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MONOPOLISTIC COMPETITION AND OLIGOPOLY

C h a p t e r K e y I d e a sSearching the Globe for a Niche

A. Independent firms facing stiff global competition in the market seek out a competitive edge to gain market power.1. These firms often try to differentiate themselves from the

competition by finding a unique niche in the market that they can serve.

2. If the firm succeeds in finding a niche, will it be able to remain profitable?

3. How would the structure of such a market full of niche producers look evolve over time?

B. Only two firms (Intel and Advanced Micro Devices) make nearly all of the processing chips that run our personal computers. Clearly

2they are not operating in a competitive environment, and both firms are large enough that the market is not a monopoly, either.1. Does the decision making of one firm influence the decision

making of the other?2. If the two firms retain their respective market power, will they

be able to remain profitable?3. How would firms in a market with more than one dominant firm

behave?

O u t l i n eI. What is Monopolistic Competition?

A. Monopolistic competition is a market with the following characteristics:1. A large number of firms compete.2. Each firm produces a differentiated product.3. Firms compete on product quality, price, and marketing.4. Firms are free to enter and exit.

B. The presence of a large number of firms in the market implies:1. Each firm supplies only a small part of the total industry output

and so has only limited power to influence the price of its product.

2. Each firm is sensitive to the average market price but pays no attention to any one individual competitor.

3. No one firm can dictate market conditions and no one firm’s actions directly affect the actions of another.

4. Collusion, or conspiring to fix prices, is impossible.C. Firms in monopolistic competition practice product

differentiation, which means that each firm makes a product that is slightly different from the products of competing firms.

D. Product differentiation enables firms to compete in three areas: quality, price, and marketing.1. The quality of a product is the physical attributes that make it

different from the products of other firms. Examples include product design, reliability, and service.

2. Each firm faces a downward-sloping demand curve for its own product because each firm produces a differentiated product. This allows each firm to set its own price. The price is related to quality: A higher quality product allows the firm to set a higher price.

3. A firm in monopolistic competition must market its product because all other firms offer differentiated products. This fact means the product must be marketed using advertising and packaging.

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W H A T I S E C O N O M I C S ? 3E. There are no barriers to entry or exit in monopolistic competition,

so firms cannot earn an economic profit in the long run. 1. Examples of a monopolistically competitive industry include

audio and video equipment, computers, frozen foods, men’s clothing, and sporting goods.

2. Figure 13.1 shows market share of the largest four firms for each of ten industries that operate in monopolistic competition.

II. Price and Output in Monopolistic CompetitionA. Similar to a monopoly, the MR curve for a firm in monopolistic

competition is downward sloping and lies under its demand curve. In the short run, a firm in monopolistic competition makes its output and price decision just like monopoly firm does. 1. A firm that has decided the quality of its product and its

marketing program produces the profit maximizing quantity at which MR = MC.

2. A firm in monopolistic competition can earn an economic profit in the short run only if P > ATC.

3. Figure 13.2 shows a short-run equilibrium output and price decision for a firm in monopolistic competition making a positive economic profit.

B. In the long run, firms in monopolistic competition will be unable to earn economic profit.1. When firms are earning

economic profit (that is,

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4when P > ATC), the existence of the economic profit induces entry by new firms, which continues as long as firms in the industry earn an economic profit.a) As firms enter the industry, each existing firm loses some of

its market share. The demand for its product decreases and the demand curve shifts leftward.

b) The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity.

c) The price the firm charges and the quantity it sells falls as firms enter. Eventually entry results in P = ATC and the firms earn zero economic profit (normal profit).

2. When firms are incurring an economic loss (that is, when P < ATC), the economic loss will induce firms to leave the market, which continues as long as firms in the industry bear an economic loss. Figure 13.3 illustrates a firm in monopolistic competition making an economic loss.a) As firms exit the industry,

each remaining firm gains some of its market share. The demand for its product increases and the demand curve shifts rightward.

b) The increase in demand increases the quantity at which MR = MC and raises the maximum price that the firm can charge to sell this quantity.

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c) The price that each remaining firm charges and the quantity it sells rise as firms exit. Eventually exist results in P = ATC and firms again earn zero economic profit (normal profit).

d) Figure 13.4 shows the long run output and price decision for a firm in monopolistic competition.

C. Comparing Monopolistic Competition with Perfect Competition1. Firms in monopolistic are

inefficient and operate with excess capacity, which means the firm produces a quantity less than the minimum efficient scale.a) Figure 13.5 illustrates this proposition.

2. Firms maximize profit by choosing to produce output where MR = MC.a) The firm in monopolistic competition retains some market

power, which means MR < P for all quantities. b) The fact that the firm has some market power means that at the

profit maximizing level of output chosen by the firm P > MC. c) A firm’s markup is the amount by which price exceeds marginal

cost.

3. Because a firm in monopolistic competition has P > MC, the firm produces where MC < MB since price equals the marginal benefit to society. a) The under-production in monopolistic competition creates a

deadweight loss.b) Monopolistically competitive firms produce at inefficient levels

of output relative to perfect competition.c) But firms in monopolistic competition produce a variety of

different goods whereas firms in perfect competition produce identical goods. People value variety, so monopolistic competition is not necessarily inferior to perfect competition.

III. Product Development and MarketingA. A firm in monopolistic competition must be in a state of continuous

product development to keep earning an economic profit.1. New product development allows a firm to gain a competitive edge,

if only temporarily, before competitors imitate the innovation.2. Firms pursue product development until the marginal revenue from

innovation equals the marginal development cost.3. Production development may benefit the consumer (by providing

improvements in product quality) or it may mislead the consumer (by giving only the appearance of change in product quality).

4. Regardless of whether a product improvement is real or imagined, its value to the consumer is its marginal benefit, which is the amount the consumer is willing to pay for the improvement.

B. Firms use advertising and packaging as the two principal methods to differentiate its products from competitors by actively marketing their products to consumers.1. Firms in monopolistic

competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product.

2. Figure 13.6 shows estimates of this percentage of sale price for different monopolistic competition markets.

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3. These selling costs (like advertising expenditures, fancy retail buildings, etc.) are fixed costs.a) This fact means selling

costs increase average total costs at any given level of output but do not affect the variable costs (including the marginal cost) of production.

b) Figure 13.7 shows how an advertising expenditures shift the ATC curve upward.

C. Selling efforts such as advertising are successful only if they increase demand for the firm’s product. 1. When each firm advertises its product, the advertising increases the

price the firm can charge but it also makes the demand more elastic.

2. A firm’s increased demand and profits can only be experienced by firms in the short run.

3. Profits lead to the entry of more firms into the market, which decreases the demand for each firm’s product in the long run and lowers the price each firm can charge.

D. To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are an efficient allocation of resources.1. Similarly, developing and marketing a brand name provides

information about the quality of a product to consumers and an incentive to the producer to achieve a high and consistent quality standard.

2. Heavy marketing and advertising expenditures by a firm are a signal to consumers that their product is of high quality. A signal is an action taken by an informed person (or firm) to send a message to uninformed people.

IV. OligopolyA. The distinguishing features of an oligopoly are that:

1. Natural or legal barriers prevent the entry of new firms.2. A small number of firms compete.

B. Oligopoly markets share some characteristics of other market structures:1. Oligopoly is similar to a monopoly in that each firm has market

power to determine its own price.

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2. Oligopoly might be similar to monopolistic competition in that each firm makes a differentiated product, but this is not a necessary condition for oligopoly.

C. The number of firms in a natural oligopoly can be determined by the minimum efficient scale of the firms and the total size of the market.1. The minimum efficient scale, combined with the size of the total

market demand for the product, will determine how many firms survive in the market.

2. If only two firms operate in an oligopoly market, it is called a duopoly.

D. The quantity sold by one firm in an oligopoly depends on each firm’s own price and the prices and quantities sold by all the other firms.1. This interdependence between firms motivates each firm to behave

cooperatively instead of competitively toward each other in an attempt to maximize profits for all firms.

2. A cartel is a group of firms acting together—colluding—to limit output, raise price, and increase economic profit.

E. There are two traditional oligopoly models1. The kinked demand curve model of oligopoly is based on the

assumption that each firm believes that if it raises its price, others will not follow but that if it cuts its own price, so will the other firms. a) Figure 13.11 shows the

kinked demand curve model. The demand curve that an oligopoly firm believes it faces has a kink at the current price and quantity.

b) Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged and below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.

c) The kink in the demand curve means that the MR curve is discontinuous at the current quantity.

d) Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged.

e) The beliefs that generate the kinked demand curve are not always correct. In particular, if MC increases enough, all firms raise their prices and the kink vanishes.

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2. In the dominant firm oligopoly model, there is one large firm that has a significant cost advantage over the other, smaller competing firms and it produces a large part of the industry output.a) The large firm operates as a monopoly, setting its price and

output to maximize its profit.b) The small firms act as perfect competitors, taking as given the

market price set by the dominant firm and producing output to satisfy the remaining demand in the market.

c) Figure 13.12 shows a dominant firm industry.

V. Oligopoly GamesA. Game theory is a tool for studying strategic behavior, which is

behavior that takes into account the expected behavior of others and the recognition of mutual interdependence.

B. All games share four important features:1. The rules of a game describe the setting of the game, the actions

the players may take, and the consequences of those actions.2. The strategies are all the possible actions of each player in the

game.3. The payoffs are described in a payoff matrix, which is a table that

shows the payoffs for every possible action by each player for every possible action by each other player.

4. The outcomes of a game are the results produced by the interaction of all the choices made by each of the players’ decisions. In a Nash equilibrium, player A takes the best possible action given the action of player B and player B takes the best possible action given the action of player A.


C. The prisoners’ dilemma is a good game for illustrating these four features. The following is an example.1. Art and Bob have been caught stealing cars. The rules of their

prisoner’s dilemma game are as follows:a) Both have been convicted of committing this crime and will be

sentenced to two years in jail. b) Both prisoners are also strongly suspected of committing a more

serious crime for which there exists insufficient evidence for a conviction.

c) During interrogation for the more serious crime, Art and Bob are held in a separate cell and they cannot communicate with each other.

d). Each is told that they are both suspected of committing the more serious crime and that the other is being asked to confess in return for a lighter prison sentence for the more serious crime.

e) Each prisoner is given a deal to consider: Each prisoner is told that he will receive only a 1-year jail sentence for the serious crime and no time for the less serious crime (for a total of 1 year jail time for both crimes) if he cooperates by giving up a confession that implicates them both and the other prisoner denies the crime. However, if he refuses to confess and his partner does confess, then he will get the full 8 years jail term for the serious crime a total of a 10-year sentence to be served for committing both crimes.

f) Each prisoner knows that if they both confess to the more serious crime, each will receive a total of 3 years in jail for committing both crimes. Otherwise, if neither confesses, each prisoner will serve only a 2-year sentence for the minor crime.

2. The strategies for both prisoners are the same: a) Each can confess to committing the serious crime.b) Each can deny committing the serious crime.

3. The game’s payoff matrix is a table, like the one in Table 13.1, that shows the payoffs for every possible action by each player for every possible action by the other player. a) In Table 13.1, Art’s

payoff from each combination of actions is shown in the top of each payoff box, and Bob’s payoff is shown in the bottom of each payoff box.

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b) There are four possible outcomes: Bob and Art both confess (top left payoff box), Bob and Art both deny (bottom right payoff box), Bob confesses but Art does not (top right payoff box), and Art confesses but Bob does not (bottom left payoff box).

c) If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him given any possible action to be taken by the other player. If both players are rational and choose their actions in this way, the outcome is called a Nash equilibrium—first proposed by John Nash.

4. The dilemma of the prisoners’ dilemma game is that the best strategy is for each prisoner to confess, which does not create the best outcome for either prisoner.a) Regardless of Bob’s decision, Art’s best payoff occurs by

confessing. b) Regardless of Art’s decision, Bob’s best payoff occurs by

confessing. c) So both prisoners confess and the Nash Equilibrium outcome

that results is that each prisoner gets 3 years in jail for committing both crimes.

d) Both players would be better off if each had denied the crime, but because they can’t communicate about their decisions, there is no way to strike a deal that enables them to cooperate and get the best joint outcome.

D. An application of the prisoners’ dilemma can help us understand the behavior of firms in a natural duopoly, which captures the essence of an oligopoly market.1. Figure 13.13 shows a natural duopoly:

a) Demand and cost conditions are such that two firms can produce the good to satisfy demand at a lower ATC than only one firm or three firms.

b) The firms in a duopoly can enter into a collusive agreement, which is an agreement in which two (or more) competitors agree to restrict output, raise the price, and increase profits.


c) Firms that have entered into a collusive agreement have formed a cartel (which is illegal in the United States.)

2. In a cartel, each firm has two strategies: a) Comply with the agreement b) Cheat on the agreement

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3. There are four possible payoffs depending upon the strategy followed by each player:a) If both firms comply, they maximize industry profit by producing

the same output as a monopoly would, charging the monopoly price, and sharing the resulting economic profit. Figure 13.14 shows this outcome.

b) If one firm cheats and the other complies, the firm that complies incurs an economic loss, and the firm that cheats makes an economic profit that is larger than its share of the maximum industry profit if it complies. Figure 13.15 shows this outcome.

c) If both firms cheat, they each earn a normal profit (zero economic profit). Figure 13.16 shows this outcome.


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4. Table 13.2 shows the payoff matrix for this game. a) The Nash equilibrium is

where both firms cheat. b) The quantity and price

are those of a competitive market, and the firms earn normal profit.

E. Another application of the prisoners’ dilemma can also help us understand the behavior of two firms operating in a market of monopolistic competition that are engaged in developing and marketing rival products. Consider the situation facing both Procter & Gamble and Kimberly-Clark as they compete in the disposable diaper market:1. The key to success for each firm is to develop a product that is

more highly valued by consumers and less costly to produce than the rival firm.a) Higher valued products increase market share and increase the

price and total revenues for the firm.b) Lower costs and higher prices combine to increase profits.c) However, research and development (R&D) costs are high and

must be subtracted from these higher profits.2. There are two different strategies that each firm can pursue:

a) Spend money on R&D.b) Do not spend money on R&D.

3. The payoff matrix in Table 13.3 illustrates the four different payoffs that can arise in this game. The payoff for Procter and Gamble appear in the top of each box and the payoff for Kimberly-Clark appears in the bottom of each box. The payoff matrix has four boxes, representing the four possible outcomes:a) Both firms spend

money on R&D.b. Neither firm spends

money on R&D.c) Procter & Gamble spends on R&D and Kimberly-Clark will not.d) Kimberly-Clark spends on R&D and Procter & Gamble will not.


4. The Nash equilibrium outcome is that both firms spend money on R&D.a) Regardless of what Kimberly-Clark decides to do, the best

strategy for Procter & Gamble is to spend money on R&D.b) Regardless of what Procter & Gamble decides to do, the best

strategy for Kimberly-Clark is to spend money on R&D.c) Both firms create innovative products that are cheaper to

produce, which benefits the consumer but fails to maximize joint profits.

d) A dominant strategy equilibrium is a Nash Equilibrium outcome where the best strategy for any player in the game is to cheat on the agreement (act non-cooperatively) regardless of the strategy of the other player.

F. A Game of ChickenA game of “chicken” is exemplified by two cars racing toward each other.1. The first driver to swerve and avoid crashing is “chicken.”2. The payoffs are a big loss for both players if no one chickens, zero

for both if both chicken, and if one chickens, a loss for the chicken and a gain for the other player.

3. R&D that creates a new technology that any firm can use is an economic example of the game of chicken.

4. There are two equilibrium outcomes, one in which each player chickens (that is, each player undertakes the research) and the other player does not. This equilibrium is not a Nash equilibrium.

VI. Repeated Games and Sequential GamesA. If a game is played repeatedly, it is possible for players of the game

(like in the two firms in the duopolies game) to act cooperatively and successfully collude (to earn a monopoly profit). 1. Knowing that multiple chances to play the same game will occur

changes the dominant strategy for players in this type of sequential game.

2. Many different outcomes are possible because information about players’ behavior in prior games can be incorporated into current games.

B. For example, additional punishment strategies in a repeated prisoners’ dilemma duopoly game enable the firms to comply and achieve a cooperative equilibrium, in which the firms make and share the monopoly profit.1. One possible punishment strategy is a tit-for-tat strategy, in which

one player cooperates in the current period if the other player cooperated in the previous period, but cheats in the current period if the other player cheated in the previous period.

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2. A more severe punishment strategy is a trigger strategy, in which a player cooperates if the other player cooperates but plays the Nash equilibrium strategy forever thereafter if the other player cheats.

C. A tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game, allowing all firms to enjoy economic profit.1. If each firm cooperates in the first period, then this cooperation

might provide evidence of trustworthiness that the other firms can rely upon in choosing their second period strategy.

2. However, a price war might result from relying on a tit-for-tat strategy, especially when there is the additional complication of uncertainty about unforeseen changes in consumer demand. a) A random decrease in demand might convince some firms to

lower their priceb) It is difficult for the firms to determine if the low price is the

result of weaker demand or of non-cooperative behavior on the part of those firms lowering their price.

c) This fall in price might result in a round of tit-for-tat punishment by all firms.

D. However, non-cooperative outcomes are also possible if the firms operate in a contestable market. 1. A contestable market is a market in which firms can enter and

leave so easily that those firms in the market face competition from potential entrants. These firms play a sequential entry game.

2. Figure 13.17 shows the game tree for a sequential entry game in a contestable market.

a. In this entry game, the firms in the market set a competitive price and earn only a normal profit to keep the potential entrant out.

b. However, a less costly strategy is limit pricing, which sets the price at the highest level that inflicts a loss on the entrant. This strategy will keep the potential entrant out while allowing the existing firms to earn economic profit.


R e a d i n g B e t w e e n t h e L i n e sThe economy in China is rapidly changing and often in the news. An example of a firm owner’s challenges operating within China’s fruit juice market nicely illustrates the workings of a monopolistically competitive market.

N e w i n t h e S e v e n t h E d i t i o nThe section on game theory has been refined and enhanced. A discussion of a game of chicken has been added. The Reading Between the Lines now looks at monopolistic competition in China’s fruit juice market.

Te a c h i n g S u g g e s t i o n s1. Monopolistic Competition

Understanding real world markets. Students can readily see monopolistic competition in the world all around them. Emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of monopolistic competition, as its name implies, is a mixture of both extremes. Some of what they learned in each of the two previous chapters survives and operates in the middle ground of monopolistic competition.Product differentiation—the heart of the space between monopoly and competition. An old ice-cream on the beach analogy really nails down the idea of product differentiation and explains how monopolistic competition fills the space between monopoly and perfect competition. Draw a line on the blackboard and label the two ends A and B. Tell the students that the line represents a beach (a long beach) along which beachgoers are uniformly spaced. An ice-cream vendor decides to set up shop on the beach—the only one. Where will she locate? The students will quickly see that the center—midway between A and B is the spot that will get the most customers because the cost of an ice cream is the market price plus the walking time to get it (remind them that the beach is very long!) Now a second ice-cream vendor opens up. Where does he locate? With a bit of help, the students will see that the best spot is right next to the first one. With one producer, there is monopoly and no variety—no product differentiation. With two producers, there is still no differentiation—technically, there is minimum differentiation. Now suppose a third and fourth ice-cream vendor come along. Where to they locate? At the ends of the beach at A and B. They differentiate as much as possible from each other and from the first two. Further entry has new ice-cream vendors locating in the middle of the gaps between the existing ones, always going into the widest gap. If the market could stand the competition, eventually, there would be ice-cream vendors so close to each other all along the beach that the members of any adjacent group were indistinguishable to a customer. Product differentiation would have been pushed to the point that there is no “space” for additional variety and the market would look like perfect competition.

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Real products are like the beach example. Talk about sports shoes, breakfast cereals, and any other goods that interest you and for which there are good locally observable examples and encourage the students to see that they are like the beach example. The variety of products fill the available variety “space.”

2. Output and Price in Monopolistic CompetitionThe demand for a firm’s differentiated product in monopolistic competition. Remind the students about the ceteris paribus condition that defines a demand curve. Along the demand curve for Nike tennis shoes, the prices of Adidas, Fila, Head, K Swiss, Prince, Reebok, and Wilson tennis shoes are constant. Some people prefer Nike to the other brands and will pay a bit more for Nike. Other people prefer some other brand and will buy Nike only if its price is low enough. Buyers have brand preferences, but they will switch brands if price differences are large enough. So the higher the price of a Nike shoe, the prices of the other brands remaining the same, the smaller is the quantity of Nike shoes demanded—a downward sloping demand curve.Entry and exit shift the demand curve for a firm’s product. Students seem to have a bit of trouble appreciating that entry and exit change the demand for a firm’s product. Explain this effect by sticking with the tennis shoes example. Explain that the demand for Nike tennis shoes changes and the demand curve for Nike tennis shoes shifts if other firms enter or exit. If Tommy Hilfiger and the Gap started to make tennis shoes, some of Nike’s former customers would switch to these two new brands, and the demand for Nike shoes would decrease—despite no change in price—and demand shifts leftward. If Adidas, Fila, and Reebok stopped making tennis shoes, some of their former customers would switch to Nike, and the demand for Nike shoes would increase—again without a change in price. The demand curve for Nike shoes would then shift rightward.

3. Product Development and MarketingShock Treatment: The Marketing Cost of Nike Tennis Shoes. Students like to know what they’re paying for when they buy something. You can open their eyes (and even shock them) by providing some numbers on the marketing costs of pair of Nike tennis shoes. Here are the numbers from an industry source:

ATC AFC AVCManufacturer (Asia)Materials 9.00 9.00Cost of labor 2.75 2.75Cost of capital 3.00 3.00Profit 1.75 1.75Shipping 0.50 0.50Import duties 3.00 3.00Nike (Beaverton, Oregon)Sales, distribution, etc. 5.00 5.00Advertising 4.00 4.00Research and development 0.25 0.25Nike's profit 6.25 6.25Retailer (your town)


Sales clerks wages 9.50 9.50Shop rent 9.00 9.00Retailers other costs 7.00 7.00Retailer’s profit 9.00 9.00Totals $70.00 $6.50 $63.50

4. OligopolyUnderstanding real world markets. Students can also readily see oligopoly in the world around them. Again, emphasize that the work they’ve just done understanding the models of perfect competition and monopoly are not wasted because the real-world situation of oligopoly can be better understood by building on some of the features of competition and monopoly. Again, some of what they learned in each of the two previous chapters survives and operates in oligopoly.Traditional oligopoly models. Many instructors today want to skip the traditional models of oligopoly. Others want to teach only these models and skip the game theory approach. Your choice! This chapter is written in self-contained sections so that you can skip either approach.The kinked demand curve and discontinuous marginal revenue curve. Students aren’t too troubled with the kinked demand curve, but the discontinuous MR curve needs a bit of explanation. An approach that works well is to extend the lower section of the demand curve all the way to the y-axis and draw its MR curve. Then erase the segment of the demand curve and the associated segment of the MR curve to the left of the kink.

5. Oligopoly GamesGame Theory. Game theory is an entirely different approach to modeling a firm’s output and price decisions. It allows for the expected actions of all other firms in the market to be explicitly considered in the firm’s decision-making process. Game theory is a big step for the student and need a significant amount of time to develop. This chapter is designed to be flexible and provide you with many options on just how far to go.1. We noted above that if you wish you can avoid game theory completely

and stop at page 297.2. You might want to introduce only the prisoner’s dilemma game. Pages

298–299 enable you to do that.3. You might want to spend serious time applying the prisoner’s dilemma

to a cartel game. Pages 300–304 enable you to do that.4. You might want to extend the range of examples and apply the

prisoner’s dilemma to a real-world research and development game. Pages 304–306 enable you to do that.

5. Finally, you might want to introduce repeated and sequential games and some of their applications and implications. Pages 307–309 enable you to do that.

6. Each of the steps laid out above is optional, but cumulative. You can stop at any point, but shouldn’t try to skip one step with the exception that you can teach the R&D game based on the general introduction to the prisoner’s dilemma without teaching the longer and more complex cartel game.

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The prisoners’ dilemma. Take things a step at a time and begin by playing the prisoner’s dilemma game. A good Web version of the game can be found on a site operated by a group called Serendip at Bryn Mawr College in Pennsylvania. The URL is http://serendip.brynmawr.edu/playground/pd.html. If you can use the Web in your classroom, open two browsers and go to this site twice. Get two teams trying to beat Serendip.A Cartel Game. The prisoner’s dilemma to a cartel game on pages 300–304 has been carefully designed to get the maximum payoff from the knowledge your students have of the perfect competition and monopoly results of the two preceding chapters and to introduce them to game theory in a setting that is as close to the previously studied settings as possible.1. The natural duopoly setting ensures that there is a zero profit

equilibrium that corresponds to perfect competition and monopoly profit equilibrium.

2. Instead of just asserting a payoff matrix, the numbers in the matrix come directly from monopoly profit-maximizing and competitive outcomes. You need to do a bit of work (and so do your students) to generate the payoff numbers, but the whole story hangs together so much better when the student can see where the numbers come from and can see the connection between the oligopoly set up and those of competition and monopoly.

3. Start with Figure 13.14 and after you’ve explained the cost and demand conditions shown in the figure, ask the students what they think the price and quantity will be in this industry. There will be differences of opinion. This diversity of opinion motivates the need for a model of the choices the firms make.

4. The game is set up so that the competitive equilibrium is the Nash equilibrium. You might want to emphasize, that this outcome is efficient even though it is not the best joint outcome for the firms.

The R&D Game. This example really happened. You can flesh out the time line of developments in this industry at http://www.gpoabs.com.mx/cricher/timeline.htm.

6. Repeated Games and Sequential GamesThe repeated prisoners’ dilemma and punishment. The interesting fact about this extension of the prisoners’ dilemma is that punishment strategies can support a cooperative equilibrium, lead to maximum (monopoly) profit, and an inefficient allocation of resources.Entry game. The textbook uses the simplest possible example to illustrate the sequential entry game in a contestable market. It doesn’t explicitly explain the backward induction method of solving such a game, but it implicitly uses that method. You might want to be explicit.


T h e B i g P i c t u r eWhere we have been

Chapter 13 wraps up the analysis of the firm’s output and price decision by filling in the gap between perfect competition and monopoly. This chapter also examines efficiency using the ideas introduced and explained in Chapters 2 and 5, and uses the market concentration measures explained in Chapter 9.

Where we are goingChapter 14 discusses government regulation and antitrust laws and is a natural complement to Chapters 11 through 13. Chapters 15 and 16 examine market failure and public choices. Chapters 17 and 18 go back to the big questions of microeconomics and pick up the question “for whom.” Chapter 17 examines competitive factor markets, and an appendix looks at monopolistic elements in labor markets and labor unions. Chapter 18 examines the distribution of income, the trends in the distribution, and some of the reasons for inequality and the trends.

O v e r h e a d Tr a n s p a r e n c i e sTransparency Text figure Transparency title

82 Figure 13.2 Economic Profit in the Short Run83 Figure 13.4 Price and Output in the Long Run84 Figure 13.5 Excess Capacity and Markup85 Figure 13.7 Selling Costs and Total Cost86 Figure 13.8 Advertising and the Markup87 Figure 13.13 Costs and Demand88 Figure 13.14 Colluding to Making Monopoly Profits89 Figure 13.16 Both Firms Cheats90 Table 13.1 Prisoners’ Dilemma Payoff Matrix91 Table 13.2 Duopoly Payoff Matrix

E l e c t r o n i c S u p p l e m e n t sMyEconLabMyEconLab provides pre- and post-tests for each chapter so that students can assess their own progress. Results on these tests feed an individualized study plan that helps students focus their attention in the areas where they most need help. Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are

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A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s1. Could you manage a successful cartel? Emphasize the fragility of

cartel arrangements by using the following numerical example. Point out that if a cartel is to operate successfully, all the firms must behave collectively as a monopoly, producing market output where MR = MC and charging the resulting profit-maximizing price. Because there are multiple firms in a cartel, and each firm is likely to have different production cost functions, then this raises two critical issues: How should production quotas be allocated across firms to minimize

total production costs and maximize potential profits? How should the profit quotas be allocated across firms to maintain

compliance?Start by assuming that the profit-maximizing level of output for a monopoly would occur at 9 units per period, where MR = $3. Assume that there are no fixed costs.If you were the leader for the cartel, how would you propose the production quotas be allocated to minimize production costs and maximize profits to share?

Quantity MC for Firm A MC for Firm B MC for Firm C1 2 1 22 1 2 33 2 3 44 3 4 55 4 5 6

Based on minimizing variable costs, and knowing that MR = $3 at 9 units of output, Firm A should produce 4 units, Firm B should produce 3 units and Firm C should produce at 2 units per period. Total output is 9 units, MC = $3 for all three firms, and the total cost of industry production is: $8 for


Firm A, $6 for firm B, and $5 for firm C for a total cost of $19 per period.How should the profit quotas be distributed across the firms? Ask the students to consider allocating profits according to each firm’s share of total production costs. Firm A would receive 8/19 of the profits, firm B would receive 6/19 and firm C would receive 5/19 of the profits. Most students will accept this as a “fair” allocation of profits for the firms. But this agreement will not work for long.Will the cartel survive using this profit quota arrangement? Point out that what keeps each firm in compliance with the agreement is not an independent assessment of “fairness” for the ultimate profit distribution. The profit quota agreement must be worthwhile to each and every firm in the cartel. Emphasize that the opportunity cost of cheating must exceed the opportunity cost of complying for each firm if the cartel agreement is to be successful in the long run. What is the opportunity cost for complying for each firm? Point out that based on Firm C’s cost function, the prospect of its competing with the other firms is rather grim. But Firm A’s cost function implies that it would not fear the threat of competition from the other firms cheating and would have the upper hand in determining profit quotas for the cartel. Point out that Firm A will want as much profit as it can have from each of the other firms without making their opportunity cost of cheating exceed their opportunity cost for complying. That is the only profit sharing arrangement that will allow the cartel to survive over time.

2. In what sense is a firm in monopolistic competition similar to a monopoly firm? Emphasize that each firm has some ability to raise market price through marketing effort and product differentiation. This means MR < P at all levels of output. In the long run, both markets are inefficient because: i) production does not occur at the lowest possible unit cost, and ii) P > MC at equilibrium and each firm produces less output than is socially efficient.In what sense is a firm in monopolistic competition similar to a perfectly competitive firm? Emphasize that entry and exit affect the market price that each firm can charge in both markets. Also, low barriers to entry and exit make it impossible for any firm to enjoy economic profits in the long run.

3. Is advertising real information or is it just hype? Have the class discuss whether an increase in the consumer’s willingness to pay for a product is sufficient to justify advertising as socially beneficial. There are only normative answers to this question, but it is still a useful exercise in carefully thinking about how we define efficiency in economic modeling: If the consensus is information, challenge the assumption by asking the

class exactly what does the depiction of scantily clad women flirting with rather homely looking men have anything to do with conveying the real quality differences among brands of beer? What is the social benefit of spending millions of dollars for a 30 second television advertisement during the super bowl that shows a bunch of guys doing nothing but saying, “WHAAZZUUP”? Ask the students if they can name the product being promoted, and if they can, identify the brand. Most will not be able to recall either, which is a common problem in the

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advertising industry. People vividly remember the creative commercial, but fail to recall the brand product or brand name.

If the consensus is hype, then ask your students what it means for efficient resource allocation. Does it mean that the consumer is not the best judge of what is good for her or him? It that is so, then who is the best judge? Should consumers not be exposed to marketing efforts that are deemed “hype” by some higher authority?


A n s w e r s t o t h e R e v i e w Q u i z z e sPage 285

1. The distinguishing characteristics of monopolistic competition are: i) a large number of firms, each producing a different product than its competitors, ii) firms compete on quality, price, and marketing, and iii) there are no barriers to entry into the industry.

2. Firms in monopolistic competition compete in three areas: Quality—the physical attributes of a product, including the product’s design and reliability, the service provided with the product, and the ease of access to the product; price—because the firms produce slightly different products, each one has a downward-sloping demand curve for its own product; and marketing—firms must make consumers aware of the quality of their differentiated products through advertising and packaging.

3. Students should not have trouble coming up with a variety of local examples of monopolistic competition industries. For example, hamburger restaurants, coffee shops, and juice bars are examples of firms competing in their own respective industry, each industry being a market described by monopolistic competition.

Page 2891. A firm that has already decided the quality of its product and its

marketing program produces the output at which its marginal revenue equals its marginal cost (MR = MC) because this output maximizes profit. The price is determined from the demand curve for the firm’s product and is the highest price the firm can charge for the profit-maximizing quantity.

2. A firm in monopolistic competition can earn an economic profit only in the short-run because economic profit induces entry, which decreases the demand for the firm’s product, lowers its profit maximizing output, price, and economic profit. In long-run equilibrium, when entry ends, each firm earns zero economic profit.

3. A firm’s capacity output is the output at which average total cost is at its minimum. In monopolistic competition, MR = MC and P = ATC at the long run equilibrium, it is the case that MC < ATC, which means that ATC is falling with output in this range and so production occurs at an output level that is less than capacity output.

4. There is a markup because it is the case that in monopolistic competition P > MR at all levels of output. Because the firm produces where MR = MC, the fact that P > MR means that P > MC so that there is a markup.

5. Monopolistic competition is not efficient. Product differentiation in monopolistic competition means that P > MR, which implies that P > MC at the quantity where MR = MC. Because P = MB, the result is that MB > MC, which signals inefficiency.

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The two main ways that firms in monopolistic competition compete other

than price are product development and marketing.2. Product innovation and development is efficient to the extent that

innovations represent actual improvements to the product and not simply the perception of improvement. The value of these innovations to the consumer is the marginal benefit or the extra amount consumers are willing to pay to have the new product. If the marginal benefit to the consumer is equal to the marginal cost of product innovation, then it is efficient.

3. Advertising expenditures increase a firm’s fixed cost, which increase the firm’s total cost. This means that average fixed cost (AFC) curve shifts up, pushing up the average total cost (ATC) curve. Variable costs do not change, which implies that the marginal cost (MC) and average variable cost (AVC) curves remain unchanged. The difference between AVC and ATC curves becomes larger at lower levels of output, but this difference shrinks as output increases.

4. If a firm’s advertising program is successful, it will shift the firm’s demand curve rightward in the short run. But if this shift in demand increases economic profits, this will attract firms to enter the industry, shifting each existing firm’s demand curve back leftward as they each lose some market share. In the long run, each firm experiences zero economic profits, and demand for the firm will not be increased through advertising.

5. A firm in monopolistic competition is not efficient because it produces where price exceeds marginal cost (P > MC). It also tends to have high advertising costs that push up the sales price. But consumers value product variety, which is a benefit provided by a monopolistically competitive industry that is missing from a perfectly competitive industry. Additionally, firm in monopolistic competitions have a large incentive to innovate in order to gain a (temporary) advantage over their competitors. To the extent that the lost benefits from inefficiency are made up for in additional benefits that consumer’s gain from innovation and product variation, a market characterized by monopolistic competition might arguably be considered efficient.

Page 2931. The kinked demand curve model predicts that for small changes in cost,

the firm does not change its price or its quantity of output. It assumes that each firm believes that if it raises its price, no other firm will raise its price. But if all firms experience a large increase in marginal cost, then all firms raise their price.

2. In the dominant firm model, the dominant firm operates as a monopoly and earns an economic profit. If there are not large enough barriers to entry, other large firms will enter the market and so the market might well evolve so that it is no longer a dominant firm model.


All games share four factors in common: rules, strategies, payoffs, and

outcomes.2. In the prisoners’ dilemma game, each prisoner faces two strategies:

confess or deny. There are four outcomes: i) Both prisoners confess and each receives more years in prison than if they both did not confess, ii) both prisoners deny, iii) prisoner A confesses and prisoner B denies, and iv) prisoner B confesses and prisoner A denies. In these last two outcomes, the confessing prisoner gets a lower sentence than if both confessed and lower than if they both denied. The dominant strategy for both prisoners is to confess. Regardless of what the other prisoner does, the best strategy for each prisoner is to confess, and both prisoners confess. This outcome is worse for both prisoners than if they each denied the crime, which creates the dilemma.

3. Each firm has the possibility of sharing monopoly profits with other members of the cartel if each firm abides by the agreement. But each firm has an incentive to cheat against the collusive agreement in a cartel. If they all cheat, the outcome for each firm is far worse than if they had both held to the agreement.

4. All firms in a collusive agreement face the same optimal strategies: their payoff is high if they all comply, but the payoff to any one firm that cheats is even higher if all the other firms comply. This motivates each firm to cheat on the agreement.

5. Each firm sees that its own profit is higher if it cheats on the agreement, and this strategy is best regardless of how any of the other firm act. This motivates all firms to cheat, and they all suffer an outcome that is far less profitable than if they all had complied with the agreement.

6. In the prisoners’ dilemma R&D game, a firm can use the R&D only if it conducts R&D. So if one firm conducts R&D, the firm will incur the costs of the R&D but then it alone will reap the rewards of the R&D. In this situation, both firms have the incentive to cheat on any agreement to restrict R&D because each firm knows that if it, and it alone cheats, its profit will increase. In the R&D game of chicken, a firm can use the R&D if either it conducts the R&D or if its competitor conducts the R&D. So if one firm conducts the R&D, it bears the cost and reaps the reward but the other firm reaps only the reward because it pays none of the costs. So in a game of chicken, neither firm “wants” to do the R&D—both firms would prefer that the other conduct the R&D.

Page 3091. Two strategies for motivating compliance in a repeated prisoner’s

dilemma game are: i) a tit-for-tat strategy, where cheating by one firm in current period is punished by the other firm cheating in the next period, but compliance by one firm in the current period is rewarded by compliance in the next period, ii) a trigger strategy, where cheating by one firm in the current period is punished in by cheating by the other firm in all subsequent periods. Both strategies may create a cooperative equilibrium where all players share in the maximum possible benefit.

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2. A contestable market occurs when the one, two, or even three firms in a market face potential entry in the market due to low barriers to entry. While a monopoly free from the threat of entry will charge a high price and maximize profits, the firm(s) in a contestable market will keep price low and quantity produced high in order to deter potential entry by other firms outside the industry. This benefits consumers, who enjoy near-competitive levels of output and market price.


A n s w e r s t o t h e P r o b l e m s1. a. Lite and Kool produces 100 pairs a week.

To maximize profit, Lite and Kool produces the quantity at which marginal revenue equals marginal cost.

b. Lite and Kool charges $20 a pair.To maximize profit, Lite and Kool charges the highest price for the 100 pairs of shoes, as read from the demand curve.

c. Lite and Kool makes a profit of $500 a week.Economic profit equals total revenue minus total cost. The price is $20 a pair and the quantity sold is 100 pairs, so total revenue is $2,000. Average total cost is $15 a pair, so total cost equals $1,500. Economic profit equals $2,000 minus $1,500, which is $500 a week.

2. a. The Stiff Shirt produces 40 shirts an hour.To maximize profit, the Stiff Shirt produces the quantity at which marginal revenue equals marginal cost.

b. The Stiff Shirt charges $80 a shirt.To maximize profit, the Stiff Shirt charges the highest price for which it cam sell 40 shirts, as read from the demand curve.

c. The Stiff Shirt makes a profit of $800 a hour.Economic profit equals total revenue minus total cost. The price is $80 a shirt and the quantity sold is 40 shirts, so total revenue is $3,200. Average total cost is $60 a shirt, so total cost equals $2,400. Economic profit equals $3,200 minus $2,400, which is $800 an hour.

3. a. (i) The firm produces 100 pairs.To maximize profit, the firm produces the quantity at which marginal cost equals marginal revenue. Marginal cost is $20 a pair. The firm can sell 200 pairs at $20 a pair, so the marginal revenue is $20 at 100 pairs. (Marginal revenue curve lies halfway between the y-axis and the demand curve.)(ii) The firm sells them for $60 a pair.The firm sells the 100 pairs at the highest price that consumers will pay, which is read from the demand curve. This price is $60 a pair.(iii) The firm’s economic profit is zero.The firm produces 100 pairs and sells them for $60 a pair, so total revenue is $6,000. Total cost is the sum of total fixed cost plus total variable cost of 100 pairs. Total cost equals $4,000 plus ($20 multiplied by 100), which is $6,000. The firm’s profit is zero.

b. (i) The firm produces 200 pairs.To maximize profit, the firm produces the quantity at which marginal cost equals marginal revenue. Marginal cost is $20 a pair. At $20 a pair, the firm can sell 400 pairs (twice the number with no advertising), so the marginal revenue is $20 at 200 pairs. (The marginal revenue curve lies halfway between the y-axis and the demand curve.)(ii) The firm sells them for $60 a pair.The firm sells the 200 pairs at the highest price that consumers will pay—read from the demand curve. This price is $60 a pair.(iii) The firm makes an economic profit of $1,000.

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The firm produces 200 pairs and sells them for $60 a pair, so total revenue is $12,000. Total cost is the sum of total fixed cost plus the advertising cost plus total variable cost of 200 pairs. Total cost equals $4,000 plus $3,000 plus ($20 multiplied by 200), which is $11,000. The firm makes an economic profit of $1,000.

c. The firm will spend $3,000 advertising because it makes more economic profit than when it does not advertise.

4. a. The firm produces 112.5 pairs and sells them for $110 a pair.To maximize profit, the firm produces the quantity at which marginal cost equals marginal revenue. Marginal cost is $20 a pair. At $20 a pair, the firm can sell 225 pairs so the marginal revenue is $20 at 112.5 pairs. (The marginal revenue curve lies halfway between the y-axis and the demand curve.)The firm sells the 112.5 pairs at the highest price that consumers will pay—read from the demand curve. This price is $110 a pair.

b. The firm makes an economic profit of $3,125. The firm produces 112.5 pairs and sells them for $110 a pair, so total revenue is $12,375. Total cost is the sum of total fixed cost plus the advertising cost plus total variable cost of 112.5 pairs. Total cost equals $4,000 plus $3,000 plus ($20 multiplied by 112.5), which is $9,250. The firm makes an economic profit of $3,125.

c. The firm will spend $3,000 advertising because it makes more economic profit than when it does not advertise.

d. Economic profit in the long run is zero.In monopolistic competition, there are no barriers to entry, so economic profit encourages new firms will enter. The supply of running shoes will increase, and the price will fall. The entry of new firms will stop when price equals average total cost and every firm is making zero economic profit.

5. The firm will not change the quantity it produces or the price it charges. The firm makes less economic profit.The firm maximizes profit by producing the output at which marginal cost equals marginal revenue. An increase in fixed cost increases total cost, but it does not change marginal cost. So the firm does not change its output or the price it charges. The firm’s total costs have increased and its total revenue has not changed, so the firm makes less economic profit.

6. If the marginal cost curve still intersects the break in the marginal revenue curve then the firm will not change the quantity it produces or the price it charges. If the marginal cost curve now intersects the marginal revenue curve outside of the break, then the firm will decrease the quantity it produces and raise the price. In both cases the firm makes less economic profit.The firm maximizes profit by producing the output at which marginal cost equals marginal revenue. An increase in variable cost increases marginal cost. The marginal cost curve shifts leftward. When the firm does not change its output or price, economic profit decreases because total costs increase. When the firm decreases output and raises the price, economic


profit decreases because total revenue decreases (demand is elastic above the kink) and total costs increase.

7. a. The price rises, output increases, and economic profit increases.The dominant firm produces the quantity and sets the price such that it maximizes its profit. When demand increases, marginal revenue increases, so the firm produces a larger output. The highest price at which the dominant firm can sell its output increases. Because price exceeds marginal cost, economic profit increases.

b. The price rises, output increases, and economic profit increases.The small firms are price takers, so the price they charge rises. Because these firms are price takers, the price is also marginal revenue. Because marginal revenue increases, the small firms move up along their marginal cost curves (supply curves) and increase the quantity they produce. Because price exceeds marginal cost, economic profit increases.

8. a. The price rises, output decreases, and economic profit decreases.The increase in total variable cost increases the marginal cost of all firms in the industry. For each firm in the industry, the marginal cost curve shifts upwards by the increase in total variable cost. The supply curve of the 100 small firms is the horizontal sum of the marginal cost curves of the 100 small firms, so the supply of the 100 small firms decreases and their supply curve shifts upwards by the increase in marginal cost. But when the small firms' supply decreases, the demand facing the dominant firm increases (the XD curve in Figure 13.7 shifts rightward) and its marginal revenue increases. The vertical distance by which the dominant firm's demand curve shifts is less than the increase in marginal cost because the demand curve facing the 100 small firms slopes downward. So for the dominant firm, its marginal cost increases by more than its marginal revenue, so it decreases its output. And with a small output and increased demand, the dominant firm raises its price. Because marginal cost increases by more than marginal revenue, its economic profit decreases.

b. The price rises, output decreases, and economic profit decreases.The small firms are price takers and they charge the same price as the dominant firm. So their price rises. Because marginal cost has increased, their supply has decreased. But the increase in marginal cost exceeds the increase in price, so the small firms decrease output. As price takers, their marginal revenue equals price. So the increase in price increases marginal revenue, but the increase in marginal revenue is less than the increase in marginal cost. So their economic profit decreases.

9. a. The game has 2 players (A and B), and each player has 2 strategies: to answer honestly or to lie. There are 4 payoffs: Both answer honestly; both lie; A lies, and B answers honestly; and B lies, and A answers honestly.

b. The payoff matrix has the following cells: Both answer honestly: A gets $100, and B gets $100; both lie: A gets $50, and B gets $50; A lies and

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B answers honestly: A gets $500, and B gets $0; B lies and A answers honestly: A gets $0, and B gets $500.

c. Equilibrium is that each player lies and gets $50.If B answers honestly, the best strategy for A is to lie because he would get $500 rather than $100. If B lies, the best strategy for A is to lie because he would get $50 rather than $0. So A’s best strategy is to lie, no matter what B does. Repeat the exercise for B. B’s best strategy is to lie, no matter what A does.

10. The prisoners’ dilemma is described on pages 298–299.11 a. The best strategy for each firm is to cheat

(i) Each firm makes a zero economic profit or normal profit. If both firms cheat, each firm will lower the price in an attempt to gain market share from the other firm. In the process, the price will be driven down until each firm is making normal profit.(ii) If Suddies abides by the agreement, the best strategy for Soapy is to cheat because it would make a profit of $1.5 million rather than $1 million. If Suddies cheats, the best strategy for Soapy is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $0.5 million. So Soapy’s best strategy is to cheat, no matter what Suddies does. Repeat the exercise for Suddies. Suddies’s best strategy is to cheat, no matter what Soapy does.(iii) The payoff matrix has the following cells: Both abide by the agreement: Soapy makes $1 million profit, and Suddies makes $1 million profit; both cheat: Soapy makes $0 profit, and Suddies makes $0 profit; Soapy cheats and Suddies abides by the agreement: Soapy makes $1.5 million profit, and Suddies incurs a $0.5 million loss; Suddies cheats and Soapy abides by the agreement: Suddies makes $1.5 million profit, and Soapy incurs $0.5 million loss.(iv) The equilibrium is that both firms cheat and each makes normal profit.

b. Each firm can adopt a tit-for-tat strategy or a trigger strategy. Page 307 give descriptions of these strategies.

12. a. (i)The payoff matrix has the following cells: Both abide by the agreement: Healthy makes $4 million profit, and Energica makes $4 million profit; both cheat: Healthy makes $0 profit, and Energica makes $0 profit; Healthy cheats and Energica abides by the agreement: Healthy makes $6 million profit, and Energica incurs a $1.5 million loss; Energica cheats and Healthy abides by the agreement: Energica makes $6 million profit, and Healthy incurs $1.5 million loss.(ii) The best strategy for each firm is to cheat. If Energica abides by the agreement, the best strategy for Healthy is to cheat because it would make a profit of $6 million rather than $4 million. If Energica cheats, the best strategy for Healthy is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $1.5 million. So Healthy’s best strategy is to cheat, no matter what Energica does. Repeat the exercise for Energica. Energica’s best strategy is to cheat, no matter what Healthy does.


(iii) The equilibrium is that both firms cheat and each makes normal profit.

b. Each firm can adopt a tit-for-tat strategy or a trigger strategy. Page 307 give descriptions of these strategies.

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A d d i t i o n a l P r o b l e m s1. The figure shows the situation

facing Well Done, Inc., a producer of steak sauce.a. What quantity does Well

Done produce?b. What does it charge?c. How much profit does Well

Done make?2. Two firms, Faster and Quicker,

are the only two producers of sports cars on an island that has no contact with the outside world. The firms collude and agree to share the market equally. If neither firm cheats on the agreement, each firm makes $3 million economic profit. If either firm cheats, the cheater can increase its economic profit to $4.5 million, while the firm that abides by the agreement incurs an economic loss of $1 million. Neither firm has any way of policing the actions of the other.a. Describe the best strategy for each firm in a game that is played once.b. What is the economic profit for each firm if they both cheat?c. What is the payoff matrix of a game that is played just once?d. What is the equilibrium if the game is played once?e. If this game can be played many times, what are two strategies that

could be adopted?


S o l u t i o n s t o A d d i t i o n a l P r o b l e m s1. a. Well Done produces 200 bottles a week.

To maximize profit, Well Done produces the quantity at which marginal revenue equals marginal cost.

b. Well Done charges $4 a bottle.To maximize profit, Well Done charges the highest price for the 200 bottles of steak sauce, as read from the demand curve.

c. Well Done makes a profit of $200 a week.Economic profit equals total revenue minus total cost. The price is $4 and the quantity sold is 200 bottles, so total revenue is $800. Average total cost is $3, so total cost equals $600. Economic profit equals $800 minus $600, which is $200 a week

2. a. Each firm makes a zero economic profit or normal profit.If both firms cheat, each firm will lower the price in an attempt to gain market share from the other firm. In the process, the price will be driven down until each firm is making normal profit.

b. The payoff matrix has the following cells: Both abide by the agreement: Faster makes $3 million profit, and Quicker makes $3 million profit; both cheat: Faster makes $0 profit, and Quicker makes $0 profit; Faster cheats and Quicker abides by the agreement: Faster makes $4.5 million profit, and Quicker incurs a $1 million loss; Quicker cheats and Faster abides by the agreement: Quicker makes $4.5 million profit, and Faster incurs $1 million loss.

c. The best strategy for each firm is to cheat.If Quicker abides by the agreement, the best strategy for Faster is to cheat because it would make a profit of $4.5 million rather than $3 million. If Quicker cheats, the best strategy for Faster is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $1 million. So Faster’s best strategy is to cheat, no matter what Quicker does. Repeat the exercise for Quicker. Quicker’s best strategy is to cheat, no matter what Faster does.

d. The equilibrium is that both firms cheat and each makes normal profit.e. Each firm can adopt a tit-for-tat strategy or a trigger strategy. Page 307

gives descriptions of these strategies.

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