Short-Run Profit Maximization by a Competitive Firm
• Marginal
revenue
equals
marginal cost at a point at
which the marginal cost curve
is rising.
CHOOSING OUTPUT IN THE SHORT RUN
The Short-Run Profit of a Competitive Firm
A Competitive Firm Making a
Positive Profit
In the short run, the
competitive firm maximizes
its profit by choosing an
output q* at which its
marginal cost MC is equal to
the price P (or marginal
revenue MR) of its product.
The profit of the firm is
measured by the rectangle
ABCD.
Any change in output,
whether lower at q1 or
higher at q2, will lead to
lower profit.
CHOOSING OUTPUT IN THE SHORT RUN
The Short-Run Profit of a Competitive Firm
A Competitive Firm Incurring
Losses
A competitive firm should
shut down if price is below
AVC.
The firm may produce in
the short run if price is
greater than average
variable cost.
Shut-Down Rule: The firm should shut down if the price of the
product is less than the average variable cost of production at the
profit-maximizing output.
THE COMPETITIVE FIRM’S SHORT-RUN
SUPPLY CURVE
The firm’s supply curve is the portion of the marginal cost curve for
which marginal cost is greater than average variable cost.
The Short-Run Supply Curve for a
Competitive Firm
In the short run, the firm
chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.
The short-run supply curve is
given by the crosshatched
portion of the marginal cost
curve.
Producer Surplus in the Short Run
● producer surplus Sum over all units produced by a firm
of differences between the market price of a good and the
marginal cost of production.
Producer Surplus for a Firm
Alternatively, it is equal to
rectangle ABCD because the
sum of all marginal costs up to
q* is equal to the variable costs
of producing q*.
Producer Surplus for a Market
Producer Surplus in the Short Run
Producer Surplus versus Profit
Producer surplus = PS = R − VC
Profit = π = R − VC − FC
The producer surplus for a market is the
area below the market price and above
the market supply curve, between 0 and
output Q*.
CHOOSING OUTPUT IN THE LONG RUN
Long-Run Competitive Equilibrium
Entry and Exit
Long-Run Competitive Equilibrium
Initially the long-run equilibrium
price of a product is $40 per
unit, shown in (b) as the
intersection of demand curve D
and supply curve S1.
In (a) we see that firms earn
positive profits because longrun average cost reaches a
minimum of $30 (at q2).
Positive profit encourages entry
of new firms and causes a shift
to the right in the supply curve
to S2, as shown in (b).
The long-run equilibrium occurs
at a price of $30, as shown in
(a), where each firm earns zero
profit and there is no incentive
to enter or exit the industry.
Long-Run Competitive Equilibrium
• A long-run competitive equilibrium occurs when three
conditions hold:
1. All firms in the industry are maximizing profit.
2.No firm has an incentive either to enter or exit the
industry because all firms are earning zero economic
profit.
3.The price of the product is such that the quantity
supplied by the industry is equal to the quantity
demanded by consumers.
THE INDUSTRY’S LONG-RUN SUPPLY CURVE
The Effects of a Tax on the firm
Effect of an Output Tax on a
Competitive Firm’s Output
An output tax raises the
firm’s marginal cost curve
by the amount of the tax.
The firm will reduce its
output to the point at
which the marginal cost
plus the tax is equal to the
price of the product.
The Effects of a Tax on Industry
Effect of an Output Tax on
Industry Output
An output tax placed on all
firms in a competitive
market shifts the supply
curve for the industry
upward by the amount of
the tax.
This shift raises the
market price of the
product and lowers the
total output of the industry.
CONSUMER SURPLUS
.
EVALUATING THE GAINS AND LOSSES
FROM GOVERNMENT POLICIES—
CONSUMER AND PRODUCER SURPLUS
Review of Consumer and Producer Surplus
EVALUATING THE GAINS AND LOSSES
FROM GOVERNMENT POLICIES—
CONSUMER AND PRODUCER SURPLUS
● welfare effects
producers
Gains and losses to consumers and
Change in Consumer and Producer
Surplus from. Price Controls
Gain in consumer surplus
consumers who can buy=A
for
Loss in consumer surplus who
cannot buy=B
The gain to consumers is the
difference between rectangle A and
triangle B.
Loss in producer surplus for
producers who remain in the
market=A
Loss in producer surplus since
prodn. Has reduced= C
The loss to producers is the sum of
rectangle A and triangle C.
Triangles B and C together
measure the deadweight loss from
price
controls.(A-B)+(-A-C)=total
change in surplus.
● deadweight loss Net loss of total
(consumer plus producer) surplus.
Effect of Price Controls When Demand Is Inelastic
If demand is sufficiently
inelastic, triangle B can be
larger than rectangle A. In this
case, consumers suffer a net
loss from price controls.
Efficiency of a Competitive market
• Economic efficiency is maximization of
aggregate consumer and producer surplus.
• Policy interventions in perfect markets leads
to dead weight loss but may still be required
to avoid negative externalities and demerit
goods.(taxi fares, liquor licenses, import
quotas, tariff,
Monopoly
•
•
•
•
•
•
•
•
•
•
•
One seller
No close substitute
Firm is a price maker.
There are barriers to entry
It is possible to earn abnormal profits in the short and long run
Barriers to entry(Legal, control over raw material, know-how, economies
of scale, small market size, superior efficiency, copyrights, patents)
Profit maximisation leads to higher prices and lower output than perfect
competition
Governments are concerned about monopolies exploiting consumers.
Price is greater than MR
Monopolies are allocatively inefficient since P>MC
Monoploist is also productively inefficient since because it is not
producing at the minimum of the acerage cost curve.
MONOPOLY
• Average Revenue and Marginal Revenue
● marginal revenue
Change in revenue
resulting from a one-unit increase in output.
TABLE 10.1
Price (P)
Total, Marginal, and Average Revenue
Quantity (Q)
Total
Revenue (R)
Marginal
Revenue (MR)
Average
Revenue (AR)
6
0
0
---
---
5
1
5
5
5
4
2
8
3
4
3
3
9
1
3
2
4
8
-1
2
1
5
5
-3
1
MONOPOLY
• Average Revenue and Marginal Revenue
Average and Marginal
Revenue
Average and marginal
revenue are shown for
the demand curve
P = 6 − Q.
The Monopolist’s Output Decision
Profit Is Maximized When Marginal
Revenue Equals Marginal Cost
Q* is the output level at which
MR = MC.
If the firm produces a smaller
output—say, Q1—it sacrifices
some profit because the extra
revenue that could be earned
from producing and selling the
units between Q1 and Q*
exceeds the cost of producing
them.
Similarly, expanding output from
Q* to Q2 would reduce profit
because the additional cost
would exceed the additional
revenue.
Monopoly making losses
A Rule of Thumb for Pricing
Marginal cost should be equal to P plus P(1/Ed). The markup should be equal to
minus the inverse of elasticity of demand. Thus price is a markup over cost.
The markup over marginal cost as a percentage of price = (P-MC)/P.
In perfect competition: P=MC
In monopoly: price exceeds MC by an amount that depends inversely on the
elasticity of demand. If demand is very elastic, price will be very close to MC.
Supply curve
• There is no one to one relationship between price
and quantity produced.
• Output decision depends not only on MC but also
on shape of the demand curve.
• shift in demand curve can lead to changes in both
price and output
• A competitive industry supplies a specific
quantity at every price but in monoply, there can
be same quantity supplied at different price
depending on the elasticity or different quantity
supplied at same price.
Effect on equilibrium on Shifts in Demand
Upward shift in the demand curve
may result in more quantity and
higher , lower or same price.
Effect in demand depend on the
extent of the shift and on the price
elasticity of demand.
If elasticity has increased it is
profitable for the monopolist to not
only increase the output but also
lower the price.
Effect on equilibrium on increase in
cost
• An increase in costs increases price and
reduces quantity
• Effect of specific tax- increases price and
reduces quantity
• Effect of lump sum tax- the equilibrium does
not change as MC curve is not affected. The
total profits of the monopolist reduces.
MONOPOLY POWER
Measuring Monopoly Power
Remember the important distinction between a perfectly competitive firm
and a firm with monopoly power: For the competitive firm, price equals
marginal cost; for the firm with monopoly power, price exceeds marginal
cost.
● Lerner Index of Monopoly Power
Measure of monopoly power calculated as
excess of price over marginal cost as a
fraction of price.
Mathematically:
This index of monopoly power can also be expressed in terms of the elasticity of
demand facing the firm.
(10.4)
Elasticity of Demand and Price
Markup
• The markup (P − MC)/P is equal to minus the
inverse of the elasticity of demand facing the
firm.
• If the firm’s demand is elastic the markup is
small and the firm has little monopoly power
(eg: grocery stores vs. supermarket chains)
• The opposite is true if demand is relatively
inelastic (eg. Designer jeans)
SOURCES OF MONOPOLY POWER
The Elasticity of Market Demand
If there is only one firm—a pure monopolist—its demand curve is the market
demand curve.
Because the demand for oil is fairly inelastic (at least in the short run), OPEC
could raise oil prices far above marginal production cost during the 1970s and
early 1980s.
Because the demands for such commodities as coffee, cocoa, tin, and copper
are much more elastic, attempts by producers to cartelize these markets and
raise prices have largely failed.
In each case, the elasticity of market demand limits the potential monopoly
power of individual producers.
SOURCES OF MONOPOLY POWER
The Number of Firms
When only a few firms account for most of the sales in a market, we say that
the market is highly concentrated.
● barrier to entry Condition that
impedes entry by new competitors.
SOURCES OF MONOPOLY POWER
The Interaction Among Firms
Firms might compete aggressively, undercutting one another’s prices to
capture more market share.
This could drive prices down to nearly competitive levels.
Firms might even collude (in violation of the antitrust laws), agreeing to limit
output and raise prices.
Because raising prices in concert rather than individually is more likely to be
profitable, collusion can generate substantial monopoly power.
Other measures of monopoly power
• Cross elasticity of demand
– The value is zero in case for pure monopoly and
infinity for perfect markets.
– Lower this value, greater will be the degree of
monopoly power.
THE SOCIAL COSTS OF MONOPOLY POWER
Deadweight Loss from Monopoly Power
The shaded rectangle and triangles
show changes in consumer and
producer surplus when moving from
competitive price and quantity, Pc
and Qc,
to a monopolist’s price and quantity,
Pm and Qm.
Because of the higher price,
consumers lose A + B
and producer gains A − C. The
deadweight loss is B + C.
The dead weight loss is the social
cost of monoply/.
Comparison bt. Perfect
competition and monopoly
• Monopolist can either determine his output or price not both
whereas in perfect competition he can decide only output.
• In long run, output will be lower and price higher at profit
maximisation. This is because firm makes normal profits at
minimum cost in long run under perfect comp. and monopoly
firms make abnormal profits.
• At eq. elasticity can be any value in perfect comp but in monopoly
it is less greater than 1.
• In monopoly there is no certainty that firm will incur min. cost at
long run.
• Supply firm is not uniquely determined in monopoly.
• In perfect comp. there are no abnormal profits in the long run.
PRICING
●If a firm can charge only one price for all its customers,
that price will be P* and the quantity produced will be Q*.
Ideally, the firm would like to charge a higher price to
consumers willing to pay more than P*, thereby capturing
some of the consumer surplus under region A of the
demand curve.
The firm would also like to sell to consumers willing to pay
prices lower than P*, but only if doing so does not entail
lowering the price to other consumers.
In that way, the firm could also capture some of the surplus
under region B of the demand curve.
CAPTURING CONSUMER SURPLUS
Capturing Consumer Surplus
●Customers in region A can pay more and in B (capturing consumer
surplus) , since P>MC, prices could be reduced. Firms can have
different prices according to where customers are along the demand
curve. If it charges some customers higher than P* (say P1) and some
lower than P*(say P2) and some P* it can capture customer surplus.
PRICE DISCRIMINATION
● first-degree price discrimination Practice of
charging each customer its maximum price.
Additional Profit from Perfect First-Degree
Price Discrimination
When only a single price, P*, is charged, the
firm’s variable profit is the area between the
marginal revenue and marginal cost curves.
Variable profit is yellow area.
Consumer surplus is the black triangle.
Because the firm charges each consumer her
reservation price, it is profitable to expand
output to Q** (AR=MC). Variable profit is
yellow plus blue area.
With perfect price discrimination, this profit
expands to the area between the demand
curve and the marginal cost curve. Now it
produces Q** where AR=MC
● variable profit (profit ignoring fixed cost) Sum of profits on
each incremental unit produced by a firm; i.e., profit ignoring
fixed costs. Variable profit is increased. All consumer surplus
has been captured.
PRICE DISCRIMINATION
First-Degree Price Discrimination
Perfect Price Discrimination
The additional profit from producing and selling an incremental unit
is now the difference between demand and marginal cost.
Imperfect Price Discrimination
First-Degree Price Discrimination in
Practice
Firms usually don’t know the
reservation price of every
consumer, but sometimes
reservation prices can be roughly
identified.
Here, six different prices are
charged. The firm earns higher
profits, but some consumers may
also benefit.
With a single price P*4, there are
fewer consumers.
The consumers who now pay P5 or
P6 enjoy a surplus.
PRICE DISCRIMINATION
Second-Degree Price Discrimination
Second-Degree Price Discrimination
● second-degree price discrimination Practice of charging different
prices per unit for different quantities of the same good or service.
● block pricing Practice of charging different prices for different
quantities or “blocks” of a good. Eg: electric power, natural gas, water
etc.
Different prices are charged for
different quantities, or “blocks,” of
the same good. Here, there are
three blocks, with corresponding
prices P1, P2, and P3.
There are also economies of
scale, and average and marginal
costs are declining. Seconddegree price discrimination can
then make consumers better off
by expanding output and lowering
cost.
Third-Degree Price Discrimination
● third-degree price discrimination Practice of dividing consumers
into two or more groups with separate demand curves and charging
different prices to each group. Eg: airlines, railways, liquor, canned
food, student discounts.
Creating Consumer Groups
If third-degree price discrimination is feasible, how should the firm decide
what price to charge each group of consumers?
• We know that however much is produced, total output should be
divided between the groups of customers so that marginal revenues
for each group are equal.
• We know that total output must be such that the marginal revenue for
each group of consumers is equal to the marginal cost of production.
Third-Degree Price Discrimination
Determining Relative Prices
(11.2)
Third-Degree Price Discrimination
Consumers are divided into two groups, with
separate demand curves for each group. The
optimal prices and quantities are such that
the marginal revenue from each group is the
same and equal to marginal cost.
Here group 1, with demand curve D1, is
charged P1,
and group 2, with the more elastic demand
curve D2, is charged the lower price P2.
Marginal cost depends on the total quantity
produced QT.
Note that Q1 and Q2 are chosen so that MR1
= MR2 = MC.
PRICE DISCRIMINATION
Third-Degree Price Discrimination
Determining Relative Prices
No Sales to Smaller Market
Even if third-degree price discrimination
is feasible, it may not pay to sell to both
groups of consumers if marginal cost is
rising.
Here the first group of consumers, with
demand D1, are not willing to pay much
for the product.
It is unprofitable to sell to them because
the price would have to be too low to
compensate for the resulting increase in
marginal cost.
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.
MONOPOLISTIC COMPETITION
• Features
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.
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.
2. Limited monopoly power
3. Eg: toothpaste, shaving cream, shampoo, soap, bicycles, reatail
trade
4. Product differentiation creates brand loyalty and gives rise to
downward sloping demand curve
5. Product differentiation provides the rationale of selling
expenses.
6. Product changes, advertising and salesmanship are the main
means of product differentiation.
A Monopolistically Competitive Firm in the Short 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 yellowshaded rectangle.
Equilibrium 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.
More output can be
produced at lowest cost
, therefore excess
capacity exists. If no. of
firms are reduced and
output of each is
increased, cost will
reduce.
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 zeroprofit point occurs at
the point of minimum
average cost.
Monopolistic Competition and Economic Efficiency
Under monopolistic
competition, price
exceeds marginal cost.
Thus there is a
deadweight loss, as
shown by the yellowshaded area.
The demand curve is
downward-sloping, so
the zero profit point is
to the left of the point of
minimum average cost.
In evaluating monopolistic competition, these
inefficiencies must be balanced against the gains to
consumers from product diversity.
Impact of advertising and other
costs of prodn and selling
• Advertising and selling costs increase AC.
• Advertising is an alternative to reduction in prices.
• In the long run, profits will disappear since new entrants
will copy advertising campaigns.
• Consumers do not benefit since prices do not fall due to
higher selling costs.
• As a result of advertising, each monopolistically
competitive firm produces more than it would otherwise
which reduces excess capacity but consumers do not
benefit since prices are not lowered.
• Continuous product development also leads to more cost
and more profits but more profits can disappear in the
long run due to copying.
OLIGOPOLY
Only a few firms account for most or all of total production. A rule of
thumb is that an oligopoly exists when the top five firms in the market account
for more than 60% of total market sales.
In oligopolistic markets, the products may or may not be differentiated.
Product branding: Each firm in the market is selling a branded product.
Entry barriers: Entry barriers maintain supernormal profits for the dominant
firms. It is possible for many smaller firms to operate on the periphery of an
oligopolistic market, but none of them is large enough to have any significant
effect on prices and output
Inter-dependent decision-making: Inter-dependence means that firms must
take into account the likely reactions of their rivals to any change in price,
output or forms of non-price competition.
Non-price competition: Non-price competition is a consistent feature of the
competitive strategies of oligopolistic firms. (advertising, after-sales service,
free gifts)
•Examples of oligopolistic industries include automobiles, steel,
aluminum, petrochemicals, electrical equipment, and computers.
NON-PRICE COMPETITION
• Practiced by oligopoly and monopolistic
competition.
Various forms:
 Competitive advertising – to reinforce product
differentiation and harden brand loyalty.
 Promotional offers – eg. Household detergent,
toothpaste, shampoo (buy 2 get 1 free), (25%
extra at no extra cost).
 Extended guarantees/after sales service – esp. for
consumer durables, by offering free spare parts,
labour guarantee.
 Better credit facility
 Attractive gift wrappings
KINKED DEMAND CURVE
• ASSUMPTIONS
• There are many firms
• Each produces a product which is a close
substitute.
• Product qualities are constant, advertising
expenditures are 0.
• Rivals lower the price if he lowers the price but
do not raise it if he raises it.
£
Stable price under conditions of a kinked
demand curve
MC2
MC1
P1
a
D = AR
b
O
Q
Q1
MR
KINKED DEMAND CURVE THEORY
• If the firm lowers its price below OP1, its rivals will follow.
 If the other firms do follow A’s price changes, then there is going to be less
substitution taking place and the demand for A’s product is going to be relatively
INELASTIC (steep slope). Its demand will expand along the relatively inelastic
section of the demand curve below OP1 and total revenue will fall.
 If the firm raises its price above OP1, none of its competitors will follow.
 If the other firms do not follow then the demand for A’s product will be relatively
ELASTIC (flat slope). Its demand for prices above OP1 will contract along the
relatively elastic section of the demand curve and total revenue will fall.
• As a result of action and non-reaction to price changes, an oligopolist is faced with
a kinked demand curve at OP1.
• Price rigidity is due to the kinked demand curve and the resulting discontinuity in
the MR curve.
•
There is limited real-world evidence for the kinked demand curve model. The
theory can be criticised for not explaining why firms start out at the equilibrium
price and quantity. That said it is one possible model of how firms in an oligopoly
might behave if they have to consider the likely responses of their rivals.
Kinked Demand Curve
• When firms believe that their product is a
close substitute for their competitor’s
product, they do not have much incentive
to change price:
• A price decrease will be matched, so they
have nothing to gain by lowering price.
• A price increase will not be matched, so
they have a lot to lose by raising price.
54
Changing cost conditions
Even though MC may be rising or falling,
MC=MR in the portion of discontinuity will
leave price and output unchanged at OP1 and
OQ1.
 Changes in costs has no effect on profit
maximising price and out put because the firm
is still producing where MC=MR.
ADVANTAGES OF OLIGOPOLY
• When firms collude – monopoly –supernormal
profit – extra profit – extra capital – to fund
R&D – benefit to consumer.
• Product differentiation – non-price
competition– greater variety to consumers.
• Price stability/rigidity – helps in planning,
reduce uncertainty.
DISADVANTAGES OF OLIGOPOLY
• Collusive oligopoly
 if they agree upon output – no variety and improvement in
quality – bad for consumers.
o Acting like a monopoly
 Restrict output and charge a higher price
 Producer sovereignty
 Consumer sovereignty not respected
 Greater inequality in income (supernormal profits)
Collusive Oligopoly
• To avoid uncertainty, oligopolistst may enter into
collusive agreements.
• A cartel arrangement occurs when the firms in an
industry cooperate and act together as if they
were a monopoly.
• Cartel arrangements may be tacit or formal
• Conditions that influence the formation of cartels
–
–
–
–
–
–
Small number of firms in the industry
Geographical proximity of the firms
Homogeneous products
Stage of the business cycle
Difficult entry
Uniform cost conditions
Cartels aimed at joint profit
maximisation
• The central agency will calculate the market
demand curve and the corresponding MR
curve.
• The market MC is obtained from horizontal
summation of individual MC curves.
• The joint profit is maximized where MC=MR.
• Allocation of output between A and B is
determined by equating common MR with
MC1 and MC2.
• Equilibrium condition: MR= MC1=MC2
•
•
•
•
•
Profits for each firm are shown in blue. We assume that each firm earns profits only
from its own sales.
Firms may earn different levels of profit.
Combined profits are maximized.
Incentive for firms to cheat on agreement.
Cartels are unstable.
Cartels aimed at market-sharing by
non-price competition
• Firms agree to share the market and agree on
a common price which is set by bargaining
such that all members make some profits. The
members can vary the style of the product
and can compete on a non-price basis.
• This form of cartel is more unstable as low
cost firms will to break away and charge a
lower price. This may lead to price war and
instability.
Sharing of the market by agreement
on quotas
• There is an agreement on the quantity that
each member may sell at the agreed price.
• Shares on the basis of cost differential is
decided by bargaining.
• Conditions for Cartel Success
• Agreement on price and production levels
• Potential for monopoly power.
Price leadership
• Price leadership is another form of collusion in
oligopoly.
• Types of price leadership
– Price leadership by a low-cost firm
– By a dominant firm
– Barometric price leadership
Dominant Price Leadership
– One firm is recognized as the industry leader.
– Dominant firm sets price with the realization that
the smaller firms will follow and charge the same
price.
– Determining the optimal price is illustrated in the
following graphs.
Price Leadership
• DT is the demand curve facing
the entire industry.
• MCR is the summation of the
marginal cost curves of all of
the follower firms. You can
think of MCR as a supply curve
for these firms.
• In choosing its price, the
dominant firm has to consider
the amount supplied by the
follower firms.
Price Leadership
• For any price chosen by
the dominant firm, some
of the market demand will
be satisfied by the
follower firms. The
“residual” is left for the
dominant firm.
• The demand curve facing
the dominant firm is found
by subtracting MCR from
DT. This “residual demand
curve” is labeled DD.
Price Leadership
• To determine price, the
dominant firm equates its
marginal cost with the
marginal revenue from its
residual demand curve.
• The dominant firm sells A
units and the rest of the
demand (QT – A) is
supplied by the follower
firms.
Follower Supply
Follower Supply
Barometric Price Leadership
– One firm in an industry will initiate a price change
in response to economic conditions.
– The other firms may or may not follow this leader.
– Leader may change.
Game theory
• A mathematical technique for analyzing the decisions
of interdependent oligopolistic firms in uncertain
situations.
• A “game” is simply a competitive situation where
two or more firms or individuals pursue their
interests and no person can dictate the final outcome
or “payoff”.
• Players choose their strategy without certain
knowledge of the other players strategies, but may
eventually learn which way the opposition is leaning.
69
Elements of a Game
• Basic elements
– The players
– The strategies
– The payoffs
• Payoff matrix
– The fundamental tool of game theory.
– This is simply a way of organizing the
potential outcomes of a given game in a
table that describes the payoffs in a game for
each possible combination of strategies
70
Strategies
• Dominant strategy
– A strategy that yields a higher payoff no matter what the other
players in a game choose. The dominant strategy is each
player’s unique best strategy regardless of the other players’
action
• Dominated strategy
– Any other strategy available to a player who has a dominant
strategy
• Nash Equilibrium
– Any combination of strategies in which each player’s strategy is
his best choice, given the other players’ strategies
– IOW: Nash equilibrium is achieved when all players are playing
their best strategy given what the other players are doing.
71
Prisoner’s dilemma
Prisoner A
Confess
Prisoner B
Deny
Confess
(3 years, 3 years)
(1 year, 10 years)
Deny
10 years, 1 year)
(2 years, 2 years)
A simple game and payoff matrix
• Duopoly situation – each of the two firms A and B must
decide whether to mount an expensive advertising
campaign.
• If each firm decides not to advertise, each will earn a
profit of $50,000.
• If one firm advertises and the other does not, the firm
that does will increase its profits by 50% to $75,000,
and drive the competition into a loss.
• If both firms advertise, they will earn $10,000 each
because the advertising expense forced by competition
wipes out large profits
73
Example continued…
• If firms could agree to collude, the optimal strategy
would obviously be to not advertise – maximize joint
profits = $100,000
– Let’s assume they cannot collude, and therefore do not
know what the competition is doing.
• A “Dominant Strategy” is the one that is best no
matter what the opposition does.
74
Dominant strategy and nash
equilibirum
• Payoff matrix for advertising game
Firm B
Firm A
advertise
Don’t
advertise
Advertise
10,5
15, 0
Don’t
advertise
6,8
10,2
Firm B
Firm A
advertise
Don’t
advertise
Advertise
10,5
15, 0
Don’t
advertise
6,8
20,2
Nash equilibrium
• It is a set of strategies such that each player is doing the best
it can given the actions of its opponents. The strategies are
stable as players do not have any incentive to deviate.
• Dominant strategy equilibrium is a special case of Nash
equilibrium.
Firm B
Firm A
Crispy
Sweet
Crispy
-5,-5
10,10
Sweet
10,10
-5,-5
• If firm 1 indicates through a price release that that it is about
to introduce sweet cereal, the nash equilibrium will be the left
hand corner of the matrix and will be a stable one.
Pricing Strategies
• Penetration Pricing-Price set to ‘penetrate the
market’,‘Low’ price to secure high volumes,
typical in mass market products – chocolate
bars, food stuffs, household goods, etc., useful
in launching new products.
• Market Skimming-High price, Low volumes,
Suitable for products that have short life
cycles or which will face competition at some
point in the future (e.g. after a patent runs
out)
• Examples include: Playstation, jewellery,
digital technology, new DVDs, etc.
• Value Pricing-Price set in accordance with
customer perceptions about the value of the
product/service.
• Loss Leader-Goods/services deliberately sold
below cost to encourage sales elsewhere, e.g.
‘Free’ mobile phone when taking on contract
package
• Psychological Pricing-Used to play on consumer
perceptions, eg: 99/, 999/-,9.99%
• Going Rate (Price Leadership)-In case of price
leader, rivals have difficulty in competing on
price – too high and they lose market share,
too low and the price leader would match
price and force smaller rival out of market. Eg:
banks, petrol, supermarkets, electrical goods
• Tender Pricing
• Price Discrimination
• Destroyer/Predatory Pricing
• Full Cost Pricing- to cover both fixed and
variable costs
• Absorption Cost Pricing- Price set to ‘absorb’
some of the fixed costs of production
• Marginal Cost Pricing-Particularly relevant in
transport where fixed costs may be relatively
high
• Target Pricing
• Cost-Plus Pricing- AC plus a mark up
Practice sums
• Quantity demanded of a product decreases from
4000 units to 3000 units wheb price of the
product increases from Rs.40 to Rs.45. If income
effect is estimated to be 900, substitution effect
of the price change is…?
• MU of good X is 300 utils and its price is Rs.12.If
price of good Y is Rs.30,the MU of good Y at
equilibrium is…?
• A consumer is willing to buy 100 units of a
product at a price of Rs.10. If the current market
price of the product is Rs.9, consumer surplus is?
• Assume that utility can be measured in Rs. From the utility schedule given
below, find how many cokes the consumer would consume at the price of
Rs.9 per coke.
Coke
Total utility
(Rs.)
1
30
2
45
3
54
4
59
5
59
• Vinod has a monthly income of Rs.340. Being an addict to fruit juices, he
spends all his income on Apple, Mango, and orange juices. The prevailing
prices of apple, mango and orange juices are Rs. 20 per bottle,Rs.40 per
bottle and Rs.50 per bottle, respectively,. The TU schedule of Vinod is
given below:
Vinod has a monthly income of Rs.340. Being an addict to fruit juices, he
spends all his income on Apple, Mango, and orange juices. The prevailing
prices of apple, mango and orange juices are Rs. 20 per bottle,Rs.40 per
bottle and Rs.50 per bottle, respectively,. The TU schedule of Vinod is given
below:
Bottles
consumed
TU of apple TU of
juice
Mango
juice
TU of
orange
juice
1
140
170
320
2
260
330
580
3
340
420
820
4
410
500
1020
5
460
570
1180
6
500
630
1300
7
520
670
1360
Capital
TP
AP
MP
1
10
4
4
4
2
10
10
5
6
3
10
21
7
11
4
10
40
10
19
5
10
55
11
15
6
10
60
10
5
7
10
63
9
3
8
10
64
8
1
9
10
63
7
-1
Identify the
three stages of
production.
•
Marginal product schedule of a firm at various levels of inputs is given below:
No. of
units
•
•
•
1
2
3
4
5
6
Labour 144
96
60
48
36
24
Capital 120
84
60
30
20
10
The wage rate is Rs.12 and cost of capital is Rs.6. If budget of the firm is Rs.60, what is
the optimum labor and capital to be employed by the firm?
The following schedule shows the total,average and marginal productivity of labour. The
wage per unit of labor is constant at Rs.600.
L
1
2
3
4
5
6
7
TPl
200
600
1400
2000
2400
2600
2700
APl
200
300
466
500
480
434
385
MPl
200
400
800
600
400
200
100
If the firm produces 2400 units of output what is the average variable cost of
production.
• During the last period, the sum of profit and
FC for a firm totaled Rs. 100,000. Units sold
were 10,000. If VC per unit is Rs.4, SP is Rs. 14,
what is the profit change if the firm sells
11,000 units of output?
• Hint: chg in profit= chg in quantityx (P-AVC)
• A firm in a perfectly competitive industry has the following
total cost schedule:\
Output Q
Total cost (Rs)
10
110
15
150
20
180
25
225
30
300
35
385
40
480
• The going market price of Q is Rs 17. What is the optimal level of
output that this firm should produce> what are the profits at this
optimal level of output? Is Rs 17 also the equilibrium price in the
long run.
•
•
•
The following table shows the demand curve facing a monopolist who produces at
a constant marginal cost of a Rs 10.
What are the firm’s profit-maximising output and price? What is its profit?
What would the equilibrium price and quantity be in a competitive industry?
Price
Quantity
18
0
16
4
14
8
12
12
10
16
8
20
6
24
4
28
2
32
0
36
• If MR=30,Ed=1.5,what will be the price?
• Following is the dales data for motorbikes in
Firm
Sales
India.
A
12000
B
21021
C
43102
D
24226
E
921
F
402
Total
101672
• what is the value of Herfindahl index?
• Expansion in a production facility is a strategy
considered by firms in an oligopolistic market.
The situation faced by two firms is as follows:
Firm 2
Firm 1
Expand
Do not
expand
Expand
8,8
20,0
Do not
expand
0,20
10,10
• Does either firm have a dominant strategy?