ECON 101: Microeconomics Exam #3

Federal Trade Commission Act

(WW) 1914 , A government agency established in 1914 to prevent unfair business practices and help maintain a competitive economy, support antitrust suits

Shape of the Total Revenue Curve

- At low levels of output, the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small. - As output rises (beyond 10 on the graph from previous slide), total revenue actually falls. This reflects the fact that at high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it now has to lower the price on many units of output, making the price effect very large.

Price Effect

- Lower prices = producer makes more

Quantity Effect

- When price increases, fewer units are sold

Conditions Necessary for Price Discrimination

1) Firm must have market power - Monopoly, Oligopoly - Perfectly competitive firms do not 2) Firm must be able to identify differences in willingness to pay between consumers 3) Firm must be able to limit resale of product

Two Key Conditions for Perfect Competition

1) For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share. - A producer's market share is the fraction of the total industry output accounted for by that producer's output. 2) An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent. - Homogeneous product (standardized product) -- Consumers regard the products of different producers as the same good.

Justice Department HHI Classifications

1) HHI below 1,500: Unconcentrated Market - Strongly competitive 2) HHI between 1,500 and 2,500: Moderately-Concentrated Market HHI above 2,500: Highly Concentrated Market

Types of Price Discrimination

1) Perfect Price Discrimination Charge the maximum amount each consumer is willing to pay 2) Quantity Discrimination Firm charges a different price for large quantities than for small quantities 3) Multi-Market Price Discrimination Charge different groups of customers different prices 4) Two-Part Tariff Charge customer a lump-sum fee for the right to buy the good at specified price

Elements of Game Theory

1) Players - Decision Makers (Firms) 2) Number of Periods One Period, Repeated Game 3) Order of Play - Simultaneous, Sequential 4) Strategies - Possible courses of action for each player 5) Payoffs - Reward received by a player in a game (Profits) -- Often illustrated by a payoff matrix 6) Equilibrium - Each player attempts to maximize their individual payoffs

Perfectly Competitive Markets in the Long-Run

1) Production Decision - Produce quantity where Price (MR) = Marginal Cost (MC) -- Profit maximizing condition for a perfectly competitive firm: P = MC 2) Shutdown Decision - All costs are avoidable in the long-run - Shutdown and exit the industry if Price < Average Total Cost -- P < ATC

Perfectly Competitive Markets in the Short-Run

1) Production Decision - Produce quantity where Price (MR) = Marginal Cost (MC) -- Profit maximizing condition for a perfectly competitive firm: P = MC 2) Shutdown Decision - Shutdown if Price < Average Variable Cost -- P < AVC -- Fixed inputs cannot be changed in the Short-Run

Conditions for Cooperation

1) Repeated Interactions Over time - Tit for Tat strategy 2) Easy to monitor other firms - Good information concerning prices and output levels 3) Entry by non-colluding firms difficult - Easier to successfully collude if collectively hold high market share 4) Merge - To avoid problem of cheating some firms merge into single entity - Mergers may reduce costs and increase efficiency - Subject to approval by Government

Antitrust Legislation

1) Restrict the formation of cartels and prohibit other collusive practices regarded as being in restraint of trade 2) Restrict mergers and acquisitions of organizations which could substantially lessen competition 3) Restrict the creation of a monopoly and abuse of monopoly power

Mergers: General Standards

1) Small Change in Concentration - Mergers involving an increase in HHI of less than 100 points. - Unlikely to have adverse competitive effects and ordinarily require no further analysis 2) Mergers in Moderately Concentrated Markets (HHI: 1,500 - 2,500) - Mergers that involve an increase in the HHI of more than 100 points potentially raise significant competitive concerns 3) Mergers in Highly Concentrated Markets (HHI > 2,500) - Mergers in highly concentrated markets that involve an increase in HHI of between 100 to 200 points potentially raise significant concerns 4) Mergers in highly concentrated markets that involve an increase in HHI of more than 200 points will be presumed to be likely to enhance market power

Calculating HHI

1) Square each firm's share of market sales 2) Add together the squared market shares for all firms in the industry. *Takes into account the relative size distribution of the firms in the market* *Gives proportionately greater weight to larger market shares*

Sherman Antitrust Act

1890 - A federal law that committed the American government to opposing monopolies, it prohibits contracts, combinations and conspiracies in restraint of trade.

Robinson-Patman Act

1937 - Amended federal anti-trust laws so as to outlaw "price discrimination," whereby companies create a monopolistic network of related suppliers and vendors who give each other more favorable prices than they do others.

Price-Taking Consumer

A consumer whose actions have no effect on the market price of the good he or she buys.

Cartel

A formal organization of producers that agree to coordinate prices and production - Firms acting together as if a monopoly

Perfectly Competitive Market

A market in which all market participants are price-takers.

Reason Monopolies Exist

A monopolist has market power. - Charges a higher price than perfectly competitive outcome - Produces a lower quantity than the perfectly competitive outcome - Creates deadweight loss - Generates economic profits for the firm In order for profits to persist in the long-run, some form of barrier to entry must be in place. - Otherwise, other firms will enter

Prisoner's Dilemma

A particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. Both Prisoners have a dominant strategy to confess It is in the joint interests of both prisoners not to confess, but it is in the individual interest to confess Outcome is the worst possible outcome, collectively - Both players are worse off than they would have been had they cooperated

Two-Part Tariff

A pricing system in which the firm charges a customer a lump-sum fee for the right to buy as many units of the good as the consumer wants at a specified price -Lump Sum Fee - Per-Unit Price

Price-Taking Producer

A producer whose actions have no effect on the market price of the good it sells.

Clayton Act

Act that minimally restricted the use of injunctions against labor and legalized peaceful strikes, picketing, and boycotts.

Duopoly Collusion

Agreement among times in a market about quantities to produce or prices to charge each produce half of monopoly output

Perfectly Competitive Industry

An industry in which producers are price-takers.

Monopoly Regulation

Break-up Monopoly - Anti-trust legislation Price Regulation (Price Ceiling) - If set at proper amount can get rid of welfare losses Increase Competition - Grant more licenses - Reduce trade barriers for foreign firms - Alter patent laws - Subsidize competing firms (offer tax breaks)

Barriers to Entry (Example #2)

COST ADVANTAGE Large fixed costs - High initial set-up costs - A given quantity of output produced at a lower ATC by one large firm than by two or more smaller firms - Natural monopoly -- Local utilities: water, gas, electricity

Marginal Revenue (MR)

Change in Total Revenue (TR) generated by selling an additional unit of output. MR = ∆TR/∆Q

Price Discrimination

Charging different prices to different consumers for the same good. -In many cases, a price searcher can charge different prices to different consumers

Imperfect Competition

Competition among firms who have some market power - Price Searchers - Decisions made by each firm has an impact on the market - Each firm must consider the actions of the other firms in the industry - Strategic Behavior

Barriers to Entry (Example #1)

Control of scarce resource or input

Types of Imperfect Competition (Cooperative)

Decisions made jointly - Price or Quantity Setting (typically illegal) - Collusion - Two or more firms acting together to set prices or quantity rather than competing

Why is it Profitable to Price Discriminate?

Differences exist in consumer willingness to pay for a good. Price discrimination is profitable when consumers differ in their sensitivity to the price - Firms would like to charge higher prices to consumers who are willing to pay more and are less likely to stop buying the good if their price rises

Types of Imperfect Competition (Non-Cooperative)

Each firm makes decisions about output and price without consulting each other - Choices impact each other

Quantity Discrimination

Firm charges a different price for large quantities than for small quantities of a good - All customers who buy a given quantity pay the same price Takes advantage of downward sloping demand curves - Consumers willing to pay a lower price for successive units

Perfect Price Discrimination

Firm charges each customer exactly what they are willing to pay (maximum each is willing to pay) - Price = Marginal Value If able to do so, the Marginal Revenue curve becomes the Demand Curve Will continue to sell the good as long as Price exceeds the Marginal Cost of producing an additional unit Stop producing when: - Price = Marginal Cost Perfectly Price Discriminating Monopolist results in an efficient outcome - Net Benefits to Society are Maximized -- No Deadweight Loss - Same quantity produced as with perfect competition All benefits go to Producer -Consumer surplus is zero - Efficient, not equitable

Monopolist In the Market

Firm faces downward sloping, market demand curve - If the monopolist alters their quantity produced, the market price will change - As a result: Marginal revenue will not equal price - Has important implications for which price they charge and how many units they sell.

Price Searcher

Firms that have at least some influence on market price - Downward sloping demand curve - Monopoly, Oligopoly

Price Takers In the Market

For price takers (Perfect Competition) marginal revenue equals price - Firm has horizontal demand curve - Can sell all they want at the market price - Each additional unit sold provides additional revenue (marginal revenue) equal to the market price. - No individual firm large enough to influence market price

Barriers to Entry (Example #3)

Government Created Monopoly - Government License -- Government grants firm exclusive right to serve given area - Patents and Copyrights -- Patents: 20 years from date of filing -- Copyrights: 70 years post death

Elasticity, Total Revenue, and Marginal Revenue (elastic demand)

If demand for a good is elastic: - The quantity effect will dominate the price effect - A decrease in price will increase total revenue - If total revenue is increasing, marginal revenue must be positive -- As the price continues to be lowered, the good becomes less elastic and marginal revenue becomes smaller.

Elasticity, Total Revenue, and Marginal Revenue (inelastic demand)

If demand for a good is inelastic: - The price effect will dominate the quantity effect - A decrease in price will decrease total revenue - If total revenue is decreasing, marginal revenue must be Negative

Elasticity, Total Revenue, and Marginal Revenue (unit elastic demand)

If demand for a good is unit elastic: - The price and quantity effects will offset - Marginal revenue will be zero -- Marginal revenue curve crosses the horizontal axis at this point.

Payoff Matrix

In game theory, a table listing the payoffs that each player can expect from each move based on the actions of the other player

Monopolist Price and Quantity Effects

In order to attract new customers, the monopolist must lower price - Due to fact that the monopolist faces the downward sloping market demand curve An increase in production by a monopolist has two opposing effects on revenue: - A QUANTITY EFFECT: one more unit is sold, increasing total revenue by the price at which the unit is sold. - A PRICE EFFECT: in order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.

Monopolist's Production Decision

In order to maximize profit, the monopolist (like all firms) will continue to produce more units of a good until the additional revenue from the last unit produced equals the additional cost. - MR = MC At that level of output profits are maximized

Monopolist Profit Maximizing Condition

In order to maximize profits, a firm continues to produce as long as the additional revenue from an additional unit of output is greater than the additional cost from an additional unit of output. - Keep producing as long as MR > MC - Profits are maximized by producing the quantity at which the marginal cost of the last unit produced is equal to its marginal revenue. Stop producing where MR = MC

Profit Maximizing Condition

In order to maximize profits, a firm should continue to produce as long as the additional revenue from an additional unit of output is greater than the additional cost from an additional unit of output. - Keep producing as long as MR > MC - Profits are maximized by producing the quantity at which the marginal cost of the last unit produced is equal to its marginal revenue. Stop producing where MR = MC - (Or last unit for which MR > MC; Do not produce if MR < MC)

Price Takers

Individual firms that have no impact on market price

Firm should shutdown if:

Long-Run: TR < TC - Shutdown and exit the industry Short-Run: TR < VC

Oligopoly

Market structure characterized by having a small number of producers - Firms have market power - Face downward sloping demand curve - Decisions made by each firm has an impact on the market - Each firm must consider the actions of the other firms in the industry - Competition is limited; barriers to entry still exist - Can either collude or compete -- If firms collude, they want to collectively produce the monopoly outcome

Monopoly

Market with a single supplier of a good Monopolists know their actions influence market price - Take this into account when deciding how much to produce Choose price and quantity to maximize profits Constrained by the Demand Curve - Face downward sloping demand curve

Herfindahl-Hirschman Index

Measure of market concentration Used by the Justice Department when evaluating potential mergers -Is used to measure industry concentration and determine when a merger should be challenged

Monopolies Effects On Welfare

Monopolist charges a price higher than marginal cost and produces output at a level lower than the efficient, perfectly competitive output level. - As a result, monopolies cause deadweight loss to society.

Multi-Market Price Discrimination

Multi-Market Price Discrimination: - Firm charges different groups different prices according to willingness to pay for the group - Most common type of Price Discrimination Identify different groups of customers - Charge each group a different price -- Essentially act a single price monopolist within each group - Won't know individual willingness to pay, but have some idea about willingness to pay for groups -- Need to identify which group individual belongs

Nash Equilibrium

Occurs when, holding the strategies of all other players constant, no player can obtain a higher payoff by choosing a different strategy. Given what the other players are currently doing, no player can gain by altering their own strategy

Duopoly

Oligopoly with two firms

Why do firms attempt to Price Discriminate?

PROFITS!!!

Monopoly Versus Perfect Competition

Perfectly Competitive Firms produce where P=C Monopolies produce where P > MR = MC. Compared with a competitive industry, a monopolist: - Produces a smaller quantity: Qm < Qc - Charges a higher price: Pm > Pc - Earns a profit in both short-run and long-run.

Zero Economic Profit in the Long-Run

Perfectly competitive firms earn zero economic profit in the long-run - Due to free entry and exit If Profits > 0, other firms will enter the market - Leads to an increase in Supply -- Puts downward pressure on prices -- Price falls toward ATC and reduces profits to breakeven point If Profits < 0, firms will exit the market - Leads to a decrease in Supply -- Puts upward pressure on prices -- Price rises and profits are increased When Profits = 0, no incentive for firms to enter or exit Therefore, in long-run: P = AC = MC

Monopolist's Shutdown Decision

Shutdown if: - Short-Run: P < AVC - Long-Run: P < ATC Monopolist can charge higher price than perfectly competitive firm

Dominant Strategy

Strategy that gives the player a higher payoff no matter what strategy the opponent is playing.

Market Power

The ability of a firm to raise its price above the competitive level.

Marginal Cost (MC)

The additional cost incurred by producing an additional unit of output. MC = ∆TC/∆Q

Market Share

The ratio of sales revenue of the firm to the total sales revenue of all firms in the industry, including the firm itself.

Free Entry and Exit

There is free entry and exit into and out of an industry when new producers can easily enter into or leave that industry. - There are no barriers to entry or exit in the long-run. Free entry and exit ensure: 1) The number of producers in an industry can adjust to changing market conditions. 2) Producers in an industry cannot artificially keep other firms out.

Profit Maximization In Perfectly Competitive Markets

Under perfect competition: MR = Price - The marginal revenue curve shows how marginal revenue varies as output varies. Average Revenue (AR): Revenue per unit of output - AR = TR/Q = (P*Q)/Q = P - Average Revenue = Price - Under Perfect Competition: AR = MR = P

Profit Maximization Assumption

We assume that Firms attempt to maximize profits - Profit = Total Revenue (TR) - Total Cost (TC) Total Revenue = Price * Quantity = P*Q - The amount of income received from all units sold Total Cost is a function of Quantity [C(Q)] - The total cost of producing a given quantity of output