MARKETS WITH MARKET POWER - Tufts University

convenience, etc., but it can also reduce social well-being. Students should recognize that
advertising can impose costs on society by increasing prices, encouraging irresponsible
spending, and targeting children. Some non-price competition, such as disposable products
and single-serve portions can increase environmental impacts.
4.1. a) In a prisoner’s dilemma situation, each firm would benefit from having the lower price.
However, with both firms taking a low-price strategy and no cooperation, neither firm will
gain a price advantage. The result will likely be lower profits for both due to a price war.
b) If the two firms collude to set price, they can both maintain high profits. Note, however,
that each firm also has an incentive to lower price and capture a larger market share and
higher profits.
4.2. The payoff matrix with revised labels is given below. The “Low Price” labels are replaced
with “Spend a lot” and “High Price” is replaced with “Spend a little.” Firms undertake
advertising because they want to increase sales and revenues (and raise profits), but
advertising also costs money (an expense which reduces profits). In this case, each firm
perceives a benefit from a lot of advertising because, if its rival doesn’t advertise as much, it
will be able to steal the other’s customers and make high profits. If one chooses not to spend
much while its rival spends a lot, the situation is reversed, and the first firm will make losses.
However, if both spend a lot, they have to split the customer base while having high
expenses, yielding low profits. If both spend only a little, they will again split the customer
base, but their expenses (for ads that essentially cancel each other out) aren’t as high, so their
profits will be moderate. Each one will realize that the worst they can do if they spend a lot is
get a low profit, while if they only spend a little they could end up making losses. As a
result, the noncooperative outcome is for both firms to spend a lot of money on advertising,
and make low profits (the upper left cell in the figure below). If advertising were severely
limited by law, each firm would save on ineffective advertising costs and the moderate profit
(lower right cell) payoff could be reached instead. Thus, the companies’ profits would
increase if they are both forced to cut back. While the government has limited advertising of
cigarettes and alcohol for public health reasons, this could have the somewhat perverse result
of increasing profits to the cigarette and alcohol manufacturers!
Firm 2’s Options
Firm 1’s Options
Spend a
lot
Spend a
little
Spend a lot
low profit
low profit
high profit
loss
Spend a little
loss
high profit
moderate profit
moderate profit
5.1. Recall from Chapter 5 that Braeburn does have a monopoly on the particular book of
poetry they are selling, but they compete with many other publishing firms. Thus, the market
structure of monopolistic competition corresponds most with Braeburn’s position. As they
increase the price of the book, they will lose some (but not all) customers. Braeburn will
Chapter 12 − Markets with Power 6