ECON 101 - Principles of Microeconomics - Week 10 - M30 wo iClicker PDF

ECON 101 – Principles of Microeconomics Instructor: Kairon Shayne D. Garcia TA: Keanu Hua Office: SSPA 351 Office: SSPA 323 Office Hours: 9:00am-11:00am M/W Office Hours: 3:30pm-4:30pm W/Th (in-person) (in-person) Email: k...

ECON 101 – Principles of Microeconomics Instructor: Kairon Shayne D. Garcia TA: Keanu Hua Office: SSPA 351 Office: SSPA 323 Office Hours: 9:00am-11:00am M/W Office Hours: 3:30pm-4:30pm W/Th (in-person) (in-person) Email: [email protected] Email: [email protected] Module 30: Oligopoly Learning Points Oligopoly and its characteristics Collusion  Review: the Four Types of Market Structure Number of firms? Many firms One firm Type of products? Few firms Differentiated Identical products products Monopoly Oligopoly Perfect Monopolistic Tap water Tennis balls Competition Competition Cable TV Cigarettes Wheat Novels Movies Milk Oligopoly Oligopolists operate in a state of interdependence This means that pricing and production decisions of one firm significantly affect the profits of its rivals Oligopoly Market Structure in which only a few sellers offer similar or identical products Oligopoly Duopoly Simplest type of Oligopoly A market with only two sellers (each firm is known as a duopolist)  Table 30-1, Demand Schedule for Tires Duopoly Example Price of tire Quantity of tires demanded (millions) Total revenue (millions) $12 0 $0 Suppose, there are only two 11 10 110 producers of auto tires: 10 20 200 Bridgestone and Hitachi. 9 30 270 Also assume that once a 8 40 320 7 50 350 company has incurred the 6 60 360 fixed cost needed to produce 5 70 350 the tires, the MC of 4 80 320 producing another tire is 3 90 270 zero. 2 100 200 1 110 110 0 120 0  Table 30-1, Demand Schedule for Tires Duopoly Example Price of tire Quantity of tires demanded (millions) Total revenue (millions) $12 0 $0 In a perfectly competitive 11 10 110 market: 10 20 200 Firms would produce until 9 30 270 price equal MC which is zero, 8 40 320 yielding a total output of 120 7 50 350 million tires and zero revenue 6 60 360 for both firms. 5 70 350 4 80 320 3 90 270 2 100 200 1 110 110 0 120 0  Table 30-1, Demand Schedule for Tires Duopoly Example Price of tire Quantity of tires demanded (millions) Total revenue (millions) $12 0 $0 Yet under duopoly, with only 11 10 110 two firms in the industry, 10 20 200 they’ll realize that by 9 30 270 producing more drives down 8 40 320 the market price. 7 50 350 So each firm, like a 6 60 360 monopolist, will realize that 5 70 350 profits would be higher if it and 4 80 320 its rival limited their 3 90 270 production. 2 100 200 1 110 110 0 120 0  Table 30-1, Demand Schedule for Tires Duopoly Example Price of tire Quantity of tires demanded (millions) Total revenue (millions) $12 0 $0 So, how much will the two 11 10 110 firms produce? 10 20 200 One possibility is that the two 9 30 270 firms will engage in collusion – 8 40 320 they will cooperate to raise 7 50 350 their joint profits. 6 60 360 5 70 350 4 80 320 3 90 270 2 100 200 1 110 110 0 120 0 Collusion Collusion Agreement among firms in a market about quantities to produce or prices to charge One possible duopoly outcome Cartel A group of firms acting in unison and agree how much each is allowed to produce Once a cartel is formed, the market is in effect served by a monopoly Cartels Price Price Competitive Market As if controlled (constant cost) by a monopolist PM Profit shared by members of cartel PC Supply MC = AC D MR D QC Quantity QM Quantity A cartel tries to move a market from “Competitive” toward “As If Controlled By a Monopolist.” Cartels An oligopoly that tries to act together to reduce supply, raise prices, and increase profits The Organization of Petroleum Exporting Countries (OPEC) is a cartel of oil-exporting countries. Between 1970 and 1974 OPEC cut back on their production of oil. Cartels There’s a reason this cartel is an agreement among governments (rather than firms): cartels among firms are illegal in the US and many other jurisdictions.  Table 30-1, Demand Schedule for Tires Duopoly Example Price of tire Quantity of tires demanded (millions) Total revenue (millions) $12 0 $0 So, how much will the two 11 10 110 firms produce? 10 20 200 Assume these two firms 9 30 270 formed a cartel and acted as it 8 40 320 it were a monopolist. To maximize combined profits, 7 50 350 the cartel should set a total 6 60 360 industry output at 60 million 5 70 350 tires, which would sell at a 4 80 320 price of $6 per tire, leading to a revenue of $360 million (the 3 90 270 max possible). 2 100 200 1 110 110 0 120 0  Table 30-1, Demand Schedule for Tires Duopoly Example Price of tire Quantity of tires demanded (millions) Total revenue (millions) $12 0 $0 How much each firm will 11 10 110 produce? 10 20 200 A fair solution might be for 9 30 270 each firm to produce 30 million 8 40 320 tires with revenues for each 7 50 350 firm of $180 million. 6 60 360 5 70 350 4 80 320 3 90 270 2 100 200 1 110 110 0 120 0  Table 30-1, Demand Schedule for Tires Duopoly Example Price of tire Quantity of tires demanded (millions) Total revenue (millions) $12 0 $0 But even if the two firms 11 10 110 agreed on such a deal, they 10 20 200 might have a problem: 9 30 270 Each of the firm would have 8 40 320 an incentive to break its word 7 50 350 (“cheat”) and produce more 6 60 360 than the agreed-upon quantity. 5 70 350 4 80 320 3 90 270 2 100 200 1 110 110 0 120 0 Why would individual firms have an incentive to “cheat”? Short answer: Because neither firm has a strong incentive to limit its output as a true monopolist would. Why would individual firms have an incentive to “cheat”? Recall that a profit maximizing monopolist sets Marginal Cost equals Marginal Revenue (MC=MR), and producing an additional unit of good has two effects: 1. A positive quantity effect: one more unit is sold, increasing total revenue by the price at which that unit is sold. 2. A negative price effect: to sell one more unit, the monopolist must cut the market price on all units sold. Why would individual firms have an incentive to “cheat”? The negative effect is the reason marginal revenue (MR) for a monopolist is less than the market price. In the case of oligopoly, when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not those of its fellow oligopolists. Why would individual firms have an incentive to “cheat”? In our example, both Bridgestone and Hitachi suffer a negative price effect if Bridgestone decides to produce extra tires and so drives down the price. But Bridgestone cares only about the negative price effect on the units it produces, not about the loss of Hitachi. Why would individual firms have an incentive to “cheat”? This tells us that an individual firm in an oligopolistic industry faces a smaller price effect from an additional unit of output than does a monopolist. Therefore, the marginal revenue that such firm calculates is higher. So it will seem to be profitable for any one company in an oligopoly to increase production, even if that increase reduces the profits of the industry as a whole. But if everyone thinks this way, everyone earns a lower profit! EXAMPLE 2: Gas Station Duopoly in Unionville P Q The table: Unionville’s demand $0 10,000 schedule for gasoline 1 9,200 Assume that Unionville has only two 2 8,400 gas stations: “Fuel 4 Gas” & “Diesel 3 7,600 and BP” (Duopoly) 4 6,800 Q: gallons of gasoline 5 6,000 Each firm’s costs are 6 5,200 MC = $1 and FC = $0 7 4,400 8 3,600 9 2,800 EXAMPLE 2: Unionville, Competition vs. Monopoly P Q Revenue Cost Profit Competitive $0 10,000 $0 $10,000 -$10,000 outcome: 1 9,200 9,200 9,200 0 P = MC = $1 2 8,400 16,800 8,400 8,400 Q = 9,200 3 7,600 22,800 7,600 15,200 Profit = $0 4 6,800 27,200 6,800 20,400 Monopoly 5 6,000 30,000 6,000 24,000 outcome: 6 5,200 31,200 5,200 26,000 P = $7 7 4,400 30,800 4,400 26,400 Q = 4,400 8 3,600 28,800 3,600 25,200 Profit = $26,400 9 2,800 25,200 2,800 22,400 Practice Problem: Collusion in Unionville? P Q Duopoly outcome with collusion 10,00 $0 0 1 9,200 Each gas station agrees to sell Q = 2,200 2 8,400 at P = $7, each earns profit = $13,200 3 7,600 4 6,800 5 6,000 6 5,200 7 4,400 8 3,600 9 2,800 Practice Problem 1: Collusion in Unionville? Question 1: What happens if Fuel 4 Gas & Diesel cheats on the agreement and plans to sell Q = 3,000, what happens to the market price? Calculate Fuel 4 Gas & Diesel’s profit. Practice Problem 1: If Fuel 4 Gas & Fuel cheats P Q If Fuel 4 Gas & Fuel cheats: Q1 = 3,000 $0 10,000 1 9,200 2 8,400 Market quantity = 3,000 + 2,200 = 5,200 3 7,600 P = $6 4 6,800 Fuel 4 Gas & Fuel’s profit = 3,000×(6 – 1) 5 6,000 = $15,000 6 5,200 7 4,400 8 3,600 9 2,800 Practice Problem 2: Collusion in Unionville? Question 2: Is it in Fuel 4 Gas & Diesel interest to cheat on the agreement? Practice Problem 2: Collusion in Unionville? Question 2: Is it in Fuel 4 Gas & Diesel interest to cheat on the agreement? Yes. Higher profit! $15,000 (cheats) vs $13,200 (cooperate) Practice Problem 3: Collusion in Unionville? Question 3: If both gas stations cheat and plan to sell Q = 3,000 each, calculate their profits. Practice Problem 3: Collusion in Unionville? P Q Question 3: If both gas stations cheat and plan $0 10,000 to sell Q = 3,000 each, calculate their profits. 1 9,200 2 8,400 If both cheat: Q1 = Q2 = 3,000 3 7,600 4 6,800 Market quantity = 6,000 5 6,000 P = $5 6 5,200 Each firm’s profit = 3,000×(5-1) = $12,000 7 4,400 8 3,600 9 2,800 Collusion vs Self-Interest Summary Case Profit of each firm If both cooperate $13,200 If one cheats $ 15,000 (cheater) If both cheats $ 12,000 Both firms would be better off if both stick to the collusion agreement (form a cartel) But each firm has incentive to cheat on the agreement. Lesson It is difficult for oligopoly firms to form cartels and honor their agreements. Tacit Collusion When firms limit production and raises prices in a way that raises on another’s profits, even though they have not made any formal agreement, they are engaged in tacit collusion. Although tacit collusion is common, it rarely allows an industry to push prices all the way up to their monopoly level; collusion is usually far from perfect. Factors that make it Difficult to coordinate on high prices 1. Less concentration In a less concentrated industry, the typical firm will have a smaller market share than in a more concentrated industry. This tilts firms toward noncooperative behavior because when a smaller firm cheats and increases its output, it gains for itself all of the profit from the higher output. If its rivals retaliate by increasing their output, the firm’s losses are limited because of its relatively modest market share. A less concentrated industry are often an indication that there are low barriers to entry. Factors that make it Difficult to coordinate on high prices 2. Complex Products and Pricing Schemes In our tire example, the two firms produce only one product. In reality, oligopolists sell a variety of different products. Keeping track of who cooperates or cheats is difficult. Factors that make it Difficult to coordinate on high prices 3. Differences in Interests In our tire example, a tacit agreement for the firms to split the market equally is a natural outcome, probably acceptable for both firms. But in reality, firms often differ both in their perceptions about what is fair and in their real interests. Factors that make it Difficult to coordinate on high prices 4. Bargaining Power of Buyers Often, oligopolists sell not to individual consumers but to large buyers –other industrial enterprises, nationwide chains of stores, etc. These large buyers are in a position to bargain for lower prices from the oligopolists: they can ask for a discount and warn that they will go to a competitor is turned down.