1

Microeconomics II
Agec1062
(BSc in Agricultural Economics)
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Chapter 1
Analysis of Market
Structures
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Market structure
 refers to:
 relative number & size of firms in an industry
 characteristics of market that significantly affect
the behavior & interaction of buyers & sellers
 Four main characteristics:
 number & size distribution of sellers
 number & size distribution of buyers
 product differentiation
 conditions of entry & exit
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Types of market structure

1. Perfectly competitive
2. Pure monopoly
3. Monopolistic competition
4. Oligopoly
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1.1 Perfect Competition

 What is it?
 Firm behavior
 Short run
 Long run
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Features of perfectly competitive market

• Many buyers and sellers

• Identical (homogenous) products
• Free entry & exit in the market
• Prices known
• Buyers & sellers have perfect information
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 Perfect competitive market has following

outcomes
 each buyer & seller is price taker- takes price as
given that the market makes
 actions of any single buyer or seller in the market
do not affect market price
Examples: markets for agricultural
products such as, wheat, egg, etc
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Firm behavior

to maximize profits

 TR > TC: economic profits
 TR = TC: normal profits (zero
economic profit)
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Firm is price taker

• cannot influence price- takes price
as given, chooses Q
• firm’s demand- perfectly elastic
(horizontal line)
• MR = P: firm sells all it wants at
price (P)
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Profit maximizing
• firm chooses Q to maximize profits
 where TR - TC is largest- at a point
MR=MC
• why MR = MC?
 MR > MC, extra output adds to profit
 MR < MC, extra output reduces
profit
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Market for syrup (all firms)

P S

$8

Q (cans/day)
100
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Firm’s demand & cost curve

P MC

$8 D = MR = P

Q (cans/day)
10
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 firm is price taker, what if price too

low to earn profit?
 faces economic loss
 will firm exit?
 depends on time horizon
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Costs and exit

• in SR, firm will stay if P>AVC
• why?
 if firm exits, loses TFC
 if P=AVC, loss from staying = loss
from exit
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Firm’s SR decision to shut down

firm shuts down if revenue is less
than variable cost of production
Shut down if TR  VC
TR VC

Q Q
P  AVC
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Short-run supply curve

 competitive firm
will produce at
level of output
where P=MC so
long as P>AVC
 firm’s SR supply
curve- portion of
MC curve above
min’ AVC
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SR equilibrium
• two cases:
 economic profit
 economic loss
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Case 1: economic profit

• P = $8, Q = 10
• ATC = $5
• profit = ($8)(10) - ($5)(10) = $30
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P economic
profit MC
ATC

$8 D = MR = P

$5

Q (cans/day)
10
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Case 2: economic loss

• P = $3, Q = 7
• ATC = $5
• profit = ($3)(7) - ($5)(7) = - $14
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P economic
loss MC ATC

$5

$3 D = MR = P

Q (cans/day)
7
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LR equilibrium

• entry & exit of firms

• firms earn normal profit
 when economic profit will be zero
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Why zero economic profit?

• If economic profit > zero,

 firms enter (SS shifts right)
 price falls
 profit falls to zero
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Market for syrup

P S
S’

$8
$5

Q (cans/day)
100 120
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Syrup firm in LR
P zero MC
economic
profit ATC

$5 D = MR = P

Q (cans/day)
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• If economic profit < zero

 firms exit (SS shifts left)
 price rises
 profit rises to zero
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Market for syrup

P S’’
S

$5
$3

Q (cans/day)
120 140
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P economic
loss MC ATC

$5

$3 D = MR = P

Q (cans/day)
7
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Syrup firm
P MC
zero
economic ATC
profit

$5 D = MR = P

Q (cans/day)
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Shifts in market demand

• price change in SR
 profits or losses
• price change in LR affects exit/entry
 return to zero economic profit
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Firm’s LR decision to exit/enter market

firm exits if revenue is less than total cost
of production
Exit if TR < TC
TR/Q < TC/Q
P < ATC
firm enters industry if such an action
would be profitable
Enter if TR > TC
TR/Q > TC/Q
P > ATC
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Summary: perfect competition

• firms are price takers
• MR = MC determines equilibrium Q
 SR: economic profit or loss
 LR: economic profit is zero due to
entry or exit
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Summary: perfect competition

• since competitive firm is price taker, its
revenue is proportional to amount of output
it produces
• firm chooses Q, where MR=MC to maximize
profit
• at maximum profit, P=MC=MR=AR
• firm’s MC curve above shutdown point (AVC)
& above ATC- SR & LR supply curve resp.
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Exercise 1.1: perfect competition

1.Consider a profit maximizing competitive firm. Suppose
market price is birr 50 and firm faces total cost function of
TC = 10 + 5q2, find profit maximizing level of output &
maximum profit possible. (Ans. q=5, =br 115)
2.Firm in perfectly competitive industry is producing 50 units
at its profit maximizing quantity. If industry price is Birr 2
& ATC of firm at profit-maximizing level is Birr 1.50, what
is firm's economic profit? (Ans. =br 25)
3.Assume at output level of 100 units, firm incurs AVC of birr
5 and AFC of birr 2. Compare losses/gains of shutting down
and continuing to produce if equilibrium price is birr (a) 8,
(b) 7, (c) 6, (d) 5 and (e) 4
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1.2. Pure Monopoly

• How it happens
• Firm behavior
• Monopoly vs. competition
• Price discrimination
• Policy
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What makes a monopoly?

• single supplier of product to entire
market
 firm supply = market supply
(monopoly)
 firm demand = market demand
(monopsony)
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Features of monopoly market

1.One supplier of commodity in question
 monopolist
2.No close substitutes for commodity
3.Barriers to entry for new firms
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How it happens
1. no close substitutes
otherwise, competition among makers of
substitutes
examples: electricity, road, water
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2. Barriers to entry
• fundamental cause of monopoly
• nearly impossible for new firms to enter
market
• 3 main barriers:
a) resource ownership
b) legal
c) natural
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a) Resource monopoly
• a firm may entirely own strategic
resource/input, prevent others from
entering to market
• example: Alcoa US Aluminum Company
had complete control over bauxite ore
required to produce aluminum
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b) Legal monopoly
 government gives firm exclusive right to supply
product, via license, patent, copyright
 examples:
 postal services in most countries franchised &
licensed by government
 patent for technology generated- Microsoft office
 copyright for book published
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c) Natural monopoly
 industry’s average cost of production declines
throughout entire market
 single firm supplies product to entire market at
smaller cost than two or more firms did
 as firm’s scale of operation becomes larger,
 unit costs fall
 smaller-scale competitors exit market
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Causes of natural monopoly

 Economies of scale
• large ES over wide range of output
 High fixed costs
• firm with high FCs relative to VCs leads to natural
monopoly
 One firm meets market demand with lowest cost
• market demand is too small to absorb many firms
• costs of production make single firm more efficient
than large number of firms
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Examples
 Distribution of water, electricity, natural gas &
telephone services
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Local monopoly
• Geographical location bestows some monopoly
power for firm
• Example: local newspapers
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Actions by firms to create & protect

monopoly power

• Patents and copyrights

• High advertising expenditures result in high sunk
costs (costs not recoverable on exit)
• Illegal actions designed to restrict competition
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Monopolist & prices

 has power to set price or quantity to sell, but
not both at same time
 price maker (price setter)
 Power to set prices depends on:
 ability to ban entry
 availability of close substitutes
 Monopolists charge either:
 single price to everyone or
 various prices for different groups/units
 price discrimination
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Monopoly behavior

• single price case

• same rule:
 choose Q where MR = MC
• but, different outcome
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P & MR
For monopoly, always MR < P
Why?
 increase Q, additional revenue but at
lower P
 downward sloping demand curve
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TR = $7 x 5 = $35
P
TR = $6 x 6 = $36
$7
MR = $1 from 5 to 6
$6

Q
5 6
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MR & D
P, MR

D
MR
Q
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Profit maximizing

• choose Q where MR = MC
• charge highest price (P) possible
 using demand curve
• profit
= (P – ATC)(Q)
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P, MR MC

P*

D
MR

Q* Q
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economic profit

P, MR MC

P*
ATC

D
MR

Q* Q
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Monopoly vs. competition

• Monopoly
 smaller output
 higher price
• Perfect competition
 larger output
 lower price
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P, MR MC
Pm > Pc
Pm Qm < Qc
Pc

D
MR

Qm Qc Q
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Is monopoly efficient?
• No
• why?
• too low output
 marginal benefit > MC
 deadweight loss
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Competition
P, MR consumer
S=MC
surplus

Pc

producer Q
Qc
surplus
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Monopoly
P, MR consumer
MC
surplus

Pm deadweight
loss

D
MR

producer Qm Q
surplus
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Price discrimination
 business practice of selling same good at d/t
prices to d/t customers, despite costs of
production same for all customers
 Firms charge each buyer higher price possible
 convert consumer surplus to economic profit
 Firms must
 identify & separate buyers by their elasticity
of demand (WTP)
 prevent reselling of product
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How?
• charge d/t prices to d/t groups of buyers
• groups have d/t willingness to pay (WTP)
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Example: airlines
• separate business & tourist travelers
 businesses have less elastic demand, will pay
more
 get consumer surplus from business travelers
 still have low fairs for tourism, having more
elastic demand
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Example: air travel

•.
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Other price discrimination

• charge differently for different units
• Example
 1 pizza, $10
 2 pizzas, $14
• People value 1st pizza more
• MC of 2nd pizza to the same house is small
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Price discrimination …
 Two important effects of price discrimination
 increase monopolist profit
 reduce deadweight loss
 but, to price discriminate, firm must
 separate customers on basis of WTP
 prevent customers from reselling product
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Price discrimination …
 Monopolist has to decide total output to produce,
how much & at what price to sell in each market
 Let firm has two markets for discriminating price.
Total profit is maximized when monopolist
equates common MC to individual marginal
revenues in each market
MC = MR1 = MR2
 If MR in market one is larger, monopolist would
sell more in that market & less in other until
above condition satisfied
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Exercise 1.2: Price discrimination

Given information below about price discriminating
monopolist aiming to maximize profit sold its product
in Markets I &II, find equilibrium quantities (q1 & q2),
equilibrium prices (p1 & p2), profit (π) & elasticities (ε1
& ε2)
total demand for product: q=50-0.5p (p=100-2q)
demand in Market I: q1= 32-0.4p1(p1=80-2.5q1)
demand in Market II: q2= 18-0.1p2(p2=180-10q2)
cost function: C= 50+40q (q = q1+ q2)
(Ans. q1=8,q2=7; p1=60, p2=110; π=600; ε1=3,
ε2=1.57)
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Multi-plant monopolist
 Consider monopolist with two plants each with
d/t cost structures at two d/t locations
 Monopolist now expected to make two decisions:
 How much output to produce altogether & at
what price to sell to maximize profit?
 How to allocate production of optimal (profit
maximizing) output between two plants?
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Multi-plant monopolist …
 Monopolist maximizes total profit by utilizing each
plant up to the level at which marginal costs
equal to each other and to common marginal
revenue
MC1= MC2= MR
 If MC1< MC2, monopolist would rise profit by
increasing production in plant 1 & decreasing in
plant 2 until MC1=MC2=MR
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Exercise 1.3: multi-plant monopolist

Suppose demand equation for multi-plant
monopolist is q= 200-2p (p=100–0.5q) and costs of
two plants are C1  10q1 & C2  0.25q22
Find equilibrium levels of price & outputs to be
produced in two plants & maximum level of profit
(Ans. q1=70, q2=20, p=55, π=4150)
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Exercise 1.4: Monopoly

1. Assume you have market where demand curve is p=100-
4q and all firms produce the good using constant
marginal cost function where MC=4, no matter how
many units are produced.
a) What price will maximize sum of producer & consumer
surplus in market (socially optimum price)?
b) What price will be set in market if monopolist sets price
to maximize profit?
c) What is loss in CS resulting from monopoly?
d) How much of CS is converted into (i) economic profit
and (ii) DWL resulting from monopoly
Ans. a) pC=4 b) pM=52 c) loss in CS=864 d) i= 576 &
ii=288
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Exercise 1.4. Monopoly …

2. If demand curve for profit maximizing
monopolist is q= 40-0.2p & cost function as
C=30+30q, find equilibrium output, monopolist
price and profit.
Ans. q=17, p=115, π=1415
3. If inverse demand curve for profit maximizing
monopolist is p= 60−2q & cost function as
C= q3 −2q2+12q+30, find equilibrium output,
monopolist price & profit.
Ans. q=4, p=52, π=98
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Exercise 1.4 …
4. Monopolist faces inverse demand function
described by p=32-5q & it has no fixed cost &
MC=7 at all levels of output. Derive monopolist’s
profit function. (Ans. 25q-5q2)
5. Monopolist faces inverse demand curve p=192-4q.
At what level of output is total revenue
maximized? (Ans. q=24)
6. If demand for monopoly is q=900-300p, derive MR
function.
q
Ans. MR  3 
150
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Welfare cost of monopoly

 Unlike competitive firm, monopoly charges price
above MC
 High price makes monopoly
• undesirable from viewpoint of consumers
• very desirable from viewpoint of firm owners
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Other costs associated with monopoly

 Inefficiency- firms don’t have incentive to engage in
least-cost production (as no competitive pressure)
 monopolist produces less than socially efficient
quantity of output
 Rent seeking behavior- cost of using resources
(such as lawyers, lobbyists, etc.) in an attempt to
acquire monopoly power
 does not benefit society & diverts resources away
from productive activities
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Why allow monopolies?

 inefficient
 deadweight loss
 but there are gains
 economies of scale
 natural monopolies: utilities
 innovation
 drug patents reward research
 copyrights reward creativity
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Monopoly & public policy

 Government responds to problem of monopoly in
one of 4 ways:
 making monopolized industries more competitive
 regulating behavior of monopolies
 turning some private monopolies into public
enterprises
 doing nothing at all
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Summary: Monopoly
 Monopoly- sole seller in market
 Faces downward-sloping demand curve for product
 Monopoly’s MR is always below price of good
 Like competitive firm, monopoly maximizes profit by
producing quantity at which MR=MC
 Unlike competitive firm, its price exceeds MR as well
as MC
 Monopolist’s profit-maximizing level of output is
below the level that maximizes sum of consumer &
producer surplus
 Monopoly causes DWL similar to DWL caused by taxes
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Summary: Monopoly …
 Policymakers can respond to inefficiencies of
monopoly behavior with regulation of prices or by
turning monopoly into government-run enterprise
 If market failure deemed small, policymakers may
decide to do nothing at all
 Monopolists can raise profits by charging d/t prices to
d/t buyers based on their WTP- price discrimination
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1.3 Monopolistic Competition

. Number of firms?
Many
firms
Type of product?
One Few
firm firms Differentiated Identical
products products

Monopolistic Perfect
Monopoly Oligopoly
competition competition
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Features of monopolistic competition

 large number of firms
 product differentiation- each firm produces
similar, but not identical product
 relatively easy entry & exit
 firm is price maker facing downward sloping
demand curve
 compete with quality, price, marketing
 no one firm dominates the market
 no collusion among firms
 mix of features of monopoly & perfect
competition
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Examples
• running shoes
• fast food franchises
• clothing
• cleaning supplies
• beauty products
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Relationship to other market models

 similar to perfect competition:
 many buyers & sellers
 no barriers to entry & exit
 similar to monopoly:
 each firm is sole producer of particular product
(although exist close substitutes)
 firm faces downward sloping demand curve for its
product
 84

Product differentiation
 Each firm produces good at least slightly d/t from
other firms, by:
 physical differences- color, size, taste ...
 location- convenience, drug stores
 services- delivery
 image- high quality vs. value
 rather than being price taker, each firm faces
downward-sloping demand curve
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Firm behavior in short run

 demand curve slopes downward

 less elastic than perfect competition
 more elastic than monopolist
 choose price & output
 like monopolist
 86

P, cost
MC

$70

D
MR
Q (jeans/day)
150
 87

SR equilibrium in monopolistic competition

P, cost economic profit
($70-$20)(150)
MC
= $7500
T C
A
$70

$20
D
MR
Q (jeans/day)
150
 88

SR equilibrium ….

 SR economic profits encourage new firms to enter

market,
 increases number of products offered
 reduces demand faced by firms already in market
 incumbent firms’ demand curves shift to left &
their profits decline
 89

LR equilibrium in monopolistic competition

 Zero economic profit
 Why?
 economic profit leads to entry
 economic loss leads to exit
 no entry/exit with zero economic profit
 90

LR equilibrium …

 Entry continues until

economic profit
equals zero for
typical firm
 This equilibrium often
referred as tangency
equilibrium
 91

SR equilibrium with economic losses

 SR economic losses encourage firms to exit

market,
 decreases number of products offered
 increases demand faced by remaining firms
 shifts remaining firms’ demand curves to right
 increases remaining firms’ profits
 92

SR equilibrium with economic losses

 Economic losses
lead to exit & rise in
demand facing
typical firm
 93

Monopolistic competitor in LR
 two characteristics:
 as in monopoly, P>MC
• profit maximization requires MR=MC
• downward-sloping demand curve makes MR<P
 as in competitive market, P=ATC (but not at
minimum ATC)
• free entry & exit drive economic profit to zero
 94

Monopolistic vs. perfect competition

 two remarkable differences between
monopolistic & perfect competition
 excess capacity
 markup
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Excess capacity in monopolistic competition

 no excess capacity in perfect competition in LR
 free entry results competitive firm produces at
min’ ATC- efficient scale of firm
 excess capacity in monopolistic competition in LR
 firm’s output is not at minimum ATC
 output too small- loss of economic welfare
 in monopolistic competition, output is less than
efficient scale of perfect competition
 96

Excess capacity….
 97

Excess capacity …
 98

Markup in monopolistic competition

 markup over marginal cost
 in perfectly competitive firm, P = MC
 in monopolistic competitive firm, P > MC
 b/s price exceeds MC, an extra unit sold at posted
price means more profit for monopolistic
competitive firm
 Markup = P-MC
 99

Markup in monopolistic competition

 100

Monopolistic competition & efficiency

 As # firms rises, demand for monopolistically
competitive firm becomes more elastic
 As # firms in market expands, it approaches
perfectly competitive market
 Economic inefficiency may be smaller as large #
firms exist in monopolistically competitive
market
 101

Advertising & marketing

 Firms in monopolistic competition spend more on
advertising than perfect competition
 cost curves are higher
 is this a waste? or
 do consumers benefit from greater selection?
 e.g., advertising expenditure of USA (see Fig
below)
102
 103

Advertising ….
 Monopolistically competitive firms may get SR
economic profit from successful product
differentiation & advertising
 When firms sell differentiated products & charge
prices above MC, each firm has incentive to
advertise in order to attract more buyers for its
particular product
 Profits are expected to disappear in LR as other
firms copy successful innovations
 104

Advertising ….
 Why advertising?
 proponents argued, advertising
 provides information to consumers
 increases competition by offering greater
variety of products & prices
 critics argued, advertising
 manipulates consumers’ tastes
 impedes competition by implying products are
more d/t than they are truly
 105

Brand name
 economists argued, brand names
 useful way for consumers to ensure goods they
are buying are of high quality
• providing information about quality
• giving firms incentive to maintain high quality
 critics argued, brand names
 cause consumers to perceive differences that
do not really exist
 106

Monopolistic competition & welfare of society

 product-variety externality due to entry
 b/s consumers get some consumer surplus from
introduction of new product, entry of new firm
conveys positive externality on consumers
 business-stealing externality due to entry
 b/s other firms lose customers & profits from
entry of new competitor, entry of new firm
imposes negative externality on existing
firms
 107

Summary: monopolistic competition

 Monopolistic competitive market is characterized
by 3 main attributes:
 many firms
 differentiated products
 free entry & exit
 Equilibrium in monopolistic competitive market
differs from perfect competition
 each firm has excess capacity & charges P>MC
 Product differentiation inherent in monopolistic
competition leads to use of advertising & brand
names
 108

1.4 Oligopoly
 Features of oligopoly
 a few # of firms produce most output
 standardized or differentiated product
 interdependent behavior
 barriers to entry
 duopoly is an oligopoly with only two members
 109

Examples

• Soft drinks
• Bottled water
• Auto-industry
• Cigarette industry
• Bus services
• Pvt schools
• Automobiles
 110

Oligopoly outcomes
 When firms in oligopoly individually choose
production to maximize profit, they produce
quantity of output:
• greater than level produced by monopoly
• less than level produced by competition
 Oligopoly price:
• less than monopoly price
• greater than competitive price
 111

Theory of oligopoly
 has to consider how rivals would react to any
price or production change
 no satisfactory comprehensive theory of oligopoly
 tension exists b/n cooperation & self-interest
 Oligopolists may engage in non-price competition
 especially where price war might force price down
to such low level that losses would result
 Non-price competition may include:
 product differentiation by means of advertising
 packaging
 styling or
 after-sale services
 112

What types of barriers?

economies of scale
 auto industry
legal restrictions
brand recognition
 soft drinks
control over essential resources
 113

Firm behavior
no one model of behavior
set of possible behaviors
 114

Cartels
 Cartel- when group of oligopolists engage in collusion
to make agreements about prices to be charged
and/or level of output to be produced
 e.g. OPEC
 Objective of collusive oligopoly- to act like a
monopolist- earning maximum profits
 overt cartels
• terms of agreement generally known
 covert cartels
• terms of agreement known only to participants
 especially when cartels prohibited by legislation
relating to competition
 115

Cartels …
 While it pays for firms to collude (earn positive
profits), also pays to cheat on collusive agreement
 If one firm cuts its price slightly below
others, it could gain lot of business
 Cartels are likely to breakdown in LR
 firms have incentive to cheat by producing in
excess of their quota & undercutting agreed
price
 116

Cartels …
 Firms collude to act like a single monopolist
 restrict output, charge higher price
 block entry
 Cartels are tough to maintain
 each firm has output quota
 each firm tempted to cheat
 tough to block new entry
 117

Price leadership
 informal collusion
 dominant firm sets price
 other firms follow to avoid price war
 steel, airline, auto industries
 118

Collusion and cartels

 firms may collude
 divide market
 fix prices
 illegal in U.S.
 examples
 OPEC
 ADM & others
 119

Models of oligopoly
 Sweezy’s kinked demand curve
 Cournot model
 Game theory models
 more commonly used models to describe
oligopoly behaviors
 (We’ll discuss in Ch.5 under Game Theory)
 120

Sweezy’s kinked demand curve

• Assumptions
1.If a firm rises prices, other firms won’t follow
& the firm loses lot of business
 demand is very elastic to price increases
2.If a firm lowers prices, other firms follow & the
firm doesn’t gain much business
 demand is fairly inelastic to price decreases
 121

Kinked demand curve …

 122

Kinked demand curve …

 Other firms are assumed to match price
decreases, but not increases
 Only little evidence suggests this model
describes behavior of oligopoly firms
 123

Kinked demand, MR & MC curves

 124

Economic profit for oligopoly firm

 For firm with economic

profit (positive), part
of ATC curve lies under
part of demand curve
 125

Economic loss for oligopoly firm

 For firm with

economic loss, ATC
curve is entirely
above demand curve
 126

Breakeven point
 For firm with breaking
even, ATC curve is
tangent to demand
curve at the kink
 127

Profit possibilities for oligopolist

 Short run
 positive profits, losses, or breaking even
 Long run
 positive profits, or breaking even
 128

Is oligopoly efficient?
 In oligopoly, p>MC
 quantity produced is less than efficient
quantity
 Oligopoly suffers from same source & type of
inefficiency as monopoly
 129

Public policy toward oligopolies

 Cooperation among oligopolists is undesirable
from viewpoint of society, b/s it leads to:
 too low production
 higher prices
 130

Cournot model
 The essence is that each firm bases its output
decision assuming output level of other firms in
the market
 captures interdependence in non-cooperative
setting
 Each firm has a reaction function
 Firm 1’s reaction function shows how much
Firm 1 will produce given each possible
output of Firm 2
 131

Convergence to equilibrium
Q1
• Firm 1 thinks Firm 2 will
produce nothing so
chooses to produce
quantity A
• Firm 2 observes this &
chooses to supply B
A • Firm 1 sees that Firm 2 is
producing B & reacts by
C
Z producing C, & so on
• Ultimately up to Z

O Q2
B
 132

If Firm 2 makes the same conjectures, then we get

the following:
 133

Numerical example
• Assume market demand to be: P=30-Q
• where Q=Q1+Q2 that industry output
constitutes firm 1 & firm 2’s output, resp.
• Further assume Q1=Q2 and AC=MC=12
• Find equilibrium price (P) & quantities (Q1 &
Q2) produced by Firm 1 & 2 and their profits
 134

• To find profit maximizing output of Firm 1

given Firm 2’s output, we need to find Firm
1’s marginal revenue (MR) and set it equal
to MC. So,
• Firm 1’s total revenue is
R1 = (30-Q) Q1
R1 = [30 -(Q1+Q2)]Q1
= 30Q1 - Q12 - Q1Q2
• Firm 1’s MR is
MR1 =30 - 2Q1 - Q2
 135

1
• If MC=12, then Q1  9  Q2
2
 Firm 1’s reaction curve

• If we had begun by examining Firm 2’s profit

maximizing output, we would find its
reaction curve as Q  9  1 Q
2 1
2
• Solve these 2 equations simultaneously to
find equilibrium quantities & price
Ans. Q1=6, Q2=6, P=18, 1= 2=36
 136

Reaction curves/functions
 137

Exercise 1.5
• Suppose there are two firms producing Highland
and Abysinia spring water. Also assume that the
industry demand is P=2000-Q, where Q=Qh+QA
(Qh=Highland’s sales; QA=Abysinia’s sales). Again
assume that MC=ATC=0 for both (the water just
bubbles out of the ground)
• Using Cournot Model, find reaction functions and
equilibrium price and quantities for the two firms
• (Ans. reaction functions: Qh=1000-0.5QA,
QA=1000-0.5Qh; Qh=QA=666.7 and P=666.7)
 138

Summary oligopoly market

• Possible outcomes if oligopoly firms pursue their own
self-interests:
 Joint output is greater than monopoly quantity but less
than competitive industry quantity
 Market prices are lower than monopoly price but
greater than competitive price
 Total profits are less than monopoly profit
• Oligopolists maximize their total profits by forming
cartel and acting like a monopolist
• Prisoners’ dilemma shows self-interest can prevent
people from maintaining cooperation, even cooperation
is in their mutual self-interest (We’ll see Ch.5)
 139

Summary: properties of monopoly, oligopoly,

monopolistic and perfect competition
 140

Economics of Cooperation
 141

5.1 Economics of Cooperation: Game Theory

 As we have seen in Ch.1, oligopolies would like to reach
monopoly outcome,
• but doing so requires cooperation, which at times is
difficult to maintain
 Here we look more closely at problems people face when
cooperation is desirable but difficult
 To analyze economics of cooperation, we need to learn a
little about game theory
 142

Game theory & its applications

► Game theory- a study of how people behave in strategic
situations
► any strategic situation can be modeled as game by
specifying 4 basic elements:
1.players- each decision maker in a game
2.strategies- player’s plan of moves & counter-moves
3.payoffs- possible outcomes of strategies given rival’s
counter strategies
4.information- what players know when they make their
moves
 143

Other important terms

► Payoff matrix- a table illustrating all payoffs
► Dominant strategy- player’s best strategy given rival’s
counter strategies
 player’s best strategy to follow regardless of strategies
chosen by other players
► Nash equilibrium- a set of strategies, one for each player,
that are mutual best responses
► Best response- a strategy that produces highest payoff
among all possible strategies for a player given what the
other player is doing
 144

Branches of game theory

► Cooperative game theory
− assumes the group of players reaches an outcome that is
best for the group as a whole, producing the largest ‘‘pie’’
to be shared among them
− focuses on rules for how the pie should be divided
► Non-cooperative game theory
− players are guided by self interest
− more widely used by economists
 145

Prisoners’ dilemma (PD)

► most famous of all non-cooperative games that can illustrate
basic components of a game & concept of Nash equilibrium
• Two suspects (say X & Y) are arrested for a crime. The district
attorney has little evidence in the case & is anxious to extract a
confession.
He separates suspects & privately tells each, ‘‘If you Confess & your
partner doesn’t, I can promise you will be left free, & on basis of
your confession, your partner will get 20 years. If you both Confess,
you will each get 8-year sentence.’’ Each suspect also knows that if
neither of them confesses, lack of evidence will cause them for
lesser crime for which they will receive 1-year sentences.
• See Fig 5.1 below
 146

Fig 5.1 Prisoners’ dilemma

 147

PD….
► strategies of players (prisoners) in PD
 Confess- a player admits guilty without cooperation with
other player
 Not-confess (remains silent)- a player lives up to
cooperation with other player to decide they are innocent
(not guilty)
 difficult to maintain cooperation (not-confess)
 b/s, cooperation is individually irrational (not in the best
interest of each player)
 148

PD….
► What is payoff for X’s best response to Y’s playing
• Confess? 8 years
• Not confess? Goes free
o Confess is the dominant strategy for player X, allowing X gets
these best responses regardless of Y’s strategies?
► What is payoff for Y’s best response to X’s playing
• Confess? 8 years
• Not confess? Goes free
o Confess is the dominant strategy for Y too, allowing Y gets
these best responses regardless of X’s strategies?
► Thus
• Nash equilibrium is (8,8) years-inferior outcome
• cooperative equilibrium is (1,1) years
 149

PD….
► both end up confessing & gets 8 yrs of prison, though
cooperation is better with only 1 yr prison period
 b/s if X chooses to play a strategy of “confess” by denying
cooperation while Y chooses “not-confess” by maintaining
cooperation, X will be left free while Y in prison for 20 yrs
► provides insight into difficulty to maintain cooperation
► often people (firms) fail to cooperate with one another even
cooperation would make them better off
 150

Application of game theory in oligopoly

► b/s # of firms in oligopolistic market is small, each firm

must act strategically to maximize its profit
► each firm knows its profit depends not only on how much
it produces but also on how much other firms produce
► It applies to:
a)oligopoly market
b)advertising
c)common resources
 151

Fig 5.2 Oligopoly game b/n Iran & Iraq

 152

Oligopolies as PD

► High production is a dominant strategy for both actors

in the above example
► Self-interest makes difficult for oligopoly to maintain
cooperative outcome
• low production, high prices & monopoly profits
► Nash equilibrium- a situation in which economic actors
interacting with one another, each choose their best
strategy given strategies that all others have chosen
• non-cooperative equilibrium
 153

Welfare of society & PD

► as shown in PD, cooperation is difficult to maintain,
though would make both players better off
► Is this lack of cooperation (non-cooperative equilibrium) a
problem from perspective of players of the game?
► What about from perspective of society as a whole?
• the answer depends on the circumstances
• in some cases, non-cooperative equilibrium is bad for
society as well as players
 154

Welfare of society….
► in case of common-resources game
• cooperative (monopoly) outcome is desirable for society
• but non-cooperative (competitive) outcome is bad for
society as well as for players
• b/s extra wells dug by Arco & Exxon, for e.g., are pure waste
► in case of oligopoly market
• monopoly outcome is good for oligopolists, but not
society- b/s bad for consumers
• non-cooperation is desirable for society
• b/s competitive outcome maximizes its total surplus
 155

► the invisible hand guides markets to allocate resources

efficiently only when markets are competitive, and
► markets are competitive only when firms in the market
fail to cooperate with one another
► thus, PD is a dilemma for prisoners, but can be a boon to
everyone else
 156

Why people sometimes cooperate

► PD shows cooperation is difficult, is it impossible?
• cartels sometimes do manage to maintain collusive
arrangements, despite incentive for individual members to
defect
• very often, the reason players can solve PD is that they play
the game not once but many times
• cooperation is easier to enforce in repeated games
 157

Non-cooperative equilibrium
► a pair of strategies (S1, S2) is a non-cooperative
equilibrium if & only if each player has no incentive to
change his strategy provided that the opponent does not
change his strategy
• no player has an incentive to unilaterally deviate from an
equilibrium position
 158

Dominant strategies
► no matter what strategy player 1 plays, there is a single
strategy that maximizes payoff of player 2
► Equilibrium in dominant strategies is necessarily a non-
cooperative equilibrium
• Why?
• b/s no player wants to unilaterally deviate from a
dominant strategy equilibrium
 159

In summary
► Game theory is not necessary for understanding
competitive or monopoly markets
► In competitive market, each firm is so small compared to
the market that strategic interactions with other firms are
not important
► In monopoly market, strategic interactions are absent as
the market has only one firm
► But, quite useful for understanding the behavior of
oligopolies
► monopoly outcome is jointly rational for oligopoly, but
each oligopolist has an incentive to cheat
 160

5.2 Economics of Information & Uncertainty

► Uncertainty and risk

► Asymmetric information
 Adverse selection (hidden information)
 Moral hazard (hidden action)
► Principal-agent model
 insurance, credit & land markets
 161

Role of information
• information is important in economics
• most often we have assumed free flow of
information
• in reality:
 information is costly
 needs time and money
 decisions made under uncertainty
 lack of complete information
 some parties have more information
 162

Uncertainty and risk

• uncertainty
 which event will occur?
 with uncertainty, comes risk
• risk
= possibility of bad outcome
 financial or property loss
 illness
 death
 163

Uncertainty
• so far, we have assumed prices, incomes & other
variables are known with certainty
• but, many of the choices that people make involve
considerable uncertainty
• what is uncertain in economic systems?
• tomorrow‘s prices
• future wealth
• future availability of commodities
• present & future actions of other people
• etc
 164

Uncertainty …
• uncertainty is fact of life
• people face risks anytime they make decisions
• example: people borrow money with intention to pay in
future
• but future incomes are uncertain, …
• how should we consider uncertainties in making major
consumption or investment decisions?
• consumer is presumably concerned with probability
distribution of getting different consumption bundles of
goods
 165

Example: uncertainty
• Suppose you have $100 now & you are contemplating
buying lottery ticket #13. The ticket costs $5. If #13 is
drawn in the lottery, you will be paid $200.
• the two outcomes that are of interest:
• the event that the ticket is drawn
• the event that it isn't
• the amount you would have if you had not purchased
lottery ticket is $100
• if you buy the lottery ticket for $5, you will have:
• $295 if the ticket is a winner
• $95 if it is not a winner
 166

Concept: expected value (EV)

• need
 probability of outcome
 value of outcome
• EV = sum of (probability)(value) for each outcome
• EV is like the “average outcome”
 actually center of distribution of outcome
 167

Example: expected value

• what is EV of a lottery game with following payoffs (or
possible outcomes) & probabilities
Payoffs Probability
($) (%)
0 80
2 12
5 7.9
500 0.1

EV  (.8  0)  (.12  2)  (.079  5)  (.001 500)

 $1.135
 168

Preferences under uncertainty

• Think of a lottery
• Win $90 with probability 1/2 & win $0 with probability
1/2
• U($90) = 12, U($0) = 2
• Expected utility is

1 1
EU   U ($90)   U ($0)
2 2
1 1
  12   2  7
2 2
 169

Preferences under uncertainty …

• Expected money value of the lottery is
1 1
EM   $90   $0  $45
2 2
• Now compare EU and U(EM)
• EU = 7 and EM = $45
• If U($45) > 7  $45 for sure is preferred to lottery 
risk-aversion
• If U($45) < 7  lottery is preferred to $45 for sure 
risk-loving
• If U($45) = 7  lottery is preferred equally to $45 for
sure  risk-neutral
 170

Types of risk preferences

• preferences described by a utility function with:

• diminishing MU of wealth- risk averse
• increasing MU of wealth- risk loving
• constant MU of wealth- risk neutral
 171

Other examples

flip a coin
• 2 outcomes:
▫ 50% chance of heads
▫ 50% chance of tails
• game: flip a coin
▫ if heads, you get $0
▫ if tails, I pay you $20
 172

expected value of the game

EV  (.5  0)  (.5  20)

 $10
 Note that $10 is not a possible outcome
 but, played over & over, expect to average
$10/game
 173

example of tossing a coin …

• What if I gave you a choice,

(1) take $10 and walk away
(2) take the gamble
• If you take $10, risk averse
 prefer risk free $10 to the game with EV of $10
• If you take the gamble, risk loving
• If you don’t care, risk neutral
 174

example of tossing a coin …

• What if I gave you a choice,

(1) take $5 and walk away
(2) take the gamble
• if you take $5
▫ still risk averse
▫ “paying” to avoid the gamble
 175

How to minimize risk

• insurance- offers a way to change probability distribution
• diversification- growing various crops on the farm
• risk pooling/spreading- each consumer spreads his risk over
all other consumers & thereby reduces amount of risk he
bears
• spreading over time or space also possible
• stock market- allows original owners of firm to convert their
stream of returns over time to a lump sum
• a way of spreading risk over large # of shareholders
• invest in additional information
 176

Risk aversion
• all else equal, we do not like risk
• basic assumption in finance
• explains
▫ insurance market
▫ risk-return tradeoff in financial assets
 177

Risk pooling & insurance

• risk is inevitable
• what to do?
 spread out risk among many
 loss for any one event is small
 risk pooling
 178

Example
• $10,000 in stock market
1.all of it in Google
2.spread out among 500 stocks, including Google
• What if Google loses 20% of value?
• option 2 takes less of a hit
 offset by gains in other stocks
 179

Insurance market
• based on
 customers paying to avoid risk
 risk averse
 firm pooling the risks of many customers
 risk pooling
• my home burning down is catastrophic for me, a
small set back for State Farm
 180

Asymmetric Information
• It is a difference in access to relevant knowledge
• we haven’t yet discussed problems raised by differences in
information
• there are many markets in real world for which it may be very
costly or even impossible to gain accurate information about
quality of goods being sold
• in a given transaction, there are two parties
• one has better information than the other
 could exploit this for his/her advantage
• e.g., seller knows more about a product than buyer does,
workers knows her skills than employer does
• if not controlled, this leads to markets breaking down
 181

Asymmetric information …
• when some people know more than others, the market may
fail to put resources to their best uses
• AI can lead to drastic differences in the nature of market
equilibrium
• study of AI gives us new reason to be wary of markets
• the decision consumer makes when outcomes are uncertain is
based on limited information
• If more information were available, consumer could make
better predictions & reduce risk
• b/s information is valuable commodity, people will pay for it
 182

Value of information
• the difference between expected value of a choice when
there is complete information and expected value when
information is incomplete
Value of info=EV with info minus EV with uncertainty
 183

Asymmetric information affects

▫ buy/sell goods
▫ insurance market
▫ credit market
▫ land market
 184

two problems of asymmetric info

• adverse selection
 occurs before the transaction
 when there is hidden information
• moral hazard
 occurs after the transaction
 when there is hidden action
 185

Adverse selection
• a situation in which AI results in high-quality partners
being squeezed out of transactions b/s they cannot
demonstrate their quality
• a tendency for mix of unobserved attributes to become
undesirable from standpoint of an uniformed party
• a situation where one side of the market has to guess type or
quality of product based on behavior of other side of the
market
• a process by which the less desirable potential trading partners
volunteer to exchange
 186

Adverse selection ….

• people who are most risky are more likely to

 seek insurance
 borrow money
 sell their crappy stuff
• the adverse are more likely to be selected
 187

Adverse selection …

• why a problem?
 uninformed party may leave market
 beneficial transactions do not occur
• solution?
 screening
 certification
 188

Example 1: life insurance

• adverse selection:
 sick/dying people more likely want life insurance
• solution
 health history, blood work, etc
 or group membership
 189

Example 2: bank loan

• adverse selection:
 riskier people more likely need money
• solution
 credit history, references….
 group lending
 190

Example 3: used cars

• adverse selection:
 used cars for sale b/s owner wanted to dump it
• solution:
 VIN checks, certified, warranty
 191

Moral hazard
• a tendency of a person who is imperfectly monitored to
engage in dishonest or undesirable behavior, after
transaction
• a situation where one side of the market cannot observe
actions of the other side (hidden action)
• people likely to engage in risky behavior or not “do the
right thing”
• hazard of lack of moral conduct
 192

Moral hazard …
• why a problem?
 uninformed party may leave market
 beneficial transactions do not occur
• solution?
 monitoring
 restrictions on allowed behavior
 193

Example 1: auto insurance

• moral hazard
 given insurance coverage, drive less carefully or do
not lock up
• solution
 monitor for tickets
 discount for anti-theft device
 194

Example 2: bank loan

• moral hazard
 get the loan & “blow the money” so cannot pay it
back
• solution
 collateral
 insurance to protect collateral
 consequences on credit report
 195

Summary
• risk is central to most transactions
• information is costly and not perfect
▫ a big benefit of the internet is how it lowered the cost
of information
• all else equal, we do not like risk or uncertainty
▫ risk pooling, screening & monitoring all manage this
 196

Principal-agent relations

• the Principal is owner of resources

• the Agent is hired by the principal and given a certain
stewardship over owner’s resources
• an Agent is a person who is performing an act for another
person (called principal)
• a Principal is a person for whom another person (called
the agent) is performing some act
 197

Examples

• Restaurant owner –waiter

• Software company –salesman
• Auto manufacturer –customer leasing a car
• Insurance company –insured
 198

Principal-agent relations ….
• How can the manager ensure the agent performs as
desired?
• Principal designs contract and offers it to agent
• Agent decides to accept or not
• If accepts, then the agent decides on the level of effort
• The firm‘s revenue is observed
• Principal pays the agent according to contract terms
 199

Principal-agent relations ….
• The arrangement will usually be based on a contract
describing future contingencies
• Post-contractual behavior of the agent must be either
monitored or properly motivated
• In reality, the action taken by the agent is usually
unobservable
• Moral hazard characterizes many principal-agent situations
• Alternative: If possible, offer a contract where the wage
depends on the outcome
 200

End of Ch.5