MATH 464HOMEWORK 3SPRING 2013The following assignm.docx

MATH 464
HOMEWORK 3
SPRING 2013
The following assignment is to be turned in on
Thursday, February 7, 2013.
1. Three couples are invited to a dinner party. They will
independently
show up with probabilities 0.9, 0.8, and 0.75 respectively. Let N
be the
number of couples that show up. Calculate the probability that
N = 2
2. Statistics show that 5% of men are color blind and 0.25% of
women are
color blind. If a person is randomly selected from a room with
35 men and
65 women, what is the likelihood that they are color blind?
3. Do Exercise 26 on page 14 of the book.
4. On a multiple choice exam with four choices for each
question, a student
either knows the answer to a question or marks it at random.
Suppose the
student knows the answers to 60% of the exam questions. If he
marks the
answer to question 1 correctly, what is the probability that he
knows the

answer to that question?
5. In a certain city, 30% of the people are conservative, 50% are
liberals, and
20% are independents. In a given election, 2/3 of the
conservatives voted,
80% of the liberals voted, and 50% of the independents voted. If
we pick a
voter at random, what is the probability that this person is a
liberal?
6. Let (Ω,F, P ) be a probability space and suppose that
{An}∞n=1 is an
increasing sequence of events. For each integer n ≥ 1, set
Cn =
{
A1 if n = 1
An An−1 for n ≥ 2.
Show that the Cn’s are mutually disjoint and that
∞⋃
n=1
An =
∞⋃
n=1
Cn .
1

2 SPRING 2013
7. Let (Ω,F, P ) be a probability space and suppose that
{An}∞n=1 is a
sequence of events. Set
Bn =
∞⋃
m=n
Am and Cn =
∞⋂
m=n
Am
It is clear that Bn is a decreasing sequence of events, while Cn
is an increasing
sequence of events. Show that
B =
∞⋂
n=1
Bn = {ω ∈ Ω : ω ∈ An for infinitely many values of n}
and
C =
∞⋃
n=1
Cn = {ω ∈ Ω : ω ∈ An for all but finitely many values of n}

8. Do exercise 4 on page 24 of the book.
9. Suppose we roll two fair 6-sided dice. Let X be a random
variable
corresponding to the minimum value of the two rolls. Find the
probability
mass function fX corresponding to the random variable as a
table of values
(see below).
10. The probability mass function of a discrete random variable
X is given
below as a table of values. Compute the following:
a) the probability that X is even (here we regard 0 and -4 as
even)
b) the probability that 1 ≤ X ≤ 8
c) the probability that X is -4 given that X ≤ 0
d) the probability that X ≥ 3 given that X > 0
x -4 -1 0 2 4 5 6
fX(x) 0.15 0.2 0.1 0.1 0.2 0.2 0.05
©2012 Cengage Learning. All Rights Reserved. May not be
scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
*
Monopolistic Competition and Oligopoly
Survey of ECON
Robert L. Sexton
Chapter 9

ied or duplicated, or posted to a publicly accessible website, in
whole or in part.
*
*
Chapter 9 Sections
– Monopolistic Competition
– Price and Output Determination in
Monopolistic Competition
– Monopolistic Competition versus
Perfect Competition
– Oligopoly
– Collusion and Cartels
– Game Theory and Strategic
Behavior
*
*

*
Section 1
SECTION 1 QUESTIONS
*
MONOPOLISTIC COMPETITION
a market structure with many firms selling differentiated
products
*Monopolistic competition has features in common with both
monopoly and perfect competition. Like monopoly, individual
sellers believe that they have some market power.

*Monopolistic competition is similar to perfect competition.
Relatively free entry of new firmsLong-run price and output
behaviorZero long-run economic profitsHowever, the
monopolistically competitive firm produces a differentiated
product, which leads to some degree of monopoly power.
Monopolistic Competition:
Characteristics
*In a sense, each seller in a market of monopolistic competition
may be regarded as a “monopolist” of its own particular brand
of the commodity.Unlike a firm in the monopoly model, there is
competition by many firms selling similar (but not identical)
brands.
*
The Three Basic Characteristics of

*Product differentiation is the accentuation of unique product
qualities, real or perceived, to develop a specific product
identity. With differentiation, buyers believe that the products
of the various sellers are not the same, whether the products are
actually different or not.
Product Differentiation
*Product differentiation leads to preferences among buyers to
deal with particular sellers or to purchase the products of
particular sellers. Sources of differentiation:Physical
differencesPrestige considerationsLocationService
considerations
Product Differentiation
*When many firms compete for the same customers, any
particular firm has little control over or interest in what other
firms do.
Impact of Many Sellers
*Entry in monopolistic competition is relatively unrestricted.
New firms may easily start the production of close substitutes

for existing products. Economic profits tend to be eliminated in
the long run, as is the case in perfect competition.
Significance of Free Entry
*
Section 1
*
Price and Output Determination in Monopolistic Competition
*
Section 2
SECTION 2 QUESTIONS

*Monopolistically competitive sellers are price makers rather
than price takers, they do not regard price as a given by market
conditions like perfectly competitive firms.The cost and
revenue curves of a typical seller are shown in Exhibit 9.1.
Determining Short-Run Equilibrium
*
Exhibit 9.1: Short-Run Equilibrium in Monopolistic
Competition
*The intersection of the marginal revenue and marginal cost
curves indicates that the short-run profit-maximizing output will
be q*. By observing how much will be demanded at that output
level, we find our profit-maximizing price, P*.That is, at the
equilibrium quantity, q*, we go vertically to the demand curve
and read the corresponding price on the vertical axis, P*.
Determining Short-Run Equilibrium
*
1. Find where MR = MC and proceed straight down to the

horizontal quantity axis to find q*, the profit-maximizing output
level.
2. Go up to the demand curve then to the left to find the market
price. Once P* and q* are identified, total revenue can be
found, TR = P × q.
3. To find total costs, go straight up from q* to the ATC curve,
then left to the vertical axis to compute the ATC per unit. (TC =
ATC × q).If TR > TC at q*, the firm is generating total
economic profits.If TR < TC at q*, the firm is generating total
economic losses.
Three-Step Method for
*If we take the product price at P* and subtract the average cost
at q*, this will give us per-unit profit.If we multiply this by
output, we will arrive at total economic profit, that is, (P* −
ATC) × q* = total profit.The cost curves include implicit and
explicit costs—that is, even at zero economic profits the firm is
covering the total opportunity costs of its resources and earning
a normal profit or rate of return.
Three-Step Method for
Short-Run Profits and Losses in Monopolistic CompetitionIn

Exhibit 9.1(a), the total revenue is greater than total cost so the
firm has a total economic profit. In Exhibit 9.1(b), price is
below average total cost, so the firm is minimizing its economic
loss.
*
Determining Long-Run EquilibriumThe short-run equilibrium
situation, whether involving profits or losses, will probably not
last long, because there is entry and exit in the long run.If
market entry and exit are sufficiently free: New firms will enter
when there are economic profits.Some firms will exit when
there are economic losses.
© MARCUS LINDSTRÖM/ISTOCKPHOTO.COM
*
Determining Long-Run EquilibriumIf existing firms are earning
economic profits, new firms enter to take advantage of the
economic profits. The demand curves for each of the existing
firms will fall and become more elastic due to increasing
substitutes.

*Long‑run equilibrium will occur when demand is equal to
average total cost for each firm at a level of output at which
each firm’s demand curve is just tangent to its ATC curve.
Achieving Long-Run Equilibrium
*The point of tangency will always occur at the same level of
output as where MR = MC. At this equilibrium point, there are:
Zero economic profitsNo incentives for firms to either enter or
exit the industry
Achieving Long-Run Equilibrium
*
Exhibit 9.2: Long-Run Equilibrium for a Monopolistically
Competitive Firm
*
Section 2

*
Monopolistic Competition versus Perfect Competition
*
Section 3
SECTION 3 QUESTIONS
*
Monopolistic Competition versus Perfect Competition Both
monopolistic competition and perfect competition have many
buyers and sellers and relatively free entry. However, product
differentiation allows a monopolistic competitor the ability to
have some influence over price.
*A monopolistic competitive firm has a downward-sloping
demand curve, but it tends to be more elastic than the demand

curve for a monopolist because of the large number of good
substitutes for its product.
Monopolistic Competition versus Perfect Competition
*
The Significance of Excess CapacityBecause of the downward
slope of the demand curve, its point of tangency with ATC will
not and cannot be at the lowest level of average cost.
Therefore, even when long-run adjustments are complete, firms
will not be operating at a level that permits the lowest average
*The existing plant, even though optimal for the equilibrium
volume of output, will not be used to capacity.
The Significance of Excess Capacity
EXCESS CAPACITY
occurs when the firm produces below the level at which
average total cost is minimized
*Unlike a perfectly competitive firm, a monopolistically

competitive firm could increase output and lower its average
total costs. However, increasing output to attain lower average
costs would be unprofitable. The price reduction necessary to
sell the greater output would cause MR to fall below MC of the
increased output.
*Consequently, in monopolistic competition, there is a tendency
toward too many firms in the industry, each producing a volume
of output less than that which would allow lowest cost.
Economists call this tendency a failure to reach productive
efficiency.
*
Failing to Meet Allocative
Efficiency, TooIn monopolistic competition, firms are not
operating where P = MC. At the intersection of MC and MR,
curves (q*), P > MC .This means that society is willing to pay
more for the product (the price, P*) than it costs society to
produce it (MC at q*). The firm is not allocatively efficient,
(where P = MC). Too many firms are producing at output levels
that are less than full capacity.

*Perfectly competitive firms reach Productive efficiency (P =
ATC at the minimum point on the ATC curve).Allocative
efficiency (P = MC).
Efficiency, Too
*In monopolistic competition, the higher average costs and the
slightly higher price and lower output may just be the price we
not met the conditions of productive and allocative efficiencies,
it is not obvious that society is better off.
Efficiency, Too
*
Exhibit 9.3: Comparing Long-Run Perfect Competition and

*
What are the Real Costs of Monopolistic Competition?Perfect
competition meets the test of allocative and productive
efficiency and monopolistic competition does not. A remedy
for a monopolistically competitive firm to look more like an
efficient, perfectly competitive firm might entail using
government regulation, as in the case of a natural monopoly.
*However, this process would be costly because a
monopolistically competitive firm makes no economic profits in
the long run.Therefore, asking monopolistically competitive
firms to equate price and marginal cost would lead to economic
losses, because long-run ATC would be greater than price at P =
MC. Consequently, the government would have to subsidize the
firm.
What are the Real Costs of Monopolistic Competition?
*The monopolistically competitive firm does not operate at the
minimum point of the ATC curve, whereas the perfectly
competitive firm does.The excess capacity that exists in
monopolistic competition is the price we pay for product
differentiation.In short, the inefficiency of monopolistic
competition is a result of product differentiation.

*Because consumers value variety—the ability to choose from
competing products and brands—the loss in efficiency must be
weighed against the gain in increased product variety. The gains
from product diversity can be large and may easily outweigh the
inefficiency associated with a downward-sloping demand curve.
Firms differentiate their products to meet consumers’ demand.
*
Section 3
*
Oligopoly

*
Section 4
SECTION 4 QUESTIONS
*
OligopolyThe products may be homogeneous or differentiated,
but the barriers to entry are often very high, which makes it
very difficult for firms to enter into the industry. Firms in the
industry may earn long-run economic profits.
OLIGOPOLY
a market structure in which relatively few firms control all
or most of the production and sale of a product
*
Mutual InterdependenceOligopolists must strategize, much like
good chess or bridge players, constantly observing and
anticipating the moves of their rivals.
MUTUAL INTERDEPENDENCE
when a firm shapes its policy with an eye to the policies of
competing firms

*Oligopoly occurs when the number of firms in an industry is so
small that any change in output or price by one firm appreciably
impacts the sales of competing firms, so competitors respond
directly to these actions in determining their own policy.
Mutual Interdependence
*
Why Do Oligopolies Exist?Primarily, oligopoly is a result of
the relationship between technological conditions of production
and potential sales volumes. For many products, a reasonably
low cost of production cannot be obtained unless a firm is
producing a large fraction of the market output. In other words,
substantial economies of scale are present.
*
Measuring Industry ConcentrationOligopolies exist, by
definition, when relatively few firms control most of the
production and sale of a given product or class of products.A
way of measuring the extent of oligopoly power in various
industries is by using concentration ratios.

*A concentration ratio indicates the proportion of total industry
shipments (sales) of goods that a specified number of the largest
firms in the industry produced, or the proportion of total
industry assets held by those largest firms.
Measuring Industry Concentration
*The extent of oligopoly power is indicated by the four-firm
concentration ratio for the U.S. (Exhibit 9.4).Concentration
ratios of 70 to 100 percent are common in oligopolies.That is, a
high concentration ratio means that a few sellers dominate the
market.
*
Exhibit 9.4: Four-Firm Concentration Ratios, U.S.
Manufacturing
SOURCE: U.S. Census Bureau, 2002 Economic Census,
Concentration Ratios, 2002.
Washington, D.C. (Issued May, 2006). Available at
http://www.census.gov/epcd/
www/concentration.html, (accessed April, 16, 2010).

SOURCE: U.S. Census Bureau, 2002 Economic Census,
Concentration Ratios, 2002. Washington, D.C. (Issued May,
2006). Available at
http://www.census.gov/epcd/www/concentration.html, (accessed
April, 16, 2010).
*However, concentration ratios are not a perfect guide to
industry concentration.One problem is that they do not take into
consideration foreign competition.
*
Economies of Scale as a
Barrier to EntryEconomies of large‑scale production make
operation on a small scale during a new firm’s early years
extremely unprofitable. A firm cannot build up a large market
overnight; in the interim, ATC is so high that losses are heavy.
Recognition of this fact discourages new firms from entering
the market.

*
Exhibit 9.5: Economies of Scale as a Barrier to Entry
*
Equilibrium Price and Quantity in OligopolyWith mutual
interdependence, an oligopolist generally faces considerable
uncertainty as to the shape of its demand and marginal revenue
curves. In order to know anything about its demand curve, a
firm must know how other firms will react to its prices and
other policies.
*Thus, in the absence of additional assumptions, equating
marginal revenue and marginal cost is relegated to guesswork.
Thus, it is difficult for an oligopolist to determine its profit-
maximizing price and output.
Equilibrium Price and Quantity in Oligopoly
*
Section 4

*
Collusion and Cartels
*
Section 5
SECTION 5 QUESTIONS
*
Collusion and CartelsThe uncertainties of pricing decisions are
substantial in oligopoly, so the implications of misjudging the
behavior of competitors could prove to be disastrous. Because
of this uncertainty, some believe that oligopolists change their
prices less frequently than perfect competitors, whose prices
may change almost continuously.

*The empirical evidence, however, does not clearly indicate
that prices are in fact always slow to change in oligopoly
situations.
Collusion and Cartels
*
CollusionBecause the actions and profits of oligopolists are so
dominated by mutual interdependence, the temptation is great
pricing and other matters.
*If firms believe they can increase their prices by coordinating
their actions, they will be tempted to collude. Collusion reduces
uncertainty and increases the potential for monopoly profits.
Collusion
*From society’s point of view, collusion has the same

disadvantages as monopoly.Goods are overpriced.Goods are
under-produced.Consumers lose out from a misallocation of
resources.
Collusion
*
Joint Profit MaximizationAgreements between firms on sale,
pricing, and other decisions are usually called cartel
agreements.A cartel is a collection of firms making an
agreement.Cartels may lead to joint profit maximization, which
requires the determination of price based on the marginal
revenue function derived from the total (or market) demand
schedule for the product and the marginal cost schedules of the
various firms.
*
Exhibit 9.6: Collusion in Oligopoly
*With outright agreements—necessarily secret because of
antitrust laws—firms that make up the market will attempt to
estimate demand and cost schedules, and will set optimum price

and output levels accordingly.
Joint Profit Maximization
*Equilibrium quantity and price for a collusive oligopoly, like
those of a monopoly, are determined according to the
intersection of the marginal revenue curve derived from the
market demand curve and the horizontal sum of the short-run
marginal cost curves for the oligopolists.
*Collusion facilitates joint profit maximization for an
oligopoly. Like monopoly, if the oligopoly is maintained in the
long run: It charges a higher price.It produces less output.It
fails to maximize social welfare relative to perfect competition.
*The manner in which total profits are shared among firms in
the industry depends in part upon the relative costs and sales of
the various firms.

*Firms with low costs and large supply capability will obtain
the largest profits because they have great bargaining power.
With outright collusion, firms may agree upon market shares
and the division of profits.
*Division of total profits depends on: Relative bargaining
strength of the firmsRelative financial strengthAbility to inflict
damage (through price wars) on other firmsAbility to withstand
similar action on the part of other firmsRelative costsConsumer
preferencesBargaining skills
*
Why are Most Collusive Oligopolies Short Lived?Fortunately,
most strong collusive oligopolies are rather short lived for two
reasons. First, in the United States and in some other nations,
collusive oligopolies are strictly illegal under antitrust laws.
Second, for collusion to work, firms must agree to restrict
output to a level that will support the profit-maximizing price.

*At profit-maximizing prices, firms can earn positive economic
profits. Yet a great temptation exists for firms to cheat on the
agreement of the collusive oligopoly. And because collusive
agreements are illegal, the other parties have no way to punish
the offender.
Why are Most Collusive Oligopolies Short Lived?
*Why do oligopolists have a strong incentive to cheat?Any
individual firm could lower its price slightly and increase sales
and profits, as long as it is undetected. Undetected price cuts
could bring in new customers, including rivals’ customers. In
addition, there are non-price forms of spurring defection.
Why are Most Collusive Oligopolies Short Lived?
*
Price LeadershipOver time, an implied understanding may
develop in an oligopoly market that a large firm is the price
leader. Competitors that go along with the pricing decisions of
the price leader are called price followers.

*
What Happens in the Long Run if Entry is Easy?Mutual
interdependence in itself is no guarantee of economic profits,
even if the firms in the industry succeed in maximizing joint
profits. The extent to which economic profits disappear
depends on the ease with which new firms can enter the
industry.
*When entry is easy, excess profits attract newcomers. New
firms may break down existing price agreements by cutting
prices in an attempt to establish themselves in the
industry.Older firms may reduce prices to avoid excessive sales
losses.As a result, the general level of prices will begin to
approach average total cost.
What Happens in the Long Run if Entry is Easy?
*
How Do Oligopolists Deter Market Entry?The profit-
maximizing level of profits in oligopoly could be quite high,
which would encourage entry. But oligopolists often initiate
pricing policies that reduce the entry incentive for new firms,
holding prices below the maximum‑profit point. This lower-

than-profit-maximizing price may discourage newcomers from
entering.
*Because new firms would likely have higher costs than
existing firms, the lower price may not be high enough to cover
their costs. However, once the threat of entry subsides, the
market price may return to the profit-maximizing price.
How Do Oligopolists Deter Market Entry?
*
Exhibit 9.7: Long-Run Equilibrium and Deterring Entry
Antitrust and MergersThe Justice Department and the Federal
Trade Commission use the Herfindahl-Hirshman Index (HHI) to
determine if a potential merger would result in an oligopoly.

Antitrust and Mergers:
Three Types of Mergers
*If the price is deliberately kept low (below AVC) to drive a
competitor out of the market, it is called predatory pricing. It is
difficult to distinguish predatory pricing from vigorous
competition.
Predatory Pricing
*
Section 5
*
Game Theory and Strategic Behavior

*
Section 6
SECTION 6 QUESTIONS
*
Game Theory and Strategic BehaviorNoncollusive oligopoly
resembles a military campaign or a poker game. Firms take
certain actions not because they are necessarily advantageous in
themselves but because they improve the position of the
oligopolist relative to its competitors and may ultimately
improve its financial position.
*A firm may deliberately cut prices, sacrificing profits either to
drive competitors out of business or to discourage them from
undertaking actions contrary to the interests of the other firms.
Game Theory and Strategic Behavior
*

What is Game Theory?Some economists have suggested that the
entire approach to oligopoly equilibrium price and output
should be recast. They replace the analysis that assumes that
firms attempt to maximize profits with one that examines firm
behavior in terms of a strategic game.
GAME THEORY
firms attempt to maximize profits by acting in ways that
minimize damage from competitors
*With the game theory approach, there is a set of alternative
actions, and the action that would be taken in a particular case
depends on the specific policies followed by each firm.The firm
may try to figure out its competitors’ most likely countermoves
to its own policies and then formulate alternative defense
measures.
What is Game Theory?
*
Cooperative and Noncooperative GamesInteractions can either
be cooperative or noncooperative. A cooperative game would be
two firms that decide to collude in order to improve their profit
maximization position. Consequently, most games are
noncooperative games, in which each firm sets its own price
without consulting other firms.

*The primary difference between cooperative and
noncooperative games is the contract.Players in a cooperative
game can talk and set binding contracts. Those in
noncooperative games are assumed to act independently, with
no communication and no binding contracts.
Cooperative and Noncooperative Games
*Because antitrust laws forbid firms to collude, we will assume
that most strategic behavior in the marketplace is
noncooperative.
Cooperative and Noncooperative Games
*
The Prisoners’ DilemmaA firm’s decision makers must map out
a pricing strategy based on a wide range of information. They
also must decide whether their strategy will be effective only
under certain conditions regarding the actions of competitors or
if the strategy will work regardless of the competitors’ actions.

*
Dominant Strategy
DOMINANT STRATEGY
strategy that will be optimal regardless of opponents’
actions
*The prisoners’ dilemma is a famous game that has a dominant
strategy and demonstrates the basic problem confronting
noncolluding oligopolists. Two bank robbery suspects are
caught. The suspects are placed in separate jail cells and are not
allowed to talk with each other.
The Prisoners’ Dilemma
*There are four possible results in this situation:Both prisoners
confess.Neither confesses.Prisoner A confesses but Prisoner B
doesn’t.Prisoner B confesses but Prisoner A doesn’t.

*The payoff matrix summarizes these possibilities. If each
prisoner confesses, they will each serve two years in jail. If
neither confesses, each prisoner may only get one year because
of insufficient evidence. If one prisoner confesses and the other
does not, the confessor gets six months and the other prisoner
gets six years.
The Prisoners’ Dilemma:
The Payoff Matrix
*
Exhibit 9.8: The Prisoners’ Dilemma Payoff Matrix
*Looking at the payoff matrix, if one prisoner confesses, it is in
the best interest of the other prisoner to confess. Since both
know the temptation of the other to confess, the dominant
strategy is to confess. That is, the prisoners know that
confessing is the way to make the best of a bad situation.

*Firms in oligopoly often behave like the prisoners in the
prisoners’ dilemma, carefully anticipating the moves of their
rivals in an uncertain environment.
*
Profits Under Different
Pricing StrategiesTo demonstrate how the prisoners’ dilemma
can shed light on oligopoly theory, let us consider the pricing
strategy of two firms.In Exhibit 9.9, we present the payoff
matrix—the possible profits that each firm would earn under
different pricing strategies.
*
Exhibit 9.9: The Profit Payoff Matrix
*At a Nash equilibrium, each firm is doing as well as it can,
given the actions of its competitor. Each will make the choice

that minimizes the risk of the worst scenario.The Nash
equilibrium is also the dominant strategy.
Nash Equilibrium
*The Nash equilibrium takes on particular importance because it
is a self-enforcing equilibrium. Once this equilibrium is
established, there is no incentive for either firm to move.
Nash Equilibrium
*If two firms were to collude, it would be in their best interest.
However, each firm has a strong incentive to lower its price if
this pricing strategy goes undetected by its competitor.
Profits under Different
Pricing Strategies
*However, if both firms defect by lowering their prices from the
joint profit-maximization level, both will be worse off than if
they had colluded, but at least each will have minimized its
potential loss if it cannot trust its competitor. This situation is
the oligopolist’s dilemma.

Profits under Different
Pricing Strategies
*
Advertising: Prisoners’ Dilemma ExampleAdvertising can lead
to a situation like the prisoners’ dilemma.Perhaps the decision
makers of a large firm are deciding whether or not to launch an
advertising campaign against a rival firm.
*According to the payoff matrix in Exhibit 9.10, if neither
company advertises, the two companies split the market, each
making $100 million in profits.
Advertising
*
Exhibit 9.10: The Advertising Payoff Matrix

*They also split the market if they both advertise, but their net
profits are smaller ($75 million) because they would both incur
advertising costs that are greater than any gains in additional
revenues from advertising.
Advertising
*However, if one advertises and the other does not, the
company that advertises takes customers away from the
rival.The dominant strategy—the optimal strategy regardless of
the rival’s actions—is to advertise.
Advertising
*
Arms Race: Prisoners’ Dilemma ExampleThe arms race
provides a classic example of prisoner’s dilemma.For each
country, the dominant strategy is to build arms. Self interest
drives each participant into a noncooperative game that is worse
for both.

*
Exhibit 9.11: The Arms Race Payoff Matrix
*
Repeated Games
TIT-FOR-TAT STRATEGY
used in repeated games, the strategy in which one player
follows the other player’s move in the previous round; leads to
greater cooperation
*
Exhibit 9.12: Characteristics of the Four Major Market
Structures
*
Section 6

*
Monopoly
Survey of ECON
Robert L. Sexton
Chapter 8
© HULTON ARCHIVE/GETTY IMAGES
*
*
*
Chapter 8 Sections
– Monopoly: The Price Maker
– Demand and Marginal Revenue in
Monopoly
– The Monopolist’s Equilibrium
– Monopoly and Welfare Loss
– Monopoly Policy
– Price Discrimination

*
Monopoly:
The Price Maker
*
Section 1
SECTION 1 QUESTIONS
*
MonopolyA true or pure monopoly exists when there is only one
seller of a product for which no close substitute is available.The
firm and “the industry” are one and the same.

*Because a monopoly firm faces the industry demand curve, it
can pick the most profitable point on that demand curve.
Monopolists are price makers (rather than takers) that try to
pick the price that will maximize their profits.
Monopoly: Price Makers
*
Pure Monopoly is a RarityPure monopolies are a rarity because
few goods and services truly have only one producer.Near-
monopoly conditions may exist, such as many public utilities,
but absolute total monopoly is rather unusual. However, the
number of situations in which monopoly conditions are fairly
closely approximated are numerous enough to make the study of
monopoly useful.
*
Barriers to EntryFor a monopoly to persist, it must be virtually
impossible for other firms to overcome barriers to entry.
Barriers to entrylegal barrierseconomies of scalecontrol of
important inputs

*
Legal BarriersLegal barriers include franchising (the postal
service), licensing to ensure quality (trade industries), and
patents.
*The situation in which one large firm can provide the output of
the market at a lower cost than two or more smaller firms is
called a natural monopoly. With a natural monopoly, it is more
efficient to have one firm produce the good. The reason for the
cost advantage is economies of scale throughout the relevant
output range.
Economies of Scale
*
Exhibit 8.1: Economies of Scale
*Another barrier to entry is control over an important
input.Alcoa’s control over aluminum in the 1940s De Beers’
control over much of the world’s output of diamonds

Control of Important Inputs
*
Section 1
*
Demand and Marginal Revenue in Monopoly
*
Section 2
SECTION 2 QUESTIONS
*

Demand and Marginal Revenue in MonopolyIn monopoly, the
market demand curve may be regarded as the demand curve for
the firm’s product because the monopoly firm is the market for
that particular product.Unlike in perfect competition,
monopolists (and all other firms that are price makers) face a
downward-sloping demand curve. If the monopolist raises its
price, it will lose some, but not all of its customers.
*
Exhibit 8.2: Comparing Demand Curves: Perfect Competition
versus Monopoly
*
Exhibit 8.3: Total, Marginal, and Average Revenue
*Because a monopolist’s marginal revenue is always less than
the price, the marginal revenue curve will always lie below the
demand curve.If the seller wants to expand output, it will have
to lower the price on all units.

*The monopolist receives additional revenue from the new unit
sold (the output effect), but will receive less revenue on all the
units it was previously selling (the price effect).So when the
monopolist cuts prices to attract new customers, the old
customers benefit.
*
Exhibit 8.4: Demand and Marginal Revenue for the Monopolist
*In Exhibit 8.5, we can compare marginal revenue for the
competing firm with the marginal revenue for the monopolist.
Marginal Revenue: The Competing Firm and the Monopolist
*
Exhibit 8.5: Marginal Revenue—Competitive Firm versus

Monopolist
*
The Monopolist’s Price in the
Elastic Portion of the Demand CurveThe relationship between
the elasticity of demand and marginal and total revenue are
shown in Exhibit 8.6.In the elastic portion of the curve, when
the price falls, total revenue rises, so that marginal revenue is
positive. In the inelastic portion of the curve, when the price
falls, total revenue falls, so that marginal revenue is negative.
*
Exhibit 8.6: The Relationship between the Elasticity of Demand
and Total and Marginal Revenue
*A monopolist will never knowingly operate in the inelastic
portion of its demand curve. Increased output will lead to lower
total revenue and higher total cost in that region.
The Monopolist’s Price in the

Elastic Portion of the Demand Curve
*
Beyond the Book: The Cable CarCable cars in San Francisco are
one of the main tourist attractions. Consider a cable car
company that decided to increase prices from $3 to $5.
Consequently, the number of users would fall, as locals would
substitute into buses and other forms of transportation. The
demand by tourists for cable car rides, however, would be
relatively inelastic. So as cable car fares rose, so would total
revenue; so the firm must have been operating in the inelastic
portion of its demand curve.
*Of course, as we just learned, this is clearly not the profit-
maximizing part of the demand curve; monopolists can improve
their profits by operating on the elastic portion of their demand
curve.However, one might argue that there are positive
externalities from keeping cable car fares low. Lower fares
could attract more visitors and help local businesses.
Beyond the Book: The Cable Car

*
Section 2
*
*
The Monopolist’s Equilibrium
*
Section 3
SECTION 3 QUESTIONS
*
The Monopolist‘s EquilibriumThe monopolist, like the perfect
competitor, will maximize profits at that output where MR =
MC. Profits continue to grow until that output is reached.
Therefore, the equilibrium output is where MR = MC.

*
Exhibit 8.7: Equilibrium Output and Price for a Monopolist
*
Three-Step Method for MonopolistsThe three-step method for
determining economic profits, economic losses, or zero
economic profits:Find where MR equals MC, which is the
profit-maximizing output level. Go straight up to the demand
curve, then left to find the corresponding market price.Find TC
as ATC times the quantity produced.
*If TR > TC (the price exceeds average total cost), the
monopolist is generating economic profits.If TR < TC (the price
is less than average total cost), the monopolist is generating
economic losses.
Profits for a Monopolist

*
Exhibit 8.8: A Monopolist’s Profits
*In perfect competition, profits in an economic sense will
persist only in the short run because in the long run,new firms
will enter the industry, increasing industry supply, and thus
driving down the price of the good. Thus, profits are eliminated.
*In monopoly, profits are not eliminated because barriers to
entry exist. Other firms cannot enter, so economic profits can
persist in the long run.
*Being a sole supplier does not guarantee that consumers will
demand your product.A monopolist will incur a loss if there is
insufficient demand to cover average total costs at any price and
output combination along the demand curve.
Losses for the Monopolist

*
Exhibit 8.9: A Monopolist’s Losses
*
PatentsPatents and copyrights examples of monopoly
powerdesigned to provide an incentive to develop new
productsThe fall in the price of a patented good when the patent
expires illustrates the effect of introducing competition.
*
Exhibit 8.10: Impact of Patent Protection on Equilibrium Price
and Quantity
*
Section 3

*
*
Monopoly and
Welfare Loss
*
Section 4
SECTION 4 QUESTIONS
*
Does Monopoly Promote Inefficiency?The major objections to
monopoly:Not “fair” for monopoly owners to have persistent
economic profits Monopoly leads to lower output and higher
prices than would exist under perfect competition

*
Does Monopoly Promote Inefficiency?Efficiency objection:
monopolists charge higher prices and produce less
output.monopolist produces an output where the price is greater
than its cost, so that the value to society from the last unit
produced is greater than its cost, so the monopoly is not
producing enough of the good from society’s perspective,
creating a welfare loss.
*
Exhibit 8.11: Perfect Competition versus Monopoly
*The actual amount of the welfare loss in monopoly is of
considerable debate among economists. Estimates vary from 0.1
percent to 6 percent of national income.
Welfare Loss in Monopoly
*

Does Monopoly Retard Innovation?Some argue that a lack of
competition retards technological advance. Already reaping
monopolistic profits, firms do not work at: product
improvement technical advances designed to promote
efficiencyNotion that monopoly retards innovation can be
disputed. Many near‑monopolists are important innovators.
*Indeed, innovation helps firms initially obtain a degree of
monopoly status.Even monopolists want more profits, and any
innovation that lowers costs or expands revenues creates profits
for a monopolist.Therefore, the incentive to innovate may well
exist in monopolistic market structures.
Does Monopoly Retard Innovation?
*
Section 4
*
Monopoly Policy

*
Section 5
SECTION 5 QUESTIONS
*
Monopoly PolicyTwo major approaches to dealing with the
monopoly problem: antitrust policies regulation
*
Antitrust PoliciesBy imposing monetary and nonmonetary costs
on monopolists, antitrust policies reduce the profitability of
monopoly.The fear of lawsuits Jail sentences
*

Antitrust LawsThe first important law regulating monopoly was
the Sherman Antitrust Act. The Sherman Act prohibited
“restraint of trade”—price fixing and collusion—but narrow
court interpretation of the legislation led to a number of large
mergers, such as U.S. Steel.
*Antitrust efforts were strengthened by subsequent legislation,
the most important of which was the Clayton Act in 1914.
Additional legislation in the same year created the Federal
Trade Commission (FTC), which became the second government
agency concerned with antitrust actions.
Antitrust Acts Strengthened
*The Clayton Act made it illegal to engage in predatory
pricing—setting prices to drive out competitors or deter
potential entrants in order to ensure higher prices in the future.
The Clayton Act also prohibited mergers if it led to weakened
competition.
The Clayton Act
*Not all of the later legislation actually served to enhance

competition. The Robinson-Patman Act of 1936 (forbade most
forms of price discrimination) The Cellar-Kefauver Act in 1950,
(toughened restrictions on mergers that reduced competition)
Further Antitrust Legislation
*Many professional associations restrict the promotion of price
competition by prohibiting advertising among their members.
Both the FTC and the Justice Department successfully attacked
these types of restrictions on the grounds that they violate the
antitrust laws.
Promoting More Price Competition
*
Have Antitrust Policies Been Successful?The success of
antitrust policies can be debated. It is very likely that at least
some anticompetitive practices have been prevented simply by
the very existence of laws prohibiting monopoly‑like practices.
*Although the laws were probably enforced in an imperfect
fashion, on balance they impeded monopoly influences to at
least some degree.

Have Antitrust Policies Been Successful?
*
Government RegulationGovernment regulation is an alternative
approach to dealing with monopolies. The goal is to achieve the
efficiency
of large-scale production without permitting the high monopoly
prices and low output that can promote allocative inefficiency.
*Regulators often face a basic policy dilemma. Without
regulation, profit-maximizing monopolists will produce where
MR = MC. At that output, the price exceeds average total cost,
so economic profits exist.
Government Regulation
*The monopolist isproducing relatively little outputcharging a
relatively high priceproducing at a point where price is above
marginal cost
Government Regulation

*
Exhibit 8.12: Marginal Cost Pricing versus Average Cost
Pricing
*Socially allocative efficiency where P = MCWith natural
monopoly, where P = MC, the ATC > PThe optimal output,
then, is an output that produces losses for the producer.
Allocative Efficiency
*Any regulated business that produced for long at this
“optimal” output would go bankrupt; it would be impossible to
attract new capital to the industry. Therefore, the “optimal”
output from a welfare perspective really is not viable.
Allocative Efficiency

*A compromise between unregulated monopoly and marginal
cost pricing is average cost pricing, where price equals average
total cost. The monopolist is permitted to price the product
where economic profits are zero, meaning that a normal return
is being permitted, like firms experience in perfect competition
in the long run.
Average Cost Pricing
*
Difficulties in Average Cost PricingThe actual implementation
of a rate (price) that permits a “fair and reasonable” return is
more difficult than the graphical analysis suggests.The
calculations of costs and values is very difficult, often forcing
regulatory agencies to use profits as a guide instead.
*Another problem is that average cost pricing gives the
monopolist no incentive to reduce costs (which regulators have
tackled by letting the firm keep some of the profits that come
from lower costs).
Difficulties in Average Cost Pricing

*
Exhibit 8.13: Changes in Average Costs
*Also, consumer groups are constantly battling for lower rates,
while the utilities themselves are lobbying for higher rates so
that they can achieve some monopoly profits.The temptation is
great for the commissioners to be generous to the utilities. On
the other hand, there may be a tendency for regulators to bow to
pressure from consumer groups.
Difficulties in Average Cost Pricing
*
Section 5
*
Price Discrimination

*
Section 6
SECTION 6 QUESTIONS
*
Price Discrimination
Under certain conditions, the monopolist finds it profitable to
discriminate among various buyers, charging higher prices to
those that are more willing to pay and lower prices to those less
willing to pay.
PRICE DISCRIMINATION
the practice of charging different consumers different prices for
the same good or service
*
Conditions for Price Discrimination
Three conditions are necessary for the monopolist to practice
price discrimination:Monopoly PowerMarket SegregationNo
Resale

*
Monopoly PowerPrice discrimination is possible only with
monopoly or where members of a small group of firms follow
identical pricing policies. When there are a number of
competing firms, discrimination is less likely because
competitors tend to undercut higher prices charged by the firms
engaging in price discrimination.
*Price discrimination can only occur if the demand curve for
markets, groups, or individuals are different. If the demand
curves are not different, a profit-maximizing monopolist would
charge the same price in both markets. In short, price
discrimination requires the ability to separate customers
according to their willingness to pay.
Market Segregation
*For price discrimination to work, the purchaser buying the
product at a discount must have difficulty in reselling the
product to customers being charged more. Otherwise, consumers
would buy extra product at the discounted price and sell it at a
profit to others, reducing the number of customers paying the
higher price.

No Resale
*
Why Does Price Discrimination Exist?Price discrimination
results from the profit-maximization motive.Different groups of
people have different demand curves and therefore react
differently to price changes.A producer can make more money
by charging these different buyers different prices.
*
Exhibit 8.14: Price Discrimination in Movie Ticket Prices
*
Price Discrimination Examples: Airline TicketsSeats on airlines
usually go for different prices. The airlines can discriminate
against business travelers who usually have little advance
warning and often travel on weekdays—preferring to be home
on the weekends. Because the business traveler has a high
willingness to pay (a relatively inelastic demand curve) the
airlines can charge them a higher price.

*The coupon cutter, who spends an hour looking through the
Sunday paper for coupons, will probably have a relatively more
elastic demand curve than, say, a busy and wealthy physician or
executive. Consequently, firms charge a lower price to
customers with a lower willingness to pay (more elastic
demand)—the coupon cutter—and a higher price to those who
don’t use coupons (less elastic demand).
Price Discrimination Examples: Coupons
*
Students who are well off financially tend to pay more for their
education than do students who are less well off because of
different financial aid packages.
Price Discrimination Examples: College and University Tuition
*The seller charges a higher price for the first unit than for later
units, allowing the producer to extract some consumer surplus.A
six-pack of soda might be less expensive than buying each
separately. Or you might be able to buy a baker’s dozen of
donuts—13 for the price of 12.With this type of price
discrimination, you are charging more for the first units than,

say, for the 20th unit.
Price Discrimination Examples: Quantity Discounts
*
Section 6
*
Firms in Competitive Markets
Survey of ECON
Robert L. Sexton
Chapter 7
© SCOTT OLSON/GETTY IMAGES
*

*
Chapter 7 Sections
– A Perfectly Competitive Market
– An Individual Price Taker’s
Demand Curve
– Profit Maximization
– Short-Run Profits and Losses
– Long-Run Equilibrium
– Long-Run Supply
*
A Perfectly Competitive Market
*
Section 1
SECTION 1 QUESTIONS

*
A Perfectly Competitive Market
© MARIE-FRANCE BÉLANGER/ISTOCKPHOTO.COM
*
Many Buyers and SellersIn a perfectly competitive market,
there are many buyers and sellers.Because each firm is so small
in relation to the industry, its production decisions have no
impact on the market.For this reason, perfectly competitive
firms are called price takers.
*
Consumers believe that all firms in perfectly competitive
markets sell identical or homogeneous products.For example, in
the wheat market we are assuming that it is not possible to
determine any significant and consistent qualitative differences
in the wheat produced by different farmers.
Identical (Homogeneous) Products

*
Product markets characterized by perfect competition have no
significant barriers to entry or exit. This means that it is fairly
easy for entrepreneurs to become suppliers of the product or, if
they are already producers, to stop supplying the product.
Easy Entry and Exit
*Barriers to entry are modest, so large numbers of firms can
enter the business if they so desire.Because of easy market entry
and exit, perfectly competitive markets generally consist of a
large number of small suppliers.
Easy Entry and Exit
*Highly organized markets for securities and agricultural
commodities are the best examples of perfectly competitive
markets.
Perfectly Competitive Markets: Examples

*While the assumptions for perfect competition may seem a bit
unrealistic, the model is useful.Many markets resemble perfect
competition: firms face very elastic demand curves and
relatively easy entry and exit. It gives us a standard of
comparison.
Easy Entry and Exit
*
Section 1
*
An Individual Price Taker’s Demand Curve
*
Section 2
SECTION 2 QUESTIONS

*
An Individual Price Taker’s Demand CurvePerfectly
competitive firms are price takers, selling at the market-
determined price.An individual seller cannot sell at any price
higher than the current market price because buyers could
purchase the same good from someone else at the market price.
A seller would not charge a lower price when he could sell all
he wants at the market price.
*
An Individual Firm’s
Demand CurveIn a perfectly competitive market, an individual
seller can change his output and it will not alter the market
price. Each producer provides such a small fraction of the total
supply that a change in the amount he or she offers does not
have a noticeable effect on market price.
*In a perfectly competitive market, then, an individual firm can
sell as much as it wishes to place on the market at the
prevailing price.The demand, as seen by the seller, is perfectly
elastic at the market price.

Demand Curve
*A perfectly competitive seller won't charge more than the
market price because no one will buy at higher prices, and will
not charge less because the seller can sell all she wants at the
market price.Thus, the demand curve is horizontal at the market
price over the entire range of output that she could possibly
produce.
Demand Curve
*
Exhibit 7.1: Market and Individual Firm Demand Curves in a
Perfectly Competitive Market
*The position or height of each firm’s demand curve varies with
every change in the market price.Sellers are provided with
current information about market demand and supply conditions

as a result of price changes.
A Change in Market Price and the Firm’s Demand Curve
*The perfectly competitive model does not assume any
knowledge on the part of individual buyers and sellers about
the good they sell.
A Change in Market Price and the Firm’s Demand Curve
*
Exhibit 7.2: Market Prices and the Position of a Firm’s Demand
Curve
*
Section 2

*
Profit Maximization
*
Section 3
SECTION 3 QUESTIONS
*
Profit Maximization The firm’s objective is to maximize
profits.It wants to produce the amount that maximizes the
difference between its total revenues and total costs.
*
Total revenue for a perfectly competitive firm equals the market
price of the good (P) times the quantity (q) of units sold.
Total Revenue

TR = P × q
TOTAL REVENUE (TR)
the product price times the quantity sold
*
Average Revenue and Marginal Revenue
AVERAGE REVENUE (AR)
the total revenue divided by the number of units sold
MR = ΔTR ÷ Δq
MARGINAL REVENUE (MR)
the increase in total revenue resulting from a one-unit
increase in sales
AR = TR ÷ q
= (P × q) ÷ q
*In a perfectly competitive market, additional units of output
can be sold without reducing the market price.Therefore,
marginal revenue is constant and equal to the market price,
which is also the average revenue.
Average Revenue and Marginal Revenue

*In perfect competition, marginal revenue, average revenue, and
price are all equal:
P = MR = AR
Average Revenue, Marginal Revenue, and Price
*
Exhibit 7.3: Revenues for a Perfectly Competitive Firm
*In all types of market environments, the firm will maximize its
profits at the level of output that maximizes the difference
between total revenue and total cost, which is at the same
output level at which marginal revenue equals marginal cost.
How Do Firms Maximize Profits?
*
Equating Marginal Revenue and Marginal Cost The importance
of equating marginal revenue and marginal costs for maximizing
profits is straightforward.

*As long as the marginal revenue derived from expanded output
exceeds the marginal cost of that output, the expansion of
output creates additional profits. However, expansion of output
when the marginal cost of production exceeds marginal revenue
will lead to losses on the additional output, decreasing profits.
Equating Marginal Revenue and Marginal Cost
*The profit-maximizing output rule says a firm should always
produce where its
MR = MC.
The Profit-Maximizing Level of Output
*
Exhibit 7.4: Finding the Profit-Maximizing Level of Output

*As long as marginal revenue exceeds marginal cost, producing
and selling those units add more to revenues than to costs; in
other words, they add to profits. However, once the production
is expanded beyond four units of output, the costs are less than
the marginal revenues, and profits begin to fall.
The Profit-Maximizing Level of Output
*
Exhibit 7.5: Cost and Revenue Calculations for a Perfectly
Competitive Firm
*
Section 3
*
Short-Run Profits and Losses

*
Section 4
SECTION 4 QUESTIONS
*
Short-Run Profits and LossesProducing at the profit-maximizing
output level does not mean that a firm is actually generating
profits.It merely means that a firm is maximizing its profit
opportunity at a given price level. A firm could be: Earning
profitsGenerating lossesBreaking even
*Three easy steps to determine economic profits, economic
losses, or zero economic profits:
Where MR equals MC proceed down to horizontal axis to find
q*, the profit-maximizing output level.
At q*, go straight up to demand curve, then to price axis to find
the market price, P*. Now you can find TR at the profit-
maximizing output level because TR = P x q.
The Three-Step Method

*
The last step is to find total costs. Go straight up from q* to the
short-run average total cost (SRATC) curve; this will give you
the average cost per unit. If we multiply average total costs by
the output level, we can find the total costs TC = ATC x q.
*If TR > TC at the profit-maximizing output level, the firm is
generating economic profits. If TR < TC, the firm is generating
economic losses. If TR = TC, the firm is earning zero economic
profits,Covering both implicit and explicit costs, economists
sometimes call zero economic profit a normal rate of return.
*
Exhibit 7.6: Short-Run Profits, Losses, and Zero Economic
Profits

*Alternatively, to find total economic profits we can take the
product price at P* and subtract the ATC at q*. This will give
us per-unit profit. If we multiply this by output, we will arrive
at total economic profit. Or (P* - ATC) × q* = total economic
profit.Economists sometimes call the zero economic profit a
normal rate of return. That is, the owners are doing as well as
they could elsewhere, in that they are getting the normal rate of
return on the resources they invested in the firm.
*A firm generating an economic loss faces a tough choice.
Should it continue to produce or shut down its operation? To
make this decision, we need to consider average variable costs.
Evaluating Economic Losses in the Short Run
*If a firm cannot generate enough revenues to cover its variable
costs, then it will have larger losses if it operates than if it shuts
down (losses in that case = fixed costs).Thus, a firm will not
produce at all unless the price is greater than its average
variable costs.
Evaluating Economic Losses in the Short Run

*At price levels greater than or equal to average variable costs,
a firm may continue to operate in the short run even if average
total costs—variable and fixed costs—are not completely
covered. Because fixed costs continue whether the firm
produces or not, it is better to earn enough to cover a portion of
these costs than to earn nothing at all.
Operating at a Loss
*When price is less than average total costs but more than
average variable costs, the firm produces in the short run, but at
a loss. To shut down would make this firm worse off because it
can cover at least some of its fixed costs with the excess of
revenue over its variable costs.
Operating at a Loss
*
Exhibit 7.7: Short-Run Losses: Price above AVC but below
ATC
*When the price a firm is able to obtain for its product is below

its average variable costs at all ranges of output, it is unable to
cover even its variable costs in the short run.Since it is losing
even more than the fixed costs it would lose if it shut down, it
is more logical for the firm to cease operations.
The Decision to Shut Down
© BEAU LARK/PHOTOLIBRARY
*
Exhibit 7.8: Short-Run Losses: Price below AVC
*At all prices above minimum AVC, a firm produces in the
short run, even if ATC is not completely covered. At all prices
below the minimum AVC, the firm shuts down.Therefore, the
short-run supply curve of an individual competitive seller is
identical to that portion of the MC curve that lies above the
minimum of the AVC curve.
The Short-Run Supply Curve
*As a cost relation, the MC curve above minimum AVC shows
the marginal cost of producing any given output.As a supply
curve, the MC curve above minimum AVC shows the

MATH 464HOMEWORK 3SPRING 2013The following assignm.docx

MATH 464HOMEWORK 3SPRING 2013The following assignm.docx

Recommended

Recommended

More Related Content

Similar to MATH 464HOMEWORK 3SPRING 2013The following assignm.docx

Similar to MATH 464HOMEWORK 3SPRING 2013The following assignm.docx (20)

More from andreecapon

More from andreecapon (20)

Recently uploaded

Recently uploaded (20)

MATH 464HOMEWORK 3SPRING 2013The following assignm.docx