ANNOUNCEMENTS Review class: Monday, December 13 4:15-5:15, LC6 Final Exam: Friday, December 17 10:30-12:30, LC1 80 multiple choice choice questions Chapts & questions Chapts questions

DUOPOLY Firm A Firm B Given the only the two output choices of the duopolists, when they both believe their competitor will produce 2.5 units they both will have an incentive to increase their output to 3.5 and raise their profit to However, when they both increase output to 3.5, they both see their profits

DUOPOLY Firm A Firm B fall to 7. When they both believe that their competitor will produce 3.5 units, they each have an incentive to decrease their output to 2.5 to increase their profit to 7.5. Therefore, neither both producing 2.5 nor both producing 3.5 is an equilibrium, since they both have an incentive to

DUOPOLY Firm A Firm B change their output level. In many situations, there are combinations of choices that agents can make, that they will have no incentive to change. When economic agents have each chosen their best strategy, given the strategies of the other agents, a Nash equilibrium exists.

DUOPOLY Firm A Firm B change their output level. In many situations, there are combinations of choices that agents can make, that they will have no incentive to change. When economic agents have each chosen their best strategy, given the strategies of the other agents, a Nash equilibrium exists. For example, when A

DUOPOLY Firm A Firm B believes that B will produce 2.5, A’s best strategy is to produce 3.5; and when B believes that A will produce 3.5, B’s best strategy is to produce 2.5. Therefore when A produces 3.5 and B produces 2.5, neither will have an incentive to change. This is a Nash equilibrium. Similarly, A

DUOPOLY Firm A Firm B producing 2.5 and B producing 3.5 is a Nash equilibrium. Therefore there can be more than one Nash equilibrium. For these duopolists, the Nash equilibrium that maximizes their combined or joint profits is when both produce 3 units of output.

DUOPOLY Q B Q A Q P TR A TC A PROFIT When B produces 3, A will maximize profits by producing 3. Similarly, when A produces 3,

DUOPOLY Q A Q B Q P TR B TC B PROFIT B will maximize profits by producing 3. Then each producing 3 units of output is a Nash equilibrium where each have profits of 9.

DUOPOLY The Nash equilibrium with each duopolist producing 3 units of output and having profits of 9 gives industry output of 6, market price of 4, industry profit of 18, and a deadweight loss of (1/2)x(4-1)x(9-6) = 4.5.

DUOPOLY Industry Market Industry Deadweight output price profit loss Monopoly Duopoly (Nash equil 3,3) Perfect Competition The oligopoly result is between monopoly and perfect competition. The greater the number of firms, the closer the result is to perfect competition.

INDUSTRIAL ORGANIZATION Examining three possible ways to organize markets, perfect competition, oligopoly, and monopoly, perfect competition is the only market structure that efficiently allocates resources (when there are no externalities or natural monopolies). There is another market structure which needs examination.

MONOPOLISTIC COMPETITION Monopolistic competition is a market structure that is characterized by many sellers, product differentiation and free entry and exit. It is like perfect competition since there are many firms with free entry and exit; and it is like monopoly since each firm is the only producer and seller of its product. However, unlike monopoly, each firm’s product is similar to the product of its competitors’ products. Examples are tooth paste, shampoo,

MONOPOLISTIC COMPETITION MC ATC AVC $ Q D MR P Q breakfast cereal, and soft drinks. Since each firm has a monopoly selling its own product, it faces a downward sloping demand curve whose elasticity depends on the number and closeness of good substitutes. The firm chooses an output Q where MR=MC, and prices according to demand.

MONOPOLISTIC COMPETITION MC ATC AVC $ Q D MR P Q ECONOMIC PROFIT It earns a profit equal to (P-ATC)xQ. Since it produces where P>MC, it produces less than the socially efficient output and, therefore, has a deadweight loss. DEADWEIGHT LOSS

MONOPOLISTIC COMPETITION MC ATC AVC $ Q D’ MR’ P’ Q’ D When economic profits are being earned, this will be a signal for new firms to enter this industry. The new firms will decrease demand for existing firms, which will be forced to lower price and output. New firms will enter until economic profits are zero. This is the long- ZERO ECONOMIC PROFITS

MONOPOLISTIC COMPETITION MC ATC AVC $ Q D’ MR’ P’ Q’ run equilibrium. When economic profits are zero, the demand curve and the ATC curve are tangent at the profit maximizing price and output combination (where MR=MC). Even though there are zero economic profits, there is still a deadweight loss. Tangency of demand and ATC curves DEADWEIGHT LOSS

MONOPOLISTIC COMPETITION $ D MR MC AVC ATC Q ATC’ P Q Firms in monopolistically competitive industries attempt to protect themselves from competition, by advertising their product to maintain consumer loyalty. However, advertising raises costs. Since the level of advertising is

MONOPOLISTIC COMPETITION $ D MR MC AVC ATC Q ATC’ P Q not determined by the level of output, it is a fixed cost, increasing ATC without affecting MC or AVC. When advertising expenditures push ATC up to a tangency of demand, economic profits are zero and new firms will not enter. Tangency of demand and ATC curves

MONOPOLISTIC COMPETITION $ D MR MC AVC ATC Q ATC’ P Q not determined by the level of output, it is a fixed cost, increasing ATC without affecting MC or AVC. When advertising expenditures push ATC up to a tangency of demand, economic profits are zero and new firms will not enter. DEADWEIGHT LOSS

MONOPOLISTIC COMPETITION In the short run, monopolistic competitors can earn economic profits. In the long run, economic profits are driven down to zero by loss of market share or increased advertising costs. When all firms in the industry are earning zero economic profits, the industry is in long-run equilibrium. However, in long-run equilibrium the industry is producing less than is socially optimal, causing a deadweight loss, and not producing at minimum ATC.

MONOPOLISTIC COMPETITION Since regulation is too expensive and difficult to do properly, monopolistically competitive markets are generally unregulated except for advertising claims and the monopolizing effect of potential mergers.

MONOPOLISTIC COMPETITION Monopolistically competitive firms usually allocate vast amounts of resources to advertising and product differentiation. While consumers gain by being given some choice among products and from advertising that gives information about the product, excessive differentiation may be wasteful, as is advertising designed to psychologically manipulate consumer tastes and preferences. However, the fact that a firm is willing to spend on

MONOPOLISTIC COMPETITION advertising may be a signal that the firm believes that it has a high quality product. Brand names are important for monopolistic competitors, since this is how consumers can identify the product. Large amounts of resources may be wasted on advertising designed to protect and create “brand loyalty”. However, brand name products are generally of known and uniform

MONOPOLISTIC COMPETITION quality, and as such brand names provide information to the consumer. Firms that have an investment in establishing a brand name have an incentive to maintain the quality of its product. In summary, monopolistic competition misallocates resources by producing a less than socially optimal output level in plants that are too large, and potentially wastes resources on psychological

MONOPOLISTIC COMPETITION advertising designed to attract customers and strengthen brand name recognition. While total losses from monopolistic competition may be large in absolute amount, they are relatively small compared to the value of the total output of the U.S.

INDUSTRIAL ORGANIZATION In the absence of externalities and natural monopolies, organizing markets as perfect competition will efficiently allocate resources. Monopoly, oligopoly and monopolistic competition all misallocate resources and may require government intervention to improve the allocation of resources through regulation or enforcement of the antitrust laws.