Microeconomics Ch.14
Consider a market with two firms, Hewlett-Packard (HP) and Dell, that sell printers. Both companies must choose whether to charge a high price ($450) or a low price ($300) for their printers. These price strategies with corresponding profits are depicted in the payoff matrix to the right. HP's profits are in red and Dell's are in blue. Suppose HP and Dell are initially at the game's Nash equilibrium. Then, HP and Dell advertise that they will match any lower price of their competitors. For example, if HP charges $300, then Dell will match that price and also charge $300. What effect will matching prices have on profits (relative to the Nash equilibrium without price matching)? HP's profit will change by $_____ and Dell's profit will change by______.
$55;$55
Subgame-perfect equilibrium
A Nash equilibrium in which no player can make himself better off by changing his decision at any decision node. If GM offers a high price, then Securitex will accept the offer because profit of $15 million for Securitex from accepting is better than profit of $11 million from not accepting. GM's profit will then be $10 million. If GM offers a low price, then Securitex will not accept the offer because profit of $11 million for Securitex from not accepting is better than profit of $9 million from accepting. GM's profit will then be $0 million. Therefore, GM should offer a high price because profit of $10 million is better than profit of $0 million (from offering a low price). In turn, Securitex should accept GM's offer. GM offering a high price and Securitex accepting the offer is the subgame-perfect equilibrium.
The five competitive forces model
A model developed by Michael Porter of the Harvard Business School that shows how five competitive forces determine the overall level of competition in an industry. The five competitive forces are: 1. Competition from existing firms. 2. The threat from potential entrants. 3. Competition from substitute goods or services. 4. The bargaining power of buyers. 5. The bargaining power of suppliers. For example: follows ≻Automobile companies have significant bargaining power in the tire market, which tends to lower tire prices and limit the profitability of tire manufacturers. follows ≻Wal-Mart has significant bargaining power over its suppliers and has required many of them to alter their distribution systems to accommodate Wal-Mart's need to control the stocks of goods in its stores.
Nash equilibrium
A situation in which each firm chooses the best strategy, given the strategies chosen by other firms. In this example: If Dell charges $450, then HP is better off charging $300 and receiving profit of $100 (instead of profit of $90 from charging $450). If Dell charges $300, then HP is better off charging $300 and receiving profit of $35 (instead of profit of $20 from charging $450). Since HP is better off charging $300 regardless of what Dell does, charging $300 is HP's dominant strategy. Similarly, if HP charges $450, then Dell is better off charging $300 and receiving profit of $100 (instead of profit of $90 from charging $450). If HP charges $300, then Dell is better off charging $300 and receiving profit of $35 (instead of profit of $20 from charging $450). Since Dell is better off charging $300 regardless of what HP does, charging $300 is Dell's dominant strategy. Therefore, the Nash equilibrium is for both companies to charge $300 and earn profit of $35. The offer to match prices is an enforcement mechanism that changes the payoffs. With price matching, if either company charges $300, then the other company will also charge $300, so profit for both companies will be $35 unless both choose $450. As a result, both companies will charge $450. his results in profit of $90 for each company. Therefore, profit increases by $55 for HP and Dell with price matching, from $35 (with $300 prices) to $90 (with $450 prices).
Suppose Best Buy is the only electronics store in a particular market, but RadioShack is thinking about entering the market. Best Buy chooses how much to produce first and then RadioShack chooses whether to enter the industry. The strategies and corresponding profits for Best Buy (BB) and RadioShack (RS) are depicted in the decision tree to the right. What will the firms do?
Best Buy will choose the large quantity and RadioShack will not enter. Since Best Buy chooses how much to produce first: If Best Buy produces a small quantity, then RadioShack will enter because profit of $49 for RadioShack from entering is better than profit of $0 from not entering. Best Buy's profit will then be $49. If Best Buy produces a large quantity, then RadioShack will not enter because profit of $0 for RadioShack from not entering is better than profit of minus −$12 from entering. Best Buy's profit will then be $60. Therefore, Best Buy should produce a large quantity because profit of $60 is better than profit of $49 (from producing a small quantity). In turn, RadioShack should not enter.
Erin Reinhardt and her friend Carol Newman have just arrived in the country Boloni for a summer holiday. While renting a car on their first day in Boloni they notice that the car rental rates are so much higher than rates back home. Carol says that in a matter of time, competition should drive prices down. Erin feels that the market for car rentals is probably competitive enough; it could just be high cost of operations in Boloni that are responsible for the high prices. Which of the following conclusions is most strongly supported by the given information? A. The economy of Boloni is mainly driven by the tourism sector. B. The rate of inflation is higher in Boloni than in Erin's home country. C. The price of gasoline is higher in Boloni than in Carol's home country. D. Both Carol and Erin think that the car rental industry in Boloni does not have significant barriers to entry. E. Carol thinks that the demand for rented cars is stronger in Boloni than in her home country.
Both Carol and Erin think that the car rental industry in Boloni does not have significant barriers to entry. This is also incorrect. Carol is only comparing the prices of car rentals in the two countries based on her own experience. She is not comparing the demand for this service in the two countries.
Nutco is a cashew-processing firm that operates in the developing country of Ecotopia. After procuring raw cashews from farms around the country, Nutco processes them using a labor-intensive method. The workers at Nutco recently demanded a 20 percent increase in their overtime wage rate. All members of Nutco's labor union, which was a substantial proportion of the company's labor force, went on an unannounced strike when the management only agreed to a 5 percent hike. During negotiations that followed, the management informed the union leader that this was a take-it-or-leave-it offer. The union leader was not convinced and declared that the workers would not come back to work unless their demands were fully met. Kurt Whitman, Nutco's human resources manager, however thinks that the strike will end soon because of the company's strong stand. Which of the following, if true, would suggest that the management's threat of not accepting the workers' demands is not credible? A. The production subsidies that Nutco receives as a part of the Ecotopian government's export promotion program were recently reduced. B. Cashew-processing industries in other countries are relatively more capital-intensive. C. Nutco had accepted the labor union's demand for a higher number of sick leaves last year. D. The demand for products like cashew wine and cashew brittle declined in spite of extensive promotion and advertising undertaken by the firms in this industry. E. Due to the impact on production and the consequent delay in delivering export orders, several of Nutco's customers have indicated that they may cancel existing contracts.
Due to the impact on production and the consequent delay in delivering export orders, several of Nutco's customers have indicated that they may cancel existing contracts.
Eleanor Alback is an equity research analyst working on a report on the semiconductor industry in the country Sillikon. The price of semiconductor chips is quite low. Since it is an important input in the production of personal computers, she feels that firms could increase prices without drastically affecting sales. However, it appears that none of the firms are interested in hiking the price of their product despite high demand. Lan Shih, who works at a government think-tank, attributes the low prices to intense price wars between the firms. Which of the following, if true, would weaken Lan's claim that price-war is the cause of low prices? A. The skilled engineers that the industry hires are very well-paid. B. Some commentators feel that the growth in this industry can only be sustained with continuous innovation. C. The boom in the semiconductor industry led to productivity gains in many industries that use semiconductors. D. Although many firms in this industry own patents on their products, similar products are almost always introduced by a rival firm for a lower price. E. Existing firms in the semiconductor industry consciously target different market segments that are mutually exclusive.
Existing firms in the semiconductor industry consciously target different market segments that are mutually exclusive.
Firms must typically purchase inputs from suppliers to produce output. What effect might suppliers have on an industry?
If many firms can supply an input, then suppliers are unlikely to have the bargaining power to limit a firm's profits. According to the five competitive forces model, the bargaining power of suppliers affects the level of competition in an industry. If only a few firms can supply an input or if the input is specialized, the suppliers are likely to have the bargaining power to limit a firm's profits. Next Question
Nutco is a cashew-processing firm that operates in the developing country of Ecotopia. After procuring raw cashews from farms around the country, Nutco processes them using a labor-intensive method. The workers at Nutco recently demanded a 20 percent increase in their overtime wage rate. All members of Nutco's labor union, which was a substantial proportion of the company's labor force, went on an unannounced strike when the management only agreed to a 5 percent hike. During negotiations that followed, the management informed the union leader that this was a take-it-or-leave-it offer. The union leader was not convinced and declared that the workers would not come back to work unless their demands were fully met. Kurt Whitman, Nutco's human resources manager, however thinks that the strike will end soon because of the company's strong stand. Which of the following, if true, will strengthen Kurt's claim that the workers will accept the 5 percent hike and call off the strike? A. In order to make Ecotopia more business-friendly, the government made it mandatory for workers to give firms 2 weeks' notice before going on strike. B. Firms in this industry import cheaper raw cashews and process them for exports. C. The production of processed cashews in a neighboring country, Demerus, has increased significantly due to tax sops and subsidies. D. The canning industry in Ecotopia is still in its infancy; employment is high but output produced is low. E. The government recently introduced a price floor for raw cashews procured by processing firms like Nutco.
In order to make Ecotopia more business-friendly, the government made it mandatory for workers to give firms 2 weeks' notice before going on strike.
How is game theory used in economics? In economics,
In economics, game theory is the study of the decisions of firms in industries where the profits of each firm depend on its interactions with other firms. In business situations, rules of the game include not just laws that a firm must obey but also other matters beyond a firm's control long dash —such as its production function. A business strategy is a set of actions that a firm takes to achieve a goal, such as maximizing profits. The payoffs are the profits earned as a result of a firm's strategies interacting with the strategies of the other firms.
Erin Reinhardt and her friend Carol Newman have just arrived in the country Boloni for a summer holiday. While renting a car on their first day in Boloni they notice that the car rental rates are so much higher than rates back home. Carol says that in a matter of time, competition should drive prices down. Erin feels that the market for car rentals is probably competitive enough; it could just be high cost of operations in Boloni that are responsible for the high prices. Which of the following, if true, would weaken Erin's argument that high costs are responsible for high prices? A. The car rental industry in Boloni is valued at $50 million. B. Most households in Boloni own at least one car. C. After global oil prices increased, the government of Boloni decided to ration the quantity of gasoline sold. D. Only 3 firms account for almost 88 percent of the car rental market. E. Most of the growth in the car rental industry comes from the high-value rentals of luxury cars.
Only 3 firms account for almost 88 percent of the car rental market. Erin argues that rental rates are high because the cost of operations in Boloni must be higher. However, if 88 percent of the market is shared between only 3 firms, this is likely to indicate that the firms in the market have some degree of market power and this is keeping prices artificially high. Next Question
Getchecked Inc. is a leading medical devices manufacturer. A cosmetic surgeon, Dr. Matt Breen is discussing the prices of Getchecked's medical devices with his colleague, Dr. Ed Walter. Matt says, Getchecked probably finds it difficult to make profits. The medical device market is highly crowded." Ed replies, Well, they do have quite a few patented products so the profits must be flowing in." Meanwhile James Radford, a medical technician, agrees that Getchecked must be doing well. Given that Getchecked's products are widely used in the market, even an increase in prices would not affect sales or profits according to James. Which of the following, if true, would weaken Matt's argument that Getchecked's profits are most likely negligible due to competition? A. Lifestyle-related diseases like diabetes and hypertension are on the rise in this country. B. Getchecked recently hiked the per-unit commission paid to its salesmen. C. Product differentiation in terms of quality is common in this market because the buyers are very quality-conscious. D. Some firms in the market have started manufacturing medical devices that can be directly used by the final consumer. E. Doctors choose the brand of medical devices that should be used in the hospital.
Product differentiation in terms of quality is common in this market because the buyers are very quality-conscious.
Eleanor Alback is an equity research analyst working on a report on the semiconductor industry in the country Sillikon. The price of semiconductor chips is quite low. Since it is an important input in the production of personal computers, she feels that firms could increase prices without drastically affecting sales. However, it appears that none of the firms are interested in hiking the price of their product despite high demand. Lan Shih, who works at a government think-tank, attributes the low prices to intense price wars between the firms. Which of the following, if true, would explain why the prices are low despite the high demand? A. With new advances in computing technology, the prices of personal computers have been falling in spite of high demand. B. Since the semiconductor industry has high fixed costs, a low price charged by existing firms can keep new entrants out of the market. C. Although semiconductors are crucial to the production of personal computers, they form a small proportion of the total inputs used to produce personal computers. D. Investment in manufacturing facilities forms a substantial proportion of the fixed cost in this industry. E. The demand for personal computers has been growing at a remarkable annual rate of 30 percent for the last five years.
Since the semiconductor industry has high fixed costs, a low price charged by existing firms can keep new entrants out of the market.
Getchecked Inc. is a leading medical devices manufacturer. A cosmetic surgeon, Dr. Matt Breen is discussing the prices of Getchecked's medical devices with his colleague, Dr. Ed Walter. Matt says, Getchecked probably finds it difficult to make profits. The medical device market is highly crowded." Ed replies, Well, they do have quite a few patented products so the profits must be flowing in." Meanwhile James Radford, a medical technician, agrees that Getchecked must be doing well. Given that Getchecked's products are widely used in the market, even an increase in prices would not affect sales or profits according to James. Which of the following, if true, would weaken Ed's claim that Getchecked's patents would ensure profits in this market? A. Getchecked entered the pharmaceutical industry last year and recently acquired a pharma company that owns several patents. B. Some of Getchecked's recently patented products are completely new to the market and the demand for them is uncertain. C. The sale of used medical equipment in the country is not regulated by the government. D. The Medical Administrative Authority in the country has increased the annual registration fee that needs to be paid by firms that produce medical devices. E. The market for healthcare and medical devices in developing countries is projected to grow by 15 percent in the next five years.
Some of Getchecked's recently patented products are completely new to the market and the demand for them is uncertain.
Nutco is a cashew-processing firm that operates in the developing country of Ecotopia. After procuring raw cashews from farms around the country, Nutco processes them using a labor-intensive method. The workers at Nutco recently demanded a 20 percent increase in their overtime wage rate. All members of Nutco's labor union, which was a substantial proportion of the company's labor force, went on an unannounced strike when the management only agreed to a 5 percent hike. During negotiations that followed, the management informed the union leader that this was a take-it-or-leave-it offer. The union leader was not convinced and declared that the workers would not come back to work unless their demands were fully met. Kurt Whitman, Nutco's human resources manager, however thinks that the strike will end soon because of the company's strong stand. Which of the following, if true, would suggest that the labor union's threat of not resuming work is credible? A. Most firms cannot take advantage of economies of scale because the industry is highly fragmented. B. The yield of cashews this year was low due to unfavorable climatic conditions. C. The demand for labor in this industry has increased due to an increase in the demand for Ecotopian cashews abroad. D. Most of Nutco's employees are migrant female workers who are willing to work for slightly lower wages. E. Due to the occupational hazards of cashew-processing, the Ministry of Labor closely monitors the working conditions in this industry.
The demand for labor in this industry has increased due to an increase in the demand for Ecotopian cashews abroad. An increase in the demand for labor will imply that Nutco's workers can find employment at other cashew-processing firms and need not resume work at Nutco if their demands are not fully met.
Getchecked Inc. is a leading medical devices manufacturer. A cosmetic surgeon, Dr. Matt Breen is discussing the prices of Getchecked's medical devices with his colleague, Dr. Ed Walter. Matt says, Getchecked probably finds it difficult to make profits. The medical device market is highly crowded." Ed replies, Well, they do have quite a few patented products so the profits must be flowing in." Meanwhile James Radford, a medical technician, agrees that Getchecked must be doing well. Given that Getchecked's products are widely used in the market, even an increase in prices would not affect sales or profits according to James. Which of the following is the best rebuttal to James' claim that Getchecked can increase prices without significantly affecting sales? A. Product differentiation plays a crucial role in the market for medical devices. B. Getchecked produces cosmetic medical devices that are used only to alter appearances and are not used to treat medical conditions. C. Medical devices are subject to stringent government specifications and quality checks before they can be sold in the market. D. The popularity of Getchecked's products does not necessarily indicate that demand for them is inelastic. E. Most of the cosmetic devices produced by Getchecked have a short shelf life.
The popularity of Getchecked's products does not necessarily indicate that demand for them is inelastic. James assumes that Getchecked can comfortably increase prices because they have a large market share. However, whether an increase in prices will significantly affect sales will depend upon how elastic the demand for the product is and not on how widely it is used.
Game theory
The study of how people make decisions in situations in which attaining their goals depends on their interactions with others. Games share three characteristics: 1. Rules determine what actions are allowable. 2. Players employ strategies to attain their objectives in the game. 3. Payoffs are the results of the interaction among the players' strategies
Erin Reinhardt and her friend Carol Newman have just arrived in the country Boloni for a summer holiday. While renting a car on their first day in Boloni they notice that the car rental rates are so much higher than rates back home. Carol says that in a matter of time, competition should drive prices down. Erin feels that the market for car rentals is probably competitive enough; it could just be high cost of operations in Boloni that are responsible for the high prices. Which of the following, if true, would weaken Carol's argument that competition will drive prices down? A. The car rental industry recently implemented no-show fees for customers who do not pick up their cars after making a reservation. B. Information on car rental rates being easily available, it is almost impossible for firms to charge different consumers different prices. C. To reduce emissions, the government has recently introduced tax per mile driven on automobiles. D. Compared to Carol's home country, people in Boloni have lower purchasing power. E. The government of Boloni set aside a substantial amount of money this year for the construction of freeways.
To reduce emissions, the government has recently introduced tax per mile driven on automobiles. Carol claims that the entry of new firms in the market will drive prices down. However, the tax introduced by the government will increase costs for firms in the industry. This could suggest that even with the entry of new firms, prices will not fall much as costs are high.
Eleanor Alback is an equity research analyst working on a report on the semiconductor industry in the country Sillikon. The price of semiconductor chips is quite low. Since it is an important input in the production of personal computers, she feels that firms could increase prices without drastically affecting sales. However, it appears that none of the firms are interested in hiking the price of their product despite high demand. Lan Shih, who works at a government think-tank, attributes the low prices to intense price wars between the firms. Which of the following, if true, would strengthen Lan's claim that price-war is the cause of low prices? A. The personal computer industry is an industry which has the least amount of government regulation in Sillikon. B. With the removal of import quotas, the semiconductor market has been flooded with cheaper products. C. The global semiconductor industry was founded and continues to be based in the country Sillikon. D. Most firms in this industry export semiconductors to other countries. E. Following a series of mergers in this industry, some of the largest firms in Sillikon are now vertically integrated with their suppliers.
With the removal of import quotas, the semiconductor market has been flooded with cheaper products.
The five competitive forces model suggests the threat from potential entrants affects industry competition. How might an existing firm deter entry of new firms? An existing firm might
advertise to create product loyalty.
Encyclopedia Britannica is an encyclopedia publisher who sells printed encyclopedias. In the 1990s, encyclopedias began to be sold electronically. What effect did electronic encyclopedias have on Encyclopedia Britannica? Electronic encyclopedias
served as a new product that fills a consumer need better than printed encyclopedias did.