MARKETS WITH MARKET POWER - Tufts University

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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
most likely engage in non-price competition to differentiate themselves from other publishers. They may advertise to specific markets, sponsor books signings, and use other tactics to promote their books. 5.2. This question is designed to tap into the real-world knowledge that some students might have about market structure. It may be best run as a full-class exercise, taking the experience of one or a few students, and having a full-class discussion of each case. Students should be encouraged not just to tell stories, but rather use the stories to unravel and illustrate (and even critique) the “conditions” for the various market structures described in the text. For less experienced classes, you might substitute a general call for examples, with an example of your own of a well-known consumer-good manufacturer that has been in the news. Answers to End-of-Chapter Review Questions 1. The three idealized market structures with market power are: pure monopoly (only one seller), monopolistic competition (many sellers, but they sell slightly different things), and oligopoly (so few sellers that they each need to watch what the others are doing). 2. Pure monopoly is characterized by: only one seller, the good being sold has no close substitutes, and barriers of entry exist. 3. Three types of barriers to entry are: economic barriers (high fixed costs, network externalities, economies of scale), legal barriers (copyrights, franchises, patents, trademarks), and deliberate barriers (exclusionary practices, predatory pricing, dumping). 4. A pure monopolist is imagined to maximize profits by producing where marginal revenue equals marginal cost but charging as high a price as it can on the market demand curve. 5. Monopolists are inefficient because: deadweight loss is created (the price level exceeds marginal cost), innovations may be reduced, costs may be spent to maintain barriers to entry, and rent-seeking behavior. 6. Monopoly market power generally leads to inefficiencies in the form of deadweight loss. The monopolist produces at an output level at which price exceeds marginal cost and society could gain from increased output of the product. See Figure 12.2. 7. Four cases in which a monopoly might be efficient are: natural monopolies (economies of scale dictate that one firm can produce at the minimum per-unit cost), intellectual property (the potential benefits of patents, trademarks, etc. actually encourage innovations), pressure to appear competitive (firms worry that too-high monopoly profits will attract too much attention so they operate more like a competitive firm), and perfect price discrimination (the monopolist is able to charge every buyer his or her maximum willingness to pay). Chapter 12 − Markets with Power 7
Page 1 and 2: Chapter 12 MARKETS WITH MARKET POWE
Page 3 and 4: • Monopolists may also use their
Page 5: Notes on Text Discussion Questions
Page 9 and 10: Quantity of Output (Demanded) Selli
Page 11 and 12: Competition and Concentration There
Page 13 and 14: Table 2: Production and Costs under
Page 15 and 16: Exercise on Monopoly Profit-Maximiz
Page 17 and 18: Question on Monopoly Profit Maximiz
Page 19 and 20: industry demand curve AWE's MR q p
Page 21: The Grading Game a) suppose that I

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