This post is 5th in a 7-part series of my personal notes outlining N. Gregory Mankiw’s economics textbook “Principles of Microeconomics” (8th Edition).
Index of Outlines for Principles of Microeconomics:
* Part 1: Introduction (Chapters 1-3)
* Part 2: How Markets Work (Chapters 5-6)
* Part 3: Markets and Welfare (Chapters 7-9)
* Part 4: The Economics of the Public Sector (Chapters 10-12)
* Part 5: Firm Behavior and the Organization of Industry (Chapters 13-17)
* Part 6: The Economics of Labor Markets (Chapters 18-20)
* Part 7: Topics for Further study (Chapters 21-22)
Part 5: Firm Behavior and the Organization of Industry
- Industrial organization: The study of how firms’ decisions about prices and quantities depend on market conditions.
- “How does the number of firms affect the prices in a market and the efficiency of the market outcome?”
- Costs are a key determinant of production and pricing decisions.
Chapter 13: The Costs of Production
13-1 What are Costs?
- The assumed objective for firms is to maximize profit.
- Total revenue: The amount a firm receives for the sale of its output.
- Total cost: The market value of the inputs a firm uses in production.
- Profit: Total revenue minus total cost.
Types of costs:
- Explicit costs: Input costs that require an outlay of money by the firm. Example: Payroll expenses.
- Implicit costs: Input costs that do not require an outlay of money by the firm. Example: Example: Business owner could work more profitably in another field (an opportunity cost).
Which costs are accounted for is dependent on who performs the analysis:
- Economists analyze a business based on both explicit and implicit costs.
- Accountants are only interested in the money that flows into and out of firms. They measure explicit costs and ignore implicit costs.
The cost of financial capital invested in the business is an important implicit costs and an opportunity cost.
- Example: Founder invests $300,000 of their own money in a business. They could have left the money in an interest bearing account instead.
- Economic profit: Total revenue minus total cost, including both explicit and implicit costs.
- Accounting profit: Total revenue minus total explicit cost.
- “Economic profit is an important concept because it motivates the firms that supply goods and services…a firm making positive economic profit will stay in business.”
13-2 Production and Costs
- Production function: The relationship between the quantity of inputs used to make a good and the quantity of output of the good. Example: 1 worker produces 50 cookies, 2 workers produce 90 cookies, etc.
- Marginal product: The increase in output that arises from an additional unit of input. Example: when the number of workers in the example above goes from 1 to 2, cookie production increases from 50 to 90. The marginal product of the second worker is 40 cookies.
- Diminishing marginal product: The property whereby the marginal product of an input declines as the quantity of the input increases. Example: With each added worker, the output per worker is not constant but decreases (this can be the result of many factors: factory crowding, more overhead, etc.).
- Total cost curve shows the relationship between quantity produced (horizontal axis) and cost (vertical axis).
13-3 The Various Measures of Cost
Two types of costs:
- Fixed costs: Costs that do not vary with the quantity of output produced. Example: Rent paid for the factory (must be paid regardless of output).
- Variable costs: Costs that vary with the quantity of output produced. Example: If running a coffee shop, the cost for ingredients for each cup of coffee (beans, milk, sugar, cups) are variable depending on the number of units produced.
A firm’s total costs are the sum of its fixed and variable costs.
Average total cost: Total cost divided by the quantity of output.
- Average fixed cost: Fixed cost divided by the quantity of output.
- Average variable cost: Variable cost divided by the quantity of output.
Marginal cost: The increase in total cost that arises from an extra unit of production.
Important distinction between average total cost and marginal cost:
- “Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced.”
- “Marginal cost tells us the increase in total cost that arises from producing an additional unit of output.
- Average-Cost and Marginal-Cost curves:
Four curves displayed:
- Average total cost (ATC, or AC)
- Average variable cost (AVC)
- Average fixed cost (AFC)
- Marginal cost (MC)
Observations from the above cost curves:
Marginal cost rises as the quantity of output increases. This is the property of “diminishing marginal product.”
Average total cost is U-shaped. At low output: fixed costs are high and variable costs are low per unit. At high output: fixed costs are low and variable costs are relatively higher per unit.
- Efficient scale: The low point of the ATC curve where average total cost is minimized.
Relationship between Marginal Cost and Average Total Cost
When MC is below ATC, average total cost is falling.
When MC is above ATC, average total cost is rising.
Mankiw uses a GPA analogy to explain the relationship of MC and ATC:
- ATC is your cumulative grade point average.
- MC is the grade you will get in your next course (it will either cause the cumulative GPA to rise or fall).
“The marginal-cost curve crosses the average-total-cost curve at its minimum.”
13-4 Costs in the Short Run and in the Long Run
“The division of total costs between fixed and variable costs depends on the time horizon.”
Example: Car manufacturer like Ford Motor Company:
- Ford cannot adjust the number or size of its car factories.
- The only lever to increase production is to hire more workers at existing factories.
- The cost of the factories in this time-frame are fixed.
- Ford can expand the size of existing factories.
- Ford can build new factories (and close old ones).
- The cost of factories in this time-frame are variable.
The long-run average total-cost curve helps us understand how costs vary with scale (i.e. the size of a firm’s operations).
- Economies of scale: The property whereby long-run average total cost falls as the quantity of output increases.
- Diseconomies of scale: The property whereby long-run average total cost rises as the quantity of output increases.
- Constant returns to scale: The property whereby long-run average total cost stays the same as the quantity of output changes.
What causes economies or diseconomies of scale?
- Increased productivity levels through worker specialization.
- Coordination problems resulting from more inefficient management teams.
- Costs vary with the quantity of output a firm produces.
- Cost curves can help firms make important production decisions.
Chapter 14: Firms in Competitive Markets
14-1 What is a Competitive Market?
Competitive market characteristics:
- There are many buyers and many sellers in the market.
- The goods offered by the various sellers are largely the same.
- Firms can freely enter or exit the market. (this is not an essential condition).
The actions of a single buyer or seller have negligible impact on the market price.
Each buyer and seller takes the market price as given (price takers).
Average revenue: Total revenue divided by the quantity sold. Average revenue equals the price fo the good.
Marginal revenue: The change in total revenue from an additional unit sold. For competitive firms, marginal revenue equals the price of the good.
To achieve a profit-maximizing quantity:
- When marginal revenue is higher than marginal cost, increase production.
- When marginal revenue is less than marginal cost, decrease production.
- At the profit-maximizing level of output, marginal revenue and marginal cost are equal.
“Because the firm’s marginal-cost curve determines the quantity of the good the firm is willing to supply at any price, the marginal-cost curve is also the competitive firm’s supply curve.”
14-2 Profit Maximization and the Competitive Firm’s Supply Curve
- Example of profit maximization: Vaca Family Dairy Farm (chart below)
- Marginal revenue is > marginal cost at 1-3 gallons. Farm should produce MORE milk.
- Marginal revenue is < marginal cost at 6-8 gallons. Farm should produce LESS milk.
- By thinking at the margin, the farm can make incremental adjustments to production level and produce the profit-maximizing quantity.
Another type of decision: Temporary shutdown or permanent exit from the market?
- Shutdown is a short-run decision not to produce during a specific period of time due to market conditions. Downside: fixed costs must still be accounted for.
- Exit is a long-run decision to leave the market altogether. Fixed costs and variable costs no longer paid.
Example of shutdown vs. exit:
Farmer needs to determine between the two choices.
If farmer decides for shutdown, the farmer still pays for the fixed costs of the land (which will lie fallow).
- This fixed cost is a sunk cost (a cost that is spent and cannot be recovered).
If the farmer decides to exit, the farmer can sell the land. In this scenario, the cost of the land is not sunk.
Shutdown if Total Revenue is < Variable Costs
- Equivalent to shutdown if Price < Average Variable Cost
“The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost.”
“The firm exits the market if the revenue it would get from producing is less than its total cost.”
14-3 The Supply Curve in a Competitive Market
Two cases to consider:
A market with a fixed number of firms.
A market in which the number of firms can change as old firms exit the market and new firms enter.
- At the end of the process of entry and exit, firms that remain must be making zero economic profit.
- The process of entry and exit ends only when price and average total cost are driven to equality.
- In the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale.
“Because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than the short-run supply curve.”
14-4 Conclusion: Behind the Supply Curve
- “When you buy a good from a firm in a competitive market, you can be assured that the price you pay is close to the cost of producing that good.”
- “If firms are competitive and profit-maximizing, the price of a good equals the marginal cost of making that good.”
- “If firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production.”
Chapter 15: Monopoly
15-1 Why Monopolies Arise
Monopoly: A firm that is the sole seller of a product without any close substitutes.
Barriers to entry: The circumstances that prevent other firms from entering a market to compete with the incumbent.
Types of barriers to entry:
- Monopoly resources: Essential resources necessary for production is owned/controlled by a single firm.
- Government regulation: The government grants a single firm exclusive rights for the production of a specific good or service.
- The production process: A single firm can produce output at a lower cost that a group of firms (aka “natural monopoly”).
Examples of monopoly resources:
- Owner of a single well for fresh water in a small town.
- DeBeers, the South African diamond company.
Examples of government-created monopolies:
- Patent and copyright laws: Afford the creator an exclusive period to produce and sell their creation.
Examples of natural monopolies:
- Natural monopoly: A type of monopoly in which a single firm can supply a good at a lower cost than two or more firms.
- Example: Distribution of water in a city. In order to provide water, the firm must build a network of pipes. If multiple firms were to compete, each would need to build a similar network of pipes (high fixed costs).
- Example: A lightly trafficked bridge. Larked fixed costs to build the bridge and negligible marginal costs for additional users (since it is lightly trafficked).
- Natural monopolies carry low risks of competition and new entrants. Reason is that a competitive market would result in smaller profits for each firm.
- Size of the market is one determinant of whether an industry is a natural monopoly. Market expansion may drive the need for a competitive market (for instance, the building of a second bridge).
15-2 How Monopolies Make Production and Pricing Decisions
Monopolies have pricing power (price makers). In contrast with competitive firms which do not have pricing power (price takers).
Compare the demand curves of monopolies vs. competition:
Competitive firms have a horizontal demand curve.
Monopolist firms have a downward sloping curve.
- If the monopolist raises the price, consumers buy less.
- If the monopolist reduces quantity, the output price increases.
Marginal revenue for monopolies is different from marginal revenue for competitive firms.
When a monopoly increases the amount it sells, this action has two effects on total revenue (P * Q):
- The output effect: More output is sold, so Q is higher, which increases total revenue.
- The price effect: The price falls, so P is lower, which decreases total revenue.
Competitive firms can sell all the goods they want at the market price (remember, competitive firms are small and do not impact market demand or prices on their own).
Monopolistic firms, on the other hand, are the market. Increased production impacts price. As a result, a monopoly’s marginal revenue is less than its price.
- Monopoly marginal revenue and demand curve:
- Monopoly marginal revenue curve with demand curve:
Profit is maximized by:
- Selecting the quantity at which marginal revenue intersects with marginal cost.
- Setting the price at which the demand and quantity intersect.
- “In competitive markets, price equals marginal cost. In monopolized markets, price exceeds marginal cost.”
- Total profit is represented as the grey box in the figure above. Effectively represents quantity sold (P * Q) less the total cost.
15-3 The Welfare Cost of Monopolies
- From a consumer standpoint, monopolies are undesirable.
Monopolies function like private tax collectors:
- The monopoly’s market power allows it to charge a price above marginal cost.
- This results in deadweight loss similar to a tax.
- The deadweight loss results in a lower than socially optimum quantity sold.
- Unlike a tax, the monopoly profit goes to the firm.
Monopoly profit causes a shift it in the allocation of total surplus for a good:
- A monopoly doesn’t reduce the size of the economic pie per se.
- A monopoly yields a larger piece of the pie for the seller and a smaller piece of the pie for consumers.
- “Unless consumers are for some reason more deserving than producers—a normative judgement about equity that goes beyond the realm of economic efficiency—the monopoly profit is not a social problem.”
- The economic problem with monopolies is that the quantity sold is not ideal (not the profit).
15-4 Price Discrimination
- Price discrimination: The business practice of selling the same good at different prices to different customers.
- Price discrimination is not possible in a competitive market.
Case study: The publishing industry
Readalot Publishing Company pays an author $2M for the exclusive rights to publish their book.
Assume the cost of printing the book is $0.
Readalot’s marketing department identifies two types of readers:
- 100,000 die-hard fans willing to spend $30.
- 400,000 normal fans willing to spend $5.
If Readalot charges a single price to customers, what price maximizes profit?
- At $30, Readalot makes $1M in profit.
- At $5, Readalot makes $500k in profit.
In each of the above scenarios, there is a deadweight loss associated with a single-price strategy.
Instead, the publisher price discriminates:
- It initially releases a hardback book at $30
- Months later is releases the paperback book at $5
Three lessons about price discrimination:
- Price discrimination is a rational strategy for profit-maximization.
- Price discrimination requires the ability to separate customers according to their willingness to pay. Factors might include: geo-location, age, income, etc.
- Price discrimination can raise economic welfare by boosting economic welfare and consumer surplus.
Examples of price discrimination:
- Movie tickets: lower prices for children and senior citizens.
- Airline prices: lower prices for round-trip tickets if the traveler stays over a Saturday night. This allows airlines to separate business travelers from leisure travelers (and charge the former more).
- Discount coupons: Companies are able to identify a customer’s willingness to pay for a good. Rich individuals are unlikely to clip discount coupons (and will pay the higher price). An unemployed person is more likely to clip coupons and have a lower willingness to pay.
- Financial aid: Wealthy students have a higher willingness to pay than needy students.
- Quantity discounts: This is a form of price discrimination since unit prices vary based on quantity purchased.
15-5 Public Policy toward Monopolies
Ways policymakers can respond to the problem of monopolies:
- Make the monopolized industry more competitive.
- Regulate the behavior of monopolies.
- Turn a private monopoly into a public enterprise.
- Do nothing.
Antitrust laws: A collection of statues aimed a curbing monopoly power.
- Sherman Antitrust Act: First and most important antitrust law passed by Congress in 1890.
- Clayton Antitrust Act: Passed in 1914. Strengthened the government’s powers and authorized private lawsuits.
Antitrust laws allow the government to review and prevent mergers.
- 1994: Government blocked Microsoft from buying Intuit.
- 2011: Government blocked AT&T from buying T-Mobile.
Antitrust laws carry costs (as well as benefits):
- Some corporate mergers result in cost-savings through joint production.
- Synergies: the benefits resulting from a merger.
- Critics of government intervention are skeptical of the government’s ability to perform a cost-benefit analysis when evaluating antitrust cases.
Regulations are commonly employed in the case of natural monopolies:
- Examples: Water and electric companies.
- Prices are regulated for these companies.
Pricing regulations are problematic because:
- May require government subsidies to make up for the firm’s loses (Mankiw uses the example of marginal-cost pricing).
- Reduces firm’s incentives to reduce costs. Example: Firm reduces costs only to see the government readjust pricing and effectively wipe out any resulting profits.
Public ownership is common in European countries where governments own and operate telephone, water and electric companies.
Public ownership removes the profit-incentive that drives cost-cutting and innovation in private ownership.*
15-6 Conclusion: The Prevalence of Monopolies
- Table summarizing the differences between competition and monopoly:
Chapter 16: Monopolistic Competition
- Monopolistic competition: describes industries that possess a combination of monopolistic and competitive characteristics.
Example: The market for books.
- Each book is unique and allows publishers some latitude in determining price.
- Sellers in this market are price makers rather than price takers. Book prices exceed marginal cost. Books are sold for $25 while the marginal cost to print an additional copy is less than $5.
- Bookstores contain a wide variety of titles and genres (competing products).
- Barriers to entry are low since anyone can enter the industry by writing and publishing a book.
16-1 Between Monopoly and Perfect Competition
Review of key points regarding competitive markets:
- Price in a perfectly competitive market always equals the marginal cost of production.
- In the long run, entry and exit drive economic profit to zero so the price also equals average total cost.
Review of key points regarding monopolistic markets:
- Monopoly firms use their market power to keep prices above marginal cost.
- This results in economic profit for the firm and a deadweight loss for society.
Competition and monopoly are extreme forms of market structure:
- Competition occurs when there are many firms in a market offering essentially identical products.
- Monopoly occurs when there is only one firm in a market.
Most industries and companies fall somewhere between the extremes of perfect competition and monopoly. Economists call this imperfect competition.
Types of imperfectly competitive markets:
Oligopoly: A market with only a few sellers.
Concentration ratio: Statistic that measures market dominance of the top 4 firms in a market.
- The ratio looks at the percentage of total output in the market supplied by the four firms.
- Concentration ratio < 50% means that the industry is not overwhelmingly dominated by a small group of sellers.
- Concentration ratio > 90% means that the industry is dominated by the top 4 firms (an oligopoly).
Example of industries with high concentration ratios:
- Household appliances: 90%
- Tires: 91%
- Light bulbs: 92%
- Soda: 94%
- Wireless telecommunications: 95%
Monopolistic competition: A market structure in which many firms sell products that are similar but not identical.
Each firm has a monopoly over its specific product, but other firms make similar products that compete for the same customers.
- Many sellers: Many firms competition for the same customers.
- Product differentiation: Each firm produces a product that is at least slightly different from their competitor’s. Each firm faces a downward-sloping demand curve.
- Free entry and exit: Firms and enter and exit the market without restriction. The number of firms in the market adjusts until economic profits are driven to zero.
Examples of industries with monopolistic competition:
- Computer games
- Piano lessons
- Diagram illustrating the 4 types of market structure:
16-2 Competition with Differentiated Products
To understand monopolistically competitive markets:
- Consider the decisions facing an individual firm.
- Examine what happens in the long run as firms enter and exit the industry.
- Compare the equilibrium under monopolistic competition to the equilibrium under perfect competition.
- Consider whether the outcome in a monopolistically competitive market is desirable to society as a whole.
Short-run equilibrium under monopolistic competition (Fig.1):
Product is differentiated and faces a downward-sloping demand curve.
Follows the monopolist’s rule for profit maximization:
- Produce the quantity at which marginal revenue equals marginal cost.
- Use the demand curve to find the price at which it can sell that quantity.
Long-run equilibrium under monopolistic competition (Fig.2):
The situation illustrated in Fig.1 (above) does not last long.
If firms are making profits (per Fig.1) other firms will enter the market.
New entrants increase the number of products available to buyers which results in reduced demand for each incumbent firm.
- Profit encourages new entrants and entry shifts the demand curves for incumbents to the left.
As demand falls, firms experience declining profit.
Conversely, if firms are generating losses, incumbent firms have an incentive to exit the market. The exit of sellers from a market should result in increased demand for the remaining firms in the market.
The process of entry and exit continues until firms int he market are making exactly zero economic profit.
Summary of long-run equilibrium in a monopolistically competitive market:
- As in a monopoly market, price exceeds marginal cost (P > MC).
- As in a competitive market, price equals average total cost (P = ATC).
Two important differences between monopolistic and perfect competition:
- Excess capacity: Monopolistically competitive companies produce at quantities less than the efficient scale (quantity that minimizes average total cost). This is termed excess capacity.
- Markup over marginal cost: Monopolistically competitive firms retain some pricing power and can set prices above the marginal cost.
Market inefficiencies resulting from monopolistically competitive markets:
Markup over marginal cost results in some transactional inefficiency (deadweight loss) for consumers, who value the good at more than the marginal cost of production but less than the price, who refuse to buy.
- No easy solution to marginal-cost pricing. Regulatory measures are not desirable and would be costly.
Number of firms in the market is not “ideal”: Too much or too little entry.
- Product-variety externality: Entrance of new firms result in positive consumer externality.
- Business-stealing externality: Entrance of new firms imposes a negative externality on incumbent firms when they lose customers and profits from new competition.
“Monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets…because the inefficiencies are subtle, hard to measure, and hard to fix, there is no easy way for public policy to improve the market outcome.”
Advertising varies by product type:
- Highly differentiated consumer goods spend 10-20% of revenue on advertising. Examples: Over-the-counter drugs, perfumes, soft drinks, razor blades, cereals and dog food.
- Industrial products spend very little on advertising. Examples: Drill presses and communications satellites.
- Homogeneous products: Wheat, salt, sugar and crude oil spend no money on advertising.
The debate over the social and economic value of advertising:
- Critical view: Advertising is a manipulation of taste. It is psychological rather than informational. Advertising creates false desires. Branding creates false differentiation for what are otherwise fairly undifferentiated products. Brand loyalty results in larger markup over marginal costs and less demand elasticity.
- Proponents view: Advertising provides essential consumer information. It conveys pricing, feature, availability and existence of goods to consumers. Information fosters better consumer decisions and effective allocation of resources. Advertising provides a strategy for new entrants.
One theory: Advertising as a “signal of quality”: If the firm is willing to spend money to promote its good—contents of the advertising not-withstanding—the result is legitimacy in the eyes of the consumer.
Brand names: The rational choice over generic substitutes?
- Critics: The result of an irrational consumer response to advertising.
- Defenders: Consumers should pay more for brand-name products because they can be confident about the quality of these products (and brands have a strong incentive to maintain that perception).
- Summary of monopolistic competition vis a vis perfect competition and monopoly:
Chapter 17: Oligopoly
17-1 Markets with Only a Few Sellers
Oligopoly: A market structure in which only a few sellers offer similar or identical products.
Because oligopolies involve a small number of participants, it presents an ideal case for the use of game theory as a sense for understanding the decisions of market participants.
Game theory: The study of how people behave in strategic situations.
“A key feature of oligopoly is the tension between cooperation and self-interest.”
Duopoly: An oligopoly with only two sellers.
Duopoly example: The case of the small town water well
- Background: Small town in which two individuals, Jack and Jill, own the only wells producing drinking water for the town. Once a week the two decide how many gallons of water to to pump, bring to town and sell.
- Assumption: Jack and Jill can pump as much water they want without cost. The marginal cost of water is 0.
- The demand schedule for water:
Consider how the price and quantity of water is impacted by the market structure (per table above):
Competitive: Firms would drive price to equal marginal cost. Equilibrium price would be 0 and quantity would be 120 gallons.
Monopoly: Firm would maximize profit. The maximum profit (per the demand schedule) is at $60/gallon and a quantity of 60 gallons.
Duopoly that colludes:
- Collusion: An agreement among firms about the quantities to produce or prices to charge.
- A group of firms acting in unison is called a cartel. A cartel effectively operates as a monopoly (maximize total profit).
- Cartels must determine the total output AND the amount produced by each member of the cartel (i.e. the oligopoly must split the monopoly production).
- Allocation among cartel members may create tension as profit-motive drives individual participants to seek a larger share of the pie.
Duopoly that pursues self-interests:
- Imagine that Jack expects Jill to produce 30 gallons (half of the monopoly optimal amount).
- Jack could produce 30 gallons ($1800 profit) OR Jack could produce 40 gallons ($2000 profit).
- Jack decides to supply 40 gallons, but much to his dismay, so does Jill. Now both parties only make $1600 profit and are worse off.
- There is little incentive to produce 50 gallons since that will further push the price and resulting profit down for Jack and Jill.
- Nash equilibrium: A situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen.
Oligopolies must face constant tension between cooperation and self-interest.
- Oligopolists are better off cooperating and arriving at the monopoly outcome.
- Optimal outcome is subverted by self-interest. The group is unable to maximize their joint profit.
- Each party is tempted to raise production and capture more market share.
- As total production rises, prices fall and so does profit.
“When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by perfect competition.
The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).”
The size of an oligopoly affects market outcomes:
- With each new entrant the ability for a cartel to coordinate output and pricing becomes more difficult as the pendulum between self-interest and cooperation weighs more heavily towards the former.
Firms must consider the two following effects:
- The output effect: When price is above marginal cost, selling one more unit at the going price will raise profit.
- The price effect: Raising production increases the total amount sold which lowers price and profit on all other gallons sold.
If the output effect > the price effect, firms can increase production.
If the price effect > the output effect, firms will not increase production.
“As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.”
17-2 The Economics of Cooperation
- Prisoner’s dilemma: An example of a game used to illustrate why cooperation is so difficult to maintain even when it is mutually beneficial.
The prisoner’s dilemma explained:
Two criminals, Bonnie and Clyde, have been captured by the police.
The police question the criminals in separate rooms and offer each an opportunity to confess (and implicate their partner) or remain silent.
Punishments are contingent on the following outcomes:
- If Bonnie and Clyde both confess (and betray each other): Each gets 8 years prison.
- If Bonnie confesses (and implicates Clyde) and Clyde stays silent: Bonnie goes free and Clyde gets 20 years prison.
- If Clyde confesses (and implicates Bonnie) and Bonnie stay silent: Clyde goes free and Bonnie gets 20 years prison.
- If Bonnie and Clyde both stay silent: Each gets 1 year in prison.
Dominant strategy: A strategy that is best for a player in a game regardless of the strategies chosen by the other players.
In this game, confessing is the dominant strategy because the worse case (8 years) and best case (going free) are considered superior to the alternative outcomes when the actor doesn’t know how the other party will choose.
However, the dominant strategy does not result in the best possible outcome. The best possible outcome would be both parties staying silent (1 year of prison each).
Since each party is pursuing their own best interests, the resulting outcome is suboptimal given the available strategies and possible outcomes.
“Cooperation is individually irrational.”
Real life examples of the prisoner’s dilemma:
- OPEC and the world oil market: OPEC is the oil cartel that successfully maintained high oil prices form 1973 to 1985. After this period member nations argued about production levels and failed to cooperate. Prices have since fallen sharply.
- The nuclear arms race: The United States and the Soviet Union were locked in a prolonged military competition. The dilemma was whether to build more weapons or disarm.
Tit-for-tat: A strategy for repeated prisoners’ dilemma games. This strategy defaults to cooperation at the beginning of the game. Once the other player defects, this tit-for-tat player also defects until the opposing player cooperates again. This strategy has been shown to be very effective in these types of games.
17-3 Public Policy toward Oligopolies
- Cooperation among oligopolists is good for the oligopolists but not good for society. Society receives lower quantity of goods at a higher price under an oligopoly (compared to a more competitive market structure).
- Policymakers use regulations to encourage firms to compete rather than cooperate.
- Antitrust laws prohibit price-fixing agreements among competing firms.
Other potential antitrust behaviors that are actively debated by policymakers:
Resale price maintenance
- A firm fixes the retail price for its good above the wholesale price for resellers of the good.
- Defenders say this strategy has a legitimate goal: To ensure that retailers provide a satisfactory buying experience and to prevent discount retailers to poach those buyers (discounters would effectively be getting a free-ride from the full-service retailers).
- A firm reduces prices with the intent of driving its competition out of business.
- Defenders say that it is rarely a profitable business strategy: To drive a rival out of business, prices have to go below cost. The firm with greater market share will effectively reap a greater share of losses.
- Tying is a form of bundling. For example: A movie studio produces two films and offers theaters both films at a single price (rather than separately).
- Defenders of this strategy state that tying does not alter underlying economics nor does it increase market power. Tying may be a form of price discrimination.
- The 1998 antitrust suit against Microsoft involved tying: Bundling/integration of an Internet browser into the Windows operating system.
“Business practices that appear to reduce competition may in fact have legitimate purposes.”
- “Oligopolies would like to act like monopolies, but self-interest drives them toward competition.”
- The Prisoner’s Dilemma is one way to understand why oligopolies fail to cooperate despite cooperation being mutually beneficial.
- Policymakers sometimes regulate oligopolies through antitrust laws. There is a great deal of debate and disagreement about whether or not this is a valid application of these types of laws.