11

Imperfect Introduction 11

Chapter Outline 11.1 What Does Equilibrium Mean in an ? 11.2 Oligopoly with Identical Goods: and 11.3 Oligopoly with Identical Goods: 11.4 Oligopoly with Identical Goods: 11.5 Oligopoly with Identical Goods but with a First-Mover: 11.6 Oligopoly with Differentiated Goods: Bertrand Competition 11.7 11.8 Conclusion Introduction 11

Markets rarely fit all of the assumptions of or . In this chapter, we explore structures that are collectively referred to as imperfect competition. • Market structures with characteristics between those of perfect competition and monopoly

We relax a number of assumptions to examine markets in a more realistic manner: • Allow for varying degrees of competition • Allow for differentiated products • Allow for strategic behavior Market Classification

• How is the competitiveness of a market (or lack thereof)measured?

• Herfindahl–Hirschman Index (HHI) 푛 2 ෍(푠푖) 푖=1 Sum of squared market shares

• Concentration Ratios

– CR 4 – Total market share of top 4 firms – CR 8 – Total market share of top 8 firms Market Classification

• An empirical approach to market classification I – Monopolistic Competition Market Classification

• An empirical approach to market classification II – Oligopoly Monopolistic Competition 11.7

• If there are no barriers to entry in a differentiated product market, we have monopolistic competition. ‒ A characterized by many firms selling a differentiated product and with no barriers to entry

Model Assumptions: Monopolistic Competition 1. Industry firms sell differentiated products that consumers do not view as perfect substitutes. 2. Other firms’ choices affect a firm’s residual demand curve. 3. Firms ignore any strategic interactions between their own quantity or price choice and their competitors’ choices. 4. The market allows free entry and exit. Monopolistic Competition 11.7

Equilibrium in Monopolistically Competitive Markets To understand how equilibrium is reached in a monopolistically competitive market, first examine how free entry affects noncompetitive market outcomes.

Consider a small town with a single fast-food burger restaurant. • The restaurant is effectively a monopolist.

• The demand curve is Done, indicating a single firm. • The firm will choose a level of production that equates marginal revenue with . Monopolistic Competition 11.7

Figure 11.6 Demand and Cost Curves for a Monopoly

Price and cost Marginal cost, MC ($/meal) Average total cost, ATC

P*ONE How do we identify the level of output chosen by Profit the monopolist to produce? ATC *

Demand, DONE

Marginal revenue, MRONE Q* Quantity ONE of meals Monopolistic Competition 11.7

Equilibrium in Monopolistically Competitive Markets The result is a monopoly . Now suppose a second firm notices the profitability of operating a fast-food restaurant in this town. • With no barriers to entry, the second firm opens a restaurant.

Two things happen to the demand curve DONE when another firm enters. 1. First, because the second firm offers an (imperfect) substitute product, the demand curve for the first firm’s food becomes flatter (more elastic).

2. Second, because demand is now split across two firms, DONE shifts in as well. Unlike in previous oligopoly models, each firm takes the other’s actions as given, and there is no strategic response to the behavior of rivals. Monopolistic Competition 11.7

Figure 11.7 The Effect of Firm’s Entry on Demand for a Monopolistically Competitive Firm

Price and cost MC ($/meal) ATC

As a second firm enters, demand shifts downward P*TWO Profit and becomes more elastic. ATC*

DONE

MRTWO DTWO MRONE Q* Quantity TWO of meals Monopolistic Competition 11.7

Equilibrium in Monopolistically Competitive Markets Just as with perfect competition, entry will continue to occur until economic profit is equal to zero. However, unlike with perfect competition, this does not mean that price is equal to marginal cost. • The firms always face a downward-sloping demand curve. • Entry will occur until demand is tangent with the average total cost curve. • This is the point at which economic profits are exhausted. Monopolistic Competition 11.7

Figure 11.8 Long-Run Equilibrium for a Monopolistically Competitive Market

Price MC and cost ATC ($/meal) Because there is free entry, in the long run firms in monopolistic competition cannot sustain economic profit.

P*N = ATC* However, since each firm faces a downward-sloping demand curve, in the long run average total costs are not minimized in monopolistic competition. D MRN N Q* Quantity N of meals Oligopoly? 11.1

The second market structure we consider is oligopoly. • Competition between a small number of firms

It is important to examine what equilibrium means in an oligopoly. • Under perfect competition or monopoly, short-run equilibrium refers to a price– quantity combination that results in a market clearing. ‒ The market is stable at this point: there is no excess supply or demand, and consumers and producers do not want to change their decisions. • More complicated under oligopoly ‒ In an oligopolistic industry, each company’s actions influences what the other companies want to do. ‒ To determine an outcome when no firm wants to change its decision, we must determine more than just a price and quantity for the industry as a whole. ‒ Equilibrium starts with the same idea as perfect competition or monopoly: the market clears but requires that no company want to change its behavior (price or quantity) once it knows what other companies are doing. Oligopoly with Identical Goods: Collusion and Cartels 11.2

The situation described in the previous example means that there is an incentive for firms to engage in collusion or to form a . • Oligopoly behavior occurs when firms coordinate and collectively act as a monopoly to gain monopoly profits.

Model Assumptions: Collusion and Cartels 1. Firms make identical products. 2. Industry firms agree to coordinate their quantity and pricing decisions. 3. No firm deviates from the agreement, even if breaking it is in the firm’s best interest. Oligopoly with Identical Goods: Collusion and Cartels 11.2

The Instability of Collusion and Cartels The problem with maintaining collusion is that each firm has an incentive to cheat. Consider two firms, A and B, producing an identical product. • Inverse demand is P = 20 −Q and marginal cost is MC = $4. If the firms collude, they will produce the monopoly output. • Equate marginal revenue and marginal cost: MR  20  2Q  MC  20  2Q  4  Q  8 • The monopoly price will be $12, and total profits will be $64.

Assuming firms split production, each will produce 4 units, and each firm will earn $32 in profit. Oligopoly with Identical Goods: Collusion and Cartels 11.2

The Instability of Collusion and Cartels The problem is that each firm has an incentive to defect. • What happens if Firm A decides to produce 5 units instead of 4? ‒ Total production is 9 units instead of 8, and total industry profit will fall. • Given inverse demand P = 20 −Q, the new price will be $11, and total profits will be $63. • However, Firm A has increased individual profit:

Profit A  P  cQA  Profit A  (11 4)5  $35 • And Firm B has reduced profit:

ProfitB  P  cQB  ProfitB  (11 4)4  $28 This incentive to defect makes it difficult to maintain collusive agreements. Oligopoly with Identical Goods: Collusion and Cartels 11.2

Figure 11.1 Cartel Instability

Cartel members would maximize joint Price profits by acting like a monopoly. ($/unit) $20 Firm A , however, has an incentive to cheat on the agreement and produce another unit of output. 12 11

4 MC MR D 0 8 9 Quantity Oligopoly with Identical Goods: Collusion and Cartels 11.2

What Makes Collusion Easier? A number of things can make it easier to sustain collusive agreements: • Making it easy to detect and punish cheaters • Little variation in marginal costs across producers; since the goal is to produce at lowest cost, it is difficult to share profits if production costs vary greatly across cartel members. • Long time horizon makes defection more costly, as future monopoly profits are given more weight. Oligopoly with Identical Goods: Bertrand Competition 11.3

With the collusion model, firms are focused on their output decision. • In reality, firms often focus on their price decision instead. • The Bertrand competition model describes an oligopoly in which each firm chooses the price of its product. • Strategic interaction ensues, with each firm responding to its rivals’ price decision.

Model Assumptions: Bertrand Competition with Identical Goods 1. Firms make identical products. 2. Firms compete by choosing the price at which they sell their products. 3. Firms set their prices simultaneously. Oligopoly with Identical Goods: Bertrand Competition 11.3

Setting Up the Bertrand Model Suppose two firms, Target and Walmart, are selling Sony Playstations. • Products are identical; assume marginal cost is identical.

• Total quantity purchased is Q. Price at Walmart is PW; price at Target is PT.

Demand for Playstations at Walmart Demand for Playstations at Target

Q, if PW  PT Q, if PT  PW Q Q , if P  P , if P  P 2 W T 2 T W

0, if PW  PT 0, if PT  PW

The only way to sell Playstations is to match or beat your competitor. Oligopoly with Identical Goods: Bertrand Competition 11.3

Nash Equilibrium of a Bertrand Oligopoly What should Target do if Walmart lowers the price of PlayStations to less than Target’s? • Target is left with two options if it still wants to sell PlayStations. ‒ It can match Walmart, so that the market is shared equally. ‒ it can undercut Walmart, so that all consumers purchase from Target.

What is the in this structure? • Equilibrium occurs when each firm charges the marginal cost of production. • With identical firms and products, if one firm is charging more than its marginal cost, the other firm always has an incentive to undercut. • Even though competition is imperfect, in Bertrand competition, market equilibrium is identical to perfect competition and price equals marginal cost. Oligopoly with Identical Goods: Cournot Competition 11.4

If instead firms focus on the quantity decision • Oligopolists in a local market may compete on price, but producers in larger markets (e.g., commodities) may have to set production, because capacity constraints may keep each firm from losing all of its customers. This type of structure is called Cournot competition. • Oligopoly model in which each firm chooses its production quantity rather than price Model Assumptions: Cournot Competition with Identical Goods 1. Firms make identical products. 2. Firms compete by choosing a quantity to produce. 3. All goods sell for the market price, which is determined by the sum of quantities produced by all firms in the market. 4. Firms choose quantities simultaneously. Oligopoly with Identical Goods: Cournot Competition 11.4

Setting Up the Cournot Model Assume there are two firms in a Cournot oligopoly. • Each firm has a constant marginal cost c.

• Firms 1 and 2 simultaneously choose production quantities q1 and q2. Inverse demand is given by

P  a bQ; Q  q1  q2 Firm 1’s profit is 1  q1P c substituting in for P : 1  q1 a bq1  q2 c Each firm’s profit depends on actions And Firm 2’s profit is: of the other firm. 2  q2 a bq1  q2 c Oligopoly with Identical Goods: Cournot Competition 11.4

Equilibrium in a Cournot Oligopoly Assume only two countries, Saudi Arabia and Iran, supply oil to the world. • Each has a constant marginal cost of $20 per barrel. Inverse demand is given by

P  200  3Q; Q  qSA  qI Solving for the equilibrium in this model is similar to the monopoly case, except Q is the sum of quantities. Rewriting the inverse demand curve,

P  200  3Q  200  3qSA  qI  P  200  3qSA  3qI Oligopoly with Identical Goods: Cournot Competition 11.4

Equilibrium in a Cournot Oligopoly The slope of the marginal revenue curve is twice the slope of the inverse demand curve.

For Saudi Arabia: MRSA  200  6qSA  3qI

Solving for Saudi Arabia’s profit-maximizing output:

MRSA  MC

200  6qSA  3qI  20

qSA  30  0.5qI

Similarly, Iran’s profit-maximizing output is qI  30  0.5qSA Oligopoly with Identical Goods: Cournot Competition 11.4

Equilibrium in a Cournot Oligopoly This differs from the monopoly outcome in that the profit-maximizing output for each country depends on the choices of the other. For instance, if the Saudis expect Iran to produce 10 million barrels per day, they face the inverse demand curve

P  200  3qSA  3qI  200  3qSA  310 170  3qSA This leftover demand is the residual demand curve. • In Cournot competition, the demand remaining for a firm’s output given competitor firms’ production quantities

Similarly, a residual marginal revenue curve is a marginal revenue curve corresponding to a residual demand curve. Oligopoly with Identical Goods: Cournot Competition 11.4

Cournot Equilibrium: A Graphical Approach

The relationship between two firms’ output decisions in a Cournot oligopoly can be seen graphically through the use of reaction curves. • A function that relates a firm’s to its competitor’s possible actions • In Cournot competition, this is the firm’s best production response to its competitor’s possible quantity choices. Oligopoly with Identical Goods: Cournot Competition 11.4

Figure 11.4 Reaction Curves and Cournot Equilibrium

Saudi Arabia’s quantity of oil, qS (millions of barrels/day) The same holds true for Iran. 70 Iran’s reaction curve 60 1 Saudi Arabia’s best I (qI = 30 − 2qs ) reaction to an increase 50 Nash in Iranian output is to 40 lower output. A equilibrium 30 B Saudi Arabia’s E reaction curve 20 C 1 SA (qS = 30 − 2qI ) 10 D

0 10 20 30 40 50 60 70 Iran’s quantity of oil, qI (millions of barrels/day) Oligopoly with Identical Goods: Cournot Competition 11.4

Cournot Equilibrium: A Mathematical Approach We can also solve for a Cournot equilibrium mathematically. • Substitute one firm’s reaction curve into the other. • In the oil production example

qSA  30  0.5qI , qI  30  0.5qSA qSA  30  0.530  0.5qSA  30 15  0.25qSA

qSA  20 million Saudi Arabia’s equilibrium output is 20 million barrels per day. Since Iran and Saudi Arabia have identical production costs, Iran will also produce 20 million barrels per day, and the market price will be

P200  3 qSI  3 q  200  3 20  3 20  $80 per barrel Oligopoly with Identical Goods: Cournot Competition 11.4

Cournot Equilibrium: A Mathematical Approach Finally, we can compute the profit earned by Saudi Arabia:

 SAqP SA  $20  20 million  $80  $20  $1.2 billion and Iran:

 IIqP  $20  20 million  $80  $20  $1.2 billion Total output is 40 million barrels of oil per day, and total profit is $2.4 billion. Oligopoly with Identical Goods: Cournot Competition 11.4

Comparing Cournot to Collusion and to Bertrand Oligopoly Under collusion, Saudi Arabia and Iran will act as a single monopolist, splitting production evenly because production costs are the same. • Following the normal procedure, that marginal revenue equals marginal cost, total output is 30 million barrels per day (BPD), with associated market price P  200330 $110 • Total profit is

SA I PQ $20   $110  $20  30 million  $2.7 billion

• Under collusion, production is less than that observed in the Cournot equilibrium (40 million BPD), and profits are higher by $300 million per day. Oligopoly with Identical Goods: Cournot Competition 11.4

Comparing Cournot to Collusion and to Bertrand Oligopoly With Bertrand competition, firms compete on price. • Price will equal marginal cost; using the inverse demand curve P  MC 200  3Q  $20 Q  60 million • The 2 countries would split this demand equally, selling 30 million barrels each.

 How much profit do Saudi Arabia and Iran earn? ‒ Because both firms sell at a price equal to MC, each earns zero economic profit.

At the Bertrand equilibrium, output quantity is higher than at the Cournot equilibrium, price is lower, and there is no profit. Oligopoly with Identical Goods: Cournot Competition 11.4

Comparing Cournot to Collusion and to Bertrand Oligopoly Oligopoly with Identical Goods: Cournot Competition 11.4

Comparing Cournot to Collusion and to Bertrand Oligopoly In summary • Output under the three industry structures:

Qm  Qc  Qb ‒ Monopoly results in the lowest quantity produced, while Bertrand results in the most.

• Market price under the three industry structures:

Pb  Pc  Pm ‒ Bertrand yields the lowest price, while monopoly yields the highest.

• Profit under the three industry structures:

 b  0   c   m ‒ Bertrand yields the lowest profit (0), while monopoly yields the highest. Oligopoly with Identical Goods: Cournot Competition 11.4

What Happens If There Are More than Two Firms in a Cournot Oligopoly? The approach presented in previous slides extends to the case of multiple firms. • In general, as the number of firms increases, market outcomes still fall between the monopoly and perfectly competitive cases, but ‒ outcomes will approach the perfectly competitive case. ‒ more competitors mean higher industry output, lower market price, and lower industry profit. Oligopoly with Identical Goods: Stackelberg Competition 11.5

So far, we have considered only the case in which competitors with choose output or price simultaneously. • In reality, firms may make decisions before or after observing a competitor’s choice. This type of structure is called Stackelberg competition • Oligopoly model in which firms make production decisions sequentially

Model Assumptions: Stackelberg Competition with Identical Goods 1. Firms make identical products. 2. Firms compete by choosing a quantity to produce. 3. All goods sell for the market price, which is determined by the sum of quantities produced by all firms in the market. 4. Firms do not choose quantities simultaneously; they do it one after another, having seen the other firms’ choices. Oligopoly with Identical Goods: Stackelberg Competition 11.5

Consider the outcomes of the Cournot competition model. • Each firm chooses its optimal quantity based on what the firm believes its competitor(s) might do.  What happens if one firm observes the other producing more than the Cournot output? ‒ Could punish competitor by changing its own production.

Reaction curves are downward-sloping; the best response is to reduce output from the Cournot equilibrium level. The ability of a first mover to manipulate its competitor’s output in Stackelberg competition means that there is a first-mover advantage. • In Stackelberg competition, the advantage is gained by the initial firm in setting its production quantity. Oligopoly with Identical Goods: Stackelberg Competition 11.5

Let’s return to Saudi Arabia and Iran in Cournot competition. Inverse demand is given by (quantity measured in millions of barrels)

P  200  3Q; Q  qSA  qI Each country has a constant marginal cost of production of $20 per barrel. The two countries will produce where marginal revenue equals marginal cost, yielding the following reaction functions: Saudi Arabia Iran

MRSA  200  6qSA  3qI  20 MRI  200  6qI  3qSA  20

qSA  30  0.5qI qI  30  0.5qSA Oligopoly with Identical Goods: Stackelberg Competition 11.5

Stackelberg Competition and the First-Mover Advantage Now suppose Saudi Arabia is a Stackelberg leader.This means it chooses its optimal quantity of output before Iran does. • Iran’s incentives remain the same; for any quantity Saudi Arabia chooses to produce, Iran’s reaction function describes the optimal response. • Importantly, Saudi Arabia realizes Iran will do this before it makes its first move. ‒ However, Saudi Arabia’s reaction curve is different; specifically, we must substitute Iran’s reaction curve into the inverse demand curve. Oligopoly with Identical Goods: Stackelberg Competition 11.5

Stackelberg Competition and the First-Mover Advantage • Substitute Iran’s reaction curve into the inverse demand curve and solve for the optimal output for Saudi Arabia. P  200  3qSA  3qI

P200  3 qSA  3(30  0.5 q SA )

P 110 1.5qSA MRSA 110  3qSA  20 qSA  30

• Plug this in to Iran’s reaction function.

qI 30 0.5(30) qI 15 Oligopoly with Identical Goods: Stackelberg Competition 11.5

Let’s compare Saudi Arabia’s decisions under a Stackelberg competition structure to the Cournot outcome. Cournot Stackelberg

P  200  3qSA  3qI P  200  3qSA  3qI P  200  3q  3 30  0.5q MRSA  200  6qSA  3qI  20 SA  SA qSA  30  0.5qI P 110 1.5qSA MR 110  3q  20 ..... SA SA

qSA  30 qSA  qI  20 qI  30  0.530 15 In the Cournot equilibrium, each country produces 20 million barrels per day; now Saudi Arabia produces 30 million barrels per day and Iran, 15 million. Oligopoly with Identical Goods: Stackelberg Competition 11.5

Market price is P  200  3  45   per$65 barrel, and profit for each country is Saudi Arabia Iran

 SA  qSAP  20  3065  20  I  qI P  20 1565  20

 SA  $1,350,000,000 / day  I  $675,000,000 / day

Saudi Arabia makes slightly more (by $150 million) than the Cournot equilibrium of $1.2 billion per day as a result of holding first-mover advantage, whereas Iran does much worse. Oligopoly with Differentiated Goods: Bertrand Competition 11.6

Every model we have considered so far has shared a common assumption: that all firms in a particular market sell an identical product. • A more realistic situation—particularly with consumer goods—is that products in a specific market are differentiated in important ways • A differentiated product market is a market with multiple varieties of a common product. • We start by examining Bertrand competition with differentiated products.

Model Assumptions: Bertrand Competition with Differentiated Goods 1. Firms do not sell identical products. They sell differentiated products, meaning consumers do not view them as perfect substitutes. 2. Each firm chooses the price at which it sells its product. 3. Firms set prices simultaneously. Oligopoly with Differentiated Goods: Bertrand Competition 11.6

Equilibrium in a Differentiated-Products Bertrand Market Suppose there are two snowboard manufacturers, Burton and K2. • Products are substitutes but not perfect substitutes. • Differentiation means each firm faces a unique demand curve.

• Consider the following demand curves for the two companies’ snowboards, where price is measured in dollars: Burton K2 qB  900  2 pB  pK qK  900  2 pK  pB

As the price of Burton snowboards increases, Burton is in less demand but K2 is in greater demand, and vice versa. Oligopoly with Differentiated Goods: Bertrand Competition 11.6

Equilibrium in a Differentiated-Products Bertrand Market Each company sets its price to maximize profits. • For simplicity, assume the marginal cost of producing snowboards is zero. • Burton and K2 set their price so that marginal revenue is equal to zero. Burton K2

MRB  900  4 pB  pK  0 MRK  900  4 pK  pB  0 4 pB  900  pK 4 pK  900  pB

pB  225  0.25pK pK  225  0.25pB These are the reaction curves for Burton and K2: as the competitor’s price rises, own price rises. ‒ This is the opposite of quantity reaction in Cournot competition.  Why does this occur? Oligopoly with Differentiated Goods: Bertrand Competition 11.6

Equilibrium in a Differentiated-Products Bertrand Market To find the equilibrium prices, plug one company’s reaction curve in to the other’s pB  225  0.25pK

pB  225  0.25 225  0.25pB  0.9375pB  281.25 pB  $300

Plugging this price in to K2’s reaction curve yields K2’s equilibrium price.

pK  2250.25300 $300 We can also find the equilibrium graphically. Oligopoly with Differentiated Goods: Bertrand Competition 11.6

Figure 11.5 Nash Equilibrium in a Bertrand Market

Burton’s The same holds for K2. price, pB K2’s reaction curve As K2's chosen price rises, $500 (pK = 225 + 0.25 pB ) Nash Burton's best response is 400 equilibrium to raise its price. Burton’s reaction curve 300 (pB = 225 + 0.25 pK ) 225 200

100

0 $100 200 300 400 500 K2’s price, pK2 225 Conclusion 11.8

In this chapter, we examined a number of models of imperfect competition: • Bertrand, Cournot, and Stackelberg competition with identical goods • Collusion • Bertrand competition with differentiated goods • Monopolistic competition Choosing which model is a good fit for a particular market requires judgment on the part of the economist. In the next chapter, we look more closely at the concept of strategic interaction, which underlies some of the models from this chapter. In-text figure it out

Suppose Squeaky Clean and Biobase are a small town’s only producers of chlorine for swimming pools. The inverse demand curve for chlorine is 푃 = 32 − 2푄 where quantity is measured in tons and price is measured in dollars per ton. The two firms have an identical marginal cost of $16 per ton.

Answer the following questions: a. If the two firms collude, splitting the work and profits evenly, how much will each firm produce at what price? How much profit will each firm earn? b. Does Squeaky Clean have an incentive to cheat by producing an additional ton of chlorine? Explain. c. Does Squeaky Clean’s decision to cheat affect Biobase’s profit? Explain. d. Suppose both firms agree to each produce 1 ton more than they were producing in part (a). How much profit will they earn? Does Biobase have an incentive to cheat? In-text figure it out a. If the firms collude and act like a monopoly, they will set marginal revenue equal to marginal cost: MR  32  4Q

MR  MC  32  4Q 16  Q  4

P 32  2 4  $24per ton

and the profit for each firm (assuming they split output equally) is

1 1 ProfitSC  ProfitBB  P  cQ  24 16 4 2 2

ProfitSC  ProfitBB  $16 In-text figure it out

b. If Squeaky Clean produces one more ton, total quantity rises to 5. The new price is P  32  25  $22 and Squeaky Clean’s profit is

ProfitSC  P  cQSC  22 163

ProfitSC  $18

which is larger than the $16 under collusion. Yes, Squeaky Clean has an incentive to cheat and produce one more ton of chlorine. c. If Squeaky Clean cheats, the price falls to $22. This reduces Biobase’s profits to ProfitBB  P  cQBB  22 16 2  $12 In-text figure it out d. If each firm produces one more ton of chlorine, the new price is P  32  26  $20 and profits for each firm are 1 1 ProfitSC  ProfitBB  P  cQ  20 16 6 2 2 ProfitSC  ProfitBB  $12 Both firms are worse off. Does Squeaky Clean have an incentive to cheat and produce one more ton? When producing 4 tons of chlorine, the new price is P  32  27  $18 And Squeaky Clean ’s profit is ProfitSC  P  cQSC  18 16 4

ProfitSC  $8 which is lower than $12, so Squeaky Clean has no incentive to cheat. Additional figure it out

Suppose there are only two driveway paving companies in a small town, Asphalt, Inc. and Blacktop Bros. The inverse demand curve for paving services is 푃 = 1,600 − 20푄 where quantity is measured in pave jobs per month and price, in dollars per job. The firms have an identical marginal cost of $400 per driveway.

Answer the following questions: a. If the two firms collude, splitting the work and profits evenly, how many driveways will each firm pave, and at what price? How much profit will each firm make? b. Does Asphalt, Inc. have an incentive to cheat by paving one more driveway each month? c. Suppose each firm decides to pave one more driveway each month. Does Asphalt, Inc. have an incentive to cheat? Additional figure it out a. If the firms collude, they will set marginal revenue equal to marginal cost

MR 1,600  40Q

MR  MC 1,600  40Q  400  Q  30 P 1,600  2030  $1,000 and the profit for each firm (assuming they split output equally) is

1 1 Profit AI  ProfitBB  P  cQ  1,000  40030 2 2

Profit AI  ProfitBB  $9,000 Additional figure it out

b. If Asphalt, Inc. paves one more driveway, total quantity rises to 31. The new price is P 1,600  2031  $980 and Asphalt, Inc.’s profit is

Profit AI  P  cQAI  980  40016

Profit AI  $9,280 which is larger than the $9,000 under collusion. Yes, Asphalt, Inc. has an incentive to cheat and pave one more driveway. Additional figure it out c. If both firms pave one more driveway each month, the new price is P 1,600  2032  $960 and profits for each firm are 1 1 Profit AI  ProfitBB  P  cQAI  960  40032 2 2

Profit AI  ProfitBB  $8,960 Both firms are worse off. Does Asphalt, Inc. have an incentive to cheat and pave one more driveway? With 33 driveways per month, the new price is P 1,600  2033  $940 And Asphalt, Inc.’s profit is Profit AI  P  cQAI  940  40017

Profit AI  $9,180 which is higher than $8,960, so yes, Asphalt, Inc. has an incentive to cheat. In-text figure it out

OilPro and GreaseTech are the only two firms that provide oil changes in a local market in a Cournot (a two-firm oligopoly). The inverse demand curve for oil changes is P 100  2Q where quantity is measured in oil changes per year in thousands and price is measured in dollars per job. Assume OilPro has a marginal cost of $12 per job and GreaseTech has a marginal cost of $20.

Answer the following questions: a. Determine each firm’s reaction curve. b. How many oil changes will each firm produce in Cournot equilibrium? c. What will the market price of an oil change be? d. How much profit does each firm earn? In-text figure it out

a. Begin by substituting Q = qO + qG into the market inverse demand curve: P 100  2q  q  100  2q  2q where qO and qG represent the quantityO of oilG changes done byO OilProGand GreaseTech, respectively. Now, derive each firm’s marginal revenue curve:

MRO 100  4qO  2qG Each firm will set marginalMR revenueG  100equal to2 qmarginalO  4q costG to maximize profit; since marginal revenue is a function of the other firm’s production choice, this represents the reaction curve. OilPro GreaseTech

MRO  MC 100  4qO  2qG 12 MRG  MC 100  2qO  4qG  20

4qO  88  2qG 4qG  80  2qO

qO  22  0.5qG qG  20  0.5qG In-text figure it out b. To solve for the equilibrium, substitute one firm’s reaction curve into the other’s: qO  22  0.520  0.5qO  qO 12  0.25qO 0.75qO 12 qO 16 Using GreaseTech’s reaction curve:

qG  20  0.516

qG 12 c. The market price is found by substituting the market quantity into the market inverse demand curve.

P 100  2qO  qG  P 100  216 12 P  $44 In-text figure it out d. Finally, profit for each firm is OilPro GreaseTech

O  qO P 12 G  qG P  20

O 16,00044 12 G 12,00044  20

O  $512,000 G  $288,000

The firm with the lower marginal cost provides more oil changes and makes more profit. Additional figure it out

Let’s return to the example of the two small-town driveway paving companies, Asphalt, Inc. and Blacktop Bros. The inverse demand curve for paving services is P 1,600  20Q where quantity is measured in pave jobs per month and price is measured in dollars per job. Assume Asphalt, Inc. has a marginal cost of $400 per driveway and Blacktop Bros. has a marginal cost of $200.

Answer the following questions: a. Determine each firm’s reaction curve and graph it. b. How many oil changes will each firm produce in Cournot equilibrium? c. What will the market price of an oil change be? d. How much profit does each firm earn? Additional figure it out

a. Begin by substituting Q = qAI + qBB into the market inverse demand curve P 1,600  20qAI  qBB  1,600  20qAI  20qBB where qAI and qBB represent the quantity of driveways paved by Asphalt, Inc. and Blacktop Bros., respectively. Now, derive each firm’s marginal revenue curve.

MRAI1,600  40 q AI  20 q BB

MRBB1,600  20 q AI  40 q BB Each firm will set marginal revenue equal to marginal cost to maximize profit; since marginal revenue is a function of the other firm’s production choice, this represents the reaction curve. Asphalt, Inc. Blacktop Bros. MR 1,600  40q  20q  400 AI AI BB MRBB 1,600  20qAI  40qBB  200 40q 1,200  20q AI BB 40qBB 1,400  20qAI

qAI  30  0.5qBB qBB  35  0.5qAI Additional figure it out b. To solve for the equilibrium, substitute one firm’s reaction curve into the other’s: qAI  30  0.535  0.5qAI 

qAI 12.5  0.25qAI

0.75qAI 12.5

qAI 16.67 Using Blacktop Bros.’ reaction curve:

qAI  35  0.516.67

qAI  26.67 c. The market price is found by substituting the market quantity into the market inverse demand curve.

P1,600  20 qAI  q BB  P 1,600  20 16.67  26.67 P  $733.33 Additional figure it out d. Finally, profit for each firm is Asphalt, Inc. Blacktop Bros.

 AI  qAI P  400  BB  qBB P  200

 AI 16.67733.33 400  AI  26.67733.33 200

 AI  $5,556.61  AI  $14,223.91

The firm with the lower marginal cost paves more driveways and makes more profit. In-text figure it out

Return to the case of the two oil change producers OilPro and GreaseTech from the previous figure it out. Recall the inverse market demand for oil changes: P 100  2Q where quantity is measured in thousands of oil changes per year, representing the combined production of O and G; Q = qO + qG; and price is measured in dollars per change. OilPro has a marginal cost of $12 per change, and GreaseTech has a marginal cost of $20.

Answer the following questions: a. Suppose the market is a Stackelberg oligopoly and OilPro is the first mover. How much does each firm produce? What will the market price be? How much profit does each firm earn? b. Now suppose GreaseTech is the first mover. How much will each firm produce, and what is the market price? How much profit does each firm earn? In-text figure it out a. Since OilPro moves first, calculate GreaseTech’s reaction curve and plug that in to the market demand curve to determine OilPro’s output. To find GreaseTech’s reaction curve, set marginal revenue equal to marginal cost.

MR  MC 100  2qO  4qG  20

Substitute GreaseTech’s reactionqqGO curve20 into 0.5the market demand curve:

P100  2 qOGOO  q  100  2( q  20  0.5 q ) P 100  2qO  40  qO which is OilPro’s inverse demand curve Pas a first60  mover.qO Setting marginal revenue equal to marginal cost yields MR  MC 60  2qO 12 qO  24 In-text figure it out

Substituting OilPro’s output choice into GreaseTech’s reaction function yields the latter’s output choice qG  20  0.5qO qG  20  0.5(24) qG  8 To find the market price, return to the inverse demand curve

P 100  2qO  qG  P 100  224  8 P  $36

And the profit for each firm is given by

O  P  $12 qO G  P  $20 qG O  $36  $12 24,000 G  $36  $208,000

O  $576,000 G  $128,000 In-text figure it out b. We repeat the process for part b. Since GreaseTech moves first, calculate OilPro’s reaction curve and plug that in to the market demand curve to determine OilPro’s output. To find OilPro’s reaction curve, set marginal revenue equal to marginal cost. MR  MC 100  4qO  2qG 12 qO  225  0.5qG Substituting OilPro’s reaction curve into the market demand curve yields

P100  2 qOGGG  q  100  2( q  22  0.5 q ) P 100  2qG  44  qG P  56  qG which is GreaseTech’s inverse demand curve as first mover. Setting marginal revenue equal to marginal cost yields MR  MC 56  2qG  20 qG 18 In-text figure it out

Substituting GreaseTech’s output choice into OilPro’s reaction function yields the latter’s output choice. qO  22  0.5qG qO  22  0.5(18) qO 13 To find the market price, return to the inverse demand curve. P 100  2qO  qG  P 100  218 13 P  $38 The profit for each firm is given by

O  P  $20 qO G  P  $12 qG O  $38  $2013,000 G  $38  $1218,000

O  $338,000 G  $324,000 Additional figure it out

Consider the case of two theaters, Jay’s Cinema (JC) and Mezzanine Inc. (MI). The inverse demand for theater tickets is given as P =120- 4Q where quantity is measured in thousands of theater tickets per year, representing the combined production of JC and MI, Q = qJC + qMI , and price is measured in dollars per ticket. JC has a marginal cost of $6 per ticket, and MI has a marginal cost of $8. Answer the following questions: a. Suppose the market is a Stackelberg oligopoly and JC is the first mover. How much does each firm produce? What will the market price of a movie be? How much profit does each firm earn? b. Now suppose MI is the first mover. How much will each firm produce? What is the market price? How much profit does each firm earn? Additional figure it out a. Since JC moves first, we must calculate MI’s reaction curve and plug that in to the market demand curve to determine what output level JC will choose. To find MI’s reaction curve, set marginal revenue equal to marginal cost MR  MC 120  4qJC  8qMI  8 qMI 14 .5qJC Substituting MI’s reaction curve into the market demand curve yields P 120  4qJC  qMI  120  4(qJC 14 .5qJC ) P 120  4qJC  56  2qJC P  64  2qJC which is JC’s inverse demand curve as a first mover. Setting marginal revenue equal to marginal cost yields MR  MC 64  4qJC  6 qJC 14 Additional figure it out

Substituting JC’s output choice into MI’s reaction function yields the latter’s output choice qMI 14  0.5qJC qMI 14  0.5(14) qMI  7 To find the market price, return to the inverse demand curve

P 120  4qJC  qMI  P 120  414  7 P  $36

And the profit for each firm is given by,

 JC  P  $6 qJC  MI  P  $8 qMI  JC  $36  $614,000  MI  $36  $8 7,000

 JC  $420,000  MI  $196,000 Additional figure it out b. We repeat the same process for part b. Since MI moves first, we must calculate JC’s reaction curve, and plug that in to the market demand curve to determine what output level MI will choose. To find JC’s reaction curve, set marginal revenue equal to marginal cost MR  MC 120  8qJC  4qMI  6 qJC 14.25  0.5qMI Substituting JC’s reaction curve into the market demand curve yields

P120  4 qJC  q MI  120  4( q MI  14.25  0.5 q MI ) P 120  4qMI  57  2qMI P  63  2qJC which is MI’s inverse demand curve as a first mover. Setting marginal revenue equal to marginal cost yields MR  MC 64  4qMI  6 qMI 14.5 Additional figure it out

Substituting MI’s output choice into JC’s reaction function yields the latter’s output choice. qJC 14.25  0.5qMI qJC 14.25  0.5(14.5) qJC  7 To find the market price, return to the inverse demand curve.

P 120  4qJC  qMI  P 120  47 14.5 P  $34

The profit for each firm is given by

 JC  P  $6 qJC  MI  P  $8 qMI  JC  $34  $6 7,000  MI  $34  $814,500

 JC  $196,000  MI  $377,000 In-text figure it out

We just determined the Nash equilibrium for Burton and K2, with each firm producing 600 snowboards (plug price back in to individual demand curves) at a price of $300 per board. Now, suppose Burton launches an advertising campaign so that the demand for Burton snowboards rises to qB = 800 – 1.5pB + 1.5pK and demand for K2 boards falls to qK = 1,000 – 2pK + 0.5pB . Assume the marginal cost for each firm is still zero.

Answer the following questions: a. Derive each firm’s reaction curve. b. What happens to each firm’s optimal price? c. What happens to each firm’s optimal output? d. Draw the reaction curves in a diagram and indicate the equilibrium. In-text figure it out

a. To determine the firms’ reaction curves, first solve for each firm’s marginal revenue curve:

MRB 1000  3pB 1.5pK

MRK  800  4 pK  0.5pB

Setting each firm’s marginal cost equal to marginal revenue provides the reaction curve for each firm:

MRB 1000  3pB 1.5pK  0 MRK  800  4 pK  0.5pB  0

3pB 1000 1.5pK 4 pK  800  0.5pB

pB  333.33  0.5pK pK  200  0.125pB In-text figure it out

b. Substituting K2’s reaction curve into Burton’s reaction curve yields the equilibrium price for Burton. pB  333.33  0.5pK

pB  333.33  0.5200  0.125pB  pB  433.33  0.625pB pB  $462.22 We can substitute Burton’s price into K2’s reaction curve to find the equilibrium price for K2

pK  200  0.125pB pK  200  0.125$462.22 pK  $257.78 In-text figure it out c. To find each firm’s output, substitute the prices from part b into the inverse demand curve for each firm.

qB 1000 1.5pB 1.5pK qK  800  2 pK  0.5pB 1000 1.5462.221.5257.78  800  2257.78 0.5462.22 qB  693.34 qK  515.55 d. The reaction curves: In-text figure it out

Sticky Stuff produces taffy in a monopolistically competitive market. The inverse demand for its product is P  50  Q where quantity is measured in thousands of cases per year and price is measured in dollars. Assume Sticky Stuff has a constant marginal cost of $10 per case and has no fixed cost. It’s total cost curve is TC = 10Q. Answer the following questions: a. To maximize profit, how many cases of taffy should Sticky Stuff produce each year? b. What price will cases of taffy sell for? c. How much profit will Sticky Stuff earn each year? d. In reality, firms in monopolistic competition face fixed costs in the short run. Given the answers to the previous questions, what would Sticky Stuff’s fixed costs have to be in order for this industry to be in long-run equilibrium? Explain In-text figure it out a. Sticky maximizes profit by setting marginal revenue equal to marginal cost; since the inverse demand curve is linear, the marginal revenue curve is also linear, with the same intercept and twice the slope. MR  50  2Q 10 40  2Q Q  20,000 cases per year b. Plugging 20 in to the inverse demand curve gives the price.

P 50  20  $30 per case c. Sticky’s profit is the quantity produced times the price, net of the constant marginal cost. d. Long-run equilibrium  Q occurs P  whenMC industry 20 profits30 10 are zero,$400 or ,when000 Sticky’s daily fixed costs are exactly equal to its annual profit of $400,000. Additional figure it out

Mangos produces smoothies in a monopolistically competitive market. The inverse demand for its product is P  8  0.05Q where quantity is measured in smoothies per day and price is measured in dollars. Assume Mangos has a constant marginal cost of $2 per smoothie.

Answer the following questions: a. To maximize profit, how many smoothies should Mangos produce each day? b. What price will smoothies sell for? c. What will be Mangos’ daily profit? d. Firms in monopolistic competition face fixed costs in the short run. What would Mangos’ fixed costs have to be for this industry to be in long-run equilibrium? Additional figure it out a. Mangos maximizes profit by setting marginal revenue equal to marginal cost; since the inverse demand curve is linear, the marginal revenue curve is also linear, with the same intercept and twice the slope. MR  8  0.1Q  2 0.1Q  6 Q  60 b. Plugging 60 in to the inverse demand curve gives the price. c. Mangos’ profit is theP quantity 8 0produced.0560 times $5 the price, net of the constant marginal cost. d. Long-run equilibrium QP occurs MC when industry605 profits2 are$180 zero, or when Mangos’ daily fixed costs are \equal to its daily profit of $180.