Microeconomics Merged

R.
GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
MICROECONOMICS
FIFTH EDITION
GLOBAL EDITION
© Pearson Education Limited 2015
CHAPTER
CHAPTER
14 Firms in Less Competitive Markets

Oligopoly:
Chapter Outline and

Learning Objectives
14.1 Oligopoly and Barriers to

Entry
14.2 Using Game Theory to
Analyze Oligopoly
14.3 Sequential Games and
Business Strategy
14.4 The Five Competitive Forces
Model
© Pearson Education Limited 2015 2 of 34

Oligopoly: A Very Different Market Structure
In the previous chapters, we examined perfect and monopolistic
competition.
We were able to use similar logic to argue how those firms would
behave: they would produce until their marginal cost was equal to
marginal revenue, and the low barriers to entry would result in profit
being competed away in the long run.
Oligopoly, a market structure in which a small number of
interdependent firms compete, will require completely different tools
to analyze. Why?
1. Oligopolists are large, and know that their actions have an effect
on one another.
2. Barriers to entry exist, preventing firms from competing away
profits.

Oligopoly and Barriers to Entry
14.1 LEARNING OBJECTIVE

Show how barriers to entry explain the existence of oligopolies.

Which Markets Are Oligopolistic?
Before we analyze how oligopolists behave, it is useful to know which
firms/markets we are discussing.
A useful tool for identifying the type of market structure is the four-firm
concentration ratio: the fraction of an industry’s sales accounted for
by its four largest firms.
A four-firm concentration ratio larger than 40% tends to indicate an
oligopoly.
Although there are limits to how useful four-firm concentration ratios
can be, they are a useful tool in discussing the concentration of
market power within an industry.

Examples of Oligopolies
Retail Trade Manufacturing
Four-Firm Four-Firm
Concentration Concentration
Industry Ratio Industry Ratio
Discount department 97% Cigarettes 98%
stores
Warehouse clubs and 94% Beer 90%
supercenters
College bookstores 75% Computers 87%
Hobby, toy, and game 72% Aircraft 81%
stores
Radio, television, and 70% Breakfast cereal 80%
other electronic stores
Athletic footwear stores 68% Dog and cat food 71%
Pharmacies and 63% Automobiles 68%

drugstores
Table 14.1 Examples of oligopolies in

retail trade and manufacturing
Why Do Oligopolies Exist?
Oligopolies often exist because of barriers to entry: anything that
keeps new firms from entering an industry in which firms are earning
economic profits.
One example of a barrier to entry is economies of scale: the

situation when a firm’s long-run average costs fall as the firm
increases output.
• This can make it difficult for new firms to enter a market, because
new firms usually have to start small, and will hence have
substantially higher average costs than established firms.

Economies of Scale and the Extent of Competition
An industry will be
competitive if the
minimum point on the
typical firm’s long-run
average cost curve
(LRAC1) occurs at a
level of output that is a
small fraction of total
industry sales, such as
Q1.
The industry will be an

oligopoly if the minimum
point comes at a level of
output that is a large Figure 14.1 Economies of scale help
fraction of industry determine the extent of
competition in an industry
sales, such as Q2.
Why Else Do Oligopolies Exist?
Ownership of a key input
• If control of a key input is held by one or a small number of firms, it
will be difficult for additional firms to enter.
• Examples: Alcoa—bauxite for aluminum production
De Beers—diamonds
Ocean Spray—cranberries
Government-imposed barriers
• Governments might grant exclusive rights to some industry to one
or a small number of firms.
• Examples: Occupational licensing for dentists and doctors
Patents
Tariffs and quotas imposed on foreign companies
Patent: The exclusive right to a product for a period of 20 years from
the date the patent is filed with the government.
Using Game Theory to Analyze Oligopoly

Use game theory to analyze the strategies of oligopolistic firms.

Why Do We Need a Special Theory for Oligopoly?
Perfect and monopolistic competitors were easily analyzed using a
graph of their own costs and revenues.
But remember that each of these firms were small relative to the
market, so their actions were essentially insignificant to other firms.
This is not true for oligopolies. Oligopolists are large relative to the
market, and the actions of one oligopolist make large differences in
the profits of another.
Oligopolies are best analyzed using a specialized field of study called
game theory.
Game theory: The study of how people make decisions in situations
in which attaining their goals depends on their interactions with
others; in economics, the study of the decisions of firms in industries
where the profits of a firm depend on its interactions with other firms.

Game Theory
Game theory was developed during the 1940s and advanced by
mathematicians and social scientists like economists.
All “games” share certain characteristics:
1. Rules that determine what actions are allowable
2. Strategies that players employ to attain their objectives in the
game
3. Payoffs that are the results of the interactions among the players’
strategies
For example, we can model firm production as a “game”:

• Rules: the production functions and market demand curve
• Strategies: Firms’ production decisions
• Payoffs: Firms’ profits

A Duopoly Game: Price Competition Between Two Firms
In this payoff matrix, Sony’s

profits are in blue, and
Microsoft’s profits are in red.
Sony and Microsoft would
each make profits of $10
million per month on sales of
video game consoles if they Figure 14.2 A duopoly game
both charged $499.
If one charges $499 and the other charges $399, the one with a
low price earns $15 million per month, while the other earns only
$5 million per month.
If both firms charge $399, they would each make a profit of only
$7.5 million per month.
How would you “play” this duopoly game?
Duopoly: An oligopoly with two firms
A Dominant Strategy for Sony
Suppose you are Sony in

this duopoly game.
• If Microsoft charges
$499, you earn more
profit by charging $399.
• If Microsoft charges
$399, you earn more Figure 14.2 A duopoly game
profit by charging $399.
Either way, charging $1,000 seems makes the most profit. It is a
dominant strategy for Sony.
Dominant strategy: A strategy that is the best for a firm, no matter

what strategies other firms use.

A Dominant Strategy for Microsoft Also
Now suppose you are

Microsoft:
• If Sony charges $499,
you earn more profit by
charging $399.
• If Sony charges $399,
you earn more profit by Figure 14.2 A duopoly game
charging $399.
Either way, charging $399 seems makes the most profit. It is a
dominant strategy for Microsoft to charge $399 also!
Each firm charging $399 is a Nash equilibrium: a situation in

which each firm chooses the best strategy, given the strategies
chosen by the other firms.

Could the Firms Do Better?
Notice that this outcome

is not good for Sony or
Microsoft; if they could
cooperate somehow, they
could each earn more Figure 14.2 A duopoly game
profit.
This is the benefit of collusion: an agreement among firms to

charge the same price or otherwise not to compete.
Collusion is against the law in the United States, but you can see
why firms might be tempted to collude: their profits could be
substantially higher.

Prisoner’s Dilemma
Economists and other social scientists refer the situation with Sony
and Microsoft as a prisoner’s dilemma: a game in which pursuing
dominant strategies results in noncooperation that leaves everyone
worse off.
The name comes from a problem faced by two suspects the police
arrest for a crime.
• The police offer each suspect a suspended prison sentence in
exchange for confessing to the crime and testifying against the
other suspect.
• Each suspect has a dominant strategy to confess; but if both
confess, they both go to jail for a long time, while they both could
have gone to jail for a minimal length if they had both remained
silent.

Making Is There a Dominant Strategy for Bidding on eBay?
the
Connection
Standard eBay auctions
function as second-price
auctions: the high bidder
wins the item, and pays the
price bid by the second-
highest bidder.
An intuitive strategy for
bidding on eBay is to shade
your bid: bidding somewhat
less than your valuation.
But this intuition is incorrect. In fact, eBay bidders have a dominant
strategy: bid exactly how much they value the object.
How can this be?

Making
the A Dominant Strategy for Bidding on eBay
Connection
Suppose you are bidding on
a concert ticket worth $200
to you.
If you bid less than $200,
then either:
• You win—but you pay the
same as if you had bid
$200, so there was no
advantage to bidding
less; or
• You lose; if someone bids more than $200, then you would have
lost anyway. But if the winning bid was less than $200, you will
wish you had bid $200.
Similar logic applies if you bid more than $200. Bidding $200 is a
dominant strategy!
Can Firms Escape the Prisoner’s Dilemma?
Suppose Domino’s and Pizza
Hut are deciding how to price
a pizza: $12 or $10.
• This game gets played not
once, but every day.
A clever way to avoid the low-
profit Nash equilibrium is to
advertise a price-match
guarantee. Then if either firm
cuts prices, the other has
guaranteed to do so as well.
• Now neither firm will have
an incentive to cut prices.
• Price-match guarantees
aren’t as good for
consumers as they appear. Figure 14.3 Changing the payoff matrix
© Pearson Education Limited 2015 in a repeated game 20 of 34
Other Methods for Avoiding Price Competition
A price-match guarantee is an enforcement mechanism, making
automatic the decision about whether to punish a competing firm for
charging a low price.
Another method is price leadership, a form of implicit collusion in
which one firm in an oligopoly announces a price change and the
other firms in the industry match the change.
• Example: In the 1970s, General Motors would announce a price
change at the beginning of a model year, and Ford and Chrysler
would match GM’s price change.
Such forms of implicit collusion are desirable for firms, because

explicit collusion is illegal, resulting in government fines and penalties,
along with a possible public backlash.

Making
the With Price Collusion, More Is Not Merrier
Connection
Airlines are a good example of
an oligopoly. Airlines often
implicitly collude, having
unspoken understandings with
one another not to compete on
price.
If one airline cuts prices, the
others will retaliate, decreasing
industry profits for all (since
airline travel is relatively price-
inelastic).
Thus, the same route is often identically priced by several different
airlines.
Implicit understandings like this are easier to enforce with fewer
competitors, which helps to explain why price competition often
results when new firms enter a market.
Cartels: The Case of OPEC
A cartel is a group
of firms that collude
by agreeing to
restrict output to
increase prices and
profits.
This form of explicit
collusion is illegal in
the United States;
but not in some
other locations. Figure 14.4 Oil prices, 1972 to mid-2013
The most well-known cartel is OPEC, the Organization of the

Petroleum Exporting Countries.
• OPEC members colluded to restrict output and raise prices in the
1970s and 1980s.
• But collusion has proved difficult to maintain over time.
Analyzing the OPEC Cartel with Game Theory
Because Saudi Arabia
can produce much
more oil than Nigeria, its
output decisions have a
much larger effect on
the price of oil.
• Saudi Arabia has a
dominant strategy to
cooperate and
Figure 14.5 The OPEC cartel with
produce a low unequal members
output.
Nigeria, however, has a dominant strategy not to cooperate and
instead produce a high output.
• In order to punish Nigeria for defecting, Saudi Arabia would have
to hurt itself substantially. Would it be worth it to you?

Sequential Games and Business Strategy

Use sequential games to analyze business strategies.

Simultaneous vs. Sequential Games
The game theory models we have analyzed so far have been
simultaneous: the players have made their decisions at the same
time.
But some games are sequential in nature: one firm makes a decision,
and the other makes its decision having observed the first firm’s
decision.
• We analyze such games using a decision tree, indicating who gets
to make a decision at what point, and what the consequences of
their decision will be.

The Decision Tree for an Entry Game
In this game, Apple

decides whether to
charge $1000 or
$800 for its new ultra
light laptop;
then Dell decides
whether or not to Figure 14.6
enter the market. The decision tree for an entry game
Apple “looks ahead”, and realizes that if it charges the high price,
Dell will enter and compete with Apple.
If Apple charges the low price, Dell’s rate of return will not be
sufficient to warrant entry.
So Apple can deter Dell from entering the market by preemptively
charging the low price.
The Decision Tree for a Bargaining Game
Dell is deciding
whether to offer $20
or $30 per copy for
TruImage’s software.
Then TruImage will
have the opportunity
to accept or reject Figure 14.7
the offer. The decision tree for a bargaining game
Dell will look ahead, and realize that TruImage is better off
accepting Dell’s offer, no matter what price Dell offers.
Therefore Dell should offer the low price, anticipating that TruImage
will accept the offer.

Can TruImage Threaten Not to Accept the Offer?
Notice that
TruImage would
like to threaten to
reject an offer of
$20.
If Dell believed the
threat, its best
action would be to Figure 14.7
offer $30. The decision tree for a bargaining game
But Dell shouldn’t believe the threat; it is not credible, since it would
involve TruImage hurting itself with no opportunity for redemption.
Only the original outcome is a subgame-perfect equilibrium: a Nash
equilibrium in which no player can improve their outcome by changing
their decision at any decision node.

The Five Competitive Forces Model

Use the five competitive forces model to analyze competition in an industry.

The Five Competitive Forces Model
Michael Porter of Harvard Business School identifies five separate
competitive forces that determine the overall level of competition in an
industry:
1. Existing firms
Example: Educational Testing Service administers the SAT ($51) and
GRE ($150) tests. The SAT has competition from the ACT, helping
keep its price low. The GRE has no similar competitor.
2. Threat from new entrants

Example: In the previous section, Apple charged a low price to deter
Dell from entering its market.

The Five Competitive Forces Model—continued
3. Competition from substitutes
Example: Printed encyclopedia sets used to cost well over $1000, but
parents would buy them because there were no good substitutes.
But the advent of cheap computer-based encyclopedias helped drive
printed encyclopedia producers out of business.
4. Bargaining power of buyers

Example: Large companies like Wal-Mart can threaten to buy goods
from competitors, forcing suppliers to keep their prices low.
5. Bargaining power of suppliers

Example: As a start-up, Microsoft couldn’t force IBM to pay a high
price for its operating system.
But as Microsoft became the dominant player in operating systems, it
could charge much more to computer manufacturers.
Making Predicting Which Firms Will Continue to be Successful
the
Connection
It is generally very difficult to predict
which companies will be successful
long-term.
For example, in 2002 a best-selling
business book identified Circuit City
as a company that might “achieve
enduring greatness”.
• But in 2009, Circuit City filed for
bankruptcy.
“Enduring greatness” and continued

economic profits require a firm to
constantly work to maintain its
advantage.
• A good dose of luck goes a long
way, too.
Common Misconceptions to Avoid
When analyzing game-theoretic situations in class, stick to the rules
of the game.
• For example, many students disbelieve the prisoner’s dilemma
story, and try to use undescribed motivations to decide what to do.
“Obvious answers” are often not correct when analyzing strategic

situations. For example, price-match guarantees are actually good for
firms, and much less good for consumers.

R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
MICROECONOMICS
FIFTH EDITION
GLOBAL EDITION
CHAPTER
CHAPTER
Monopolistic Competition:
13 The Competitive Model in
a More Realistic Setting
Chapter Outline and
Learning Objectives
13.1 Demand and Marginal Revenue for a
Firm in a Monopolistically
Competitive Market
13.2 How a Monopolistically Competitive
Firm Maximizes Profit in the Short
Run
13.3 What Happens to Profits in the Long
Run?
13.4 Comparing Monopolistic
Competition and Perfect Competition
13.5 How Marketing Differentiates
Products
13.6 What Makes a Firm Successful?
Perfect Competition vs. Monopolistic Competition
The perfectly competitive markets in the previous chapter had the
following three features:
1. Many firms
2. Firms sell identical products
3. No barriers to entry to new firms entering the industry
The first two features implied a horizontal demand curve for individual
firms, while the third implied zero long-run profit.
Monopolistically competitive firms share features 1. and 3.; but their
products are not identical to their competitors’.
So we expect monopolistically competitive firms to have zero long-run
profit, but not to face a horizontal demand curve.

Demand and Marginal Revenue for a Firm in a
Monopolistically Competitive Market

Explain why a monopolistically competitive firm has downward-sloping demand
and marginal revenue curves.

Monopolistic Competition
Monopolistic competition is a market structure in which barriers to
entry are low and many firms compete by selling similar, but not
identical, products.
The key feature here is that the products that monopolistically
competitive firms sell are differentiated from one another in some
way.
Example: Starbucks sells coffee, and competes in the coffee market
against other firms selling coffee.
But Starbucks’ coffee is not identical to the coffee that other firms sell.

The Demand Curve for a Monopolistically Competitive Firm
Starbucks sells caffè

lattes; while other firms
sell caffè lattes also,
some people have a
preference for the
ones that Starbucks
sells.
If Starbucks raises the
price of its caffè lattes,
it will lose some, but
not all, of its
customers.
Therefore Starbucks
faces a downward- Figure 13.1 The downward-sloping
demand for caffè lattes
sloping demand curve
at a Starbucks
for caffè lattes.
Marginal Revenue When Demand Is Downward-Sloping
CAFFÈ LATTES PRICE (P)
SOLD PER
WEEK (Q)
0 $6.00 $0.00 ― ―
1 5.50 5.50 $5.50 $5.50
2 5.00 10.00 5.00 4.50
3 4.50 13.50 4.50 3.50
4 4.00 16.00 4.00 2.50
5 3.50 17.50 3.50 1.50
6 3.00 18.00 3.00 0.50
7 2.50 17.50 2.50 –0.50
8 2.00 16.00 2.00 –1.50
9 1.50 13.50 1.50 –2.50
10 1.00 10.00 1.00 –3.50
The first two columns show the Table 13.1 Demand and marginal
demand schedule for Starbucks. revenue at a Starbucks
Total revenue increases initially, then decreases; Starbucks has to

lower the price in order to sell additional caffè lattes.
Hence marginal revenue is initially positive, then negative.
How a Price Cut Affects Firm Revenue
When Starbucks
reduces the price
of a caffè latte, it
can sell more
output.
Its revenue
increases because
of the additional
sale (at the new
price); this is the
output effect of the
price reduction. Figure 13.2 How a price cut affects
a firm’s revenue
But its revenue decreases also. In order to sell the
additional caffè latte, it must reduce the price on all cups it
will sell. The loss in revenue on the 5 cups it would have
sold anyway is the price effect of the price reduction.
Marginal Revenue
Starbucks’ marginal
revenue for selling the
additional caffè latte is
equal to the green area
minus the pink area:
the output effect minus
the price effect.
Since the output effect
is just equal to the
price, marginal
revenue is lower than
price. Figure 13.2 How a price cut affects
a firm’s revenue
For any firm with a downward-sloping demand curve, the
marginal revenue curve must therefore be below the
demand curve.
Demand and Marginal Revenue Curves
The graph shows the
Starbucks’ demand and
marginal revenue curves for
caffè lattes.
After the 6th caffè latte,
reducing the price in order to
increase sales results in
revenue decreasing
(negative marginal revenue);
the output effect (equal to
the height of the demand
curve) can no longer offset
the price effect (the vertical
difference between demand
Figure 13.3 The demand and marginal
and marginal revenue revenue curves for a
curves). monopolistically competitive
firm
How a Monopolistically Competitive Firm Maximizes
Profit in the Short Run

Explain how a monopolistically competitive firm maximizes profit in the short
run.

Profit Maximization
Just like a perfectly competitive firm, a monopolistically competitive
firm should not simply try to maximize revenue.
Each additional unit of output incurs some marginal cost.
Profit maximization requires producing until the marginal revenue
from the last unit is just equal to the marginal cost: MC = MR.
This same rule holds for all firms that can marginally adjust their
output.

Profit Maximization Using a Table
The 1st, 2nd, 3rd, and 4th caffè lattes Figure 13.4 Maximizing profit in a
monopolistically
each increase profit: MC < MR. competitive market
The 5th does not alter profit: MC = MR.

The 6th and subsequent caffè lattes decrease profit: MC > MR.
Profit Maximization Using Graphs
Starbucks sells caffè lattes up until Figure 13.4 Maximizing profit in a

monopolistically
MC = MR. competitive market
This selects the profit-maximizing quantity. Then the demand curve
shows the price, and the ATC curve shows the average cost.
Since Profit = (P – ATC) x Q, we can show profit on the graph with
the green rectangle.
Identifying Profit Graphically
Be careful to perform these steps
in the correct order:
1. Use MC=MR to identify the
profit-maximizing quantity.
2. Draw a vertical line at that
quantity.
3. The vertical line will hit the
demand curve: this is the
price.
4. The vertical line will also hit
the ATC curve: this is the Figure 13.4b Maximizing profit in a
average cost. monopolistically
competitive market
5. The difference between price and
average cost is the profit (or loss) per unit.
6. Show the profit or loss with the rectangle with height (P – ATC)
and length (Q* – 0), where Q* is the optimal quantity.
What Happens to Profits in the Long Run?

Analyze the situation of a monopolistically competitive firm in the long run.

How the Entry of New Firms Affects Profits of Existing Firms
Figure 13.5 How entry of new firms

Suppose demand is relatively high, eliminates profits
so that Starbucks can make a profit in the market for caffè lattes.
This profit will attract new firms who will compete with Starbucks,
reducing the demand for Starbucks’ caffè lattes.
Demand falls until, in the long run, no profit can be made: P = ATC.
Monopolistic Competition: Short Run, Firm Making Profit
Relationship between Price Relationship between Price Profit and Loss

and Marginal Cost and Average Total Cost
Short Run Short Run Short Run
P > MC P > ATC Economic profit
Table 13.2a The short run and the long run for a
monopolistically competitive firm
In the short run, a monopolistically competitive firm might make a

profit or a loss.
The situation where the firm is making a profit is above.
Notice that there are quantities for which demand (price) is
above ATC; this is what allows the firm to make a profit.
Monopolistic Competition: Short Run, Firm Making Loss

Short Run Short Run Short Run
P > MC P < ATC Economic loss
Table 13.2b The short run and the long run for a
Now the firm is making a loss.

Notice that there is now no quantity for which demand (price) is
above ATC; this firm must make a (short-run, economic) loss, no
matter what quantity it chooses.

Monopolistic Competition: Long Run, Firm Breaking Even

Long Run Long Run Long Run
P > MC P = ATC Zero economic profit
Table 13.2c The short run and the long run for a
In the long run, the firm must break even.

Notice that the ATC curve is just tangent to the demand curve.
The best the firm can do is to produce that quantity.
There is no quantity at which the firm can make a profit; the ATC
curve is never below the demand curve.
Zero Profit in the Long Run?
Our model of monopolistic competition predicts that firms will earn
zero profit in the long run.
However firms need not passively accept this long-run outcome. They
could:
• Innovate so that their costs are lower than other firms, or
• Convince their customers that their product/experience is better
than that of other firms, either by actually making it better in some
unique way, or making customers perceive that it is better, perhaps
through advertising.
Think of the long-run as “the direction of trend”; demand will continue
to fall to the zero (economic) profit level, unless the firm is able to do
something about it.

Making
the The Rise and Decline and Rise of Starbucks
Connection
From the mid-1990s to the mid-2000s,
Starbucks achieved strong profits by
differentiating its product and experience
from other coffeehouses.
As other firms started to mimic its experience,
Starbucks’ profitability went down.
By 2013, Starbucks had engineered a
turnaround, with innovations like wi-fi,
customization of drinks, a loyalty program,
smartphone-based payments, overseas
expansion, and higher-quality drinks.
But like all monopolistically competitive firms,
Starbucks will have to continue to innovate,
or the long-run outcome of zero economic
profit will catch up to it.
Comparing Monopolistic Competition
and Perfect Competition

Compare the efficiency of monopolistic competition and perfect competition.

Is Monopolistic Competition Efficient?
Last chapter we learned that perfectly competitive firms achieved
productive and allocative efficiency.
• Productive efficiency refers to producing items at the lowest
possible cost.
• Allocative efficiency refers to producing all goods up to the point
where the marginal benefit to consumers is just equal to the
marginal cost to firms.
Monopolistic competition results in neither productive nor allocative

efficiency.

Efficiency of Perfectly Competitive Firms
Figure 13.6a Comparing long-run equilibrium under perfect

competition and monopolistic competition
In panel (a), a perfectly competitive firm in long-run equilibrium
produces at QPC, where price equals marginal cost, and average
total cost is at a minimum.
The perfectly competitive firm is both allocatively efficient and
productively efficient.
Inefficiency of Monopolistically Competitive Firms
Figure 13.6a&b Comparing long-run equilibrium under perfect

competition and monopolistic competition
Monopolistically competitive firms in panel (b) produce the quantity
where MC=MR. The marginal benefit to consumers is given by the
demand curve, so MC≠MB: not allocatively efficient.
And average cost is above its minimum point: not productively
efficient.
Is Monopolistic Competition Bad for Consumers?
The lack of efficiency suggests that monopolistic competition is a bad
situation for consumers.
But consumers might benefit from the product differentiation.
Example: If you were buying a car, would you prefer one

a. Produced and sold at the lowest possible cost, but not well-suited
to your tastes and preferences; or
b. Produced and sold at a higher cost, but designed to attract you to
purchasing it?
Many consumers are willing to accept a higher price for a

differentiated product. So monopolistic competition is not necessarily
bad for consumers.
Making
the Peter Thiel and Monopolistic Competition
Connection
Peter Thiel is a billionaire entrepreneur:
a co-founder of PayPal, and an early
investor in LinkedIn, Zynga, and
Facebook.
Thiel recommends entrepreneurs focus
on the monopoly part of monopolistic
competition; there are economic profits
to be made in the short run if you can
“own a market”; according to Thiel, by:
• Having brand, scale, or cost
advantages
• Taking advantage of network effects
• Having proprietary technology
Thiel’s latest project: investing in NJOY,
a firm making e-cigarettes.
How Marketing Differentiates Products

Define marketing and explain how firms use marketing to differentiate their
products.

Marketing and Product Differentiation
Making customers believe that your product is worthwhile and
different from those of other firms is not a trivial exercise. It typically
involves some degree of marketing.
Marketing: All the activities necessary for a firm to sell a product to a
consumer.
Once a firm manages to differentiate its product, it must continue to

do so, or risk heading toward the long-run outcome of zero economic
profit. The process of doing this is known as brand management.
Brand management: The actions of a firm intended to maintain the
differentiation of a product over time.

Advertising
Advertising is a critical element of marketing for monopolistically
competitive firms.
By advertising effectively, firms can increase demand for their
products.
But they can also use advertising to differentiate their products:
effectively making the demand curve more inelastic.
This allows firms to charge a higher price and earn more short-run
profit.

Defending a Brand Name
Marketing experts and psychologists agree: a critical aspect of
marketing is creating a brand name for your product.
A successful brand name can help to maintain product differentiation,
and delay the ability of other firms to compete away your profits.
But firms must always try to maintain the perception of their product
as better than others, making sure that, for example:
• A highly-successful name like Coke, Xerox, or Band-Aid is
uniquely associated to that product, and not to generic products,
• Other firms don’t illegally use their brand name, and
• Franchisees and others legally allowed to use their brand name
maintain the level of quality and service you expect.

What Makes a Firm Successful?

Identify the key factors that determine a firm’s success.

What Makes a Firm Successful?
A firm’s ability to differentiate its product and to produce it at a lower
average cost than competing firms creates value for its customers.
Some factors that affect a firm’s profitability are not directly under
the firm’s control. Certain factors will affect all the firms in a market.
The factors under a

firm’s control—the
ability to differentiate
its product and the
ability to produce it
at lower cost—
combine with the
factors beyond its
control to determine
the firm’s profitability.
Figure 13.7 What makes a firm successful?

Making Is Being the First Firm in the Market a Key to Success?
the
Connection
By being the first to sell a particular good, a firm
may gain a first-mover advantage, finding its name
closely associated with the good in the public’s
mind.
Surprisingly, though, recent research has shown
that the first firm to enter a market often does not
have a long-lived advantage over later entrants.
The Reynolds International Pen Company was
replaced by Bic; Apple’s iPod was not the first
digital music player; and Hewlett-Packard, which
currently dominates the laser printer market was
preceded by its inventor, Xerox. The same can be
said for disposable diapers, and web browsers.
In the end, providing customers with good products
at a low price is probably the best way to ensure
success.
Monopolistically competitive firms produce the quantity where MC =
MR, not the lowest possible average cost.
Use the marginal cost and marginal revenue curves to determine

quantity; then use the demand and average total cost curves to
determine price, cost, and profit or loss.
Although our model predicts zero economic profit in the long run, the
long run might be delayed indefinitely by innovative firms.

MICROECONOMICS
Ninth Edition
By Robert S. Pindyck and Daniel L.

Rubinfeld
Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved
Chapter 12
Monopolistic Competition and Oligopoly
CHAPTER OUTLINE LIST OF EXAMPLES
12.1 Monopolistic Competition 12.1 Monopolistic Competition in the
12.2 Oligopoly Markets for Colas and Coffee
12.3 Price Competition 12.2 A Pricing Problem for Procter &
12.4 Competition versus Collusion: Gamble
The Prisoners’ Dilemma 12.3 Procter & Gamble in a Prisoners’
12.5 Implications of the Prisoners’ Dilemma
Dilemma for Oligopolistic 12.4 Price Leadership and Price Rigidity in
Pricing Commercial Banking
12.6 Cartels 12.5 The Prices of College Textbooks
12.6 The Authors Debate the Cartelization
of Intercollegiate Athletics
12.7 The Auto Parts Cartel
Monopolistic Competition and
Oligopoly
Monopolistic competition Market in which firms can enter
freely, each producing its own brand or version of a
differentiated product.
Oligopoly Market in which only a few firms compete with
one another, and entry by new firms is impeded.
cartel Market in which some or all firms explicitly collude,
coordinating prices and output levels to maximize joint
profits.
12.1 Monopolistic Competition (1 of 6)
The Makings of Monopolistic Competition
A monopolistically competitive market has two key
characteristics:
1. Firms compete by selling differentiated products that are
highly substitutable for one another but not perfect
substitutes. In other words, the cross-price elasticities of
demand are large but not infinite.
2. There is free entry and exit: It is relatively easy for new
firms to enter the market with their own brands and for
existing firms to leave if their products become
unprofitable.
Equilibrium in the Short Run and the Long Run
Figure 12.1 (1 of 2)
A MONOPOLISTICALLY COMPETITIVE FIRM

IN THE SHORT AND LONG RUN
Because the firm is the only producer of its

brand, it faces a downward-sloping demand
curve.
Price exceeds marginal cost and the firm has

monopoly power.
In the short run, described in part (a), price also

exceeds average cost, and the firm earns profits
shown by the yellow-shaded rectangle.
Equilibrium in the Short Run and the Long Run
A MONOPOLISTICALLY
COMPETITIVE FIRM IN THE
SHORT AND LONG RUN
In the long run, these profits attract

new firms with competing brands.
The firm’s market share falls, and
its demand curve shifts downward.
In long-run equilibrium, described in

part (b), price equals average cost,
so the firm earns zero profit even
though it has monopoly power.
Monopolistic Competition and Economic Efficiency
COMPARISON OF MONOPOLISTICALLY
COMPETITIVE EQUILIBRIUM AND
PERFECTLY COMPETITIVE EQUILIBRIUM
Under perfect competition, price equals

marginal cost.
The demand curve facing the firm is

horizontal, so the zero-profit point occurs at
the point of minimum average cost.
Monopolistic Competition and Economic Efficiency
COMPARISON OF
MONOPOLISTICALLY
COMPETITIVE EQUILIBRIUM AND
PERFECTLY COMPETITIVE
EQUILIBRIUM
Under monopolistic competition, price
exceeds marginal cost.
Thus there is a deadweight loss, as
shown by the yellow-shaded area.
The demand curve is downward-
sloping, so the zero profit point is to
the left of the point of minimum
average cost.
In both types of markets, entry occurs
until profits are driven to zero.
Is monopolistic competition then a socially undesirable market structure that should be
regulated? The answer—for two reasons—is probably no:
1. In most monopolistically competitive markets, monopoly power is small.
Usually enough firms compete, with brands that are sufficiently substitutable, so that no
single firm has much monopoly power. Any resulting deadweight loss will therefore be
small. And because firms’ demand curves will be fairly elastic, average cost will be close to
the minimum.
2. Any inefficiency must be balanced against an important benefit from monopolistic

competition: product diversity.
Most consumers value the ability to choose among a wide variety of competing products
and brands that differ in various ways. The gains from product diversity can be large and
may easily outweigh the inefficiency costs resulting from downward-sloping demand
curves.
EXAMPLE 12.1
MONOPOLISTIC COMPETITION IN THE MARKETS FOR COLAS AND COFFEE
The markets for soft drinks and coffee illustrate the characteristics
of monopolistic competition. Each market has a variety of brands
that differ slightly but are close substitutes for one another.
Table 12.1 ELASTICITIES OF DEMAND FOR COLAS AND

COFFEE
Blank
BRAND ELASTICITY OF DEMAND
Colas RC Cola − 2.4
minus 2.4
Blank
Coke − 5.2 to − 5.7

minus 5.2 to minus 5.7
Ground coffee Folgers − 6.4 minus 6.4
Blank
Maxell House − 8.2 minus 8.2
Blank
Chock Full o’ Nuts − 3.6 minus 3.6
With the exception of RC Cola and Chock Full o’ Nuts, all the colas and coffees are quite
price elastic. With elasticities on the order of − 4 to − 8, each brand has only limited
monopoly power. This is typical of monopolistic competition.
12.2 Oligopoly (1 of 11)
In oligopolistic markets, the products may or may not be
differentiated.
What matters is that only a few firms account for most or all
of total production.
In some oligopolistic markets, some or all firms earn
substantial profits over the long run because barriers to entry
make it difficult or impossible for new firms to enter.
Oligopoly is a prevalent form of market structure. Examples
of oligopolistic industries include automobiles, steel,
aluminum, petrochemicals, electrical equipment, and
computers.
Scale economies may make it unprofitable for more than a
few firms to coexist in the market; patents or access to a
technology may exclude potential competitors; and the need
to spend money for name recognition and market reputation
may discourage entry by new firms. These are “natural”
entry barriers—they are basic to the structure of the
particular market. In addition, incumbent firms may take
strategic actions to deter entry.
Managing an oligopolistic firm is complicated because
pricing, output, advertising, and investment decisions involve
important strategic considerations, which can be highly
complex.
Equilibrium in an Oligopolistic Market
In an oligopolistic market, however, a firm sets price or
output based partly on strategic considerations regarding the
behavior of its competitors. With some modification, the
underlying principle to describe an equilibrium when firms
make decisions that explicitly take each other’s behavior into
account is the same as the equilibrium in competitive and
monopolistic markets: When a market is in equilibrium, firms
are doing the best they can and have no reason to change
their price or output.
Equilibrium in an Oligopolistic Market
NASH EQUILIBRIUM
Nash equilibrium Set of strategies or actions in which each firm does
the best it can given its competitors’ actions.
Nash Equilibrium: Each firm is doing the best it can given what its
competitors are doing.
duopoly Market in which two firms compete with each other.
The Cournot Model
Cournot model Oligopoly model in which firms produce a homogeneous
good, each firm treats the output of its competitors as fixed, and all firms
decide simultaneously how much to produce.
Figure 12.3
FIRM 1’S OUTPUT DECISION
Firm 1’s profit-maximizing output depends on how
much it thinks that Firm 2 will produce.
If it thinks Firm 2 will produce nothing, its demand
curve, labeled D1 ( 0 ) , is the market demand curve.
The corresponding marginal revenue curve, labeled
MR1 ( 0 ) , intersects Firm 1’s marginal cost curve
MC1 at an output of 50 units.
If Firm 1 thinks that Firm 2 will produce 50 units, its

demand curve, D1 ( 50 ) , is shifted to the left by this
amount. Profit maximization now implies an output
of 25 units.
Finally, if Firm 1 thinks that Firm 2 will produce 75
units, Firm 1 will produce only 12.5 units.
REACTION CURVES
reaction curve Relationship between a firm’s profit-maximizing output and the amount it
thinks its competitor will produce.
Figure 12.4
REACTION CURVES AND COURNOT EQUILIBRIUM
Firm 1’s reaction curve shows how much it will produce

as a function of how much it thinks Firm 2 will produce.
(The xs at Q 2=0, 50, and 75 correspond to the
examples shown in Figure 12.3.)

Firm 2’s reaction curve shows its output as a function
of how much it thinks Firm 1 will produce.
In Cournot equilibrium, each firm correctly assumes
the amount that its competitor will produce and
thereby maximizes its own profits. Therefore, neither
firm will move from this equilibrium.
COURNOT EQUILIBRIUM
Cournot equilibrium Equilibrium in the Cournot model in which each
firm correctly assumes how much its competitor will produce and sets its
own production level accordingly.
Cournot equilibrium is an example of a Nash equilibrium (and thus it is
sometimes called a Cournot-Nash equilibrium).
In a Nash equilibrium, each firm is doing the best it can given what its
competitors are doing.
As a result, no firm would individually want to change its behavior. In the
Cournot equilibrium, each firm is producing an amount that maximizes its
profit given what its competitor is producing, so neither would want to
change its output.
The Linear Demand Curve—An Example
Two identical firms face the following market demand curve P =30 −Q
Also MC =MC =0
1 2
Total revenue for the two firms: R = PQ =(30 − Q) Q = 30 Q − Q − Q Q

1 1 1 1
2
1 2 1
then MR = ΔR ΔQ = 30 − 2Q −Q
1 1 1 1 2
Setting MR1=0 (the firm’s marginal cost) and solving for Q1, we find
Firm 1’s reaction curve: Q = 15 − 1Q
1 2 (12.1)
2
By the same calculation, Firm 2’s reaction curve. Q 2 = 15 − 1Q 2 (12.2)
2
Cournot equilibrium: Q = Q =10
1 2
Total quantity produced: Q = Q +Q = 20 1 2
The Linear Demand Curve—An Example
If the two firms collude, then the total profit-maximizing quantity is:
Total revenue for the two firms: R = PQ = ( 30 – Q ) Q = 30Q – Q 2 ,
then MR1 = ΔR / ΔQ = 30 – 2Q
Setting MR = 0 (the firm’s marginal cost) we find that total profit is maximized at
Q = 15.
Then, Q1 + Q2 = 15 is the collusion curve.
If the firms agree to share profits equally, each will produce half of the total
output:
Q1 = Q 2 =7.5
Figure 12.5
DUOPOLY EXAMPLE
The demand curve is P = 30 − Q, and both

firms have zero marginal cost. In Cournot
equilibrium, each firm produces 10.
The collusion curve shows combinations of
Q1 and Q2 that maximize total profits.
If the firms collude and share profits equally,

each will produce 7.5.
Also shown is the competitive equilibrium, in

which price equals marginal cost and profit
is zero.
First Mover Advantage—The Stackelberg Model
Stackelberg model Oligopoly model in which one firm sets its output before other firms do.
Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes
its output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react.
P = 30 – Q
Also, MC1 = MC2 = 0
Firm 2’s reaction curve: Q =15 − 21Q
2 1 (12.2)
Firm 1’s revenue: R1 = PQ 1 =30Q 1 − Q12 − Q 2Q 1 (12.3)
R1 =30Q1 − Q12 − Q1 (15 − 1Q1)=15Q1 − 1Q12

2 2
MR1 = ΔR1 ΔQ1 =15 − Q1 (12.4)
Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5
We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much
profit. Going first gives Firm 1 an advantage.
12.3 Price Competition (1 of 5)
Price Competition with Homogeneous Products—The Bertrand
Model
Bertrand model Oligopoly model in which firms produce a
homogeneous good, each firm treats the price of its competitors as fixed,
and all firms decide simultaneously what price to charge.
Let’s return to the duopoly example of the last section.
P = 30 – Q
MC1 = MC 2 =$3
Q1 = Q2 = 9, and in Cournot equilibrium, the market price is $12, so that
each firm makes a profit of $81.
Price Competition with Homogeneous Products—The
Bertrand Model
Now suppose that these two duopolists compete by
simultaneously choosing a price instead of a quantity.
Nash equilibrium in the Bertrand model results in both firms
setting price equal to marginal cost: P1 = P2 = $3. Then industry
output is 27 units, of which each firm produces 13.5 units, and

both firms earn zero profit.
In the Cournot model, because each firm produces only 9 units,
the market price is $12. Now the market price is $3. In the
Cournot model, each firm made a profit; in the Bertrand model,
the firms price at marginal cost and make no profit.
Price Competition with Differentiated Products
Suppose each of two duopolists has fixed costs of $20 but zero
variable costs, and that they face the same demand curves:
Firm 1’s demand: Q 1 =12 − 2P 1 + P 2 (12.5a)
Firm 2’s demand: Q 2 =12 − 2P 2 + P 1 (12.5b)
Price Competition with Differentiated Products
CHOOSING PRICES
Firm 1’s profit: Π1 = P 1Q1 − 20 =12P 1 − 2P12 − 20
Firm 1’s profit maximizing price: ΔΠ ΔP =12 − 4P + P =0

1 1 1 2
Firm 1’s reaction curve: P 1 =3+ 1 P 2

4
Firm 2’s reaction curve: P 2 =3+ 1 P 1

4
Figure 12.6
NASH EQUILIBRIUM IN PRICES

Here two firms sell a differentiated product, and
each firm’s demand depends both on its own price
and on its competitor’s price. The two firms choose
their prices at the same time, each taking its
competitor’s price as given.
Firm 1’s reaction curve gives its profit-maximizing
price as a function of the price that Firm 2 sets, and
similarly for Firm 2.
The Nash equilibrium is at the intersection of the
two reaction curves: When each firm charges a
price of $4, it is doing the best it can given its
competitor’s price and has no incentive to change
price.
Also shown is the collusive equilibrium: If the firms
cooperatively set price, they will choose $6.
EXAMPLE 12.2
A PRICING PROBLEM FOR PROCTER & GAMBLE
P&G’s demand curve for monthly sales: Q = 3375 P −3.5 (PU ) .25 (PK ) .25
Assuming that P&G’s competitors face the same demand conditions, with what price
should you enter the market, and how much profit should you expect to earn?
Table 12.2: P&G’S PROFIT (IN THOUSANDS OF DOLLARS PER MONTH)
COMPETITORS (EQUAL) PRICES ($)
COMPETITORS (EQUAL) PRICES ($)
P& G’s
Price ($) 1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80
1.10 − 226
minus 226
− 215
minus 215
− 204
minus 204
− 194
minus 194
− 183
minus 183
− 174
minus 174
− 165
minus 165
− 155
minus 155
1.20 − 106
minus 106
− 89
minus 89
− 73
minus 73
− 58
minus 58
− 43
minus 43
− 28
minus 28
− 15
minus 15
−2minus 2
1.30 − 56
minus 56
− 37
minus 37
− 19
minus 19
2 15 31 47 62
1.40 − 44
minus 44
− 25
minus 25
−6minus 6
12 29 46 62 78
1.50 − 52
minus 52
− 32
minus 32
− 15
minus 15
3 20 34 52 68
1.60 − 70
minus 70
− 51
minus 51
−34
minus 34
− 18
minus 18
−1minus 1
14 30 44
1.70 − 93
minus 93
− 76
minus 76
− 59
minus 59
− 44
minus 44
− 28
Minus 28
− 13
minus 13
1 15
1.80 − 118
minus 118
− 102
minus 102
− 87
minus 87
− 72
minus 72
− 57
minus 57
− 44
minus 44
− 30
minus 30
− 17
minus 17
$1.40 is the price at which your competitors are doing the best they can, so it is a Nash
equilibrium. As the table shows, in this equilibrium you and your competitors each make a
profit of $12,000 per month. If you could collude with your competitors, you could make a
larger profit. You would all agree to charge $1.50, and each of you would earn $20,000.
12.4 Competition versus Collusion:
The Prisoners’ Dilemma (1 of 3)
In our example, there are two firms, each of which has fixed costs of $20 and zero variable
costs. They face the same demand curves:
Firm 1’s demand: Q1 =12 − 2P1 + P2
Firm 2’s demand: Q2 =12 − 2P2 + P1
We found that in Nash equilibrium each firm will charge a price of $4 and earn a profit of
$12, whereas if the firms collude, they will charge a price of $6 and earn a profit of $16.
Π2 = P 2Q 2 − 20 = (4)[(12 − (2)(4) + 6] − 20 = $20
Π1 = P 1Q1 − 20 = (6)[(12 − (2)(6) + 4] − 20 = $4
So if Firm 1 charges $6 and Firm 2 charges only $4, Firm 2’s profit will increase to $20.
And it will do so at the expense of Firm 1’s profit, which will fall to $4.
noncooperative game Game in which negotiation and enforcement of binding contracts

are not possible.
PAYOFF MATRIX
payoff matrix Table showing profit (or payoff) to each firm given its decision and the
decision of its competitor.
Table 12.3 PAYOFF MATRIX FOR PRICING GAME
Blank Blank
FIRM 2 FIRM 2
Blank Blank
Charge $4 Charge $6
Firm 1 Charge $4 $12, $12 $20, $4
Firm 1 Charge $6 $4, $20 $16, $16
THE PRISONERS’ DILEMMA
prisoners’ dilemma Game theory example in which two prisoners must decide separately
whether to confess to a crime; if a prisoner confesses, he will receive a lighter sentence
and his accomplice will receive a heavier one, but if neither confesses, sentences will be
lighter than if both confess.
Table 12.4 PAYOFF MATRIX FOR PRISONERS’ DILEMMA
Blank Blank
PRISONER B PRISONER B
Blank Blank
Confess Don’t confess

− 5, − 5 − 1, − 10
minus 5, minus 5 minus 1, minus 10
Prisoner A Confess
− 10, − 1 − 2, − 2
minus 10, minus 1 minus 2, minus 2
Prisoner A Don’t confess
If Prisoner A does not confess, he risks being taken advantage of by his former
accomplice. After all, no matter what Prisoner A does, Prisoner B comes out
ahead by confessing. Likewise, Prisoner A always comes out ahead by
confessing, so Prisoner B must worry that by not confessing, she will be taken
advantage of. Therefore, both prisoners will probably confess and go to jail for
five years. Oligopolistic firms often find themselves in a prisoners’ dilemma.
EXAMPLE 12.3
PROCTER & GAMBLE IN A PRISONERS’ DILEMMA
We argued that P&G should expect its competitors to charge a price of $1.40 and should
do the same. But P&G would be better off if it and its competitors all charged a price of
$1.50.
Table 12.5 PAYOFF MATRIX FOR PRICING PROBLEM

Blank Blank
UNILEVER AND UNILEVER AND

KAO KAO
Blank Blank
CHARGE $1.40 CHARGE $1.50

P&G CHARGE $1.40 $12, $12 $29, $11
P&G CHARGE $1.50 $3, $21 $20, $20
Since these firms are in a prisoners’ dilemma, it doesn’t matter what Unilever and Kao do.
P&G makes more money by charging $1.40.
12.5 Implications of the Prisoners’
Dilemma for Oligopolistic Pricing (1 of 4)
Does the prisoners’ dilemma doom oligopolistic firms to aggressive
competition and low profits? Not necessarily. Although our imaginary
prisoners have only one opportunity to confess, most firms set output
and price over and over again, continually observing their competitors’
behavior and adjusting their own accordingly. This allows firms to
develop reputations from which trust can arise. As a result, oligopolistic
coordination and cooperation can sometimes prevail.
Price Rigidity
price rigidity Characteristic of oligopolistic markets by which firms are
reluctant to change prices even if costs or demands change.
kinked demand curve model Oligopoly model in which each firm faces
a demand curve kinked at the currently prevailing price: at higher prices
demand is very elastic, whereas at lower prices it is inelastic.
Figure 12.7
THE KINKED DEMAND CURVE
Each firm believes that if it raises its price above

the current price P*, none of its competitors will
follow suit, so it will lose most of its sales.
Each firm also believes that if it lowers price,

everyone will follow suit, and its sales will increase
only to the extent that market demand increases.
As a result, the firm’s demand curve D is kinked at

price P*, and its marginal revenue curve MR is
discontinuous at that point.
If marginal cost increases from MC to M C’, the

firm will still produce the same output level Q* and
charge the same price P*.
Price Signaling and Price Leadership
price signaling Form of implicit collusion in which a firm
announces a price increase in the hope that other firms will follow
suit.
price leadership Pattern of pricing in which one firm regularly
announces price changes that other firms then match.
In some industries, a large firm might naturally emerge as a
leader, with the other firms deciding that they are best off just
matching the leader’s prices, rather than trying to undercut the
leader or each other.
Price leadership can also serve as a way for oligopolistic firms to
deal with the reluctance to change prices, a reluctance that arises
out of the fear of being undercut or “rocking the boat.”
EXAMPLE 12.4
PRICE LEADERSHIP AND PRICE RIGIDITY IN COMMERCIAL BANKING
Figure 12.8
PRIME RATE VERSUS CORPORATE

BOND RATE
The prime rate is the rate that major

banks charge large corporate customers
for short-term loans. It changes only
infrequently because banks are reluctant
to undercut one another. When a change
does occur, it begins with one bank, and
other banks quickly follow suit.
The corporate bond rate is the return on

long-term corporate bonds. Because
these bonds are widely traded, this rate
fluctuates with market conditions.
EXAMPLE 12.5
THE PRICES OF COLLEGE TEXTBOOKS
Most textbooks sold in the United States have retail prices in the
$200 to $300 range. In fact even other microeconomics
textbooks—which are clearly inferior to this one—sell for nearly
$300. Publishing companies set the prices of their textbooks, so
should we expect competition among publishers to drive down
prices? Partly because of mergers and acquisitions over the last
decade or so, college textbook publishing is an oligopoly.
These publishers have an incentive to avoid a price war that could drive prices down. The
best way to avoid a price war is to avoid discounting and to increase prices in lockstep on a
regular basis. The retail bookstore industry is also highly concentrated, and the retail
markup on textbooks is around 30 percent. Thus a $300 retail price implies that the
publisher is receiving a net (wholesale) price of about $200. The elasticity of demand is low,
because the instructor chooses the textbook, often disregarding the price. On the other
hand, if the price is too high, some students will buy a used book or decide not to buy the
book at all. In fact, it might be the case that publishers could earn more money by lowering
textbook prices. So why don’t they do that? First, that might lead to a dreaded price war.
Second, publishers might not have read this book!
The Dominant Firm Model
dominant firm Firm with a large share of total sales that sets price to maximize profits,
taking into account the supply response of smaller firms.
Figure 12.9
PRICE SETTING BY A DOMINANT FIRM
The dominant firm sets price, and the other firms

sell all they want at that price. The dominant firm’s
demand curve, DD , is the difference between market
demand D and the supply of fringe firms SF .
The dominant firm produces a quantity QD at the
point where its marginal revenue MRD is equal to its
marginal cost MCD .

The corresponding price is P*. At this price, fringe
firms sell QF so that total sales equal QT
12.6 Cartels (1 of 5)
Producers in a cartel explicitly agree to cooperate in setting
prices and output levels.
If enough producers adhere to the cartel’s agreements,
and if market demand is sufficiently inelastic, the cartel
may drive prices well above competitive levels.
Cartels are often international. While U.S. antitrust laws
prohibit American companies from colluding, those of other
countries are much weaker and are sometimes poorly
enforced. Furthermore, nothing prevents countries, or
companies owned or controlled by foreign governments,
from forming cartels. For example, the O P E C cartel is an
international agreement among oil-producing countries
which has succeeded in raising world oil prices above
competitive levels.
CONDITIONS FOR CARTEL SUCCESS
First, a stable cartel organization must be formed whose
members agree on price and production levels and then adhere
to that agreement.
The second condition, and may be the most important, is the
potential for monopoly power. Even if a cartel can solve its
organizational problems, there will be little room to raise price if
it faces a highly elastic demand curve.
Analysis of Cartel Pricing
Cartel pricing can be analyzed by using the dominant firm
model discussed earlier. We will apply this model to two cartels,
the O P E C oil cartel and the C I P E C copper cartel. This will help
us understand why O P E C was successful in raising price while
C I P E C was not.
ANALYZING OPEC
Figure 12.10
THE OPEC OIL CARTEL
TD is the total world demand curve for oil, and SC is the
competitive (non-O PEC) supply curve.
O PEC’s demand D O PE C is the difference between the
two.
Because both total demand and competitive supply are
inelastic, O PE C’s demand is inelastic.
O PEC’s profit-maximizing quantity QOPEC is found at the
intersection of its marginal revenue and marginal cost
curves; at this quantity, O PE C charges price P*.
If O PE C producers had not cartelized, price would be PC ,

where O PEC’s demand and marginal cost curves intersect
ANALYZING CIPEC
Figure 12.11
THE CIPEC COPPER CARTEL
TD is the total demand for copper and SC is the

competitive (non-C I PE C) supply.
C I PE C’s demand DCIPEC is the difference between the

two.
Both total demand and competitive supply are
relatively elastic, so CI PEC’s demand curve is elastic,
and C I PE C has very little monopoly power.
Note that C I PE C’s optimal price P* is close to the
competitive price PC .
As the examples of OPEC and CIPEC illustrate, successful
cartelization requires two things:
First, the total demand for the good must not be very price
elastic.
Second, either the cartel must control nearly all the world’s
supply or, if it does not, the supply of noncartel producers
must not be price elastic.
Most international commodity cartels have failed because
few world markets meet both conditions.
EXAMPLE 12.6 (1 of 2)
THE AUTHORS DEBATE THE CARTELIZATION OF INTERCOLLEGIATE ATHLETICS
Intercollegiate athletics provides entertainment and promotes school

spirit but it is also a big—and an extremely profitable—industry. This
profitability is the result of monopoly power, obtained via cartelization.
The cartel organization is the National Collegiate Athletic Association
(N CAA).
At issue is whether the N CAA is a “good” cartel, in the sense of
creating benefits for both the student athletes and the fans who watch
the games. Or is the N CAA on net harmful, and if so, should it be
restricted in the constraints it imposes on college sports? Here our
authors disagree.
“It’s true that when it comes to football and basketball, the NCAA has
been a source of considerable profits for the largest Division 1
schools,” says Rubinfeld, “but a substantial portion of those profits are
used to subsidize women’s athletics and other men’s sports, and
some support other college and university activities.
“I agree that the fans greatly value college sports,” counters Pindyck.
“And I can see why you call it a ‘good cartel,’ since you’re an avid
basketball fan. But it’s still a cartel, and it has used its cartel power to
generate huge profits.
EXAMPLE 12.6 (2 of 2)
THE AUTHORS DEBATE THE CARTELIZATION OF INTERCOLLEGIATE ATHLETICS
“My biggest beef with the NCAA is its restraint not

to pay the so-called student athletes,” says
Pindyck.
“I agree,” replies Rubinfeld, “that this restraint is
central to the NCAA. But the question is whether
the benefits from this restraint exceed the possible
harm.
This question is being argued in the courts, which
for now have decided that the restraint is legal.
Perhaps we will have a Supreme Court decision
that finally resolves our dispute. If so, we’ll write
about it in the 10th edition of this book.”
EXAMPLE 12.7
THE AUTO PARTS CARTEL
In September 2011, the U.S. Department of Justice (DO J)

announced the settlement of its investigation into an
international auto parts cartel that had engaged in bid-
rigging and price fixing across a wide range of auto parts
industries, including manufacturers of steering wheels, seat
belts, and windshield wipers. The investigations into the
auto parts cartel in the U.S. have led to criminal
indictments of more than 58 individuals and 38 companies
and have generated more than $2.6 billion in fines.
What is clear is that the successful operation of the cartel
or cartels was aided by regular communications (in-person
meetings and telephone calls) in which agreements were
reached not only with respect to price but also on ways of
monitoring the actions of the cartel members and finding
ways to punish members that did not support the
agreement.
The extent to which the auto parts cartel has adversely
affected car buyers is unclear and will require substantial
economic analyses of parts markets.
Copyright
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R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
MICROECONOMICS
FIFTH EDITION
GLOBAL EDITION
CHAPTER
CHAPTER
15 Monopoly and
Antitrust Policy
Chapter Outline and
Learning Objectives
15.1 Is Any Firm Ever Really a

Monopoly?
15.2 Where Do Monopolies Come
From?
15.3 How Does a Monopoly
Choose Price and Output?
15.4 Does Monopoly Reduce
Economic Efficiency?
15.5 Government Policy Toward
Monopoly

What is Monopoly and Why Do We Study It?
Monopoly is a market structure consisting of a firm that is the only
seller of a good or service that does not have a close substitute.
Monopoly exists at the opposite end of the competition spectrum from
perfect competition.
We study monopolies for two reasons:
1. Some firms truly are monopolists, so it is important to understand
how they behave.
2. Firms might collude in order to act like a monopolist, with
important implications for firm behavior.

Is Any Firm Ever Really a Monopoly?

Define monopoly.

Are There Really Monopolies?
It is reasonable to ask whether monopolies truly ever exist.
For example, suppose you live in a small town with only one pizzeria.
Is that pizzeria a monopoly?
1. It has competition from other fast-food restaurants
2. It has competition from grocery stores that provide pizzas for you
to cook at home
If you consider these alternatives to be close substitutes for pizzeria
pizza, then the pizza restaurant is not a monopoly.
If you do not consider these alternatives to be close substitutes for
pizzeria pizza, then the pizza restaurant is a monopoly.
Regardless, the pizzeria’s unique position may afford it some
monopoly power to raise prices, and obtain positive economic profit.

Making
the Is Google a Monopoly?
Connection
Although there are many other
firms that offer search engines,
Google has a dominant
market share: 70% in the U.S.,
and 90% in Europe.
In the strictest sense, Google

is not a monopoly in the
search-engine market. But its
dominant market position provides it with many advantages, like
the ability to exclude competitors from its content.
Of course, Google argues that its superiority is what has caused

the high market share.
Modern governments realize that monopolies are generally “bad

for consumers”, and discourage their existence.

Where Do Monopolies Come From?

Explain the four main reasons monopolies arise.

Reasons Why Monopolies Exist
For a firm to exist as a monopoly, there must be barriers to entry
preventing other firms coming in and competing with it.
The four main reasons for these barriers to entry are:
1. Government restrictions on entry
2. Control over a key resource
3. Network externalities
4. Natural monopoly
The next few slides will examine these in detail.

1. Government Restrictions on Entry
In the U.S., governments block entry in two main ways:
a. Patents, copyrights, and trademarks
Newly developed products like drugs are frequently granted patents,
the exclusive right to produce a product for a period of 20 years from
the date the patent is filed with the government.
Similarly, copyrights provide the exclusive right to produce and sell
creative works like books and films.
Patents and copyrights encourage innovation and creativity, since
without them, firms would not be able to substantially profit from their
endeavors. Trademarks, also known as brand names, work similarly.
b. Public franchises
A government designation that a firm is the only legal provider of a
good or service is known as a public franchise. These might exist,
for example, in electricity or water markets.
Making Does Hasbro Have a Monopoly on Monopoly?
the
Connection
Hasbro is the multinational
American company that owns
Monopoly.
• Hasbro acquired Parker
Brothers, which trademarked
the name Monopoly for a
board game in 1935.
• Unlike patents and
copyrights, trademarks never
expire.
Without the trademark, other firms could market similar games with
the same title, diluting Hasbro’s profits.
• For example, in the 1970s a Californian economics professor
started selling a game called Anti-Monopoly. Hasbro sued the
professor; eventually the two parties reached an agreement where
he could license the name Monopoly from Hasbro.
2. Control Over a Key Resource
For many years, the Aluminum Company of America (Alcoa) either
owned or had long-term contracts for almost all the world’s supply of
bauxite, the mineral from which we obtain aluminum.
Such control over a key resource served as a substantial barrier to
entry for additional firms.
The National Football League (NFL) acts as a monopoly in this
manner too: it ensures that the majority of the world’s best football
players are under contract to the NFL, and unable to be used for
another potential league.

Making
the Are Diamond Profits Forever?
Connection
The most famous monopoly based on
control of a raw material is the De
Beers diamond monopoly.
The South African De Beers firm
sought to control as much of the supply
of diamonds as possible, resulting in it
being able to keep prices high.
• But by 2000, new competitors had
eroded De Beers’ control of the
world’s diamond production to 40%.
Seeking to maintain its monopoly
power, De Beers has started branding
its diamonds with a “Forevermark”,
supposedly indicating high quality. Do
you think this marketing strategy will be
successful long-term?
3. Network Externalities
Economists refer to network externalities as a situation in which the
usefulness of a product increases with the number of consumers who
use it.
Examples: HD televisions
Computer operating systems (like Windows)
Social networking sites (like Facebook)
These network externalities can set off a virtuous cycle for a firm,
allowing the value of its product to continue to increase, along with
the price it can charge.
But consumers may be locked into an inferior product.

4. Natural Monopoly
A natural monopoly
occurs when economies
of scale are so large that
one firm can supply the
entire market at a lower
average total cost than
can two or more firms.
In the market for
electricity delivery, a
single firm (point A) can
deliver electricity at a
Figure 15.1 Average total cost
lower cost than can two
curve for a natural
firms (point B). monopoly
This is often because of high fixed costs; in this example, the cost of
erecting power lines and transformers, for example.

How Does a Monopoly Choose Price and Output?

Explain how a monopoly chooses price and output.

The Return of Marginal Cost and Marginal Revenue
In our study of oligopoly, we abandoned the idea of marginal cost and
marginal revenue, because the strategic interaction between firms
overrode these concepts.
Monopolists have no competitors, and hence no concern about
strategic interactions.
• They seek to maximize profit by choosing a quantity to produce,
just like perfect and monopolistic competitors.
In fact, monopolists act very much like monopolistic competitors: they

face a downward sloping demand curve.
• The difference is that barriers to entry will prevent other firms from
competing away their economic profit.

Calculating a Monopoly’s Revenue
Time Warner Cable
is a monopolist in
the market for cable
television services.
The first two
columns of the
table show the
market demand
curve, which is also
Time Warner’s
demand curve.
Total, average, and
marginal revenue
are all calculated in
Figure 15.2a Calculating a monopoly’s
the usual manner. revenue (table)

Calculating a Monopoly’s Revenue—continued
As the monopolist seeks to
expand its output, two effects
occur:
1. Revenue increases from
selling an additional unit
of output at whatever
price is necessary to
convince an additional
customer to purchase it.
2. Revenue decreases,
because the price
reduction is shared with
existing customers.
So marginal revenue is
Figure 15.2b Calculating a monopoly’s
always below demand for a revenue (graph)
monopolist.
Profit-Maximizing Price and Output for a Monopoly
Figure 15.3a Profit-maximizing price and

output for a monopoly
The monopolist maximizes profit by producing the quantity where the
additional revenue from the last unit (marginal revenue) just equals
the additional cost incurred from its production (marginal cost).
MC = MR determines quantity for a monopolist.
Price and Output for a Monopoly—continued
Figure 15.3a&b Profit-maximizing price and

output for a monopoly
At this quantity,
• The demand curve determines price, and
• The average total cost (ATC) curve determines average cost.
Profit is the difference between these (P–ATC), times quantity (Q).
Long-Run Profits for a Monopoly
Since there are barriers to entry, additional firms cannot enter the
market.
• So there is no distinction between the short run and long run for a
monopoly.
Then, unlike for monopolistic competitors, we expect monopolists to

continue to earn profits in the long run.

Does Monopoly Reduce Economic Efficiency?

Use a graph to illustrate how a monopoly affects economic efficiency.

Comparing Monopoly and Perfect Competition
Suppose that a market could be characterized by either perfect
competition or monopoly. Which would be better?
The thought experiment here is to suppose there is some market that
is perfectly competitive, such as the market for smartphones.
Then a single firm buys up all of the smartphones in the country.
What would happen to:
• Price of smartphones?
• Quantity of smartphones traded?
• The net benefit for consumers (i.e. consumer surplus)?
• The net benefit for producers (i.e. producer surplus)?
• The net benefit for all of society (i.e. economic surplus)?

If a Perfect Competition Became a Monopoly…
Figure 15.4 What happens if a perfectly competitive

industry becomes a monopoly?
The market for smartphones is initially perfectly competitive.
Price is PC, quantity traded is QC.
Now the market is supplied by a single firm. Since the single firm is
made up of all of the smaller firms, the marginal cost curve for this
new firm is identical to the old supply curve.
… Quantity Will Fall and Price Will Rise
Figure 15.4 What happens if a perfectly competitive

industry becomes a monopoly?
But the new firm maximizes market profit, producing the quantity
where marginal cost equals marginal revenue (MC = MR).
This quantity (QM) is lower than the competitive quantity (QC)…
… and the firm charges the corresponding price on the demand
curve, PM. This price is higher than the competitive price, PC.
Measuring the Efficiency Losses from Monopoly
Fewer smartphones will be traded at a higher price.
• Consumer surplus will fall (with the higher price).
• Producer surplus must rise, otherwise the firm would have chosen
the perfectly competitive price and quantity.
Could the increase in producer surplus offset the decrease in

consumer surplus?
• No! Perfectly competitive markets maximized the economic (total)
surplus in a market; if fewer trades take place, the economic
surplus must fall.

The Inefficiency of Monopoly
With the higher monopoly
price, consumer surplus
decreases by the areas
A+B.
Producer surplus falls by
C, but rises by A; an
overall increase.
Area A is simply a
transfer of surplus:
neither inherently good
nor bad.
But areas B and C are
lost surpluses:
deadweight loss.
Figure 15.5 The inefficiency of
monopoly
How Large Are the Efficiency Losses?
There are relatively few monopolies, so the loss of economic
efficiency due to monopolies must be relatively small.
• But many firms have market power: the ability of a firm to charge
a price greater than marginal cost.
• In fact, the only firms that do not have market power are perfectly
competitive firms; and perfect competition is rare.
Economists estimate that overall, the loss of efficiency in the United
States due to market power is probably less than 1% of total U.S.
production—about $500 per person annually.
• Why so low? Most firms face a relatively large degree of
competition, resulting in prices much closer to marginal cost than
we would see with monopolies.
So deadweight loss due to market power is relatively small.

An Argument in Favor of Market Power
Market power may produce some benefit for an economy; the
prospect of market power (and the resulting economic profits) drives
firms to innovate, creating new products and services.
• This drive affects large firms—who reinvest profits in the hope of
making larger future profits—and small firms—who hope to obtain
profits for themselves—alike.
The Austrian economist Joseph Schumpeter claimed that this drive

would create a “gale of creative destruction” that would eventually
benefit consumers more than increased price competition.
• This helps to explain governmental ambivalence regarding large
firms with market power.

Government Policy toward Monopoly

Discuss government policies toward monopoly.

Antitrust Laws and Antitrust Enforcement
Date
In the 1870s and Law Enacted Purpose
1880s, several “trusts” Sherman 1890 Prohibited “restraint of trade,”
had formed: boards of Act including price fixing and collusion.
trustees that oversaw Also outlawed monopolization.
the operation of several Clayton Act 1914 Prohibited firms from buying stock
in competitors and from having
firms in an industry, directors serve on the boards of
and enforced collusive competing firms.
agreements. Federal 1914 Established the Federal Trade
Trade Commission (FTC) to help
This helped prompt Commission administer antitrust laws.
Act
U.S. antitrust laws,
Robinson- 1936 Prohibited firms from charging
aimed at eliminating Patman Act buyers different prices if the result
collusion and would reduce competition.
promoting competition Cellar- 1950 Toughened restrictions on mergers
among firms. The most Kefauver by prohibiting any mergers that
Act would reduce competition.
important of these laws
are detailed here. Table 15.1 Important U.S. antitrust
laws
Making
the Did Apple’s e-Book Pricing Violate the Law?
Connection
When Apple introduced the iPad in 2010,
the prices of new e-books and bestsellers
increased from $9.99 to $12.99 or $14.99.
• The Justice Department claimed that
Apple had organized an agreement with
five large book publishers to raise the
price of e-books: “an old-fashioned,
straight-forward price-fixing agreement.”
At trial, Apple defended its pricing by
claiming it was using an agency-pricing
model similar to their iTunes store: allowing
publishers to set the price, and keeping
30% of the sales revenue.
• In the end, the judge sided with the
DOJ: Apple did indeed conspire with
publishers to raise e-book prices.
Mergers without Efficiency Gains
The Federal government is
particularly concerned about
horizontal mergers: mergers
between firms in the same
industry, as opposed to vertical
mergers between two firms at
different stages of the production
process.
• Such mergers are likely
enhance firms’ market power.
The graph shows such a merger,
increasing the price from the
competitive price (PC) to the
monopoly price (PM), and
resulting in deadweight loss.
Figure 15.6 A merger that makes
consumers better off
Mergers with Efficiency Gains
Firms seeking to merge typically
argue that the resulting larger
firm will have lower costs, and
hence be able to produce more
efficiently.
• Then even if they charge the
(new) monopoly price, the
result is an improvement for
consumers.
However, costs may not
decrease by as much as the
firms claim, resulting in
consumers being worse off.
• Economists with the FTC and
Department of Justice review Figure 15.6 A merger that makes
potential mergers one-by-one. consumers better off
DOJ and FTC Merger Guidelines
Economists and lawyers at the Department of Justice and the Federal
Trade Commission developed guidelines for themselves and firms to
use in evaluating whether potential merger was acceptable.
These include:
1. Market definition
2. Measure of concentration
3. Merger standards

1. Market Definition
Suppose Hershey Foods sought to merge with Mars Inc.
• In what market do these firms compete? The market for candy?
The market for snacks? The market for all food?
The more broadly defined the market, the smaller (and more
harmless) the merger appears.
To determine the appropriate scope of the market, the government

tries to determine which goods are close substitutes for those
produced by the firms.
• The “appropriate market” is defined as the smallest market
containing the firms’ products for which an overall price rise within
the market would result in total market profits increasing.
• (If profits would decrease, there must be adequate substitutes
available; hence the market is too narrowly defined.)
2. Measure of Concentration
A market is concentrated if a relatively small number of firms have a
large share of total sales in the market.
To determine if a market is concentrated, the government uses the
Herfindahl-Hirschman Index (HHI), created by squaring the
percentage market shares of each firm, and adding up the results.
Some examples are given below:
Firm market shares Formula HHI

100% 1002 10,000
50%, 50% 502 + 502 5,000
30%, 30%, 20%, 20% 302 + 302 + 202 + 202 2,600
10%, 10%, …, 10% 10 x 102 1,000

3. Merger Standards
Based on the calculated HHI values, the DOJ and FTC apply the
following standards to determine if they ought to challenge the
potential merger of two or more firms:
Increase in HHI
Post-merger
HHI < 100 100 – 200 > 200
< 1,500 Challenge unlikely Challenge unlikely Challenge unlikely
1,500 – 2,500 Challenge unlikely Challenge possible Challenge possible
> 2,500 Challenge unlikely Challenge possible Challenge very likely
Firms having their merger applications challenged must satisfy the

DOJ and FTC that their merger would result in substantial efficiency
gains. The burden of proof is on the merging firms.
Regulating Natural Monopolies
Natural monopolies have the potential to serve customers more
cheaply than multiple firms. But the usual market forces that drive
prices down do not exist.
Local and/or state regulatory commissions typically set prices for
these natural monopolies, instead of allowing the firms to set their
own price.
But that raises the question: what price should the regulators choose?
• A price that makes the monopoly make zero profit?
• The efficient price that would maximize consumer welfare?

Regulating a Natural Monopoly
If the natural
monopoly were
not subject to
regulation, it
would choose
quantity QM and
price PM.
Efficiency (MC =
MR) suggests a
price of QE. But
then the firm
makes a loss. Figure 15.7 Regulating a natural monopoly
The typical compromise is to allow the firm to charge a price

where it can make zero economic profit: PR. The resulting quantity
QR is hopefully close to the efficient level, keeping deadweight
loss small.
Monopoly is a market structure; natural monopoly is a reason the
monopoly market structure might exist. Monopolies need not be
natural monopolies.
No monopolist, not even a natural monopolist, tries to minimize cost.
MC = MR guides an (unregulated) monopolist.
While our graphs tend to show the efficiency loss from monopolies to
be high, estimates of the efficiency loss due to all market power are
really quite low: <1% of total output.
Monopolists cannot just charge any price they want; they are always
subject to the market demand curve.

R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
MICROECONOMICS
FIFTH EDITION
GLOBAL EDITION
CHAPTER
CHAPTER
12 Firms in Perfectly
Competitive Markets
Chapter Outline and
Learning Objectives
12.1 Perfectly Competitive Markets
12.2 How a Firm Maximizes Profit in a

Perfectly Competitive Market
12.3 Illustrating Profit or Loss on the
Cost Curve Graph
12.4 Deciding Whether to Produce or
Shut Down in the Short Run
12.5 “If Everyone Can Do It, You Can’t
Make Money at It”: The Entry and
Exit of Firms in the Long Run
12.6 Perfect Competition and
Efficiency
Market Structures
For the next few chapters, we will examine several different market
structures: models of how the firms in a market interact with buyers to
sell their output.
The market structures we will examine are, in decreasing order of
competitiveness:
• Perfectly competitive markets
• Monopolistically competitive markets
• Oligopolies, and
• Monopolies.
Each market structure will be applicable to different real-world
markets and will give us insight into how firms in certain types of
markets behave.

Table of Market Structures
Market Structure
Perfect Monopolistic
Characteristic Competition Competition Oligopoly Monopoly
Number of firms Many Many Few One
Type of product Identical Differentiated Identical or Unique
differentiated
Ease of entry High High Low Entry blocked
Examples of • Growing • Clothing • Manufacturing • First-class
industries wheat stores computers mail delivery
• Growing • Restaurants • Manufacturing • Tap water
apples automobiles
Table 12.1 The four market

structures

Perfectly Competitive Markets

Explain what a perfectly competitive market is and why a perfect competitor
faces a horizontal demand curve.

Introduction to Perfectly Competitive Markets
The first market structure we will examine is the perfectly
competitive market: one in which
• There are many buyers and sellers;
• All firms sell identical products; and
• There are no barriers to new firms entering the market
The first and second conditions imply that perfectly competitive firms
are price-takers: they are unable to affect the market price. This is
because they are tiny relative to the market, and sell exactly the same
product as everyone else.
As you might have already guessed, perfectly competitive markets

are relatively rare.

The Demand Curve for a Perfectly Competitive Firm
By definition, a perfectly
competitive firm is too small to
affect the market price.
Agricultural markets, like the

market for wheat, are often
thought to be close to
perfectly competitive.
Suppose you are a wheat

farmer; whether you sell
6,000…
… or 15,000 bushels of
wheat, you receive the same
price per bushel: you are too Figure 12.1 A perfectly competitive
firm faces a horizontal
small to affect the market demand curve
price.
How Is the Firm’s Demand Curve Determined?
There are thousands of Figure 12.2 The market demand for

individual wheat farmers. wheat versus the demand
for one farmer’s wheat
Their collective supply, combined with the overall market demand for
wheat, determines the market price of wheat in the first panel.
The individual farmer takes this market price as his or her demand
curve: the second panel.
How a Firm Maximizes Profit in a Perfectly Competitive
Market

Explain how a firm maximizes profit in a perfectly competitive market.

Profit Maximization: the Goal of the Firm
We assume that all firms try to maximize profits—including perfectly
competitive ones.
Recall that
Profit = Total Revenue – Total Cost
Revenue for a perfectly competitive firm is easy to analyze: the firm

receives the same amount of money for every unit of output it sells.
So
Price = Average Revenue = Marginal Revenue
Average revenue: Total revenue divided by the quantity of the

product sold.
Marginal revenue: the change in total revenue from selling one more
unit of a product.

Revenues for a Perfectly Competitive Firm
Number of Market Price Total Average Marginal
Bushels (per bushel) Revenue Revenue Revenue
(Q) (P) (TR) (AR) (MR)
0 $7 $0 - -
1 7 7 $7 $7
2 7 14 7 7
3 7 21 7 7
4 7 28 7 7
5 7 35 7 7
6 7 42 7 7
7 7 49 7 7
8 7 56 7 7
9 7 63 7 7
10 7 70 7 7
For a firm in a perfectly competitive Table 12.2 Farmer Parker’s revenue

from wheat farming
market, price is equal to both average
revenue and marginal revenue.

Profit Maximization for Farmer Parker
Quantity Total
(bushels) Revenue Total Cost Profit
(Q) (TR) (TC) (TR – TC)
0 $0.00 $10.00 -$10.00
1 7.00 14.00 -7.00
2 14.00 16.50 -2.50
3 21.00 18.50 2.50
4 28.00 21.00 7.00
5 35.00 24.50 10.50
6 42.00 29.00 13.00
7 49.00 35.50 13.50
8 56.00 44.50 11.50
9 63.00 56.50 6.50
10 70.00 72.00 -2.00
Table 12.3 Farmer Parker’s profit

Suppose costs are as in the table. from wheat farming
We can calculate profit; profit is maximized at a quantity of 7

bushels. This is the profit-maximizing level of output.
Profit Maximization for Farmer Parker: MR=MC
Quantity Total Marginal Marginal
(bushels) Revenue Total Cost Profit Revenue Cost
(Q) (TR) (TC) (TR – TC) (MR) (MC)
0 $0.00 $10.00 -$10.00 - -
1 7.00 14.00 -7.00 $7.00 $4.00
2 14.00 16.50 -2.50 7.00 2.50
3 21.00 18.50 2.50 7.00 2.00
4 28.00 21.00 7.00 7.00 2.50
5 35.00 24.50 10.50 7.00 3.50
6 42.00 29.00 13.00 7.00 4.50
7 49.00 35.50 13.50 7.00 6.50
8 56.00 44.50 11.50 7.00 9.00
9 63.00 56.50 6.50 7.00 12.00
10 70.00 72.00 -2.00 7.00 15.50
Table 12.3 Farmer Parker’s profit

We can also calculate marginal from wheat farming
revenue and marginal cost for the firm.
Profit is maximized by producing as long as MR>MC; or until
MR=MC, if that is possible.
Showing Revenue, Cost, and Profit
If we show total revenue and
total cost on the same graph,
the vertical difference
between the two curves is the
profit the firm makes.
(Or the loss, if costs are
greater than revenues.)
At the profit-maximizing level

of output, this (positive)
vertical distance is maximized.
Figure 12.3a The profit-maximizing

level of output

Showing Marginal Revenue and Marginal Cost
It is generally easier to
determine the profit-
maximizing level of output
on a graph of marginal
revenue and marginal cost.
Marginal revenue is
constant and equal to price
for the perfectly
competitive firm.
The firm maximizes profit

by choosing the level of
output where marginal
revenue is equal to
Figure 12.3b The profit-maximizing
marginal cost (or just less, level of output
if equal is not possible).
Rules for Profit Maximization
The rules we have just developed for profit maximization are:
1. The profit-maximizing level of output is where the difference
between total revenue and total cost is greatest.
2. The profit-maximizing level of output is also where MR = MC.
However neither of these rules require the assumption of perfect
competition; they are true for every firm!
For perfectly competitive firms, we can develop an additional rule,

because for those firms, P = MR; this implies:
3. The profit-maximizing level of output is also where P = MC.

Illustrating Profit or Loss on the Cost Curve Graph

Use graphs to show a firm’s profit or loss.

A Useful Formula for Profit
We know profit equals total revenue minus total cost; and total
revenue is price times quantity. So write:
Profit = (𝑃 × 𝑄) − 𝑇𝐶
Dividing both sides by Q, we obtain:
Profit (𝑃 × 𝑄) 𝑇𝐶
= −
𝑄 𝑄 𝑄
The “Q”s cancel in the first term, and the second is average total cost;
so we can write:
Profit
= 𝑃 − 𝐴𝑇𝐶
𝑄
Multiplying both sides by Q, we obtain:
Profit = 𝑃 − 𝐴𝑇𝐶 × 𝑄
The right hand side is the area of a rectangle with height (P – ATC)
and length Q. We can use this to illustrate profit on a graph.

Showing the Maximum Profit on a Graph
A firm maximizes profit
at the level of output at
which marginal
revenue equals
marginal cost.
The difference between

price and average total
cost equals profit per
unit of output.
Total profit equals profit

per unit of output, times
the amount of output:
the area of the green
Figure 12.4 The area of maximum
rectangle on the graph. profit

Incorrect Level of Output
It is a very common error to
believe the firm should
produce at Q1: the
level of output where
profit per unit is maximized.
But this does NOT
maximize overall profit;
the next few units of
output bring in more
marginal revenue than
their marginal cost.
You can know this because
MR>MC at Q1; this
demonstrates that Q1 is
Figure 12.4 The area of maximum
NOT the profit-maximizing profit
level of output.
Reinterpreting Marginal Revenue = Marginal Cost
We know we should produce at the level of output where marginal
cost equals marginal revenue (MC=MR).
We have been calling this the profit-maximizing level of output. But

what if the firm doesn’t make a profit at this level of output, or at any
other?
In this case, we would want to make the smallest loss possible.

• Note that sometimes a loss may be unavoidable, if we have high
fixed costs.
It turns out that MC=MR is still the correct rule to use; it will guide us
to the loss-minimizing level of output.

A Firm Breaking Even
In the graph on the left, price

never exceeds average cost,
so the firm could not possibly
make a profit.
The best this firm can do is to

break even, obtaining no profit
but incurring no loss.
The MC=MR rule leads us to

this optimal level of
production.
Figure 12.5 A firm breaking even and
a firm experiencing a loss

A Firm Experiencing a Loss
The situation is even worse

for this firm; not only can it not
make a profit, price is always
lower than average total cost,
so it must make a loss.
It makes the smallest loss

possible by again following
the MC=MR rule.
No other level of output allows

the firm’s loss to be so small.
Figure 12.5 A firm breaking even and
a firm experiencing a loss

Identifying Whether a Firm Can Make a Profit
Once we have determined the quantity where MC=MR, we can
immediately know whether the firm is making a profit, breaking even,
or making a loss. At that quantity,
• If P > ATC, the firm is making a profit
• If P = ATC, the firm is breaking even
• If P < ATC, the firm is making a loss
Even better: these statements hold true at every level of output.

Deciding Whether to Produce or to Shut Down in the
Short Run

Explain why firms may shut down temporarily.

Responses of Perfectly Competitive Firms to Losses
Suppose a firm in a perfectly competitive market is making a loss. It

would like the price to be higher, but it is a price-taker, so it cannot
raise the price. That leaves two options:
1. Continue to produce, or
2. Stop production by shutting down temporarily
If the firm shuts down, it will still need to pay its fixed costs. The firm
needs to decide whether to incur only its fixed costs, or to produce
and incur some variable costs, but obtain some revenue.
The firm’s fixed costs should be treated as sunk costs, costs that
have already been paid and cannot be recovered, because even if
they haven’t literally been paid yet, the firm is still obliged to pay
them.
Sunk costs should be irrelevant to your decision-making.

The Supply Curve of a Firm in the Short Run
The firm’s shut down decision is based on its variable costs; it should
produce nothing only if:
Total Revenue < Variable Cost
(P x Q) < VC
Dividing both sides by Q, we obtain:
P < AVC
So if P < AVC, the firm should produce 0 units of output.
If P > AVC, then the MC = MR rule should guide production: produce

the quantity where MC = MR. For a perfectly competitive firm, this
means where MC = P.
So the marginal cost curve gives us the relationship between price

and quantity supplied: it is the firm’s supply curve!
The Firm’s Short-Run Supply Curve
The firm will produce at the level
of output at which MR = MC.
Because price equals marginal
revenue for a firm in a perfectly
competitive market, the firm will
produce where P = MC.
So the firm supplies output
according to its marginal
cost curve; the marginal
cost curve is the supply
curve for the individual firm.
However if the price is too low, i.e.
below the minimum point of AVC,
the firm will produce nothing at all. Figure 12.6 The firm’s short-run
supply curve
The quantity supplied is zero
below this point.
Short-Run Market Supply Curve
Figure 12.7 Firm supply and market supply
Individual wheat farmers take the price as given…
…and choose their output according to the price.
The collective actions of the individual farmers determine the market

supply curve for wheat.
“If Everyone Can Do It, You Can’t Make Money at It”:
The Entry and Exit of Firms in the Long Run

Explain how entry and exit ensure that perfectly competitive firms earn zero
economic profit in the long run.

Costs for a Small Carrot Farmer
Sacha starts a small carrot farm, Explicit Costs
borrowing money from the bank Water $10,000
and using some of her savings. Wages $15,000
Fertilizer $10,000
Her explicit costs are straight-
Electricity $5,000
forward; her implicit costs Payment on bank loan $45,000
include the opportunity cost of Implicit Costs
using her savings, and the Forgone salary $30,000
salary she gives up to start the Opportunity cost of the $100,000 $10,000
farm. she has invested in her farm
Sacha produces 10,000 boxes Total cost $125,000
of carrots each year, and sells

Table 12.4 Farmer Gillette’s costs
them for $15 each. Her total per year
revenue is $150,000.
Sacha’s farm makes an economic profit (the firm’s revenues minus all
of its costs, implicit and explicit) of $25,000 per year.

Costs for a Small Carrot Farmer
Sacha starts a small carrot farm, Explicit Costs
borrowing money from the bank Water $20,000
and using some of her savings. Wages $15,000
Fertilizer $15,000
Her explicit costs are straight-
Electricity $10,000
forward; her implicit costs Payment on bank loan $10,000
include the opportunity cost of Implicit Costs
using her savings, and the Forgone salary $30,000
salary she gives up to start the Opportunity cost of the $100,000 $10,000
farm. she has invested in her farm
Sacha produces 10,000 boxes Total cost $110,000
of carrots each year, and sells

Table 12.4 Farmer Gillette’s costs
them for $15 each. Her total per year
revenue is $150,000.
Sacha’s farm makes an economic profit (the firm’s revenues minus all
of its costs, implicit and explicit) of $40,000 per year.

Economic Profit Leads to Entry of New Firms
Unfortunately for Sacha, the profits in the carrot farming business will
not last. Why?
Additional firms will enter the market, attracted by the profit. Perhaps:
• Some farms will switch from other produce to carrots, or
• People will open up new farms.
However it happens, the number of firms in the market will increase,

increasing supply; this will in turn lower the price Sacha can receive
for her output.

The Effect of Entry on Economic Profit
Figure 12.8 The effect of entry on economic profit
Sacha Gillette’s costs are given in the panel on the right.

The price of output is determined by the market, on the left.
Sacha makes an economic profit when the price is $15.
The profit attracts new firms, which increases supply.
The Effect of Entry on Economic Profit—continued
Figure 12.8 The effect of entry on economic profit

The increased supply causes the market equilibrium price to fall.
It falls until there is no incentive for further firms to enter the market;
that is, when individual farmers make no economic profit.
For this to be true, the price must be equal to ATC; but since
P=MC, that means all three must be equal.
The Effect of Economic Losses
Figure 12.9a,b The effect of exit on economic losses
Price is $10 per box, and carrot farmers are breaking even.
Then demand for carrots falls. Price falls to $7 per box.
Sacha can no longer make a profit; she makes the smallest loss
possible by producing 5000 carrots: where MC = MR.
The Effect of Economic Losses—continued
Figure 12.9c,d The effect of exit on economic losses
Discouraged by the losses, some firms will exit the market.

The resulting decrease in supply causes prices to rise.
Firms continue to leave until price returns to the break-even price
of $10 per box.
Long-Run Equilibrium in a Perfectly Competitive Market
The previous slides have described how long-run competitive

equilibrium is achieved in a perfectly competitive market:
• If firms are making an economic profit, additional firms enter the

market, driving down price to the break-even level.
• If firms are making an economic loss, existing firms exit the

market, driving price up to the break-even level.
Since the long-run average cost curve shows the lowest cost at which
a firm is able to produce a given quantity of output in the long run, we
expect price to be driven down to the minimum point on the typical
firm’s long-run average cost curve.
Long-run competitive equilibrium: The situation in which the entry

and exit of firms has resulted in the typical firm breaking even.

Long-Run Supply in a Perfectly Competitive Market
This means that in the long run, the market will supply any demand
by consumers at a price equal to the minimum point on the typical
firm’s average cost curve.
Hence the long-run supply curve is horizontal at this price.
In a perfectly competitive market, the long-run price is completely

determined by the forces of supply.
The number of suppliers adjusts to meet demand, at the lowest

possible price.
Long-run supply curve: A curve that shows the relationship in the

long run between market price and the quantity supplied.

Long-Run Supply
Figure 12.10 The long-run supply curve in a

perfectly competitive industry
The panels show how an increase or decrease in demand is met
by a corresponding increase or decrease in supply.
Price always returns to the long-run (break-even) level.
Making
the Easy Entry Makes the Long Run Pretty Short
Connection
When firms earn economic profits in a
market, other firms have a strong
economic incentive to enter that market.
This is exactly what happened with iPhone

apps, first provided by Apple in mid-2008.
Proving to be highly profitable in an
instant, more than 25,000 apps were
available in the iTunes store within a year.
The cost of entering this market was very

small. Anyone with the programming skills
and the time to write an app could have it
posted in the store.
As a result of this enhanced competition,

the ability to get rich quick with a killer app
faded quickly.
Increasing-Cost and Diminishing-Cost Industries
Industries where the production process is infinitely replicable are
modeled well by this horizontal supply curve.
But what if this is not the case?
1. If some factor of production cannot be replicated, additional firms
may have higher costs of production.
Example: If certain grapes grow well only in certain climates, then
the cost to produce additional grapes may be higher than for
existing firms.
2. On the other hand, sometimes additional firms might generate
benefits for other firms in the market, leading additional firms to
have lower costs of production.
Example: Cell phones require specialized processors. As more
firms produce cell phones, economies of scale in processor-
production reduce cell phone costs.

Perfect Competition and Efficiency

Explain how perfect competition leads to economic efficiency.

Types of Efficiency
Efficiency in economics really refers to two separate but related
concepts:
Productive efficiency is a situation in which a good or service is

produced at the lowest possible cost.
Allocative efficiency is a state of the economy in which production

represents consumer preferences; in particular, every good or service
is produced up to the point where the last unit provides a marginal
benefit to consumers equal to the marginal cost of producing it.

Are Perfectly Competitive Markets Efficient?
We have shown that in the long run, perfectly competitive markets are
productively efficient.
But they are allocatively efficient also:
1. The price of a good represents the marginal benefit consumers

receive from consuming the last unit of the good sold.
2. Perfectly competitive firms produce up to the point where the price

of the good equals the marginal cost of producing the good.
3. Therefore, firms produce up to the point where the last unit

provides a marginal benefit to consumers equal to the marginal
cost of producing it.
Productive and allocative efficiency are useful benchmarks against

which to measure the actual performance of other markets.

While a perfectly competitive firm faces a horizontal demand curve,
the market demand curve is still “normal” (downward-sloping).
In this chapter there are many supply curves described: the individual
firm’s supply curve, the market short-run supply curve, the market
long-run supply curve; do not confuse these.
Remember that “zero economic profit” is an adequate level of profit to

cover opportunity costs; it is not a bad outcome for a firm.
The reasons for shutting down in the short run and exiting the market
in the long run are different: P<AVC for the short run, P<ATC for the
long run.

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R.

14 Firms in Less Competitive Markets

Chapter Outline and

14.1 Oligopoly and Barriers to

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14.1 LEARNING OBJECTIVE

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Pharmacies and 63% Automobiles 68%

Table 14.1 Examples of oligopolies in

One example of a barrier to entry is economies of scale: the

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The industry will be an

14.2 LEARNING OBJECTIVE

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For example, we can model firm production as a “game”:

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In this payoff matrix, Sony’s

Suppose you are Sony in

Dominant strategy: A strategy that is the best for a firm, no matter

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Now suppose you are

Each firm charging $399 is a Nash equilibrium: a situation in

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Notice that this outcome

This is the benefit of collusion: an agreement among firms to

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Such forms of implicit collusion are desirable for firms, because

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The most well-known cartel is OPEC, the Organization of the

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14.3 LEARNING OBJECTIVE

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In this game, Apple

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14.4 LEARNING OBJECTIVE

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2. Threat from new entrants

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4. Bargaining power of buyers

5. Bargaining power of suppliers

“Enduring greatness” and continued

“Obvious answers” are often not correct when analyzing strategic

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13.1 LEARNING OBJECTIVE

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Starbucks sells caffè

Total revenue increases initially, then decreases; Starbucks has to

13.2 LEARNING OBJECTIVE

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The 5th does not alter profit: MC = MR.

Starbucks sells caffè lattes up until Figure 13.4 Maximizing profit in a

13.3 LEARNING OBJECTIVE

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Figure 13.5 How entry of new firms