Profit Maximization
Profit Maximization
Maximization
chapter 9
In our pursuit to develop a market supply curve, we started from conceptualizing production, and then developing the idea
of Cost function, and now, have reached our final destination in this chapter where we shall develop the individual firm
supply curve.
•
Perfectly Competitive Markets – Underlying assumptions
PRICE TAKING - both consumers and firms accept price as an exogenous parameter that they are
incapable of influencing. Both sides of market are “PRICE TAKER”
• Individual firms must believe that whatever they produce will get sold at the going market
price value which they presume during taking output decisions.
• So essentially, “market clears”, that is, market equilibrium OCCURS when (i) their
prediction/assumption of market price is a perfect match with the realized market price,
and (ii) all produced output gets sold.
• In reality, the market (real) price over time continue to fluctuate over a period of time unless firms
and consumers arrive at this conceptual match.
• Because each individual firm sells a sufficiently small proportion of total market output, its
decisions have no impact on market price – internet market place, fish auctions?
PRODUCT HOMOGENEITY - Products of all of the firms in a market are perfectly substitutable
with one another—that is, they are homogeneous. Hence, no firm can raise the price of its product above
the price of other firms without losing most or all of its business. Example: world market for wheat!!!
• In contrast, when products are heterogeneous, each firm has the opportunity to raise its price
above that of its competitors without losing all of its sales. Hence, the need for advertising!!
• The assumption of product homogeneity is important because it ensures that there is a
single market price, consistent with supply-demand analysis.
FREE ENTRY AND EXIT - With free entry and exit, buyers can easily switch from one supplier to
another, and suppliers can easily enter or exit a market. So there can be no special costs that make it
difficult for a firm to enter (or exit) an industry.
NO TRANSACTION COST - Sellers and buyers can easily locate each other and engage in a
meaningful discussion or negotiations of prices without fear or barriers.
Do Firms Maximize Profit?
Firms that do not care about maximizing profit are not likely to survive (their brand
names may survive though). The firms that do survive make long-run profit
maximization one of their highest priorities: [Case in point: Masayoshi Son issued a
call for profit maximization after his huge investment in WeWork went bust as the
company shut down due to immense losses.]
PROFIT MAXIMIZATON
MR(q) = MC(q)
A competitive firm supplies only a small portion of the total output of all the firms in an industry.
Therefore, the firm BELIEVES (takes) the market price revealed by the supreme AI AND THAT
SHE CAN SELL AS MUCH SHE WANTS AT THIS PRICE – hence, choosing its output on the
assumption that the price will be unaffected by the output choice.
Hence (a) the demand curve perceived by the firm is perfectly elastic, even though the actual market
demand curve in (b) is downward sloping.
• Along the perceived horizontal demand curve, marginal revenue, average
revenue (= R(q)/q), and price are all equal.
• Hence, the perfectly competitive structure of the market leaves firms to decide
only one question: HOW MUCH TO PRODUCE? (unlike a monopolist who –
not being a price taker – may ask a different question : “how much to charge?”
NOTE THAT ANY FIRM BEHAVING IN SUCH AN IDEALIZED MANNER ENGAGES IN WHAT IS KNOWN AS
„MARGINAL COST PRICING”, THAT IS, THEY SELL EACH UNIT OF TOTAL OUTPUT Q* AT THE
MARGINAL COST MC(Q*).
AS WE SHALL SEE LATER, SUPPLY CURVE CAN EXIST AS MATHEMATICAL/CONCEPTUAL ENTITY ONLY IF THE FIRMS IN MARKET ARE PERFECTLY COMPETITIVE. MORE
IMPORTANTLY, THIS MEANS THE MARKET DEMAND-SUPPLY ANALYSIS IS INVALID FOR MARKETS WHERE FIRMS AND CUSTOMERS DO NOT BEHAVE IN A PERFECTLY
COMPETITIVE MANNER (OR A PRICE TAKER).
The Short-Run Market/Industry Supply Curve
(horizontal summation)
The short-run industry
supply curve is the
summation of the supply
curves of the individual
firms.
Because the third firm has
a lower average variable
cost curve than the first two
firms, the market supply
curve S begins at price P1
and follows the marginal
cost curve of the third firm
MC3 until price equals P2,
when there is a kink.
Elasticity of Market Supply
For P2 and all prices above
it, the industry quantity Es = (ΔQ/Q)/(ΔP/P)
supplied is the sum of the
quantities supplied by each
of the three firms.
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.
Therefore in long run, that is, when C(0)=0, producer surplus is same as profit.
The Short Run Effects of a „per unit‟ Tax on an Individual Firm‟s Supply.
BUT IF A FIRM EARNS POSITIVE ECONOMIC PROFIT, NEW FIRMS WILL STEADILY ENTER THE MARKET,
SHIFTING THE INDUSTRY SUPPLY CURVE TO THE RIGHT WITHOUT AFFECTING THE INDUSTRY
DEMAND CURVE. THIS WOULD LEAD TO REDUCTION IN MARKET PRICE, WHICH WOULD REDUCE
ECONOMIC PROFITS OF ALL INDIVIDUAL FIRMS. THIS PHENOMENON WOULD CONTINUE UNTILL ALL
FIRMS IN THE MARKET EARN ZERO ECONOMIC PROFITS.
π = R − wL − rK
S1
market equilibrium.
Increase in
consumers’ cost
• Note the increased price per gallon S
Pb paid by consumers due P0 + T
to the tax.
Pb B
P0
• Note the price pocketed by A
sellers for each unit sold is PS = Pb - T C
Ps (shown by Point C). Decrease in
gas stations’
receipts per
gallon
• Note how imposition of
tax drives a WEDGE D
between price paid by
buyer and that RECEIVED QT Q0
by seller. Gallons of gas per month
15-16
“Incidence” of a Specific Tax
• Incidence: how much of the tax burden is borne by
various market participants
Incidence of a Specific Tax applied on seller
• Sellers bear the entire burden of the tax in both the
following extreme cases.
15-18
Incidence of a Specific Tax applied on seller
• Buyers bear the entire burden of the tax in the
following two extreme cases.
15-19
Incidence of a Specific Tax
• The more elastic demand is, and the less
elastic supply is, more of the tax is borne by
seller
• For small values of taxes - roughly:
– Es
Buyers ' share =
Es Ed
Effects of a Specific Tax applied on buyer
(downward shift in demand curve)
• Point A shows the
market equilibrium
• Point B shows the
Price paid by buyers ($/gallon)
• We will focus on such pricing for a monopolist – but these same pricing
scheme are also useful in markets with “FEW” sellers, better known as
Oligopoly (we study this at a later stage).
So if you can sell a product at a mark up from her marginal cost of production, you
can very likely do better by price discriminating. Some products suitable for price
discrimination:
– Electricity [difficult to resale by nature].
– Books [publishers use tariffs and non-tariff/ legal barriers to sell the same edition at different prices
in different countries].
– Computer software [two options: (i) provide student discounts for full version while legally
restricting resale, or (ii) alter the product at zero cost and sell to students a limited version, thus
automatically making resale immaterial]
BCG consults on Price discrimination – so stay awake
In this chapter we will see how to “AVOID AVERAGE PRICING” without the additional complication of
“ALTERNATIVE SUPPLIERS”. For the latter part, I plan to float a dedicated elective in Term 5 – but its
uncertain.
Perfect (First degree) Price Discrimination
(almost impossible in real life)
A monopolist can engage in perfect price discrimination if he
knows a customer’s willingness to pay for each unit he sells, and
can charge a different price for each unit to each customer.
ADDITIONAL PROFIT FROM PERFECT FIRST-DEGREE PRICE DISCRIMINATION
n(T,P*(T))T+[P*(T)-MC(Q)].Q THEN BOTH DERIVED GOODS ARE SOLD VIA UNIFORM PRICING.
Second degree price discrimination
(Each consumer faces the same price schedule – but price schedule is such that the cost of
purchasing q units changes non-linearly as q changes.)
One such method is ―block pricing‖ which is practice of charging different prices for different
quantities or ―blocks‖ of a good. Another method could be practice of giving volume subsidies of bulk
discount were per unit consumption is cheaper only when aggregate consumptions exceeds some
threshold.
Monopolists also use this technique when the consumer have extreme desire/willingness to pay for the product up till a certain threshold
level - after which it declines sharply. For example: a certain amount of electricity is essential to running a household (to run
TV/AC/refrigerator etc.) – but beyond that level, conservation of energy becomes easier (leading to a fall in willingness to pay).
CUSTOMER SEGMENTATION
Three scenarios:
(1) Observable consumer groups (that is, customers are differentiable in eyes of seller) and there
are no legal barriers to price discrimination.
(2) Observable consumer groups but there are legal barriers to price discrimination.
(3) Unobservable consumer groups.
CASE (1):
• firm can distinguish consumers by their socio-economic characteristics
which are easy to verify, which in turn, reveal the EXTENT of their
willingness to pay for a product.
• essentially, based on these characteristics the monopolist may divide the
market in two separate markets, and charge different profit maximizing
prices in each market - example: railway tickets
Note that we continue to assume that: not only can the seller segregate customers into different markets but it
ALSO KNOWS THEIR RESPECTIVE DEMAND curves for sure.
Third-Degree Price Discrimination: Case (1)
Definition: Practice of dividing consumers into two or more groups with separate demand
curves and charging different prices to each group (UNIFORM PRICE WITHIN EACH
GROUP), when customer characteristics are observable and no legal barriers to doing
so.
If third-degree price discrimination is feasible, how should the firm decide what price to
charge each group of consumers?
1. Total output should be sold in the two markets in such a way that marginal revenues
for each group are equal.
2. Total output must be such that marginal revenue for each group of consumers is
equal to the marginal cost of production.
Let P1 be the price charged to the first group of consumers, P2 the
price charged to the second group, and C(QT) the total cost of
producing output QT = Q1 + Q2. Total profit is then
𝜋 = 𝑃1 𝑄1 + 𝑃2 𝑄2 − 𝐶 𝑄𝑇
∆𝜋 ∆ 𝑃1 𝑄1 ∆𝐶
= − =0
∆𝑄1 ∆𝑄1 ∆𝑄1
MR1 = MC
MR 2 = MC
𝑃1 1 − 1 |𝐸𝑑 𝑄2 |
=
𝑃2 1 − 1 |𝐸𝑑 𝑄1 |
Profit with 3rd degree price discrimination across to two
groups of consumers
Graphically, at least in this example, we can see that price discriminating producer surplus/
profit is GREATER than when not discriminating. MUST BE TRUE IF POSITIVE OUTPUT SOLD IN
EACH MARKET.
WHAT IF I CANNOT PHYSICALLY IDENTIFY CUSTOMERS FROM DIFFERENT GROUPS FOR SURE? WHAT IF I CAN DO SO BUT
AM LEGALLY MANDATED TO NOT DISCRIMINATE?
Changes in Consumer Surplus with 3rd degree discrimination
across two groups of consumers.
SOLUTION:
Self-selection: when the firm offers a menu of alternatives,
designed so that different customers will make different
choices based on their willingness to pay.
CS of low demander from low plan =0, CS of high demander from high plan = blue area
ASSUMPTION: DEMAND CURVES OF BOTH SEGMENTS ARE KNOWN – BUT INDENTIFICATION OF A CONSUMER AS HIGH
DEMAND OR LOW DEMAND IS NOT POSSIBLE
Capping Minutes In the Low-Demand Plan
Fix one plan for low demand consumers where fixed fee is 4.5$ and 20 cents per minute of usage with
maximum usage available is 30 units. This ensures that the low demand buyer has no consumer
surplus. Fix another plan for high demand customer, and charge a fixed fee X$ and (same uniform price)
10 cents per minute without any LIMIT on usage. Define Y$ to be the possible consumer surplus of high
demand person IF she were to consume her demand at price of 20 cents per unit without any fixed fee.
For self-selection choose X$ such that Y-X = the consumer surplus of high demand customer if she
consumes only 30 minutes of cellular service at 20 cents per minute and fixed fee 4.5$ = BLUE AREA. That is
X= (Y - BLUE AREA).
Combination of third degree price discrimination with two part tariff with
second degree price discrimination to induce self-selection.
• Note that this plan leads to self selection. But the profit earned is
lesser in the 1st application case that we saw.
• That is because in the current (that is, 2nd application) case, my high
demand plan DOES NOT allow high demand consumer to get ‘a lot
of’ surplus so as to ensure SELF SELECTION where she can be
indifferent between choosing high demand plan and the low
demand plan.
– That is, restrict consumption of low plan up to 30 which is less
than what high demander wants to consume as low plan price of
20 cents.
– This reduces the area of CS she can get achieve by choosing low
plan, and so, allows me to charge even greater amount of fixed
fee in my high plan.
So, its more profitable to ensure self selection along with quantity
capping in low demand plan. Also it may be profitable to price NO
markup to the high demand persons
COUPONS AND REBATES
(special application of 3rd degree price discrimination in presence of unobservable customer
segmentation)
Coupons offer discount to carriers of these. But why waste money printing and circulating
coupons when one could simply lower prices? Because coupons provide a means of price
discrimination so offer lower prices to only those who really want then..
NUSERS OF COUPONS
PRICE ELASTICITIES OF DEMAND FOR USERS VERSUS NO
PRICE ELASTICITY
PRODUCT NONUSERS USERS
Toilet supplies – 0.60 –0.66
Stuffing/dressing –0.71 –0.96
Shampoo –0.84 –1.04
Detailed analysis can be found in a paper by Cooking/salad oil –1.22 –1.32
Chakravarthy Narasimhan in journal MARKETING Dry mix dinners –0.88 –1.09
SCIENCE in 1984. He estimates price elasticity
Cake mix –0.21 –0.43
differences between coupon users of different
commodities, and finds that users have greater Cat food –0.49 –1.13
elasticity on average. Frozen entrees –0.60 –0.95
Gelatin –0.97 –1.25
Spaghetti sauce –1.65 –1.81
Crème
–0.82 –1.12
rinse/conditioner
Soups –1.05 –1.22
Hot dogs –0.59 –0.77
AIRLINE FARES
Travelers are often amazed at the variety of fares available for round-trip flights from
New York to Los Angeles.
A few years ago, the first-class fare was above $2000; the regular (unrestricted)
economy fare was about $1000, and special discount fares (often requiring the
purchase of a ticket two weeks in advance and/or a Saturday night stayover) could be
bought for as little as $200. These fares provide a profitable form of price discrimination.
The gains from discriminating are large because different types of customers, with very
different elasticities of demand, purchase these different types of tickets.
Airline price discrimination has become increasingly sophisticated. A wide variety of
fares is available.
FARE CATEGORY
ELASTICITY FIRST CLASS UNRESTRICTED COACH DISCOUNTED
Price –0.3 –0.4 –0.9
Income 1.2 1.2 1.8
Note the high price elasticity of demand for discounted fares which are typically bought by families well in
advance or leisure travellers. Demand for first class typically comes from business travellers who have less
flexibility on dates of travel and so have less price elasticity of demand.
In the case of cellular service, providers have taken the two-part tariff and turned it
into an art form.
In most parts of the United States, consumers can choose among four national
network providers—Verizon, T-Mobile, AT&T, and Sprint. These providers compete
among themselves for customers, but each has some market power. Market power
arises in part from oligopolistic pricing and output decisions (WE WILL STUDY LATER),
but also because consumers face switching costs (in India government has tried to
make this zero by ensuring number portability): Most service providers impose a
penalty upwards of $200 for early termination. Because providers have market power,
they must think carefully about profit-maximizing pricing strategies. The two-part tariff
provides an ideal means by which cellular providers can capture consumer surplus and
turn it into profit.
CELLULAR PLANS EXAMPLE - US
QUESTION: Why don’t the firms offer a simple common two part tariff price for their
products that is easier to administer, and account for?
THE ANSWER VARIES FROM CASE TO CASE DEPENDING ON ECONOMIC & LEGAL CONDITIONS
OF THE SETTINGS YOU ARE ANALYZING.
And if that weren’t enough, you still have to advise your client on
optimality of breaking down their product into multiple separate ones.
This is know as Bundling – and we shall study it now.
Bundling
Practice of selling two or more products as a package. Typically, makes sense
when customers are segmented/heterogeneous and identifiable - but
monopolist CANNOT price discriminate (why – maybe government bans it?)
To see how a film company can use customer heterogeneity to its advantage, suppose that there
are two movie theaters and that their reservation prices for our two films (made by the same
company/ distributor) as follows:
AVENGER EXTRACTION
Theater A $12,000 $3000
Theater B $10,000 $4000
Suppose the films cost the same amount of money to make (say, $ 1K). If the films are rented
separately, the maximum price that could be charged for AVENGER is $10,000 because charging
more would exclude Theater B. Similarly, the maximum price that could be charged for
EXTRACTION is $3000.
But suppose the films are bundled. Theater A values the pair of films at $15,000 ($12,000 +
$3000), and Theater B values the pair at $14,000 ($10,000 + $4000). Therefore, we can charge
each theater $14,000 for the pair of films and earn a total revenue of $28,000.
Relative Valuations
Why is bundling more profitable than selling the films separately? Because the relative
valuations of the two films are reversed. That is, the demands are negatively correlated—the
customer willing to pay the most for Avenger is willing to pay the least for Extraction.
Suppose INSTEAD that demands are positively correlated—that is, Theater A would pay more for
each film than Theatre B.
AVENGER EXTRACTION
Theater A $12,000 $4000
Theater B $10,000 $3000
If we bundled the films, the maximum price that could be charged for the package is
$13,000, yielding a total revenue of $26,000, the same as by renting the films
separately.
In general, effectiveness of bundling depends to the extent demands for two products
(of a single firm) are negatively correlated – that is, customer with high WTP for a
company’s product X have low WTP for the same company’s other product Y.
A MORE GENERAL ANALYSIS IN TERMS OF RESERVATION PRICES
In (a), because demands are perfectly positively correlated, the firm does not gain by bundling: It
would earn the same profit (as bundling) by selling the goods separately.
In (b), demands are perfectly negatively correlated. Bundling is the ideal strategy—all the
consumer surplus can be extracted.
Mixed vs Pure Bundling
mixed bundling: Selling two or more goods both as a package and individually.
For a restaurant, mixed bundling means offering both complete dinners (the
appetizer, main course, and dessert come as a package) and an à la carte
menu (the customer buys the appetizer, main course, and dessert separately).
At the same time, the complete dinner package (that is, bundle) retains those
customers who have lesser variations in their reservation prices (willingness to
pay) for different dishes (e.g., customers who attach moderate values to both
appetizers and desserts).
THE COMPLETE DINNER VERSUS À LA CARTE:
(A RESTAURANT PRICING PROBLEM)
For a restaurant, mixed bundling means offering complete dinners and an à la carte
menu. This strategy allows the à la carte menu to be priced to capture consumer
surplus from customers who value some dishes much more highly than others.
Bundling makes sense. Successful restaurateurs know their customers’ demand
characteristics and use that knowledge to design a pricing strategy that extracts as
much consumer surplus as possible.
MC DONALD’S MENU IN US (2011?)
• Describe the Bertrand model and the Cournot model, and identify the
Nash equilibrium in each model.
• Determine the number of firms that will enter a market and discuss the
factors that affect this number.
• Describe the main U.S. antitrust statutes and discuss their rationales.
Overview
• Analyze what a firm’s best actions are in oligopolies using
game theory
Or else there will be a different NE, the seller with lower marginal costs – under
some assumption of suitable discrete pricing – will charge the largest possible
price less than marginal cost of the high cost firm and sell to the whole market,
while the high cost firm will produce zero.
Cournot Model of Oligopoly
(a model of quantity competition)
Firms choose how much to produce
simultaneously (more importantly, without any
knowledge of what the other is choosing), and the
price clears the market given the total
quantity produced.
P = 60
Q = 2,000 MR = MC
P = 50, Q = 1,000
Joe behaves like a
monopolist given his
MR = MC
residual demand
Best-Response/Reaction Curves in the Cournot Duopoly
• 2 firms
• Identical products
• Output choice competition
• Simultaneous choice of production amount: that is, one does not know
the choice of the other while making own choice
To solve for the Nash equilibrium (Q*1, Q*2) , we set MR1 = C (the firm’s marginal cost)
∗ ∗
and we find that Firm 1’s reaction curve: 2Q 1 = 30 − Q 2 - C
∗
By the same calculation, Firm 2’s reaction curve: 2Q 2 = 30 − 𝑄 1- C
∗
Note the demand by Hyundai chairman to reduce GST to help tide over the current auto
industry crisis. So what he is saying is that auto sales are down (for very
specific political and economic reasons beyond the scope of this course) so that the value
’30’ in demand curve has now become ‘20‘ leading to reduction in output produced and
hence, labour employed. If taxes are reduced sufficiently, then the output will increase again
as ‘C’ will reduce to say, ‘C-10’, and the initial output and employment levels would be
regained – albeit at a significant loss of Government revenue.
Stackelberg duopoly model
The two firms choose their outputs sequentially – lets assume for the sake of this example, Rebecca’s firms is already
functional where as Joe’s firm is potentially getting ready to open his firm too. His startup cost is $15000.
REBECCA CAN NOW CONTROL HOW MUCH JOE WILL PRODUCE IF HE ENTERS – AND SO SHE CAN CONTROL WHETHER HE
ENTER AT ALL
Rebecca will choose to produce (or CREDIBLY commit to produce) 4000 units, which will
deter Joe from entering (as post entry profits would be 10000$, and thus, yield Rebecca
a profit of 80000$. 19-16
Strategic Pre-commitment to ensure “Detrrence”
When a firm “commits to certain actions” or “takes certain actions”
before rivals take theirs, with the aim of affecting rivals’ later
choices.
• Examples
– Stackelberg competition, or equivalently, output choice by a
first-mover (by signing a big labour contract in advance or setting up a
large plant whose technology requires it to run at almost full capacity – like
alumina refining plants)
– Spanish Conquistador (CORTES’) in 1519 burning ships to
eliminate option retreat while invading Aztec city of
Tenochtitlan
– Entry deterrence (making a large enough output choice, in the manner
mentioned above which makes profits consequent to entry so low for the
competitor that she does not enter)
19-17
Entry Deterrence
(OUT PUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)
Put simply, pre-committing limits the firm’s ability to respond to changing market conditions.
For example, DuPont once tried to deter rivals from producing titanium dioxide (a whitener
used in paints and plastics) by committing to an extensive expansion of its facilities.
Unfortunately for DuPont, an unexpected recession struck, and market demand turned out to
be much lower than DuPont forecasted, causing the firm’s clever strategy to yield a
disappointing loss.
HENCE THE NEED FOR PROFESSIONAL STATISITICIANS/ ECONOMISTS WHO CAN PREDICT
BUSINESS CYCLES.
19-18
Entry Deterrence via threats only
(OUTPUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)
• However, often firms prefer to set up the excess capacity (by signing a
labour contract or setting up a plant) but not actually increase
production prior to possible entry of competitor.
• Effectively, the existing firms are threatening the entrant that they
will render this decision to enter a financially COSTLY decision if they
DARE to enter.
Options range from lobbying, to buying critical input in bulk, to fomenting labour trouble at
competitors’ plant. There is much documentary and punishment evidence in US itself. 19-22
Collusion
Competing firms could merge become monopoly and earn monopoly profits that are
divided equally among shareholders of all firms. The is formation of CARTEL such as
OPEC. However, in domestic markets most countries have made such HORIZONTAL
MERGERS to be ILLEGAL.
So firms, if they want to collude in a domestic market must do so without any legal or
public declaration. This causes a problem because two separate production
technologies not integrated to each other need to agree to charge HIGH price – that
is, not cheat each other by charging LOW price while the other charges HIGH price.
Unfortunately, they can view their interaction to be an infinitely repeated game so use
special NE strategies (as the GRIM strategies) to sustain cooperation. That is, firms
may adopt a strategy in which they charge the monopoly price if no one has yet
undercut that price; otherwise they charge a price near or at their marginal cost.
Example: (OPEC and Russia)
So the next step was for them to fix market share to each firm – if any firm sold
more leading to less sales from other fellow cartel members, she had to buy lysine
from them at the cartel decided price. Thus, they move from price coordination
(opposite of competition) to quantity coordination (opposite of competition).
This eliminated the incentive to cheat among members and led to sustaining of
cooperation until FBI arrested all CEOs.
Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)
Under monopolistic
competition, price exceeds
marginal cost, and
production is carried out at
an inefficient level where
costs are not minimized.
Thus there is a deadweight
loss, as shown by the
yellow-shaded area.
The demand curve is
downward-sloping, so the
zero profit point is to the left In both types of markets, entry occurs until profits are driven to
of the point of minimum zero.
average cost.
FOR THE SAKE OF EXAMINATION, READING
THIS CHAPTER FROM SLIDES IS ENOUGH.
Chapter 21
Markets with asymmetric information about quality/ value of the good being traded.
Quality Uncertainty and the Market for Lemons
asymmetric information is typically found in situation in which a buyer and a seller possess
different information about a transaction (perhaps about the quality of produce being exchanged).
• Used cars sell (NO MATTER HOW YOUNG) for much LESS than new cars because
there is asymmetric information about their quality:
• REASON: The seller of a used car knows much more about the car than the prospective buyer
does as he has much more research on who was the original owner, how many kilometers did
the car run - in general being in the business of selling cars day in and day out gives the seller
a greater expertise to GAUGE quality of a car.
Thus, a prospective buyer is suspicious of the seller because she cannot sure of its
quality or believe seller‘s statement about its quality (who is going to make more
money by selling a low quality car as high quality product) - BECAUSE NICER THE CAR
LOOKS, MORE WILL SHE WONDER WHETHER THERE IS SOMETHING MAJORLY WRONG WITH THIS
CAR - OR ELSE WHY DID THE USER DECIDE SELL THIS NEW LOOKING CAR!!
The implications of asymmetric information about product quality were first analyzed
by George Akerlof and go far beyond the market for used cars.
The markets for insurance, financial credit, and even employment are also
characterized by asymmetric information about product quality.
THE MARKET FOR USED CARS
When sellers of products have better information about product quality than buyers, a
LEMONS PROBLEM may arise in which low-quality goods drive out high quality goods.
In (a) the demand curve for high-quality cars is DH.
However, as buyers lower their expectations about the average quality of cars on the
market, their perceived demand shifts to DM.
THE MARKET FOR USED CARS
Likewise, in (b) the perceived demand curve for low-quality cars shifts from DL to DM.
As a result, the quantity of high-quality cars sold falls from 50,000 to 25,000,
and the quantity of low-quality cars sold increases from 50,000 to 75,000.
Eventually, only low quality cars are sold.
LEMONS MARKET/PROBLEM: Low- quality goods driving out high-quality goods out of
the market. Occurs due to information asymmetry.
MARKET FAILURE DUE TO ADVERSE SELECTION
Consumers cannot in fact easily determine the quality of a used car until after they
purchase it. As a result, the price of used cars falls, and high-quality cars are driven out
of the market.
Market failure arises, therefore, because there are owners of high-quality cars who value
their cars less than potential buyers of high-quality cars. Both parties could enjoy gains
from trade, but, unfortunately, buyers‘ lack of information prevents this mutually
beneficial trade from occurring.
adverse selection: Form of market failure resulting when products of different qualities
GET sold at a single price because of asymmetric information, so that too much of the
low-quality product and too little of the high-quality product are sold.
SOLUTION: If as a seller, you are convinced of a high quality car – offer HUGE
WARRANTIES or FREE REPAIRS FOR 5 YEARS. Applying such warranties to a bad
quality car would create HUGE losses to you. Since the buyers realize this logic, they
will rely on your rationality to AVOIDING such huge losses and BELIEVE that the car
that you are trying to sell them is actually a high quality car which will NOT BREAK
DOWN TOO MUCH in coming 5 years.
SOLUTION: “Pool risks”. For health insurance, the government might take on this role, as
it does with the MEDICARE (in US) program. By providing insurance for all people over
age 65, the government eliminates the problem of adverse selection.
Health care reform has been at the forefront of policy debates in the United States and
worldwide for years. A core issue in the United States is whether everyone should have
health insurance, and whether participation in some kind of public or private insurance
program should be mandatory.
All people over 65 participate in Medicare—those expecting low health care costs along
with those who expect high costs.
Of course, the low-cost participants are subsidizing those with high costs. But because
adverse selection is not a problem with a mandatory program, the overall cost of
Medicare is lower than the cost of most private insurance systems.
Indeed, Medicare has earned a reputation as one of the most successful and efficient
public programs in the United States.
Market Signaling
(A SOLUTION TO ADVERSE SELECTION)
● market signaling: Process by which sellers send signals to buyers conveying
information about product quality.
• What characteristics can a firm examine to obtain information about people‘s
productivity before it hires them? Can potential employees convey information about
their productivity?
• Dressing well for the job interview might convey some information, but even
unproductive people can dress well. Dressing well is thus a weak signal—it doesn‘t
do much to distinguish high-productivity from low-productivity people.
• To be strong, a signal must be easier for high-productivity people to give than for low-
productivity people to give, so that high-productivity people are more likely to give it.
(example: LONG UNREASONABLE WARRANTIES)
High-productivity people will excel at top college education/ IIT BTech to signal their
productivity; firms will read this signal and offer them a high wage.
MARKET SCREENING
(another solution to ADVERSE SELECTION)
Take the example of labour market. Faced with two type of workers: high and low type;
the firm may ask them to take a test which only a high type can ace.
Of course, the knowledge being tested in such an exam MAY not be relevant to the
Production technology of the firm but still it can solve the adverse selection problem
caused by information asymmetry. (example: IAS exam in math?)
Screening is different from signalling because the uninformed party makes the first
move – in this case, invite people for the test, fix the question paper etc. In contrast, in
case of signalling, the informed party makes the first move by sending a signal – that is
opt for high grades from a top college.
moral hazard: When an economic agent‘s action are unobservable to some other
agent who is supposed to make payments contingent upon these actions.
• The possibility that an individual who has FULLY insured against theft of her vehicle
will now TAKE LESS CARE to protect her vehicle is logical – since such protection is
costly (car theft alarm or other kinds of steering lock).
• So for the insurance company, being able to sell the insurance increases probability
of the theft happening leading to higher chance of financial payout.
The concept of moral hazard applies not only to problems of insurance, but also
to problems of workers who perform below their capabilities when employers
cannot monitor their behavior (“job shirking”).
The Principal–Agent Problem
(a crucial moral hazard issue)
• Managers can often pursue their own objectives (such as increase in stock prices),
rather than pursuing the objective of the shareholders which is to maximize the value
of the firm (why? Since their compensations may have stock options).
• Because shareholders cannot observe every daily action taken by the manager.
They will only focus on final profits which depend not only upon manager’s
actions – but also upon random event in world economy.
• Hence, the problem of hidden action/ moral hazard appears. Managers may not
work hard enough leading to loss in profits – but later claim that bad results were
due to external random factors.
• Hence, compensation schemes of CEOs and CFOs need to be designed
carefully.
• Economists have warned about this a long time but it took ENRON and the Sub-
prime crisis in the world financial community to start standardizing carefully
designed compensation schemes and mandatory disclosure rules (some of
which has been captured as BASEL III regulations).
• Still goes on – check out the documentary on WeWork which is a company that
lost 47 billion in valuation (by analysts) and 4 billion in hard cash - in six months.
• The average annual compensation (not just salary) for PRODUCTION WORKERS in
the U.S. went from $18,187 in 1990 to $32,093 in 2009. But in constant dollar terms,
the 2009 average salary was only $19,552 (in 1990 dollars), which represents only a
7.5% increase in real terms.
• At the same time, the average annual compensation (not just salary) for CEOs has
grown from $2.9 million to $8.5 million, or about $5.2 million (in 1990 dollars) – that is,
in constant dollars, CEO compensation has risen nearly 80% in real terms.
Why?
Have top managers become more productive, or are CEOs simply becoming more
effective at extracting economic rents from their companies – due to their
monopoly power and a pretention that a good CEO is as rare as a diamond?
The answer lies in the principal–agent problem, which is at the heart of CEO salary
determination. Lets see the problem in a bit more detail.
chapter 8
In the last class, we saw a description of all efficient production methods that a firm may use. Now we will see how
a producer must accommodate this efficiency with the constraint of a limited amount of money available to carry out
production.
Main Topics
• Types of cost
• What do economic costs include?
• Short-run cost: one variable input
• Long-run cost: cost minimization with two
variable inputs
• Average and marginal costs
• Effects of input price changes
• Economies and diseconomies of scale
Critical concept in firm operation
• A firm can choose to produce zero output in a short run – kind of hibernating but not
out of the business.
• To really stop being in business, the firm must wait till the current short run is over,
after which it can reduce all its inputs to zero (that is necessary for quitting the
business).
• The firm may choose to produce a positive output in the next short run, after
choosing to produce zero output in current short run (wealthy small scale MSMEs
after demonetization).
8-3
*Variable cost: costs of VARIABLE inputs that vary with the firm’s
output level.
*Fixed cost: costs of FIXED inputs whose use does not vary with the
firm’s output level if the firm operates in SHORT RUN and is zero other
wise.
*Sunk costs: costs incurred by the firm irrespective of the level at
which firm operates or whether it shuts down (irrespective of short or
long run – like bribes, lobbying expenditure etc.).
– Fixed: firm does not have to incur this cost if it chooses to produce zero output
but not exit the market. Hence, it can termed AVOIDABLE
– Sunk: firm has to incur this cost EVEN if it decides to exit the market. Hence,
can be termed UNAVOIDABLE (example, the non-refunded security deposit paid
the carpenter in the last slide)
– So to differentiate between the two, we must think in terms of a thought
experiment where the firm chooses to EXIT the business in long run
– So conceptually, in LONG RUN, a firm may consider itself incurring a sunk cost, but
cannot consider itself incurring a fixed cost !!
Fixed vs Sunk- bit more nuance
• The amount of non-variable cost of setting up and carrying out
production, that can be recovered upon exiting the business – IS
FIXED COST WHILE THE REST IS SUNK COST.
• Level of both fixed and sunk costs are invariant to the positive
levels of output chosen to be produced.
• So fixed cost does not influence the decision on how much to
produce or how to price. It ONLY influences the decision to shut
down operations (produce zero output) in short run (BUT NOT
EXIT).
And sunk cost does not affect ANY operational or shutting down or
exit decisions in short or long run.
Fixed versus Sunk: continued
ESSENTIALLY, SUNK COST PLAYS NO ROLE IN DETERMINING THE OPTIMAL OPERATIONAL
output or product mix DECISIONS. It may, however, be amortized to compute profits for an
accounting period. This would be mere window dressing of the realized profits.
Delta wanted to know how its costs would change if it reduced the number of its
scheduled flights by 10 percent.
The answer depends on whether we are considering the short run planning horizon or
the long run planning horizon.
Over the short run - say six months - schedules are fixed and it is difficult to lay off or
discharge workers. As a result, most of Delta’s short-run costs are fixed and won’t be
reduced significantly with the flight reduction.
In the long run - say five years or more - the situation is quite different as Delta has
sufficient time to sell or lease planes that are not needed and to discharge un-needed
workers. In this case, most of Delta’s costs are variable and thus can be reduced
significantly if a 10-percent flight reduction is put in place.
SINCE THERE ARE NO FIXED INPUTS IN LONG RUN, THERE ARE NO FIXED
COSTS IN LONG RUN.
Opportunity Cost and Economic Cost
• Some economic costs are hidden, such as lost
opportunities to use inputs in other ways
– Example: Using time to run your own firm means giving up the
chance to earn a salary in another job
• Opportunity Cost: the cost associated with an INPUT
forgoing the opportunity to employ it in its best
POSSIBLE/FEASIBLE alternative use.
– In practical usage, one needs a well functioning market for the
input in question to exist to appropriately evaluate the
opportunity cost.
• A firm’s true economic costs of production in any accounting
period, consists of BOTH out of pocket expenditures for that
period as well as the opportunity costs that can be estimated
`REASONABLY’ for that period.
CHOOSING THE LOCATION FOR A NEW LAW SCHOOL BUILDING
The Northwestern University Law School has long been located in Chicago, along the
shores of Lake Michigan. However, the main campus of the university is located in the
suburb of Evanston. In the mid-1970s, the law school began planning the construction of
a new building.
The downtown (city center) location had many prominent supporters. They argued in
part that it was cost-effective to locate the new building in the city because the university
already owned the land. A large parcel of land would have to be purchased in Evanston
if the building were to be built there.
Does this argument make economic sense? No. It makes the common mistake of failing
to appreciate opportunity cost. From an economic point of view, it is very expensive to
locate downtown because the opportunity cost of the valuable lakeshore location is high:
That property could have been sold for enough money to buy the Evanston land with
substantial funds left over. THAT IS, THERE IS A POSITIVE COST OF USING DOWNTOWN LAND
EVEN THOUR THE UNIVERSITY LEGALLY OWNS IT, AND THIS COST IS VERY HIGH.
In the end, Northwestern decided to keep the law school in Chicago. This was a costly
decision. It may have been appropriate if the Chicago location was
commensurately HIGHLY valuable to the law school, but it was inappropriate if it
was made on the presumption that the downtown land had no cost.
The concept of a Cost Function
3. This optimization will take different forms depending on whether we are in the long
run planning horizon where all input usage levels are variable and hence,
legitimate choice variables – or whether we are in short run planning horizon
where at least of the input usage level must be treated as parameter.
4. The value function or the minimized cost obtained by solving this problem must be
a function of Q.
5. We call this value function of Q to be a (short run or long run) COST FUNCTION:
C(Q).
6. In what follows in the rest of the slides, we drop the word function, and merely refer
to C(Q) as cost to save time. However, you must remember that we are always
talking about value function of a optimization problem.
Short run cost with one Variable input
• Suppose a firm has production function Q=f(K,L) = 2KL.
• Say in the short run, the capital input, say garage space, is fixed at level K*.
• We ask the question: what is the least amount of cost to be incurred in producing
X units of benches or output, when cost of a unit of capital is ‘r’, and cost of a unit
of labour is ‘w?.
• Given the production function we can easily see that Q=x if and only if L = x/2K*,
that is, we need to hire x/2K* units of labour hours to produce X benches in the
cheapest possible manner. That is, we need to incur the MINIMUM cost of labour
equal to {wx}/{2K*} produce X benches.
TYPICALLY, AVERAGE VARIABLE COSTS ARE U SHAPED. THIS FOLLOWS FROM OUR EMPIRICALLY
OBSERVED TYPICAL PRODUCTION FUNCTION WHERE AVERAGE PRODUCT OF LABOUR CURVE IS
AN INVERTED U SHAPED.
Short run AC, AVC, and
MC Curves
Note that, for the purposes of this class, the marginal cost curve is a U shaped curve
that always cuts the U shaped AVC curve and the U shaped AC curve at their minimum
points. Also, MC curve and AVC curve always have the same intercept.
Graphical Analysis of Long run Cost Minimization
• For simplicity of graphical exposition, assume two inputs – both
of which are variable.
• Objective, as before, is to find out the least possible cost
needed to be incurred to produce a target level of output (Q).
Efficient
scale of
production
From long run Total Cost to long
run Marginal Cost
Relationship between long run Average
and Marginal Cost
• When output is finely
divisible, the AC curve is
upward sloping at Q if
MC > AC, downward
sloping if MC < AC, and
neither rising nor falling
if MC = AC
Effects of Input Price Changes
• After an increase in the
price of an input, a
cost-minimizing firm
never uses more of that
input to produce a
given amount of
output, and usually
employs less.
• Point B reflects a
higher cost of capital
than in point A
Relation between Short-Run and Long-Run Cost - A Sociological Reality
Note that because there are economies and diseconomies of scale (assuming away
learning effects for simplicity) THE MINIMUM POINTS OF SAC curves corresponding to
ALL possible ‘FIXED CAPITAL’ levels DO NOT LIE on LAC curve. This property holds only
at a unique specific point where LAC curve is minimized.
Long run average cost curve is the LOWER ENVELOPE of all possible short run
average cost curves. In other words, choosing to operate at a point P on LAC,
implies choosing to procure X number of planes (or X amount of capital inputs)
such that – the SAC curve corresponding ‘fixed capital’ input at level X; touches
the LAC curve at point P.
A new way of connection between short run and long run
• At any given point in time period, say T, a firm producing positive output is operating
in a short run, because there is at least one input that can not varied for some time in
future.
• Long run cost minimization with respect to a target output Q, therefore, becomes an
exercise in choice of the CORRECT short run to produce Q in a least cost manner.
• That is, if the long run cost minimization tells you to hire K*(Q) and L*(Q) to produce
Q in a least cost manner, then it tells you to operate in the short run where capita
input is fixed at a level equal to K*(Q).
Thus, the long run average cost curve is a collection of single points from the infinite possible short run
average cost curves. So for any target output Q, the corresponding LAC(Q) is same as the SAC(Q)
corresponding to the fixed capital input level K*(Q) - where K*(Q) is long run cost minimizing amount of
capital input.
Economies and Diseconomies of Scale
(An implication of very commonly observed U-shaped Long run AC curve)
• This MAY or MAY NOT be caused by increasing returns to scale at low output
levels, followed by decreasing returns to scale at high output levels.
chapter 9
•
Perfectly Competitive Markets – Underlying assumptions
PRICE TAKING - both consumers and firms accept price as an exogenous parameter that they are
incapable of influencing. Both sides of market are “PRICE TAKER”
• Individual firms must believe that whatever they produce will get sold at the going market
price value which they presume during taking output decisions.
• So essentially, “market clears”, that is, market equilibrium OCCURS when (i) their
prediction/assumption of market price is a perfect match with the realized market price,
and (ii) all produced output gets sold.
• That is, market (real) price over time continue to fluctuate over a period of time unless firms and
consumers arrive at this conceptual match.
• Because each individual firm sells a sufficiently small proportion of total market output, its
decisions have no impact on market price – internet market place?
PRODUCT HOMOGENEITY - Products of all of the firms in a market are perfectly substitutable
with one another—that is, they are homogeneous. Hence, no firm can raise the price of its product above
the price of other firms without losing most or all of its business. Example: world market for wheat!!!
• In contrast, when products are heterogeneous, each firm has the opportunity to raise its price
above that of its competitors without losing all of its sales. Hence, the need for advertising!!
• The assumption of product homogeneity is important because it ensures that there is a
single market price, consistent with supply-demand analysis.
FREE ENTRY AND EXIT - With free entry and exit, buyers can easily switch from one supplier to
another, and suppliers can easily enter or exit a market. So there can be no special costs that make it
difficult for a firm to enter (or exit) an industry.
NO TRANSACTION COST - Sellers and buyers can easily locate each other and engage in a
meaningful discussion or negotiations of prices without fear or barriers.
Do Firms Maximize Profit?
Firms that do not come close to maximizing profit are not likely to survive. The
firms that do survive make long-run profit maximization one of their highest
priorities: [Case in point: Masayoshi Son issued a call for profit maximization after his
huge investment in WeWork went bust as the company shut down due to immense
losses.]
PROFIT MAXIMIZATON
MR(q) = MC(q)
A competitive firm supplies only a small portion of the total output of all the firms in an industry.
Therefore, the firm takes (BELIEVES) the market price of the product as given AND THAT SHE
CAN SELL AS MUCH SHE WANTS AT THIS PRICE) – hence, choosing its output on the
assumption that the price will be unaffected by the output choice.
In (a) the demand curve facing the firm is (believed to be) perfectly elastic, even though the
market demand curve in (b) is downward sloping.
• The demand curve d facing an individual firm in a competitive market is both
its average revenue curve and its marginal revenue curve.
• Along this demand curve, marginal revenue, average revenue (= R(q)/q), and
price are all equal.
• Hence, the perfectly competitive structure of the market leaves firms to decide
only one question: HOW MUCH TO PRODUCE?
MC(q*) = MR(q*) = P
Short-Run Profit Maximization by a Competitive Firm
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.
A firm should shut d ow n, that is, cease prod uction in short run (w hen it cannot exit
the m arket, if its profit by prod ucing positive output is w eakly lesser than that from
prod ucing no output. This is equivalent to Price being greater than m inim um possible
value of average variable cost (AVC).
A 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. It tells us how much a profit maximizing firm is willing
to supply at each possible price level P, provided it believes P to be the (future) market equilibrium
price at which she can sell as much she wants.
NOTE THAT ANY FIRM BEHAVING IN SUCH AN IDEALIZED MANNER ENGAGES IN WHAT IS KNOWN AS
‘MARGINAL COST PRICING”, THAT IS, THEY SELL EACH UNIT OF TOTAL OUTPUT Q* AT THE
MARGINAL COST MC(Q*).
AS WE SHALL SEE LATER, SUPPLY CURVE CAN EXIST AS MATHEMATICAL/CON CEPTUAL EN TITY ON LY IF THE
FIRMS IN MARKET ARE PERFECTLY COMPETITIVE. MORE IMPORTAN TLY, THIS MEAN S THE MARKET D EMAN D -
SUPPLY AN ALYSIS IS IN VALID FOR MARKETS WHERE FIRMS D O N OT BEHAVE IN A PERFECTLY COMPETITIVE
MAN N ER (OR A PRICE TAKER).
The Firm’s Response In Short run to an Input Price Change
(horizontal summation)
The short-run industry
supply curve is the
summation of the supply
curves of the individual
firms.
Because the third firm has
a lower average variable
cost curve than the first two
firms, the market supply
curve S begins at price P1
and follows the marginal
cost curve of the third firm
MC3 until price equals P2,
when there is a kink.
Elasticity of Market Supply
For P2 and all prices above
it, the industry quantity Es = (ΔQ/Q)/(ΔP/P)
supplied is the sum of the
quantities supplied by each
of the three firms.
Producer Surplus in the Short Run
Producer surplus = PS = R − VC
Profit = π = R − VC − FC
Therefore in long run, that is, w hen C(0)=0, producer surplus is same as profit.
The Short Run Effects of a ‘per unit’ Tax on an Individual Firm’s Supply.
BUT IF A FIRM EARNS POSITIVE ECONOMIC PROFIT, NEW FIRMS WILL STEADILY ENTER THE MARKET,
SHIFTING THE INDUSTRY SUPPLY CURVE TO THE RIGHT WITHOUT AFFECTING THE INDUSTRY
DEMAND CURVE. THIS WOULD LEAD TO REDUCTION IN MARKET PRICE, WHICH WOULD REDUCE
ECONOMIC PROFITS OF ALL INDIVIDUAL FIRMS. THIS PHENOMENON WOULD CONTINUE UNTILL ALL
FIRMS IN THE MARKET EARN ZERO ECONOMIC PROFITS.
(THIS IS THE INFERENCE DRAWN FROM THE MOST BASIC IDEALIZED MODEL IN AN INTRODUCTORY CLASS. FOR MOST
REALISTIC DESCRIPTION, ONE NEEDS TO SEE ADVANCED BOOKS.)
H ence each ind ivid ual price taking profit m axim izing firm that chooses to not exit in long
run – makes ZERO economic profit. This brings u s the follow ing d istinction:
One such opportunity cost is the return to the firm’s owners if their capital/ labour/ other inputs were used
elsewhere.
For example: Accounting profit may equal revenues R minus labor cost wL (minus depreciation) which is likely
to be positive, if I bought capital stock in the last accounting cycle. Economic profit 𝜋 for the current cycle,
however, equals revenues R minus labor cost wL minus the capital cost, rk that is foregone by not renting out
the capital stock. That is, .
π = R − wL − rK
Best response: a strategy that provides player with the highest possible
payoff, assuming other players behave in a specified way
Consider two friends Oscar and Roger caught with stolen goods guaranteeing
2 months in prison. If any one turns court approver giving testimony that the
other has stolen the goods – he will be rewarded by reduction from 2 to 1
month jail, while the other will be convicted for stealing as well as obstruction
of justice implying an increased jail time of 6 months. Of course if both turn
approvers against each other, they both go to jail for 5 months each (to
reward them for NOT obstructing justice).
They are taken to two separate interrogation rooms (they cannot contact
each other in any manner) and presented with these possibilities. What will
they do?
Prisoners’ Dilemma
Best Responses in the Prisoners’
Dilemma
12-8
Equilibrium in the Prisoner’s Dilemma
-2
Nash Equilibrium
Nash equilibrium: the
strategy played by each
individual is a best
response to the strategies
played by everyone else.
12-10
NO NASH EQUILIBRIUM IN PURE STRATEGY IN “MATCHING COINS” GAME
MATCHING COINS
Player B
Heads Tails
Heads 1, –1 –1, 1
Player A
Tails –1, 1 1, –1
In this game, each player CHOOSES heads or tails and the two players reveal their coins
at the same time. If the coins match Player A wins and receives a dollar from Player B. If
the coins do not match, Player B wins and receives a dollar from Player A.
Note that there is no Nash equilibrium in pure strategies for this game. No combination
of heads or tails leaves both players satisfied—one player or the other will always want
to change strategies.
You (Y) and a competitor (C) plan to sell IDENTICAL soft drinks on a beach at
IDENTICAL price.
If vacationers are spread evenly across the beach and will walk to the closest vendor,
the two of you will locate next to each other at the center of the beach. This is the only
Nash equilibrium. If your competitor located at point A, you would want to move until
you were just to the left, where you could capture three-fourths of all sales. But your
competitor would then want to move back to the center, and you would do the same.
Game with Perfect Information
(A special type of multi stage game)
In the pre-mobile times, Tony and
Maria decide go on a movie date –
but say Tony manages to reach the
theatre first. Tony decides to go
ahead and buy tickets for himself –
they have a pact of going Dutch on
every date. This is the story of his
decision on which movie ticket to
buy.
• Describe the Bertrand model and the Cournot model, and identify the
Nash equilibrium in each model.
• Determine the number of firms that will enter a market and discuss the
factors that affect this number.
• Describe the main U.S. antitrust statutes and discuss their rationales.
Overview
• Analyze what a firm’s best actions are in oligopolies using
game theory
Or else there will be a different NE, the seller with lower marginal costs – under
some assumption of suitable discrete pricing – will charge the largest possible
price less than marginal cost of the high cost firm and sell to the whole market,
while the high cost firm will produce zero.
Cournot Model of Oligopoly
(a model of quantity competition)
• Firms choose how much to
produce simultaneously (more
importantly, without any knowledge of
what the other is choosing),
and the
price clears the market given
the total quantity produced.
• Compared to Bertrand’s
model, everything is same
except for the choice
variable for both firms is
quantity of output. This may
be more realistic in markets
where no single firm can
cater to WHOLE MARKET at
all prices
Residual Demand Curves
Residual demand curve: shows the relationship between a
firm’s output and the market price given the outputs of the
firm’s rivals
Joe’s residual demand
Joe’s residual demand when Rebecca
when Rebecca produces produces 4,000
2,000
P = 60
Q = 2,000 MR = MC
P = 50, Q = 1,000
Joe behaves like a
monopolist given his
MR = MC
residual demand
Best-Response/Reaction Curves in the Cournot Duopoly
• 2 firms
• Identical products
• Output choice competition
• Simultaneous choice of production amount: that is, one does not know
the choice of the other w hile making ow n choice
For simplicit y of exposit ion in class, assume ident ical CO NSTANT marginal
cost s ‘C’.
Cournot Duopoly - A Linear Demand Curve
To solve for the Nash equilibrium (Q*1, Q*2) , we set MR1 = C (the firm’s marginal cost)
∗ ∗
and we find that Firm 1’s reaction curve: 2Q 1 = 30 − Q 2 - C
∗
By the same calculation, Firm 2’s reaction curve: 2Q 2 = 30 − 𝑄∗ 1- C
Note the demand by Hyundai chairman to reduce GST to help tide over the current auto
industry crisis. So what he is saying is that auto sales are down (for very
specific political and economic reasons beyond the scope of this course) so that the value
’30’ in demand curve has now become ‘20‘ leading to reduction in output produced and
hence, labour employed. If taxes are reduced sufficiently, then the output will increase again
as ‘C’ will reduce to say, ‘C-10’, and the initial output and employment levels would be
regained – albeit at a significant loss of Government revenue.
Deadweight Loss from Duopoly versus
Monopoly
• The deadweight loss
of monopoly is
larger because the
monopoly price is
further above
marginal cost than is
the oligopoly price
Price Competition with Differentiated
Products
• Differentiated products: when consumers do not
view similar products as perfect substitutes
Bertrand Competition with
Differentiated Products
Coke’s Best Responses
So firms, if they want to collude in a domestic market must do so without any legal or
public declaration. This causes a problem because two separate production
technologies not integrated to each other need to agree to charge HIGH price – that
is, not cheat each other by charging LOW price while the other charges HIGH price.
Unfortunately, they can view their interaction to be an infinitely repeated game so use
special NE strategies (as the GRIM strategies) to sustain cooperation. That is, firms
may adopt a strategy in which they charge the monopoly price if no one has yet
undercut that price; otherwise they charge a price near or at their marginal cost.
So the next step was for them to fix market share to each firm – if any firm sold
more leading to less sales from other fellow cartel members, she had to buy lysine
from them at the cartel decided price.
This eliminated the incentive to cheat among members and led to sustaining of
cooperation until FBI arrested all CEOs.
Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY or NOMINAL ENTRY COSTS)
Under monopolistic
competition, price exceeds
marginal cost, and
production is carried out at
an inefficient level where
costs are not minimized.
Thus there is a deadweight
loss, as shown by the
yellow-shaded area.
The demand curve is
downward-sloping, so the
zero profit point is to the left In both types of markets, entry occurs until profits are driven to
of the point of minimum zero.
average cost.
Back to Oligopoly - Raising Rival’s
Costs
Options range from lobbying, to buying critical input in bulk, to fomenting labour trouble at
competitors’ plant. There is much documentary and punishment evidence in US itself.
How to Raise a Rival Firm’s Marginal
Cost
• Lobbying
– Imposing stringent environmental regulations
– Imposing a tariff
• Increasing the cost of a rival’s inputs
• Examples
– Output choice by a first-mover (by signing a big labour contract
in advance or setting up a large plant whose technology requires it to
run at almost full capacity – like alumina refining plants)
– Spanish Conquistador (CORTES’) in 1519 burning ships to
eliminate option retreat while invading Aztec city of
Tenochtitlan
– Entry deterrence (making a large enough output choice, in the
manner mentioned above which makes profits consequent to entry so
low for the competitor that she does not enter)
Output Choice by a First-Mover
(UNDER THE ASSUMPTION THAT SECOND MOVER ENTERS THE MARKET AT A LATER DATE)
If the entry cost of Joe is 15000$, then Rebecca will choose to produce (or commit to
produce) 4000 units, which will deter Joe from entering (as post entry profits would be
10000$, and thus, yield Rebecca a profit of 80000$. 19-29
Entry Deterrence
(OUT PUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)
Put simply, pre-committing limits the firm’s ability to respond to changing market conditions.
For example, DuPont once tried to deter rivals from producing titanium dioxide (a whitener
used in paints and plastics) by committing to an extensive expansion of its facilities.
Unfortunately for DuPont, an unexpected recession struck, and market demand turned out to
be much lower than DuPont forecasted, causing the firm’s clever strategy to yield a
disappointing loss. HENCE THE NEED FOR PROFESSIONAL STATISITICIANS/ ECONOMISTS WHO
CAN PREDICT BUSINESS CYCLES.
19-30
Entry Deterrence
(OUTPUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)
• By expanding one’s output sufficiently, a firm may reduce the profit
its rival foresees enough to deter them from entering the market.
• However, often firms prefer to set up the excess capacity (by signing a
labour contract or setting up a plant) but not actually increase
production prior to possible entry of competitor.
• Effectively, the existing firms are threatening the entrant that they
will render this decision to enter a financially COSTLY decision if they
DARE to enter.