Chapter 8: Managing in Competitive, Monopolistic, and Monopolistically

Competitive Markets
In this chapter we characterize the optimal price, output and advertising decisions of
managers under three market structures: (1 perfect competition! (" monopoly! and (#
monopolistic competition$
%&'(&C) C*M%&)I)I*+
)he key five assumptions for perfect competition are:
1$ )here are many small ,uyers and sellers in the market$
"$ (irms- products are homogeneous (identical or perfect su,stitues$
#$ .uyers and sellers have perfect information of output, price and /uality$
0$ )here are no transaction costs (traveling costs from one store to another$
1$ In the long run there is free entry and exit in and from the market$
)he first four assumptions imply that single sellers are too small to have a percepti,le
influence on the price$ &ach seller is a price taker and the price or inverse demand
equation for the firm is a constant$ )he second assumption implies that the products are
perfect substitutes ,ecause they are identical$
2ince in the 0
th
assumption there are no transaction costs (e$g$: cost of traveling to a
store, then if one firm charges a higher price consumers would not shop at that firm$
3ssumption (1 implies if the industry e4periences a positive profit, new firms will enter
the market and the market price drops and the economic profit shrink until it ,ecomes
zero (profit pays the opportunity costs for the owner$ 2imilarly, if there are sustaining
losses in the market firms are free to leave and price would move up, losses shrink and
the firms earn zero profit$ )his implies that in the long run the perfectively competitive
firm earns zero or normal economic profit$
3n e4ample of perfect competition that fits the five assumptions a,ove is agriculture
(e$g$: corn, wheat, pork, ,eef, etc$$ 3nother e4ample is the catfish farm industry in the
52$ )here are ",666 small catfish farmers in the 52$ 3nother e4ample is the T-shirt
retailers in the 52$
7emand at the Market and (irm 8evels
)he (output and demand for the firm and the industry are represented ,y (9, 7
f
and
(9m, 7, respectively, as shown ,elow:
1
Market (industry) demand for corn shows how much corn all consumers will ,uy at each
possi,le price in the market$ Market demand (for corn is downward sloping ,ecause
consumers as a group ,uy more (corn at each lower price$
)he individual firm sells additional corn at the same price (i$e$, it is a price taker and the
price is constant or the firm-s demand curve is a horizontal line$
2hort run output decisions: (*ne decision
)o ma4imize profit in the short run, the manager must take fixed costs as given and use
the market price and varia,le cost to determine the optimal output level$ (9:$ %erfect
competition is the easiest market structure for mangers to make decisions$ )hey only
have to determine the optimal output level !, given the market;determined price$
Ma4imizing %rofit in the "hort-#un
)his leads to determining the profit;ma4imizing output 9:$ )he plant size (< is
fi4ed and there is a fi4ed cost ,ecause this is the short run$
8et # ,e total revenue which is defined ,y %:9 where % is constant$ )hen profit is
%rofit $ # % T& (where T& $ '& ( )& or
= > # % T& > total profit
)he marginal profit per additional unit of output is:
*+ , * $ (*#,*) % (*T&,*) $ M# % M&
If M# - M& then firm should increase output (?
"
()ypical (I'M (Corn I+752)'@
9 9m
7
2
%
%
Aorizontal line
B0 B0
7f
If M# . M& then firm should decrease output (C
If M# $ M& then there is no change in $ )his output is called equilibrium output (or
the profit;ma4imizing output and will ,e referred to ,y !/ )his rule M# $ M& is
called the first profit-maximizing rule (output choice Q*).
De can e4amine profit ma4imization under perfect competition using two approaches:
the total approach and the marginal approach$
)he total approach
3s noted a,ove, total profit is given ,y
E > total revenues F total cost > %
:
9 F C(9$
)ig 0-1 #evenue2 &osts2 and 3rofits for a 3erfectly &ompetitive )irm
In Fig. 8-2, total revenue under perfect competition is a straight line originating from the
#
origin ,ecause the price is constant (#$ 3
-
!$ )he cost function is generally a cubic
e/uation$ In this figure, the profit or loss at any output level is the vertical difference
,etween sales revenues(# and the cost function (&($ )he maximum vertical difference
or ma4imum profit is located where the slope of the cost function e/uals to the slope of
the total revenue or M# $ M& (or slope of T# > 2lope of C(9$
)his profit ma4imization rule (output choice determines the firm-s e/uili,rium level
!
that ma4imizes profit$ )his is the 4
st
profit-maximization rule/
5nder perfect competition2 it can be rewritten as 3 $ M& ,ecause total 'evenue is linear$
)hat is, *# , * $ *(3!), * $ 3!*, * $ 3$
)he Marginal 3pproach
3n alternative approach to the total approach is the marginal approach as depicted ,y
Fig. 8-3$ )his approach applies the same 1
st
profit ma4imization rule ,ut also uses the
average and marginal costs instead of the total cost ,ecause in the short run part of the
cost is fi4ed and that does not influence optimal decisions$ 5nder this approach we will
look at three cases of profit ma4imization$
Case 1 )irm earning a positive profit in ",#/
(irst draw the two average cost curves and the MC curve going through the minimums of
the averages$ )hen determine output 9: where M' > MC o
)ig/ 0-67 3rofit Maximization under 3erfect &ompetition
!"# $rofit %aximization #ule:
0
MC
%
e
> 3'
3)C
3GC
d;Curve
3)
:
C
%
e
%
/
9: 6
3
.
MC > M' ,ut as mentioned ,efore ,ecause M' > % then this rule can ,e rewritten as
%C & $
%
e
3
= > rectangle >
3)C: .
)his rectangle gives the ma4imum (total profit$ It is given ,y its ,ase (9: times the
height H3
e
%8T&!I which is the profit per unit, where 8T&! $ T& , ! or C (9: J 9:/
)hat is, this profit area e/uals to
!93
e
- :(& (!) , !KI > 3
e
:! ; &(!)$ total revenue % total cost
+ote again that H3
e
% 8T&I is the profit per unit of output$
T# > %
e
3
6 9:
)C > 3)C: .
6 9:
Example 17 3 watch;making firm$ 2uppose:
T& $ 4;; (
1
< M& $ *T& , * $; ( 1
1-4
$ ; ( 1 > 1 (M& is a straight line
starting from the origin)/ )& $ =4;; and '& $
1
and 8'& $
1
, $ (8'& is also a
straight line but with a lower slope than M&$ +ote 8T& $ 4;;, (
1
, $ 4;;, (
3
e
> BL6 (the firm is a price-taker working under perfect competition
(irst profit;ma4imization rule: 3 $ M&
BL6 > "9: o
Q* & '()"2 & 3) units$
%rofit > # - T& > 3!! - T&> (BL6:(3) F M166 N (3)
"
K > B866$
%rofit > '8)). In this e4ample, M& and 8'& are linear (see graph ,elow
3" $ 3rofit ( )& $ =0;; ( =4;; $ =>;;/ (+*)&7 3" $ T#-'&$ T# - (T&-)&)
*r 3" $ T#-T& ( )& $ 3rofit ( )&2 which is 3" $ T# - '&/
1
%rice
Costs
%rofit
)'
)C
*xample 2 '& $ 6 (
1
((C is unknown and is not needed for determining 9: ,ut
we cannot determine profit
M& $ *'& , * $ 4!6
4-4
(1
1-4
$ 6 ( 1
3
e
> BO (constant for perfect competition
"et 3
e
$ M&
=> $ 6 ( 1! or ? $ 1!
Q* = 6/2 = 3 units Then PS = TR VC = $9*3 (3*3+ (3)
2
) = $27 $1! = $9
+emonstration 8-1 (ma4imizing profits
!uppose the total cost function of a firm operating un,er perfect competition is
gi-en ./
C(Q) = " + Q
2
0n, the mar1et price is '2) per unit. 2hat price shoul, the manager charge3
2hat4s the le-el of output that maximizes profit (Q*)3 5o6 much is the profit3
(5int #C & ) 7 2Q
2-1
& 2Q)
0ns6er 8he firm4s price is the mar1et price ('2)) .ecause the firm is a price-ta1er.
!et P = #C (1
st
profit maximization rule) an, sol-e for Q
'2) & 2Q* Q* & 1) units.
8he maximum profit is
= > %:9: ; )C > ("6 (16 F (1N16
"
> "66 F 1 F 166 > BO1
Case 2 )irm @arning a Aoss in ",#/ should it shut downB

L
MC >"9
3GC > 9
/
9:
%
e
> L6
%rofit
MC 3)C
3)C > (1))"Q N 9
3)C:
3t point 3, set $ & %C 9 Q*
= > rectangle
3)C: . %
e
3
P
6 9: 6 9:
8oss > 3)C: .
%
e
3
In case ", the firm produces at a loss in the short run$ 2hould this firm shut downQ Aere,
8oss R (C$ )he firm covers part of the fi4ed cost ((C > 9::3(C$
2ince, 3)C: . 3)C: .
P
3GC: C %
e
3
If it produces, it will cover part of the fi4ed cost (how much is coveredQ, if it shuts down
it will incur all of the (C$ 2ince 8oss R )& then there is no shut down$
+emonstration 8-2 (minimizing losses 6ith linear %C an, 0:C e;uations)
!uppose the cost function of a perfectl/ competiti-e firm is gi-en ./
S
3GC
/
9:
3)C:
%
e
3GC:
8oss
6
.
C
3
Min3GC
,-cur-e
'
loss
)C
(C loss
C(Q) = 1$$ + Q
2
6here %C & '1))< :C & Q
2
an, the mar1et price is '1).
2hat le-el of output Q* shoul, the firm pro,uce to maximize profits or minimize
losses3 2hat4s the le-el of profit or loss3 !houl, the firm pro,uce or shut ,o6n3
0ns6er *;uili.rium con,ition
P = #C
1) & 2Q* Q* & = units.
$rofit & P**Q* TC & ('1)) (=) > (1))7=
2
) & -'?= (loss)
8he firm shoul, not shut,o6n .ecause
&'(( ) %C
'?= @ '1))
or 0A8*#B08C:*AD P
e
* +VC = VC / Q* & Q
2
/Q or 1) E (=
2
) " = & =
(6hich is e;ui-alent to Aoss @ F8). 8he firm shoul, not shut,o6n.
Ca(e 3, &'((e( -./h Sh0/ 1'-n R0le
Cf 3 . min 8'& or loss - )& < ! $ ; the firm should shut down/
The firm should shut down because the loss is greater than )& (that is2 Aoss - )&)/
Aow to show that those two shutdown conditions are e/uivalentQ
8et 3 . min 8'&/ Multiply ,oth sides ,y 7
!3 . !8'&$ 2u,stitute in revenue and '&:
# . '&$
2u,stitute for '& as the difference between T& and )&:
# R T& % )&/ #earrange7
)& R T& - #
)& R Aoss or
8oss P (C (shut down, which is e/uivalent to 3 . min 8'&/
)he 2hort;'un and Industry 2upply Curves
8
)he supply curve for a firm descri,es how much output a firm will produce at each price
level during a given period of time$ )his can ,e derived from the two profit ma4 rules$
AowQ 2ee ,elow$
(or a perfectly competitive firm the price 3! is determined in the market ,y intersection
of market supply and demand$ )he firm-s e/uili,rium output ! in the short run is
determined ,y the two rules:
1$ )he profit;ma4imization rule!
3 $ M&
"$ )he shutdown rule if there is a loss!
whether 3 T min 8'& or loss R (C (no shutdown and ! is positive
If %6 > min 3GC then 9: can ,e positive or zero$
If % R min 3GC then 9: > 6 or shutdown$ (8oss P (C$
If %1 P min 3GC then! 91: P 6 no shutdown$ (8oss R (C$
If %" P min 3GC then! 9": P 6$ (positive profit$
O
2 %
9
/
3GC
MC > 2J' 2upply curve
3)C
9
/
6 96 91 9"
%"
%1
%6
Min 3GC
Competiti-e Firm4s
!"# !uppl/ Cur-e
%.2, !67 "hort run supply curve for a perfectly competitive firm
)he firm-s supply curve in the short run is the cross-hatched portions of the vertical axis
below 3; and the marginal cost curve above min 8'&/ )his is the supply graph in the
previous graph for the perfectly competitive firm-s supply in the short;run$ It is a cost
curve$
The market (or industry) supply is closely related to the supply curve of the
individual firms in a perfectly competitive industry$ )he market supply is the horizontal
sum of the marginal costs (above min 8'& of all firms and it determines how much total
output will ,e produced at each price$
16
%.2 !77 The Market "upply &urve
(ig 8;S illustrates the relation ,etween a typical individual firm-s supply curve (MC
i

and the market supply curve (2 for an industry that has, say =)) firms$ 2uppose when
the price is B1" each firm produces, say, 1 unit of output$ 3t B1" the industry total
/uantity is 166 units$ Dhat would ,e the industry output if the price is B1" and each firm
produces " unitsQ 2uppose when % >B11, each firm produces " units$ )he market supply
is much flatter than the individual firm-s supply, depending on the num,er of firms in the
industry$
8ong;'un 7ecision Hnormal or zero economic profit
In the long;run there is a free entry into the competitive market if there is a positive
profit$ )here is also an exit if losses e4ist$ In the case of free entry, the market supply (2
6

shifts to the right to (2
1
if there are more firms entering$ It shifts to the left to (2
"
if
11
)ig 0-0 @ntry and @xit7 The Market and )irmDs Eemand
firms e4it$ 3t the firm level, the horizontal demand curve will also shift$ In the case of
positive profits, the firm-s demand curve (7
f
shifts from %
6
to %
1
$ )his decline in the
price will shrink economic profit to zero in the case of entry$ In the case of exiting the
market as a result of negative profit, the increases in the price reduce losses to zero$
)hus, under either way economic profit under perfect competition in the long run is zero
(normal economic profit$ )hat is,
(3
e
%8&)
!
! > %rofit per unit
:
9: ; 6 (which is e/uivalent to )otal
'evenue > )otal Cost$
(or economic profit to ,e zero, 3 $ 8& (or # $ T& as well as 3
e
$ M&$
(or those two conditions to ,e satisfied the demand line or price line which is
horizontal must ,e tangent to the min 3C curve$ )hus the long-run competitive
equilibrium is characterized ,y the following conditions:
1$ %
e
> MC
"$ %
e
> min 3C ( or zero econ profit
2ee (ig 8;O$
1"
%.2, !97 Aong-#un &ompetitive @quilibrium
%onopol/
3 monopolist is a sole producer who sells a product that does not have a close su,stitute$
Dhen one thinks of a monopoly, it is important to specify the relevant market$ Is the
market local, regional or nationalQ 3 utility company is a local monopoly in a city$
%eople in this city must ,uy their electricity from this company or move to another city$
Monopoly does not mean a large firm$ 3 gas station in an isolated small town is a UsmallV
monopoly$ .ecause the monopolist is the sole seller, it has a monopoly power over the
price$ It can restrict output to increase the price over M&$ Moreover, the demand curve
for the monopolist-s product is the market demand$ )hat means E
f
$ E
m
(firm-s demand >
market demand and thus the demand curve has a negative slope (see Fig 8-11$ If the
monopolist sets the price too high, consumers do not have to ,uy the product$
1#
)ig 0-447 The MonopolistDs Eemand
!ources of %onopol/ $o6er
)here are sources of monopoly power that constitute a ,arrier to entry in the market$
)hese sources include economies of scale and scope, cost complementarities, patents and
other legal ,arriers$
*conomies of !cale
)his means average cost decreases when output increases$ (or many companies there is a
certain range of output like H6 ; 9:I in Fig 8-13 where economies of scale e4ist$ 3ny
output a,ove 9: generates diseconomies of scale$ If one firm e4ists in this market and
produces say
m
to meet the demand, the 8T& is 8T&
m
$ In this case the sole firm is
making a profit ,ecause % P 3)C
m
$ If another firm enters and ,oth firms share the output
(9
m
J " for each then 3)C for each one at 9
m
J " is H3)C(9
m
J "I which is higher then
the price$ .oth firms will earn a loss$ )his will deter the second firm from entering the
market$
10
)ig 0-41 @conomies of "cale and Minimum 3rices/
)he num,er of firms that are a,le to fully e4ploit economies of scale depends on the size
of the total market demand and the technology of the product$ 3 study found for a plant to
fully e4ploit economies of scale, it should produce at its minimum 3)C$ )his study
e4amined this issue for twelv e industries in six countries$ It was found that this num,er of
firms varies from industry to another and from one country to another$ (or e4ample, there
are many plants that can fully e4ploit the economies of scale in the shoe industry2 giving
rise to a more competitive market in this industry$ In the refrigerator industry the num,er
is very small, implying an oligopolistic market structure$
11
*conomies of !cope
If economies of scope e4ist, then it is easier and cheaper to produce two outputs 91 and
9" Wointly in one firm than to produce them in two separate firms$ &fficient production
re/uires that the two outputs ,e produced in one firm$ In this case the e4istence of
economies of scope encourages ,uilding larger companies instead of small ones$ )his in
turn gives greater access to capital markets, otherwise large capital can ,e a ,arrier$
Cost Complementarit/
Dhen the marginal cost of producing one product decreases when production of another
product is increased, then this encourages the esta,lishment of multi-product firms$ 2uch
firms have large capital re/uirements which, discourages other firms from entering the
market$ )his cost complementarily can ,e a ,arrier to entry$
$atent an, other Aegal Farriers
)he a,ove sources of monopoly power are technological in nature$ )his legal source has
to do with government regulations and policies which, for e4ample, may grant a
monopoly power for only one pu,lic utility in a specific city$ *ther e4amples include
patents, trademarks and copyright protection$ 2ee I+2I7& .52I+&22 8;#$
1L
%aximizing $rofits un,er %onopol/ in Contrast to $erfect Competition
)he manager under monopoly ma4imizes profit ,y choosing ,oth e/uili,rium
price %
e
and e/uili,rium /uantity 9
e
, knowing that it has monopoly power (i$e$, % P MC$
)he monopolist ma4imizes profit ,y setting
M' > MC$
)hen it determines 9
e
and %
e
$
%arginal #e-enue Formula
)he general relation ,etween price and M' is given ,y
M# $ 93x(4(@)F,@,
where @ is the direct price elasticity of demand, XY9 J XY% > (Y9 J Y%:(% J 9,
(and @ must be elastic$ )his relationship shows that M' is less than the price$ (or
e4ample if demand is elastic, M# is positive ,ut less than % (e$g$, & > ;" then M' >
H%M(1;"J;"KI > Z %$ If the elasticity is unitary, (&C > ;1 then M# $ 93x:(4-4),4 GF > 6
and T# is at its ma4imum, which is less than the price since the price is positive$ Dhen
demand is inelastic (say @ > ;1J" and the price is positive then M# > H%4M(1;1J"J;1J"KI
> -3$ )his is less than the positive price$ De can summarize the relationship ,etween the
price and M# in Fig. 8-13 as follows$ Dhen demand is relatively elastic, M' is positive,
and when it is inelastic M' is negative$ Moreover, when demand is unitary elastic, M' is
zero$ )he implication of this relation is that the monopolist will not operate in the output
1S
range where demand is inelastic ,ecause this means the contri,ution to the total revenue
is negative or M' R 6$ Dhen demand is elastic an increase in output and a decrease in
price are associated with an increase in total revenue$ *n the other hand, when demand is
inelastic, an increase in output and a decrease in price are associated with a decline in
total revenue$ (inally, when demand is unitary total revenue is at its ma4imum and M' >
6 ()' ma4imization$ Dhen demand is zero ( % > 6, total revenue # is zero$ 2ince the
price changes when /uantity changes, then total revenue (> 3! is not linear ,ut is
concave/
18
)ig 0-46 @lasticity of Eemand and Total #evenues
Formula +eri-ing %# from Ainear Cn-erse +eman, *;uations
2ince demand has a negative slope under monopoly, that is, changes in /uantity affect the
price, and then the price is a function of /uantity$
% > % (9$
)his is called an inverse demand function where the price is a function of output and is
not a constant like under perfect competition$ )he most common form of this inverse
demand function is the linear inverse demand$
P = a 3Q,
where (a is the constant and (;, is the (inverse slope > Y% J Y9$ It can ,e shown that
M' for the inverse linear demand can ,e written as %# & a > 2.Q$ )hat is,
2lope of M' > " : slope of (inverse demand$
[raphically, this result implies that M# curve divides the interval on the horizontal a4is
,etween zero and where the demand curve hits this a4is into half$
+emonstration 8>G +etermining t/pe of price elasticit/ from %#.
2uppose the inverse demand function is given ,y P = 1$ 2Q$
Hhat is the M# equationB
#R = 1$ 2 * 2Q = 1$ 4Q
Hhat is the maximum price a monopolist can sell if output $ 6 unitsQ
3 $ 4; % 1!(6) $ =I/
Hhat is M# associated with 6 units of outputQ
M# $ 4; % I!(6) $ -1$
)he third unit reduced total revenue ,y B"$
Cs demand elastic or inelastic at $ 6B 2ince M' is negative, then demand is ;;;;;;;$
8he Hutput +ecision
.oth the price and total cost are functions of output under monopoly$ )hen profit can ,e
written as:
J $ #() % &()/
where #() is total revenue and &( is total cost$
1O
)he monopoly profit;ma4imization rule is M# (
m
) $ M& (
m
), which can ,e solved for
monopoly profit;ma4imizing output 9
m
$ *utput 9
m
can then ,e inserted in the inverse
price e/uation, giving rise to the monopoly price rule: 3
m
$ 3(
m
)/
+emonstration 8-= profit maximization un,er monopol/
2uppose T& $ K; (
1
\ M& $ 1 is a straight line$
2uppose P & 4$ Q (price is a function and not a constant \ #R = I; 2 (twice
the slope of 3)/
# $ 3 $ (I; )! $ I; %
1
(that is, multiply 3 ,y
1. (or e/uili,rium< set %# & %C
06 F "9
m
> "9
m
Q
#
> 06J0 > 1) units \
%lug Q
m
into

$
m
> 06 F 1) > '3)$
Calculate profitQ
%rofit > %
m
: 9
m
F )C > B#6:16 F H16 N (16
"
I > B#66 ; B116 > '1=)
)he [eneral Case for %rofit Ma4imization: )he Marginal 3pproach
Aere we skip the total approach for profit ma4imization to concentrate on the marginal
approach$
3s mentioned a,ove, for monopoly one sets
M# $ M&
and solves for 9
m
$
)hen it su,stitutes 9
m
into the inverse demand e/uation to solve for %
m
$
In the graph ,elow, total profit is: *utput: unit profit
%rofit > 9
m
:
(%
m
F 3)C
m

where (%
m
F 3)C
m
> unit profit, or
%rofit > )' F )C > %
m
:9
m

;)C
"6
)ig 0-4K7 3rofit Maximization under Monopoly
0.sence of !uppl/ Cur-e un,er %onopol/
Monopoly does not have a supply curve ,ecause this curve is usually derived from
e/uili,rium points formed ,y e/uating % and MC$ 5nder monopoly, e/uili,rium is
determined from having M' > MC and % P M'$
%onopolistic Competition
@xamples7 fast;food, toothpaste (see handout, soap, shampoo, cold medicine, etc$
&haracteristics7
Monopolistic competition has three key characteristics:
1 &ach firm competes ,y selling differentiated products$ )he differentiated products
are highly su,stituta,le ,ut are not perfect su,stitutes like under perfect
competition (i$e$ the cross price elasticity of demand ,etween the products of the
firms is positive and high ,ut not infinite$ Crest is different from Colgate, 3im,
and Close;up] etc$ )herefore, ,ecause of differentiation there is consumer
loyalty on part of some consumers$ Consumers are willing to pay "1^ to 16^
more (,ut may ,e not a 1B$ )herefore, %roctor _ [am,le has some ,ut limited
"1
monopoly power/ Aowever, some of the customers may move to the su,stitutes$
)herefore, advertising is important under monopolistic competition$
" )he demand curve is downward sloping ,ut is fairly price elastic$ )he demand
elasticity for crest is FS$ )hus, ,ecause of its limited monopoly power, %_[
charges a price that is higher than marginal cost ,ut not much higher$
# )here is free entry and exit$ It-s easier and cheaper to introduce, new ,rands of
toothpaste than to start new models of cars$ )he latter re/uires large capital and
technology to realize economies of scale$ )he free entry and exit implies that
economic profit under monopolistic competition is zero (normal$
*;uili.rium in the short run an, the long run 8ike in monopoly, firms under
monopolistic competition have monopoly power and, thus, they face a downward
sloping demand curve$ )herefore, M' R %$ )he profit ma4imization rule is
M' > MC$
In the short run the firm can earn a positive economic profit as shown in Fig. 8-18.
)ig/ 0-407 3rofit Maximization under Monopolistic &ompetition
If there is a positive profit, there will ,e an entry into this market and prices should
drop$ )his will shift ,oth demand and M# curves of the individual firm down, and
""
%rofit B
7
2'
M' > MC
M' 9:
2'
%:
3)C:
3)C
MC
profit will shrink until it ,ecomes zero ( T#$ T& or 3 > 8T& as shown ,y the
tangency ,etween the new inverse demand 3 and 8T& curve ((ig$ 8;1O$
)ig/ 0-4>7 @ffect of @ntry on Monopolistically &ompetitive )irmDs Eemand
8ike in perfect competition, ,ecause of free entry and e4it firms under monopolistic
competition earn zero economic profit in the 8J'$ )he point where M#>M& should
correspond to the point where the demand curve is tangent to the 8T& curve to realize
zero profit$
8he Aong run
)he positive profit will induce entry ,y other firms who introduce competing ,rands$
)he incum,ent firm will lose some market share and the demand curve will shift
down$ 8T& and M& may also shift when more firms enter the market$ 3ssume no
shift in those cost curves$ )he EA# will shift down until it ,ecomes tangent to the long
"#
run 3C corresponding to where M'>MC$ In this case the profit is zero$ De have two
rules for the long run under monopolistic competition:
1$ M# > M& ()he 4
st
profit-max rule
2. P & +TC P min 8T& zero profit (,ecause # > T&$ 2ee fig$8;"6$ )his
condition is different from the long run condition for perfect competition 3 > min
3)C$
(ig$ 8;"6: 8ong;'un &/uili,rium under Monopolistic Competition
Cmplication of $ro,uct +ifferentiation 0,-ertising
3s mentioned a,ove, monopolistically competitive firms differentiate their products in
order to have some control over the price$ In this case, the products are not perfect
su,stitutes, and this makes the demand less than perfectly elastic$ )he implication of this
is that some consumer won-t switch when the prices go up within a limit, while others are
willing to switch$ )o keep the other consumers from switching to the su,stitutes, firms
under monopolistic competition spend a lot of money on advertising$ )here are two kinds
of advertising under monopolistic competition$
"0
3C8' > %:8'
9:8' M'8'
78'
3C
MC
1 &omparative 8dvertising7 )his involves campaigns designed to differentiate a given
firm-s ,rand from ,rands sold ,y competing firms$ Comparative advertising is common
in the fastFfood industry, where firms such as Mc7onalds attempt to simulate demand for
their ham,urgers ,y differentiating them from competing ,rands$ )his may induce
consumers to pay a premium for a particular ,rand$ )his additional value for a ,rand in
the price is called brand equity$
" Liche Marketing7 (irms under monopolistic competition fre/uently introduce new
products$ )he products could ,e totally UnewV or Unew improvedV$ (irms can also
advertise a product that fills special needs in the market$ )his advertising strategy targets
a special group of consumers$ (or e4ample Ugreen marketingV advertise Uenvironmentally
friendlyV products to target the segment of the society that is concerned with the
environment$ )he firm packages a product with materials that are recycla,le$
)hese advertising strategies can ,ring positive profits in the short%run$ In the longFrun
other firms will mimic their strategy and reduce profits to zero$
Hptimal 0,-ertising +ecisions
*ptimal advertising is determined ,y the following formula
(ormula: )he profit ma4imizing advertising;to;sales ratio$
8,# $ 9(@

2
8
) , (@

2
3
)F P 6,
where 8 is e4penditure on advertising and # is sales revenue$ +ote: 8,# is a positive
fraction ,ecause (@2 3 is already negative and multiplied ,y a minus$
@2 8 $ MN , MN8 $ (N , N8)!(8,)
is advertising elasticity of demand, and
@2 3 $ MN , MN3 $ (N , N3)!(3 , ,
is the ownFprice direct elasticity of demand, which is negati-e.
Cf EQ5 P & - I (demand is perfectly price elastic under perfect competition, then
8,# > 6$ )hat is, the optimal advertising-to-sales ratio is zero for the perfectly
competitive firm$
"1
)he more elastic the demand with respect to own price (i$e$, products are less
differentiated and more su,stituta,le, the lower the optimal advertising;to;sales
ratio$ )his is a case of more competition than less, and there is not much need for
advertising$
)he more elastic the demand with respect to advertising, the higher the optimal
advertising; to;sales ratio$
+emonstration 8-8
2uppose Corpus Industries operates under monopolistic competition and produces a
product at a constant MC$ 2uppose the demand for its product is estimated with a log
linear e/uation and the elasticities are:
&9, % > ; 1 (price elasticity of demand
&9, 3 > N 6$" (advertising elasticity of demand
)o ma4imize revenue what portions of revenue should this firm spend on advertisingQ
3nswer:
8,# $ @2 8 , @2 3 > HN6$" J ; (;1$6I > (N6$" J N1$6 > 6$" > N"6X of total sales$
"L
Chapter O: .asic *ligopoly Models
)his chapter discusses managers- decisions under five different oligopolistic
market structures: 2weezy, Cournot, 2tackel,erg, .ertrand and Collusion$ Comparison of
the outcomes in these different oligopolistic situations reveals the following$ )he highest
mar1et output is produced under .ertrand oligopoly, followed ,y 2tackel,erg, then
Cournot, and finally collusion$ $rofits are highest for the 2tackel,erg leader and the
colluding firms, followed ,y Cournot, then the 2tackel,erg follower$ .ertrand
oligopolists earn the lowest level of profits$
CHB+C8CHB! FH# HACJH$HAD
&4amples of *ligopoly: 2teel industry, airline industry and auto industry$
3n *ligopoly is a market structure where there are few large firms in an industry$ +o
e4plicit num,er is re/uired$ Aowever, the num,er is usually ,etween two and ten firms$
If there are two firms, then the market structure is called duopoly$ )he product under
oligopoly can ,e homogeneous (steel or differentiated (airlines travel$ )he manager has
a more difficult Wo, in making decisions under oligopoly than under other market
structures$ 5nder oligopoly there is firm rivalry and interdependence in decision making$
3 manager, ,efore it lowers the price of its product, it should consider the impact of the
lower price on the other firms in the industry$
85* #HA* HF F*AC*F! 0B+ !8#08*JCC CB8*#0C8CHB!
)he optimal decision whether to increase or decrease the price depends on how
the manager believes other managers in the industry will respond$ If other managers
lower the price in reaction to this firm-s lowering the price, this firm will not increase its
sales much$ In (igure O$1, the reference point is . where the price is %o$ )he demand
curve +1 is the demand when other firms match any price change$ If the manager of a
certain firm lowers hisJher price, and the other firms in the market match this price
decrease, then the /uantity will not increase much as given ,y 71$ .ut if they don-t match
the price decrease then the manager can sell more as given ,y +2. )hus, the match 71 is
more inelastic than the no;match 7" , or 7" is more elastic than 71$
"S
If the manager increases the price and the other firms match, the firm-s sales will not
decline much$ 2o the matching demand curve will ,e 71 $.ut if they do not match the
price increase, the firm will lose some market share and its demand will ,e the non;
matching 7"$ )he only difficulty for the firm manager to make decisions is determining
whether or not rivals will match price changes$
+emonstration K-2 (8he 1in1 +eman,)
)hus if, for e4ample, other firms match price reductions (71 and do not match price
increases (7" then the oligopoly effective demand is kinked as given ,y 3.71 as in Fig.
K-1. )his assumption gives rise to what is known as the kinked demand curve 3.71$
)ig >-47 8 )irmDs Eemand Eepends on 8ctions of #ivals
)hen the kinked demand is given ,y the two segments defined ,y 3, . and 7
1$
"8
$#HFC8 %0LC%CM08CHB FH# HACJH$HAD !*88CBJ!
De will e4amine profit ma4imization under four alternative assumptions on how rivals
respond to price or output changes$
!6eez/ Hligopol/
3n industry is characterized as 2weezy oligopoly if
1$ )here are few firms serving many customers$
"$ )he firms produce differentiated products$
#$ :&ach firm ,elieves that rivals will respond to p6.7e reductions (effective 71 ,ut
will not respond to price increases (effective 7" (3.71 is kinked demand as in
7emonstration O;"$ )his assumption represents the kinked demand curve$
0$ .arriers to entry e4ist$
In Fig. K-2, the kinked demand curve that fits assumption 3 is given ,y 3.71$ If the price
is ,elow %6 then the demand is the match demand 71, while if the price is a,ove %6, then
the demand is the no;match 7"$ )he corresponding M' to the kinked demand is 3C&($
8he Nin1e, +eman, Cur-e
%
6
%rice
9
6
F
9
+o Match
Match
7
1
7
"
"O
)ig >-17 "weezy Oligopoly
%rofit ma4imization occurs when M# $ M&$ 8et us for simplicity assume that M& is
linear (or straight line$ If marginal cost is M&4 then profit ma4imization occurs at point &
and the price is %6$ If M& is M&; the profit ma4imization occurs at point C and the price
is 3;$ +ote that if M& moves ,etween points & and C (called the M# gap there will ,e no
change in the e/uili,rium price 3;$ )his model is good in explaining that firms avoid
price wars and thus prefer price stability ,y keeping the price at 3; even if M& changes
(however, within a limited range$ )his model is criticized for not e4plaining how the
firm arrived at point . in the first place$ +evertheless, the 2weezy model shows that
strategic interactions among firms in terms of prices and the managers- ,eliefs on how
other firms would react to their price increases and decreases has a profound effect on
pricing decisions$
#6

#1
)he kinked demand is given ,y 3.C and ,eyond as shown a,ove$ )he corresponding
gapped M' curve is depicted ,elow$ If the MC curve passes through the M' gap, modest
shifts, upward or downward, in this curve will not change the industry price or the firms
output$ )he (igure ,elow (the cost cushion shows the shifts in the MC1 curve to the MC"
and MC# curves without a change in output or price (price sta,ility$ 'ecall, the 1
st
profit
ma4imization rule re/uires that
M' > MC /: p:
&4ample: if the Match 71 is given ,y 34 $ 4K % 1/K4 and the no match 7" is given ,y 31 $ 4; %
;/K1, how do you determine the current or reference ; and 3; at point 8 of the PinkQ Can you derive
M'1 and M'"Q Can you calculate the M' gap Q
0ns6er !et +1 & +2 an, sol-e for the current or reference Q) (&2.=) an, $) (&'8.?=). 8hen su.stitute
Q) in the respecti-e marginal re-enues (%#1 & 1= > 2*1/K4 ($=1/KB) and M#1 $ 4; % 1!;/K1 ($=Q/K)
to calculate the M# gap/ #ecall2 the slope of the M# equation is twice the slope of the inverse demand
equation/ To find M& in the gap and profit maximization point2 substitute ; into the M& equation/
Cournot Hligopol/
3n industry is a Cournot oligopoly if
1$ )here are few firms serving many customers$
"$ )he products are either differentiated (e$g$ automo,ile or homogenous (steel$
#$ :&ach firm ,elieves that rivals will hold their '0/p0/( constant if it changes its
own output (na`ve ,elief$ +ote that decision varia,les are outputs and not prices$
0$ .arriers to entry e4ist$
#"
)hus, in contrast to 2weezy oligopoly which uses prices, the firm under Cournot
oligopoly ,elieves that its output decisions have no effect on rivals output/
#eaction Functions in Cournot Hligopol/
)o make matters easier suppose there are two firms$ In this case, the market structure is a
duopoly$ )o determine the optimal output level, firm 1 will e/uate its M#4 to its M&4, and
firm " e/uate M#1to its M&1/ 8he #R1 an, %#2 e;uations are derived from the inverse
market demand e/uation$
3 $ a % b(
4
(
1
)$ a % b
4
-b
1
(note: output is homogenous there is one
%
#R1 is derived ,y multiplying the slope b of Q1 ,y 2$
M#
4
$ a 2*3Q
1
- b
1
(irm 1-s marginal revenue M#4 is affected ,y firm "-s output (1, as well as by its own
4/ )he greater firm "-s output, the lower is the marginal revenue of firm 1$ In this case,
firm 1-s profit;ma4imizing output depends on firm "-s output level 1 and its 4$ 2et M#4
$ M&4 and solve for 4 as a function of 1/ )his relationship ,etween firm 1-s profit;
ma4imization output 4 and firm "-s output 1 is called a reaction function of firm 4$
)he same applies to firm " setting M#1 $ M&1 where
M#
1
$ a % b
4
% 2*3 Q
2
and deriving its reaction function which specifies 1 as a function of 4$
)herefore, a reaction function for firm 1 is its profit;ma4imizing output (4 as a function
of firm "-s output (1$ )hat is,

4
> r
1
(
1
,
where r4 is a Ureaction function ofV$
##
2imilarly, the reaction function of firm " is its profit; ma4imizing output as a function of
firm 1-s output$ )hat is,

1
> r
"
(
4
$
[raphically, the reaction functions for a duopoly are given in (ig O$# where firm
1-s output is measured on the horizontal a4is and firm "-s output on the vertical a4is$

4
> r
1
(
1
, and
1
> r
"
(
4
$
)ig >/67 &ournot #eaction )unctions and 8dRusting to @quilibrium
If firm " produces a zero output, then firm 1 is a monopoly and its profit; ma4imizing or
optimal output is 4
M
$ )he greater firm "-s output in (irm 1- reaction function is, the
lower firm 1-s profit;ma4imizing output$ (or e4ample, if the firm "-s output is !1 then
the profit;ma4imizing output for firm 1 is !4$
2imilarly, if firm 1-s output is zero, then firm " is a monopoly and its profit;
ma4imizing output is 1
M
$ (irm "-s profit ma4imizing;output will go down if firm 1-s
output in firm "-s reaction function increases$ Dhat is the firm "-s profit ma4imizing
output when firm 1-s output is !4Q It is !1/
#0
*;uili.rium in Cournot Hligopol/
[raphically, we will descri,e how the duopoly reaches the equilibrium point (E
,ased on movements along the two reaction functions$ 2uppose firm 1 produces 4
M
/
Inserting this output into firm "-s reaction function (,y assumption #, then this firm-s
profit;ma4imizing output corresponds to point 8 on the r1 reaction function$
*n the other hand, given the positive output for firm " in the reaction function of
firm 1, then firm 1-s profit ma4imizing;output will correspond to point S$ [iven firm 1-s
output corresponding to point S in firm "-s reaction function, then firm "-s profit;
ma4imizing output will correspond to point &$ [iven this output in firm1-s reaction
function, firm 1-s output corresponds to point E$ )hen this will continue until it leads to
point E, where the two reaction functions intersect$
Therefore2 equilibrium in &ournot oligopoly is determined by the intersection of the two
reaction functions which determine !4 and !1/
Formula %arginal #e-enues for Cournot +uopol/
2uppose for a Cournot duopoly with a homogenous product, inverse demand function is
3 $ a % b(
4
(
1
)
(we sum up the two outputs ,ecause the product is assumed to ,e homogeneous$
2ince the slope of M' is twice that of price then
M#
4
$ a % b
1
% 2b
4
(only slope of 4 is doubled)

and
M#
1
$ a % b
4
% 2b
1
(only slope of 4 is doubled)
Marginal products depend on own and the other firm-s outputs$
Formula #eaction Functions for Cournot +uopol/
2uppose the inverse demand function is linear
3 $ a % b(4 ( 1),
and the cost functions with no fi4ed costs are
#1
&4(4) $ c4!4 (the cost function is linear starting from the origin and c4 is M&4
&1(1) $ c1!1 (where c1 is M&1
)o derive the reaction function for firm 1, set M#4 $ M&4 and solve for 4 as a function
of 1$
a % b1 % 1b4 > c4 (divide ,oth sides ,y 1b and solve for 91, we have
a,1b % 4,11 % c4,1b $ 4$(com,ine the two constant terms a,1b and % c4,1b

4
$ r
4
(
1
) $ (a - c
4
) , 1b % 4,1
1
Hplease remem,er this formulaI
2imilarly for the reaction function of firm ", set and solve for 1 as a function of 4$
M#
1
> M&
1
$
a % b
4
% 1b
1
> c
1
(divide ,oth sides ,y 1b and solve for
1

1
$ r
1
(
4
) $ (a - c
1
) , 1b % 4,1
4 Hplease remem,er this formulaI
)o find the Cournot e/uili,rium (4!2 1!) for this duopoly, su,stitute 1 into the
reaction function 4 $ r1(1) and solve for !4/ )hen su,stitute !4 into 1 > r1(4) and
solve for !1$ The &ournot equilibrium is (4!2 1!)/
2&& )A& 2*8G&' )&M%83)& (*' )A& 2*85)I*+ *( 8I+&3' Cournot case on
the we,site$
+emonstration K-G. (#emem.er in this example 72 & ) an, 71 &))
!uppose
8he in-erse ma68e/ ,eman, function is
P = 1$ Q1 Q2 6here a &1) an, 3 &1.
8he firms4 cost functions are
C1(Q1) & ) 6here C1(Q1) is total cost an, #C1 is assume, to .e 71 &)
C2(Q2) & ) 6here 72 & ). !ame as a.o-e
8he long 6a/ for .oth firms
8hen ,eri-e the t6o marginal re-enues
#R
1
& 1$ Q
2
2Q
1
(twice the slope of inverse demand for
4
)
#R
2
& 1$ Q
1
2Q
2
((twice the slope of inverse demand for
1
)
#L
Aong 6a/ for Firm 1
Bext for firm 1< set
#R1 = #C1
1$ Q2 2Q1 & 7
1

1$ Q2 2Q1 &

)
(#C1 or 7
1
is assume, to .e zero in this example. $lease 1eep in min, that 7
1
&

) is a
special case) an, then sol-e for Q1 & 61(Q2) 6hich implies that Q
1
= (1$$)/) $,"Q
2
('emem,er: (irm 1-s reaction function which is Q
1
$ H(a - c
4
) , 1b % 4,1
1
I$
8he Formula 6a/ for Firm 1 use the a.o-e formula an, P = 1$ Q1 Q2 6here
a &1) an, 3 &1. 5ere 7
1
is assume, to .e zero.
4 $ (a - c4),1b % ;/K1 $ (4; - ;),1 % ;/K1 & (1$/2) 1/2Q2 < where a>16, b > 1 and c4 >
6$
Aong 6a/ for Firm 2.
!imilarl/< for firm 2 set #R2 & #C2 (the long 6a/)
1$ Q1 2Q2 = 7
2
1$ Q1 2Q2 = $ -he6e 7
2
= $
an, ,i-i,e .oth si,e ./ 2 an, then sol-e for Q2 & 62(Q1)
Q
2
=(1$$)/2 1/2Q
1
((irm "-s reaction function$
Formula 6a/ for Firm 2 Ose the formula
Q
2
= (a 7
2
)/23 $,"Q
1
& (1)-))"2 -1"2Q
1
where c
1
> 6.
8o fin, the Cournot e;uili.rium point< su.stitute Q2 into Q1
Q
1
& 1)"2 > P*Q
2
& 1)"2 -1"2(1)"2 -1"2Q
1
) & 1)"2 -1)"G 71"GQ
1
Q
1
> ("6 F 16J0 N 1"GQ
1
$ )hen move the last term to the left,
#J0 Q
1
= 1$/4
sol-e for Q
1
* & (1$/4)*(4/3) = 1)"3& 3.33 units.
#S
8o sol-e for Q
2
*< su.stitute Q
1
* into the Q
2
*reaction function
Q
2
= (a 7
2
)/23 $,"Q
1
Q
2
=1$/2 9(3,33)
an, sol-e for Q
2
*.
Q
2
* & 1)"3& 3.33 units.
8he result is &ournot equilibrium (4!2 1!) $ (3,35 3,33)
&alculate the market price where the output is homogenous7
$* & 1) > Q1* > Q2* & 1) -1)"3 -1)"3 & 1) -2)"3 & (3) -2))"3 & '1)"3
Cal70la/e ma68e/ :0an/./; Q* & Q
1
* 7 Q
2
* & 2)"3 units.
!ee the ,etaile, continuation of the example sol-e, a.o-e in the pages .elo6
(/ou ma/ s1ip the secon, part .ecause it is re,un,ant)
#8
#O
06
1$ )o calculate profits for firm 1 define
=1 > %::91: ; c191: > (B16J#: (16J# F 6: (16J# > B166JO
$rofit of firm 2 can .e ,efine, similarl/.
= " > %::9": ; c"9": > B166JO
$rofit in Cournot oligopol/ Csoprofit cur-e.
&ach firm has its own isoprofit curves given ,y the e/uation %:9i F )C > =i where =i is
constant$ &ach level =i of gives an isoprofit curve$ &ach curve includes com,inations of
outputs of ,oth firms$ (or firm 1 the closer the curve to 91
M
the greater the profit$ In Fig
K-G< the points (, 3 and [ for e4ample have the same profit ,ecause profit is constant
along the single isoprofit line =i6 and so on$ )he formula for the isoprofit line for firm 1 is:
(a F,91 F,9":91 > =1 which is a constant$ 2olve for 91 as a function of 9"$ 'epeat it$
01
)ig/ >-I7 Csoprofit &urves for )irm 4
)he Isoprofit curve =" is associated with greater profit than =1 and so on$ (DhyQ
)he chosen point should ,e on the intersection of the isoprofit curves with the
respective reaction function line ,ecause the reaction functions come from profit
ma4imization$ )his is also where the isoprofit curves reach their peaks2 given the outputs
of the other firm$ (or e4ample, for given output of firm ", say 9:", if we move
horizontally away from the peak point C in Fig. K.= we will ,e on lower and lower
isoprofit curves along the way compared to a
C
1 $ (or a given output of firm ", say 9:",
0"
compare isoprofit curves associated with points 3, . and 7 with that associated with
point C which lies on the reaction function of firm 1 in (ig O;1$
)ig >-K Sest #esponse to )irm 1Ds Output
2imilarly, Fig. K-( illustrates the isoprofit curves increase in value as they approach 9
M
"$
0#
)ig/ >-?7 )irmDs 1 #eaction )unction and Csoprofit &urves
+ow we can ,ring (igures O;1 and O;L together in one graph to determine Cournot
e/uili,rium and profits for the two firms$ )he two isoprofit lines T
&
4 and T
&
1 through
point C, where the two reaction functions intersect, represent the maximum profits for
firm1 and firm " as in Fig K-?. )hus, the e/uili,rium in a Cournot duopoly is given ,y
point & which defines (!4 and !1$ 3t this point, the two isoprofit lines also intersect$
00
)ig >-Q &ournot @quilibrium and 3rofits
Changes in %arginal Costs un,er Cournot
In a Cournot oligopoly, the effect of a change in marginal cost is very different than in a
2weezy model$ 2uppose the firms are initially in Cournot e/uili,rium (!4 and !1) at
point & in (ig$ O;8 ,elow$ +ow suppose that (irm "- M& declines$ )hen for this firm "
M#1 > M&1/
)he reaction function of firm " is
1 $ (a - c1),1b % 4,14
)his means that this function will shift up and intersect firm 1-s reaction function at a
higher output for firm " and lower output for firm 1$ Dhat will happen to profits of ,oth
firmsQ (hint7 compare new profit level to that of monopoly or add the isoprofit curves$
01
)ig/ >-0 @ffect of a decline in )irm 1Ds &ost under &ournot
!tac1el.erg Hligopol/
)he industry under this oligopoly has the following assumptions:
1$ )here are few large firms serving many customers$
"$ )he products can ,e differentiated or homogenous$
#$ :In an oligopoly there is a leader (firm 1 and a follower (firm "$
0$ )here are ,arriers to entry$
In this oligopoly, the leader acts first and determines its output, knowing the reaction
of the follower to its output decision$ It has the first mover advantage$ In this case, the
leader ma4imizes profit, given the followerDs reaction function which depends on the
leaders output$ )he follower ma4imizes profit given the leaders output 4 as is the case in
Cournot oligopoly$ )hus, the follower-s reaction function is given ,y 1 $ r1 (4)/
(or example< suppose the inverse market demand e/uation is given ,y the linear
function
3 $ a - b(
4
(
1
) where output is homogenous/
and firm "-s cost function is &4$ c41 and &1 $ c11 where c1 is M&1$
0L
(irm ", the follower, sets M#1 > M&1$ )hat is,
a - b
4
% 1b
1
$ c
1
(move 1b
1
to the left;hand side
1b
1
$ a - b
4
% c
1
(ne4t divide ,oth sides ,y 1b

1
$( a-% c
1
),1b

- 4,1
4
('emem,er: follower-s reaction function$
)his follower firm solves for 1 as a function of 4, which is its Cournot reaction
function:

1
$ r
1
(
4
) $ (a - c
1
),1b %9(4,1)
4
/
+e4t (irm 1, the leader, knows this reaction function and plugs it into its profit e/uation
in place of 1 after substituting the inverse demand equation for 3 below:
+4 > $$91 F c191> Qa - .(Q
1
7 Q
2
)R:4 F c14 (su,stitute follower-s reaction
function for Q2 .elo6)
+4 > Ma F ,H9
1
N (a - c
2
)"2. >(1"2)Q
1
IK:4 F c14 (multiply things out)
+4 > a4 % b4
1
- b(a 7
2
)/23)4 + 3(1/2)Q
1
2
% c44
+4 > a4 % b4
1
% (a 7
2
)/2)4 + 3(1/2)Q
1
2
% c44
It then ma4imizes profit with respect to its own output 4 ,y taking the derivative of +4
with respect to 4$
d+4 , d4 $ a % 1b4 % (a 72)/2 ( b4 71 > 6$
Com,ine the constant terms together ,y com,ining a and c1:
d+4 , d4 > (a ( c1),1 % c4 % 1b4 ( b4 > (a ( c1)J" F c4 % b4 > 6$
2olve for 4 ,y dividing ,y b$ )hat is, !4 $ (a ( c1),1b - c4,b
3t the end for this linear case, (irm 1 has the following value for its output 4:
!
4
$ (a ( c
1
- 1c
4
),1b Hremem,er this formula for the leaderI
)he final step is to plug 4
!
into the reaction function for 1 a,ove (see page ##1 of the
te4t and the 2olver template on my De,site or in your C7$
&4ample on !tac1el.erg Hligopol/ (+emonstration K-()
2uppose that the inverse demand function for a homogenous 2tackel,erg *ligopoly is
given ,y:
3 $ K; %4 - 1 where a > 16 and b > 1$
3nd the cost functions are given ,y
0S
&4(4) $ 14 (where M&4 $ c4 > "
&1(1) $ 11 (where M&1 $ c1 > "
1. 7etermine firm "-s reaction function$ )his is a Cournot$
2et M#1 > M&1 which is 16 F 4 - 21 > " and solve for 1 as a function of 4$
*' use the formula for firm "-s reaction function directly:
Q
2
*

= (a 7
2
)/23 1/2Q
1
*:
(follower-s reaction function
)hen
1
$ 9(K; - 1),1F % 4,1
4 > "0 F Z 4
2. Dhat is (irm 1-s output Q1* that ma4imizes profit
Q
1
*
= (a + 7
2
27
1
)/23 (8eader-s reaction function
4
!
> (16 N " ; 0J" > "0 units
3. 7erive the follower-s output 1
!
1
!
$ (a - c
1
),1b % (4,1)
4
:
> (16 F "J" F (1J"9
1
:
> "0 ;1J"("0 > 1" units
G. Calculate the market price
3! > 16 F 4
!
% 1: > 16 ;"0 ;1" > B10$
=. 7&)&'MI+& (I'M 1-2 %'*(I)$
+4 $ T#4 - T&4$ 3!4
!
% c44
!
> B10:"0 F B":"0 > B##L ; B08 > B"88 (leader-s profit
(irm "-s profit can ,e determined the same way$
+1 > %:9": F c"9": > 10:1" ; B":1" > B1L8 F B"0 > B100 (follower-s profit
Fertran, Hligopol/
1$ )here are few large firms selling to too many customers$
"$ )he products can ,e identical or differentiated/
#$ :)he firm sets the price (not the output that ma4imizes profit, given the price of
the rival firm$ ()his is different from the kinked demand curve of 2weezy$
0$ :Consumers have perfect information and there are no transaction costs$
1$ )here are ,arriers to entry$
2uppose first firm 1 charges the monopoly price (initially one firm)$ )he consumers have
perfect information, there are no transaction costs and the products are identical $ (irm "
enters$ If firm 2 slightly undercuts the monopoly price and since consumers know all
08
prices, they would switch to firm "-s output (,ecause of identical product, perfect
information and no transaction costs$ In this case firm " would capture the whole market$
)herefore, firm 1, finding itself with no customers, would retaliate ,y undercutting firm
"-s lower price, thus recapturing the entire market$ )hen there is a price war under
homogeneous product .ertrand with perfect information and no transaction cost$ Dhen
would this Uprice warV endQ
Dhen each firm charges a price e/ual to M&, 34 > 31 > M&$ +o firm would choose to
lower this price ,elow M& ,ecause it would make a loss$ )his is know as the U.ertrand
)rapV$ )his is like perfect competition ,ut the solution variable is the price (not output)
and the profit is zero/
In short, this type of .ertrand oligopoly, would lead to a situation where firms
charge a price e/ual to M& and earn zero economic profit$ )hen the e/uili,rium is found
,y setting
3
4
$ 3
1
$ M&
and then solving for 4! and 1! and 3:$
In any oligopoly with differentiated products including .ertrand, each firm has
monopoly power over its ,rand loyal customers and it can charge a price higher than M&
and earn positive economic profit$ Fig K-1G illustrates .ertrand e/uili,rium with
differentiated products$
0O
)ig >-4I7 #eaction )unctions and @quilibrium in a differentiated Sertand
)hen, in contrast to Cournot oligopoly, the reaction functions of .ertrand oligopoly with
differentiated products are for prices and have positive slopes$ Dhen 31 is theoretically
zero, the minimum price for firm 1 is 34
min
$ )his is a (high price that firm 1 charges to its
brand loyal customers who won-t switch to firm "-s product despite firm 1-s higher price$
3s 31 increases, so does 34$ Sertrand equilibrium in this case is given ,y point 8/
#emin,er Fertran, oligopol/ is ,ifferent from !6eez/ 6hich has match an, no
match ,eman, cur-es.
Collusion
(inally, we will determine the collusive outcome, which results when the firms choose
output to ma4imize total industry profits$ )his model is similar to the monopoly model as
e4plained in Fig. 8-1= in chapter 8$ Dhen firms collude, total industry output is the
monopoly level, ,ased on the industry or market inverse demand curve$ 2ince the inverse
16
market demand curve, which is result of summing up horizontally the outputs of all firms
in the industry at each price, is
3 $ 42;;; % > 1,666 F (
4
(
1
, where $
4
(
1
(sum means homogenous
output$
)he associated industry or market M# is
M# $ 42;;; % 2 > 1,666 F 2(
4
(
1
(double the slopes for both 4 and 1)
+otice that this M# function assumes the firms act as a single profit;ma4imizing firm,
which is what collusion is all a,out$
3ssume total cost for the ith firm is:
T&i $ cii > Ii, where ci > B0 > M&i and i > 1," (assume identical MCs$
2etting industry M# e/ual to M&i (which is e/ual to B0 as shown a,ove yields
Market M# > M&i
42;;; - 1! $ I2 where $
4
(
1
42;;; - I $ 1!
)hen total industry output Q* is:
KK( $ 1!
Q* & KK("2& GK8 units$
)hus, total industry output under collusion is GK8 units, with each firm producing half of
the market share:
Q1
*
= $,"Q* = "0O units
Q2
*
= $,"Q
*
= "0O units$
11
The .n<0(/6;=( p6.7e .(>
P
*
$ 42;;; %
!
> 42;;; % I>0 $ ="$2.
2ince each firm had 16X of total output$
&ach firm earns profits > T#i % T&i > 3
!
!4
!
% c44 > %
:
: 6.1Q
*
F B0:(6.1Q
*

> B16":"0O ; B0:"0O

> '12G<))2.
1"
Chapter 16
[ame )heory: Inside *ligopoly
In this chapter, we will continue the discussion on managerial decisions in presence of
strategic interaction and interdependence$ De will develop tools using game theory that
will assist future managers in making decisions in oligopolistic markets$
!ummar/
)here should ,e a distinction ,etween one;move games and repeated games$ )here also
should ,e a difference ,etween one;move, competing games and one;move, coordination
games$
1$ If each of the two players in a simultaneous;move, one;shot game has a dominant
strategy, those strategies constitute a Lash e/uili,rium$
"$ If player 1 has a dominant strategy, while player " does not, then the optimal
strategy for player 1 is his dominant strategy$ )he ,est strategy for player " should
,e the strategy with highest payoff given player 1-s optimal strategy (,oth in the
same cell$
#$ If the simultaneous;move game is a one;shot game and there is no tomorrow, the
collusion will not ,e sustained as a +ash e/uili,rium$ &ach player will cheat$ In
this case$ +ash e/uili,rium will not have the highest payoffs$
0$ If player 1 has a dominant strategy and player " does not, player "-s secure
strategy should correspond to player 1-s dominant strategy (in the same cell$
1$ 2uppose the simultaneous game is a one;shot game$ 2uppose each of the two
diagonal cells of the two players is identical ,ut, those num,ers in each cell are
not$ 2uppose the two off;diagonal cells have identical cells ,ut their num,ers are
lower than the num,ers in the diagonal cells$ )hen the game has two Lash
e/uili,riums, which are the diagonal cells$ If the game is infinitely repeated then it
1#
is possi,le for collusion to ,e the +ash e/uili,rium (check the condition for
sustaina,le collusion$
*verview of [ames and 2trategic )hinking
In a game, managers are players and the plans of managers are strategies$ )he
payoffs are the profit or losses that result from the strategies$ 7ue to strategic
interdependence among firms, one player-s payoff depends on this player-s strategy and
those of the other players$
In a simultaneous-move game2 each player makes decisions without the
knowledge of other player-s decisions (an e4ample of this game is the .ertrand duopoly
game$ In a sequential move game one player makes a move after o,serving the other
players- move (e$g$: chess, )ic;tac;toe, checkers and 2tackel,erg oligopoly$ If the
underlying game is played once, it-s a one-shot game$ If the underlying game is played
more than once, it-s a repeated game/ (irst, we will study the foundation of game$ De
will ,egin with the study of simultaneous;move, one;shot games$
2imultaneous Move, *ne 2hot [ames
2uch games are important to managers operating in an environment of
interdependence$ 8et us e4amine the general theory which is used in analyzing managers-
decision in these games$ (irst, strategies are decision rules that descri,e players- actions$
2econd, normal;form representation of a game includes the players, the players- possi,le
strategies and the possi,le payoffs$ )o understand these concepts let us look at 8a.le 1)-
1$ )here are two players: 3 and . who are engaged in a situation of strategic interaction$
@ou could think of the two players as managers of two firms competing in a duopoly$
%layer 3 has two possi,le strategies: U5pV and U7ownV! while . has also two possi,le
strategies: U8eftV and U'ightV$
Table 4;-47 8 Lormal )orm Uame7 Eominant "trategies

$
l
a
/
e
r

0
$la/er F
!trateg/ Aeft #ight
5p 16,"6 11,8
Eown ;16,S 16,16
10
&ach cell in the matri4 a,ove represents payoffs for the two players$ (or e4ample,
the cell U5pV for player 3 and U8eftV for player . contains player 3-s payoff e/ual to 16
and player .-s payoff e/ual to "6$ )he game is a simultaneous move, one shot game, the
players make only one decision and they make it at the same time without any conditions$
*ne shot implies that there is no future ,etween the two players
Dhat is the optimal strategy for a player in a simultaneous move, one shot gameQ
De characterize UoptimalV ,y a situation that involves a dominant strategy$ 3 strategy is
dominant if it results in the highest payoff for a player regardless of what the opponent
chooses$ In 8a.le 1)-1, assume player . chooses U8eftV, then find the highest payoff for
player 3 over ,oth hisJher strategy (5%>16$ 2imilarly, fi4 player .-s strategy at U'ightV
and let player 3 choose the highest payoffs over ,oth hisJher strategies (5%>11$ )hen the
dominant (optimal strategy for payoffs is U5%V$ ?@ a pla;e6 ha( a <'m.nan/ (/6a/e2;
he/(he -.ll pla; ./,
$rinciple: If a player has a dominant strategy, heJshe will play it$
In some games a player may not have a dominant strategy (see ,elow$
+emonstration 1)-1.
Cn 8a.le 1)-1 a.o-e< ,oes pla/er A ha-e a ,ominant strateg/3 (Vint7 move row-wise
to look for SDs dominant strategy)/
8he ans6er is Bo. Bote that if pla/er + chooses SO$T< the .est choice for pla/er A
6oul, .e SA*F8T since the pa/off 2) is .etter than the pa/off 8 she 6oul, earn ./
choosing S#CJ58T. Fut if $la/er + chooses S+H2BT the .est choice ./ pla/er A
6oul, .e S#CJ58T< since 1) is .etter than ? she 6oul, realize ./ choosing SA*F8T.
8he .est choice for A ,epen,s on 6hat pla/er + ,oes. 8hus< pla/er A ,oes not ha-e a
,ominant strateg/.
Dhat should a player do in the a,sence of dominant strategyQ *ne possi,ility is to play a
secure strategy: a strategy that guarantees the highest payoff given the worst possi,le
scenario (ma4;min$ )his situation is not an optimal strategy! it Wust ma4imizes the payoff
of the Uworst case scenarioV$
11
+emonstration 1)-2
2hat is the secure strateg/ for pla/er A in 8a.le 1)-13
0ns6er. $la/er F mo-es column 6ise to choose its secure strateg/. Cf pla/er F
chooses SA*F8T< its pa/off are (2)< ?). Cts min or 6orst pa/off is ?. Cf this pla/er
chooses S#CJ58T< its pa/offs are (8< 1)). Cts 6orst pa/off is 8. H-erall< the secure or
max-min strateg/ for pla/er F is S#CJ58T 6ith pa/off 8.
%layer 3 will play its dominant strategy$
!hortcomings of Se706e !trateg/
1$ It is a conservative strategy that should ,e considered only if you have a good
reason to ,e e4tremely risk;averse$
"$ It does not take into consideration the optimal (dominant strategy of the rival!
and thus, it may prevent the player (manager with the secure strategy from
earning a significantly higher payoff$ If player . reasons that in such a game
player 3 will choose the dominant strategy and that player will therefore choose
U5pV, then player . will earn "6 ,y choosing U8eftV instead of U'ightV that ,rings
8$ "o if the rival has a dominant strategy2 the other player should anticipate that
the rival will use it/
+ash &/uili,rium
)his e/uili,rium represents a condition in which each player does the ,est heJshe can,
given the decision of the other player$ In other words, no player can improve hisJher
payoff ,y unilaterally changing his strategy, given the other players- strategies$ +o player
can improve hisJhr payoff without hurting the other player$ In 8a.le 1)-1< given that
player 8 chooses dominant strategy U5%V, the +ash e/uili,rium for player S is to take
this dominant strategy as given and choose strategy U8&()V which gives "6 units of
payoff-s compared to for U'I[A)V$ 2imilarly, if player S chooses U8&()V +ash
e/uili,rium for %layer 8 is U5%V which gives 16 units of payoffs$
3pplication of *ne;2hort [ames (look for dominant strategies first
3n application of simultaneous move, one;shot game is .ertrand duopoly (b&'*
%'*(I)2$ 8a.le 1)-2 has two players with two possi,le strategies: to charge high price
1L
or low price$ )he collusion is ,oth charge high price and cheating is one charges the low
price$ )he two num,er cells are the profits for firm 8 and firm .$ (or e4ample, in the cell
corresponds for low price for firm . and high price for firm 3, the first num,er (;16 is a
loss for firm 3, and the second num,er (16 is the profit of firm .$
Table 4;-17 8 3ricing Uame (Sertrand Euopoly)
F
i
r
m

0
Firm F
$rice Aow Vigh
Aow 6,6 16,;16
Vigh ;16,16 16,16
In a one shot play of the game, the +ash e/uili,rium strategies are for each firm to charge
lo6 price$ DhyQ .ecause if firm S charges high price, firm 8 will make 16 ,y charging
the low price which is ,etter than the 16 it will make ,y charging a high price$ 2imilarly,
if firm . charges the low price, firm 3 will charge the low price and make zero payoff
which is higher than (;16 that firm 3 will make ,y charging the high price$ )his is also a
dominant strategy for firm 3$ )hus firm 3 will always charge lo6 price regardless of firm
.-s decision$ )he same argument goes for firm . which should charge the low price
regardless of what firm 3 will choose$ )his is also the dominant strategy for firm .$ )he
outcome of the game is ,oth firms charge the low price and earn zero profit in a .ertrand
duopoly$
%rofits under +ash e/uili,rium (6, 6 are less than under collusion (16, 16$ If the
firms collude ,oth would charge the Aigh price and make 16 profits for each of them$
)his makes the +ash e/uili,rium inferior to the collusion$ )his result is called a dilemma$
.ut collusion is illegal and if the firms colluded secretly, one firm may cheat ,y charging
the low price and make the other firm-s customers switch to it$ In this case the firm that
did not cheat will suffer from a loss (;16$ )he manager of this firm that did not cheat
either has to reveal to the shareholders that he colluded ,ut did not cheat and
conse/uently suffered a loss$ )his will ,ring him to Wail$ )he second alternative is to
e4plain nothing for making a loss and in this case he will ,e fired$ )hen this manger will
cheat in one shot games$ )he situation can ,e different under repeated games$
1S
+emonstration 1)-G 0,-ertising an, +ominant !trategies
Firms a,-ertise in or,er to entice customers from other competing companies.
!uppose there are t6o firms 0 an, F< an, t6o strategies to a,-ertise or not to
a,-ertise as illustrate, in 8a.le 1)-3.
Table 4;-67 8n 8dvertising Uame
F
i
r
m

0
Firm F
!trateg/ 8dvertis
e
Eo not
8dvertise
8dvertise B0,B0 B"6,B1
Eo not
8dvertise
B1,B"6 B16,B16
8he profit maximizing strategies for .oth firms are to Sa,-ertiseT to cancel each
other a,-ertising out. 8hese to-a,-ertise strategies are ,ominant strategies for .oth
firms. For each pla/er S8H 0+:*#8C!*T .rings more mone/ than the S+H BH8
0+:*#8C!*T< regar,less of 6hat the strateg/ of the other pla/er< .ecause of
cheating. 8hus if .oth Sa,-ertiseT each 6ill ma1e 'G. Bote that if .oth collu,e an,
agree, to S+o not a,-ertiseT each 6ill ma1e more mone/ ('1)). Fut collusion ,oes
not 6or1 in one-shot games. Cf one cheats an, Sa,-ertisesT it 6ill ma1e '2) an, the
one that S,i, not a,-ertiseT 6ill ma1e '1. Cn one-shot game< the game is o-er right
after it is pla/e, an, there is no chance for punishment. !o collusion (1)< 1)) ,oes
not 6or1. 5ere a,-ertising .rings more mone/. 8he a,-ice is to a,-ertise.
Coor,ination James
In the previous games, the firms were competing in the sense, what one firm-s gains are
at the e4pense of the other firm$ In coordination games, firms find it more profita,le to
coordinate their actions and do like wise$ 3n e4ample of coordination games is two
producers of electric appliances$
&ach firm has a choice of producing one of two types of outlets: 1"6 volt, two prong
outlets! and O6 volt, four prong outlets$ If those firms coordinate and produce likewise,
then in this case consumers do not have to spend more money on wiring their houses with
18
different outlets and will have more money to ,uy appliances$ If they do not, then that
will make consumers spend less to ,uy the appliances ,ecause in this case they have to
spend more money in wiring their houses$ 8et us assume that the two firms- profits are
given ,y the matri4 in 8a.le 1)-G$
Table 4;-I7 8 &oordination Uame
F
i
r
m

0
Firm F
!trateg/ 41; volt >; volt
41; volt B166,B166 B6,B6
>; volt B6,B6 B166,B166
[iven firm .-s strategy of producing 1"6 volt or O6 volt outlets, firm 3 would
ma4imize profit ,y choosing to profit ,y matching .-s chosen strategy$ In this case firm
3-s profit would ,e 166 compared to zero profit ,y not coordinating$ 2imilarly, given
firm 3-s strategy of choosing either 1"6 volt or O6 volt, firm . would ma4imize profit ,y
matching 3-s chosen strategy$ In this case, the firms must match each other$ In this
coordinating game, there are two +ash e/uili,riums: an e/uili,rium of B166 profit for
,oth firms choosing 1"6 volt outlet, and another e/uili,rium with B166 profit for ,oth
choosing O6 volt outlets$ In this case each firm should guess what the other firm is going
to do$ If the firm has no clue of the other firm-s choice, then this firm will have a very
tough decision$ If the firms cannot talk and coordinate, then the government can set up
standards re/uiring all firms to operate on, for e4ample, 1"6 volt$ In this case, there are
no incentives to cheat$ Coordination games are different from competing (advertising
game in )a,le 16;#$
I+(I+I)&8@ '&%&3)&7 [3M&2
In the simultaneous move, one shot games, collusion is not very likely ,ecause games
are played only once and punishment is too late$ )here is today ,ut no tomorrow, if one
firm cheats in such unrepeated games the profits from cheating e4ceed those from
collusion$ Aowever, in reality, firms compete every week, every year over and over again
and forever$ )hus, the games are repeated$ In the case when games are repeated infinitely
it is possi,le under certain conditions that collusion will stick (i$e$, ,e the solution$
1O
)heory
Dhen a repeated game is played, players receive payoffs during each repetition of the
game$ %ayoff received today has a higher time;value than payoff that will ,e received
tomorrow$ )he future payoffs must ,e discounted and we must compare the present
values of the future payoffs to today-s value of the current payoff$ In case of cheating, we
have to compare the value of current one;time profit from cheating plus present value of
+ash payoffs (no more cheating after this and we will have the present value of the +ash
payoff for each game after that with the present value of the stream of profits from
cooperation or collusion over infinite time$
%resent Galue (%G
%Gfirm > = 6 N =1 J (1Ni N =" J ( 1Ni
"
N ;;;;;N =) J ( 1Ni
)
where = 6 is profit today, = 1 profit a year from now, = ) is from ) years from now, and i is
the interest rate or discount rate and H4, (4(i)I is the discount factor and also the term of
the series$ If the period is not infinite and profit is constant (+ C $ + , then the a,ove series
can ,e written as:
3'firm $ + , ( 4(i)
;
( + , ( 4(i) ( + , ( 4(i)
1
( -----( + , ( 4(i)
T
for T repeated games/
/
3'firm $ +94 ( 4, (4(i) N4, (4(i)
1
( 4, (4(i)
6
(W( 4 , ( 4(i)
inf
F
$ + ! t $;
t$

inf
4 , ( 4(i)
t
for infinitely repeated games$
If the period is infinite and profit +i is constant, then the series is e4pressed as
3'firm $

=
+
6
t
i 1 (
1
t

)he series

=
+
6
t
i 1 (
1
t
converges or has a limit ,ecause it-s typical term or element
(4,4(i) is a fraction$ )he converging limit of this series is1JH1; &8&M&+) *( 2&'&2I >
1JH1;1J(1NiI > (1N i Ji$ 2u,stitute this limit into %Gfirm e/uation a,ove, we have
3'
firm
$ 9(4(i),iF !+
)his is the term which we will use for cheating to compare the profit from cheating today
(plus %G of +ash payoffs if non zero in the future with the present value, %Gfirm ,of
streams of current and future profits from collusion or cooperati on over the life span of
the firm$
)a,le: Infinitely 'epeated [ames
L6
F
i
r
m

0
Firm F
$rice Aow Vigh
Aow 16, 16 ?)<;06
Vigh ;06,?) 16,16
PV@.6m (7hea/) = Chea/.n2 Pa;'@@ a/ 7066en/ pe6.'< + PV(Ba(h Pa;'@@()
%Gfirm (cheat > S6 J( 1Ni
6
N 16 J (1Ni N 16J (1Ni
"
N ;;;;;N 16 J (1Ni
Inf
where ?) is one
time payoff from cheating$ .reak ?) into () an, 1) ,ecause 16 is +ash and is needed for
convergence for a series with a constant which 16 in this case
PV@.6m (7hea/)= 6$ + 1$(1+.)
$
+ 1$ / (1+.) + 1$/ (1+.)
2
+ C + 1$ / (1+.)
?n@

> L6 N 16H

=
+
6
t
i 1 (
1
t
I
> ?; ( 4;(4(i),i where (4(i),i is the limit and 16 is +ash payoff$
PV@.6m (C'll0(.'n) = "$ + "$/ (1+.) + "$/ (1+.)
2
+ C + "$ / (1+.)
?n@
>
16H

=
+
6
t
i 1 (
1
t
I > K;(4(i),i
@ou can plug the value for . in ,oth %G e/uations and then compare$
2upporting Collusion with )rigger 2trategies
3s mentioned a,ove, collusion in infinitely repeated games is possi,le under certain
conditions$ (irms enter into a collusion agreement ,ased on past plays of the firms$ If a
firm deviates and cheats then there will ,e a deviation from past plays$ In this case other
firms will use trigger strategies that are intended to punish the deviation$ )he punishment
means that other firm will punish the cheater ,y doing e4actly what he did, they would
lower the price (they go to +ash if e4ists$ If every firm relies on trigger strategies
collusion will last if
current profit from cheating (plus discounted non zero future +ash profits if e4ist
R %G of future streams of profits under collusion$
L1
as e4plained in the %G e/uations a,ove$
)a,le 16;8 is an e4ample for that with +ash payoffs are zeros (.ertrand$
$
)a,le 16;8: 3 %ricing [ame )hat is 'epeated (.ertrand
F
i
r
m

0
Firm F
$rice Aow Vigh
Aow 6,6 16,;06
Vigh ;06,16 16,16
If ,oth firms collude in this repeated game, then the stream of future profits for each firm
is 16$ If one player cheats, while the other one sticks to the collusion agreement, the
cheater will make 16, while the non cheater would make ;06$ If the collusion ,reaks
down and ,oth firms recourse to low prices (or +ash then each will make zero profits in
the future for this .ertrand oligopoly$
8he $: 0pproach
2uppose firm 3 cheats, while firm . does not$ )he game is over after one play$ )hen
%G
Cheat
(irm 3 > current B cheating payoff N disct-d +ash1 N disct-d +ash1 N] > B16 N 6 N
6 N;;; > B16
(+ote: in this e4ample +ash e4ists and e/uals zero$ If firm 3 does not cheat and
UcooperatesV in this repeated game, the present value is
%G
Coop
(irm 3 > 16 N 16J ( 1Ni N 16 J ( 1Ni
"
N16 J ( 1Ni
#
N ]$ > 16(1Ni J i
where i is the interest rate$ )hus, there is no incentive for (irm 3 to cheat if:
%G
Cheat
(irm 3
U %G
Coop
(irm 3
%G
Cheat
(irm 3
> 16 N 6 N 6N ] U 16 (1Ni J i > %G
Coop
(irm 3
16 U 16 (1NiJi or
L"
16J16 c (1NiJI (divide ,oth sides ,y 1
K X (4(i),i (multiply ,oth sides ,y i
Ki X 4( i
Ki -i X 4
Ii D 4 (su,tract one from ,oth sides
*r i X Y (no cheating$
2olve for i$ (In this case i $ 1KM)
If i . 1KM, (irm 3 will lose more in present value ,y cheating than it will gain ,y
cooperating$ )he solution is C**%&'3)I*+$ In general, the lower the interest rate is,
the more likely that conclusion will persist, and vice versa$
More generally, we can write the principle for sustaining collusion in terms of one shot-
game payoffs without using preset values as follows$
(T
&heat
- T
&oop
J (T
&oop
% T
L
) c 1Ji ( no cheating
*r (T
&heat
- T
&oop
) X 4,i (T
&oop
% T
L
)
where T
&heat
is the ma4imum one-shot payoff if the player cheats, T
&oop
is the one;shot
cooperative or collusive payoff and T
L
is the one;shot +ash e/uili,rium$ If any player
cheats, the trigger strategy is to punish the player ,y choosing the +ash one;shot
e/uili,rium strategy forever after$ 0ppl/ this con,ition to example 1)-8 6hen i & 1)V.
(16 F 16J(16 ; 6 R 1J6$1 > 16 for no cheating
0 R 16$
(collusion is more profita,le$ &ach firm can earn a payoff of 16$
Intuitively, the a,ove condition for sustaining collusive or cooperative outcomes is that
Uprovided the one-time gain from breaking the collusive agreement (cheating) is less than
the present value of what would be given up by cheating (cooperation)2 players find it to
their interest to live up to the agreementZ
)he lower the interest rate, the more likely that conclusion will persist, and vice versa$
+emonstration 1)-( 8he $rinciple to the !ustaina.ilit/ 0pproach
L#
5se the information in 8a.le 1)-8 an, appl/ the a.o-e principle to the sustaina.ilit/
of collusi-e agreements 6hen i & G)V (higher than .efore). Chec1 if cooperation or
collusion 6ill persist o-er cheating.
(16 F 16J(16 ; 6 @ 3 1J6$0 > "$1 for no cheating (cooperation
06J16 P "$1
(cheating and no collusion ,ecause interest rate is very high
8he other $: approach re;uires that 6e chec1 if

%G
Cheat
(irm 3
c %G
Coop
(irm 3

=) 7 ) 7 W 3 1) 7 1)"(1.G) 7 1)"(1.G)
2
7 1)"(1.G)
3
7

W. 6here ).G) & i (-er/ high).
=) 3 1)*(1Ni J i
=)3 1)*Q1.G " ).GR
=) X 3= (cheat no collusion).
!ince the matrix in ta.le 1)-8 is s/mmetric each firm has the .n7en/.Ee /' 7hea/,
(Dou can also use the principle of collusion sustaina.ilit/ state, a.o-e here)
(actors 3ffecting Collusion in %ricing [ames (increases in monitoring costs reduce
incentives to collude$
1$ +um,er of (irms ('emem,er the Aeinz case study
Collusion is easier when there are fewer firms rather than many$ If there are five firms
in the market, each firm must ,e monitored four times ,y its rivals$ )otal num,er of
monitoring in the industry is 1:0 > "6 total firms monitored$ )he cost of monitoring
reduces the gains to colluding$
"$ (irm 2ize
It is easier for a large firm with "6 outlets to monitor a small firm with one outlet$ )he
large firm must monitor 1 store, ,ut the small firm must monitor "6 stores$
#$ Aistory of the Market
(irms may not meet to collude ,ut they can reach an understanding of the way the
game has ,een played over time$ )hus, the firms reach a tacit coordination/ 2o they
accomplish collusion indirectly ,y learning from past experience$
L0
0$ %unishment Mechanism
%unishing a rival has a cost$ If a firm posts a single price to all its current and
potential customers then if it punishes its rival ,y lowering the price it must lower it
on all the customers including those of the rival$ )his results in high punishment cost
for the firm$ .ut if this firm charges different prices to different customers, it can Wust
lower the prices for the rival-s customers$ In this case the cost of punishment for the
firm is lower$
(I+I)&8@ '&%&3)&7 [3M&2
)here are two types of finitely repeated games: one type that has a known final
end period! and the second that has an uncertain or unknown final or end period
(inite [ames with 5ncertain end of period$
)hese games, although finite, is similar to infinite games/ )he firms know that
their product has a finite lifespan and some day they will ,ecome o,solete ,ut they do not
know when$ )hus, the end of the finite period is uncertain$ 2uppose ,oth firms played the
game today$ )hey know that the pro,a,ility that the game will end tomorrow is d and
that it will continue until tomorrow is (1; d$ +ote that 6R d R1$ (or the ne4t two days,
the pro,a,ility it will end is d : d > d
"
and the pro,a,ility that it will continue for two
days is (1; d:(1; d > (1; d
"
$ )he pro,a,ility it will end in three days is d
#
and will
continue for three days is (1; d
#
and so on$ 8et us apply this type of games to )a,le 16;
16$
Table 4;-4;7 8 3ricing Uame that is )initely #epeated
F
i
r
m

0
Firm F
$rice Aow Vigh
Aow 6,6 =),;06
L1
Vigh ;06,=) 1)<1)
If there is collusion and ,oth firms adopt high price strategies, the payoff for each of
them is 16$ )his will continue until the product terminates and the game ends$ 3ssume
interest rate is zero (no discounting for simplicity$ )hen (%G of payoff from
cooperation for firm 3 is:
%G e
firm 3

Coop
> 16 N (1;d16 N (1; d
"
16 N (1; d
#
16 ]$>16J d
)he term of seres is (1; d and the limit of the series is 1J(1; term of seriesI >H1J(1; (1;
d > H1J dI
((ootnote: this e/uation is similar to the e/uation of collusion for the infinitely repeated
games with (4- [) are replacing H4,(4( i)I as the term of series$ In ,oth games they
receive the same ,enefits$ De assume i >6$
+ote that if the games will end or terminate tomorrow and that d >1 then the pay
from collusion is 16 (+ash is zero in this e4ample$ )his is a one;shot game$ If the firm
cheats, then the relationship ,etween the payoff from cheating and that from collusion
which assumes that the game will continue is:
%G e
firm 3

Cheat
> 16 N 6 N ]X %G e
firm 3

Coop
> 16J1 > 16$
(that is greater than the payoff from collusion in a one shot game$ In this case there is no
incentive for firms to collude$ 2ince the matri4 in 8a.le 1)-1) is symmetric (compare the
off;diagonal cells firm . will have the same thing and there will ,e no cooperation$ *n
the other hand, if d is a small fraction such that
%G e
firm 3

Coop
> P %G e
firm 3

Cheat
> 16 (which is the cheating payoff N %G
(+ash for future payoffs
16J d P 16 N 6 N 6 N ]
6r
16J d P 16,

(where

d > 16J16 > 6$"6$
LL
then the firms will cooperate and collude$ More precisely2 if [ . ;/1; (i/e/2 4,K) then the
firms will cooperate and collude/
He can conclude by saying that the lower [ and the higher (4- [)2 the more likely the
firms will cooperate and collude$
+emonstration 1)-? Fill.oar, 0,-ertising Jame
!uppose t6o cigarette manufacturers repeate,l/ pla/e, the follo6ing simultaneous
>mo-e .ill.oar, a,-ertising game as illustrate, in 8a.le 1)-11.
Ta3le 1$11> + A.ll3'a6< +<Ee6/.(.n2 Fame
F
i
r
m

0
Firm F
!trateg/ +<Ee6/.(
e
1' n'/
+<Ee6/.(e
+<Ee6/.(e )<) 2)<-1
1' n'/
+<Ee6/.(e
-1<2) 1)<1)
Cn this ta.le< if .oth companies cooperate an, S+H BH8 0+:*#8C!*T (collusion)
each 6ill earn '1)< 6hile if the/ .oth S0+:*#8C!*T (Bash) each 6ill ma1e zero. Cf
one a,-ertise an, the other ,oes not (cheating)< the one that a,-ertise, ma1es '2)
an, the one that ,oes not ma1e -'1. 0ssume there is a 1)V chance that the
go-ernment 6ill 3an (end cigarette sales in an/ gi-en /ear< can the firms Scollu,eT
./ agreeing not to a,-ertise3 Bote that 1-d > 6$O$
Cf firm 0 cooperates an, ,oesn4t cheat it can expect to earn
$: Y
firm 0

Coop
& 16 N (1;d16 N (1; d
"
16 N (1; d
#
16 ]$>16J d
$: Y
firm 0

Coop
& 1) 7 (.K)1) 7 (.K)
2
1) 7 (.K)
3
1) 7W. & 1)".1) & '1)).
!ince '2) @ '1)) the firm has no incenti-e to cheat (that is the solution is collusion).
8he incenti-es for firm F are the same. 8hus< firms can collu,e ./ using this t/pe of
trigger strateg/ 6hich in-ol-es punishing the cheating firm ./ charging a lo6er
price until the game en,s.
LS
'epeated [ames with a <nown (inal %eriod: )he &nd;of;%eriod %ro,lem
2uppose a game is repeated some known num,er of times with strategies and payoffs as
supposed in 8a.le 1)-12$
Table 4;-417 8 pricing Uame
F
i
r
m

0
Firm F
$rice Aow Vigh
Aow 6,6 16,;06
Vigh ;06,16 16,16
8et us assume for simplicity the game is repeated twice (two one;shot games and the
players know the game will end in period two$ )his means after the game is played twice
there is no tomorrow (at the end of the second period$ 3t that time there are no trigger
strategies and no punishments even if player 8 cheats$ The two-shot game is really played
as a one-shot game twice/ %layer 8 kept charging the high price$ In this case since there is
no tomorrow$ %layer 3 can charge a low price in the second period and player S cannot
punish himJher$ In fact player 8 would ,e happy if player S continues charging the high
price in the second$ In this case player 8 if charges the low price it will earn 16$ .ut
player . knows that player 3 will charge the low price and thus . will do likewise$ )his
means this two;shot game will end in the first period and will not go to the second or end
period in this e4ample$ Lash equilibrium in this two-shot game is to charge low price in
each period/ )he game is played as two one;shot games and each player will earn zero
profit in each of the two periods$
In that collusion will not work even if the game is pla/e, three< four< 1))) times$ )his
type of U,ackward unravelingV continues until the players realize no effective punishment
can ,e used during any period$ )he key reason is that each player knows that promises of
cooperation will ,e ,roken any time ,ecause the period has an end and then there is no
tomorrow$ 2o the solution is low prices with zero profits$
+emonstration 16;8
L8
2uppose firms 3 and . will play the game in 8a.le 1)-12 twice$ 3ssume that firm 3-s
strategy is to charge high price each period provided that firm . (the opponent never
charged a low price in any previous period$ 3ssume interest rate > 6$
1$ Aow much will firm . earnQ
"$ Aow much firm 3 earn$
0ns6er: 2ince firm 8 will also charge a high price each period, the opponent firm S will
,e a,le to trick firm 8 in the second period ,ecause in this period the game will end$
(irm 8 will stick to its strategy for the first and second periods ,ecause it will not
discover .-s cheating until the second period, and at that time it will ,e too late to punish
firm .$ )hen firm . will charge a high price in the first period and earn 16 and charge a
low price and earn 16 in the second period for a total of L6 (this is ,etter than cooperating
and charging higher price in each period for a total profit of 16 N 16 in the two periods$
Correspondingly, (irm 3 will earn 16 in the first period and make a loss of 06 in the
second period, for a total loss of #6 in the two periods$ 2ince each player knows when the
game will end and trigger strategies will not enhance profits$
3pplications of the &nd;of;%eriod %ro,lem
&nd of period pro,lem arises when workers know precisely when a repeated game will
end$ In the final period, there is no tomorrow and there is no way to punish a player for
doing something wrong in the last period$ Aere is an implication of the end;of;period
pro,lem for managerial decisions$
'esignations and 9uits
Dorkers weigh the benefits from shirking with the cost of being fired$ If the ,enefits are
less than the costs, workers will find it in their interest to work hard$ If the worker
announces today that heJshe will /uit tomorrow than there is no reason for the worker to
work hard ,ecause the threat of ,eing (the trigger strategy fired has no ,ite$
Dhat can the manager do to overcome the end;of;period pro,lemQ Ae can fire the
worker today ,ut legally this may not ,e feasi,le$ Moreover, there is a more fundamental
reason why the manger should not adopt this policy$ )o avoid ,eing fired on
announcement, workers will not announce their plans of /uitting until the end of the day
and in this case they get to work longer than if they announce their plans$ Conse/uently,
LO
the manager will not solve the end;of;period pro,lem ,ut instead heJshe will ,e
continuously ,e surprised ,y worker resignations$
3 good strategy is to give the workers some rewards for good work that e4tend
,eyond the termination of employment with the firm$ In this case the worker will not take
advantage of the end;of;period pro,lem$ .ut if the worker takes advantage of the end;of;
the period pro,lem the manager, ,eing well connected, can punish the worker ,y
informing potential employers a,out it$
%ultistage James
)hese games differ from the class of simultaneous games one;shot infinitely
repeated games in the sense that timing is very important for multistage games$ In
particular, multistage games permit players to make se/uential rather than simultaneous
decisions$
)heory
In order to understand how multistage games differ from one shot and infinitely
repeated games$ De need to introduce the e4tensive form of a game$ 3n e4tensive; form
game summarizes who these players are, the information sets availa,le to those players at
each stage, the strategies availa,le to the players, the order of moves and the payoffd
from the alternative strategies$
(ig$ 16;1 depicts the e4tensive form of a game assume that there are two players:
3 and .! and that player 3 is the first mover and player . is the second mover$ &ach
player has two strategies: 5p and 7own$ )he num,ers at the end of ,ranches in this
figure are the players payoffs since player 3 is the first mover the first num,er is that
players payoff and the second num,er is player .-s payoff$
((ig$ 16
S6
(6, 6
(L, "6
(1, 1
(16, 11
3
.
.
7own
7own
7own
5p
5p
5p
S1
In Fig. 1)-1, player 3 moves first, and once this player moves, it-s player .-s turn$
If player 3 chooses 5p and player . makes the same 5p move, then the payoff for 3 and
., respectively, are (16,11$ .ut if player . moves in the other direction and chooses the
Eown strategy then their respective payoffs are (1, 1$ 3s in simultaneous; move games,
each player-s payoff depends on ,oth player-s actions$ )his is the similarity ,etween
these types of games$ (or e4ample, if the first move of player 3 is Eown and player .
chooses 5p then player 3-s payoff is (6, ,ut if . chooses Eown player 3-s payoff is (L$
)here is important difference ,etween the se/uential and simultaneous types of games$
2ince player 3 is the first mover in this case, this player cannot make decisions ,ased on
player .-s moves, ,ut player . gets to make decision after player 3$ )hus, there is no
conditional UifV in player 3-s strategy$
8et-s see how strategies work in this game$ 2uppose the strategies are: player .
chooses Eown if player 3 chooses Eown$ Dhat is the ,est strategy for 3Q )he ,est
strategy for 3 is Eown ,ecause in this case 3 will make L, which is ,etter than 1$ [iven
that player 3 chooses Eown2 does player . have an incentive to change his strategyQ )he
answer is +*$ Choosing Eown instead of 5p, . earns "6 instead of 6$ 2ince neither
player has an incentive to change hisJher strategies then there is a +ash e/uili,rium
associated with those strategies$
3layer 87 Eown\
3layer S7 Eown if player 8 chooses 5p2 and Eown if player 8 chooses Eown$ (player .
threatens to play Eown all the time$
)he payoff: (L, "6
Is this a reasona,le gameQ Dhy doesn-t 3 choose 5p and make 16 instead of choosing
7own and making LQ )he answer is in the way .-s strategy is formulated$ If 3 chooses
5p, . threatens to choose Eown all the time$ In this case 3 will make 1 instead of L$
2hould 3 ,elieve .-s threatsQ If . chooses 7own it will make 1$ Dhat to make out of all
thisQ )here are two +ash e/uili,ria in this game$
+ash &/uili,rium: 3s e4plained a,ove when . threatens to play Eown all the time$
+ash &/uili,rium: Dhen 3 finds that .-s threats are not credi,le$
S"
3layer 87 5p
3layer S7 5p if player 8 chooses 5p and Eown if player 8 chooses Eown$
%layer . will have to chooses 5p if 3 chooses 5p$ In this case, the neither player has an
incentive to change hisJher mind$ )he second +ash e/uili,rium is more reasona,le
,ecause .-s threats are not credi,le in the sense that 3 can choose 5p and this will force
. to choose 5p and +*) 7own ,ecause it will have a lower payoff (1 instead of 11 if it
follows upon its threat to choose 7own$
S#
Chapter 11
%ricing 2trategies for (irms with Market %ower
In this chapter we deal with pricing strategies of firms that have some market
power: firms in monopoly, oligopoly and monopolistic competition$ 3s we learned in
chapter 8, firms in perfect competition are price takers and they don-t have a pricing
strategy of their own$ )his chapter goes as far as providing practical advice on
implementing pricing strategies for those firms with market power, typically using
information that is readily availa,le to managers, including pu,licly availa,le
information such as the price elasticity of demand$
)he optimal pricing strategies for firms with market power vary depending on the
underlying market structure and the instruments (e$g$, advertising availa,le$ )o account
for that, this chapter presents more sophisticated pricing strategies that ena,le a manger
to e4tract greater profits from the consumers$
.32IC %'ICI+[ 2)'3)&[I&2
De will first look at the very ,asic pricing strategy which relies on single or
uniform pricing/ )his strategy uses the profit;ma4imizing rule: M'>MC to derive the
optimal price$ )his rule is then mathematically manipulated to provide a rule of thum,
that makes use of the markup to arrive at the price$
'eview of the .asic 'ule of %rofit Ma4imization
(irms with market power can restrict output to charge a higher price! thus they
have a downward;sloping demand curve$ In this case the price is different from marginal
revenue$ )he profit;ma4imizing rule for firms with market power is given ,y
M' > MC$
)his rule is first solved for the e/uili,rium output which in turn is su,stituted in the
inverse demand e/uation to solve for the optimal or e/uili,rium price as was illustrated in
chapter 8$ Managers of large firms may have research department that have economists
who can estimate demand and cost functions and apply this rule and to solve for optimal
price and output
S0
+emonstration 11-1
2uppose the inverse demand e/uation is given ,y
% > 16 ;"9 (downward sloping demand > market power
and the cost function is
C(9 > "9$
7etermine the profit;ma4imizing output and price$
3nswer: 'ecall M' has twice the slope of the price in this case$
)hen
M' >16 F 09$
2et M' > MC
16;09: > "
2olve for 9:$ )hen Q* & 2 units$ %lug 9: into the inverse demand e/uation
$* & 1) -2Q* & '(.
3 2imple %ricing 'ule for Monopoly and Monopolistic Competition
2ome small firms such as retail clothing stores do not hire economists to estimate
their demand and cost functions$ )hey can, however, rely on pu,licly availa,le
information such as information on price elasticity of demand (see chapter S for estimates
of price elasticity for different industries$ De can derive a rule of thum, from the profit;
ma4imization rule and estimate the price with minimal or crude information and still ,e
consistent with profit;ma4imization$
(ormula: Marginal 'evenue for a firm with Market %ower (Monopoly and Monopolistic
Competition:
M' > %H(1N&
f
J&
f
I where &
f
> Xf9JXfp > (f9Jf%:%J9
where &f is the firm-s own direct price elasticity of demand$ 2u,stitute this in the profit;
ma4imization rule
%H(1N&
f
J&
f
I > MC
S1
2olve for the price:
% > H&
f
J(1N&
f
IMC
or
% > (<MC
where < > &
f
J(1N&
f
can ,e viewed as the profit ma4imization (optimal factor
markup factor$
*xample: )he clothing store-s ,est estimate of elasticity is ;0$1 and this is known$ )hus,
the optimal markup is
< > ;0$1J(1; 0$1 > 1$#"$
)hen the optimal price
$ & (N)%C & 1.32*%C
()hat is, 1$#" times marginal cost$
)he manger should note two things a,out this price elasticity: (irst, the more
elastic the price is2 the lower the markup factor and the price (if &f > ;infinity, then <> 1
and % > MC as is the case in perfect competition! the lower M& is2 lower the price$
+emonstration 11;"
!uppose the manger of a con-enience store competes in a monopolisticall/
competiti-e mar1et an, .u/s !o,a at a price of '1.2= per liter. Chapter ? reports
that the price elasticit/ of ,eman, for the t/pical grocer/ is -3.8. 8he manger of this
con-enience store .elie-es that ,eman, is slightl/ more elastic than -3.8. Aet the
price elasticit/ of the con-enience store is -G. 2hat is the profit maximizing price for
this store3
$ & Q-G"(1-G)R%C & 1.3 %C
3 2imple %ricing 'ule for Cournot *ligopoly
2trategic interaction is an important issue in Cournot oligopoly$ &ach firm
ma4imizes profit taking into account of the output of the rival firms in the industry$ It
,elieves that the output of the rivals will stay constant$ )he ma4imization rule is the same
as in the monopoly case,
SL
M# $ M&$
.ut under Cournot monopoly, M' depends on the firm-s output and on the rivals- output
as well$ &ach oligopolistic firm uses this rule to derive its interaction functions in which
its own output depends on the rivals- outputs$ )hen the interaction functions are used to
determine the profit;ma4imizing outputs (4!2 1:
(ortunately and similar to monopoly, a simple markup pricing rule can ,e used in
Cournot oligopoly when the oligopolistic firms have identical cost structures and
producing similar products$ 2uppose the industry consists of + firms with each firm
having identical cost structures and produces similar products$ In this case we can use
the markup pricing rule for monopoly and monopolistic competition to derive a pricing
formula for a firm in a Cournot *ligopoly$ (irst, it can ,e shown that if products are
similar then
@f $ L!@M
where @f is the price elasticity of demand for the typical firm, &M is the industry-s price
elasticity of demand and + is the num,er of firms in the industry$ 'ecall that the markup
pricing rule under monopoly and monopolistic competition is given ,y
3 $ 9@f ,(4(@f)FM&
where M& is the individual firm-s marginal cost$ 5pon su,stitution for @f from a,ove, the
profit ma4imizing price for a firm under Cournot is given ,y:
3 $ 9L@
M
,(4(L@
M
)F!M& (rule of thum, pricing under Cournot
+emonstration 11-3
2uppose a Cournot industry has three firms, with market elasticity &m e/ual ;" and the
individual firm-s MC is B16$ Dhat is the firm-s profit ma4imizing price under Cournot
oligopoly
% > M(#(;"JH1N(#(;"I

K:B16 > BL6
SS
2)'3)[I&2 )A3) @I&87 &G&+ ['&3)&' %'*(I)2
)hese are strategies that can ,e implemented under monopoly, monopolistic competition
and oligopoly ,y which the manager can earn a profit greater that it can get using the
single pricing rule (M' > MC whether directly or through a pricing formula$ )hese
strategies which include: price discrimination, twoFpart pricing, ,lock pricing and
commodity ,undling, are appropriate for firms with various cost structures and degrees of
market interdependence$
&4tracting 2urplus from Consumers
3ll the a,ove four strategies aim at e4tracting consumer surplus and turn it into profit for
the producers$
I$ %rice 7iscrimination
%rice discrimination is the practice of charging different prices to different consumers for
the same good or service sold$ )here are three types of discrimination! each re/uires that
the manager have different types of information a,out consumers$
(irst; degree price discrimination (perfect price discrimination
)his type of prices discrimination amounts to charging each customer the ma4imum price
it is willing and a,le to pay$ )his price is called the reservation price$
7efinition: #eservation 3rice7 )he ma4imum price the customer is willing to pay (e/g/ 34
and 31 ), which is greater than or e/ual to the actual price$
3ctual %
%
9
7
%1
%"
S8
Cf monopoly single pricing strategy is used and the monopoly price is %:M, then
consumer surplus (C2 in the graph ,elow is the yellow triangle a,ove the %:M;
line and ,elow the 7;curve$
Cf 4
st
degree price discrimination is practiced then7 &onsumer surplus (rectangle area >
6, (,ecause the price is the ma4imum price the consumer is willing to pay$
(ig$ 11;1a ,elow shows the firms- total (operating profit (C2 N %2 when the firm
charges the ma4imum price$ It is the area ,elow the demand curve and a,ove the MC
curve up to 9:M$ +ote that the area ,elow the MC curve and ,elow the price line %:M up
to the /uantity 9:M is the producer surplus (%2$
)irst-degree price discrimination is also called perfect price discrimination because it
requires identifying the reservation price for each consumer under alternative quantities/
This is not possible in the real world/

C2
%C
MC
%:M
9:M
M'
M
SO
)ig/ 44-4 )irst and "econd Eegree 3rice Eiscrimination
"econd Eegree 3rice Eiscrimination (discrimination based on quantity)
)his type of price discrimination leaves the consumer with some consumer surplus$ )hus
relative to the first degree price discrimination, the total profit under the second degree is
lower$ )his discrimination practice is ,ased on giving discount for ,uying e4tra /uantities
of the good$
In Fig. 11-1., the firm charges the consumers B8 a unit for the first two units$ In this case
it e4tracts H1J":(8;1:"> B#I of the consumer surplus which would have gone to the
consumers under single pricing$ It also e4tracts some more ,y charging B1 per unit of on
the units from " to 0$ )his is an additional e4traction of C2$ )he firms cannot e4tract all
consumer surpluses! some consumer surplus will ,e left to the consumers under the "
nd
degree;price discrimination$
Example> &lectric companies: it works ,y charging different prices for different
/uantities or ,locks of the same good or service (<DA$ )his is the case of natural
monopoly (economies of scale where ,oth 3G and MC curves are declining all the way$
+atural Monopoly: M' > MC
.reakeven: % > 3C or )' > )C
86
Uraph7 Latural monopoly with second-degree price discrimination/
(ig$ 11;1(, a,ove shows how much of the consumer surplus is e4tracted ,y the firm
when the second;degree practice is used$
Third-Eegree 3rice Eiscrimination
Customers are divided into few groups with a separate demand curves or elasticities for
each group$ )his is the most prevalent form of price discrimination$
@xample7 3irline fares: 3irline passenger tickets are divided into groups 1
st
class fare,
regular unrestricted economy fare, and restricted economy fare$
Vow are customers divided into groupsB
2ome characteristic is used to divide consumers- into distinct groups: willingness to pay,
Identity can ,e readily esta,lished (I7 ]$etc
Hhat price to charge each groupB
[iven whatever total output is produced, this total output is allocated among the groups
,ased on the profit ma4imization rule 1$
1$ M'1 > M'" > ;;; > M'+
)hat is, prices should ,e designed as a result of e/uating M'2 and read off their
corresponding demand curves$
9#
91
%#
%"
%M:
%1
M' 7
MC
9" 9M:
1
st
,lock "
nd
,lock #rd ,lock
3C
.reak even
&M
81
If for e4ample M'1 P M'" output should ,e shifted from group " to group 1 (,ecause the
first group is adding more to total revenue, this will lower %1 and increase %" until that
M'1 > M'"
"$ Eetermination of total output (!) is by equating M') > MC)
Dhere M') is the horizontal sum of all groups M'i , i > 1,], n$ )hat is, fi4 M'i at a
certain level then add up the corresponding /uantities 91, 9",$ $$,9n$ )hen repeat this
process ,y fi4ing M'i at a different level and so on$ @ou will get M')$
)hen e/uate M'1 > M'" > ;;; > M'+ > MC) to divide the total output among the n
customer groups$
Dhere MC) is the marginal cost of total output$
If M'i P MC) for all groups i, then profit will increase ,y increasing total output and
lowering prices$
M'i R MC) then profit will increase ,y decreasing total output and increasing prices$
)his continues until M'i > MC) for all groups i > 1,]$, n$
2uppose there are two groups
Jroup 1 Jroup 2 8otal output
91 9"
9) > 91 N 9"
%1 %"
)otal cost function C > C (9)
)'1 > %191
)'" > %" 9"
= > %191 N %"9" F C(9) (profit
91 will increase until incremental profit f= J f91> 6
f= Jf91 > f (%191 J f91 F fC J f91 > 6 which means
M'1 F MC > 6
this implies that
8"
M'1 > MC
2imilarly 9" will increase until incremental profit f= J f9" > 6
M'" > MC
%utting these relationships together
M'1 > M'" > MC (which is the condition allocating total output 9: among the two
groups$
)his is the condition for profit ma4imization under third degree monopoly$
Monopolists practicing this price discrimination may find it easier to think in terms of
the relative prices that should ,e charged to each group and to relate these prices to
elasticity$
'ecall M'1 > %1 N %1(1 J &%1
71
> %1(1N1J&%1
71

'ecall M'" > %" N %"(1 J &%"

7"
> %"(1N1J&%"
7"

+ote that &

p1
1

J(1N&
p1
71
> ( 1

N1J&%1
71

)his can ,e rewritten as

%
1
H(1N&
1
J&
1
I > MC
%"H(1N&"J&"I > MC
)herefore from 1
st
profit ma4 ruler under #
rd
price discrimination:
M'1 > M'"
%1(1N1J&%1
71
> %"(1N1J&%"
7"

%
1
> H1N(1J&
%"
7"
I
%
"
H1N(1J&
%1
71
I
)he higher price will go to the consumers with the lower elasticity$
8#
@xample7 &%1
71
> ; " (lower elasticity
&%"
7"
> ; 0 (higher elasticity$
%1 J %" > (1;1J0 J (1;1J" > 1$1
*r %1 > 1$1%"
+emonstration 11-G
Aocal monopol/ is near campus. Aet %C &'( per pizza.
+uring the ,a/ onl/ stu,ents eat there< 6hile at night facult/ mem.ers eat. Cf
stu,ent4s elasticit/ of ,eman, is -G an, of facult/ is -2< 6hat shoul, .e the pricing
polic/ .e to maximize profit3
0ns6er
8he facult/ has more elastic ,eman,
$1Q(17*1)"*1R & %C
$2Q(17*2)"*2R & %C
Aet A &lunch or ,a/ pizza< an, + & +inner pizza.
$AQ(1-G)"-GR & '(
$+ Q(1-2)"-2R & '(
8hen $A &'8 (more elastic )an, $+ &'12 (less elastic)
II$ )wo;)ier (%art %ricing
Dith two;part pricing, the firm charges a fi4ed fee for the right to purchase its goods,
plus a per;unit charge for each unit purchased$ )his pricing policy is commonly used ,y
athletic and night clu,s$ 3s is the case with price discrimination, the purpose of this
policy is to enhance the seller-s profit ,y e4tracting consumer surplus from consumers$
2imilar to the first;degree price discrimination, this two;part pricing strategy allows firms
to e4tract the entire consumer surplus$ )o address this pricing strategy, we first present
the case of profit ma4imization ,y a firm with market power (say monopoly and
estimate its profit ,ased on using a single pricing policy$ )hen we use the two;part
80
pricing policy and estimate the profit for this policy$ In this e4ample, we will show how
the two;part pricing gives higher profit$
)ig/ 44-17 &omparison of "tandard Monopoly 3ricing and Two-3art 3ricing
(ig$11;"(a gives the profit ma4imization for a firm with market power using
single pricing which ,ased on the rule:
M' >MC$
2uppose that the demand curve is given ,y
9 > 16; %$
81
)hen the inverse demand is given ,y
% > 16 F9
and, thus,
M' > 16 F "9$
2uppose that the total cost function is given ,y:
C(9 > "9,
which implies that MC > " (in this case MC > 3C and constant$
)he firm-s e/uili,rium output and price ,ased on single pricing are determined ,y
16 ;"9 > "$
)hen 9: > 8J"> 0 units and %: > BL$
)otal profit > (% F MC:MC > (L F ":0 > '1(
Consumer surplus > (1J":(16 ;L: 0 > '8
+ow let us use the two;part pricing strategy$ 2uppose the demand function in (ig$ 11;"
(a ,e for a single consumer$ )he firm can use the following two;part pricing strategy: the
fi4ed initiation fee for the right to purchase units B#" and that the price per unit is B"$
)his situation is depicted in (ig$ 11;"(,$Dith a price of B" per unit, the consumer will
purchase
9 > 16 F % > 16 ;" > 8 units$
)he consumer surplus with 8 units is
C2 > (1J":(16 ; ":8 > B#"$
)o implement this pricing strategy, the firm can charge a fi4ed initiation fee (whether as
mem,ership fee or an entrance fee of B#"$ )his fee will e4tract the entire consumer
surplus$
+ote that at B "J unit, revenue will e/ual cost (net of fi4ed cost$ )hat is,
(Garia,le %rofit > (% F MC:9 > (";":8 > B6$
.ut the firm receives B#" as a fi4ed payment which is greater than the B18 profit which
receives ,y charging a single price
+emonstration 11-=
!uppose the total ,eman, for golf ser-ices is Q & 2) > $ an, %C &'1. 8he total
,eman, function is .ase, on in,i-i,ual ,eman,s of 1) golfers. 2hat is the optimal
8L
t6o part pricing strateg/ for this golf ser-ices firm3 5o6 much profit 6ill the firm
earn3
0ns6er
8he optimal per unit charge is marginal cost. 0t this price< 2)-1 & 1K roun,s of golf
6ill .e pla/e, each month. 8he total consumer surplus recei-e, ./ all 1) golfers at
this price is thus PQ(2)-1)1KR & '18).=)
!ince this is the total consumer surplus enZo/e, ./ all 1) consumers< the optimal
fixe, fee is the consumer surplus enZo/e, ./ an in,i-i,ual golfer ('18).=)"1) &
'18.)= per month). 8hus< the optimal t6o part pricing strateg/ is for the firm to
charge a monthl/ fee to each golfer of '18.)=< plus greens fee of '1 per roun,. 8he
total profits of the firm thus are '18).)= per month< minus the firm4s fixe, costs.
III$ .lock %ricing
Aere the seller packs units of the same product and sells them as one package$ )he
consumer is faced with ,uying either the whole package or none of it$ 3n e4ample of this
practice is selling eight rolls of toilet paper or 1"Fpack of soda$ )he seller will assign a
value to the package that covers the cost as well as the consumer surplus$
&4ample: 2uppose an individual consumer-s demand is given ,y
9 > 16 F %
)he inverse demand is e4pressed as
% > 16 F 9
8et the cost ,e C(9 > "9$
)hen % > MC
16 F 9 > B"
9 > 8 units$
In this case, the firm will sell eight units$ (see (ig$ 11 F #! .lock pricing$
)he cost of ,uying the eight consumer is B1L and the C2 > Z (16;":8 > B#"
)otal value of the eight units > 1LN#" > B08
8S
)ig/ 44-67 Slock pricing
)hen the profit ma4imizing price for the package of eight units > B08
+emonstration 11-(
!uppose a consumer4s (in-erse) ,eman, for gum pro,uce, ./ a firm 6ith mar1et
po6er is gi-en ./
$ & ).2 > ).)G Q
0n, the marginal cost is zero. 2hat price shoul, the firm charge for a pac1age
containing fi-e pieces of gum3
0ns6er
2hen Q & =< $ & ).2 > ).)G * (=) & )
2hen Q & )< $ & ').2 . 8he linear ,eman, is graphe, in Fig. 11-G (optimal Floc1
8otal
$ricing 6ith zero marginal cost)
88
:alue of the fi-e units & C=
& P (').2 - ')) * = & ' ).=)
8he firm extracts all consumer surplus an, charges a price if ').=) for a pac1age of
fi-e pieces.
IG$ Commodity .undling
)ravel ,undle may include Uairfare, hotel, car rental, mealsV$ 3 computer ,undle may
include Ucomputer, printer, scanner, software ]V$ )his pricing practice is different from
,lock pricing ,ecause under ,undle pricing the goods or the services are not the same,
while they are identical under price discrimination ,ecause under ,undling the sellers
know that for different consumers, price the components of the ,undle differently ,ut
cannot identify them into groups$ .ecause of this lack of information the profit under
,undling is usually less than under price discrimination$
2uppose the manager of a computer firm knows there are two groups of consumers who
value its computers and monitors differently$ )a,le 11;1 shows the ma4imum prices the
two groups would pay for a computer and a monitor$
Table 44-47 &ommodity Sundling
Consumer :aluation of Computer :aluation of %onitor
1 B"666 B"66
" B1,166 B#66
)he manager does not know the identity of those two groups, and thus cannot practice
price discrimination$ 2uppose the cost is constant and e/uals to zero to simplify matters$
)he manager can separately sell one computer and total profit e/uals
)' F )C > ",666 F 6 > B",666
If it sells it at B1,166, then
)% > #,666 F 6 >#,666
Moreover, it can also sell monitors separately$ 3t B#66 it can sell one$ 3t B"66, it can sell
two and then total profit e/uals
> B#,666 N " : B"66 > B#,066
8O
If the manager ,undles the computers and the monitors and sell them at B1,866 a ,undle
then
)otal profits > " : B1,866 > #,L66
which B"66 more than selling the computers and the monitors separately$ )hus
commodity ,undling can hence profit$
+emonstration 11-?
!uppose there are three purchasers of a ne6 car that has the follo6ing -aluations of
t6o options air con,itioner an, po6er .ra1es.
Consumer 0ir Con,itioner $o6er .ra1es
1 '1))) '=))
2 '8)) '3))
3 '1)) '8))
!uppose the costs are zero
1. Cf the manager 1no6s the -aluations an, consumer i,entities 6hat is the optimal
pricing strateg/3
$rofit from consumer 1 & 1<))) 7 =)) & 1<=))
$rofit from consumer 2 & 8)) 7 3)) & 1<1))
$rofit from consumer 3& 1)) 7 8)) & K))
8otal $rofit & '3<=))
2. !uppose the manager ,oes not 1no6 the i,entities of the .u/ers. 5oe much 6ill
the firm ma1e if the manager sells .ra1es an, air con,itioners for '8)) each .ut
offers a special options< pac1age (po6er .ra1es an, an air con,itioner) for '1<1)).
Consumer 1 an, 2 6ill .u/ the .un,le
$rofit & 2 * '1<1))
Consumer 2 6ill .u/ po6er .ra1es at '8))
8otal $rofit & '3<)))
O6
Chapter 1": )he &conomics of Information
In the previous chapters it was assumed that consumers and firms operate in an
environment of perfect information and certainty whether in terms of prices, output,
income etc$ .ut the real world is far from that$ In this chapter we will e4amine consumers
and firms- ,ehavior under imperfect information and uncertainty$ De demonstrate means
(piecing, advertising etc$ ,y which managers can cope with uncertainty$
Mean and Gariance$
5nder uncertainty the varia,le is random and has possi,le outcome and their
respective pro,a,ility of occurrence$ 3ll this information a,out a varia,le can collapse
into a single num,er which is the mean or the e4pected value$
%ean
&4ample: *ffshore oil e4ploration company
&vent : *il e4ploration$
%ossi,le outcomes: success or failure of finding oil$
%ayoffs: %rice of the stock of this company in cases of success and failure
Hutcomes $ro.a.ilities $a/offs
2uccess 1J" B 06 J 2hare
(ailure 1J" B "6 J 2hare
&4pected value > %ayoff 1: /1 N %ayoff " : /" > (06:1J" N ("6:1J" > B#6$
In general, suppose event > g
g1 > %ayoff 1! g" > %ayoff "! ]$$ ! gn > %ayoff +
&4pected values : &(g > /1:g1 N /":g" N ]] N /n:gn
:aria.ilit/ (#is1)
O1
)he mean or the risk is not enough to convey all the information a,out a random
varia,les$ 2ome varia,les may have the same mean ,ut the outcomes are deviated far
from their mean $ In other words the two varia,les have different spread or risk$
'isk is measured ,y variance or the standard deviation$ If the event has two
possi,le outcomes (g1, g" then the variance can ,e written as
h
"
> %r1 : (g1 F & (g
"
N %r" : (g" F &(g
"
where &(g > /1:g1 N /":g" is the e4pected value or weighted average for g1 and g"$
@xample: 2uppose the two events have the same e4pected income (& (g ,ut different
risks$ )hese events are two different sales Wo,s$
io, 3 : a commission Wo, with two possi,le outcomes$
io, . : a salaried Wo, with two possi,le outcomes$
&G&+) *5)C*M& 1 *5)C*M& "
Income /1 Income /1
io, 3 B ",666 6$1 B 1,666 6$1
io, . B 1,116 6$OO B 116 6$61
In Wo, ., B116 is a severance pay if the company that offers this Wo, goes out of ,usiness$
)hen the expected incomes for these Wo,s are:
& (g
3
> 6$1:g
3
1 N 6$1:g
3
" > 6$1: ("666 N 6$1:(1666 > B1,166$
& (g
.
> 6$OO:g
.
1 N 6$61:g
.
" > 6$OO:(1116 N 6$61:(116> B1,166$
)he 'ariances are h
"
3 > /1:(g1
3
F &(g
3

"
N /":(g"
3
F (g
3

"
>
> 6$1:( "666 F 1166
"
N 6$1:( 1666 F 1166
"
> B"16,666$
)he 2tandard deviation is h3 > 166$
h
"
. > /1:( g1
.
F & (g
.

"
N /":( g"
.
F &(g
.

"
>
> 6$OO:(1116 F 1166
"
N 6$61: (116 F 1166
"
> BO,O66$
)he standard deviation for this Wo, is h. > B OO$1$
)hus, Wo, 3 is much riskier than Wo, .$
+emonstration 12-2
O"
8he manager of LDM compan/ is intro,ucing a ne6 pro,uct that 6ill /iel, '1<))) in
profits if the econom/ ,oes not go into recession. Cf the recession occurs< then the
compan/ 6ill lose 'G<))). Cf economists proZect that there is a 1)V chance the
econom/ 6ill go into a recession ho6 ris1/ is the intro,uction of the ne6 pro,uct.
0ns6er
*($rofit) & ).K*(1<)))) 7 ).1*(-G<)))) & '=))
[
2
& ).K*(1<))) > =)))
2
7 ).1*(-G<))) -=)))
2
[
2
& ).K*(=)))
2
7 ).1*(-G<=)))
2
[
2
& 2<2=)<)))
[
2
& \2<2=)<))) & '1<=))
Oncertaint/ an, Consumer Feha-ior
De will see how the presence of uncertainty affects ,oth consumers and managers$
'isk 3version
%eople may have different tastes for the same set of risky prospects, and thus they e4hi,it
different preferences for these prospects$ 2uppose ( represents the uncertain prospects
associated with ,uying 166 shares of stock (, and [ is the uncertain prospect of ,uying
166 shares of stock [$ Secause attitude and preferences among consumers differ2 a risk
averse person prefers a sure amount of =M to a risky prospect with an expected value of
=M/
3 risk;loving individual prefers a risky prospect with an e4pected value of BM to the
same amount of BM$
3 risk neutral individual is indifferent ,etween a risky prospect with an e4pected value of
BM and a sure amount of BM$
%anagerial +ecisions 6ith #is1 0-erse Consumers
O#
Aere are some e4amples of how risk aversion affects managerial decisions$
%roduct 9uality
)he analysis of risk can ,e used to show how uncertainty a,out product /uality affect
consumer-s ,ehavior and how managers can deal with it$ )here is risk associated with
,uying new products$ If risk averse individual is faced with the new product @ and the
regular product g and views these two products to ,e of the same /uality, he will ,uy the
regular product g$
)he manager has two primary tactics to induce the risk averse consumers to ,uy the new
product$
1$ )he manager may lower the price of the new products$ (or e4ample, he can give
free samples (where the price is zero$
"$ )he manager can use comparative advertising to convince the consumer that the
new product is of ,etter /uality than the regular ,rand$ If consumers are
convinced they may ,uy the new product$
Chain 2tores
'isk aversion may e4plain that it is in a firm-s ,est interest to ,e part of a chain store
instead of remaining independent$ )he type and /uality of products offered ,y national
chains are certain$ &4ample, imagine a family driving through a small town and looking
for a restaurant to eat$ In this town there are two restaurants to eat: a local diner and a
national ham,urger chain$ )he family is uncertain a,out /uality of the food of the diner,
,ut it is more sure a,out the food of the national chain$ It would choose to eat at the
national chain$
)he same applies to retailing outlets, gas stations, etc$
Insurance
O0
%eople ,uy insurance on their automo,iles and homes$ )hey give a small amount of
money to avoid loosing a huge sum if a catastrophic event occurs$ Aere ,uying insurance
represents choosing the Usure thingV over the risky prospect of a catastrophic event$
Oncertaint/ an, the Firm
3s uncertainty affects consumer ,ehavior and managers must account for that uncertainty
also effects the managers- inputJoutput decisions$
'isk 3version (and the firm
iust as consumers have different preferences regarding different risky prospects, so does
the manager of the firm$
1$ 3 manager who is risk neutral is interested in ma4imizing e4pected profits$ )he
variance of profits does not have an effect on hisJher decision$
"$ 3 manager is risk averse if heJshe prefers the proWect that has a lower risk with a
lower e4pected value to the proWect that has higher risk and e4pected value$
Dhen a manager faces a decision to choose among risky proWects, it is important to
evaluate the risks and e4pected returns of the proWects and then to document this
evaluation$ 'isky proWects may have ,ad outcomes and that could get the managers fired$
)he manager is not likely to get fired if heJshe provide evidence that ,ased on the
availa,le information the decision was sound$ 3 convenient way to do this is to use mean
variance analysis as shown ,elow$
+emonstration 12-3
!uppose a ris1 a-erse manager is consi,ering t6o options expan,ing the mar1et for
.ologna an, expan,ing the mar1et for ca-iar. !uppose that there is a K)V chance of
an economic .oom an, 1)V of a recession. !uppose also< there is a ris1 free
alternati-e (sa/< a treasur/ .ill). 8he manager can ha-e a Zoint proZect that
com.ines .ologna an, ca-iar. 8he four proZects an, their pa/offs ,uring .oom an,
recession are gi-en .elo6. 2hat shoul, the manager ,o3 2h/3
O1
$roZect Foom (K)V) #ecession (1)V) %ean !tan,ar, +e-iation
Fologna ;B16,666 B1",666 ;BS,866 L,L66
Ca-iar "6,666 ;8,666 1S,"66 8,066
]oint 16,666 0,666 O,066 1,866
8-Fill #,666 #,666 #,666 6
0ns6er
8he manager shoul, not in-est in 8-.ill .ecause the lo6est pa/off for Zoint proZect is
greater than 3<))) 6hich is the pa/off for 8-.ills. %oreo-er< ris1 a-erse an, ris1
neutral managers 6ill not in-est in a proZect 6ith negati-e expecte, pa/off. 8his 6ill
eliminate the .ologna proZect. 8his 6ill lea-e the manager 6ith t6o proZects the
ca-iar an, Zoint proZects. 2hich of these t6o proZects< 6hich ha-e ,ifferent expecte,
-alues an, ris1< 6oul, the manager in-est3 Ct all ,epen,s on his"her preferences
to6ar, ris1.
8he pa/offs associate, 6ith the Zoint proZect a.o-e re-eal the importance of
,i-ersification. F/ in-esting in multiple proZects the manager< can re,uce the
s/stematic ris1.
+i-ersification also re-eals 6h/ sharehol,ers are ris1 neutral. 8he/ 6ant managers
to maximize the -alue of the firm 6ithout a regar, to ris1. 8his is .ecause
sharehol,ers ,i-ersif/ in ,ifferent stoc1s. 2e 1no6 that ,i-ersification ,i-ersifies
s/stematic ris1 a6a/.
$ro,ucer !earch
%roducers search for low prices of inputs when there is uncertainty regarding input prices,
firms employ optimal search strategies$
+emonstration 12-G
OL
$rofit %aximization On,er Oncertaint/
5nder certainty profit is
= > %9 F C (9
)hen first profit ma4imization rule is
M' > MC
3nd under perfect competition this rule is:
% > MC
which is solved for 9:$
5nder uncertainty, demand is uncertain and thus total revenue is uncertain$ )he firm
ma4imizes e4pected profit$
& = > &%:9 F C(9
where &% > /1 : p1 N /" : p" N]$$ is the e4pected price and /i is the e4pected price and /i
is the i
th
pro,a,ility$ )hen first;profit ma4imization rule is &M' > M$
Dhere &M' is the e4pected marginal revenue under perfect competition, this rule is &% >
MC Dhich can ,e solved for 9
6
Q
+emonstration 12-=
!uppose the perfectl/ competiti-e firm 0pple6a/ must ,etermine ho6 much to
pro,uce .efore the actual price is un1no6n. 8he firm 1no6s the expecte, price.
8here is a 1)V pro.a.ilit/ that the mar1et price is '2 an, ?)V that the mar1et
price '1 6hen the apple Zuice hits. 8hen the expecte, price is
*$ & ).1 * ('2) 7 ).? * (1) & ).( 7 ).?) & '1.3)
!uppose the cost function is gi-en ./
C & 2)) 7 ).)))= Q
2
5o6 much shoul, this firm pro,uce to maximize expecte, profit3 2hat are the
expecte, profits of this firm3
0ns6er
!et *$ & %C
8hen '1.3) & ).))1Q
Q* & 1<3)) gallons
*xpecte, $rofit & *$*Q > 2)) > ).)))=Q
2
& (1.3)) (1<3))) > 2)) > ).)))= (1<3)))
2
OS
& 1<(K) > 2)) > ).)))= (1<3)))
2
& '(G=
Oncertaint/ an, the %ar1et
)he presence of uncertainty may have a strong impact on the a,ility of the markets to
efficiently allocate resources ,ecause it creates pro,lems with the market$
3symmetric Information
3 situation that e4ists when some people in the market has more information than other$
)he people with the least information may choose not to participate in the market$ (or
e4ample, if a person has a ,o4 and she knows it has B16$ )hese people who do not have
this information will not accept to ,uy the ,o4 from her ,ecause she will not sell the ,o4
at a loss$
In the stock market when some traders have insider information and others do not, there
is a asymmetric information$ In e4treme cases asymmetric information can lead to the
destruction of stock markets if asymmetric information continues to e4ist$
3symmetric information ,etween consumers and the firm can affect the firm-s profit$
2uppose the firm invests heavily and produces a superior product$ If the consumer does
not have this information, it will not ,uy this superior product$
3symmetric information may also affect many managerial decisions including hiring
workers (workers know this a,ilities ,etter then managers do, issuing credit to
consumers (consumers know their credit a,ilities$ )his is why companies spend a lot of
money checking on individuals and their ,ackgrounds$
)here are two specific manifestations (types of asymmetric information: adverse
selection and moral hazard$ )hose two concepts are difficult to distinguish$
3dverse selection arises when an individual has hidden characteristics
(characteristics that she knows ,ut unknown ,y the other pro4y in an economic
transaction$ (or e4ample, the Wo, applicant knows his own a,ilities, ,ut the
employee does not$ )he workers a,ilities thus reflect a hidden characteristic$
O8
Moral hazard generally takes place when one pro4y takes hidden actions (actions
that it knows another party cannot o,serve$ (or e4ample, if a manager cannot
monitor (o,serve hidden action then the workers effort represent a hidden action$
3dverse 2election
3 situation where individuals have hidden characteristics and in a selection process
results in a pool of individuals with economically undesira,le characteristics$
&4ample1: 3n industry with firms that allow 1 days of paid sick leave$ *ne firm decides
to allow 16 days$ If the workers have hidden characteristics (the firm cannot distinguish
,etween healthy and unhealthy workers$ )his increase in the monthly sick leave will
mostly attract unhealthy workers$ Aealthy workers are not interested in this policy$
*xample2: 3 pool of poor drivers may have adverse selection$ )his pool includes two
types of poor drivers: those who have ,ad driving ha,its, and those who had a string of
,ad luck$ If the insurance companies increase the insurance premium on this pool, only
drivers with ,ad ha,its would accept to pay the higher premium ,ut those who had ,ad
luck won-t accept to pay the higher premium$ )hen the insurance company will end up
with the ,ad drivers and in this selection there is adverse impact$ )he insurance company
should not increase the premium ,ut should refuse to insure the ,ad drivers$ )here are
insurance companies who specialize in ,ad drivers and they ask them to pay a high
premium$
Moral Aazard
3 situation where one party to a contract takes a hidden action that will ,enefit himJher at
the e4pense of another party is called a moral hazard$
*xample 1 The principal agent problem$ In this case the principal (the owner offers the
agent (the manager a contract (a salary N ,enefits to do certain tasks$ 2ince the manager
will receive the salary, and hisJher ,ehavior is uno,serva,le ,y the owner, heJshe has
incentives to work less (hidden actions$ )he reduced effort may result in reducing profit$
*ne way to mitigate this moral hazard ,y the owner is to monitor the ,ehavior of the
manager (taking away the hidden action$ 3nother way is to compensate the manager
,ased on his performance$
OO
*xample 2: Vealth insurance7 Insurance companies are vulnera,le to the moral hazard
pro,lem$ )he pro,a,ility of a loss depends on the hidden efforts e4pended ,y the insured
to avoid the loss$ )his moral hazard e4ists$ Dhen individuals are fully insured they have a
reduced incentive to put forth effort to avoid a loss$
2ignaling and 2creening
Managers and other market participants can use signaling and screening to mitigate some
of the pro,lems that arise when one party to a transaction has hidden characteristics$
2ignaling is an attempt ,y an informed party to send an o,serva,le indicator of hisJher
hidden characteristic to an uninformed party$ )hus signal must ,e o,serva,le$
&4ample of Uo,serva,le indicatorsV in the product markets are that companies send
signals such as money ,ack guarantees, free trial, la,eling that indicates the product has
won a Uspecial awardV or the manufacturer has ,een in ,usiness since say, 1O##$
In the la,or markets, the signal takes the form that the Wo, applicant graduated from a
certain prestigious school$ If the productivity of the Wo, seeker is uno,serva,le that will
lead to lower salaries for ,oth the productive and unproductive workers$ In this case
productive workers should find ways to provide information to the manager that reveals
that they are indeed productive$ Aow can productive workers send the right signals to the
manager that they are productiveQ )alk is cheap$ 5nproductive workers should not easily
mimic the signal$
2creening
)he uninformed party can use screening to reduce the effects of hidden characteristics$
&4ample: In this Wo, market, the manager can use a self;selection device to distinguish
,etween peoples- skills$
*xample )wo people with different characteristics are applying for a Wo, in a company$
*ne applicant is an administrator and the other is a salesman$ )he manager can use a self;
selection device to fit the two workers to the right Wo,$ )he device may stipulate that the
manager-s Wo, will pay B"6,666 and the salesman Wo, pays 16X of total sales$ )he second
worker who identifies his characteristic to ,e a salesman he will ask for the salesman Wo,$
Ae knows he is a salesman and can generate a million dollars in sales$ )hen this salesman
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compensation is B166,666 (16X:1Mn, which is higher than the B"6,666 Wo,$ )he
manager knows that his a,ility does not fit the salesman Wo,$ Ae will go for the
administrative Wo,$;

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