# Principles of Economics

Principles of Economics will allow you to learn a new set of tools to use in personal, professional, business, and political decision making.

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## Comparison of Principles of Economics Textbooks

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### Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

### Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

### Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

### McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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#### $140 Hardcover print text only ### Always up-to-date content, constantly revised by community of professors Content meets standard for Introduction to Anatomy & Physiology course, and is updated with the latest content ### In-Book Interactivity Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook Only available with supplementary resources at additional cost Only available with supplementary resources at additional cost Only available with supplementary resources at additional cost ### Customizable Ability to revise, adjust and adapt content to meet needs of course and instructor ### All-in-one Platform Access to additional questions, test banks, and slides available within one platform ## Pricing Average price of textbook across most common format ### Top Hat Stephen Buckles, Principles of Economics, Only One Edition needed #### Up to40-60%more affordable Lifetime access on any device ### Cengage N. Gregory Mankiw, Principles of Economics, 8th Edition ####$130

Hardcover print text only

### Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

#### $175 Hardcover print text only ### McGraw-Hill McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition ####$140

Hardcover print text only

## Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

### Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

### Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

### Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

### McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

## In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

### Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

### Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

### Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

### McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

## Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

### Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

### Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

### Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

### McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

## All-in-one Platform

### Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

### Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

### Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

### McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

#### Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

#### PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

## Explore this textbook

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# Chapter 11: Between Perfect Competition and Monopoly

According to the Wall Street Journal in July 2011, Fiat, an Italy-based manufacturer and distributor of automobiles, acquired Chrysler’s ownership from both the U.S. and Canadian governments [1]. There are other consolidations happening in the auto industry since the pressure to innovate and cut cost is high. Currently, the production level for domestic auto manufacturers is back to the same level as before the Great Recession [2].

When I come down the street near campus, I drive past Chipotle, Domino’s Pizza, Taco Bell, Jack in the Box, Subway, Which Wich, Jimmy John’s, Potbelly Sandwich Shop, Sonic Drive-In, Starbucks, and Pizza Hut . They all serve lunches and dinners. However, each product is slightly different. There are many industries in which there are multiple producers of what, in essence, is the same product. In other markets, there are only a few firms that dominate.

In this chapter, we are going to consider two types of firms that are neither perfectly competitive nor the same as a monopoly.

## ​11.1 Objectives

​After reading this chapter, answering the questions in the text, and doing the exercises, you will be able to:

• ​Explain responses in the short and long runs to changes in demand and costs in monopolistically competitive and oligopolistic markets.
• Explain how those responses differ from the responses of a perfectly competitive market and a monopoly.
• Understand and use the concepts of allocative and technical efficiency in summarizing the outcomes of monopolistically competitive and oligopolistic markets.

Our competitive market and monopoly market models are useful in describing extreme forms of market competition. The model of perfect competition describes the outcome when there are many competitors all producing the same product. With only one producer, the monopoly model is useful. But what about all those in between?

We will begin with a common type of market. There are many restaurants, all producing slightly different products. There are many mystery novels published each year, all with slightly different stories. A market with many producers of somewhat different products is one that we describe as a monopolistically competitive market.

Think back to the perfectly competitive market model and to the monopolistic model. Which parts of each model might be relevant when there are many producers, each one producing a product that is slightly different from the other producers?

### Question 11.01

Question 11.01

What is similar and what is different between the automobile industry and restaurant industries?

Hover here to see the hint for Question 11.01.

## 11.2​ Monopolistic Competition

​A market that is a monopolistically competitive one will have:

• ​Many producers
• A variety of types of products, each one slightly different
• Freedom of entry and exit

​The monopolistically competitive firm is like a competitive firm in the sense that there are many firms producing in the market. There are many service stations and drugstores and restaurants and clothing stores. Each of the firms is competing with one another, but each at the same time is producing a slightly different product. The service stations may be across the street from one another and down the block from three more, but each one produces slightly different products. One provides service; another has clean bathrooms; another is Exxon/Mobil; one more is Speedway; another is a brand you never heard of.

Likewise, one restaurant sells hamburgers that are thick and juicy on your choice of bread; another serves hamburgers ready to eat; another a selection of Italian pasta; and a fourth, spicy curries from India. All are serving prepared meals. Yet each one is in a different environment, and each one produces somewhat different types (and sometimes qualities) of food.

​To make the model simpler to understand and apply, we will also assume that each business has a great deal of knowledge about how to produce its products and where to obtain low-cost resources with which to produce. That will mean that similar firms will face similar cost functions.

Finally, we will assume that entry and exit into and out of the industry is relatively easy. If a drugstore opens up on a corner and is earning large profits, another firm may get the idea that it too can earn large profits. All it has to do is build a new building or rent an existing one nearby, hire employees, buy inventory, and begin producing. This characteristic is just like perfectly competitive firms. That entry may take some time, but it can happen. There is nothing to prevent it. That is what we mean by easy entry and exit.

## 11.3 ​Short-Run Equilibrium in a Monopolistically Competitive Industry

### 11.3.1 ​Monopolistically Competitive Costs

Cost functions facing a monopolistically competitive firm will be quite similar to those facing a competitive firm. In the short run, the average cost curve will be u-shaped for the same reasons a perfectly competitive firm's average cost curve is u-shaped. The marginal cost curve may show a decline in marginal cost as the variable input increases, but once the firm begins to experience diminishing marginal returns, it will find that marginal costs rise as output expands. Where average cost equals marginal cost, average cost will be at a minimum.

One difference between perfect competition and monopolistic competition is that costs may be higher for monopolistically competitive firms than for perfectly competitive firms. Monopolistically competitive firms may use advertising to differentiate themselves from competing firms. Those costs add to the costs of production, and average costs (in most cases, fixed costs) are higher than without the advertising expenses.

### 11.3.2 Demand Curves

The real difference between our model for a perfectly competitive firm and our model for a monopolistically competitive firm is in the demand that each firm faces. A perfectly competitive firm faces a perfectly elastic demand at the price that was determined by the market supply and demand. In other words, perfectly competitive firms have zero price-setting power. The perfectly elastic demand curve means that the firm's marginal revenue is the market price. This is illustrated in Figure 11.2 below.

### Question 11.02

Question 11.02

Can you remember why a perfectly competitive firm faces a perfectly elastic demand curve?

​Hover here to see the hint for Question 11.02.

​If two restaurants are right next to one another and everything is identical about the two restaurants, there is little to help us make a choice. We indeed may be indifferent between the two. However, if consumers know about the prices and one restaurant raises its price, then most, if not all, consumers will go to the cheaper restaurant.

But if each firm produces a different product, some customers may not switch to the lower-priced restaurant. If I prefer the type of food served by the Indian restaurant to the American food served next door, I may decide to eat at the Indian restaurant instead of the American one even if I have to pay more for the Indian food.

If that is the case, the demand curve facing the Indian restaurant (and the one facing the American food restaurant), will be downward-sloping. That is, it can raise its price and its quantity demanded will fall, but it will not fall to zero. A monopolistically competitive firm may have some market power in that it can raise its price and because it produces a unique product, some buyers will continue to purchase the product at the higher price.

### Graphing Question 11.01

​A monopolistically competitive firm is going to maximize profits by producing a quantity of output where marginal revenue equals marginal cost. The price will be the highest price it can charge and still sell that amount. We find that price by looking at the demand curve.

The result is shown in Figure 11.3.

​Changes in fixed and variable costs and changes in demand have the same effects on a monopolistically competitive firm that they had in the monopoly model. The difference is that we are now thinking of a much smaller-sized firm with many close competitors.

### Question 11.03

Question 11.03

Will the monopolistically competitive firm tend to have a more elastic or less elastic demand than a monopoly? Explain why.

​​Hover here to see the hint for Question 11.03.

### Question 11.04

Question 11.04

Summarize the profit-maximizing decision.

​​​Hover here to see the hint for Question 11.04.

### Question 11.05

Question 11.05

Can you summarize the final outcome of a monopolistically competitive firm in the short run?

​​​​Hover here to see the hint for Question 11.05.

## 11.4 ​Long-Run Equilibrium in a Monopolistically Competitive Industry

​The existence of several gasoline service stations in one block or at one intersection and a number of restaurants in a shopping mall, all of which could serve a few more customers, are good examples of the long-run outcomes of monopolistically competitive firms, with excess capacity and the ability to expand production while lowering average costs.

To see why let's consider what will happen if the typical monopolistically competitive firm is making economic profits.

Question 11.06

What do you think would happen in a commercial neighborhood near your home if a restaurant in that neighborhood were making a great deal of profit (select all that apply)?

A

In-and-Out burger will open a new franchise.

B

Domino’s Pizza will move to this neighborhood from a rundown area of the town.

C

Chipotle will open a new store next door.

D

The restaurant will close down.

### 11.4.1 ​Entry and Exit

Firms will enter. And as they do, the demand for the existing firms' products will begin to diminish. Prices fall, and the incumbent firms reduce output.

​The original demand and marginal revenue curves are shown in Figure 11.4. Entry reduces the demand for each existing firms' output. The new demand and marginal revenue curves result in lower prices, lower quantity, and smaller economic profits. But if there are still economic profits, more firms will continue to enter. That process will continue until there are no longer any economic profits being earned. The typical monopolistic competitor will end up like the one shown in Figure 11.5. All economic profits have been competed away.

​In the long run, the firm will have no economic profits, as entry of new firms has caused demand to fall until they no longer exist. Price will still be higher than marginal cost. The firm will not be producing at the lowest average cost. The result – that the firm will be producing a smaller quantity of output than the level of production where average cost is a minimum – is often described as producing less than the firm's capacity. Capacity refers to the amount of production that could be produced if the firm were producing where average costs are a minimum.

### Question 11.07

Question 11.07

What will happen in the monopolistically competitive industry if demand increases?

​​​​​Hover here to see the hint for Question 11.07.

### Question 11.08

Question 11.08

What will happen in the monopolistically competitive industry if variable costs increase?

​​​​​​Hover here to see the hint for Question 11.08.

### Question 11.09

Question 11.09

What will happen in the monopolistically competitive industry if fixed cost decrease?

​​​​​​​Hover here to see the hint for Question 11.09.

### Question 11.10

Question 11.10

Summarize in your own words what a monopolistically competitive market is and what is important about that type of market structure.

​​​​​​​​Hover here to see the hint for Question 11.10.
Click here to see the answer to Question 11.10.​

## 11.5 Oligopoly

"​After a year of rebuffs, feints and secret negotiations, the chief executives of American Airlines parent AMR Corp. and US Airways Group Inc. unveiled their merger and vowed to work together to make the tie-up into the world's dominant carrier."      - The Wall Street Journal, February, 2013. [1]

​Adapted from Greek, “olig” means a few and “poly” means sellers. (Monopoly is “mono” for one and “poly” for sellers.) Oligopolies can produce differentiated products – automobile manufacturers are good examples – or identical products – like producers of crude oil. Normally, an oligopolistic industry has few producers because it has some type of barrier to entry. Often that barrier consists of significant economies of scale. Thus, a new entrant will not be able to effectively compete because it will not be able to grow fast enough to take advantage of the economies of scale enjoyed by the firms already in the industry.

### 11.5.1 Maximizing Profits

An oligopoly is a firm producing in a market with a small number of dominant firms, each producing similar or differentiated products and commonly experiencing significant barriers to entry. Each firm in the industry faces cost curves that look like the cost curves we have already studied, but they will exhibit economies of scale that permit large firms to operate more efficiently. If each firm produces a slightly differentiated product, the demand curve faced by the oligopoly will be downward sloping. If each firm produces a standardized product, identical to all other producers, the individual firm demand curve will be much more elastic, and at its extreme, it will be identical to the perfectly elastic firm demand of a perfectly competitive market.

With only a few firms in a market, it may be possible for the firms to collude and set prices and quantities of output that maximize industry profits. The process of setting prices can be done through a formal agreement that all charge the same price (as we shall see, this act is illegal in the U.S.) or by informally setting prices and not actively competing with one another to gain business by lowering prices.

If a handful of firms can agree on a price, what would that price be? Think of the firms formally meeting and discussing price. How would they set it?

### Question 11.11

Question 11.11

What is the rationale to use in setting price, if the firms in the entire industry are acting together?

​​​​​​​Hover here to see the hint for Question 11.11.

​In Figure 11.6, we have drawn a set of cost curves where average and marginal costs are constant at all levels of output. (The only reason they are constant at all levels of output is to make the diagrams easier to read.) Constant average and marginal costs are realistic in the long run for firms in an industry with no economies or diseconomies of scale. However, it is likely that most firms in most oligopolistic industries face declining average costs as output increases, followed by rising average costs at some point.

Question 11.12

Suppose that the graph below represents the cost function for the entire industry and that the demand curve and marginal revenue curve represent the entire market. If the oligopoly acted as a single decision maker, what quantity would it choose to maximize industry profit?

​​Firms in the market know the industry's profit-maximizing level of output. The challenge is to agree on producing that total amount and to determine what portion each firm will produce. It is illegal (as we shall see in the next chapter) to agree on common prices, and each firm may want to expand its share of the market.

But if the firms can somehow agree, they will have to share the market and will want, as a group, to charge the monopoly price. That is, they will have formed a perfect cartel. They have agreed upon the price to charge and the amount that each will produce. Given the demand for the good and given the costs, there is no other level of output where profits will be higher.

### Question 11.13

Question 11.13

Why are the cartel's profit-maximizing price and quantity similar to the monopoly price and quantity?

​​​​​​​​Hover here to see the hint for Question 11.13.

## 11.6 Cheating on the Agreement to Act Like a Monopoly

Suppose that each of three firms in an industry has one-third of the market demand.  (Examples might be the largest three automobile sellers in the U.S. – General Motors, Ford, and Toyota, controlling more than 65 percent of the market.  Or the three largest airlines – American, United, and Delta.)

Assume that the three are currently functioning as an effective cartel.  Now suppose one of the firms has aggressive new stockholders.  And those stockholders encourage the firm to increase its profits, and it responds by lowering its price very quietly.  Why would it follow that strategy?  After all, if all three together lower their prices, the quantity demanded will increase.  They will end up producing where marginal cost is greater than marginal revenue.  And thus, not maximizing industry profits.

To see why cheating on the cartel agreement is tempting, consider what would happen if one firm lowers its price. Figure 11.7 might help to think this though.

### Question 11.14

Question 11.14

What might happen if one firm lowers its price?

​​​​​​​​​Hover here to see the hint for Question 11.14.

If one of the firms lowers its price, it will be able to sell a lot more. Part of the increase in quantity sold will be due to new consumers who are now willing to pay the lower price offered by the more aggressive firm. This is movement along the market demand curve. However, the firm cutting price sees a larger increase in quantity sold than this.

The firm acting alone will also take some customers away from the other two firms.  As a result, the marginal revenue for the firm that lowers its price will be greater than the marginal revenue if all firms lowered price.  Because the industry marginal revenue was equal to marginal cost, the marginal revenue for the single firm is greater than the marginal cost.  Therefore, it is tempting for all firms in a cartel to cut their price. If all other firms stick with the plan, one firm can increase its profits by lowering its price.

If a single firm believes that it can get away with lowering its price and not get caught, it has a strong incentive to do so.  That is why in a cartel, there is always an incentive to cheat.  However, when the cheating happens, other firms will lose business and wonder why.  If they are able to figure out that one firm is cheating, then they will respond.  And if all firms lower prices, they will all earn lower profits.  If the products sold by all firms are very close substitutes, and the firms in an oligopoly compete aggressively, we could see price fall to the level we would see in a competitive market.

### Question 11.15

Question 11.15

Is the demand curve facing one of the firms in a cartel more elastic or less elastic than market demand? Why?

​​​​​​​​​​Hover here to see the hint for Question 11.15.

### Question 11.16

Question 11.16

Is marginal revenue facing a single firm in the cartel different than the marginal revenue curve facing the whole market? Which is higher and why?

​​​​​​​​​​​Hover here to see the hint for Question 11.16.

## 11.7 A Payoff Matrix

Another way to think about the challenges facing oligopolists when setting price is to illustrate their choices in a payoff matrix. Figure 11.8 shows a payoff matrix for automobile companies and their price setting. These payoff matrices are usually organized in a 2 by 2 table with two actors or players – in this case, Ford and General Motors. We’ve simplified things a bit so that the actors have two possible actions or strategies: lower price or not change price at all. The payoffs or profits depend on not only one’s own strategy but also the other actor’s strategy.

Suppose that Ford and General Motors are the two largest producers. Figure 11.9 shows two options for Ford – not to change their current prices or to lower their current prices. The same two options are shown for General Motors. The upper left-hand rectangle shows what happens to profits if Ford and GM do not change their prices. The upper right-hand rectangle shows the effects if Ford lowers prices and GM does not.

​Suppose at current prices, General Motors earns $10 million per year and Ford earns$20 million per year. If Ford lowers their prices, they will sell more and take some customers away from General Motors. Thus, their profits increase and General Motors loses customers (and profits). If General Motors, alone, lowers its prices, GM will gain sales and profits and Ford will lose sales and profits. However, if both firms lower prices, the industry and the companies end up producing more and earning lower profits.

### Question 11.17

Question 11.17

What incentives does Ford have to lower prices? What happens to all of the firms? What are the incentives and what might happen as a result?

​​​​​​​​​​​Hover here to see the hint for Question 11.17.

​Is this cheating or is it competition? It is cheating on an agreement, explicit or implicit, not to compete. The cheating then becomes a decision to compete with the other oligopolies.

### ​11.7.1 A Solution to the Payoff Matrix

​The payoff matrix illustrates a simple and interesting case of strategic behavior. Notice that if the firms could manage to cooperate, industry profits will be the greatest if both companies charge high prices. Lucky for consumers, that turns out to be a difficult outcome to achieve. You see, it’s in Ford’s best interest to charge a lower price. The same is true for GM! Even though both firms could make a greater total profit if they agreed to keep prices high, the temptation to earn higher profits will push them both to charge low prices.

### Question 11.18

Question 11.18

Summarize, in your own words, the economic model of oligopolistic behavior.

​​​​​​​​Hover here to see the hint for Question 11.18.

## 11.8 The Four Market Models

​At this point, you should take a few minutes to compare all four of the market models. Think about the differences in the conditions and nature of each type of model. Then see if you can summarize and compare the resulting prices, quantities, profits, and economic efficiencies of each market type in the long run.

Question 11.19

Complete the "Price = marginal cost" column by matching the market structure to the correct response.

Premise
Response
1

Perfect competition

A

Yes

2

Monopolistic competition

B

Yes

3

Oligopoly

C

Yes

4

Monopoly (unregulated)

D

No

E

No

F

No

G

No

Question 11.20

Complete the "Average cost at a minimum in the long run" column by matching the market structure to the correct response.

Premise
Response
1

Perfect competition

A

Yes

2

Monopolistic competition

B

No

3

Oligopoly

C

Yes

4

Monopoly (unregulated)

D

No

E

Yes

F

No

G

No

Question 11.21

Complete the "Economic profits in the long run" column by matching the market structure to the correct response. Assume that oligopolies are successful in cooperating with one another.

Premise
Response
1

Perfect competition

A

Yes

2

Monopolistic competition

B

Yes

3

Oligopoly

C

Yes

4

Monopoly (unregulated)

D

No

E

No

F

No

G

No

## 11.9 Summary

• ​Markets characterized by relatively easy entry and exit and with many firms producing somewhat differentiated products are described as monopolistically competitive markets.
• Firms in those markets will, in the long run, produce less than perfectly competitive firms and charge prices that are greater than marginal costs.
• Firms will tend to be technically and allocatively inefficient.
• Markets characterized by relatively few firms with relatively difficult entry and exit are called oligopolies.
• Firms in those markets will wish to act as though they are all members of a cartel agreeing on prices and quantities in such a manner that the industry profits are maximized. The firms together will attempt to act as a monopoly would.
• If they are successful, the outcome will be an economically inefficient outcome, but industry profits will be maximized.
• Members of a cartel always have incentives to cheat on agreements. The cheating that may evolve will bring the industry outcome closer to a competitive outcome.
• One should be able to compare the characteristics and outcomes of all four market models and describe behavior of each in response to changes in demand and supply conditions.

Question 11.22

An increase in product differentiation created by advertising in a market with many firms will $\_\_\_\_\_\_\_$ the elasticity of demand facing the firm:

A

Increase

B

Decrease

C

Increase or decrease

D

Not change

Question 11.23

The long-run result of that advertising will be a(n) $\_\_\_\_\_\_\_$ in the price of the good.

A

Increase

B

Decrease

C

Increase or decrease

D

Not change

Question 11.24

Monopolistically competitive firms $\_\_\_\_\_\_\_\_\_$ earn economic profits in the $\_\_\_\_\_\_\_\_\_$.

A

May; short and long runs

B

May; long run only

C

May; short run only

D

Will not; either the short or long run

​​

Question 11.25

A single oligopolistic firm charging a price where industry marginal revenue is equal to marginal cost will be tempted to $\_\_\_\_\_\_\_$ prices, because it faces a more $\_\_\_\_\_$ demand if it alone changes its price.

A

Raise; inelastic

B

Raise; elastic

C

Lower; inelastic

D

Lower; elastic

​​​

Question 11.26

An oligopolistic industry with the same costs as a monopoly will have prices:

A

Equal to a monopoly price.

B

Greater than a monopoly price.

C

Less than or equal to a monopoly price.

D

Less than a monopoly price.

E

Greater than or equal to a monopoly price.

Question 11.27

Which of the following is true for a profit-maximizing monopolistic competitor?

A

Marginal cost = price

B

Marginal cost> marginal revenue

C

Marginal cost = marginal revenue

D

Marginal cost < marginal revenue

​​​​​

## 11.10 Key Concepts

• Monopolistic competition
• Product differentiation
• Prices and outputs
• Short and long runs
• Oligopoly
• Monopoly pricing
• Cartels
• Cheating
• Economic efficiency

## 11.11 Glossary

​Cartel: A group of producers agreeing to act in concert with one another.

Monopolistic competition: An industry with many competitors, all producing slightly different products.

Oligopoly: An industry with few producers, high entry barriers, and each one has market power. They compete on either price or quantity and may charge the same or different prices.

Payoff Matrix: A payoff matrix is usually a two-by-two table with two actors or players. Each player will have a set of actions that will result in different payoffs. Each player’s payoff is dependent on both players’ course of action.

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There are far more competitors in the restaurant industry than in the automobile industry. This is likely due to the barriers to entering the automobile industry compared to opening a new restaurant. There are much larger economies of scale in automobile production compared to the production of a meal. Both industries produce goods that are unique when compared to a competitor’s product.

A perfectly competitive firm will not influence the price of the goods. Market supply and demand will determine the equilibrium price and equilibrium quantity for the whole market. For any single perfectly competitive firm, raising price will mean that all consumers will buy their products from someone next door. From a graphing perspective, we will have a horizontal demand curve.

​The monopolistically competitive firm will have a more elastic demand than a monopoly because there will likely be more close substitutes. A monopoly has fewer substitutes and no close substitutes. The greater number of substitutes will cause elasticity to increase. It is easier for individuals to switch to consuming other goods when prices rise.

​To maximize profit, we need to produce at the quantity where the marginal revenue equals marginal cost. This is the same decision rule for monopolies.

​Average cost will not be at a minimum. Marginal cost will be less than price. Economic profits can be earned (in the short run). Average costs at each level of output (with one exception) will be as low as possible, as firms are forced through competition to use the best technology and least expensive inputs. The exception is that firms may advertise or devote resources to differentiate their products in other ways. This obviously increases the cost to a level above the perfectly competitive costs.

​If demand increases, in the short run marginal revenue will rise. Firms will increase output since marginal revenue exceeds marginal cost. Economic profits will rise in the short run, new firms will enter, and this will lower demand for each firm’s output; thus, profits will go down again.

​If variable costs increase, firms will reduce production. Since average costs increased, firms will be making economic losses. In the long run, some firms will leave the industry. Demand for each remaining firm’s output will increase. The likely result will be an increase in price. It is more difficult to tell about quantity.

​If fixed costs fall, economic profits will increase. No change will be made in the short run. However, the economic profits will attract competitors, and the increased competition will increase the quantity produced and force prices down. If fixed costs rise, firms will exit the industry.

​A market that is monopolistically competitive will have many firms; a variety of types of products, each one slightly different; relatively easy entry and exit; and lots of information among buyers and sellers. Given that entry and exit is relatively easy, there will not be economic profits for firms in the long run. However, firms will produce where marginal costs are less than prices, and thus less than an allocatively efficient amount of output will be produced.

​We would use the same rationale as in the case of monopoly. We would maximize the profit for one firm within any industry structure. For firms operating in an oligopoly industry structure, setting marginal revenue equal to marginal cost will achieve that goal of maximizing profits for the industry.

​A monopoly maximizes its profits if it produces where marginal cost equals marginal revenue. Because a monopoly is the only firm in an industry, it is producing where industry profits are maximized. Thus, a small group of firms would want to produce the same level of output and price as a monopolist if total industry profits are to be maximized.

​If one firm lowers its price, it will likely attract new customers and attract some existing companies’ customers away.

​Demand facing a single firm is more elastic. This is because a small decrease in price will not only attract more buyers (movement along the market demand curve), but it will also attract buyers from the other members of the cartel who are charging a higher price.

​The marginal revenue for the individual firm includes the marginal revenue for the entire industry plus some additional revenue that it takes away from the other existing firms.

​Profits will increase for Ford if it can lower prices and get away with it, that is, not have General Motors also lower prices. The same is true for General Motors.

However, when Ford lowers prices, General Motors will find its profits falling rather dramatically as customers switch to Ford. To protect itself, General Motors may well lower prices in response to the initial cut by Ford.

The end result is that both companies end up earning less than they could have earned if they all kept their higher prices.

​The moral of the story is that oligopolistic industries will benefit from agreements to price and produce like monopolies. If they are able to do that, they will be able to maximize profits for all firms together, that is, for the entire industry. However, there is always the incentive to “cheat” on the agreement. A firm that lowers its prices will do so to increase its own production and profits. However, other firms will match the decreases. That cheating on the original attempts to maximize industry profits will result in lower profits, lower prices, and greater quantities for all firms together than the monopoly level of profits, prices, and quantities.

## Data Sources

### [1]

Source: Bennett, J., & Mitchell, J. (2011, Jul 22). Fiat acquires majority share of Chrysler. Wall Street Journal. Retrieved from https://www.wsj.com/articles/SB10001424053111903554904576460100757324330

### [2]

Source: ​U.S. Bureau of Economic Analysis, Domestic Auto Production [DAUPSA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DAUPSA, June 25, 2017.

## Image Credits

[1] Image courtesy of Ford Motor Co. under CC BY 2.0.

Monopolistically Competitive Market
An industry with many competitors, all producing slightly different products.
Think about the number of competitors within a market; ease of entry, etc.
How many units would a perfectly competitive firm sell if it charged a price higher than the market price?
Think about how likely consumers are to substitute if price rises for a monopolist and a monopolistically competitive firm.
Think in terms of marginal benefit and marginal cost.
Is average cost at a minimum? Does marginal cost = price? What are the economic profits? Are average costs as low as possible for a given quantity?
What happens to marginal revenue? How will firms respond in the short run to this change?
Think about the change in marginal cost and the resulting change in price level and profit margin.
Think about the change in economic profit. Only changing fixed cost will not have any impact on either marginal cost or marginal revenue.
Think about the following aspects of this market structure: number of firms, product differentiation, entry barriers, availability of information, and short- and long-run profitability.
Oligopolistic industry: Only a few firms producing similar (or differentiated) products.
If several firms act as one, what would they act like?
Cartel
A group of producers agreeing to act in concert with one another.
The output decision were determined by both marginal revenue and marginal cost.
Think about what will happen if one firm charges a lower price for the same product.