AP Econ Unit 4

Introduction to Imperfect Competition

Perfect and imperfect competition

• There are two main types of markets: product markets, which involve goods and services for consumption, and resource markets, which deal with inputs used in production.

• Perfect competition is a theoretical market structure where there are many firms, no barriers to entry, and no product differentiation. Firms are price takers in perfect competition.

• A monopoly exists when one firm dominates the market, often due to insurmountable barriers to entry. Monopolies can be granted legally, for instance, through patents.

• An oligopoly is a market structure with a few firms, high barriers to entry, and many buyers. Examples include the aircraft and automobile industries.

• Monopolistic competition is characterized by many firms, low barriers to entry, and product differentiation. Firms have some control over pricing due to product uniqueness.

• Monopoly is the opposite of a monopoly, where one large buyer interacts with many suppliers, typically in labor markets.

• Different industries may exhibit characteristics of these market structures, but perfect competition is mostly a theoretical concept.

Types of competition and marginal revenue

• Perfect competition features many firms, undifferentiated products, and no barriers to entry. Firms in this market simply accept the market price as their marginal revenue.

• In imperfect competition, firms are differentiated and may have some barriers to entry. Examples include monopolistic competition and monopolies.

• In monopolistic competition, firms have their own unique demand curves, and the quantity they produce affects the price they can charge.

• Marginal revenue in imperfect competition does not align with the market price, leading to a unique marginal revenue curve.

• The marginal revenue curve for a firm in an imperfectly competitive market slopes downward, and it decreases more rapidly than the demand curve.

• This discrepancy in marginal revenue impacts firm analysis and how it intersects with marginal cost in imperfectly competitive markets.

Marginal revenue and marginal cost in imperfect competition

• In a perfectly competitive market, a firm is a price-taker and sells its products at the market price.

• The firm's marginal revenue curve in a perfectly competitive market is a horizontal line, and profit maximization occurs when marginal cost equals marginal revenue.

• In an imperfectly competitive market, the firm faces a downward-sloping demand curve specific to its products.

• The firm's marginal revenue curve in an imperfectly competitive market is steeper and further downward-sloping than its demand curve.

• Profit maximization for an imperfectly competitive firm still occurs when marginal cost equals marginal revenue, but the price it can charge in the market is higher than the marginal cost at this point.

• The difference between the market price and the marginal cost at the rational production quantity is considered an inefficiency, as people are willing to pay more than the cost, but producing more units would result in a lower marginal revenue than the marginal cost.

Monopoly

Monopolies vs. perfect competition

• Perfect competition involves many firms selling undifferentiated products with no barriers to entry or exit.

• Firms in perfect competition are price takers, unable to set their own prices.

• Monopoly consists of a single firm with differentiated products and insurmountable barriers to entry.

• In a monopoly, the firm is a price setter, controlling the product's price.

• Examples of markets closer to perfect competition include agriculture and certain types of products like pistachios.

• Markets closer to monopoly include utilities providers and telecom companies, where high barriers to entry restrict competition.

• Monopolistic situations are explored further in subsequent videos, including discussions on rational quantity and profit maximization for monopolistic firms.

Economic profit for a monopoly

• The demand curve for a monopoly firm shows that as the price decreases, the quantity demanded increases, like other demand curves.

• The marginal revenue curve for a monopoly firm decreases faster than the demand curve due to pricing decisions affecting all units.

• The rational quantity for a monopoly firm to produce is where marginal cost equals marginal revenue.

• The price in a monopoly is set by the demand curve, and it results in a price greater than marginal cost.

• Monopoly firms can achieve a markup, which is not possible in perfectly competitive markets.

• Deadweight loss occurs due to the monopoly's pricing strategy, which prevents the market from gaining the full benefit of higher quantities.

• Economic profit for a monopoly firm is calculated by comparing the price in the market to the average total cost at the produced quantity.

• Monopoly firms can maintain economic profits due to high barriers to entry in the market.

Monopolistic optimizing price: Total revenue

• The video addresses how a monopoly can maximize profit by understanding the relationship between price, quantity, and total revenue.

• Total revenue is calculated as the product of price and quantity.

• The total revenue curve for a monopoly forms a downward-facing parabola.

• The formula for the demand curve is provided as price = 6 - quantity.

• The concept of marginal revenue is introduced, which is the change in total revenue divided by the change in quantity.

• Marginal revenue is the slope of the tangent line at a specific quantity, representing the extra revenue gained by selling a small additional quantity of a product.

Monopolistic optimizing price: Marginal revenue

• Marginal revenue is the change in total revenue resulting from a small change in quantity.

• The video demonstrates finding the marginal revenue on a demand curve at different points.

• When the quantity is 0, marginal revenue is 6.

• When the quantity is 1, marginal revenue is $4 per pound.

• When the quantity is 2, marginal revenue is $2 per pound.

• At the point of maximum revenue, the slope of the demand curve is 0, and marginal revenue becomes 0.

• The marginal revenue curve for a monopolist is linear and twice as steep as the demand curve.

• Marginal revenue helps in determining the quantity that a firm should produce to maximize profit while keeping the marginal cost in mind.

Monopolistic optimizing price: Dead weight loss

• The monopolist's marginal revenue curve has a different shape compared to that of perfect competition, as they are the sole producer in the market.

• To maximize profit, the monopolist must consider both revenue and cost, leading to the need for a marginal cost curve.

• The monopolist produces quantities where marginal revenue exceeds marginal cost, resulting in a unique equilibrium point.

• This equilibrium point differs from that of perfect competition, causing a deadweight loss in society.

• The deadweight loss leads to an increase in producer surplus and a decrease in consumer surplus, benefiting the monopolist at the expense of consumers and overall social welfare.

Review of revenue and cost graphs for a monopoly

• The video begins by reviewing key concepts related to monopolies and aims to enhance the understanding of graphical representations in the context of monopoly economics.

• It introduces a linear demand curve as a basis for understanding pricing and quantity decisions in a monopoly.

• The video discusses total revenue, emphasizing how it increases as quantity production rises, reaches a maximum point, and then declines.

• Marginal revenue is explained as the incremental increase in total revenue with each additional unit produced.

• Total cost is introduced, indicating that it initially consists of fixed costs and later includes variable costs.

• Economic profit, as the difference between total revenue and total opportunity cost (including both explicit and implicit costs), is highlighted as a key concept in assessing a monopoly's performance.

• The video emphasizes that economic profit is maximized when marginal revenue equals marginal cost, and it visualizes this through graphical representations.

• The concept of a monopoly, where there are no barriers to entry and no competition, is discussed as a scenario where economic profit can be sustained. In a competitive market, economic profit would attract new entrants.

Price Discrimination

Price discrimination

• The wine producer operates in a monopoly, as the wine is highly differentiated and has unique qualities, making it a monopolistic competitor in its specific market.

• The demand curve for the producer's wine is illustrated, indicating the willingness to pay for the wine at different quantities.

• Marginal revenue is twice as steep as the demand curve because of the monopoly, and marginal cost is presented as the cost of producing each additional bottle of wine.

• Average total cost is shown to decrease initially as more units are produced and then increase after a certain point.

• To maximize economic profit, the producer identifies the quantity where marginal revenue equals marginal cost, which is the quantity produced.

• Economic profit is calculated by subtracting average cost from average revenue for each unit and then multiplying by the total quantity produced.

• Consumer surplus is represented as the area between the demand curve and the price line.

• The producer decides to employ price discrimination, selling the same wine under different labels at different prices. Some wine is labeled "Super Fancy Premium" and sold at a higher price, while others are labeled "Pretty Good Wine" and sold at a lower price.

• Price discrimination is explained as a strategy to charge consumers different prices based on their willingness to pay and where they shop. This allows the producer to capture some of the consumer surplus as economic profit.

Monopoly price discrimination

• In this hypothetical scenario, the speaker describes owning the only hotel in a city, with insurmountable barriers to entry, making it a monopoly.

• The video outlines the cost structure and demand curve for a monopoly, explaining how marginal cost decreases initially and then starts to rise, while average total cost trends down.

• The video emphasizes the difference between the marginal revenue curve and the demand curve for a monopoly, illustrating that when prices are lowered, all units must be sold at the reduced price, leading to steeper marginal revenue.

• The video introduces the concept of price discrimination, where the monopolist can charge different customers different prices, ideally based on their willingness to pay.

• In the case of price discrimination, profit maximization still occurs where marginal cost intersects marginal revenue, but now the marginal revenue curve is the same as the demand curve.

• Economic profit is calculated by subtracting the average total cost from the price at the profit-maximizing quantity, resulting in larger economic profit when price discrimination is practiced.

• The video explains consumer surplus as the benefit consumers receive above what they pay and identifies deadweight loss in the monopoly scenario.

• Price discrimination can lead to allocative efficiency, where the quantity produced equals the quantity where marginal cost equals marginal revenue.

Monopolistic Competition

Oligopolies and monopolistic competition

• The video discusses the spectrum of market structures between monopolies and perfect competition.

• In the first dimension, it considers the number of competitors, ranging from a single seller (monopoly) to many competitors (perfect competition).

• In the second dimension, it examines how differentiated the competitors' products or brands are, with high differentiation (e.g., name brand clothing) and low differentiation (e.g., screws).

• The video introduces the term "oligopolies" for markets with few sellers but differentiated products. Oligopolies can exhibit characteristics of both monopolies and competitive industries.

• The term "monopolistic competition" is introduced for markets that are competitive but feature some product differentiation. These markets are closer to perfect competition than monopolies.

• Monopolistic competition is characterized by the existence of alternative or similar products on the market, which can affect demand and pricing for a specific product.

• The key distinction between monopolistic competition and perfect competition is that monopolistic competition involves some level of product differentiation.

Monopolistic competition and economic profit

• Monopolistic competitors, like Apple with its iPad, have a differentiated product but face competition from substitute products over time.

• Short-run economic profit is determined by finding the quantity that maximizes the difference between marginal revenue and marginal cost.

• In the short run, Apple can make economic profit by producing the optimal quantity of iPads.

• As competitors like Samsung, htc, HP, and others enter the market with similar products and aggressive marketing, the demand for Apple's iPads decreases, leading to a leftward shift in the demand curve.

• In the long run, the monopolistic competitor's marginal revenue curve adjusts accordingly and reaches a point where economic profit becomes zero.

• Economic profit diminishes over time as competitors erode the monopolistic competitor's market share by offering substitute products.

• Economic profit is distinct from accounting profit, and while a monopolistic competitor may still have accounting profit, economic profit can be reduced to zero due to competition from substitutes.

Long run economic profit for monopolistic competition

• In perfect competition, firms are price-takers with no economic profit in the long run, as price equals average total cost.

• Monopoly firms, as sole players with high barriers to entry, can earn economic profit by setting prices above average total cost.

• Monopolistic competition involves firms with some product differentiation, and as more firms enter the market, the demand curve for each firm's product shifts leftward, reducing economic profit.

• Economic profit disappears in the long run in monopolistic competition, resulting in deadweight loss and excess capacity.

Oligopoly and Game Theory

Oligopolies, duopolies, collusion, and cartels

• Oligopolies involve a market structure with a few sellers, and the term "oligo" comes from the Greek word for "few," while "poly" means "sellers."

• Oligopolistic firms can sometimes act like monopolies when they coordinate their actions. This coordination is known as collusion and is often illegal in many countries.

• When firms in an oligopoly have a formal agreement to collude, they are referred to as a cartel, and their behavior is akin to that of a monopoly.

• The most famous cartel is OPEC (Organization of Petroleum Exporting Countries), which controls a significant portion of the world's oil reserves and production.

• Maintaining discipline within a cartel is challenging, as there is a strong incentive for individual countries to secretly break the agreement and produce more to take advantage of higher prices.

• Oligopolies can also be highly competitive, with firms like Coke and Pepsi engaging in fierce price and marketing competition, making it a duopoly.

• The aerospace industry is an example of a duopoly, with Boeing and Airbus as major competitors.

• Airlines, despite not being a duopoly, exhibit characteristics of an oligopoly where the market approaches perfect competition, though there is awareness of each other's prices.

• Credit card networks like Visa, MasterCard, and American Express are a few dominant players in the industry, and although they compete, instances of coordination may require government regulation to promote competition.

• Governments aim to encourage competition in markets to enhance efficiency, increase total surplus, and benefit consumers.

Prisoners’ dilemma and Nash equilibrium

• Two individuals, Al and Bill, are arrested for drug-related crimes and are told they will each get two years in prison.

• The district attorney suspects they committed a more serious offense, an armed robbery, but has no hard evidence.

• The district attorney offers Al and Bill a deal: if one confesses and the other denies, the confessor gets a reduced sentence (1 year) while the denier gets a harsher sentence (10 years).

• If both confess, they both get three years, and if both deny, they get two years each.

• The scenario is known as the prisoner's dilemma, and it presents a conflict of interest between the two individuals.

• The globally optimal scenario is for both to deny and get two years, but rational self-interest may lead them to confess.

• The Nash equilibrium is when both individuals confess, as it is the best strategy for each, given the other's choice.

• The Nash equilibrium is stable because no individual has an incentive to change their strategy, as it would lead to a worse outcome.

More Nash equilibrium

• Nash equilibrium is a game theoretical concept, named after John Nash, portrayed by Russell Crowe in the movie "A Beautiful Mind."

• It is defined as a stable state of a system involving interacting participants where no participant can gain by changing their strategy as long as others remain unchanged.

• The text examines different states to see if they meet the criteria for Nash equilibrium:

  • State 1: Not a Nash equilibrium, as Al can gain by changing his strategy.

  • State 2: Appears to be a Nash equilibrium, as neither Al nor Bill can gain by changing their strategies.

  • State 3: Not a Nash equilibrium, as Al can gain by changing his strategy.

  • State 4: A Nash equilibrium, as neither Al nor Bill can gain by changing their strategies while holding the other constant.

Why parties to cartels cheat

• Companies in a duopoly often coordinate to restrict quantity and act as a single entity, similar to a monopoly.

• Coordination allows them to maximize economic profit by producing the optimal quantity at the market price.

• If both firms cooperate, they split the economic profit equally, making it a rational choice for both parties.

• However, there is a strong incentive for one or both firms to cheat the agreement by producing more than their agreed-upon quantity.

• Cheating can lead to an increase in total market production, but it results in reduced economic profit for both firms.

• The cheater benefits in the short term by increasing their individual economic profit.

• In the example provided, the cheater's economic profit increases from $250 to $280, while the non-cheater's economic profit decreases from $250 to $200.

Game theory of cheating firms

• Two firms in a duopoly can act as a monopolist by coordinating their production.

• Cheating becomes an incentive when one firm produces more than agreed upon, even though it reduces overall economic profit.

• The non-cheating firm is motivated to cheat as well, leading to increased production.

• Eventually, both firms keep increasing production until there is no economic profit left.

• The concept of Pareto optimality is introduced, where there's no way to make one party better off without making the other worse off.

• The text explores how firms change their strategies and discusses Nash equilibrium, which is a state where no player can gain by changing their strategy while holding others constant.

• The discussed scenario does not result in a Nash equilibrium because, in each state, one player can gain by changing their strategy.

• Finally, a Nash equilibrium is reached when firms stop cheating and agree to coordinate their production again, ensuring stable outcomes where neither firm can improve their position without the other changing their strategy.

Game theory worked example from AP Microeconomics

• Breadbasket and Quicklunch are two sandwich shops in an oligopoly that can choose to set high or low prices for sandwiches.

• A payoff matrix illustrates daily profits for different pricing combinations.

• Breadbasket has a dominant strategy to set a low price, while Quicklunch has no dominant strategy.

• In a non-cooperative scenario, Breadbasket's profit is $120 per day, and Quicklunch's profit is $80 per day, forming a Nash equilibrium.

• The town government introduces a $20 daily subsidy for low-priced food items, resulting in a redrawn payoff matrix.

• Quicklunch now has a dominant strategy to set a low price.

• Breadbasket's profit decreases from $120 to $95 after the subsidy is introduced.