Managerial Economics
and Financial Analysis
Dr. Ankisetti Ramachandra
Aryasri
© 2012 The McGraw-Hill Companies
1
Unit I – INTRODUCTION TO
MANAGERIAL ECONOMICS
Chapter 1
Nature and Scope of Managerial Economics
© 2012 The McGraw-Hill Companies
2
INTRODUCTION TO MANAGERIAL
ECONOMICS
 Imagine for a while that you have finished your studies and have joined as an
engineer in a manufacturing organization. What do you do there? You plan to
produce maximum quantity of goods of a given quality at a reasonable cost. On
the other hand, if you are a sale manager, you have to sell a maximum amount of
goods with minimum advertisement costs. In other words, you want to
minimize your costs and maximize your returns and by doing so, you are
practicing the principles of managerial economics.
 Managers, in their day-to-day activities, are always confronted with several
issues such as how much quantity is to be supplied; at what price; should the
product be made internally; or whether it should be bought from outside; how
much quantity is to be produced to make a given amount of profit and so on.
Managerial economics provides us a basic insight into seeking solutions for
managerial problems.
 Managerial economics, as the name itself implies, is an offshoot of two distinct
disciplines: Economics and Management. In other words, it is necessary to
understand what these disciplines are, at least in brief, to understand the nature
and scope of managerial economics.
3
Introduction to Economics
Our activities to generate income are termed as economic activities,
which are responsible for the origin and development of Economics
as a subject.
Originated as a Science of Statecraft. Emergence of
Political Economy.
1776 : Adam Smith (Father of Economics) – Science ofWealth
Economy is concerned with the production, consumption, distribution and
investment of goods and services.
4
Introduction to Economics
 Economics is a study of human activity both at individual and
national level. The economists of early age treated economics
merely as the science of wealth. The reason for this is clear.
Every one of us in involved in efforts aimed at earning money
and spending this money to satisfy our wants such as food,
Clothing, shelter, and others. Such activities of earning and
spending money are called
 “Economic activities”. It was only during the eighteenth
century that Adam Smith, the Father of Economics, defined
economics as the study of nature and uses of national wealth’.
5
Introduction to Economics
 Dr. Alfred Marshall, one of the greatest economists of the
nineteenth century, writes “Economics is a study of man’s
actions in the ordinary business of life: it enquires how he
gets his income and how he uses it”. Thus, it is one side, a
study of wealth; and on the other, and more important side;
it is the study of man. As Marshall observed, the chief aim of
economics is to promote ‘human welfare’, but not wealth.
 The definition given by AC Pigou endorses the opinion of
Marshall. Pigou defines Economics as “the study of economic
welfare that can be brought directly and indirectly, into
relationship with the measuring rod of money”.
6
Introduction to Economics
 Prof. Lionel Robbins defined Economics as “the science,
which studies human behaviour as a relationship between
ends and scarce means which have alternative uses”. With
this, the focus of economics shifted from ‘wealth’ to human
behaviour’.
 Lord Keynes defined economics as ‘the study of the
administration of scarce means and the determinants of
employments and income”.
7
What Economics is all about?
Stages & Definitions of Economics
Wealth
Definition
(Adam
Smith)
Scarcity
Welfare
Growth
Need
Definition Definition
Oriented
Oriented
(L. Robbins)
(Ayred
Definition
Definition
Marshall)
(Jacob
(Samuelsons)
Viner)
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The Economic Problem - Robbins
 Unlimited Wants
 Scarce Resources – Land,
Labour, Capital
 Resource Use
 Choices
9
Definition, scope and functions
Microeconomics
Macroeconomics
Management
Managerial Economics
10
Microeconomics
 The study of an individual consumer or a firm is called
microeconomics (also called the Theory of Firm). Micro
means ‘one millionth’. Microeconomics deals with behavior
and problems of single individual and of micro organization.
Managerial economics has its roots in microeconomics and it
deals with the micro or individual enterprises. It is
concerned with the application of the concepts such as price
theory, Law of Demand and theories of market structure and
so on.
11
Macroeconomics
 The study of ‘aggregate’ or total level of economics activity in a country is
called macroeconomics. It studies the flow of economics resources or factors of
production (such as land, labour, capital, organisation and technology) from
the resource owner to the business firms and then from the business firms to
the households. It deals with total aggregates, for instance, total national
income total employment, output and total investment. It studies the
interrelations among various aggregates and examines their nature and
behaviour, their determination and causes of fluctuations in the. It deals with
the price level in general, instead of studying the prices of individual
commodities. It is concerned with the level of employment in the economy.
It discusses aggregate consumption, aggregate investment, price level, and
payment, theories of employment, and so on.
 Though macroeconomics provides the necessary framework in term of
government policies etc., for the firm to act upon dealing with analysis of
business conditions, it has less direct relevance in the study of theory of firm.
12
Management
 Management is the science and art of getting things done
through people in formally organized groups. It is necessary
that every organisation be well managed to enable it to
achieve its desired goals. Management includes a number of
functions: Planning, organizing, staffing, directing, and controlling.
The manager while directing the efforts of his staff
communicates to them the goals, objectives, policies, and
procedures; coordinates their efforts; motivates them to sustain
their enthusiasm; and leads them to achieve the corporate
goals.
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Managerial Economics - Introduction
 Managerial Economics as a subject gained popularity in USA after
the publication of the book “Managerial Economics” by Joel Dean
in 1951.
 Managerial Economics refers to the firm’s decision making
process. It could be also interpreted as “Economics of
Management” or “Economics of Management”. Managerial
Economics is also called as “Industrial Economics” or “Business
Economics”.
 As Joel Dean observes managerial economics shows how
economic analysis can be used in formulating polices.
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Managerial Economics – Meaning and
Definition
 In the words of E. F. Brigham and J. L. Pappas Managerial Economics is “the
applications of economics theory and methodology to business administration
practice”.
 Managerial Economics bridges the gap between traditional economics theory and
real business practices in two days. First it provides a number of tools and techniques
to enable the manager to become more competent to take decisions in real and
practical situations. Secondly it serves as an integrating course to show the
interaction between various areas in which the firm operates.
 C. I. Savage & T. R. Small therefore believes that managerial economics “is
concerned with business efficiency”.
 M. H. Spencer and Louis Siegelman explain the “Managerial Economics is the
integration of economic theory with business practice for the purpose of facilitating
decision making and forward planning by management”.
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Managerial Economics – Meaning and
Definition
 t is clear, therefore, that managerial economics deals with economic
aspects of managerial decisions of with those managerial decisions,
which have an economics contest. Managerial economics may
therefore, be defined as a body of knowledge, techniques and practices
which give substance to those economic concepts which are useful in
deciding the business strategy of a unit of management.
 Managerial economics is designed to provide a rigorous treatment of
those aspects of economic theory and analysis that are most use for
managerial decision analysis says J. L. Pappas and E. F. Brigham.
 Managerial Economics, therefore, focuses on those tools and
techniques, which are useful in decision-making.
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Nature of Managerial Economics
a)
b)
c)
d)
e)
f)
g)
h)
Close to micro economics
Operates against the backdrop of macro economics
Normative statements
Prescriptive actions
Applied in nature
Offers scope to evaluate each alternative
Interdisciplinary
Assumptions and limitations
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Nature of Managerial Economics
 Managerial economics is, perhaps, the youngest of all the social sciences. Since
it originates from Economics, it has the basis features of economics, such as
assuming that other things remaining the same (or the Latin equivalent ceteris
paribus). This assumption is made to simplify the complexity of the managerial
phenomenon under study in a dynamic business environment so many things are
changing simultaneously. This set a limitation that we cannot really hold other
things remaining the same. In such a case, the observations made out of such a
study will have a limited purpose or value. Managerial economics also has
inherited this problem from economics.
 Further, it is assumed that the firm or the buyer acts in a rational manner
(which normally does not happen). The buyer is carried away by the
advertisements, brand loyalties, incentives and so on, and, therefore, the innate
behaviour of the consumer will be rational is not a realistic assumption.
Unfortunately, there are no other alternatives to understand the subject other
than by making such assumptions. This is because the behaviour of a firm or a
consumer is a complex phenomenon.
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Nature of Managerial Economics
a)
b)
c)
Close to microeconomics: Managerial economics is concerned with
finding the solutions for different managerial problems of a particular
firm. Thus, it is more close to microeconomics.
Operates against the backdrop of macroeconomics: The
macroeconomics conditions of the economy are also seen as limiting
factors for the firm to operate. In other words, the managerial
economist has to be aware of the limits set by the macroeconomics
conditions such as government industrial policy, inflation and so on.
Normative statements: A normative statement usually includes or
implies the words ‘ought’ or ‘should’. They reflect people’s moral
attitudes and are expressions of what a team of people ought to do.
For instance, it deals with statements such as ‘Government of India
should open up the economy. Such statement are based on value
judgments and express views of what is ‘good’ or ‘bad’, ‘right’ or ‘
wrong’. One problem with normative statements is that they cannot
to verify by looking at the facts, because they mostly deal with the
future. Disagreements about such statements are usually settled by
voting on them.
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Nature of Managerial Economics
d)
e)
Prescriptive actions: Prescriptive action is goal oriented. Given
a problem and the objectives of the firm, it suggests the course
of action from the available alternatives for optimal solution. If
does not merely mention the concept, it also explains whether
the concept can be applied in a given context on not. For
instance, the fact that variable costs are marginal costs can be
used to judge the feasibility of an export order.
Applied in nature: ‘Models’ are built to reflect the real life
complex business situations and these models are of immense
help to managers for decision-making. The different areas where
models are extensively used include inventory control,
optimization, project management etc. In managerial
economics, we also employ case study methods to conceptualize
the problem, identify that alternative and determine the best
course of action.
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Nature of Managerial Economics
Offers scope to evaluate each alternative: Managerial
economics provides an opportunity to evaluate each alternative
in terms of its costs and revenue. The managerial economist can
decide which is the better alternative to maximize the profits
for the firm.
g) Interdisciplinary: The contents, tools and techniques of
managerial economics are drawn from different subjects such as
economics, management, mathematics, statistics, accountancy,
psychology, organizational behavior, sociology and etc.
h) Assumptions and limitations: Every concept and theory of
managerial economics is based on certain assumption and as
such their validity is not universal. Where there is change in
assumptions, the theory may not hold good at all.
f)
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Scope of Managerial Economics
Managerial decision problems
Product price and output
Make or buy
Production technique
Internet strategy
Advertising media and intensity
Investment and financing
Economic concepts
Decision making tools
Theory of consumer behaviour
Numerical analysis
Theory of firm
Statistical analysis
Theory of market structures and
pricing
Forecasting
Game theory
Optimisation
Managerial Economics
Use of economics concepts and
decision making tools to solve
managerial decision problems
Optimal solutions
© 2012 The McGraw-Hill Companies
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Scope of Managerial Economics
The scope of managerial economics refers to its area of study.
Managerial economics refers to its area of study. Managerial economics,
Provides management with a strategic planning tool that can be used to
get a clear perspective of the way the business world works and what can
be done to maintain profitability in an ever-changing environment.
Managerial economics is primarily concerned with the application of
economic principles and theories to five types of resource decisions
made by all types of business organizations.





The selection of product or service to be produced.
The choice of production methods and resource combinations.
The determination of the best price and quantity combination
Promotional strategy and activities.
The selection of the location from which to produce and sell goods or
service to consumer.
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Main Areas of Managerial Economics
1. Demand Decision
2. Input-Output Decision
3. Price Output Decision
4. Profit Analysis
5. Capital or Investment analysis
6. Economic Forecasting and Forward
planning
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Demand Decision
 A firm can survive only if it is able to the demand for its product at the
right time, within the right quantity. Understanding the basic concepts
of demand is essential for demand forecasting. Demand analysis should
be a basic activity of the firm because many of the other activities of the
firms depend upon the outcome of the demand fore cost. Demand
analysis provides:
 The basis for analyzing market influences on the firms; products and
thus helps in the adaptation to those influences.
 Demand analysis also highlights for factors, which influence the demand
for a product. This helps to manipulate demand. Thus demand analysis
studies not only the price elasticity but also income elasticity, cross
elasticity as well as the influence of advertising expenditure with the
advent of computers, demand forecasting has become an increasingly
important function of managerial economics.
25
Input-Output Decision
 Input-output decision or Production analysis is in physical
terms. While the cost analysis is in monetary terms cost
concepts and classifications, cost-out-put relationships,
economies and diseconomies of scale and production
functions are some of the points constituting cost and
production analysis.
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Price Output Decision
 Pricing decisions have been always within the preview of
managerial economics. Pricing policies are merely a subset of
broader class of managerial economic problems. Price theory
helps to explain how prices are determined under different
types of market conditions. Competitions analysis includes
the anticipation of the response of competitions the firm’s
pricing, advertising and marketing strategies. Product line
pricing and price forecasting occupy an important place here.
27
Profit Analysis
 Profit making is the major goal of firms. There are several
constraints here an account of competition from other
products, changing input prices and changing business
environment hence in spite of careful planning, there is
always certain risk involved. Managerial economics deals
with techniques of averting of minimizing risks. Profit theory
guides in the measurement and management of profit, in
calculating the pure return on capital, besides future profit
planning.
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Capital or Investment analysis
 Capital is the foundation of business. Lack of capital may result in small
size of operations. Availability of capital from various sources like equity
capital, institutional finance etc. may help to undertake large-scale
operations. Hence efficient allocation and management of capital is one
of the most important tasks of the managers. The major issues related to
capital analysis are:
I.
II.
III.
The choice of investment project
Evaluation of the efficiency of capital
Most efficient allocation of capital
 Knowledge of capital theory can help very much in taking investment
decisions. This involves, capital budgeting, feasibility studies, analysis of
cost of capital etc.
29
Economic Forecasting and Forward
planning
 Strategic planning provides management with a framework on
which long-term decisions can be made which has an impact on
the behavior of the firm. The firm sets certain long-term goals and
objectives and selects the strategies to achieve the same. Strategic
planning is now a new addition to the scope of managerial
economics with the emergence of multinational corporations. The
perspective of strategic planning is global.
 It is in contrast to project planning which focuses on a specific
project or activity. In fact the integration of managerial economics
and strategic planning has given rise to be new area of study called
corporate economics.
30
Managerial economics relationship
with other disciplines
 Many new subjects have evolved in recent years due to the
interaction among basic disciplines. While there are many such
new subjects in natural and social sciences, managerial economics
can be taken as the best example of such a phenomenon among
social sciences. Hence it is necessary to trace its roots and relation
ship with other disciplines.
1. Economics
2. Operations Research
3. Statistics
4. Accountancy
5. Psychology
6. Organizational Behavior
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Relationship with economics:
 The relationship between managerial economics and economics theory may be
viewed form the point of view of the two approaches to the subject Viz. Micro
Economics and Marco Economics. Microeconomics is the study of the
economic behavior of individuals, firms and other such micro organizations.
Managerial economics is rooted in Micro Economic theory. Managerial
Economics makes use to several Micro Economic concepts such as marginal
cost, marginal revenue, elasticity of demand as well as price theory and theories
of market structure to name only a few. Macro theory on the other hand is the
study of the economy as a whole. It deals with the analysis of national income,
the level of employment, general price level, consumption and investment in
the economy and even matters related to international trade, Money, public
finance, etc.
 The relationship between managerial economics and economics theory is like
that of engineering science to physics or of medicine to biology. Managerial
economics has an applied bias and its wider scope lies in applying economic
theory to solve real life problems of enterprises. Both managerial economics
and economics deal with problems of scarcity and resource allocation.
32
Managerial Economics and Operations
Research:
 Taking effectives decisions is the major concern of both managerial
economics and operations research. The development of
techniques and concepts such as linear programming, inventory
models and game theory is due to the development of this new
subject of operations research in the postwar years. Operations
research is concerned with the complex problems arising out of
the management of men, machines, materials and money.
 Operation research provides a scientific model of the system and it
helps managerial economists in the field of product development,
material management, and inventory control, quality control,
marketing and demand analysis. The varied tools of operations
Research are helpful to managerial economists in decision-making.
33
Managerial Economics and
mathematics:
 The use of mathematics is significant for managerial economics in view
of its profit maximization goal long with optional use of resources. The
major problem of the firm is how to minimize cost, hoe to maximize
profit or how to optimize sales. Mathematical concepts and techniques
are widely used in economic logic to solve these problems. Also
mathematical methods help to estimate and predict the economic factors
for decision making and forward planning.
 Mathematical symbols are more convenient to handle and understand
various concepts like incremental cost, elasticity of demand etc.,
Geometry, Algebra and calculus are the major branches of mathematics
which are of use in managerial economics. The main concepts of
mathematics like logarithms, and exponentials, vectors and
determinants, input-output models etc., are widely used. Besides these
usual tools, more advanced techniques designed in the recent years viz.
linear programming, inventory models and game theory fine wide
application in managerial economics.
34
Managerial Economics and Statistics:
 Managerial Economics needs the tools of statistics in more than
one way. A successful businessman must correctly estimate the
demand for his product. He should be able to analyses the impact
of variations in tastes. Fashion and changes in income on demand
only then he can adjust his output. Statistical methods provide and
sure base for decision-making. Thus statistical tools are used in
collecting data and analyzing them to help in the decision making
process.
 Statistical tools like the theory of probability and forecasting
techniques help the firm to predict the future course of events.
Managerial Economics also make use of correlation and multiple
regressions in related variables like price and demand to estimate
the extent of dependence of one variable on the other. The theory
of probability is very useful in problems involving uncertainty.
35
Management Economics and
Accountancy:
 Managerial economics has been influenced by the developments
in management theory and accounting techniques. Accounting
refers to the recording of pecuniary transactions of the firm in
certain books. A proper knowledge of accounting techniques is
very essential for the success of the firm because profit
maximization is the major objective of the firm.
 Managerial Economics requires a proper knowledge of cost and
revenue information and their classification. A student of
managerial economics should be familiar with the generation,
interpretation and use of accounting data. The focus of accounting
within the firm is fast changing from the concepts of store keeping
to that if managerial decision making, this has resulted in a new
specialized area of study called “Managerial Accounting”.
36
Managerial Economics and the theory
of Psychology:
 The Theory of consumer decision-making is a new field of
knowledge grown in the second half of this century. Most of
the economic theories explain a single goal for the consumer
i.e., Profit maximization for the firm. But the theory of
consumer psychology or decision-making is developed to
explain multiplicity of goals and lot of uncertainty.
 As such this new branch of knowledge is useful to business
firms, which have to take quick decision in the case of
multiple goals. Viewed this way the theory of decision making
is more practical and application oriented than the economic
theories.
37
Unit IV – INTRODUCTION TO
MARKETS AND PRICING STRATEGIES
Chapter 8
Markets
© 2012 The McGraw-Hill Companies
38
Introduction
 Pricing is an important, if not the most important function of
all enterprises.
 Since every enterprise is engaged in the production of some
goods or/and service.
 Incurring some expenditure, it must set a price for the same
to sell it in the market. It is only in extreme cases that the
firm has no say in pricing its product; because there is severe
or rather perfect competition in the market of the good
happens to be of such public significance that its price is
decided by the government.
 In an overwhelmingly large number of cases, the individual
producer plays the role in pricing its product.
39
Introduction
 It is said that if a firm were good in setting its product price it would
certainly flourish in the market. This is because the price is such a
parameter that it exerts a direct influence on the products demand as
well as on its supply, leading to firm’s turnover (sales) and profit.
 Every manager endeavors to find the price, which would best meet
with his firm’s objective. If the price is set too high the seller may not
find enough customers to buy his product. On the other hand, if the
price is set too low the seller may not be able to recover his costs.
 There is a need for the right price further, since demand and supply
conditions are variable over time what is a right price today may not
be so tomorrow hence, pricing decision must be reviewed and
reformulated from time to time.
40
Market Defined
 Market is a place where buyer and seller meet, goods and services
are offered for the sale and transfer of ownership occurs.
 A market may be also defined as the demand made by a certain
group of potential buyers for a good or service. The former one is
a narrow concept and later one, a broader concept.
 Economists describe a market as a collection of buyers and sellers
who transact over a particular product or product class (the
housing market, the clothing market, the grain market etc.).
 For business purpose we define a market as people or
organizations with wants (needs) to satisfy, money to spend, and
the willingness to spend it.
41
Market Structure
 Market structure describes the competitive environment in
the market for any good or service. A market consists of all
firms and individuals who are willing and able to buy or sell a
particular product. This includes firms and individuals
currently engaged in buying and selling a particular product,
as well as potential entrants.
 The determination of price is affected by the competitive
structure of the market. This is because the firm operates in a
market and not in isolation. In marking decisions concerning
economic variables it is affected, as are all institutions in
society by its environment.
42
Market Structure
1.
Main Elements of Market Structure
Seller Concentration
b) Buyer Concentration
c) Product Differentiation
d) Barriers to Entry
a)
2.
Additional Elements of Market Structure
Buyer Concentration
b) High Sunk Costs or Barriers to Exit
c) Growth Rate of Market Demand
d) Import Competition
a)
43
Market Structure
44
COMPETITION
Perfect Competition=
No control over price
Imperfect Competition =
Some control over price
Price
d
Price
d
Quantity
Quantity
Characteristics of a Perfectly
Competitive Market
a) A large number of buyers and sellers: The number of
buyers and sellers is large and the share of each one of them in
the market is so small that none has any influence on the market
price.
b) Homogeneous product: The product of each seller is totally
undifferentiated from those of the others.
c) Freedom to enter and exit the market: Any buyer and seller
is free to enter or leave the market of the commodity.
d) Perfect information available to buyers and sellers: All
buyers and sellers have perfect knowledge about the market for
the commodity.
Characteristics of a Perfectly
Competitive Market
e) Perfect mobility of factors of production: Factors
of
production must be in a position to move freely into or
out of industry and from one firm to the other.
f)
Each firm is a price taker: An individual firm can alter its rate of
production or sales without significantly affecting the market
price of the product.No buyer has a preference to buy from a
particular seller and no seller to sell to a particular buyer.
Perfectly competitive market also assumes the non-existence of
transport costs.
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Perfect
Competition
Example
 Market garden
 Uses simple resources
 Land, seeds, water, fertiliser,
equipment and labour
 Price determined by the market
 What will happen to the price if
demand increases?
 What may happen to the price if the
growing conditions have been
favourable?
NZ examples?
-Dairy farming
-Wool growing
-Fishing
Perfect Competition
 The concept of competition is used in two ways in
economics.
 Competition as a process is a rivalry among firms.
 Competition as the perfectly competitive market structure.
Competition as a Process
 Competition involves one firm trying to take away market
share from another firm.
 As a process, competition pervades the economy.
Competition as a Market Structure
 It is possible to imagine something that does not exist – a
perfectly competitive market in which the invisible hand
works unimpeded.
Competition as a Market Structure
 Competition is the end result of the competitive process
under highly restrictive assumptions.
• A perfectly competitive market is one in
which economic forces operate
unimpeded.
A Perfectly Competitive Market
 A perfectly competitive market is one in which economic
forces operate unimpeded.
The Necessary Conditions for
Perfect Competition
 Both buyers and sellers are price takers.
 A price taker is a firm or individual who takes the market price
as given.
 In most markets, households are price takers – they accept the
price offered in stores.
The Necessary Conditions for
Perfect Competition
 Both buyers and sellers are price takers.
– The retailer is not perfectly competitive.
– A store is not a price taker but a price
maker.
The Necessary Conditions for
Perfect Competition
 The number of firms is large.
– Large means that what one firm does has
no bearing on what other firms do.
– Any one firm's output is minuscule when
compared with the total market.
The Necessary Conditions for
Perfect Competition
 There are no barriers to entry.
– Barriers to entry are social, political, or
economic impediments that prevent other
firms from entering the market.
– Barriers sometimes take the form of
patents granted to produce a certain good.
The Necessary Conditions for
Perfect Competition
 There are no barriers to entry.
– Technology may prevent some firms from
entering the market.
– Social forces such as bankers only lending
to certain people may create barriers.
The Necessary Conditions for
Perfect Competition
 The firms' products are identical.
– This requirement means that each firm's
output is indistinguishable from any
competitor's product.
The Necessary Conditions for
Perfect Competition
 There is complete information.
– Firms and consumers know all there is to
know about the market – prices, products,
and available technology.
– Any technological advancement would be
instantly known to all in the market.
The Necessary Conditions for
Perfect Competition
 Firms are profit maximizers.
– The goal of all firms in a perfectly
competitive market is profit and only profit.
– Firm owners receive only profit as
compensation, not salaries.
The Definition of Supply and
Perfect Competition
 If all the necessary conditions for perfect competition exist,
we can talk formally about the supply of a produced good.
 This follows from the definition of supply.
The Definition of Supply and
Perfect Competition
 Supply is a schedule of quantities of goods that will be
offered to the market at various prices.
The Definition of Supply and
Perfect Competition
 This definition requires the supplier to be a price taker (the
first condition for perfect competition).
• Since most suppliers are price makers,
any analysis must be modified
accordingly.
The Definition of Supply and
Perfect Competition
 Because of the definition of supply, if any of the conditions
are not met, the formal definition of supply disappears.
The Definition of Supply and
Perfect Competition
 That the number of suppliers be large (the second condition),
means that they do not have the ability to collude.
The Definition of Supply and
Perfect Competition
 Conditions 3 through 5 make it impossible for any firm to
forget about the hundreds of other firms just itching to
replace their supply.
• Condition 6 specifies a firm's goal –
profit.
The Definition of Supply and
Perfect Competition
 Even if we cannot technically specify a supply function,
supply forces are still strong and many of the insights of the
competitive model can be applied to firm behavior in other
market structures.
Demand Curves for the Firm and
the Industry
 The demand curves facing the firm is different from the
industry demand curve.
 A perfectly competitive firm’s demand schedule is perfectly
elastic even though the demand curve for the market is
downward sloping.
Demand Curves for the Firm and
the Industry
 This means that firms will increase their output in response
to an increase in demand even though that will cause the
price to fall thus making all firms collectively worse off.
Market Demand Versus Individual
Firm Demand Curve
Market
Firm
Market supply
Price
$10
Price
$10
8
8
6
6
4
Market
demand
2
0
1,000
3,000 Quantity
Individual firm
demand
4
2
0
10
20
30
Quantity
Profit-Maximizing Level of Output
 The goal of the firm is to maximize profits.
 When it decides what quantity to produce it continually asks
how changes in quantity affect profit.
Profit-Maximizing Level of Output
 Since profit is the difference between total revenue and total
cost, what happens to profit in response to a change in output
is determined by marginal revenue (MR) and marginal cost
(MC).
• A firm maximizes profit when MC = MR.
Profit-Maximizing Level of Output
 Marginal revenue (MR) – the change in total revenue
associated with a change in quantity.
• Marginal cost (MC) -- the change in
total cost associated with a change in
quantity.
Marginal Revenue
 Since a perfect competitor accepts the market price as given,
for a competitive firm, marginal revenue is price (MR = P).
Marginal Cost
 Initially, marginal cost falls and then begins to rise.
 Marginal concepts are best defined between the numbers.
How to Maximize Profit
 To maximize profits, a firm should produce where marginal
cost equals marginal revenue.
How to Maximize Profit
 If marginal revenue does not equal marginal cost, a firm can
increase profit by changing output.
• The supplier will continue to produce as
long as marginal cost is less than
marginal revenue.
How to Maximize Profit
 The supplier will cut back on production if marginal cost is
greater than marginal revenue.
• Thus, the profit-maximizing condition of
a competitive firm is MC = MR = P.
Marginal Cost, Marginal Revenue,
and Price
Price = MR Quantity
Produced
$35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
0
1
2
3
4
5
6
7
8
9
10
MC
Marginal Costs
Cost
$28.00
20.00
16.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
68.00
60
50
40
30
A
A
C
B
P = D = MR
20
10
0
1 2 3 4 5 6 7 8 9 10 Quantity
The Marginal Cost Curve Is the
Supply Curve
 The marginal cost curve is the firm's supply curve above the
point where price exceeds average variable cost.
The Marginal Cost Curve Is the
Supply Curve
 The MC curve tells the competitive firm how much it should
produce at a given price.
• The firm can do no better than
producing the quantity at which
marginal cost equals price which in turn
equals marginal revenue.
The Marginal Cost Curve Is the
Firm’s Supply Curve
Marginal cost
$70
C
Cost, Price
60
50
40
A
30
B
20
10
0
1
2
3
4
5
6
7
8
9 10 Quantity
Firms Maximize Total Profit
 When we speak of maximizing profit, we refer to
maximizing total profit, not profit per unit.
 Firms do not care about profit per unit; as long as an increase
in output will increase total profits, a profit-maximizing firm
should increase output.
Profit Maximization Using Total
Revenue and Total Cost
 Profit is maximized where the vertical distance between total
revenue and total cost is greatest.
 At that output, MR (the slope of the total revenue curve) and
MC (the slope of the total cost curve) are equal.
Profit Determination Using Total
Cost and Revenue Curves
Total cost, revenue
TC
$385
350
315 Maximum profit =$81
280
245
210
$130
175
140
105
70
Loss
35
0
TR
Loss
1 2 3 4 5 6 7 8 9
Profit
Quantity
Total Profit at the Profit-Maximizing
Level of Output
 While the P = MR = MC condition tells us how much output
a competitive firm should produce to maximize profit, it
does not tell us the profit the firm makes.
Determining Profit and Loss From a
Table of Costs
 Profit can be calculated from a table of costs and revenues.
 Profit is determined by total revenue minus total cost.
Determining Profit and Loss From a
Table of Costs
 The profit-maximizing position is not necessarily a position
that minimizes either average variable cost or average total
cost.
• It is only the position that maximizes
total profit.
Costs Relevant to a Firm
Profit Maximization for a Competitive Firm
P = MR Output Total Cost
—
35.00
35.00
35.00
35.00
35.00
35.00
0
1
2
3
4
5
6
40.00
68.00
88.00
104.00
118.00
130.00
147.00
Marginal Average
Total
Cost
Total Cost Revenue
—
28.00
20.00
16.00
14.00
12.00
17.00
—
68.00
44.00
34.67
29.50
26.00
24.50
0
35.00
70.00
105.00
140.00
175.00
210.00
Profit
TR-TC
–40.00
–33.00
–18.00
1.00
22.00
45.00
63.00
Costs Relevant to a Firm
Profit Maximization for a Competitive Firm
P = MR Output Total Cost
35.00
35.00
35.00
35.00
35.00
35.00
35.00
4
5
6
7
8
9
10
118.00
130.00
147.00
169.00
199.00
239.00
293.00
Marginal Average
Total
Cost
Total Cost Revenue
14.00
12.00
17.00
22.00
30.00
40.00
54.00
29.50
26.00
24.50
24.14
24.88
26.56
29.30
140.00
175.00
210.00
245.00
280.00
315.00
350.00
Profit
TR-TC
22.00
45.00
63.00
76.00
81.00
76.00
57.00
Determining Profit and Loss From a
Graph
 Find output where MC = MR.
 The intersection of MC = MR (P) determines the quantity the
firm will produce if it wishes to maximize profits.
Determining Profit and Loss From a
Graph
 Find profit per unit where MC = MR.
• To determine maximum profit, you must
first determine what output the firm will
choose to produce.
• See where MC equals MR, and then
drop a line down to the ATC curve.
• This is the profit per unit.
Determining Profits Graphically
MC
MC
MC
Price
Price
Price
65
65
65
60
60
60
55
55
55
ATC
50
50
50
ATC
45
45
45
40
40 D
A
P = MR 40
P = MR
Loss
35
35
35
P = MR
Profit
30
30
30
B ATC
AVC
25
25 C
25
AVC
AVC
E
20
20
20
15
15
15
10
10
10
5
5
5
0
0
0
1 2 3 4 5 6 7 8 910 12
1 2 3 4 5 6 7 8 9 10 12
1 2 3 4 5 6 7 8 9 10 12
Quantity
Quantity
Quantity
(b) Zero profit case
(a) Profit case
(c) Loss case
Zero Profit or Loss Where MC=MR
 Firms can also earn zero profit or even a loss where MC =
MR.
 Even though economic profit is zero, all resources, including
entrepreneurs, are being paid their opportunity costs.
Zero Profit or Loss Where MC=MR
 In all three cases (profit, loss, zero profit), determining the
profit-maximizing output level does not depend on fixed cost
or average total cost, by only where marginal cost equals
price.
The Shutdown Point
 The firm will shut down if it cannot cover average variable
costs.
 A firm should continue to produce as long as price is greater
than average variable cost.
 Once price falls below that point it makes sense to shut down
temporarily and save the variable costs.
The Shutdown Point
 The shutdown point is the point at which the firm will gain
more by shutting down than it will by staying in business.
The Shutdown Point
 As long as total revenue is more than total variable cost,
temporarily producing at a loss is the firm’s best strategy
since it is taking less of a loss than it would by shutting down.
The Shutdown Decision
MC
Price
60
ATC
50
40
Loss
P = MR
30
AVC
20
$17.80
A
10
0
2
4
6
8 Quantity
Short-Run Market Supply and
Demand
 While the firm's demand curve is perfectly elastic, the
industry's is downward sloping.
 For the industry's supply curve we use a market supply
curve.
Short-Run Market Supply and
Demand
 In the short run when the number of firms in the market is
fixed, the market supply curve is just the horizontal sum of
all the firms' marginal cost curves, taking account of any
changes in input prices that might occur.
Short-Run Market Supply and
Demand
 Since all firms have identical marginal cost curves, a quick
way of summing the quantities is to multiply the quantities
from the marginal cost curve of a representative firm by the
number of firms in the market.
Long-Run Competitive Equilibrium
 Profits and losses are inconsistent with long-run equilibrium.
 Profits create incentives for new firms to enter, output will
increase, and the price will fall until zero profits are made.
 Only zero profit will stop entry.
Long-Run Competitive Equilibrium
 The existence of losses will cause firms to leave the industry.
• Zero profit condition is the requirement
that in the long run zero profits exist.
• The zero profit condition defines the
long-run equilibrium of a competitive
industry.
Long-Run Competitive Equilibrium
 Zero profit does not mean that the entrepreneur does not get
anything for his efforts.
Long-Run Competitive Equilibrium
 In order to stay in business the entrepreneur must receive his
opportunity cost or normal profits the owners of business
would have received in the nest-best alternative.
Long-Run Competitive Equilibrium
 Normal profits are included as a cost and are not included in
economic profit. Economic profits are profits above normal
profits.
Long-Run Competitive Equilibrium
 Even if some firm has super-efficient workers or machines
that produce rent, it will not take long for competitors to
match these efficiencies and drive down the price.
• Rent is an income received by a
specialized factor of production.
Long-Run Competitive Equilibrium
 The zero profit condition is enormously powerful.
– It makes the analysis of competitive
markets far more applicable to the real
world than can a strict application of the
assumption of perfect competition.
Long-Run Competitive Equilibrium
MC
Price
60
50
SRATC
40
P = MR
30
20
10
0
2
4
6
8
Quantity
LRATC
Adjustment from the Long Run to
the Short Run
 Industry supply and demand curves come together to lead to
long-run equilibrium.
An Increase in Demand
 An increase in demand leads to higher prices and higher
profits.
 Existing firms increase output and new firms will enter the
market, increasing output still more, price will fall until all
profit is competed away.
An Increase in Demand
 If the the market is a constant-cost industry, the new
equilibrium will be at the original price but with a higher
output.
• A market is a constant-cost industry if
the long-run industry supply curve is
perfectly elastic.
An Increase in Demand
 The original firms return to their original output but since
there are more firms in the market, the total market output
increases.
An Increase in Demand
 In the short run, the price does more of the adjusting.
• In the long run, more of the adjustment
is done by quantity.
Market Response to an Increase in
Demand
Market
Price
Price
Firm
S0SR
$9
7
AC
S1SR
B
C
A
SLR
MC
$9
Profit
7
B
A
D1
D0
0
700
840 1,200 Quantity
0
1012 Quantity
Long-Run Market Supply
 Two other possibilities exist:
 Increasing-cost industry – factor prices rise as new firms
enter the market and existing firms expand capacity.
 Decreasing-cost industry – factor prices fall as industry
output expands.
An Increasing-Cost Industry
 If inputs are specialized, factor prices are likely to rise when
the increase in the industry-wide demand for inputs to
production increases.
An Increasing-Cost Industry
 This rise in factor costs would force costs up for each firm in
the industry and increases the price at which firms earn zero
profit.
An Increasing-Cost Industry
 Therefore, in increasing-cost industries, the long-run supply
curve is upward sloping.
A Decreasing-Cost Industry
 If input prices decline when industry output expands,
individual firms' marginal cost curves shift down and the
long-run supply curve is downward sloping.
A Decreasing-Cost Industry
 Input prices may decline to the zero-profit condition when
output rises and when new entrants make it more costeffective for other firms to provide services to all firms in the
market.
A Real World Example
 Owners of the Ames chain of department stores decide to
close over 100 stores after experiencing two years of losses (a
shutdown decision).
A Real World Example
 Initially, Ames thought the losses were temporary.
• Since price exceeded average variable
cost, it continued to produce even
though it was losing money.
A Real World Example
 After two years of losses, its prospective changed.
• The company moved from the short run
to the long run.
A Real World Example
 They began to think that demand was not temporarily low,
but permanently low.
• At that point they shut down those
stores for which P < AVC.
A Real World Example:
A Shutdown Decision
Price
MC
ATC
Loss
AVC
P = MR
Quantity
 SLO: Describe characteristics of a perfectly competitive
firm.
Derive the demand curve for a perfectly competitive firm
given market demand and supply.
Calculate Total, Average and Marginal Revenue for firms.
Imperfect Competition
 There are five different types of market structures that are
imperfect
 Monopoly
 Monopolistic competition
 Duopoly
 Oligopoly
 Monopsony
 Duopsony
 Oligopsony
Monopoly
 Has the following characteristics
 One firm known as a monopolist
 One firm supplies the whole market or nearly the whole
market- has considerable influence on the price by varying
quantity it supplies
 Very strong barriers to entry and exit
 The product it sells has only one or no close substitutes
Monopoly
KEY
Market
Firm
Monopoly: Examples
 Tranz Rail
 Inter-island Ferry
 Postal delivery service: NZ post
Monopoly
A monopolist has a high
degree over the price by
restricting the quantity it
sells.
Price
Therefore it faces a
downwards sloping
demand curve
D
Quantity
Monopolistic Competition
 Has the following characteristics
 There are a large number of firms in the industry
 Each firm has some control over price because they can
differentiate their product
 There are weak barriers to entry and exit
 Consumer and producer knowledge is imperfect
Monopolistic Competition Examples
 Shops and other service providers.
 Dairies
 Takeaway shops
 Hairdressers
 Garages
Monopolistic Competition
Monopolistic firms
have a small level of
control over price or
output (due to
product
differentiation)
Price
D
Quantity
Therefore they face
a downwards sloping
demand curve
Oligopoly
 Has the following characteristics
 Few number of large sellers, that dominate the market
 Sells similar but differentiated products.
 Price is usually similar across the industry
 Firms have some control over price
 Firms prefer to use non-price competition to provide a competitive
advantage
 Strong barriers to entry by new firms
 Often accused of collusion, as existing firms look as though they act
together in their pricing decisions.
Oligopoly: Example
 Petrol retailing companies
 Few large competitors
 BP
 SHELL
 Caltex
 Mobil
 Smaller players
 Challenge
 Gull
Other Examples
•New car market
-Ford, Mitsubishi,
Toyota, Honda
•Fast Food market
- McDonalds, KFC,
Burger King
•Retail banking market
- BNZ, ANZ, Kiwibank,
Westpac
Sell a homogeneous product. These firms differentiate their product with
powerful branding using heavy advertising logos sponsorship and other
promotions
Kinked Demand Curve
d
If producer reduces price (from
P2 to P3) the competitors are
likely to follow. The result is a
smaller % increase in sales
from q2 to q3. (inelastic
demand).
q1 q2 q3
If producer increases price (P2
to P1) the competitors are
unlikely to follow. The result is a
larger % fall in sales from q2 to
q1 (elastic demand)
p
P1
P2
P3
q
The risk of using Price Competition
 A price war may arise ( firms keep lowering prices to try
and gain a greater market share.
 This may result in a firm or firms being unable to operate
and might be forced to leave the market altogether. While
the firms that survived, will have to settle for decreased
profits (as prices are lower) until the price war is over.
 Due to this risk, Oligopolists prefer not to use price
competition and stick to using non-price competition.
Non-Price Competition
 Product Differentiation
 Product Variation
 Make the product appear
different
 Make the product really
different
Product Differentiation
Duopoly
 Has the following characteristics
 Market is dominated by two large producers
 Have considerable influence on price
 Produce differentiated products, with the use of non-price
competition
 Strong barriers to entry of new firms
Duopoly
KEY
Market
Firm
Duopoly Examples
•Qantas Airways Limited is the national
 Mobile firm services
airline of Australia. The name was
 Telecom and Vodaphone
(one"QANTAS",
company owns
originally
an 2 degrees)

acronym/initialism for "Queensland and
Northern Territory Aerial Services".
Domestic airlines inNicknamed
NZ
"The Flying Kangaroo", the
 Quantas NZ and Airairline
NZ is based in Sydney, with its main
hub at Sydney Airport.
 Supermarkets
 Foodstuffs ( New World, Pak’ n’ Save)
 Woolworths Australia (Woolworths, Foodtown, Countdown)
Duopoly
Duoplolists have a
big influence over
price by
differentiating their
product using nonprice competition.
Price
D
Quantity
They therefore face
a downwards
sloping demand
curve
Monopsony
 Is the sole BUYER in a market
 The market is dominated by one large firm that purchases the whole market
supply or nearly the whole market
 Able to have significant influence on the price by varying the quantity it
purchases
 Example: Fonterra
Fill in the gaps table
 Perfect imperfect
 Many, few, two, one
 Homogenous, differentiated, no close substitues
 None, weak strong
Monopolistic Competition
 A monopolistically competitive industry
has the following characteristics:
 A large number of firms
 No barriers to entry
 Product differentiation
Monopolistic Competition
 Monopolistic competition is a common form of
industry (market) structure in the United States,
characterized by a large number of firms, none of which
can influence market price by virtue of size alone.
 Some degree of market power is achieved by firms
producing differentiated products.
 New firms can enter and established firms can exit such
an industry with ease.
Nine Industries with Characteristics
of Monopolistic Competition
Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 1992
INDUSTRY
DESIGNATION
SIC NO.
FOUR
LARGEST
FIRMS
EIGHT
TWENTY NUMBER
LARGEST LARGEST
OF
FIRMS
FIRMS
FIRMS
3792
Travel trailers and campers
41
57
72
270
3942
Dolls
34
47
67
204
2521
Wood office furniture
26
34
51
611
2731
Book publishing
23
38
62
2504
2391
Curtains and draperies
22
32
48
1004
2092
Fresh or frozen seafood
19
28
47
600
3564
Blowers and fans
14
22
41
518
2335
Women’s dresses
11
17
30
3943
3089
Miscellaneous plastic products
5
8
13
7605
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject Series
MC92-S-2, 1997.
Product Differentiation, Advertising,
and Social Welfare
Total Advertising Expenditures in 1998
DOLLARS
(BILLIONS)
Newspapers
44.2
Television
48.0
Direct mail
39.5
Other
31.7
Yellow pages
12.0
Radio
14.5
Magazines
10.4
Total
200.3
Source: McCann Erickson, Inc., Reported in U.S. Bureau of the Census, Statistical Abstract of the United
States, 1999, Table 947.
The Case for Product
Differentiation and Advertising
 The advocates of free and open competition believe
that differentiated products and advertising give the
market system its vitality and are the basis of its
power.
 Product differentiation helps to ensure high quality
and efficient production.
The Case for Product
Differentiation and Advertising
 Advertising provides consumers with the valuable
information on product availability, quality, and
price that they need to make efficient choices in
the market place.
The Case Against Product
Differentiation and Advertising
 Critics of product differentiation and advertising
argue that they amount to nothing more than waste
and inefficiency.
 Enormous sums are spent to create minute,
meaningless, and possibly nonexistent differences
among products.
The Case Against Product
Differentiation and Advertising
 Advertising raises the cost of products and
frequently contains very little information. Often,
it is merely an annoyance.
 People exist to satisfy the needs of the economy,
not vice versa.
 Advertising can lead to unproductive warfare and
may serve as a barrier to entry, thus reducing real
competition.
Product Differentiation Reduces the
Elasticity of Demand Facing a Firm
 Based on the availability of
substitutes, the demand curve
faced by a monopolistic
competitor is likely to be less
elastic than the demand curve
faced by a perfectly competitive
firm, and likely to be more elastic
than the demand curve faced by a
monopoly.
Monopolistic Competition in the Short Run
 In the short-run, a monopolistically competitive firm will
produce up to the point where MR = MC.
• This firm is earning
positive profits in the
short-run.
Monopolistic Competition in the Short-Run
 Profits are not guaranteed. Here, a firm with a similar cost
structure is shown facing a weaker demand and suffering shortrun losses.
Monopolistic Competition in the Long-Run
 The firm’s demand curve must
end up tangent to its average
total cost curve for profits to
equal zero. This is the
condition for long-run
equilibrium in a
monopolistically competitive
industry.
Economic Efficiency
and Resource Allocation
 In the long-run, economic profits are eliminated; thus, we might
conclude that monopolistic competition is efficient, however:
•
Price is above marginal cost.
More output could be produced at
a resource cost below the value
that consumers place on the
product.
Economic Efficiency
and Resource Allocation
 In the long-run, economic profits are eliminated; thus, we might conclude
that monopolistic competition is efficient, however:
•
Average total cost is not
minimized. The typical firm will
not realize all the economies of
scale available. Smaller and
smaller market share results in
excess capacity.
Oligopoly
 An oligopoly is a form of industry (market) structure
characterized by a few dominant firms. Products may be
homogeneous or differentiated.
 The behavior of any one firm in an oligopoly depends to a
great extent on the behavior of others.
Ten Highly Concentrated Industries
Percentage of Value of Shipments Accounted for by the Largest Firms in HighConcentration Industries, 1992
INDUSTRY
DESIGNATION
SIC NO.
FOUR
LARGEST
FIRMS
EIGHT
LARGEST
FIRMS
NUMBER
OF
FIRMS
2823
Cellulosic man-made fiber
98
100
5
3331
Primary copper
98
99
11
3633
Household laundry equipment
94
99
10
2111
Cigarettes
93
100
8
2082
Malt beverages (beer)
90
98
160
3641
Electric lamp bulbs
86
94
76
2043
Cereal breakfast foods
85
98
42
3711
Motor vehicles
84
91
398
3482
Small arms ammunition
84
95
55
3632
Household refrigerators and freezers
82
98
52
Source: U.S. Department of Commerce, Bureau of the Census, 1992 Census of Manufacturers, Concentration Ratios in Manufacturing, Subject
Series MC92-S-2, 1997.
Oligopoly Models
 All kinds of oligopoly have one thing in common:
 The behavior of any given oligopolistic firm depends
on the behavior of the other firms in the industry
comprising the oligopoly.
The Collusion Model
 A group of firms that gets together and makes price and
output decisions jointly is called a cartel.
 Collusion occurs when price- and quantity-fixing agreements
are explicit.
 Tacit collusion occurs when firms end up fixing price
without a specific agreement, or when agreements are
implicit.
The Cournot Model
 The Cournot model is a model of a two-firm industry
(duopoly) in which a series of output-adjustment decisions
leads to a final level of output between the output that would
prevail if the market were organized competitively and the
output that would be set by a monopoly.
The Kinked Demand Curve Model
 The kinked demand model is a model of oligopoly in which
the demand curve facing each individual firm has a “kink” in
it. The kink follows from the assumption that competitive
firms will follow if a single firm cuts price but will not follow
if a single firm raises price.
The Kinked Demand Curve Model
 Above P*, an increase in price,
which is not followed by
competitors, results in a large
decrease in the firm’s quantity
demanded (demand is elastic).
 Below P*, price decreases are
followed by competitors so the
firm does not gain as much
quantity demanded (demand is
inelastic).
The Price-Leadership Model
 Price-leadership is a form of oligopoly in which one
dominant firm sets prices and all the smaller firms in the
industry follow its pricing policy.
The Price-Leadership Model

Assumptions of the price-leadership model:
1.
The industry is made up of one large firm and a number of
smaller, competitive firms;
2.
The dominant firm maximizes profit subject to the
constraint of market demand and subject to the behavior of
the smaller firms;
3.
The dominant firm allows the smaller firms to sell all they
want at the price the leader has set.
The Price-Leadership Model

Outcome of the price-leadership model:
1.
The quantity demanded in the industry is split between the
dominant firm and the group of smaller firms.
2.
This division of output is determined by the amount of
market power that the dominant firm has.
3.
The dominant firm has an incentive to push smaller firms
out of the industry in order to establish a monopoly.
Predatory Pricing
 The practice of a large, powerful firm driving smaller firms
out of the market by temporarily selling at an artificially low
price is called predatory pricing.
 Such behavior became illegal in the United States with the
passage of antimonopoly legislation around the turn of the
century.
Game Theory
 Game theory analyzes oligopolistic behavior as a complex
series of strategic moves and reactive countermoves among
rival firms.
 In game theory, firms are assumed to anticipate rival
reactions.
Payoff Matrix for Advertising Game
B’s STRATEGY
A’s STRATEGY
Do not advertise
Advertise
Do not advertise
A’s profit = $50,000
B’s profit = $50,000
A’s loss = $25,000
B’s profit = $75,000
Advertise
A’s profit = $75,000
B’s loss = $25,000
A’s profit = $10,000
B’s profit = $10,000
• The strategy that firm A will actually choose depends on the information
available concerning B’s likely strategy.
Payoff Matrix for Advertising Game
B’s STRATEGY
A’s STRATEGY
Do not advertise
Advertise
Do not advertise
A’s profit = $50,000
B’s profit = $50,000
A’s loss = $25,000
B’s profit = $75,000
Advertise
A’s profit = $75,000
B’s loss = $25,000
A’s profit = $10,000
B’s profit = $10,000
• Regardless of what B does, it pays A to advertise. This is the dominant
strategy, or the strategy that is best no matter what the opposition does.
The Prisoners’ Dilemma
ROCKY
GINGER
Do not confess
Confess
Do not confess
Ginger: 1 year
Rocky: 1 year
Ginger: 7 years
Rocky: free
Confess
Ginger: free
Rocky: 7 years
Ginger: 5 years
Rocky: 5 years
• Both Ginger and Rocky have dominant strategies: to confess. Both will
confess, even though they would be better off if they both kept their mouths
shut.
Payoff Matrix for
Left/Right-Top/Bottom Strategies
Original Game
D’s STRATEGY
C’s
STRATEGY
Left
Right
Top
C wins $100
D wins no $
C wins $100
D wins $100
Bottom
C loses $100
D wins no $
C wins $200
D wins $100
• Because D’s behavior is predictable
(he will play the right-hand
strategy), C will play bottom.
• When all players are playing their
best strategy given what their
competitors are doing, the result is
called Nash equilibrium.
Payoff Matrix for
Left/Right-Top/Bottom Strategies
New Game
D’s STRATEGY
C’s
STRATEGY
Left
Right
Top
C wins $100
D wins no $
C wins $100
D wins $100
Bottom
C loses
$10,000
D wins no $
C wins $200
D wins $100
• C is likely to play top and guarantee
herself a $100 profit instead of losing
$10,000 to win $200, even if there is just
a small chance of D’s choosing left.
• When uncertainty and risk are
introduced, the game changes. A
maximin strategy is a strategy chosen
to maximize the minimum gain that can
be earned.
Contestable Markets
 A market is perfectly contestable if entry to it and exit from
it are costless.
 In contestable markets, even large oligopolistic firms end up
behaving like perfectly competitive firms. Prices are pushed
to long-run average cost by competition, and positive profits
do not persist.
Oligopoly is Consistent with
a Variety of Behaviors
 The only necessary condition of oligopoly is that firms are large
enough to have some control over price.
 Oligopolies are concentrated industries. At one extreme is the
cartel, in essence, acting as a monopolist. At the other extreme,
firms compete for small contestable markets in response to
observed profits. In between are a number of alternative models,
all of which stress the interdependence of oligopolistic firms.
Oligopoly and Economic
Performance
 Oligopolies, or concentrated industries, are likely to be
inefficient for the following reasons:
 They are likely to price above marginal cost. This means that
there would be underproduction from society’s point of view.
 Strategic behavior can force firms into deadlocks that waste
resources.
 Product differentiation and advertising may pose a real danger of
waste and inefficiency.
The Role of Government
 The Celler-Kefauver Act of 1950 extended the
government’s authority to ban vertical and conglomerate
mergers.
 The Herfindahl-Hirschman Index (HHI) is a
mathematical calculation that uses market share figures to
determine whether or not a proposed merger will be
challenged by the government.
Regulation of Mergers
Calculation of a Simple Herfindahl-Hirschman Index for Four Hypothetical
Industries, Each With No More Than Four Firms
PERCENTAGE SHARE OF:
HERFINDAHLHIRSCHMAN
INDEX
FIRM 1
FIRM 2
FIRM 3
FIRM 4
Industry A
50
50
-
-
502 + 502 = 5,000
Industry B
80
10
10
-
802 + 102 + 102 = 6,600
Industry C
25
25
25
25
252 + 252 + 252 + 252 = 2,500
Industry D
40
20
20
20
402 + 202 + 202 + 202 = 2,800
Department of Justice Merger
Guidelines (revised 1984)
ANTITRUST DIVISION ACTION
HHI
1,800
1,000
Concentrated
Challenge if Index is
raised by more than 50
points by the merger
Moderate
Concentration
Challenge if Index is
raised by more than 100
points by the merger
Unconcentrated
No challenge
0