AP Microeconomics: Test 5 Study Guide

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1 AP Microeconomics: Test 5 Study Guide Mr. Warkentin 203 Sprague Hall Academic Year Directions: The purpose of this sheet is to quickly capture the topics and skills that you will be responsible for on the upcoming Microeconomics test, which covers material from modules in the text. Key Concepts An oligopoly is a market structure in which there are a few major players which dominate the supply. The driving feature of an ologopolistic market is that the firms results depend on the behavior of other firms. In other words, the firms are interdependent. A duopoly is an oligopoly with only two major players. The soda industry (Coke and Pepsi) is a good example of this. When oligopolists manage to collude with each other, the result is known as a cartel. Game theory is the study of human behavior and decisions when there is interdependence. Individual structures/situations that players find themselves in are known as games. Oligopolies are very well modeled by a game known as the Prisoner s Dilemma, in which players have the choice whether to collude or betray each other. The game is characterized by the fact that both players would be better off colluding with each other than by betraying each other, but if only one of them betrays the other, then the traitor wins big time. A payoff matrix is (in AP Economics) a 2 2 matrix which describes the outcomes in a duopoly given a specific case of betrayal or collusion. In a game, a dominant strategy is a decision for one player which will make that player better off, no matter what the other player decides. In the Prisoner s Dilemma, the dominant strategy for both players is to betray. In a game, a Nash equilibrium is situation in which neither player has an immediate incentive to change its behavior. In the Prisoner s Dilemma, mutual betrayal is the Nash equilibrium. Collusion between players can be enforced without an explicit agreement. Strategies such as so-called tit-for-tat retaliation or establishing a price leader can allow players to collude while behaving legally. Such collusion is known as tacit collusion. The fourth (and final) market structure is known as monopolistic competition. The nature of this market is such that there are many firms facing low or nonexistent barriers to entry. However, the players are able to differentiate their product (unlike in perfect competition) through branding or other means. Because each firm has a monopoly on its specific version of the product, the firm s cost and revenues graph looks very much like a monopolists s. A firm in monopolistic competition is profitable when ATC dips below demand because this means that, at some quantity, the cost of producing each unit is, on average, lower than the price of the product. Similarly, a monopolistically competitive firm in is unprofitable when its ATC never dips below demand, and it earns normal economic profit when the ATC touches the demand curve at only one point.

2 Even though a monopolistically competitive firm s graph looks like that of a monopoly, its results are still dependent upon other firms in the industry. Thus, if a firm is profitable, other firms will enter the market and encroach upon that firm s niche, shifting demand (for that one firm) left. Thus in the long run, firms in monopolistic competition see their demand curves shift until zero economic profit is earned. Note that, due to the nature of monopolistic competition, firms do not produce at the minimum of their ATC curves (unlike in perfect competition). Thus, monopolistic competition is worse for consumers (and society) than perfect competition because products are priced higher, but firms still earn zero economic profit.

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