ANNOUNCEMENTS

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ANNOUNCEMENTS
Review class Monday, December 13
415-515, LC6 Final Exam Friday,
December 17 1030-1230,
LC1 80 multiple choice
choice questions
Chapts. 1-11 13 -- 25 questions
Chapts. 14-17 -- 55 questions
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DUOPOLY
Given the only the two output choices of the
duopolists, when they both believe their
competitor will produce 2.5 units they both will
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
have an incentive to increase their output to 3.5
and raise their profit to 10.5. However, when
they both increase output to 3.5, they both see
their profits
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DUOPOLY
fall to 7. When they both believe that
their competitor will produce 3.5 units, they
each have an incentive to decrease their output
to 2.5 to
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
increase their profit to 7.5. Therefore, neither
both producing 2.5 nor both producing 3.5 is an
equilibrium, since they both have an incentive to
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DUOPOLY
change their output level. In many
situations, there are combinations of choices
that agents can make, that they will have no
incentive to change.
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
When economic agents have each chosen their
best strategy, given the strategies of the other
agents, a Nash equilibrium exists.
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DUOPOLY
change their output level. In many
situations, there are combinations of choices
that agents can make, that they will have no
incentive to change.
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
When economic agents have each chosen their
best strategy, given the strategies of the other
agents, a Nash equilibrium exists. For example,
when A
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DUOPOLY
believes that B will produce 2.5, As
best strategy is to produce 3.5 and when B
believes that A will produce 3.5, Bs best
strategy is to produce
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
2.5. Therefore when A produces 3.5 and B
produces 2.5, neither will have an incentive to
change. This is a Nash equilibrium. Similarly,
A
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DUOPOLY
producing 2.5 and B producing 3.5 is a
Nash equilibrium. Therefore there can be more
than one Nash equilibrium. For these duopolists,
the
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
Nash equilibrium that maximizes their combined
or joint profits is when both produce 3 units of
output.
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DUOPOLY
QB QA Q P TRA TCA
PROFIT 3 0 3 7 0
0 0 3 1 4
6 6 1 5 3
2 5 5 10 2
8 3 3 6 4 12
3 9 3 4 7 3
12 4 8 3 5
8 2 10 5 5 3
6 9 1 6 6
0 3 7 10 0 0
7 -7
When B produces 3, A will maximize profits
by producing 3. Similarly, when A produces 3,
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DUOPOLY
B will maximize profits by producing 3. Then
each producing 3 units of output is a Nash
QA QB Q P TRB TCB
PROFIT 3 0 3 7 0
0 0 3 1 4
6 6 1 5 3
2 5 5 10 2
8 3 3 6 4 12
3 9 3 4 7 3
12 4 8 3 5
8 2 10 5 5 3
6 9 1 6 6
0 3 7 10 0 0
7 -7
equilibrium where each have profits of 9.
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DUOPOLY
The Nash equilibrium with each duopolist
producing 3 units of output and having profits
of 9 gives industry output of 6, market price of
4, industry profit of 18, and a deadweight loss
of (1/2)x(4-1)x(9-6) 4.5.
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DUOPOLY

Industry Market Industry Deadweight
output
price profit loss Monopoly
5 5
20 8 Duopoly (Nash equil 3,3)
6 4 18
4.5 Perfect Competition 9
1 0 0
The oligopoly result is between monopoly
and perfect competition. The greater the number
of firms, the closer the result is to perfect
competition.
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INDUSTRIAL ORGANIZATION
Examining three possible ways to organize
markets, perfect competition, oligopoly, and
monopoly, perfect competition is the only market
structure that efficiently allocates resources
(when there are no externalities or natural
monopolies). There is another market structure
which needs examination.
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MONOPOLISTIC COMPETITION
Monopolistic competition is a market structure
that is characterized by many sellers, product
differentiation and free entry and exit. It is
like perfect competition since there are many
firms with free entry and exit and it is like
monopoly since each firm is the only producer and
seller of its product. However, unlike monopoly,
each firms product is similar to the product of
its competitors products. Examples are tooth
paste, shampoo,
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MONOPOLISTIC COMPETITION

breakfast cereal, and soft drinks. Since each
firm has a monopoly selling its own product, it
faces a downward sloping demand curve whose
elasticity depends on the number and closeness of
good substitutes. The firm chooses an output Q
where MRMC, and prices according to demand.

MC
P
ATC
D
AVC
MR

Q
Q
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MONOPOLISTIC COMPETITION

It earns a profit equal to (P-ATC)xQ. Since it
produces where PgtMC, it produces less than the
socially efficient output and, therefore, has a
deadweight loss.

DEADWEIGHT LOSS
ECONOMIC PROFIT
MC
P
ATC
D
AVC
MR

Q
Q
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MONOPOLISTIC COMPETITION
When economic profits are being earned, this
will be a signal for new firms to enter
this industry. The new firms will decrease
demand for existing firms, which will be forced
to lower price and output. New firms will enter
until economic profits are zero. This is the
long-


ZERO ECONOMIC PROFITS
MC
ATC
P
D
AVC
D

MR
Q
Q
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MONOPOLISTIC COMPETITION
run equilibrium. When economic profits are
zero, the demand curve and the ATC curve are
tangent at the profit maximizing price and
output combination (where MRMC). Even though
there are zero economic profits, there is still
a deadweight loss.

DEADWEIGHT LOSS

Tangency of demand and ATC curves
MC
ATC
P
AVC
D

MR
Q
Q
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MONOPOLISTIC COMPETITION

Firms in monopolistically competitive industries
attempt to protect themselves from competition,
by advertising their product to maintain consumer
loyalty. However, advertising raises costs.
Since the level of advertising is

MC
ATC
P
ATC
AVC
D
MR


Q
Q
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MONOPOLISTIC COMPETITION

not determined by the level of output, it is a
fixed cost, increasing ATC without affecting MC
or AVC. When advertising expenditures push ATC
up to a tangency of demand, economic profits
are zero and new firms will not enter.

Tangency of demand and ATC curves
MC
ATC
P
ATC
AVC
D
MR


Q
Q
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MONOPOLISTIC COMPETITION

not determined by the level of output, it is a
fixed cost, increasing ATC without affecting MC
or AVC. When advertising expenditures push ATC
up to a tangency of demand, economic profits
are zero and new firms will not enter.

DEADWEIGHT LOSS
MC
ATC
P
ATC
AVC
D
MR


Q
Q
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MONOPOLISTIC COMPETITION
In the short run, monopolistic competitors
can earn economic profits. In the long run,
economic profits are driven down to zero by loss
of market share or increased advertising costs.
When all firms in the industry are earning zero
economic profits, the industry is in long-run
equilibrium. However, in long-run equilibrium
the industry is producing less than is socially
optimal, causing a deadweight loss, and not
producing at minimum ATC.
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MONOPOLISTIC COMPETITION
Since regulation is too expensive and difficult
to do properly, monopolistically competitive
markets are generally unregulated except for
advertising claims and the monopolizing effect of
potential mergers.
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MONOPOLISTIC COMPETITION
Monopolistically competitive firms usually
allocate vast amounts of resources to advertising
and product differentiation. While consumers
gain by being given some choice among products
and from advertising that gives information
about the product, excessive differentiation may
be wasteful, as is advertising designed to
psychologically manipulate consumer tastes and
preferences. However, the fact that a firm is
willing to spend on
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MONOPOLISTIC COMPETITION
advertising may be a signal that the firm
believes that it has a high quality
product. Brand names are important for
monopolistic competitors, since this is how
consumers can identify the product. Large
amounts of resources may be wasted on advertising
designed to protect and create brand loyalty.
However, brand name products are generally of
known and uniform
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MONOPOLISTIC COMPETITION
quality, and as such brand names provide
information to the consumer. Firms that have an
investment in establishing a brand name have an
incentive to maintain the quality of its
product. In summary, monopolistic competition
misallocates resources by producing a less than
socially optimal output level in plants that are
too large, and potentially wastes resources on
psychological
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MONOPOLISTIC COMPETITION
advertising designed to attract customers and
strengthen brand name recognition. While total
losses from monopolistic competition may be
large in absolute amount, they are relatively
small compared to the value of the total output
of the U.S.
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INDUSTRIAL ORGANIZATION
In the absence of externalities and natural
monopolies, organizing markets as perfect
competition will efficiently allocate
resources. Monopoly, oligopoly and monopolistic
competition all misallocate resources and may
require government intervention to improve the
allocation of resources through regulation or
enforcement of the antitrust laws.