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Microeconomics I
Tutorial 10

Olga Petranevskaya
A market consisting of a single buyer and many
sellers.

Monopsony 2
 The monopsonist’s profit-
maximizaion condition
Let’s imagine a firm whose production function depends
on a single input L. The firm’s total output is Q=f(L)

The company’s total revenue is thus Pf(L)

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 The monopsonist’s profit-
maximizaion condition
The marginal revenue product of labor—denoted by
MRPL—is the additional revenue that the firm gets
when it employs an additional unit of labor.

Since the firm is a price taker in its output market,

marginal revenue product is the market price times the
marginal product of labor: MRPL=P*MPL=P(∆Q/ ∆ L).

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The monopsonist’s profit-
maximizaion condition

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It tells us the wage that is necessary to induce a
given amount of labor to be offered in the market
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The firm’s total cost is the firm’s total expenditure on
labor: TC =wL.

The firm’s marginal expenditure on labor— denoted by

MEL—is the rate at which the firm’s total cost goes up,
per unit of labor, as it employs more labor.

 
The marginal expenditure on labor is thus:

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The marginal expenditure on labor is thus:

Since the supply curve for labor is upward sloping, ∆ w/∆L >0.
The marginal expenditure curve therefore lies above the
labor supply curve

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The coal mine’s profit-maximization problem is to
choose a quantity of labor L to maximize total profit ,
which is the difference between total revenue and
total cost: Pr=Pf(L)- wL. The firm will maximize profit
at the point at which marginal revenue product of
labor equals marginal expenditure on labor:
MRPL = MEL

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Task 1 10
Suppose that a monopsonist’s only input is labor and its
production function is Q=5L, where L is the quantity of labor
(expressed in thousands of hours per week).

Suppose, too, that the monopsonist can sell all the output it
wants at a market price of $10 per unit and that the supply
curve it faces for labor is w=2+2L.

Problem How much labor would the monopsonist hire, and

what wage rate would it pay, to maximize profit?

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Cournot duopoly 12
 Residual demand curve
Suppose that Samsung expects LG to produce 50 units of
output. Then, the relationship between the market price and
Samsung’s output is given by the residual demand curve
D50. A residual demand curve traces out the relationship
between the market price and a firm’s quantity when the
other firm sells a fixed amount of output (50 units, in this
case). The residual demand curve D50 is the market demand
curve (DM) shifted leftward by an amount equal to LG’s
output of 50.

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 Price Determination and
Profit Maximization in the
Cournot Model

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 Price Determination and
Profit Maximization in the
Cournot Model
Samsung acts as a monopolist relative to its residual demand
curve when it chooses its output.

A Cournot firm’s best response to a particular level of output

by rival firms is the firm’s profit-maximizing choice of output
given the rival’s output.

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 Cournot Reaction Functions
and Equilibrium

Reaction function A graph that shows a firm’s best response 16

(i.e., profitmaximizing choice of output or price) for each
possible action of a rival firm.
 Equilibrium in a Cournot
Market
At a Cournot equilibrium, each firm’s output is a best
response to the other firm’s output (i.e., in equilibrium,
each firm is doing as well as it can given the other firm’s
output)

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Task 2 18
The market demand curve DM is given by P=100-Q1-Q2,
where Q1 is the amount of output Samsung produces and Q2
is LG’s level of output. The marginal cost of each firm is $10.

Problem
a. Given this market demand curve, what is Samsung’s
profit-maximizing quantity when LG produces 50 units?

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The market demand curve DM is given by P=100-Q1-Q2,
where Q1 is the amount of output Samsung produces and Q2
is LG’s level of output. The marginal cost of each firm is $10.

Problem
b. What is Samsung’s profit-maximizing output when LG
produces an arbitrary output Q2 (i.e., what is the equation
of Samsung’s reaction function)?
(a) Compute the Cournot equilibrium quantities and price
in this market.

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The market demand curve DM is given by P=100-Q1-Q2,
where Q1 is the amount of output Samsung produces and Q2
is LG’s level of output. The marginal cost of each firm is $10.

Problem

c.Compute the Cournot equilibrium quantities and price in

this market.

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 Games
Oligopolists Play 22
When a firm’s decision significantly affects the profits of
other firms in the industry, the firms are in a situation of
interdependence

The study of behavior in situations of interdependence is

known as game theory.

The reward received by a player in a game, such as the profit

earned by an oligopolist, is that player’s payoff.

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The Prisoners’ Dilemma 24
When there are only two players, as in a duopoly, the
interdependence between the players can be
represented with a payoff matrix

A payoff matrix shows how the payoff to each of the

participants in a two - player game depends on the
actions of both. Such a matrix helps us analyze
situations of interdependence.

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For simplicity, let’s assume that ADM can pick only one of two alternatives:
produce 30 million pounds of lysine or produce 40 million pounds. Ajinomoto
has the same pair of choices.

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Payoff matrix
 Prisoners’ dilemma, it is a type of game in which the
payoff matrix implies the following:

» Each player has an incentive, regardless of what

the other player does, to cheat—to take an action
that benefits it at the other’s expense.

» When both players cheat, both are worse off than

they would have been if neither had cheated.

The Prisoners’ Dilemma 27

 “Here’s the deal: if neither of you confesses, you
know that we’ll send you to jail for 2 years. If you
confess and implicate your partner, and he
doesn’t do the same, we’ll reduce your sentence
from 2 years to 1. But if your partner confesses
and you don’t, you’ll get the maximum 5 years.
And if both of you confess, we’ll give you both 3
years.”

The Prisoners’ Dilemma 28

The Prisoners’ Dilemma 29
The answer is clear: both will confess. Look at it first
from one person 's point of view: he is better off
confessing, regardless of what his partner does. If First
one doesn’t confess, second one’s confession reduces
his own sentence from 3 years to 1. If 2nd one does
confess, 1st one’s confession reduces her sentence from
5 to 3 years. Either way, it’s clearly in 2nd’s interest to
confess. And because he faces the same incentives, it’s
clearly in 1st one’s interest to confess, too. To confess in
this situation is a type of action that economists call a
dominant strategy.

The Prisoners’ Dilemma

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An action is a dominant strategy when it is the player’s
best action regardless of the action taken by the other
player.

It’s important to note that not all games have a

dominant strategy—it depends on the structure of
payoffs in the game

In a prisoners’ dilemma, each player has a clear incentive

to act in a way that hurts the other player—but when
both make that choice, it leaves both of them worse off

Dominant strategy 31
In game theory, equilibrium, in which each player takes
the action that is best for her given the actions taken by
other players, and vice versa, is known as a Nash
equilibrium.

Because the players in a Nash equilibrium do not take

into account the effect of their actions on others, this is
also known as a noncooperative equilibrium.

Nash equilibrium 32
Overcoming the Prisoners’
Dilemma: Repeated
Interaction and Tacit
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Collusion
A firm engages in strategic behavior when it
attempts to influence the future behavior of
other firms.

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A strategy of tit for tat involves playing
cooperatively at first, then doing whatever the
other player did in the previous period.

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