Week 7 ECON201 ONLINE with Professor Haynes
Week 7 ECON201 ONLINE with Professor Haynes ECON201 Online, Stephen Haynes
Popular in Econ201
Popular in Department
This 15 page Class Notes was uploaded by Kathryn Sternberger on Friday February 20, 2015. The Class Notes belongs to ECON201 Online, Stephen Haynes at University of Oregon taught by Stephen Haynes in Winter2015. Since its upload, it has received 61 views.
Reviews for Week 7 ECON201 ONLINE with Professor Haynes
Report this Material
What is Karma?
Karma is the currency of StudySoup.
You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!
Date Created: 02/20/15
ECON201 Week 7 Book Notes Chapter 11 Market Entry and Monopolistic Competition Firms decisions on entering a market Effects of new rm entry on existing rms pro ts and prices Three ways the entry of rms squeezes pro t 1 Price decreases 2 Average cost of production increases 3 Quantity sold per rm decreases Monopolistic competition a market served by many rms that sell slightly different products Has features of both perfectly competitive market and monopoly gt Each rm produces a good slightly differing from the goods of other rms each rm is narrowly de ned as a monopoly gt The products sold by each rm are close substitutes creating competition Monopolistic competition market examples bread clothing restaurants gas ect Assumptions of the chapter A No barriers to entry B Firms do not act strategically each rm takes the actions of other rms as given No attempts to x prices or keep other rms from entering market 111 The Effects of Market Entry Consider a toothbrush company who is the only rm in the market monopoly 9 Figure 111 on page 256 Compare and contrast the market graphs for a single rm market vs the two rm market The most pro table choice for our toothbrush rm shown by Panel A is to sell 300 toothbrushes at a price of 200 where the production cost is 090 to gain a pro t of 330 When a new rm enters the market shown by Panel B the demand curve shifts to left The most pro table option for our rm in this scenario is to sell 200 toothbrushes at a price of 180 where production cost is 100 shrinking the rms pro t from 330 to 160 Entry Squeezes Pro ts From Three Sides 0 Market price drops I The competition between the two rms creates a price drop in our example from 200 to 180 The marginal principle is satis ed at a different point with two rms than it is for one 0 Quantity demanded by the rst rm decreases I The new rm will satisfy some of the demand originally ful lled by the rst rm so quantity demanded will decrease as consumers are essentially being shared between to two rms I In our example the toothbrush rm went from a quantity demanded of 300 to 200 toothbrushes o T he rst rm s average cost of production increases ECON201 Week 7 Book Notes I Decrease in quantity supplied causes the rm to move upward on its negatively sloped average cost curve average cost per toothbrush increases in our example from 090 to 100 0 Effects of entry are shown by the comparison between the pro t rectangles in Panel A and B of Figure 111 0 Pro t decreases from 330 to 160 with the entry of a new rm 0 What about the second rm I Assuming second rm has the same production costs and technology I Also assuming the products are nearly identical I The rmspeci c demand curve for the rst rm showed by Panel B will also represent the second rm Examples of Entry Car Stereos Trucking and Tires 0 Imagine you inherited money and decided to start a car stereo business I Existing monopolist sells 10 pday at 230 and has an average cost per stereo of 200 pro t of 30 per stereo I If you enter the market the price drops below 230 if you sell fewer than the monopolist did which you likely would the average cost per stereo would increase as well to 205 your pro t p sale is only 10 much lower than the monopolist o Eliminating arti cial barriers Trucking I 1980 government eliminated arti cial barriers I More rms entered the market I Freight prices dropped 22 I Deregulation increased competition decreasing prices and pro ts I The average value of a trucking license decreased from 57900 to 15 00 value of license indicates pro t that can be earned in the market 0 Empirical studies I Market entry decreases prices for consumers I Decreases pro ts for rms Application 1 Satellite vs Cable How does market entry affect prices Market for television signal Entry of a company providing satellite service The cusses to existing rms are as follows Improved quality of service Decrease in price Some cases rms increase quality and increase price Quality normally surpasses increase in price Result is consumer surplus VVVVVVV 112 Monopolistic Competition Firms continue to enter the market until economic pro t becomes 0 ECON201 Week 7 Book Notes Many rms Because there are relatively small economies of scale a small rm can produce its product about the same average cost as a large rm Small and large donut shops have about the same average cost for donuts and coffee the market has room for many rms A d erentiated product product differentiation or the process used by rms to distinguish their products from the products of competing rms No arti cial barriers to entry no patents or regulations preventing rms from entering the market The preceding 3 characteristics help explain why it is called monopolistic competition Product differentiation each rm is the sole seller of a narrowly de ned good Because products are such close substitutes competition is created The demand for a monopolistically competitive good is very elastic When Entry Stops Long Run Equilibrium O O 0 We are going to use the toothbrush example again Firms differentiate their products by bristle design color handle size and shape as well as durability In the previous toothbrush example Fig 111 on page 256 when two rms are in the toothbrush market both still make a pro t the question is will another rm enter The answer is yes the 3rd entry will move the demand line further to the left decreasing market price decreasing quantity produced per rm and increases average cost for rms If after the 3rd rm enters rms are still making economic pro t a fourth rm will enter Let s say that six rms are in the toothbrush market 9 Figure 112 LongRun Equilibrium with Monopolistic Competition page 259 0 New entry shifts rm speci c demand curve to the left Firms enter until economic pro t is 0 The graph shows us that they typical rm maximizes pro t at point A where marginal revenue marginal cost 80 toothbrushes price equals average cost so economic pro t is 0 so no further rms will enter the market Each rms pro ts are just high enough to cover it s average costs In our example of the toothbrush market from one rm in the market to six rms in the market price fell from 200 to 140 an increased total quantity demanded from 300 to 480 consistent with law of demand Differentiation by Location 0 0 Sometimes differentiation is a matter of location only Examples gas stations music stores bookstores grocery stores movie theaters icecream shops Many products sell the same products at different locations ECON201 Week 7 Book Notes 0 Each store has a monopoly in it s own neighborhood but competes with stores in the rest of the city 9 Figure 113 Long Run Equilibrium with Spatial Competition page 260 o The graph shows the market for books 0 Typical bookstore satis es marginal principle at Point A selling 70 books per hour at a price of 14 per book 0 Price average cost so economic pro t 0 o Firm chooses quantity where marginal cost marginal revenue Application 2 Opening A Dunkin Donuts Shop Are monopolistically competitive rms pro table One way franchise for nationally advertised product You could pay 40000 to own a Dunkin Donuts Can sell donuts under the corporate brand You get a few weeks of training at the corporate of ce Receive some help with a grand opening When you make money you pay 59 of your sales to corporate of ce How much are you likely to make then Your competition bakeries grocery stores other donut shops In a monopolistically competitive market you should expect to make 0 economic pro t Table 11 shows royalty fees for several franchise companies 113 Trade offs with Entry and Monopolistic Competition Average Cost and Variety 0 Examples of bene ts of product variety I Restaurant meals a city with several Italian restaurants will have a variety of menus preparation techniques atmospheres ect A city with only one Italian restaurant would only have one menu to choose from I Shoes and Clothing if there was only one type of shoe average cost of clothing would be lower but clothing choice would be eliminated 0 When rms are differentiated by location average cost increases however this is offset by decreased travel distances Monopolistic Competition vs Perfect Competition 0 Product differentiation is what differentiates haha monopolistic competition from perfect competition 9 Figure 114 Monopolistic Competition vs Perfect Competition ECON201 Week 7 Book Notes 0 Panel A of gure 111 shows the demand curve for the perfectly competitive market as a horizontal line where the marginal principle is satis ed and zero economic pro t is earned Price Marginal cost average cost 0 The only place where marginal cost and price equals average cost is at the lowest point of the averagecost curve point a 0 Panel B shows the equilibrium of a monopolistically competitive rm I Demand curve is negatively sloped differentiated product I Marginal revenue is less than price I Zeroprice condition is satis ed along the negatively sloped prtion of the averagecost curve I A monopolistically competitive rm produces less output at a higher output cost than a perfectly competitive rm Application 3 Happy Hour Pricing How does monopolistic competition compare to perfect competition Consider happy hour Bars and restaurants near workplaces face an increase in demand around 500pm Many cut prices for an hour or two With perfect competition increase in demand will lead to higher prices Why lower price when there is higher demand Bars are subject to monopolistic competition Local monopoly Competition with other bars in the city When individual demand increases each bar faces elastic demand for products Rational response to elastic demand is to lower prices Graphically demand curve facing each bar becomes atter the demand curve will be tangent to the averagecost curve at a larger quantity and lower price and average cost 114 Advertising for Product Differentiation Advertising can be used to inform customers about the features of a product or to promote an image for a product ex Athletic drink athletes performing amazing feats An advertisement that gives no information about a product still helps a consumer make decisions everyone knows when a celebrity appears in a commercial it is for monetary gain not enthusiasm for the product however these ads are still effective why I Firm sends a signal to consumers that the product is appealing and likely to be popular I These ads are used to get people to try the product once if everyone who sees the commercial buys once and half become repeat customers the rm will make a pro t exceeding the cost of the commercial 9 Table 112 Advertising Pro tability and signaling page 265 ECON201 Week 7 Book Notes The table shows the effects of advertising for a more appealing and less appealing product The table shows that celebrity advertisements are equally useful in getting people to try a product but what matters are repeat customers Celebrity endorsements and other expensive ads send a message to consumers that the rm expects repeat customers Firms undertake extensive market research to discover whether certain ads are worthwhile Application 4 Picture of Man vs Woman How does advertising affect customer choices Loan company used two different pictures for their ads Uptake rate among men was much higher when the photo was of a woman I Replacing a male model with a female model was an equivalent to cutting the interest rate by 25 holy crap The gender of the model made no significant change for female customers Chapter 12 Oligopoly and Strategic Behavior Oligopoly a market served by few firms Actions of one firm have a large effect on other firms Firms act strategically Before a firm takes action it considers possible reactions of competing firms Game theory the study of decision making in strategic situations Concentration Ratios the percentage of the market output produced by largest firms measures the degree of concentration in a market Fourterm concentration rate means the concentration of the four largest firms in the market in terms of output 9696969696 9 Table 121 Concentration Ratios in Selected Manufacturing Industries page 271 Shows that the 4 largest firms produce 97 of household slippers in the US An alternative measure to concentration ratios is the HerfmdahlHirschman Index HHI thank goodness there is an acronym for that HHI 60A2 40A2 3600 1600 5200 Found by squaring the market share of each firm in the market then summing the resulting numbers as shown above A market with 100 firms each with 10 market share would look as follows HHI10A2 x 10 100 x10 1000 ECON201 Week 7 Book Notes All rms have the same market share so instead of doing 10A2 ten times and adding them all up you just do it once and times it by then the of rms 1992 US Department of Justice established guidelines of concentration regarding a market with an HHI below 1000 as unconcentrated and a market with an HHI above 1800 as highly concentrated An oligopoly occurs for three reasons 1 Government barriers to entry By issuing patents or limiting licenses 2 Economies of scale in production Sometimes economies of scale are not large enough to generate monopoly but are large enough to generate a natural oligopoly 3 Advertising campaigns Sometimes a market cannot be entered without a huge investment in an advertising campaign 121 Cartel Pricing and the Duopolists Dilemma 96969696 9696 9696 Competition in the market leads to diversity of product and lowered prices Sometimes rms cooperate with each other instead of competing An agreement to raise prices is likely to break down unless there is some sort of enforcement mechanism for a rm that dissents We will use a duopoly market with two rms Basic insights of duopoly apply to oligopoly Consider Duopoly of air line travel market between two cities They can use price to compete for customers or they can cooperate and raise prices together For simplicity average cost of providing airline travel is 100 ppassenger Cartel a group of rms acting in unison coordinating prices and quantity decisions With our example the two rms could form a cartel and get the monopoly price 9 Figure 121 A Cartel Picks the Monopoly Quantity and Price page 273 9696969696 The graph shows that if the two rms act together they will choose the monopoly price of 400 ppassenger with 30passenger perday resulting in an economic pro t of 9000 pday p rm This is an example of price xing an arrangement in which rms conspire to x prices cartels and price xing are illegal under US antitrust law What would happen if the two rms decided to compete instead Each would have it s own demand curve Consumers will divide between the two rms Each rm only serves part of the market Demand curve for the typical duopolist is below the market demand curve 9 Figure 122 Competing Duopolists Pick a Lower Price Panel B shows that competing duopolies will choose the lower price of 300 and serve 80 passengers pday ECON201 Week 7 Book Notes Panel A shows quantity and price of an individual rm the marginal principle is satis ed at point a where marg rev marg cost giving the rm 40 passengers pday at a price of 300 ppassenger economic pro t of each rm is 8000 Price Fixing and the Game Tree 0 It is clear that rms earn more pro t in a cartel than when competing but 0 canwill cartels succeed or will rms cheat on agreements We can use a game tree graphical representation of the consequences of different actions in a strategic setting to gure this out 9 Figure 123 Game Tree for the PriceFixing Game page 274 O 0 We are calling the managers Jack and Jill Each box shows the decision of the 2 managers The equilibrium choice is the choice where neither participant has the incentive to unilaterally change their decision Choice one is the suboptimal choice both managers earn the most with this choice however in a cartel each manager has incentive to change their decision unilaterally meaning on their own because there is such a high pay off Choice four is the only equilibrium in the game because if Jack picks the low price Jill has no incentive to pick the high price UNLESS jack was going to change his decision as well which would not be a unilateral decision and the same thing vice versa Equilibrium of the Price Fixing Game I described choosing the equilibrium as picking out the choice where neither participant has the incentive to unilaterally change their decision which is how I learned how to solve these games in my political science course The book explains how to sort through the possible outcomes and nd the equilibrium by simply eliminating the choices that require an actor to behave irrationally This method does the same thing I described it is just a different way of looking at it Do whatever works for you Dominant strategy an action that is the best choice for a player no matter what the other player does I Regardless of what Jill does jack will pick the lowest price take a look back to the tree until this makes sense to you The duopolist s dilemma a situation in which both rms in a market would be better off if both chose the high price but each chooses the low price I Each rm will be upset with this equilibrium choice because there is a suboptimal option possible however it is not being reached I Dilemma occurs because of the huge pay off of underpricing the other rm and a big penalty from being underpriced Nash Equilibrium ECON201 Week 7 Book Notes 0 Nash Equilibrium an outcome of a game in which each player is doing the best he or she can given the actions of the other players 0 In the Nash equilibrium of the price xing game both rms choose the low price 0 Consider all possibilities of the game locate the choices that make rational sense for the rm to do it s best given the other rms decision Application 1 Failure of the Salt Cartel Why do cartels sometimes fail to keep prices high Salt companies formed salt pools or enterprises that set a uniform price and distributed the salt for all participating producers Output quotas Paid rms not to produce for a year Every salt pool eventually broke down In some cases individuals cheated by selling outside the cartel Other cases arti cially high price caused new rms to enter the market and underprice 9696969696 122 Overcoming the Duopolist s Dilemma The dilemma occurs because two rms are unable to coordinate pricing decisions and act as one Each rm has an incentive to underprice the other Firms can avoid the dilemma in 2 ways 1 Low price guarantees 2 Repetition of the game with retaliation for underpricing Lowprice Guarantees 0 One rm can guarantee to march the lower price of a competitor 0 Ad if you buy an airline ticket from me and then discover that Jack offers the same trip at a lower price I will pay you the difference 0 Lowprice guarantee a credible promise to match a lower price of a competitor 9 Figure 124 LowPrice Guarantees Increase Prices page 277 0 With lowprice guarantees if Jill picks the low price jack will pick the low price we will end up in the same box as before both pick low price 0 But this time if Jill picks the high price Jack will pick the high price because Jill s refund diminishes his incentive to underprice her rm9 we end up in option rectangle one with each rm making 9000 0 With low price guarantees each rm has the incentive to pick the higher price 0 Low price guarantee eliminates the possibility of underpricing and promotes cartel pricing 0 The promise is an empty promise ECON201 Week 7 Book Notes 0 Low price guarantee does not protect consumers from a higher price it actually assures that they will pay a higher price Repeated Pricing Games with Retaliation for Underpricing o Repetition makes price xing more likely because rms can punish other rms that cheat whether formally or informally I A duopoly pricing strategy A rm accepts the duopoly price once experiencing being undercut by another rm The rm now has the incentive to play it safe and avoid taking the risk of suffering the losses it had suffered before 11 A grimtrigger strategy When rm A underprices rm B rm B responds by underpricing rm A to the point it earns zero economic pro t III A titfortat strategy One rm chooses the strategy the other rm chose the preceding month 9 Figure 125 A titfortat Strategy page 279 Firm does exactly what hisher rival did the last round If Jack underprices Jill Jill will choose the low price the next month If Jack wants the cartel price back he has to let Jill underprice him for a month before she chooses the high price the following month Several studies have shown the titfortat strategy to be the best in promoting cooperation 0 Pricing schemes help promote cartel pricing by penalizing underpricing rms I Firm must weigh short term bene t against long term cost of underpricing o If the two rms expect to share the market for a long time the long term cost of underpricing will exceed the short term bene t of underpricing 0000 0 Price xing and the Law 0 Sherman Antitrust Act of 1890 explicit price xing is illegal Price Leadership 0 Because explicit price xing is illegal rms sometimes nd ways to rely on implicit pricing agreements to x prices at the monopoly level 0 Problem these implicit agreements rely on indirect signals that are often misinterpreted 0 Two rms have upheld one monopoly price for several years then one rm drops its price the other rm interprets this in two ways 1 Change in market conditions The other rm that due to production cost or demand or both that both rms would bene t from a lower price 2 Underpricing Picking a lower price at the other rms expense ECON201 Week 7 Book Notes Application 2 LowPrice Guarantee Increases Tire Prices Do lowprice guarantees generate higher or lower prices 0 We already established that lowprice guarantees result in higher prices 123 Simultaneous decision Making and the Payoff Matrix What if the two rms had to make their decisions simultaneously Payoff matrix a matrix of table that shows for each possible outcome of a game the consequences for each player Simultaneous PriceFixing Game 9 Figure 126 Payoff Matrix for the PriceFixing Game page 281 0 There is still a suboptimal choice both firms earn 9000 0 The low price is the dominant strategy for Jack therefore the equilibrium is the same as it is for the gametree approach both pick low price The Prisoner s Dilemma 0 Let s choose Bonnie and Clyde 0 Each person has the opportunity to confess to the crime and therefore shorten their sentence 0 The decision is made simultaneously by both parties The suboptimal outcome is that they BOTH confess o The equilibrium outcome is that they will both defect because when both defect neither party has the incentive to unilaterally switch decisions 0 9 Figure 127 Payoff Matrix for the Prisoner s Dilemma page 282 o Confessing is the dominant strategy for Clyde Bonnie knows this so she will confess as well 0 If both confess we have a Nash equilibrium outcome 0 There is incentive to squeal just as there is incentive for firms to underprice one another 124 The Insecure Monopolist and Entry Deterrence How might a monopolist try to prevent another firm from entering the market Let s say Mona had a monopoly in the air travel market between two cities With no competition Mona uses the marginal principle and picks the monopoly price of 400 60 passengers per day and leaving her 18000 in profit 9 Figure 128 Deterring Entry with Limit Pricing Monopolists can set their price at the zero economic profit price in order to deter other firms from entering the market ECON201 Week 7 Book Notes In our example if Mona wanted to deter another rm from entering the market she could set her price to 100 with 120 passengers per day and earn zero economic pro t If she decides against lowering her price to deter a competitor then she will end up with a duopoly as we saw earlier Entry Deterrence and Limit Pricing o How does Mona decide to be passive or to deter entry I She must ask two questions 1 What must she do to deter entry 2 Given what she must do is deterrence more pro table than being passive and sharing the market with another rm 0 What must she do to deter I Commit to serving a large number of passengers 339 There won t be a large enough number of passengers for another rm to make a pro t v There may be large economies of scale in air travel market impractical for a rm to serve fewer than 20 passengers per day v Quantity provided to deter entry is computed like this Deterring quantity zero pro t quantity minimum entry quantity 100 120 20 339 If Mona commits to serving 100 passengers for an average cost of 100 she will break even 339 If a competitor serves 20 passengers with an average cost of 100 will lose money 339 Mona must take actions to ensure serving 100 passengers is her most pro table output is 100 passengers gt Example purchasing a larger eet of airplanes and signing labor contracts that require her to hire a large workforce I So what is the more pro table choice passivity or deterrence 339 Deterrence would generate a price of 200 per passengers with an output of 100 passengers leaving her with 10000 economic pro t Pro t price average cost X quantity per rm 200 100 X 100 10000 339 This is larger than the 8000 pro t she would earn in a duopoly meaning deterrence is the best strategy ECON201 Week 7 Book Notes 9 Figure 129 Game Tree for the Entry Deterrence Game page 285 This graph shows the decision of deterrence vs passivity as a game tree You can look at the payoffs to come to the same conclusion we just discovered about Mona s decision to deter 0 v Limit pricing the strategy of reducing the price to deter entry 0 v Limit price the price that is just low enough to deter entry Examples Aluminum and Campus Bookstores 0 Aluminum Company Aluminum Company of America Alcoa I Monopolist between 18931940 for aluminum production in the US I Kept others out by producing large quantities and keeping prices relatively low 0 Campus Bookstores I Other organizations are prohibited usually by the state gov t or college itself I Internet commerce gives students another option threatening campus bookstore monopoly I Could lower prices to get you to purchase books from them instead of online Entry Deterrence and Contestable Markets 0 The existence of a monopoly or oligopoly does not necessarily generate high prices and large profits 0 To protect market share oligopolist might act like a firm in a market of many Contestable market a market with low entry and exit costs 0 Firms in contestable markets will be constantly threatened by entry therefore leading to relatively low prices and profits 0 If price to enter and exit is zero perfectly contestable then the price would be the same as in a competitive market 0 When is the Passive Approach Better 0 Key variable minimum entrance quantity how many customers one needs to make a profit 0 If the scale economies were low in our example with Mona s business committing to serve 100 passengers wouldn t be enough to deter the entry of another firm Deterring quantity zero profit quantity minimum entry quantity 110 120 10 o This combination is no longer more profitable than the 8000 profit she would earn in a duopoly Profit price average cost x quantity per firm 150 100x110 ECON201 Week 7 Book Notes 5500 Application 4 Microsoft as an Insecure Monopolist How does a monopolist respond to threat of entry Constantly threatened by entry of other firms Pure monopoly price for Microsoft software bundle 354 The actual price 143 The estimated cost for another firm to develop maintain and market an alternative software is 38 billion Microsoft s price is just low enough to make the investment unprofitable Pure monopoly profit would be 191 billion Limit pricing profit is 153 billion Duopoly profit if they allowed for entry 148 billion Deterrence is their most profitable option 969696 9696969696 125 The Advertiser s Dilemma Both firm s would be better off if neither spent money on advertising yet both firms advertise Consider 2 producers of an aspirin Each has to decide whether or not to spend 7 billion on advertising 9 Table 123 Advertising and Profit page 287 Shows the outcome of neither for advertising both firms advertising and one firm advertising The cost to the firm that does not advertise if they firm chooses to advertise that neither firm can rationally take that risk We can use game theory to solve this dilemma again 9 Figure 1210 Game Tree for the Advertisers Dilemma page 288 The game tree shows the pay offs of each outcome of decisions If Adeline chooses to advertise it is most pro table for Vern to advertise as well If Adeline chooses not to advertise it is more profitable for Vern to advertise Advertising is Vem s dominant strategy whatever Adeline decides it is more profitable for Vern to advertise The equilibrium then would be to advertise Why does the advertising dilemma happen I It happens when advertising causes a relatively low increase in sales of the industry but allows a firm that advertises to gain at the expense of the firms that don t 96969696 9696 Application 5 Got Milk What is the rationale for generic advertising The got milk Advertisement ran by National Fluid Milk Producers funded by a tax of 020 per hundredweight of processed milk Producers pool their resources to fund the ad campaign 96969696 ECON201 Week 7 Book Notes Milk is a standardized good advertising my one brand bene ts them all The got milk campaign increases demand for milk by 6 No single rm has incentive to fund an ad campaign Share the cost of ad campaign and the bene ts
Are you sure you want to buy this material for
You're already Subscribed!
Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'