Chapter 15: Industrial Organization

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1 Chapter 15: Industrial Organization Imperfect Competition Product Differentiation Advertising Monopolistic Competition Oligopoly Collusion Cournot Model Stackelberg Model Bertrand Model Cartel Legal Provisions Treble Damage Tacit Collution Outline and Conceptual Inquiries Interested in Profits? Then Consider Product Differentiation Why does every member in your economics class probably have a different type of toothbrush? Application: Production Differentiation at the Movies Advantages of Advertising (Selling Cost) Determining Profit Maximization Assessing Advertising Should you let advertising change your preferences? Application: Web 2.0 and Citizen Review Sites Monopolistic Competition Ills Does monopolistic competition lead to a large number of sick firms? Determining Short- and Long-Run Equilibrium under Monopolistic Competition Application: Moneylenders and Bankers Understanding Oligopolies Determining Price and Output Cournot Model: Commercial Real Estate Are Cournot firms zombies? Stackelberg Model: Microsoft Do you respond to some stimulus? Collusion: OPEC Bertrand Model: Airlines Do firms really compete over price? Generalized Oligopoly Models Collusion in Oligopoly Markets: Fair-Trade Pricing

2 Application: OPEC Cartel Legal Provisions: Pollution Standards Is collusion among firms allowed? Appendix to Chapter 15 Spatial Differentiation: Gas Stations Perfectly Competitive Location Why do different fast-food restaurants always seem to locate in the same vicinity? Determining the Profit-Maximizing Price Application: Is Zoning Creeping Socialism? Treble Damage Model Tacit Collusion: Beat any Price What is the real reason firms advertise that they will match any of their competitors prices? Price Leadership: New York City Banks Summary 1. Product differentiation is in the eyes of the beholder, so it may be real or imaginary. Firms may differentiate their products by quality and style, guarantees and warranties, services provided, and location of sales. 2. Given the ability of product differentiation, firms have an incentive to undertake selling costs. Selling costs are marketing expenditures aimed at adopting the buyer to the product. For profit maximization, the marginal revenue derived from selling costs must equal the marginal cost. Similarly, the marginal revenue from product differentiation must equal the marginal cost for profit maximization. 3. The two major types of advertising are informational and persuasive. Informational advertising educates consumers about firms products and prices. Persuasive advertising is when a firm attempts to modify consumers preferences. 4. Monopolistic competition is a market structure characterized by a relatively large number of firms with each firm able to practice some form of product differentiation. In contrast, an oligopoly market is characterized by the existence of a relatively small number of sellers with interdependence among sellers. 5. The Cournot model assumes oligopolistic firms do not realize the interdependence of their decisions with their competitor s decisions. In contrast, a Stackelberg model assumes that one firm is a leader and takes the likely response of a competitor, the follower, into consideration. 6. The Cournot and Stackelberg models assume that firms determine their output, and, based on the total output supplied, the market determines the price. Alternatively, the Bertrand model assumes the reverse behavior, where firms determine their price and the market then determines quantity sold.

3 7. A major cartel influencing world oil prices is the OPEC cartel. This cartel is not backed by any legal provisions, so it has a history of instability in its efforts to boost the price of crude oil. 8. (Appendix) Product differentiation in terms of location is called spatial differentiation. Even if the products are identical, a firm s location can differentiate its product from its competitors. 9. (Appendix) The necessary and sufficient conditions for the perfectly competitive equilibrium location for two firms are when the two firms locate at the same place and have no incentive to change locations. 10. (Appendix) Within the United States, certain industries are prohibited from colluding and treble damages may be assessed for illegal pricing practices. However, assessing these damages may not yield the efficiency results that the US Department of Justice enforcing the antitrust acts would yield. 11. (Appendix) When firms are unable to explicitly collude, they may attempt tacit collusion. For example, they may offer the same price for their commodities. This common price may then be altered by a price leader without any formal explicit, colluding mechanism. Key Concepts antitrust Bertrand model cartel cheating combative advertising conjectural variations Cournot model dominant firm duopoly information differentiation interloper isoprofit curve monopolistic competition oligopolistic market price leadership price war product differentiation reaction function selling cost spatial differentiation Stackelberg model Sweezy s kinked demand tacit collusion treble damage

4 Key Equations The optimal level of output is determined by setting marginal revenue equal to marginal cost of output. The optimal level of product differentiation is determined by setting marginal revenue equal to marginal cost of product differentiation. The optimal level of advertising is determined by setting marginal revenue equal to marginal cost of advertising. MR = SMC 1 = SMC 2 = = SMC n A cartel with n firms (countries) will maximize the cartel s profits by equating MR to each of the member s short-run marginal cost.

5 TEST YOURSELF Multiple Choice 1. Firms with monopoly power can use selling costs to increase their profits. These selling costs include the costs of a. Rent-seeking b. Advertising c. Store location. d. All of the above. 2. The optimal level of advertising occurs when a. The price from an additional unit of advertising is equal to marginal advertising cost b. The price from an additional unit of advertising is equal to marginal production cost c. The marginal revenue from an additional unit of advertising is equal to marginal production cost d. The marginal revenue from an additional unit of advertising is equal to marginal advertising cost. 3. The two major types of advertising are and. a. Informational; persuasive b. Television; newspaper c. Electronic; printed media d. Local; national. 4. Which of the following is not a characteristic of monopolistic competition? a. Large number of firms b. Homogeneous product c. Free entry d. Advertising and product promotion. 5. As the number of sellers in monopolistic competitive increases, the degree of product differentiation and each firm s demands becomes. a. Falls; more elastic b. Rises; more elastic c. Rises; less elastic d. Falls; less elastic. 6. Which of the following is a characteristic of monopolistic competition? a. Perfectly elastic demand b. Long-run normal profits c. Homogeneous product d. A number of firms in the market.

6 7. Which of the following is a characteristic of an oligopoly market? a. Large number of firms b. Conjectural variations c. Game theory d. The Law of One Price. 8. Assume a duopoly where each firm determines its output given its beliefs about the other firm s choice. If each firm is actually correct about its beliefs, the market will be at a a. Nash equilibrium b. Partial equilibrium c. Pareto-efficient equilibrium d. All of the above. 9. In a Cournot duopoly model, a. Conjectural variations are zero b. Conjectural variations are naive c. Conjectural variations are the partial of the reaction function to a change in another firm s decision variable d. All of the above. 10. Suppose the market for pizza in a college town is served by a duopoly. The inverse demand function for pizza is p = 10 2(q 1 + q 2 ). Each firm faces a short-run total cost function of STC j = 4q j + 1 for j = 1, 2. In this model, the Cournot reaction function for firm 1 will be a. b. c. d. 11. Refer to Question 10. The Cournot equilibrium occurs where a. b. c. d. 12. In the Stackelberg model of duopoly, a. A leader is facing a follower b. Conjectural variations are nonzero c. Collusion improves all firms profits d. Firms compete in prices.

7 13. Refer to Question 10. If firm 1 is a Stackelberg leader and firm 2 is a Cournot follower, the equilibrium outputs are a. b. c. d. 14. Refer to Question 10. If the two firms collude, the price of a pizza is a. $6.00 b. $6.50 c. $7.00 d. $7.50 e. $ Suppose a market consists of two firms that are either a leader or a follower. Let the payoff matrix be Firm 2 Leader Follower Firm 1 Leader ( 10, 10) (9, 5) Follower (5, 9) (6, 6) How many Nash equilibria are there? a. 0 b. 1 c. 2 d. 3 e In the Bertrand model, a. There is a leader and a follower b. All firms base their output decision on zero conjectural variations c. Firms have no reaction curves d. All firms base decisions on zero conjectural variations.

8 17. Refer to the following graph: p 2 Firm 1's reaction curve Firm 2's reaction curve 0 p 1 This graph illustrates a a. Stackelberg model b. Bertrand model c. Nash equilibrium d. Cournot model. 18. Suppose there are two duopoly firms that face demand functions q 1 = 8 3p 1 + 2p 2 and q 2 = 8 3p 2 + 2p 1. Assume each firm has only fixed costs. The prices determined by each firm are a. b. c. d. 19. A cartel would be interested in a. Increasing the utility of its members b. Engaging in rent-seeking behavior c. Decreasing the actions of interlopers d. All of the above. 20. (Appendix) Guaranteed price matching is a form of a. Cartel agreement b. Law of One Price c. Tacit collusion d. All of the above.

9 Short Answer 1. Describe how produce differentiation can be achieved. How does product differentiation affect a firm s ability to determine its own price? Explain. Does the Law of One Price hold in a market with product differentiation? Why or why not? 2. Explain how a firm determines its optimal level of advertising/sales ratio. 3. Describe the two major types of advertising. 4. List the characteristics of monopolistic competition. How is it similar to perfect competition? Different? 5. Illustrate graphically a monopolistically competitive firm in long-run equilibrium. What are the firm s profits? Does this result imply that long-run equilibrium in monopolistic competition is identical to long-run equilibrium in perfect competition? Explain. 6. Describe the characteristics of an oligopolistic market. 7. Describe the Cournot, Stackelberg, and Bertrand models. How are they similar? Different? Graphically illustrate a Bertrand and a Cournot equilibrium. 8. Suppose a market consists of two competitors, each of whom has two strategies: a leader or a follower. Firm 2 Leader (Firm1, Figrm 2) (! 10,! 10) Leader Fellower Firm 1 (9, 6) Fellower Firm 2 Leader (6, 9) Fellower (7, 7) Based on the above figure, illustrate the reduced game tree for this problem. What is the Nash equilibrium? 9. Suppose there are two firms in a market. How does the Cournot equilibrium compare with the Stackelberg model for each firm in terms of its output, price, and profit? 10. Compare the outcomes in a Bertrand model for perfect oligopolies and imperfect oligopolies. Explain why these differences occur. Are these outcomes efficient? Why or why not?

10 Problems 1. Suppose a firm is facing an inverse demand function that depends on the price of the product, p, and the level of a firm s advertising, A, with p = 52 4Q + A 1/2. The firm s short-run total cost function is STC = ¼Q 2 + 4Q + A + 5. What are the firm s profit-maximizing levels of advertising, price, output and profit? 2. Suppose a market is served by a duopoly. The inverse demand function is p = 32 5(q 1 + q 2 ). Each firm has the short-run total cost function STC j = 2q j + 5, for j = 1, 2. a. Find the Cournot equilibrium level of output and profit for each firm and market price. b. Suppose now firm 1 becomes a Stackelberg leader, while firm 2 remains a Cournot follower. What will be the equilibrium level of output and profit for each firm and market price? 3. Refer to Problem 2. Suppose the two firms now collude to produce a joint output. a. How much output will be produced and what is market price? b. What happens to the industry profit? c. Is this result stable? Why or why not? 4. Suppose a market consists of two firms that produce similar, but not identical, products. The demand and cost functions are For each firm, determine the Bertrand equilibrium prices and output levels, along with profits.

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