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Chapter 8
Pricing and Output

Decisions:
Perfect Competition
and Monopoly
Copyright 2011 Pearson Education,

Chapter Eight 1
Inc. Publishing as Prentice Hall.
Overview
Competition and market types

Pricing and output decisions in
perfect competition
monopoly markets
Implications for managerial
decisions
Chapter Eight 2
Learning objectives
understand the four market types
compare the degree of price competition
among the four market types
explain why the P=MC rule leads firms to
the optimal level of production
explain how the MR=MC rule helps a
monopoly to determine its optimum
explain the relationship between the
MR=MC rule and the P=MC rule
describe what happens in the long run
Chapter Eight 3
Four market types
Perfect competition (no market
power)
large number of relatively small buyers

and sellers
standardized product
very easy market entry and exit
nonprice competition
Chapter Eight
not possible
4
Four market types
Monopoly (absolute market power,
subject to government regulation)
one firm, firm is the industry
unique product or no close substitutes
market entry and exit difficult or legally

impossible
nonprice competition
Chapter Eight
not necessary
5
Four market types
Monopolistic competition (market
power based on product
differentiation)
large number of small firms acting

independently
differentiated product
market entry and exit relatively easy

Chapter Eight 6
Four market types
Oligopoly (product differentiation and/or
the firms dominance of the market)
small number of large mutually

interdependent firms
differentiated or standardized product
market entry and exit difficult
nonprice competition important

Chapter Eight 7
Four market types

Chapter Eight 8
Four market types
Examples: perfect competition
agricultural products
financial instruments
precious metals
petroleum
Chapter Eight 9
Four market types
Examples: monopoly
pharmaceuticals
Microsoft
gas station on edge of desert

Chapter Eight 10
Four market types
Examples: monopolistic competition
boutiques
restaurants
repair shops

Chapter Eight 11
Four market types
Examples: oligopoly
oil refining
processed foods
airlines
internet access
Chapter Eight 12
Pricing and output decisions
in perfect competition
Basic business decision: entering
a market using the following
questions:
how much should we produce?
if we produce such an amount, how
much profit will we earn?
if a loss rather than a profit is incurred,
will it be worthwhile to continue in this
market in the long run (in hopes that we
will eventually earn a profit) or should
we exit? Copyright
Chapter Eight
2011 Pearson Education,
13
Key assumptions of the perfectly
competitive market:
the firm is a price taker

the firm makes the distinction between
the short run and the long run
the firms objective is to maximize its
profit (or minimize loss) in the short run
the firm includes its opportunity cost of
operating in a particular market as part
of its total cost of production
Chapter Eight 14
Perfectly elastic demand
curve: consumers are
willing to buy as much as
the firm is willing to sell at
the going market price
firm receives the same

marginal revenue from the
sale of each additional unit
of product; equal to the
price of the product
no limit to the total

revenue that the firm can
gain in a perfectly
competitive market
Chapter Eight 15
Total revenue/Total cost approach:
compare the total revenue and total cost

schedules and find the level of output
that either maximizes the firms profits
or minimizes its loss

Chapter Eight 16
Marginal revenue/Marginal cost
approach
produce a level of output at which the
additional revenue received from the
last unit is equal to the additional cost of
producing that unit (ie. MR=MC)
Note: for the perfectly competitive firm,

the MR=MC rule may be restated as
P=MC because P=MR in perfectly
competitive market
Chapter Eight 17
Case A: economic
profit
The point where

P=MR=MC is the
optimal output (Q*)
profit = TR TC
=(P - AC) Q*

Chapter Eight 18
Case B: economic loss
The firm incurs a loss.

At optimum output,
price is below AC
however, since P >
AVC, the firm is better
off producing in the
short run, because it
will still incur fixed
costs greater than the
loss

Chapter Eight 19
Contribution
margin: the amount
by which total revenue
exceeds total variable
cost
CM = TR TVC
if CM > 0, the firm

should continue to
produce in the short
run in order to defray
some of the fixed cost

Chapter Eight 20
Shutdown point: the lowest price at which
the firm would still produce
At the shutdown point, the price is equal to

the minimum point on the AVC
If the price falls below the shutdown point,

revenues fail to cover the fixed costs and
the variable costs. The firm would be better
off if it shut down and just paid its fixed
costs
Chapter Eight 21
In the long run, the price in the competitive
market will settle at the point where firms
earn a normal profit
economic profit invites entry of new firms

shifts the supply curve to the right puts
downward pressure on price and reduces profits
economic loss causes exit of firms shifts the
supply curve to the left puts upward pressure
on price and increases profits

Chapter Eight 22
Observations in perfectly competitive markets:
the earlier the firm enters a market, the better
its chances of earning above-normal profit
as new firms enter the market, firms must find

ways to produce at the lowest possible cost, or
at least at cost levels below those of their
competitors
firms that find themselves unable to compete

on the basis of cost might want to try competing
on the basis of product differentiation instead
Chapter Eight 23
monopoly markets
A monopoly market consists of one firm
(the firm is the market)
firm has the power to set any price it

wants
however, the firms ability to set price is

limited by the demand curve for its
product, and in particular, the price
elasticity of demand
Chapter Eight 24
monopoly markets
Assume demand is
linear: it is downward
sloping because the
firm is a price setter
Assume MC is
constant
choose output
where MR=MC, set
price at P*

Chapter Eight 25
monopoly markets
Demand is the same
as before, as is MR
MC is upward sloping,
which shows
diminishing returns
set output where

MR=MC

Chapter Eight 26
Implications of perfect competition
and monopoly for decision making
Perfectly competitive market
most important lesson is that it is

extremely difficult to make money
must be as cost efficient as possible
it might pay for a firm to move into a

market before others start to enter

Chapter Eight 27
Implications of perfect competition
and monopoly for decision making
Monopoly market
most important lesson is not to be

arrogant and assume their ability to
earn economic profit can never be
diminished
changes in economics of a business

eventually break down a dominating
companys monopolistic power
Chapter Eight 28
Global application
Example: Bluefin tuna
sushi restaurants operate in

monopolistic competition
bluefin tuna price determined by
perfect competition
low profit margin

Chapter Eight 29
Herfindahl- Hirschman Index
(HHI)
The HHI is the sum of the
squares of the market shares of
each firm in the industry
A monopoly has 100 percent of the
market share
2
100 = (100 X 100) = 10,000
You cant get a bigger HHI number than 10,000. Every monopoly
would have an HHI of 10,000
Copyright 2002 by The McGraw-Hill Companies, Inc. All

25-12
(HHI)
Find the HHI in an industry with just two firms

Each firm has 50 percent of the market
2 2
50 + 50 = 2,500 + 2,500 = 5,000

25-13
(HHI)
Find the HHI in an industry that has four firms

Each firm has 25 percent of the market
2 2 2
25 + 25 + 25 + 25
2
625 + 625 + 625 + 625

2500

25-14
Disadvantage of 4-firm
concentration ratio:
Doesnt give extra weight to

especially large firms
33
Herfindahl Index
(S1)2+ (S2)2+
(S3)2+...+ (Sn)2
(30)2+(25)2+(2
0)2+(10)2+
(9)2+(6)2 =
900+625+400
+100+81+36=
2142
34
Herfindahl Index
Industry X Sales Market
HI = Share
6268 Firm A 790 79%
Firm B 20 2%
Firm C 20 2%
Firm D 20 2%
15 other 10 1%
firms each
with:
Total
35 1000 100%
Herfindahl Index
Increases if the number of firms
decrease
Gives extra weight to especially large
firms
36
FTCs Ranking of Competitiveness: Concentrated
Case Study
Producers in 1985 Share
Coca-Cola 37.4%
PepsiCo 28.9
Philip Morris (7-up) 5.7
Dr. Pepper Co 4.6
R.J. Reynolds (Sunkist, Canada Dry) 3.0
Royal Crown Cola 2.9
Proctor and Gamble (Orange Crush, 1.8
Hines)
Others (supermarket brands) 15.7
37
FTCs Ranking of Competitiveness: Concentrated
Case Study
Coca-Cola 37.4%
PepsiCo 28.9
Dr. Pepper Co 4.6
Hines)
Herfindahl no merger
37.42+28.92+5.72+4.62+3.02 = 2324
38
Case Study
Coca-Cola + Dr. Pepper 37.4+4.6=
42.0
PepsiCo 28.9

Hines)
Herfindahl with merger
422+28.92+5.72+3.02 = 2668
39
Price Discrimination
price discrimination Charging

different prices to different buyers.
perfect price discrimination

Occurs when a firm charges the
maximum amount that buyers
are willing to pay for each unit.
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Price Discrimination
Basic model: a monopolist charges:

A. Same price for all units.
B. Same price to all customers.
Changing one or both of these is called Price

Discrimination. Can one profit from this?
1st degree is different prices for both consumers
and units (both A and B are changed)
2nd degree is different prices for different units
(A changed).
3rd degree is different prices to different
consumers (B changed).
41
1st-Degree Price Discrimination
Different prices for both consumers and units.
To do this properly, a monopolist must have

strong information on:
Each individual consumers preferences.
1st degree captures the whole consumer

surplus.
1st degree is efficient.
42
FIRST DEGREE PRICE DISCRIMINATION
Perfect Price Discrimination
Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the whole market into each individual consumer and charges them the price they are willing and able to pay. If successful, the firm can extract all consumer
surplus that lies beneath the demand curve and turn it into extra producer revenue (or producer surplus). This is impossible to achieve unless the firm knows every consumers preferences and, as a result, is unlikely to occur in the real world. The
transactions costs involved in finding out through market research what each buyer is prepared to pay is the main block or barrier to a businesses engaging in this form of price discrimination.
If the monopolist is able to perfectly segment the market, then the average revenue curve effectively becomes the marginal revenue curve for the firm. The monopolist will continue to see extra units as long as the extra revenue exceeds the
marginal cost of production.
43
12
1 2 3 4 5 6 1 2 3 4 5 6
Examples of 1st degree price discriminators:

Car dealerships mechanics, doctors, and lawyers (service related
business).
2nd Degree Price Discrimination
In this type of discrimination the companies are actually not able to

differentiate between the different types of consumers. This practice
creates a schedule of declining prices for different quantities. Using this
strategy the company can extract some of the consumer surplus without
knowing much about the individual consumer.
This can be seen in quantity discounts, the more you purchase the more
you save. A family pack of soap powder or biscuits tends to cost less per
kg than smaller packs. This of course discriminates against people living
alone, often pensioners and students. In some supermarkets the price per
kg of product is listed, which helps the customer by providing information
on which to base decisions on.
Examples of 2nd degree price discriminators:

Electric utilities, cable companies, internet service providers, telephone
service providers.
45 of 38
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THIRD DEGREE PRICE DISCRIMINATION
This is the most frequently found form of discrimination

and involves charging different prices for the same
product in different segments of the market. The market
is usually separated in two ways: by time or by
geography.
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48 of 38
Examples of Price
Discrimination.
Book publisher having a cheap
international edition of a book.
Paperbacks.
Weekend movie shows
Lower priced tickets for morning
shows
Frequent Flyer Programs.
49
Two-Part Tariffs
Example: The gym charges a fee to join and then a
per usage fee.
Definition: A two-part tariff is a per unit fee, r, plus
a lump sum fee, F.
A fixed fee is charged (often with the justification of

it contributing to the fixed costs of supply) and then a
supplementary variable charge based on the
number of units consumed. There are plenty of
examples of this including taxi fares, amusement
park entrance charges and the fixed charges set by
the utilities (gas, water and electricity). Price
discrimination can come from varying the fixed
charge to different segments of the market and in
varying the charges on marginal units consumed (e.g.
discrimination by time).
50
Other forms of price discrimination
TYING (COMPLEMENTARY
GOODS)
Bundling (DIFFERENT FROM
TYING)
51 of 38
CONDITIONS FOR PRICE
DISCRIMINATION
Market Control: First and foremost, a seller must be able to control
the price. Monopoly is quite adept at price discrimination because it is
a price maker, it can set the price of the good. Oligopoly and
monopolistic competition can undertake price discrimination to the
extent that they are able to control the price. Perfect competition,
with no market control, does not do well in the price discrimination
arena.
Different Buyers: The second condition is that a seller must be able
to identify different groups of buyers, and each group must have a
different price elasticity of demand. The different price elasticity
means that buyers are willing and able to pay different prices for the
same good. If buyers have the same elasticity and are willing to pay
the same price, then price discrimination is pointless. The price
charged to each group is the same.
Segmented Buyers: Lastly, price discrimination requires that each
group of buyers be segmented and sealed into distinct markets.
Segmentation means that the buyers in one market cannot resell
the good to the buyers in another market. Price discriminate is
ineffective if trade among groups is possible. Those buyers charged a
higher price could simply purchase the good from those who purchase
it at a lower price.
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Chapter 9
Pricing and Output

Decisions:
Monopolistic Competition
and Oligopoly

Chapter Nine 53
Overview
Monopolistic competition
Oligopoly
Pricing under oligopoly
Competing in imperfectly
competitive markets
Strategy: the challenge for firms
in imperfect competition
Chapter Nine 54
Learning objectives
contrast monopolistic competition
and oligopoly
describe the role that mutual

interdependence plays in setting
prices in oligopolistic markets
illustrate price rigidity using the

kinked demand curve
Chapter Nine 55
Learning objectives
explain how non-price factors help
firms to differentiate their products
and services
understand the five forces in Porters

model of competition

Chapter Nine 56
Introduction
Imperfect competition
some market power but not absolute

market power
firms have the ability to set prices within
the limits of certain constraints
mutual interdependence: interaction
among competitors when making
decisions
Chapter Nine 57
Introduction
Perfect Monopoly Monopolistic Oligopoly
Competition Competition
Market power? No Yes* Yes Yes
Mutual interdependence No No No Yes

among competing
firms?
Non-price competition? No Optional Yes Yes
Easy market entry Yes No Yes No

or exit ?
* subject to government regulation

Chapter Nine 58
Monopolistic competition:
characteristics
many firms
relatively easy entry
product differentiation: can set price at
a level higher than the price established
by perfect competition
use MR = MC rule to maximize profit

Chapter Nine 59
If earning above-normal profits,
newcomers will enter the market
market supply curve shifts out and to

the right
firms demand curve shifts down and
to the left
ultimately, in the long run, firms earn
only normal profit

Chapter Nine 60
Oligopoly
Oligopoly is a market dominated by a
relatively small number of large firms
Herfindahl-Hirschman index (HH)

measures market concentration (max HH =
10,000; unconcentrated markets have HH <
1,000) n
HH Si2
i 1
n = number of firms in the industry

Si = firms market share
Chapter Nine 61
Pricing in an oligopolistic
market
Mutual interdependence:
relatively few sellers create a
situation where each is carefully
watching the others as it sets its
price
Implication: kinked demand

curve model Basic assumption is
that competitor will follow a price
decrease but will not make a change
Chapter Nine
62
market
If reduce price and
competitors match the Competitors do not
price cut then move match price increases
along more inelastic
demand segment Di Competitors
match
price cuts
If increase price and
competitors do not
follow then move
along the more elastic
segment Df
marginal revenue
curve has kink (at A)
Chapter Nine 63
market
Price leader: one firm in the industry
takes the lead in changing prices, and
assumes that other firms:
will follow a price increase
but will not go even lower in order not
to trigger a price war
Non-price leader: firm that leads the

differentiation of products on other, non-
price attributes
Chapter Nine 64
competitive markets
Non-price competition: any effort made
by firms in order to change the demand for
their product (other than the price)
Non-price determinants of demand:

tastes and preferences
income
prices of substitutes and complements
number of buyers
future expectations of buyers
financing terms
Chapter Nine 65
competitive markets
Examples: of efforts by managers to
influence non-price demand
influences:
advertising and promotion
location and distribution channels
market segmentation
loyalty programs
product extensions and new products
special customer services
product lock-in or tie-in
pre-emptive new product
announcements
Chapter Nine
66
competitive markets
Equalizing at the margin: economic
concept which managers can use to help
make an optimal decision
eg MR = MC is an example of
equalizing at the margin

can be used to decide the optimal expenditure
level on a non-price factor
may occur over a long period of time
firm must adjust MR, MC for the time value of
money
Chapter Nine 67
competitive markets
Examples: the reality of imperfect

competition
auto industry
small retailers
global credit card issuers

Chapter Nine 68
Oligopoly
few firms
either homogeneous or differentiated products
interdependence of firms - policies of one firm affect the
other firms : conjectural variation
substantial barriers to entry
examples: auto industry and cigarette industry
Interdependence
The importance of interdependence
is that it leads to strategic behavior.
Strategic behavior is the behavior

that occurs when what is best for A
depends upon what B does, and what
is best for B depends upon what A
does.
Oligopolistic behavior includes both

Three Basic Models
Competition in quantities: Cournot-
Nash equilibrium
Competition in prices: Bertrand-Nash
equilibrium
Collusive oligopoly: Chamberlin notion
of conscious parallelism
It is very useful to know some basic
game theory to understand these
models as well as other oligopoly
models.
Collusion and Competition
Oligopoly firms may collude (act as a

monopoly) and earn positive profits.
OR
Oligopolists may compete with each
other and drive prices down to where
profits are zero.
While it pays for firms to collude, in
order to earn positive profits, it also
pays to cheat on the collusive
agreement. If one firm cuts its price
to slightly below the others, it could
gain a lot of business.
If everyone cheats on the agreement,
however, the agreement falls apart.
Collusive agreements less likely
to succeed when
secret price cuts are difficult and costly to detect.
(Quality changes are difficult to monitor.)
market conditions are unstable. (Differences in
expectations make it difficult to reach an
agreement.)
vigorous antitrust action increases the cost of
collusion .
Some oligopolistic markets operate in
a situation of price leadership.
A single firm sets industry price

and the remaining firms charge the
same price as the leader.
Sweezys kinked demand curve
model of oligopoly
Assumptions:
1. If a firm raises prices, other firms wont follow
and the firm loses a lot of business.
So demand is very responsive or elastic to
price increases.
2. If a firm lowers prices, other firms follow and
the firm doesnt gain much business.
So demand is fairly unresponsive or inelastic to
price decreases.
The Kinked Demand Curve
P*
D
Q quanti
* ty
MR Curve
for the top part of the Demand Curve
$
D
P*
MR
Q quanti
* ty
Drawing MR Curve
for the bottom part of the Demand Curve
P*
MR
D
Q* quanti
ty
MR Curve
for the bottom part of the Demand Curve
P*
MR
D
Q* quanti
ty
The Kinked Demand Curve
and the MR Curve
$
P*
MR
D
Q* quanti
ty
The MC curve intersects the MR curve
in the vertical segment.
$
MC
P*
MR
D
Q* quanti
ty
If costs shift up slightly, but MC still
intersects MR in the vertical segment,
there will be no
change in
$ MC price. This
MC price rigidity
is seen in real
P*
world
oligopoly
markets.
D
Q* MR quanti
ty
The ATC curve can be added to the graph.
To show positive profits, part of ATC curve
must lie under part of the demand curve.
$
MC ATC
P*
D
Q* MR quanti
ty
The ATC* value can be found on the
ATC curve above Q*.
$
MC ATC
P*
ATC*
D
Q* MR quanti
ty
TC = ATC . Q
$
MC ATC
P*
ATC*
Q* MR quantity
TR = P . Q
MC ATC
P*
Q* MR quantity
Profit = TR - TC
$
MC ATC
P* profit
ATC*
Q* MR quantity
To show a firm with a loss, the ATC curve must be entirely
above the demand curve.
ATC
$
MC AVC
ATC* loss
P*
Q* MR quantity
To show a firm breaking even, the ATC curve must
be tangent to the demand curve at the kink.
$
MC ATC
ATC*= P*
Q* MR quantity
Profit Possibilities for the
Oligopolist
short run:
positive profits, losses, or
breaking even.
long run:
positive profits, or breaking even
OLIGOPOLY
GAME THEORY
game theory Analyzes oligopolistic

behavior as a complex series of
strategic
moves and reactive countermoves
among rival firms. In game theory,
firms are
assumed to anticipate rival
reactions.
92 of 38
Introduction to game theory
We can look at market situations with two
players (typically firms)
Although we will look at situations where each
player can make only one of two decisions,
theory easily extends to three or more
decisions
John Nash, the person portrayed in A Beautiful
Mind
John Nash
One of the
early
researchers in
game theory
His work
resulted in a
form of
equilibrium
named after
Three elements in every
game
Players
Two or more for most games that are
interesting
Strategies available to each player
Payoffs
Based on your decision(s) and the decision(s)
of other(s)
Game theory: Payoff matrix
Person 2
A payoff
Action C Action D matrix
shows the
payout to
Action 10, 2 8, 3 each
Person
1
A player,
given the
Action 12, 4 10, 1 decision
B of each
player
How do we interpret this
box?
Person 2
The first number
in each box
Actio Actio determines the
nC nD payout for Person
Perso
n1 Actio 10, 2 8, 3 1
nA The second
Actio 12, 4 10, 1 number
nB determines the
payout for Person
2
How do we interpret this
box?
Person 2
Example
If Person 1 chooses
Actio Actio Action A and
nC nD Person 2 chooses
Perso
n1 Actio 10, 2 8, 3 Action D, then
nA Person 1 receives a
payout of 8 and
Actio 12, 4 10, 1
Person 2 receives a
nB
payout of 3
Back to a Core Principle:
Equilibrium
The type of equilibrium we are
looking for here is called Nash
equilibrium
Nash equilibrium: Any combination of
strategies in which each players strategy is
his or her best choice, given the other players
choices (F/B p. 322)
Exactly one person deviating from a NE
strategy would result in the same payout or
lower payout for that person
Steps 1 and 2
Person 2
Assume
Action Action D that you
C are Person
1
Perso
n1 Action 10, 2 8, 3 Given that
A Person 2
chooses
Action 12, 4 10, 1 Action C,
B what is
Person 1s
best
Step 3:
Person 2
Underline
Action Action D best payout,
C given the
choice of
Perso
the other
n1 Action 10, 2 8, 3 player
A Choose
Action B,
since
Action 12, 4 10, 1 12 > 10
B underline 12
Step 4
Person 2
Now
Action C Action assume
D that
Person 2
Perso
n1 Action 10, 2 8, 3 chooses
A Action D
Here,
Action 12, 4 10, 1 10 > 8
B Choose
and
underline
Step 5
Person 2
Now,
Action C Action D assume
you are
Person 2
Perso
Action 10, 2 8, 3 If Person 1
n1
chooses A
A 3>2
underline 3
Action 12, 4 10, 1 If Person 1

chooses B
B 4>1
underline 4
Step 6
Person 2
Which
Action C Action D box(es)
have
underlines
Perso
Action 10, 2 8, 3 under both
n1
A numbers?
Person 1
chooses B and
Person 2
Action 12, 4 10, 1 chooses C
B This is the only

NE
Dominant strategy
Person 2
A strategy is
Action C Action D dominant if
that choice is
definitely
Perso made no
n1 Action 10, 2 8, 3
matter what
A the other
person
Action 12, 4 10, 1 chooses
Example: Person 1
B has a dominant
strategy of choosing B
New example
Person 2
Suppose
Yes No in this
example
that two
Perso
n1 Yes 20, 20 5, 10 people are
simultane
ously
going to
No 10, 5 10, 10
decide on
this game
New example
Person 2
We will go
Yes No through the
same steps
to
Perso
n1 Yes 20, 20 5, 10 determine
NE
No 10, 5 10, 10
Two NE possible
Person 2
(Yes, Yes) and
Yes No (No, No) are
both NE
Although (Yes,
Perso Yes) is the
n1 Yes 20, 20 5, 10 more efficient
outcome, we
have no way
to predict
No 10, 5 10, 10 which
outcome will
actually occur
Two NE possible
When there are multiple NE that are
possible, economic theory tells us
little about which outcome occurs
with certainty
Prisoners Dilemma
A criminal, Bonnie is arrested by the

police
Thrown into prison
For three days, she is told nothing
.Then
Prisoners Dilemma
We have your friend Clyde and he is

starting to talk
Should Bonnie confess?

Prisoners Dilemma
Clyde
Confess Dont Confess
Bonnie
( -8, -8) ( 0, -15)

Confess
Dont Confess ( -15, 0) ( -1, -1)

Prisoners Dilemma
Clyde
Bonnie
( -8, -8) ( 0, -15)

Confess
Dont Confess ( -15, 0) ( -1, -1)

Prisoners Dilemma
Clyde
Bonnie
( -8, -8) ( 0, -15)

Confess
Dont Confess ( -15, 0) ( -1, -1)

Prisoners Dilemma
Conclusion:
Bonnie will confess
And Clyde?
Prisoners Dilemma
Clyde
Bonnie
( -8, -8) ( 0, -15)

Confess
Dont Confess ( -15, 0) ( -1, -1)

Prisoners Dilemma
Clyde
Bonnie
( -8, -8) ( 0, -15)

Confess
Dont Confess ( -15, 0) ( -1, -1)

Prisoners Dilemma
Conclusion:
Clyde confesses also
Both get 8 years, even though if they

cooperated, they could get off with one
year each
For both, confession is a dominant

strategy: a strategy that yields a better
outcome regardless of the opponents
choice
Identifying Dominant Strategies
Sometimes in a matrix game, a player will have a strategy

that, given all of the resulting outcomes, would not be worth
playing.
Such a strategy would not be worth playing if it is never

better and sometimes worse than some other strategy,
regardless of the strategies of other players.
For a given player, strategies that are never better and

sometimes worse than other strategies are called
dominated strategies. (We can think of this as equal or
worse than all of the other strategies.)
On the other hand, a dominant strategy is one that is

sometimes better and never worse than all other strategies,
regardless of the strategies of the other players. (We can
think of this as equal or better than all of the other
strategies.)
Example : Dominant Strategy
Company B
raise prices no change lower prices
raise prices 1,1 1,-1 2,0
Company A no change 0,1 0,0 -1,1
lower prices -1,1 1,0 -1,-1
Suppose two companies face each other in a competitive market.

Suppose each has three strategies, as shown above, and the payoffs,
representing profits in hundreds of thousands of dollars for a given
year, are as given in the table.
Notice that, in this example, both companies have dominant strategies
of raising prices. Because both players have dominant strategies,
these form the equilibrium point of the game.
A game in which potential payoffs to each player is the same is a
symmetric game. Because potential payoffs are different in this game,
it is an example of a nonsymmetrical game.
Example : Dominant Strategy
Company B
raise prices no change lower prices
raise prices 0,0 -1,1 -1,2
Company no change 0,1 0,0 0,1

A
lower prices 2,-1 1,-1 0,0
This is an example of a symmetric game. Potential payoffs to each

player are the same.
Both players have dominant strategies in lowering prices. So the

combination of both strategies is an equilibrium point.
Prisoners Dilemma
What would they both decide if they could
negotiate?
They could both become better off if they

reached the cooperative solution.
which is why police interrogate suspects in
separate rooms.
Equilibrium need not be efficient.

Noncooperative equilibrium in the
Prisoners dilemma results in a solution
that is not the best possible outcome for
the parties.
Equilibrium
Nash Equilibrium: Neither player

has an incentive to change strategy,
given the other players choice
Both confess is a Nash Equilibrium
Both dont confess is not a Nash

Equilibrium, rival will always want to renege
OLIGOPOLY
FIGURE 14.6 Payoff Matrix for

Advertising Game
125 of 38
OLIGOPOLY
maximin strategy In game theory,

a strategy chosen to maximize the
minimum gain that can be earned.
126 of 38
OLIGOPOLY
REPEATED GAMES
retaliation strategy A companys

strategy that lets a competitor know
the company
will follow the competitors lead.
FIGURE 14.9 Payoff Matrix for

Airline Game 127 of 38
Chapter 10
Special Pricing Policies

Chapter Ten 128
Overview
Cartel arrangements
Price leadership
Revenue maximization
Price discrimination
Nonmarginal pricing
Multiproduct pricing
Transfer pricing
Chapter Ten 129
Learning objectives
analyze cartel pricing
illustrate price leadership
see how price discrimination affects

output and prices

Chapter Ten 130
Learning objectives
distinguish between marginal pricing

and cost-plus pricing
discuss the various types of

multiproduct pricing
explain how a company can use

transfer pricing

Chapter Ten 131
Cartel arrangements
A cartel is an arrangement where
firms in an industry cooperate and
act together as if they were a
monopoly
cartel arrangements may be tacit or

formal
illegal in the US: Sherman Antitrust
Act, 1890
examples: OPEC, IATA
Chapter Ten 132
Cartel arrangements
Conditions that influence the
formation of cartels
small number of large firms in the
industry
geographical proximity of the firms
homogeneous products that do not
allow differentiation
stage of the business cycle
difficult entry into industry
uniform cost conditions, usually defined
by product homogeneity
Chapter Ten 133
Cartel arrangements
In order to maximize profits, the cartel as
a whole should behave as a monopolist
the cartel determines the output which
equates MR = MC of the cartel as a whole
the MC of the cartel as a whole is the
horizontal summation of the members
marginal cost curves
price is set in the normal monopoly
way, by determining quantity demanded
where MC=MR and deriving P from the
demand curve at that Q

Chapter Ten 134
Cartel arrangements
MCT is the horizontal sum of MCI and MCII

QT is found at the intersection of MRT and MCT
price is found from the demand curve at QT
this is the price that maximizes total industry
profits

Chapter Ten 135
Cartel arrangements
to determine how much each firm should produce, draw a

horizontal line back from the MRT/MCT intersection
where this line intersects each individual firms MC
determines that firms output, QI and QII. Note that the
firms may produce different outputs
Key point: the MC of the last unit produced is equated
across both firms

Chapter Ten 136
Cartel arrangements
Profits for each firm are shown as rectangles in blue
Firms may earn different levels of profit, though

combined profits are maximized
Chapter Ten 137
Cartel arrangements
Problem: incentive for firms to cheat
on agreement, thus cartels are
unstable
Additional costs facing the cartel

formation costs
monitoring costs
enforcement costs
cost of punishment by authorities
weigh the benefits against these
costs
Chapter Ten
138
Cartel arrangements
Examples: price fixing by cartels
GE, Westinghouse
Archer Daniels Midland Company
Sothebys, Christies
Roche Holding AG, BASF AG

Chapter Ten 139
Price leadership
Barometric price leadership
one firm in an industry will initiate a

price change in response to economic
conditions
the other firms may or may not follow
this leader
leader may vary

Chapter Ten 140
Price leadership
Dominant price leadership
one firm is the industry leader

dominant firm sets price with the
realization that the smaller firms will
follow and charge the same price
can force competitors out of business or
buy them out under favorable terms
could result in investigation under
Sherman Anti-Trust Act
Chapter Ten 141
Price leadership
DT = demand curve
for entire industry
MCD = marginal cost of

the dominant firm
MCR = summation of
MC of follower firms
in setting price,
dominant firm must
consider the amount
supplied by all firms
Chapter Ten 142
Loss leadership pricing
retailers set very low price below
cost
this is done to capture large
customer base
retailer make up loss by charging
higher price in other items or
services
this strategy is used by large
multinationals who have deep
pockets to retain market share
Chapter Ten
143

Chapter Ten 144
Example:
Tata Motors offer low of basic small car

Nano to low income buyers
selling higher-end model to wealthy
customers to recoup loss for lower-end
model

Chapter Ten 145
Price leadership
Demand curve facing

the dominant firm is
found by subtracting
MCR from DT
dominant firm
equates its MC with
MR from its residual
demand curve DD
the dominant firm
sells A units and the
rest of the demand (QT
A) is supplied by the
follower firms
Chapter Ten 146
Revenue maximization
Baumol model: firms maximize revenue
(not profit) subject to maintaining a
specific level of profits
Rationale
a firm will become more competitive when it
achieves a large size
management remuneration may be related
to revenue not profits
Implication: unlike the profit maximization
case, a change in fixed costs will alter
price and output (by raising the cost curve
and lowering the profit line)
Chapter Ten 147
Price discrimination: products with
identical costs are sold in different
markets at different prices
the ratio of price to marginal cost
differs for similar products
Conditions for price discrimination

the markets in which the products are sold
must by separated (no resale between
markets)
the demand curves in the market must have
different elasticities
Chapter Ten 148
First degree price discrimination
seller can identify where each consumer

lies on the demand curve and charges
each consumer the highest price the
consumer is willing to pay
allows the seller to extract the greatest
amount of profits
requires a considerable amount of
information
Chapter Ten 149
Second degree price discrimination
differential prices charged by blocks of

services
requires metering of services consumed
by buyers

Chapter Ten 150
Third degree price discrimination
customers are segregated into different
markets and charged different prices in
each
segmentation can be based on any
characteristic such as age, location,
gender, income, etc

Chapter Ten 151
Third degree discrimination:

assume the firm operates in two markets, A and B
the demand in market A is less elastic than the demand in
market B
the entire market faced by the firm is described by the horizontal
sum of the demand and marginal revenue curves

Chapter Ten 152
the firm finds the total amount to produce by equating the

marginal revenue and marginal cost in the market as a whole: QT
if the firm were forced to charge a uniform price, it would find the
price by examining the aggregate demand DT at the output level
QT
the firm can increase its profits by charging a different price in
each market

Chapter Ten 153
in order to find the optimum price to charge in each market, draw

a horizontal line back from the MRT/MCT intersection
where this line intersects each submarkets MR curve determines
the amount that should be sold in each market: QA and QB
these quantities are then used to determine the price in each
market using the demand curves DA and DB

Chapter Ten 154
Examples of price discrimination
doctors
telephone calls
theaters
hotel industry
Chapter Ten 155
Tying arrangement: a buyer of one
product is obligated to also by a
related product from the same supplier
illegal in some cases

one explanation: a device to meter
demand for tied product
other explanations of tying
quality control
efficiencies in distribution
evasion of price controls
Chapter Ten 156
Nonmarginal pricing
Cost-plus pricing: price is set by first
calculating the variable cost, adding an
allocation for fixed costs, and then
adding a profit percentage or markup
Problems with cost-plus pricing

calculation of average variable cost
allocation of fixed cost
size of the markup
Chapter Ten 157
Nonmarginal pricing
Incremental pricing (and costing)
analysis: deals with changes in total
revenue and total cost resulting from a
decision to change prices or product
Features:
incremental, similar to marginal analysis
only revenues and costs that will change due
to the decision are considered
examples of product change: new product,
discontinue old product, improve a product,
capital equipment
Chapter Ten 158
When the firm produces two or more
products
Case 1: products are complements in terms

of demand an increase in the quantity
sold of one will bring about an increase in
the quantity sold of the other
Case 2: products are substitutes in terms of
demand an increase in the quantity
sold of one will bring about a decrease in
the quantity sold of the other
Chapter Ten 159
When the firm produces two or more
products
Case 3: products are joined in

production
products produced from one set of inputs
Case 4: products compete for

resources using resources to
produce one product takes those
resources away from producing other
products
Chapter Ten 160
Transfer pricing
Internal pricing: as the product moves
through these divisions on the way to the
consumer it is sold or transferred from one
division to another at a transfer price
Rationale:
firm subdivided into divisions, each may be
charged with a profit objective
without any coordination, the final price of
the product to consumers may not maximize
profits for the firm as a whole
Chapter Ten 161
Transfer pricing
Design of the optimal transfer

pricing mechanism is complicated
by the fact that
each division may be able to sell its

product in external markets as well as
internally
each division may be able to procure
inputs from external markets as well
as internally
Chapter Ten 162
Transfer pricing
Case A: no external markets
no division can buy from or sell to an
external market
the selling division will produce exactly
the number of components that will be
used by the purchasing division
one demand curve and two MC curves
MC curves are summed vertically
set production where MR = Total MC

Chapter Ten 163
Transfer pricing
Case B: external markets
divisions have the opportunity to buy or
sell in outside competitive markets
if selling division prices above the
external market price, the buying
division will buy from outside
if selling division cannot produce enough
to satisfy buying division demand, the
buying division will buy additional units
from the external market
Chapter Ten 164
Other pricing practices
Price skimming
the first firm to introduce a product may
have a temporary monopoly and may be
able to charge high prices and obtain
high profits until competition enters
Penetration pricing
selling at a low price in order to obtain
market share
Chapter Ten 165
Other pricing practices
Prestige pricing
demand for a product may be higher at
a higher price because of the prestige
that ownership bestows on the owner
Psychological pricing
demand for a product may be quite
inelastic over a certain range but will
become rather elastic at one specific
higher or lower price
Chapter Ten 166
Global application
Example: decline of European cartels
carton-board
vitamin
copper pipe
elevator operators

Chapter Ten 167
Chapter 11
Game Theory
and
Asymmetric Information

Chapter Eleven 168
Overview
Game theory
Game theory and auctions
Strategy and game theory
Asymmetric information
Reputation
Standardization
Market signaling
Chapter Eleven 169
Learning objectives
apply game theory to mutually
interdependent business decisions
explain the game called Prisoners

Dilemma
use the concept of a dominant

strategy to show how auctions can
help improve the price for sellers,
while still benefiting buyers
Chapter Eleven 170
Learning objectives
analyze asymmetric information
understand the concepts of adverse

selection and moral hazard
explain how market signaling can

help agents make better economic
decisions when asymmetric
information exists
Chapter Eleven 171
Game theory
Economic optimization has two
shortcomings when applied to actual
business situations
assumes factors such as reaction of

competitors or tastes and preferences of
consumers remain constant
managers sometimes make decisions

when other parties have more
information about market conditions
Chapter Eleven 172
Game theory
Game theory: is concerned with

how individuals make decisions
when they are aware that their
actions affect each other and when
each individual takes this into
account

Chapter Eleven 173
Game theory
Fundamental aspects of game theory
players are interdependent
uncertainty: other players actions are
not entirely predictable
Types of games
zero-sum or non-zero-sum
cooperative or non-cooperative
two-person or n-person

Chapter Eleven 174
Games in economics
Prisoners Dilemma
two-person, non-zero-
sum, non-cooperative
always has a dominant
strategy
equilibrium is stable
confessing is dominant
strategy for each player,
no matter what other
player chooses
each player has no

incentive to unilaterally
change his strategy

Chapter Eleven 175
Games in economics
Oligopoly pricing using
prisoners dilemma
(Low/Low) is a stable
equilibrium no
incentive for either firm
to deviate
better off at (High/High)

but it is not stable
each firm has an
incentive to deviate
(High/High) would be an
equilibrium if the
firms were allowed to
cooperate Copyright 2011 Pearson Education,
Chapter Eleven 176
Games in economics
Example: Beach Kiosk Game: a two-
person, zero-sum, non-cooperative
game
Suppose two companies provide snacks and

sunscreen on a beach
beachgoers will spread themselves out
evenly along the beach
both companies ultimately locate at the
midpoint of the beach, otherwise the other
company has an advantage (closer to more
beachgoers

Real life example:
Chapter Eleven
location
Inc. Publishing of gas stations
as Prentice Hall.
177
Games in economics
Repeated Game: game is played
repeatedly over a period of time
in a perpetual repeated game, equilibria

that are not stable may become stable due
to the threat of retaliation
however, if number of periods is fixed,

players will have incentive to cheat in the
last period due to lack of threat of
retaliation, which will then allow them to
cheat in all periods
Chapter Eleven 178
Games in economics
Example: assume (High, High) equilibrium reached
and both firms start off charging the high price
in the next period, if one firm cheats (charges low

price), it receives 600 in that period
other firm will change to low prices in the next

period to retaliate and both will end up at (Low,
Low) equilibrium
thus, incentive exists not to cheat in a perpetual

repeated game and (High, High) is a viable
equilibrium (unlike in the short game)

Chapter Eleven 179
Games in economics
Simultaneous games are games in
which players make their strategy
choices at the same time
Sequential games are games in

which players make their decisions
sequentially
In sequential games, the first mover

may have an advantage
Chapter Eleven 180
Games in economics
Consider the following payoff matrix in which firms choose
their capacity, either high or low. Suppose firm C has the
ability to move first
C would choose Low, then D would choose High

Chapter Eleven 181
Game theory and auctions
Dutch auction (a non-cooperative, non-zero-sum
game):
each buyer describes the quantity
demanded and price to pay
starting at highest price, sum quantity
demanded up to the supply available
all product is sold at the highest price
that clears the market
Seller wants to sell at highest price, buyer wants
to buy at lowest price
Solution: every players dominant strategy is to

bid as late as possible
Chapter Eleven 182
Problem: in Prisoners Dilemma, players
have a dominant strategy that leads to
suboptimal results
Commitment, explicit or implicit, can be

used to achieve preferred outcomes. It
must be credible:
burn bridges behind you
establish and use a reputation
write contracts

Chapter Eleven 183
Incentives also can be used to change the

game to achieve preferred outcomes
Illustration: GM card. GM came up with a

strategy where customers could apply
5% of their purchases to a GM vehicle
Illustration: Health insurance. Firms

provide a menu of care levels.
Chapter Eleven 184
PARTS: paradigm for studying a situation,

predicting players actions, making
strategic decisions
Players: Who are players and what are their
goals?
Added Value: What do the different players
contribute to the pie?
Rules: What is the form of competition? Time
structure of the game?
Tactics: What options are open to the players?
Commitments? Incentives?
Scope: What are the boundaries of the game?
Chapter Eleven 185
Asymmetric information: market
situation in which one party in a
transaction has more information
than the other party. Leads to many
problems in markets:
too much or too little production
difficult contracting
possible fraud
market may disappear
Chapter Eleven 186
Adverse selection: prior to
transaction, one party may know
more about the value of a good than
the other
Example: lemons (bad used

cars) seller knows the vehicle well,
but buyer does not, yet market does
not divide in two
Chapter Eleven 187
Moral Hazard: transaction changes
the incentives of a party because it
cannot be monitored after the
transaction
Example: insurance industry ...

poor information takes place after
the sale, not before

Chapter Eleven 188
Market responses:
obtaining information from third

parties
relying on reputation of the seller
standardization of products
market signaling: demonstrated
success in one activity provides
information about success/quality in
Chapter Eleven 189
another Inc. Publishing as Prentice Hall.
Example: education as a signal
attending college demonstrates certain

traits
employers see this a screening device

Chapter Eleven 190
Example: warranties
more costly on low quality goods than

high quality goods
consumers see them as a screening
device

Chapter Eleven 191
Example: banking systems
banks know less about the borrowers

ability to repay than the customer
arms length banking: US
relationship banking: Japan

Chapter Eleven 192
Price and Output Decisions in Pure Monopoly Markets
The Absence of a Supply Curve in Monopoly
A monopoly firm has no supply curve that is independent of the

demand curve for its product.
A monopolist sets both price and quantity, and the amount of

output that it supplies depends on both its marginal cost curve
and the demand curve that it faces.
A monopoly does not necessarily supply larger quantities at
higher prices or smaller quantities at lower prices.
193 of 38
Monopoly in the Long Run: Barriers to Entry
barriers to entry Factors that

prevent new firms from entering
and competing in imperfectly
competitive industries.
natural monopoly An industry

that realizes such large
economies of scale in producing
its product that single-firm
production of that good or service
is most efficient.
194 of 38
Economies of Scale
FIGURE 13.8 A
Natural Monopoly
A natural monopoly is a firm in

which the most efficient scale is
very large. The fixed cost is very
high. Here, average total cost
declines until a single firm is
producing nearly the entire amount
demanded in the market. With one
firm producing 500,000 units,
average total cost is $1 per unit.
With five firms each producing
100,000 units, average total cost is
$5 per unit.
195 of 38
Patents
patent A barrier to entry that
grants exclusive use of the
patented product or process to
the inventor.
Government Rules
Ownership of a Scarce Factor of Production
196 of 38

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Chapter 8

Pricing and Output

Copyright 2011 Pearson Education,

Competition and market types

large number of relatively small buyers

very easy market entry and exit

one firm, firm is the industry

unique product or no close substitutes

market entry and exit difficult or legally

large number of small firms acting

market entry and exit relatively easy

small number of large mutually

differentiated or standardized product

market entry and exit difficult

nonprice competition important

Copyright 2011 Pearson Education,

gas station on edge of desert

Copyright 2011 Pearson Education,

Copyright 2011 Pearson Education,

the firm is a price taker

firm receives the same

no limit to the total

compare the total revenue and total cost

Copyright 2011 Pearson Education,

Note: for the perfectly competitive firm,

The point where

Copyright 2011 Pearson Education,

The firm incurs a loss.

Copyright 2011 Pearson Education,

if CM > 0, the firm

Copyright 2011 Pearson Education,

At the shutdown point, the price is equal to

If the price falls below the shutdown point,

economic profit invites entry of new firms

Copyright 2011 Pearson Education,

as new firms enter the market, firms must find

firms that find themselves unable to compete

firm has the power to set any price it

however, the firms ability to set price is

Copyright 2011 Pearson Education,

set output where

Copyright 2011 Pearson Education,

most important lesson is that it is

must be as cost efficient as possible

it might pay for a firm to move into a

Copyright 2011 Pearson Education,

most important lesson is not to be

changes in economics of a business

sushi restaurants operate in

Copyright 2011 Pearson Education,

Copyright 2002 by The McGraw-Hill Companies, Inc. All

Find the HHI in an industry with just two firms

Copyright 2002 by The McGraw-Hill Companies, Inc. All

Find the HHI in an industry that has four firms

625 + 625 + 625 + 625

Copyright 2002 by The McGraw-Hill Companies, Inc. All

Doesnt give extra weight to

R.J. Reynolds (Sunkist, Canada Dry) 3.0

price discrimination Charging

perfect price discrimination

Basic model: a monopolist charges:

Changing one or both of these is called Price

Different prices for both consumers and units.

To do this properly, a monopolist must have