfect substitutes for Louisville=s service. A. Determine the supply curves for the Memphis and Nashville services, assuming that the firms operate as price takers. B. What is the demand curve faced by Louisville? C. Calculate Louisville=s profit-maximizing price and output levels. (Hint: Louisville=s total and marginal revenue relations are TR L = $25Q L - $ Q2L, and MR L =ΜTR L /ΜQ L = $25 - $0.0001Q L.) D. Calculate profit-maximizing output levels for the Memphis and Nashville services. E. Is the market for service from these three firms in short-run equilibrium? P13.10 SOLUTION A. Because price followers take prices as given, they operate where individual marginal cost equals price. Therefore, the supply curves for Memphis and Nashville services are: Memphis P M = MC M = -$7 + $0.005Q M 0.005Q M = 7 + P M Q M = 1, P M

33 Nashville P N = MC N = $3 + $0.005Q N 0.005Q N = -3 + P N Q N = P N B. As the industry price leader, Louisville=s demand equals industry demand minus following firm supply. Remember that P = P L = P M = P N because Louisville is a price leader for the industry: Q L = Q - Q M - Q N = 500,800-19,600P - 1, P P = 500,000-20,000P L P L = $25 - $ Q L C. To find Louisville=s profit-maximizing price and output level, set MR L = MC L and solve for Q: MR L = MC L $25 - $0.0001Q L = $5 + $0.0004Q L 20 = Q L Q L = 40,000 units P L = $25 - $ Q L = $25 - $ (40,000) = $23 D. Because Louisville is a price leader for the industry,

34 Monopolistic Competition and Oligopoly P = P L = P M = P N = $23 Optimal supply for Memphis and Nashville services are: Q M = 1, P M = 1, ($23) = 6,000 Q N = P N = ($23) = 4,000 E. Yes. The industry is in short-run equilibrium if the total quantity demanded is equal to total supply. The total industry demand at a price of $23 is: The total industry supply is: Q D = 500,800-19,600P = 500,800-19,600($23) = 50,000 units Q S = Q L + Q M + Q N = 40, , ,000 = 50,000 units Thus, the industry is in short-run equilibrium. CASE STUDY FOR CHAPTER 13 Market Structure Analysis at Columbia Drugstores, Inc

35 Demonstrating the tools and techniques of market structure analysis is made difficult by the fact that firm competitive strategy is largely based upon proprietary data. Firms jealously guard price, market share and profit information for individual markets. Nobody should expect Target, for example, to disclose profit and loss statements for various regional markets or on a store-bystore basis. Competitors like Wal-Mart would love to have such information available; it would provide a ready guide for their own profitable market entry and store expansion decisions. To see the process that might be undertaken to develop a better understanding of product demand conditions, consider the hypothetical example of Columbia Drugstores, Inc., based in Seattle, Washington. Assume Columbia operates a chain of 30 drugstores in the Pacific Northwest. During recent years, the company has become increasingly concerned with the long-run implications of competition from a new type of competitor, the so-called superstore. To measure the effects of superstore competition on current profitability, Columbia asked management consultant Anna Kournikova to conduct a statistical analysis of the company=s profitability in its various markets. To net out size-related influences, profitability was measured by Columbia=s gross profit margin, or earnings before interest and taxes divided by sales. Columbia provided proprietary company profit, advertising, and sales data covering the last year for all 30 outlets, along with public trade association and Census Bureau data concerning the number and relative size distribution of competitors in each market, among other market characteristics. As a first step in the study, Kournikova decided to conduct a regression-based analysis of the various factors thought to affect Columbia=s profitability. The first is the relative size of leading competitors in the relevant market, measured at the Standard Metropolitan Statistical Area (SMSA) level. Columbia=s market share, MS, in each area is expected to have a positive effect on profitability given the pricing, marketing, and average-cost advantages that accompany large relative size. The market concentration ratio, CR, measured as the combined market share of the four largest competitors in any given market, is expected to have a negative effect on Columbia=s profitability given the stiff competition from large, well-financed rivals. Of course, the expected negative effect of high concentration on Columbia profitability contrasts with the positive influence of high concentration on industry profits that is sometimes observed. Both capital intensity, K/S, measured by the ratio of the book value of assets to sales, and advertising intensity, A/S, measured by the advertising-to-sales ratio, are expected to exert positive influences on profitability. Given that profitability is measured by Columbia=s gross profit margin, the coefficient on capital intensity measured Columbia=s return on tangible investment. Similarly, the coefficient on the advertising variable measures the profit effects of advertising. Growth, GR, measured by the geometric mean rate of change in total disposable income in each market, is expected to have a positive influence on Columbia=s profitability, because some disequilibrium in industry demand and supply conditions is often observed in rapidly growing areas. Columbia=s proprietary information is shown in Table 13.3 Table 13.3 here

36 Monopolistic Competition and Oligopoly Finally, to gauge the profit implications of superstore competition, Kournikova used a Adummy@ (or binary) variable where S = 1 in each market in which Columbia faced superstore competition and S = 0 otherwise. The coefficient on this variable measures the average profit rate effect of superstore competition. Given the vigorous nature of superstore price competition, Kournikova expects the superstore coefficient to be both negative and statistically significant, indicating a profit-limiting influence. The Columbia profit-margin data and related information used in Kournikova=s statistical analysis are given in the preceding table. Regression model estimates for the determinants of Columbia=s profitability are shown in Table 13.4: Table 13.4 here A. Describe the overall explanatory power of this regression model, as well as the relative importance of each continuous variable. B. Based on the importance of the binary or dummy variable that indicates superstore competition, do superstores pose a serious threat to Columbia=s profitability? C. What factors might Columbia consider in developing an effective competitive strategy to combat the superstore influence? CASE STUDY SOLUTION A. The coefficient of determination R 2 = 77.7% means that 77.7% of the total variation in Columbia=s profit-margins can be explained by the regression model. This is a relatively high level of statistically significant explanation (F = 13.38) for a crosssection study such as this, suggesting that the model provides useful insight concerning the determinants of profitability. The standard error of the estimate (S.E.E. = %) means that there is roughly a 95% chance that the actual profit margins for a given store will lie within the range of the estimated or fitted value 2 Η S.E.E., or 2 Η %. The intercept coefficient of has no economic meaning because it lies far outside the relevant range of observed data. The coefficient for the market-share variable means that, on average, a 1% (unit) rise in Columbia=s market share leads to a 0.189% (unit) rise in Columbia=s profit margin. Similarly, as expected, Columbia=s profit margin is positively related to capital intensity, advertising intensity, and the rate of growth in the market area. Conversely, high concentration has the expected limiting influence. Because of the effects of leading-firm rivalry, a 1% rise in industry concentration will lead to a 0.156% decrease in Columbia=s profit margin. This means that relatively large firms compete effectively with Columbia