Convert the Multi-Plant Monopoly into an Oligopoly To maximize profits, two conditions must be satisfied when a firm has two plants: Marginal costs of each plant must be equal: MC A = MC B Marginal revenue must equal each plant’s marginal cost: MR = MC A = MC B MC A MC B qAqA qBqB MC A MC B Q D MR q A = 50 MC A = $60 q B = 100 MC B = $60 q A + q B = = 150 MR = $60P = $90 Owner retires and gives Plant A to his son Adam and Plant B to his daughter Beth Adam’s FirmBeth’s FirmTotal Production q A = 50  MC A = $60 q B = 100  MC B = $60 Q = 150 P = $90 Oligopoly Continued MR = 60

To cheat or not to cheat? If a firm believes that the other firm(s) will not retaliate, the firm has an incentive to cheat. retaliate aggressively, the firm does not have an incentive to cheat. As cheating and retaliation occurs: The joint profits of the firms fall. Consumer surplus rises. The gain in consumer surplus exceeds the loss in joint profits. Society as a whole becomes better off. Conflicting Interests of an Oligopolies and Cartels: Collective versus Individual It is in the collective interests of the firms in an industry to establish a cartel to maximize their joint profits by reducing production below the competitive level. But, if a cartel is established it may be in the individual interests of each firm to cheat on the cartel agreement by producing more to increase its individual profit. Preview

Adam’sAdam’s QuantityPriceTotal Revenue = Price  Quantity Tomorrow: Today:   (1 + 50) =  50   50 Adam’s Marginal Revenue =   50 = ( .20)  50  TR tends to rise by 89.80, the price, as a consequence of the additional unit sold.  TR tends to fall by 10.00, as a consequence of the lower price.  Output Effect  Price Effect MR A = Adam’s Marginal Revenue    =  50 AdamBethJointPrice Tomorrow Today Quantity Slope of Demand Curve = .20 To clear the market the quantity demanded must increase by 1 unit. The price must fall by.20, from $90.00 to $ Scenario 1: No retaliation - Adam cheats and Beth does not retaliate? = $79.80 MC A = $60.00 Does Adam have an incentive to cheat if Beth does not retaliate? Yes = (89.80  90.00)  50 Question: What does Adam’s marginal revenue (MR A ) equal?

MC = Change in total cost resulting from a one unit change in production MR = Change in total revenue resulting from a one unit change in production Adam’s Profit = TR  TC Produce 1 more unit  Up by $79.80  Up by $60.00  Up by $19.80 Adam produces one more unit of output and Beth does not retaliate: q A : 50  51q B = 100 MR A = $79.80 MC A = $60.00 P: $90.00  $89.80 Adam’s Profit q A : 50  51 Increased by 1 Joint Profit Maximization Firm A Cheats Firm B Does Not Retaliate Firm AFirm BJointFirm AFirm BJoint Quantity Total Revenue4,5009,0004,5808,980 Total Cost3,0005,0003,0605,000 Profit1,5004,0001,5203,980 Cons Surplus2,2502,372  Lab 18.1 Consumer surplus increases by 22

Adam’sAdam’s QuantityPriceTotal Revenue = Price  Quantity Tomorrow: Today:   (1 + 50) =  50   50 Adam’s Marginal Revenue =   50 = ( .40)  50  TR tends to rise by 89.60, the price, as a consequence of the additional unit sold.  TR tends to fall by 20.00, as a consequence of the lower price.  Output Effect  Price Effect MR A = Adam’s Marginal Revenue    =  50 AdamBethJointPrice Tomorrow Today Quantity Slope of Demand Curve = .20 To clear the market the quantity demanded must increase by 2 units. The price must fall by.40, from $90.00 to $ Scenario 2: 1-For-1 Retaliation – Adam Cheats and Beth Retaliates = $69.60 MC A = $60.00 Does Adam still have an incentive to cheat? Yes = (89.60  90.00)  50 Question: What does Adam’s marginal revenue (MR A ) equal?

Joint Profit Maximization Firm A Cheats Firm B Retaliates 1-For-1 Firm AFirm BJointFirm AFirm BJoint Quantity Total Revenue4,5009,0004,5709,050 Total Cost3,0005,0003,0605,060 Profit1,5004,0001,5103,990 Cons Surplus2,2502,310 MC = Change in total cost resulting from a one unit change in production MR = Change in total revenue resulting from a one unit change in production Adam’s Profit = TR  TC Produce 1 more unit  Up by $69.60  Up by $60.00  Up by $9.60 Adam produces one more unit of output and Beth does retaliate: q A : 50  51q B = 101 MR A = $79.80 MC A = $60.00 P: $90.00  $89.60 Adam’s Profit q A : 50  51 Increased by 1  Lab 18.1 Consumer surplus increases by 60

Adam’sAdam’s QuantityPriceTotal Revenue = Price  Quantity Tomorrow: Today:   (1 + 50) =  50   50 Adam’s Marginal Revenue =   50 = ( .80)  50  TR tends to rise by 89.20, the price, as a consequence of the additional unit sold.  TR tends to fall by 40.00, as a consequence of the lower price.  Output Effect  Price Effect MR A = Adam’s Marginal Revenue    =  50 AdamBethJointPrice Tomorrow Today Quantity Slope of Demand Curve = .20 To clear the market the quantity demanded must increase by 4 units. The price must fall by.80, from $90.00 to $ Scenario 3: 3-For-1 Retaliation – Adam Cheats and Beth Retaliates Aggressively = $49.20 MC A = $60.00 Does Adam have an incentive to cheat? No = (89.20  90.00)  50 Question: What does Adam’s marginal revenue (MR A ) equal?

Joint Profit Maximization Firm A Cheats Firm B Retaliates 3-For-1 Firm AFirm BJointFirm AFirm BJoint Quantity Total Revenue4,5009,0004,5499,188 Total Cost3,0005,0003,0605,182 Profit1,5004,0005,5001,4894,0065,495 Cons Surplus2,2502,372 Firms: Joint profit falls. Adam’s profit falls; Adam has no incentive to cheat. Consumers: Consumer Surplus rises. The increase in consumer surplus is greater than the fall in joint profits. Society as a whole (firms and consumers together) is better off. Change from Joint Profit Maximization Firm A Profit Firm B Profit Joint Profit Consumer Surplus Net Firm A Cheats Firm B Retaliates 3-For-1  5  Lab 18.2 Consumer surplus increases by 122 Adam produces one more unit of output and Beth does retaliate: q A : 50  51q B = 101 P: $90.00  $89.60

Change from Joint Profit Maximization Firm A Profit Firm B Profit Joint Profit Consumer Surplus Society as a Whole Firm A Cheats Firm B Does Not Retaliate +20 Firm A Cheats Firm B Retaliates 1-For Firm A Cheats Firm B Retaliates 3-For-1  5 To cheat or not to cheat? If a firm believes that the other firm(s) will not retaliate, the firm has an incentive to cheat. retaliate aggressively, the firm does not have an incentive to cheat. As cheating and retaliation occurs: The joint profits of the firms fall. Consumer surplus rises. The gain in consumer surplus exceeds the loss in joint profits. Society as a whole becomes better off. Summary Conflicting Interests of an Oligopolies and Cartels: Collective versus Individual It is in the collective interests of the firms in an industry to establish a cartel to maximize their joint profits by reducing production below the competitive level. But, if a cartel is established it may be in the individual interests of each firm to cheat on the cartel agreement by producing more to increase its individual profit. Question: What might affect a firm’s temptation to cheat? Personal ties.Threat of retaliation. Government regulation.

Role of the Government Antitrust legislation: Broadly speaking antitrust legislation is designed to prevent a firm from becoming a monopoly or an oligopoly from colluding and acting as a cartel. Regulation Airline Deregulation Act: In 1978, Congress passed and President Carter signed the Airline Deregulation Act. This act phased in the deregulation of the industry: CAB lost authority over domestic routes CAB lost authority over airline prices CAB was disbanded Real Price (Price adjusted for inflation) Year(Cents per passenger mile)