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Ge273.u9.pp1
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte CHAPTER 7 Firms, the Stock Market, and Corporate Governance Fernando Quijano Prepared by: When Mark Zuckerberg started Facebook in 2004, he was still a sophomore in college. Just five years later, Facebook had 150 million users.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte 7.1 Types of Firms Categorize the major types of firms in the United States. 7.2 The Structure of Corporations and the Principal–Agent Problem Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. 7.3 How Firms Raise Funds Explain how firms raise the funds they need to operate and expand. 7.4 Using Financial Statements to Evaluate a Corporation Understand the information provided in corporations’ financial statements. 7.5 Corporate Governance Policy Understand the role of government in corporate governance. Appendix: Tools to Analyze Firms’ Financial Information Understand the concept of present value and the information contained on a firm’s income statement and balance sheet. Chapter Outline and Learning Objectives CHAPTER 7 Firms, the Stock Market, and Corporate Governance
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Types of Firms Sole proprietorship A firm owned by a single individual and not organized as a corporation. Partnership A firm owned jointly by two or more persons and not organized as a corporation. Corporation A legal form of business that provides owners with protection from losing more than their investment should the business fail. Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Asset Anything of value owned by a person or a firm. Limited liability The legal provision that shields owners of a corporation from losing more than they have invested in the firm. SOLE PROPRIETORSHIP PARTNERSHIP CORPORATION ADVANTAGES • Control by owner • No layers of management • Ability to share work • Ability to share risks • Limited personal liability • Greater ability to raise funds DISADVANTAGES • Unlimited personal liability • Unlimited personal liability • Costly to organize • Limited ability to raise funds • Limited ability to raise funds • Possible double taxation of income Who Is Liable? Limited and Unlimited Liability Table 7-1 Differences among Business Organizations Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE Types of Firms
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Types of Firms Corporations Earn the Majority of Revenue and Profits FIGURE 7-1 Business Organizations: Sole Proprietorships, Partnerships, and Corporations The three types of firms in the United States are sole proprietorships, partnerships, and corporations. Panel (a) shows that only 19 percent of all firms are corporations. Yet, as panels (b) and (c) show, corporations account for a large majority of the total revenue and profits earned by all firms. Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte How Important Are Small Businesses to the U.S. Economy? Making the Connection In a typical year, 40 percent of new jobs are created by small firms like Yelp.com, which is a community-based review and directory website founded by Jeremy Stoppelman, left, and Russel Simmons. YOUR TURN: Test your understanding by doing related problem 1.6 at the end of this chapter. Entrepreneurs founding small firms have been the source of many of the most important new goods and services available to consumers. Categorize the major types of firms in the United States. 7.1 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte The Structure of Corporations and the Principal–Agent Problem Corporate Structure and Corporate Governance Separation of ownership from control A situation in a corporation in which the top management, rather than the shareholders, control day-to-day operations. Corporate governance The way in which a corporation is structured and the effect a corporation’s structure has on the firm’s behavior. Principal–agent problem A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him. Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. 7.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Solved Problem 7-2 Does the Principal–Agent Problem Apply to the Relationship between Managers and Workers? Briefly explain whether you agree with the following argument: The principal–agent problem applies not just to the relationship between shareholders and top managers. It also applies to the relationship between managers and workers. Just as shareholders have trouble monitoring whether top managers are earning as much profit as possible, managers have trouble monitoring whether workers are working as hard as possible. YOUR TURN: For more practice, do related problems 2.4 and 2.5 at the end of this chapter. Describe the typical management structure of corporations and understand the concepts of separation of ownership from control and the principal–agent problem. 7.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte CHAPTER 12 Monopolistic Competition: The Competitive Model in a More Realistic Setting Fernando Quijano Prepared by: The coffeehouse market is competitive because it is inexpensive to open a new store. Hundreds of firms in the United States operate coffeehouses.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Monopolistic Competition: The Competitive Model in a More Realistic Setting 12.1. Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves. 12.2 How a Monopolistically Competitive Firm Maximizes Profit in the Short Run Explain how a monopolistically competitive firm maximizes profit in the short run. 12.3 What Happens to Profits in the Long Run? Analyze the situation of a monopolistically competitive firm in the long run. 12.4 Comparing Perfect Competition and Monopolistic Competition Compare the efficiency of monopolistic competition and perfect competition. 12.5 How Marketing Differentiates Products Define marketing and explain how firms use it to differentiate their products. 12.6 What Makes a Firm Successful? Identify the key factors that determine a firm’s success. Chapter Outline and Learning Objectives CHAPTER 12
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Monopolistic competition A market structure in which barriers to entry are low and many firms compete by selling similar, but not identical, products. Monopolistic Competition: The Competitive Model in a More Realistic Setting
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte The Demand Curve for a Monopolistically Competitive Firm FIGURE 12-1 The Downward-Sloping Demand for Caffè Lattes at a Starbucks Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves. 12.1 LEARNING OBJECTIVE Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market If a Starbucks increases the price of caffè lattes, it will lose some, but not all, of its customers. In this case, raising the price from $3.00 to $3.25 reduces the quantity of caffè lattes sold from 3,000 to 2,400. Therefore, unlike a perfect competitor, a Starbucks store faces a downward-sloping demand curve.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Marginal Revenue for a Firm with a Downward-Sloping Demand Curve Table 12-1 CAFFÈ LATTES SOLD PER WEEK (Q) PRICE (P) TOTAL REVENUE (TR = P x Q) AVERAGE REVENUE (AR = TR/Q) MARGINAL REVENUE (MR = ΔTR/ΔQ) 0 1 2 3 4 5 6 7 8 9 10 $6.00 5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 $0.00 5.50 10.00 13.50 16.00 17.50 18.00 17.50 16.00 13.50 10.00 ― $5.50 5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 ― $5.50 4.50 3.50 2.50 1.50 0.50 –0.50 –1.50 –2.50 –3.50 Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves. 12.1 LEARNING OBJECTIVE Demand and Marginal Revenue at a Starbucks Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Marginal Revenue for a Firm with a Downward-Sloping Demand Curve FIGURE 12-2 How a Price Cut Affects a Firm’s Revenue Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves. 12.1 LEARNING OBJECTIVE If the local Starbucks reduces the price of a caffè latte from $3.50 to $3.00, the number of caffè lattes it sells per week will increase from 5 to 6. Its marginal revenue from selling the sixth caffè latte will be $0.50, which is equal to the $3.00 additional revenue from selling 1 more caffè latte (the area of the green box) minus the $2.50 loss in revenue from selling the first 5 caffè lattes for $0.50 less each (the area of the red box). Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 12-3 The Demand and Marginal Revenue Curves for a Monopolistically Competitive Firm Marginal Revenue for a Firm with a Downward-Sloping Demand Curve Any firm that has the ability to affect the price of the product it sells will have a marginal revenue curve that is below its demand curve. We plot the data from Table 12-1 to create the demand and marginal revenue curves. After the sixth caffè latte, marginal revenue becomes negative because the additional revenue received from selling 1 more caffè latte is smaller than the revenue lost from receiving a lower price on the caffè lattes that could have been sold at the original price. Explain why a monopolistically competitive firm has downward-sloping demand and marginal revenue curves. 12.1 LEARNING OBJECTIVE Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte How a Monopolistically Competitive Firm Maximizes Profit in the Short Run FIGURE 12-4 Maximizing Profit in a Monopolistically Competitive Market Explain how a monopolistically competitive firm maximizes profit in the short run. 12.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Will Apple maximize profits if it produces 800,000 iPhones per month? Does Minimizing Cost Maximize Profits? Solved Problem 12-2 Average cost reaches a minimum at a quantity of 800,000, but profits are maximized at a quantity of 600,000. YOUR TURN: For more practice, do related problem 2.6 at the end of this chapter. Explain how a monopolistically competitive firm maximizes profit in the short run. 12.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte What Happens to Profits in the Long Run? How Does the Entry of New Firms Affect the Profits of Existing Firms? FIGURE 12-5 How Entry of New Firms Eliminates Profits Panel (a) shows that in the short run Starbucks can charge a price above average total cost (point A) and make a profit, shown by the green rectangle. But this profit attracts new firms to enter the market, which shifts the demand and marginal revenue curves to the curves labeled “Long run” in panel (b). At point B, Starbucks breaks even. Analyze the situation of a monopolistically competitive firm in the long run. 12.3 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Table 12-2 The Short Run and the Long Run for a Monopolistically Competitive Firm How Does the Entry of New Firms Affect the Profits of Existing Firms? What Happens to Profits in the Long Run? Analyze the situation of a monopolistically competitive firm in the long run. 12.3 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte The Rise and Decline of Starbucks Making the Connection YOUR TURN: Test your understanding by doing related problem 3.6 at the end of this chapter. Starbucks: No longer different enough? In a monopolistically competitive industry, maintaining profits in the long run is very difficult. Analyze the situation of a monopolistically competitive firm in the long run. 12.3 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Is Zero Economic Profit Inevitable in the Long Run? What Happens to Profits in the Long Run? A firm’s profits will be eliminated in the long run only if a firm stands still and fails to find new ways of differentiating its product or fails to find new ways of lowering the cost of producing its product. Analyze the situation of a monopolistically competitive firm in the long run. 12.3 LEARNING OBJECTIVE Don’t Let This Happen to YOU! Don’t Confuse Zero Economic Profit with Zero Accounting Profit YOUR TURN: Test your understanding by doing related problem 3.4 at the end of this chapter.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Can It Be Profitable to Be the High-Price Seller? Solved Problem 12-3 YOUR TURN: For more practice, do related problem 3.7 at the end of this chapter. Because the greater demand more than offsets the higher costs, the hhgregg store makes a larger profit. Analyze the situation of a monopolistically competitive firm in the long run. 12.3 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte • Monopolistically competitive firms charge a price greater than marginal cost. • Monopolistically competitive firms do not produce at minimum average total cost. Monopolistic competition and perfect competition share the characteristic that in long-run equilibrium, firms earn zero economic profits. However, there are two important differences between long- run equilibrium in the two markets: Compare the efficiency of monopolistic competition and perfect competition. 12.4 LEARNING OBJECTIVE Comparing Perfect Competition and Monopolistic Competition
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Excess Capacity under Monopolistic Competition FIGURE 12-6 Comparing Long-Run Equilibrium under Perfect Competition and Monopolistic Competition Comparing Perfect Competition and Monopolistic Competition A monopolistically competitive firm has excess capacity: If it increased its output, it could produce at a lower average cost. Compare the efficiency of monopolistic competition and perfect competition. 12.4 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Economists have debated whether monopolistically competitive markets being neither productively nor allocatively efficient results in a significant loss of well-being to society in these markets compared with perfectly competitive markets. How Consumers Benefit from Monopolistic Competition Consumers benefit from being able to purchase a product that is differentiated and more closely suited to their tastes. Is Monopolistic Competition Inefficient? Compare the efficiency of monopolistic competition and perfect competition. 12.4 LEARNING OBJECTIVE Comparing Perfect Competition and Monopolistic Competition
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Abercrombie & Fitch: Can the Product Be Too Differentiated? Did Abercrombie and Fitch narrow its target market too much? Making the Connection YOUR TURN: Test your understanding by doing related problem 4.6 at the end of this chapter. Compare the efficiency of monopolistic competition and perfect competition. 12.4 LEARNING OBJECTIVE A firm whose strategy of product differentiation succeeds will experience increases in same-store sales.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte How Marketing Differentiates Products Marketing All the activities necessary for a firm to sell a product to a consumer. Brand Management Brand management The actions of a firm intended to maintain the differentiation of a product over time. Define marketing and explain how firms use it to differentiate their products. 12.5 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte If the increase in revenue that results from the advertising is greater than the increase in costs, the firm’s profits will rise. Advertising How Marketing Differentiates Products Define marketing and explain how firms use it to differentiate their products. 12.5 LEARNING OBJECTIVE Defending a Brand Name A firm can apply for a trademark, which grants legal protection against other firms using its product’s name.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Google Tries (and Fails) to Measure the Effectiveness of Radio Advertising Making the Connection Does spending on radio advertising attract customers? YOUR TURN: Test your understanding by doing related problem 5.7 at the end of this chapter. Define marketing and explain how firms use it to differentiate their products. A firm’s optimal level of advertising occurs where the marginal cost of advertising equals the marginal revenue earned from advertising. 12.5 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte What Makes a Firm Successful? FIGURE 12-7 What Makes a Firm Successful? Identify the key factors that determine a firm’s success. 12.6 LEARNING OBJECTIVE The factors under a firm’s control—the ability to differentiate its product and the ability to produce it at lower cost— combine with the factors beyond its control to determine the firm’s profitability.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Although not first to market, Bic ultimately was more successful than the firm that pioneered ballpoint pens. Is Being the First Firm in the Market a Key to Success? Making the Connection YOUR TURN: Test your understanding by doing related problem 6.6 at the end of this chapter. Identify the key factors that determine a firm’s success. 12.6 LEARNING OBJECTIVE The firms that were first to introduce a product ultimately lost out to latecomers who did a better job of providing consumers with products that were more reliable, less expensive, more convenient, or otherwise provided greater value.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Starbucks Faces McCompetition AN INSIDE LOOK >> The effect of entry on price, quantity, and profits at Starbucks.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte CHAPTER 13 Oligopoly: Firms in Less Competitive Markets Fernando Quijano Prepared by: Today, in the software and computer industries, fewer than 10 firms account for the great majority of sales.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte CHAPTER 13 Oligopoly: Firms in Less Competitive Markets 13.1 Oligopoly and Barriers to Entry Show how barriers to entry explain the existence of oligopolies. 13.2 Using Game Theory to Analyze Oligopoly Use game theory to analyze the strategies of oligopolistic firms. 13.3 Sequential Games and Business Strategy Use sequential games to analyze business strategies. 13.4 The Five Competitive Forces Model Use the five competitive forces model to analyze competition in an industry. Chapter Outline and Learning Objectives
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Oligopoly: Firms in Less Competitive Markets Oligopoly A market structure in which a small number of interdependent firms compete.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Oligopoly and Barriers to Entry RETAIL TRADE MANUFACTURING INDUSTRY FOUR-FIRM CONCENTRATION RATIO INDUSTRY FOUR-FIRM CONCENTRATION RATIO Discount department stores 95% Cigarettes 95% Warehouse clubs and supercenters 92% Beer 91% Hobby, toy, and game stores 72% Aircraft 81% Athletic footwear stores 71% Breakfast cereal 78% College bookstores 70% Automobiles 76% Radio, television, and other electronic stores 69% Computers 75% Pharmacies and drugstores 53% Dog and cat food 64% Table 13-1 Examples of Oligopolies in Retail Trade and Manufacturing Show how barriers to entry explain the existence of oligopolies. 13.1 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Oligopoly and Barriers to Entry Barriers to Entry Barrier to entry Anything that keeps new firms from entering an industry in which firms are earning economic profits. Economies of Scale Economies of scale The situation when a firm’s long-run average costs fall as it increases output. Show how barriers to entry explain the existence of oligopolies. 13.1 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 13-1 Economies of Scale Help Determine the Extent of Competition in an Industry Oligopoly and Barriers to Entry Barriers to Entry Economies of Scale An industry will be competitive if the minimum point on the typical firm’s long-run average cost curve (LRAC1) occurs at a level of output that is a small fraction of total industry sales, such as Q1. The industry will be an oligopoly if the minimum point comes at a level of output that is a large fraction of industry sales, such as Q2. Show how barriers to entry explain the existence of oligopolies. 13.1 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte If production of a good requires a particular input, then control of that input can be a barrier to entry. Government-Imposed Barriers Patent The exclusive right to a product for a period of 20 years from the date the product is invented. Oligopoly and Barriers to Entry Barriers to Entry Ownership of a Key Input Show how barriers to entry explain the existence of oligopolies. 13.1 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Using Game Theory to Analyze Oligopoly Game theory The study of how people make decisions in situations in which attaining their goals depends on their interactions with others; in economics, the study of the decisions of firms in industries where the profits of each firm depend on its interactions with other firms. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Using Game Theory to Analyze Oligopoly All games share three key characteristics: 1. Rules that determine what actions are allowable 2. Strategies that players employ to attain their objectives in the game 3. Payoffs that are the results of the interaction among the players’ strategies Business strategy Actions taken by a firm to achieve a goal, such as maximizing profits. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Using Game Theory to Analyze Oligopoly A Duopoly Game: Price Competition between Two Firms FIGURE 13-2 A Duopoly Game HP’s profits are in blue, and Apple’s profits are in red. HP and Apple would each make profits of $10 million per month on sales of desktop computers if they both charged $1,200. However, each firm has an incentive to undercut the other by charging a lower price. If both firms charge $1,000, they would each make a profit of only $7.5 million per month. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE Don’t Let This Happen to YOU! Don’t Misunderstand Why Each Manager Ends Up Charging a Price of $1,000 YOUR TURN: Test your understanding by doing related problem 2.14 at the end of this chapter.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Payoff matrix A table that shows the payoffs that each firm earns from every combination of strategies by the firms. Collusion An agreement among firms to charge the same price or otherwise not to compete. Using Game Theory to Analyze Oligopoly A Duopoly Game: Price Competition between Two Firms Dominant strategy A strategy that is the best for a firm, no matter what strategies other firms use. Nash equilibrium A situation in which each firm chooses the best strategy, given the strategies chosen by other firms. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Cooperative equilibrium An equilibrium in a game in which players cooperate to increase their mutual payoff. Noncooperative equilibrium An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Prisoner’s dilemma A game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off. Using Game Theory to Analyze Oligopoly Firm Behavior and the Prisoner’s Dilemma Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Solved Problem 13-2 Is Advertising a Prisoner’s Dilemma for Coca-Cola and Pepsi? Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE YOUR TURN: For more practice, do related problems 2.11, 2.12, and 2.13 at the end of this chapter. Given that Coca-Cola is advertising, Pepsi’s best strategy is to advertise. Therefore, advertising is the optimal decision for both firms, given the decision by the other firm.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Is There a Dominant Strategy for Bidding on eBay? Making the Connection On eBay, bidding the maximum value you place on an item is a dominant strategy. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE YOUR TURN: Test your understanding by doing related problem 2.15 at the end of this chapter.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 13-3 Changing the Payoff Matrix in a Repeated Game Using Game Theory to Analyze Oligopoly Can Firms Escape the Prisoner’s Dilemma? Wal-Mart and Target can change the payoff matrix for selling PlayStation 3 game consoles by advertising that they will match their competitor’s price. This retaliation strategy provides a signal that one store charging a lower price will be met automatically by the other store charging a lower price. In the payoff matrix in panel (a), there is no matching offer, and each store benefits if it charges $300 when the other charges $500. In the payoff matrix in panel (b), with the matching offer, the companies have only two choices: They can charge $500 and receive a profit of $10,000 per month, or they can charge $300 and receive a profit of $7,500 per month. The equilibrium shifts from the prisoner’s dilemma result of both stores charging the low price and receiving low profits to both stores charging the high price and receiving high profits. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Using Game Theory to Analyze Oligopoly Can Firms Escape the Prisoner’s Dilemma? Price leadership A form of implicit collusion in which one firm in an oligopoly announces a price change and the other firms in the industry match the change. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte American Airlines and Northwest Airlines Fail to Cooperate on a Price Increase Making the Connection The airlines have trouble raising the price this business traveler pays for a ticket. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE Airlines therefore continually adjust their prices while at the same time monitoring their rivals’ prices and retaliating against them either for cutting prices or failing to go along with price increases. YOUR TURN: Test your understanding by doing related problems 2.17 and 2.18 at the end of this chapter.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 13-4 Oil Prices, 1972 to mid– 2009 Cartel A group of firms that collude by agreeing to restrict output to increase prices and profits. Using Game Theory to Analyze Oligopoly Cartels: The Case of OPEC The blue line shows the price of a barrel of oil in each year. The red line measures the price of a barrel of oil in terms of the purchasing power of the dollar in 2009. By reducing oil production, OPEC was able to raise the world price of oil in the mid-1970s and early 1980s. Sustaining high prices has been difficult over the long run, however, because members often exceed their output quotas. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 13-5 The OPEC Cartel with Unequal Members Using Game Theory to Analyze Oligopoly Cartels: The Case of OPEC Because Saudi Arabia can produce much more oil than Nigeria, its output decisions have a much larger effect on the price of oil. In the figure, Low Output corresponds to cooperating with the OPEC-assigned output quota, and High Output corresponds to producing at maximum capacity. Saudi Arabia has a dominant strategy to cooperate and produce a low output. Nigeria, however, has a dominant strategy not to cooperate and instead produce a high output. Therefore, the equilibrium of this game will occur with Saudi Arabia producing a low output and Nigeria producing a high output. Use game theory to analyze the strategies of oligopolistic firms. 13.2 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 13-6 The Decision Tree for an Entry Game Sequential Games and Business Strategy Deterring Entry HP earns its highest return if it charges $600 for its netbook and Apple does not enter the market. But at that price, Apple will enter the market, and HP will earn only 16 percent. If HP charges $275, Apple will not enter because Apple will suffer an economic loss by receiving only a 5 percent return on its investment. Therefore, HP’s best decision is to deter Apple’s entry by charging $275. HP will earn an economic profit by receiving a 20 percent return on its investment. Note that the dashes indicate the situation where Apple does not enter the market, and so makes no investment and receives no return. Use sequential games to analyze business strategies. 13.3 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Solved Problem 13-3 Is Deterring Entry Always a Good Idea? Use sequential games to analyze business strategies. 13.3 LEARNING OBJECTIVE YOUR TURN: For more practice, do related problem 3.3 at the end of this chapter. Deterrence is worth pursuing only if the payoff is higher than for other strategies. In this case, expanding the market for netbooks by charging a lower price has a higher payoff, even given that Apple will enter the market.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 13-7 The Decision Tree for a Bargaining Game Sequential Games and Business Strategy Bargaining Dell earns the highest profit if it offers a contract price of $20 per copy and TruImage accepts the contract. TruImage earns the highest profit if Dell offers it a contract of $30 per copy and it accepts the contract. TruImage may attempt to bargain by threatening to reject a $20-per-copy contract. But Dell knows this threat is not credible because once Dell has offered a $20-per-copy contract, TruImage’s profits are higher if it accepts the contract than if it rejects it. Use sequential games to analyze business strategies. 13.3 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte FIGURE 13-8 The Five Competitive Forces Model The Five Competitive Forces Model Michael Porter’s model identifies five forces that determine the level of competition in an industry: (1) competition from existing firms, (2) the threat from new entrants, (3) competition from substitute goods or services, (4) the bargaining power of buyers, and (5) the bargaining power of suppliers. Use the five competitive forces model to analyze competition in an industry. 13.4 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Competition among firms in an industry can lower prices and profits. Competition in the form of advertising, better customer service, or longer warranties can also reduce profits by raising costs. Firms face competition from companies that currently are not in the market but might enter. We have already seen how actions taken to deter entry can reduce profits. The Five Competitive Forces Model Competition from Existing Firms The Threat from Potential Entrants Use the five competitive forces model to analyze competition in an industry. 13.4 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Firms are always vulnerable to competitors introducing a new product that fills a consumer need better than their current product does. If buyers have enough bargaining power, they can insist on lower prices, higher-quality products, or additional services. If many firms can supply an input and the input is not specialized, the suppliers are unlikely to have the bargaining power to limit a firm’s profits. The Five Competitive Forces Model Competition from Substitute Goods or Services The Bargaining Power of Buyers The Bargaining Power of Suppliers Use the five competitive forces model to analyze competition in an industry. 13.4 LEARNING OBJECTIVE
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Can We Predict Which Firms Will Continue to Be Successful? Making the Connection Unfortunately, Circuit City’s excellence as a company didn’t last. Use the five competitive forces model to analyze competition in an industry. 13.4 LEARNING OBJECTIVE Is it possible to draw general conclusions about which business strategies are likely to be successful in the future? YOUR TURN: Test your understanding by doing related problem 4.5 at the end of this chapter.
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© 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapte Hewlett-Packard Uses New Technology to Boost Sales of Personal Computers AN INSIDE LOOK >> Dell decides whether to sell touch-sensitive personal computers.
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