ECN 201 MIDTERM 3 REVIEW

In the late 1990s, the Government Accounting Office reported that airlines block new carriers at major airports. What effect does this have on fares and the number of flights at those airports?

Blocking entry raises fares and lowers the number of flights.

Why is a monopolists MR always below its price?

Because an increase in output lowers the price on all previous units.

One of the ways in which economists classify markets in practice is by

cross-price elasticities (the responsiveness of a change in the demand for a good to a change in the price of a related good)

Most commonly used concentration ratio

four-firm concentration ratio

Goals of advertising

include shifting the firm's demand curve to the right and making it more inelastic.

The central characteristic of oligopolistic industries is:

interdependent pricing decisions.

A cartel

is a combination of firms that acts as if it were a single firm; (a cartel is a shared monopoly).

Key characteristic of a monopolist

its output decision affects its price

At different times, U.S. antitrust law has been based on two competing views:

judgment by performance and judgment by structure.

What is the difference between judgment by performance and judgment by structure? Judgment by structure judges the competitiveness of a market by

looking at the market share of firms in the industry

average revenue =

(P) price

Why was AT&T given a monopoly in the telephone industry?

Because telephone service required substantial set-up costs, making the market a natural monopoly.

Neither the four-firm concentration ratio nor the Herfindahl index gives us a picture of corporations' bigness. Why?

Because many corporations are conglomerates

If you were an economist for a firm that wanted to merge, would you argue that the three-digit or five-digit NAICS industry is the relevant market? Why?

A three-digit industry so that the market would be more broadly defined.

What was the resolution of the AT&T case?

AT&T was broken up into smaller firms because changes in technology allowed the market to naturally become more competitive.

The contestable market model

According to it, markets that structurally look highly oligopolistic could actually be highly competitive—much more so than markets that structurally look less competitive; judging markets by performance, not structure.

What distinguishes oligopoly from monopolistic competition?

An oligopolist explicitly takes into account competitors' reactions to its output and pricing decisions, whereas a monopolistic competitor does not.

Best strategy for an oligopoly

cartelization

Is a contestable model or cartel model more likely to judge an industry by performance? Explain your answer.

Cartel model; A cartel is recognizable in that it acts like a monopolist and restricts output to raise price. Under the contestable market model, an oligopoly could perform exactly the same way that a perfectly competitive market does as long as there are no entry or exit barriers.

Discuss the effect of antitrust policy in the: c. contestable market model of oligopoly.

In this model, potential competition, not market structure, determines equilibrium, so antitrust policy would have little effect unless it influenced barriers to entry and exit.

Discuss the effect of antitrust policy in the: a. monopolistic competition model.

Each firm in this model has only a small share of the market and makes no profit, so antitrust policy would have little effect.

In 1982 Robert Crandell, CEO of American Airlines, phoned the Braniff Airways CEO and said, "Raise your fares 20 percent and I'll raise mine the next morning." c. Why should Crandell not have done this?

Explicit collusion is illegal.

How are the contestable market model and the cartel model of oligopoly related?

Firms react to other firms when setting their prices in both models.

Discuss the effect of antitrust policy in the: b. cartel model of oligopoly.

In this model, firms get together and allocate market share. Antitrust policy would prevent that, holding prices down and increasing quantity supplied.

Which industry is more highly concentrated: one with a Herfindahl index of 1,200 or one with a four-firm concentration ratio of 55 percent?

It is impossible to say.

Is an oligopolist more or less likely to engage in strategic decision making compared to a monopolistic competitor?

More. Strategic decision making is the central characteristic of oligopoly. Monopolistic competitors face too many competitors to price strategically.

In 1982 Robert Crandell, CEO of American Airlines, phoned the Braniff Airways CEO and said, "Raise your fares 20 percent and I'll raise mine the next morning." b. If you were the Braniff Airways CEO, would you have gone along?

No, it's illegal to collude.

Kellogg's, which controls 32 percent of the breakfast cereal market, cut the prices of some of its best-selling brands of cereal to regain market share lost to Post, which controls 20 percent of the market. General Mills has 24 percent of the market. The price cuts were expected to trigger a price war. Based on this information, what market structure best characterizes the market for breakfast cereal?

Oligopoly.

What technological advances threatened Microsoft's monopoly?

Open-source operating systems and cloud computing.

In what market did Microsoft have a monopoly in the late 1990s and early 2000s?

Operating systems for personal computers.

The government charged Microsoft with

Possessing monopoly power in the market for personal computer operating systems., Tying other Microsoft software products to its Windows operating system, Entering into agreements that keep computer manufacturers that install Windows from offering competing software.

Distinguish the basis of judgment for the Standard Oil and the ALCOA cases.

Standard Oil was judged by performance; ALCOA was judged by structure. Both were found guilty of being monopolies.

Cartel model

Such explicit formal collusion is against the law in the United States, but informal collusion is allowed and oligopolies have developed a variety of methods to collude implicitly. Thus, the cartel model has some relevance.

What is the difference between the contestable market model and the cartel model of oligopoly?

The pricing outcome for a contestable market is equivalent to a competitive industry. The pricing outcome for a cartel is equivalent to a monopoly.

In 1982 Robert Crandell, CEO of American Airlines, phoned the Braniff Airways CEO and said, "Raise your fares 20 percent and I'll raise mine the next morning." a. Why would he do this?

To collude to raise prices.

Judgment by performance

We should judge the competitiveness of markets by the performance (behavior) of firms in that market.

Judgment by structure

We should judge the competitiveness of markets by the structure of the industry.

Conglomerates

companies that span a variety of unrelated industries

Suppose you are an economist for Mattel, manufacturer of the doll Barbie, which was making an unsolicited bid to take over Hasbro, manufacturer of the doll G.I. Joe. a. Would you argue that the relevant market is dolls, preschool toys, or all toys including video games? Why?

You would want the regulatory boards to see more competition, so you would argue that the relevant market is all toys, which is as broad as possible. This would make it less likely that the merger would violate merger guidelines.

Suppose you are an economist for Mattel, manufacturer of the doll Barbie, which was making an unsolicited bid to take over Hasbro, manufacturer of the doll G.I. Joe. b. Would your answer change if you were working for Hasbro?

You would want to use the narrowest definition of the market, which would be dolls. This would make it more likely that the merger would violate merger guidelines.

Reasons why the U.S. government became more lenient in its interpretation of antitrust laws and has brought few major antitrust cases to the courts

a century of experience has taught businesses what the law allows, a change in American ideology, the United States has become more integrated into the global economy, technologies have become more complicated

Sherman Antitrust Act of 1890

a law designed to regulate the competitive process.

predatory pricing strategy

a strategy of pushing the price down temporarily to drive the other firm out of business to increase long-term profits

Herfindahl index

an index of market concentration calculated by adding the squared value of the individual market shares of all the firms in the industry.

North American Industry Classification System (NAICS)

an industry classification that categorizes industries by type of economic activity and groups firms with like production processes.

The contestable market model

an oligopoly with no barriers to entry sets a competitive price

In the cartel model of oligopoly, the firms would decide how much to produce where:

marginal cost equals marginal revenue.

Cartel model

oligopoly sets a monopoly price

robber barons

organizers of trusts (cartels) who engaged in the exploitation of natural resources and other unethical behavior.

Suppose there are no barriers to entry in the market for facial tissue, where two brands dominate the industry. According to the theory of contestable markets, the price charged for facial tissue will be:

roughly equal to the cost of producing a box of facial tissue.

What is the difference between judgment by performance and judgment by structure? Judgment by performance judges the competitiveness of a market by

the behavior of firms in that market

To empirically measure industry structure, economists use one of two methods

the concentration ratio or the Herfindahl index.

Antitrust policy

the government's policy toward the competitive process.

According to the kinked demand curve theory of sticky prices, in an oligopolistic market:

the kinked demand curve is elastic in the upper portion and inelastic in the lower portion of the curve.

One of the things that limits oligopolies from acting as a cartel

the threat from outside competition

Concentration ratio

the value of sales by the top firms of an industry stated as a percentage of total industry sales. (The higher the ratio, the closer the industry is to an oligopolistic or monopolistic type of market structure).

Under oligopoly:

there are only a few sellers in the industry.

An important reason supporting the structure criterion is practicality.

true

Because it squares market shares, the Herfindahl index gives more weight to firms with large market shares than does the concentration ratio measure. The Herfindahl index weights the largest firms in the industry more heavily than does the concentration ratio because it squares market shares.

true

Both judgment by structure and judgment by performance have their problems.

true

Both structure and performance criteria have ambiguities, and in the real world there are no definitive criteria for judging whether a firm has violated the antitrust statutes.

true

Economists' judgment on antitrust policy is mixed.

true

Equilibrium of oligopolies with weaker social pressures and less ability to prevent new entry is closer to the perfectly competitive solution.

true

Industrial organization economist F. M. Sherer has suggested the following rule of thumb: When two goods have a cross-price elasticity greater than or equal to 3, they can be regarded as belonging to the same market.

true

On a national scale, the outside competition comes from international firms.

true

Rapid technological change alters the nature of industries and introduces competition in ways that previously had not been possible.

true

The Herfindahl index is a method used by economists to classify how competitive an industry is.

true

The outcome of the Standard Oil case was determined by performance. The ALCOA (Aluminum Company of America) case was determined by market structure.

true

Monopolies exist because of

BARRIERS TO ENTRY into a market that prevent competition

To find a monopolist's level of output, price, and profit, follow these four steps

1. Draw the marginal revenue curve. 2. Determine the output the monopolist will produce: The profit-maximizing level of output is where the MR and MC curves intersect. 3. Determine the price the monopolist will charge: Extend a line from where MR = MC up to the demand curve. Where this line intersects the demand curve is the monopolist's price. 4. Determine the profit the monopolist will earn: Subtract the ATC from price at the profit-maximizing level of output to get profit per unit. Multiply profit per unit by quantity of output to get total profit.

Four reasons why economists don't advocate price controls more than they do:

1. For price controls to increase output and lower price, the price has to be set within the right price range—below the monopolist's price and above the price where the monopolist's marginal cost and marginal revenue curves intersect. It is unclear politically that such a price will be chosen. Even if regulators could pick the right price initially, markets may change. Demand may increase or decrease, putting the controlled price outside the desired range. 2. All markets are dynamic. The very existence of monopoly profits will encourage other firms in other industries to try to break into that market, keeping the existing monopolist on its toes. Because of this dynamic element, in some sense no market is ever a pure textbook monopoly. 3. Price controls create their own deadweight loss in the form of rent seeking. Price controls do not eliminate monopoly pressures. The monopolist has a big incentive to regain its ability to set its own price and will lobby hard to remove price controls. Economists see resources spent to regain their monopoly price as socially wasteful. 4. Economists distrust government. Governments have their own political agendas—there is no general belief among economists that governments will try to set the price at the competitive level. Once one opens up the price control gates in cases of monopoly, it will be difficult to stop government from using price controls in competitive markets.

What is the key difference between a monopolist and a perfect competitor?

A perfectly competitive firm does not take into account the effect of its output decision on the price it receives, whereas a monopolistic firm takes into account that its output decision can affect price.

In the late 1990s, the Government Accounting Office reported that airlines block new carriers at major airports. How much are airlines willing to spend to control the use of gates to block new carriers?

Airlines are willing to spend the rent they gain from blocking entry.

A monopolist is selling fish. But if the fish don't sell, they rot. What will be the likely elasticity at the point on the demand curve at which the monopolist sets the price?

Elastic.

monopolistic competitor makes ________ in long-run equilibrium.

zero economic profit

True or false? Monopolists differ from perfect competitors because monopolists make a profit. Why?

False. Both monopolists and perfect competitors earn at least normal economic profits in the long run. They will go out of business if they do not. The distinguishing feature is that a monopolist restricts output to increase price, whereas a perfectly competitive firm cannot influence the price.

What are the ways in which a firm can differentiate its product from that of its competitors? What is the overriding objective of product differentiation?

Firms differentiate products by advertising. The objective is to maintain or increase market share.

What three things must a firm be able to do to price-discriminate?

Identify groups with different elasticities., Limit the ability to resell the good between groups., Separate the groups.

How is efficiency related to the number of firms in an industry characterized by strong economies of scale?

In industries with strong economies of scale, efficiency tends to increase as the number of firms decreases. As each firm increases its output, its costs per unit fall. This means that fewer firms each producing higher output leads to greater efficiency than more firms each producing lower output.

Reasons why prices are sticky

Informal collusion; another possible reason is that firms don't collude, but do have certain expectations of other firms' reactions, which changes their perceived demand curves. Specifically, they perceive that the demand curve they face is kinked.

During the 2001 anthrax scare, the U.S. government threatened to disregard Bayer's patent of ciprofloxacin, the most effective drug to fight anthrax, and license the production of the drug to American drug companies to stockpile the drug in case of an anthrax epidemic. While the policy would lower costs to the U.S. government of stockpiling the drug, it also would have other costs. What are those costs?

Lost profit by Bayer., Fewer new drugs will be invented.

The four distinguishing characteristics of monopolistic competition are:

Many sellers., Differentiated products., Multiple dimensions of competition., Easy entry of new firms in the long run.

Both a perfect competitor and a monopolistic competitor choose output where MC = MR, and neither makes a profit in the long run. How is it, then, that the monopolistic competitor produces less than a perfect competitor?

Monopolistic competitors produce the same output as a perfect competitor. The difference is in the market structure.

Does a monopolist take market price as given? Why or why not?

No, a monopolist takes into account that its output decision can affect price, and its marginal revenue is not its price.

Say you place a lump-sum tax (a tax that is treated as a fixed cost) on a monopolist. How will that affect its output and pricing decisions?

Output and price would remain unchanged.

For a monopolistic competitor in long-run equilibrium

P = ATC >= MC =MR

The general rule that any firm must follow to maximize profit is:

Produce at an output level at which MC = MR.

Forms of competition

Product differentiation, advertising, dimensions of competition, service and distribution outlets.

How to graph marginal revenue curve

The MR line starts at the same point on the price axis as does a linear demand curve, but it intersects the quantity axis at a point half the distance from where the demand curve intersects the quantity axis.

Demonstrate graphically the profit-maximizing positions for a perfect competitor and a monopolist.

The competitive price is lower than the monopolistic price and the competitive output is higher than the monopolistic output.

If a monopolistic competitor is able to restrict output, why doesn't it earn economic profits?

The monopolistic competitor does not earn economic profits because of free entry into the market.

Will the welfare loss from a monopolist with a perfectly elastic marginal cost curve be greater or less than the welfare loss from a monopolist with an upward-sloping marginal cost curve?

The welfare loss is greater with constant marginal costs because the opportunity cost of providing additional units does not increase.

Why is marginal revenue below average revenue for a monopolist?

To sell an additional unit, the monopolist has to reduce the price not only to the marginal buyer, but to all buyers.

MR = MC condition determines the quantity a monopolist produces.

Yes, in turn, that quantity determines the price the firm will charge.

The marginal revenue curve

a downward-sloping curve that begins at the same point as the demand curve but has a steeper slope

Monopoly

a market structure in which one firm makes up the entire market; polar opposite of competition (no competitive pressure from other firms)

Monopolistic competition

a market structure in which there are many firms selling differentiated products and few barriers to entry.

oligopoly

a market structure in which there are only a few firms and firms explicitly take other firms' likely response into account.

Contestable market model

a model of oligopoly in which barriers to entry and barriers to exit, not the structure of the market, determine a firm's price and output decisions ( says that the price that an oligopoly will charge will exceed the cost of production only if new firms cannot exit and enter the market).

Cartel model of oligopoly

a model that assumes that oligopolies act as if they were monopolists that have assigned output quotas to individual member firms of the oligopoly so that total output is consistent with joint profit maximization. All firms follow a uniform pricing policy that serves their collective interest.

Monopolistic competitors have a strong incentive to

advertise

Natural monopoly

an industry in which a single firm can produce at a lower cost than can two or more firms (will occur when the technology is such that indivisible setup costs are so large that average total costs fall within the range of possible outputs)

Demand curve

average revenue curve

The monopolist's profit can be determined only by comparing

average total cost to price.

What kinds of barriers to entry can monopolies have?

can be legal barriers (as in the case where a firm has a patent that prevents other firms from entering); sociological barriers, where entry is prevented by custom or tradition; natural barriers, where the firm has a unique ability to produce what other firms can't duplicate; or technological barriers, where the size of the market can support only one firm.

Models of oligopoly (2 extremes)

cartel model & contestable market model

Price-discriminate

to charge different prices to different individuals or groups of individuals

the ability to price-discriminate allows a monopolist

to increase its profit

Patent

legal protection of a technical innovation that gives the person holding it sole right to use that innovation; (most patented goods make a loss; in fact, the cost of getting the patent often exceeds the revenues from selling the product).

What are the "monopolistic" and the "competitive" elements of monopolistic competition? Similar to a perfect competitor, a monopolistic competitor:

makes zero economic profit in the long run., has many sellers., can make profits or losses in the short run.

implicit collusion

multiple firms make the same pricing decisions even though they have not explicitly consulted with one another

Big difference between monopolistic competition and oligopoly

mutual interdependence

Oligopolistic firms are

mutually interdependent and can be collusive or noncollusive

Three important barriers to entry

natural ability, economies of scale, and government restrictions

Natural monopoly exists when:

one firm can supply the entire quantity demanded at lower cost than two or more firms.

For a monopolist, the point where the marginal revenue curve intersects the horizontal axis is:

one-half the distance between the origin and the point where the demand curve intersects the horizontal axis.

The welfare loss from monopoly is a

triangle

Demand curve tells us

what consumers will pay for a given quantity. That's why, to find the price a monopolist will charge, you must extend the quantity line up to the demand curve.

What are the "monopolistic" and the "competitive" elements of monopolistic competition? Similar to a monopoly, a monopolistic competitor:

produces where P > MR = MC., can make profits or losses in the short run., can restrict output to increase price (at least in the short run)., faces a downward-sloping demand curve.

strategic decision making

taking explicit account of a rival's expected response to a decision you are making (in oligopolies all decisions, including pricing decisions, are strategic decisions).

Equilibrium output for the monopolist is determined by

the MC = MR condition, but because the monopolist's marginal revenue is below its price, its equilibrium output is different from a competitive market.

For a price-discriminating monopolist, the marginal revenue curve is

the demand curve. So it will produce where MC = MR = D; it will produce the same output as would be produced in a perfectly competitive market.

If a monopolist produces beyond the quantity where MC = MR:

the increase in revenue is less than the increase in cost.

The key curves to look at when asking, "what output should the monopolist produce, and what price can it charge" is?

the marginal cost curve and the marginal revenue curve

Reason for welfare loss

the marginal cost of increasing output is lower than the marginal benefit of increasing output.

If price is less than average cost

the monopolist will incur a loss

If price exceeds average total cost at the output it chooses

the monopolist will make a profit

If price equals average total cost

the monopolist will make no profit (but it will make a normal return)

If a monopolistically competitive firm is earning economic profits in the short run:

these profits will be eliminated in the long run as new firms enter the industry.

Price-distrimination eliminates what from monopoly?

welfare loss

A monopolistic firm takes into account that its output decision can affect price; its marginal revenue is not its price. A monopolistic firm will reason: "If I increase production, the price I can get for each unit sold will fall, so I had better be careful about how much I increase production." (idea of something being worth more if its more rare)

true

A price-discriminating monopolist produces the same output as the combination of all firms in a competitive market.

true

An important difference between a monopolist and a monopolistic competitor is in the position of the average total cost curve in long-run equilibrium.

true

Consistent with this distinction, economists' model of monopolistic competition has a definite prediction. Economists' models of oligopoly don't have a definite prediction.

true

If MR > MC, the monopolist gains profit by increasing output. If MR < MC, the monopolist gains profit by decreasing output. If MC = MR, the monopolist is maximizing profit.

true

If oligopolies can limit the entry of other firms and form a cartel, they increase the profits going to the combination of firms in the cartel.

true

If there were no barriers to entry, profit-maximizing firms would always compete away monopoly profits.

true

In many cases a single firm, often the largest or dominant firm, takes the lead in pricing and output decisions, and the other firms (which are often called fringe firms) follow suit, even though they might have preferred to adopt a different strategy.

true

In some cases, firms collude implicitly—they just happen to make the same pricing decisions. This is not illegal.

true

In the case of a natural monopoly, not only is there no welfare loss from monopoly, but there can actually be a welfare gain since a single firm producing is so much more efficient than many firms producing.

true

In the contestable market model of oligopoly, pricing and entry decisions are based only on barriers to entry and exit, not on market structure. Thus, even if the industry contains only one firm, it could still be a competitive market if entry is open.

true

In the long run, a monopolist who is making a loss will go out of business.

true

In the short run, a monopolist can be making either a profit or a loss, or it can be breaking even.

true

Increasing production doesn't necessarily make suppliers better off.

true

Monopolists can see to it that the monopolists, not the consumers, benefit; perfectly competitive firms cannot.

true

Monopolists see to it that monopolists, not consumers, benefit.

true

Oligopolies take into account the reactions of other firms; monopolistic competitors do not.

true

Oligopolies with a stronger ability to collude (that is, more social pressures to prevent entry) are able to get closer to a monopolist solution.

true

One characteristic of informal collusive behavior is that prices tend to be sticky—they don't change frequently.

true

Since the demand curve is downward-sloping, the marginal revenue curve is below the average revenue curve. (Remember, if the average curve is falling, the marginal curve must be below it.)

true

The MR = MC condition determines the quantity a monopolist produces; in turn, that quantity determines the price the firm will charge

true

The difference is that the price-discriminating monopolist captures all of the surplus represented by areas A and B while all firms in the perfectly competitive market capture only area B.

true

The marginal cost curve is a graph of the change in the firm's total cost as it changes output

true

The marginal revenue curve tells us the change in total revenue when quantity changes

true

The profit-maximizing output is determined where the MC curve intersects the MR curve. To determine the price (at which MC = MR) that would be charged if this industry were a monopolist with the same cost structure as that of firms in a competitive market, we first find the profit-maximizing level of output for a monopolist and then extend a line to the demand curve.

true

When the demand curve has a kink, the marginal revenue curve must have a gap.

true

when the demand curve is horizontal, the marginal revenue curve is identical to the demand curve.

true

A monopolist's marginal revenue is always below its price.

true because an increase in output lowers the price on all previous units

Why is it difficult for firms in an industry to maintain a cartel?

various firms' interests often differ, so the collective interest of the firms in the industry isn't clear.

One of the reasons economists oppose monopoly

welfare cost of monopoly