Chapter 11 11.1 Capturing Consumer Surplus Pricing strategies all have one thing in common: They are means of capturing consumer surplus and transfer
Chapter 11
11.1 Capturing Consumer Surplus
Pricing strategies all have one thing in common:
They are means of capturing consumer surplus and transferring it to the producer
The firm can charge different prices to different to different customers, according to where the customers are along the demand curve
Price Discrimination
Charging different prices to different customers
Problem: identifying the different customers, and to get them to pay different prices
11.1 Price Discrimination
First-Degree Price Discrimination
In an ideal situation, a firm would like to charge a different price to each of its customers. If it could, it would charge each customer the maximum price that the customer is willing to pay for each unit bought
The maximum price is called the customers reservation price
First-degree price discrimination
The practise of charging each customer his or her reservation price
If we add up the profits on each incremental unit produced, we obtain the firms variable profit
Perfect Price Discrimination
Each customer is being charged the maximum amount that they are willing to pay
The additional profit from producing and selling an incremental unit is not the difference between demand and marginal cost
As long as demand exceeds marginal cost, the firm can increase its profit by expanding production
Nearly impossible
Note
Because every customer is being charged the maximum amount that he or she is willing to pay, all consumer surplus is captured by the firm
Imperfect Price Discrimination
Since firms don’t know the reservation price of their customers, and it is impractical to charge every customer a different price, firms use imperfect price discrimination
Customers’ interest to claim that they would pay very little
Charging imperfectly by charging a few different prices based on estimates of customers' reservation prices.
Often used by doctors, lawyers,accountants, or architects
Illustrates imperfect first-degree price discrimination,
Single price is P*4, P1-P6 are the different prices they charge customers, the lowest price is P6,
Customers not willing to pay P*4 are better in this situation
If price discrimination brings enough new customers into the market, customer welfare can increase to the point that both producer and consumer are better off
Second-Degree Price Discrimination
In some markets, as each consumer purchases many units of a good over any given period, his reservation price declines with the number of units purchased
Second-degree price discrimination
It works by charging different prices for different quantities of the same good or service
Quantity discounts are an example
A single light bulb might be priced at $5, while a box containing four of the same bulb might be priced at $14, making the average price per bulb $3.50
Block pricing
Consumer is charged different prices for different quantities or “blocks of a good, the government agency that controls rates many encourage block pricing
It can lead to expanded output and greater scale economies, this policy can increase consumer welfare while allowing for greater profit to the company
While prices are reduced overall, the savings from the lower unit cost still permits the company to increase its profit
Single price is charged P0
Quantity produced Q0
Instead three different prices are charged, based on the quantities purchased.
First clock of sales is at P1, and the rest are P2 and P3
Third-Degree Price Discrimination
Third-degree Price Discrimination
Divides consumers into two or more groups with separate demand curves for each group
Most prevalent form
Examples
Regular versus “special” airline fares
Premium versus nonpremium brands of liquor
Canned food or frozen vegetables
Discounts to students and senior citizens
Creating Consumer Groups
In each case, some characteristics are used to divide consumers into distinct groups
Example
Students and senior citizens are usually willing to pay less on average than the rest of the population (lower incomes), identities can be readily established
How should the firm decide what price to charge each group of consumers? These are two steps
We know the quantity produced, total output should be divided between the groups of customers so that marginal revenues for each group are equal. Otherwise the firm would not be maximizing profit.
If the marginal revenue of one group is greater than group 2, the firm would lower the price to the first group, and raising the price to the second group. The two prices are, they must be such that the marginal revenues for the different groups are usual
Total output must be such that the marginal revenue for each group of consumers is equal to the marginal cost of production. If this were not the case, the firm can increase its profit by raising or lowering total output
If the marginal revenues were the same for each group of consumers but the marginal revenue exceeded marginal cost. The firm can then make a grater profit by increasing its output. It would lower its prices to both groups of consumers, so that marginal revenues for each group would fall (but would still be equal to each other) and would approach marginal cost
Total Profit
Pi = P1Q1 + P2Q2 -C(QT)
P1 the price for the first group
P2 price for the second group
C(QT) is the tidal cost of producing output, QT = Q1+Q2
We need to set incremental profit for sales to the first group of consumers equal to zero:
Q1=(P1Q1)Q1-CQ1=0
(P1Q1)Q1 is the incremental revenue from an extra unit of sales to the first group of consumers (MR1)
CQ1 the incremental cost of producing this extra unit, aka MC1
So we have
MR1 = MC
MR2 = MC
Putting them together
MR1 = MR2 = MC
Determining Relative Prices
Managers may find it easier to think in terms of the relative prices that should be charged to each group of consumers and to relate these prices to the elasticities of demand
MR = P(1+1/Ed)
MR1 = P1(1+1/E1) MR2 = P2(1+1/E2)
E is the elasticities of demand for the firm’s sales in the first and second markets
This equation must hold for the prices:
P1/P2 = (1+ 1/E2)/ (1 + 1/E1)
It may not always be worthwhile for the firm to try to sell to more than one group of consumers
If demand is small for the second group and marginal cost is rising steeply, the increased cost of producing and selling to this group may outweigh the increase in revenue
11.3 Intertemporal Price Discrimination and Peal-Load Pricing
Intertemporal price discrimination
Separating consumers with different demand functions into different groups by charging different prices at different points in time
Peak-load Pricing
Charging higher prices during peak periods when capacity constraints cause marginal costs to be high
Both strategies involve charging different prices at different times, but the reasons for doing so are somewhat different in each case
Intertemporal Price Discrimination
The objective is to divide consumers into high-demand and low-demand groups by charging a price that is high at first but falls later
Example
Electronic company might price new, technologically advanced equipment, such as high-performance digital cameras or LCD television monitors, there is a small group of consumers who value the product highly and do not want to wait to buy it, then there is the group of consumers who are more willing to forgo the product if the price is too high.
The strategy is to offer the product initially at the high price selling mostly to consumers on demand curve
Later after this group of consumers has bought the product, the price is lowered and sales are made to the larger group of consumers on
Peak-Load Pricing
Peak-Load Pricing
Involves charging different prices at different points in time
Rather than capturing consumer surplus, however, the objective is to increase economic efficiency by charging consumers prices that are close to marginal cost
For some goods and services, demand peaks at particular times–
for roads and tunnels during commuter rush hours
for electricity during late summer afternoons
for ski resorts and amusement parks on weekends
Marginal cost is also high during these peak periods because of capacity constraints
Prices should be higher during peak periods
The efficiency gain from peak-load pricing is important.
If the firm were a regulated monopolist, the regulatory agency should set the prices at points where the demand curves intersect the marginal cost curve rather than where the marginal revenue curves intersect marginal cost
In that case consumers realize the entire efficiency gain
Peak-Load pricing is different from third-degree price discrimination
With third-degree marginal revenue must equal for each group of consumers and equal to marginal cost
11.4 The Two-Part Tariff
Two-part Tariff
Related to price discrimination and provides another means of extracting consumer surplus
It requires consumers to pay a fee up front for the right to buy a product
Consumers then pay a an additional fee for each unit of the product they wish to consume
Classic example is an amusement park
You pay commission fee to enter
And you also pay a certain amount for each ride
The owner of the park must decide whether to charge a high entrance fee and a low price for the rides or to admit prices for free but charge high prices for rides
Two-part tariff has been applied in many settings
Tennis and golf clibus
You pay an annual membership fee plus a fee for each use of a court or round of golf
The rental of large mainframe computers
A flat monthly fee plus a fee for each unit of processing time consumed
Telephone service
A monthly hook-up fee plus a fee for minutes of usage
The strategy also applies to the sale of products like safety razors
You pay for the razor which lets you consume the blades that fit that brand of razor
Problem
How to set the entry fee versus the usage fee
Single Consumer
Suppose the firm knows the consumers demand curve
In this case, set the usage fee equal to marginal cost and entry fee equal to the total consumer surplus for each consumer
With the fees set in this way, the firm captures all the consumer surplus as its profit
Two Consumers
The firm can set only one entry fee and one usage fee for two consumers
The firm should set the usage fee above marginal cost and then set the entry fee equal to the remaining consumer surplus of the consumer with the smaller demand
Many consumers
A lower entry fee means more entrants and thus more profit derived from the entry fee will fall
The problem is to pick an entry fee that results in the optimum number of entrants
The fee that allows for maximum profit
We can do this by starting with a price for sales of the item P, finding the optimum entry fee T, and then estimating the resulting profit
If It is impossible to determine the demand curve of every consumer, but one would at least like to know by how much individuals demands differ from one another
If consumers demands for a product are very similar you would charge a price that is close to marginal cost and make the entry fee
The ideal situation from the firm’s point of view because most of the consumer surplus could then be captured
If consumers have different demands for your product, you would probably want to set price well above marginal cost and charge a lower entry fee
In this case the two-part tariff is a less effective means of capturing consumer surplus; setting a single price may do almost as well
Firms perpetually searching for innovative pricing strategies, and a few have devised and introduced a two-part tariff with a “twist”--the entry fee entities the customer to a certain number of free units
This twist leys the firms set a higher entry fee without losing as many small customers
These small customers might pay little or nothing for usage under this scheme, the higher entry fee will capture their surplus without driving them out of the market, while also capturing more of the surplus of the large customer
11.5 Bundling
Bundled
Sold as a package
Bundling makes sense when customers have heterogeneous demands and when the firm cannot price discriminate
Example
If the firms are rented separately, the maximum price that could be charged for Wind is $10,000 because charging more would exclude Theater B
The maximum price that could charged for Gertie is $3000
Charging these two prices would yield $13,000 from each theater, for a total of $26,000 in revenue
Now if the films are bundled
Theater A values the pair of firms at $15,000
Theater B values the pair is $14,000
Total revenue is $28,000, more revenue is earned
Relative Valuations
Relative valuations
Although both the theaters would pay much more for Wind than for Gertie, Theater would pay more than Theater B for Wind, while Theater B would pay more than Theater A
The customer willing to pay the more for Wind is willing to pay the least for Gertie
Is demands are positively correlated, theater A would pay more for both firms
If we bundled the firms, the maximum price that could be charged is $16,000, total revenue is $26,000
When prices are bundled
In general, the effectiveness of bundling depends on the extent to which demands are negatively correlated
It works best when consumers who have a high reservation price for good 1 have a low reservation price for good 2, and vice versa
Mixed Bundling
Mixed bundling
The firm offers its products both separately and as a bundle, with a package price below the sum of individual prices
Pure bundling
Selling the products only as a bundle
Mixed bundling is often the ideal strategy when demands are only somewhat negatively correlated and/or when marginal production costs are significant, marginal production costs are zero
Mixed bundling is the most profitable strategy
Mixed bundling would not be the preferred strategy in this example if marginal sots were zero
In a case where, a consumer would gain more from getting sold an item individually, meaning it cant bundle
If marginal costs are zero, mixed bundling can still be more profitable than pure bundling if consumers’ demands are not perfectly negatively correlated
Why does mixed bundling give higher profits than pure bundling even though marginal costs are zero?
The reason is that demands are not perfectly negatively correlated
Two consumers have high demands for two goods and are willing to pay more for the bundle than the other two consumers who would rather pay for two of the goods separately
Tying
Tying
General term that refers to any requirement that products be bought or sold in some combination
Example
Suppose a firm sells a product that requires consumption of a secondary product.
The consumer buys the first product is also required to buy the secondary product from the same company
This requirement is usually imposed through a contract
One main benefit of tying is that it often allows a firm to meter demand and thereby practise price discrimination more effectively
Tying can also be used to extend a firm’s market power
Other uses of tying is:
To protect customer goodwill connected with a brand name
This is why franchises are often required to purchase inputs from the franchiser
11.6 Advertising
Most firms with market power have another important decision, how much to advertise
Demand moves up with advertising (obviously)
Equation to decide how much to advertise
=PQ(P,A)-C(Q)-A
Given a price, more advertising will result in more sales and thus more revenue
Advertising leads to increased output
Increase advertising until the marginal revenue from an additional dollar of advertising, just equals the full marginal cost of advertising
The full marginal cost is the sum of the dollar spent directly on the advertising and the marginal production cost resulting from the increased sales that advertising brings
The firm should advertise up to the point that
MRAds=pQA=1+MCQA=full marginal cost of advertising
This rule is often ignored by managers, who justify advertising budgets by comparing the expected benefits only with the cost of the advertising
But additional sales mean increased production costs that must also be take into account
A Rule of Thumb for Advertising
Rule of thumb for pricing for a profit-maximizing firm
The markup over marginal cost as a percentage of price should equal minus the inverse of the price elasticity of demand
Advertising-to-sales ratio
A/PQ
Advertising elasticity of demand
(A/Q)(Q/A)
Rule of thumb for advertising
A/P = -(Ea/Ep)
Ea is elasticity of advertising
Ep Elasticity of price
A is the advertising expenditures in dollars
It says that to maximize profit, the firm’s advertising-to-sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand
This rule make intuitive sense
It says firms should advertise a lot if (i) demand is very sensitive to advertising (Ea is large)
Or if (ii) demand is not very price elastic (Ep is small)
Why should firms advertise more when the price elasticity of demand is small?
A small elasticity of demand implies a large markup of price over marginal cost
Therefore, the marginal profit from each extra unit sold is high
In this case, if advertising can help sell a few more units, it will be worth the cost
Chapter 12
Chapter 12.1 Monopolistic Competition
The makings of Monopolistic Competition
We can explain that a seller of a product has some monopoly power if it can profitably charge a price greater than marginal cost
A monopolistically competitive market has two key characteristics
Firms compete by selling differentiated products that are highly substitutable for one another but not perfect substitutes. In other words, the cross-price elasticities of demand are large but not infinite
There is free entry and exit: it is relatively easy for new firms to enter the market with their own brands and for existing firms to lease if their products become unprofitable
The toothpaste market is monopolistically competitive, but the automobile market is better characterized as an oligopoly
Equilibrium in the Short Run and the Long Run
As with monopoly, monopolistic competition forms face downward-sloping demand curves
Monopolistic competition is also similar to perfect competition: Because there is free entry, the potential to earn profits will attract new firms with competing brands, driving economic profits down to zero
In the long run, this profit will induce entry by other firms
As they introduce competing brands, our firm will lose market share and sales; its demand curve will shift down
It implies zero profit because price is equal to average cost
Firms may have different costs, and some brands will be more distinctive than others.
In this case, firms may charge slightly different prices, and some will earn small profits
Monopolistic Competition and Economic Efficiency
Perfectly competitive markets are desirable because they are economically efficient
As long as there are no externalities and nothing impedes the workings of the market, the total surplus of consumers and producers is as large as possible
Two sources of inefficiency in a monopolistically competitive industry:
Unlike perfect competition, with monopolistic competition the equilibrium price exceeds marginal cost
This means that the value to consumers of additional units of output exceeds the cost of producing those units
If output were expanded to the point where the demand curve intersects the marginal cost curve, total surplus could be increased
Monopoly power creates a dead-weight loss, and monopoly power exists in monopolistically competitive markets
For the monopolistically competitive firm, output is below that which minimizes average cost.
Entry of new firms drives profits to zero in both perfectly competitive and monopolistically competitive markets
In perfect competitive market, each firm faces a horizontal demand curve, so the zero-profit point occurs at minimum average cost
In a monopolistically competitive market, however, the demand curves is downward sloping, so the zero-profit point is the the left of minimum average cost
Excess capacity in inefficient because average cost would be lower with fewer firms
These inefficiencies make consumers worse off
Is monopolistic competition a socially undesirable market structure that should be regulated?
In most monopolistically competitive markets, monopoly power is smaller
Usually enough firms compete, with brands that are sufficiently substitutable, so that no single firm has much monopoly power
Any resulting deadweight loss will therefore be small
And because firms’ demand curves will be fairly elastic, average cost will be close to the minimum
Any inefficiency must be balanced against an important benefit from monopolistic competition: Product diversity
Most consumers value the ability to choose among a wide variety of competing products and brands differ in various ways
The gains from product diversity can be large and may easily outweigh the inefficiency costs resulting from downward-sloping demand curves
12.2 Oligopoly
In oligopolistic markets, the products may or may not be differentiated
In some olgiopolistic markets, some or all firms earn substantial profits over the long run because barriers to entry make it difficult or impossible for new firms to enter
Examples of oligopolistic industries
Automomiles
Steel
Aluminum
Petrochemicals
Electrical equipment
Computers
Scale economies may make it unprofitable for more than a few firms to coexist in the market
Patents or access to a technology may exclude potential competitors
The need to spend money for name recognition and market reputation may discourage entry by new firms
These are natural entry barries
They are basic to the structure of the particular markey
In addition, incumbent firms may take strategic actions to deter entry
Example
They might threaten to flood the market and drive prices down if entry occurs
To make the threat credible, they can construct excess production capacity
Ways that make having an oligopolistic firm
Pricing
Output
Advertising
Investment decisions involve important strategic considerations
Since only a few firms are competing
Each firm must carefully consider how its actions will affect its rivals , and how its rivals are likely to react
When making decisions, each firm must weigh its competitors’ reactions, knowing that these competitors will also weigh its reactions to their decisions
When the managers of a firm evaluate the potential consequences of their decisions, they must assault that their competitors are as rational and intelligent as they are
They must put themselves in their competitors’ place and consider how they would react
Equilibrium in an Oligopolistic Market
A firm sets price or output based partly on strategic considerations regarding the behaviour of its competitors
Competitors decisions depend on the first firm decision
Nash equilibrium
Each firm will want to do the best it can given what its competitors are doing
It is natural to assume that these competitors will do the best they can given what that firm is doing
Definition
Each firm is doing the best it can given its competitors are doing
Duopoly
Two firms competing with each other
Each firm has just one competitor to take into account in making its decisions
The Cournot Model
Suppose the firms produce a homogenous good and know the market demand curve
Each firm must decide how much to produce, and the two firms make their decisions at the same time
The market price will depend on the total output of both firm
Essence of the Cournot model
Each firm treats the output level of its competitor as fixed when deciding how much to produce
Example
Firm 1 thinks that Firm 2 will produce nothing. In that case Firm 1’s demand curve is the market demand curve
Reaction curves
Firm 1’s profit-maximizing output is thus a decreasing schedule of how much it thinks Firm 2 will produce
Cournot Equilibrium
The resulting set of output levels
In this equilibrium, each firm correctly assume how much its competitor will produce, and it maximizes its profit accordingly
In Cournot equilibrium, each firm is producing an amount that maximizes its profit given what its competitor is producing, so neither would want to change its output
Cournot equilibrium doesn’t work for dynamics of the adjustment process, because both firms would be adjusting their outputs, neither output would be fixed
When is it rational for each firm to assume that its competitors output is fixed?
It is rational if the two firms are choosing their outputs only once because then their outputs only once because then their outputs cannot change
It is only rational once they are in Cournot equilibrium because then neither firm will have any incentive to change its output
First Mover Advantage—The Stackelberg Model
We assume that our two duopolists make thor output decisions at the same time
Stackelberg model
In which neither firm has any opportunity to react
Example
Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes its output decision
In this setting output, Firm 1 must therefore consider how Form 2 will react
Going first gives Firm 1 an advantage
Announcing first creates a fait accompli
No matter what your competitor does, your output will be large
To maximize profit, your competitor must take yout large output level as given and set a low level of output for itself
Unless your competitor views “getting” even as more important than making money, it would be irrational for it to produce a large amount
Cournot and Stackelberg models are alternative representations of oligopolistic behaviour
For any industry composed of roughly similar firms, none of which has a strong operating advantage or leadership position
The cournot model is probably the more appropriate
Some industries are dominated by a large firm that usually takes the lead in introducing new products or setting price
Example
The mainframe computer market is an example, with the IBM the leader
Then the Stackelberg model may be more realistic
12.3 Price Competition
In many oligopolistic industries, however, competition occurs alone price dimensions
Example
Automobile companies view price as a key strategic variable, and each one chooses its price with its competitors in mind
Price Competition with Homogenous Products–The Bertrand Model
Bertrand Model
Similar to Cournot model, it applies to firms that produce the same homogenous good and make their decisions at the same time
In this case however the firms choose prices instead of quantities
Suppose that two duopolists compete by simultaneously choosing a price instead of a quantity
What price will each firm choose, and how much profit will each earn?
Because the good is homogenous, consumers will purchase only from the lowest-price seller
The two firms charge different prices, the lower-price firm will supply the entire market anf the higher-price firm will sell nothing
If both firms charge the same price, consumer will be indifferent as to which firm they buy from and each firm will supply half the market
The nash equilibrium is the competitive outcome, both firms set price equal to marginal cost
It is doing the best it can to maximize profit, given what its competitor is doing
Why couldnt there be a Nash equilibrium in which the firms charged the same price
Because if either firm lowered its price just a little, it could capture the entire market and nearly double its profit
Each firm would want to undercut its competitor
In the Cournot model, each firm made a profit
In the Bertrand model, the firms price at marginal cost and make no profit
Bertrand model has been criticized on several counts:
When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices
Even if firms do set prices and choose the same price
The bertrand model is useful because it shows how the equilibrium outcome in an oligopoly can depend crucially on the firms’ choice of strategic variable
Price Competition with Differentiated Products
Oligopolistic markets often have at least some degree of product differentiation
Market shares are determine no just by price but also by:
Differences in design
Performance
Durability of each firm’s product
In such cases it is natural for firms to compete by choosing prices rather than quantities
The quantity that each firm can sell decreases when it raises its own price but increases when its competitor charges a higher price
Choosing Prices
We can use the nash equilibrium concept to determine the resulting prices, when firms set their prices at the same time and that each firm takes its competitors price as fixed
When the two reaction curves cross
At this point, because each firm is doing the best it can given the price its competitor has set, neither firm has an incentive to change its price
If the two firms collude
Instead of choosing their price independently, they both decide to charge the same price—namely, the price that maximizes both of their profits
Unlike stackelberg model in which firms set their quantities by moving first, the firm to move first would be at a distinct disadvantage by moving first
Why is moving first now a disadvantage?
Because it gives the firm that moves second an opportunity to undercut slightly and thereby capture a larger market share
12.4 Competition versus Collusion: The Prisoners’ Dilemma
A nash equilibrium is a noncooperative equilibrium
Each firm makes the decisions that give it the highest possible profit, given the actions of its competitors
Collusion, is illegal, and most managers prefer to stay out of jail
But if cooperation can lead to higher profits, why don't firms corporate without explicitly colluding?
In particular, is you and your competitor can both figure out the profit-maximizing price you would agree to charge is you were to collude
Why not set that price and hope you competitor will do the same?
If your competitor does do the same, you will both make more money
A firm's competitor would do better by choosing a lower price, even if it knew that you were going to set price at the collusive level
Payoff Matrix
Summarizes the results of these different possibilities
Noncooperative game
Game in which negotiation and enforcement of binding contracts are not possible
Prisoners' Dilemma
Illustrates the problem faced by oligopolistic firms
Two prisoners have been accused of collaborating in a crime
They are in separate jail cells and cannot communicate with each other
Each has been asked to confess. If both confess, each will receive a prison term of five years
If neither confeses, the prosecution’s case will be difficult to make, so the prisoners can expect to plea bargain and receive terms of two years
If one prisoner confesses and the other does not, the one who confesses will receive a term of only one year, while the other will go to prison 10 years
Both prisoners will probably confess and go to jail for five years
Oligopolistic firms often find themselves in a prisoners’ dilemma
They must decide whether to compete aggressively, attempting to capture a larger share of the market at theircompetitors expense, or to “cooperate” and compete more passively, coexisting with their competitors and settling for their current market share, and perhaps even implicitly colluding
If the firms compete passively, setting high prices and limiting output, they will make higher profits than if they compete aggressively
Like our prisoners, however, each firm has an incentive to “fink” and undercut its competitors, and each know that its competitors have the dame incentive
12.5 Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
Although our imaginary prisoners have only one opportunity to confess, most firms set output and price over and over again, continually observing their competitors’ behaviour and adjusting their own accordingly
This allows firms to develop reputations from which trust can arise
As a result oligopolistic coordination and cooperation can sometimes prevail
Example
Three or four firms that have coexisted for a long time, over the years, the managers of those firms might grow tired of losing money because of price wars, and an implicit understanding might arise by which all the firms maintain high prices and no firm tries to take market share from its competitors
Competitors will retaliate, and the result will be renewed warfare and lower profits over the long run
Sometimes managers are not content with the moderately high profits resulting from implicit collusion and prefer to compete aggressively in order to increase market share
In many industries, therefore, implicit collusions is short lived
There is often a fundamental layer of mistrust, so warfare erupts as soon as one firm is perceived by its competitors to be “rocking the boat” by changing its price or increasing advertising
Price Rigidity
Implicit collusion tends to be fragile, oligopolistic firms often have a strong desire for price stability
Price rigidity
Characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change
If costs fall or market demand declines, they fear that lower prices might send the wrong message to their competitors and set off a price war
Is costs or demand rises, they are reluctant to raise prices because they are afraid that their competitors may not raise their
Price rigidity is the basis of the kinked demand curve
According to this model, each firm faces a demand curve kinked at the currently prevailing price
Sales will expand only to the extent that a lower market price increases total market demand
Since the firm’s demand curve is kinked, its marginal revenue curve is discontinuous
The firm’s costs can change without resulting in a change in price
The kinked demand curve
It is useful mainly as a description of price rigidity rather than as an explanation of it
The explanation for price rigidity comes from the prisoners’ dilemma and from firms’ desires to avoid mutually destructive price competition
Price Signaling and Price Leadership
Price signaling
Is a firm of implicit collusion that sometimes gets around this problem
Example
A firm might announce that it has raised its price (perhaps through press release) and hope that its competitors will take this announcement as a signal that they should also raise prices
If competitors follow suit, all of the firs will earn higher profit
Price leader ship
One firm is implicitly recognized as the “leader”, while the other firms, the “price followers,” match its prices
This behaviour solves the problem of coordinating price:
Everyone charges what the leader is charging
In some industries, a large firm might naturally emerge as a leader, with the other firms deciding that they are best off just matching the leader’s prices, rather than trying to undercut the leader or each other
In some cases, a firm might look to a price leader to signal when and by how much price should change
Sometimes a large firm will act as leader from time to time
Prime rate
The interest rate that banks charge large corporate clients
The best way to avoid a price war is to avoid discounting and to increase prices in lockstep on a regular basis
The Dominant Firm Model
In some oligopolistic markets, one large firm has a major share of total sales while a group of smaller firms supplies the remainder of the market
Dominant firm
Usually the large firm
Setting a price that maximizes its own profits
The other firms, which individually could have little influence over price, would then act as perfect competitors
They take the price set by the dominant firm as given and produce accordingly
12.6 Cartels
Producers in a cartel explicitly agree to cooperate in setting prices and output levels
If enough producers adhere to the cartel’s agreements, and if market demand is sufficiently inelastic, the cartel may drive prices well above competitive levels
Nothing prevents countries, or companies owned or controlled by foreign governments, from forming cartels
Conditions for Cartel Success
1. A stable cartel organization must be formed whose members agree on price and production levels and then adhere to that agreement
Cartel members can talk to each other to formalize an agreement
Different members may have different costs, different assessments of market demand and even different objectives, and they may therefore want to set price at different levels
Each member of the cartel will be tempted to “cheat” by lowering its price slightly to capture a larger market share than it was allotted
2. The potential for monopoly power
Potential monopoly power may be the most important condition for success; of the potential gains from cooperation are large, cartel members will have more incentive to solve their organizational problems
Analysis of Cartel Pricing
A cartel usually accounts for only a portion of total production and must take into account the supply response of competitive producers when it sets price
Analyzing Opec
The demand for OPEC oil is also fairly inelastic. Thus the cartel has substantial monopoly power, and it has used that power to drive prices well above competitive
Successful cartelization requires two things
The total demand for the good must not be very price elastic
Either the cartel must control nearly all the world’s supply or, if it does not, the supply of noncartel producers must not be price elastic
Most international commodity cartels have failed because few world markets meet both conditions
Chapter 13
13.1 Gaming and Strategic Decisions
Game
Is any situation in which players (the participants) make strategic decisions-i.e. Decisions that take into account each other’s actions and responses
Example
Games include firms competing with each other by setting prices, or a group of consumers bidding against each other at an auction for a work of art
Strategic decisions result in payoffs
To the players: outcomes that generate rewards or benefits
For the price-setting firms, the payoffs are profits
For the bidders at the auction
The winners payoff is her consumer surplus, the value she places on the artwork less the amount she must pay
A key objective of game theory is to determine the optimal strategy for each player
Strategy
Is a rule or plan of action for playing the game
For our price-setting firms
A strategy might be
Ill keep my price high as long as my competitor lowers his price, ill lower mine even more
The optimal strategy
For a player is the one that maximizes the expected pay off
Noncooperative versus Cooperative Games
The economic games that firms play can be either cooperative or noncooperative
In a cooperative game
Players can negotiate binding contracts that allow them to plan joint strategies
In a noncooperative game
Negotiation and enforcement of binding contracts are not possible
The fundamental difference between cooperative and non cooperative games lies in the contracting possibilities
In cooperative games, binding contracts are possible; in non-cooperative games, they are not
Key point about strategic decision making
It is essential to understand you opponent’s point of view and to deduce his or her likely response to your actions
The games are simple that
Given some behavioural assumptions, we can determine the best strategy for each firm
13.2 Dominant Strategies
Dominant strategy
One that is optimal no matter what an opponent does
Outcome is easy to determine because both firms have dominant strategies
When every player has a dominant strategy, we call the outcome of the game an:
Equilibrium in dominant strategies
Such games are straightforward to anaylyze because each players optimal strategy can be determined without worry about the actions of the other player
A firm does not have a dominant strategy
When its optimal decision depends on what the other firm will do
13.3 The Nash Equilibrium Revisited
Dominant strategies are stable, but in many games, one or more players do not have a dominant strategy
Nash equilibrium
Is a set of strategies
Such that each player is doing the best it can give the actions of its opponents
Because each player has no incentive to deviate from its nash strategy, the strategies are stable
In the nash equilibrium, each firm is earning the largest profit it can given the prices of its competitors, and this has no incentive to change its price
Comparing the concept of a Nash equilibrium with that of an equilibrium in dominant strategies:
Dominant Strategies: I'm doing the best I can no matter what you do. You're doing the best you can no matter what I do
Nash Equilibrium: I'm doing the best I can given what you are doing. You're doing the best you can given what I am doing
Note
A dominant strategy equilibrium is a special case of Nash Equilibrium
In general a game need not have a single nash equilibrium
Sometimes there is no Nash Equilibrium, sometimes there are several
The Product Choice Problem
In this game, each firm is indifferent about which product it produces–so long as it does not introduce the same product as its competitor
If the firms behave noncooperatively
Firm 1 indicates that is is about to introduce the sweet cereal, and that Firm 2 announces its plan introduce the crispy one
Nash equilibrium: Given the strategy of its opponent, each firm is doing the best it can and has no incentive to deviate
If we have no way of knowing which equilibrium is likely to result or if either will result
One of the two nash equilibria if they both introduce the same type of cereal, they both lose money
As an industry develops, understandings often evolve as firms “signal” each other about the paths the industry is to take
The Beach Location Game
This game is based on the two firms selling the same product as rhe same price
This means for consumers, they rely on which vendor is closer in distance to them
Nash equilibrium calls for both you and your competitor to locate at the same spot in the center of the beach
If firm 2 were to be located 3/4 of the way to the end of the beach, firm 1 would want to locate near firm 2, just to the left.
Then firm 1 would capture 3/4s of all sales, and firm 2 would only capture 1/4 of the sale on the beach
The outcome is not an equilibrium because firm 1 would then want to move to the center of the beach, and firm 1 would do the same
Example can be 7-11’s and Circle-K’s only a road or two apart
Maximin Strategies
The concept of a nash’s equilibrium relies heavily on individual rationality
Each player’s choice of strategy depends not only on its own rationality, but also the rationality of its opponent
Both firms use the same encryption standard, files encrypted by one firm’s software can be read by the others–advantage for consumers
Nonetheless firm 1 has a much larger market chare
Both firms are now considering an investment in a new encryption standard
Note:
Investing is a dominant strategy for Firm 2 because by doing so it will do better regardless of what Firm 1 does
Firm 1 would also do better by investing
Only one Nash equilibrium
(invest, invest)
Firm 1 if it wants to be cautious would choose “don’t invest” because then it only loses -10
This is maximum strategy
Maximizes the minimum gain that can be earned
Maximizing the Expected payoff
If Firm 1 is unsure about what FIrm 2 will do but can assign possibiilties to each feasible action for Firm 2, it could use a strategy yhay
Maximizes its expected payoff
Probability question
Firm 1 thinks there is only a 10% chance that Firm 2 will not invest
In that case
Investing payoff
(0.1)(-100)+(0.9)(20) = $8 million
Dont invest payoff
(0.1)(0) + (0.9)(-10) = $9 million
Firm 1 should invest
Firm 1 thinks that the probability that Firm 2 will not invest is 30 percent
Firm 1’s payoff for investing
(0.3)(-100) + (0.7)(20) = $16 million
Firm 1’s payoff for not investing
(0.3)(0) + (0.7)(-10) = $7 million
Firm 1 would not invest
Firm 1’s strategy depends critically on its assessment of the probabilities of different actions by Firm 2
The Prisoner's Dilemma
In the prisoners dilemma, confessing is a dominant strategy for each prisoner-it yields a higher payoff regardless of the strategy of the other prisoner
Dominant strategies are also maximum strategies
Therefore, the outcome in which both prisoners confess is both a nash equilibrium and a maximin solution
Thus in a strong sense it is rational for each prisoner to confess