Economic theory

MBA(IB) 2025-27
Lectures 11-13

Papiya Ghosh
 Using Market Power
How to use the market power most effectively?
▪ The managers of a firm with monopoly power must not only look at the cost side but also
worry about the characteristics of demand.
▪ Even if they set a single price for the firm’s output, they must obtain at least a rough
estimate of the elasticity of demand to determine what that price (and corresponding
output level) should be.
▪ Furthermore, firms can often do much better by using a more complicated pricing
strategy—for example, charging different prices to different customers
▪ The basic objective of every pricing strategy: capturing consumer surplus and converting
it into additional profit for the firm.
▪ Next, we discuss price strategies like price discrimination, two-part tariff and bundling.

2 Papiya Ghosh
 Capturing Consumer Surplus

• If a firm can charge only one price for all its

customers, that price will be P* and the
quantity produced will be Q*.
• Ideally, the firm would like to charge a higher
price to consumers willing to pay more than
P*, thereby capturing some of the consumer
surplus under region A of the demand curve.
• The firm would also like to sell to consumers
willing to pay prices lower than P*, but only if
doing so does not entail lowering the price to
other consumers.
• In that way, the firm could also capture some
of the surplus under region B of the demand
curve.
• This can be done either by practicing price
discrimination or two-part tariffs or bundling.
 Price Discrimination
▪ Under certain conditions the monopolist can increase its profit by charging different
prices to different buyers for the same good or different prices for different units of the
same good. When the monopolist does so, he is said to be engaging in price
discrimination.
▪ Price discrimination can take three forms:
✓ Charging each customer in a single market the maximum price she or he is willing to pay
(reservation price)- first degree
✓ Charging each customer one price for the first set of units purchased and a lower price for
subsequent units purchased- second degree
✓ Charging some customers one price and other customers another price- third degree

▪ Different prices are not based on cost differences.

▪ Examples of Price Discrimination- Business travel, Movie theaters, Railway tickets,
Coupons, International trade
 First Degree Price Discrimination
▪ When a firm perfectly price discriminates each consumer is being charged the
maximum amount he or she is willing to pay.
▪ Marginal revenue is no longer relevant
▪ The additional profit from selling an incremental unit is the difference between
price received for that unit (given by the demand curve) and marginal cost.
▪ As long as the price as per the demand curve exceeds marginal cost, the firm can
increase its profit by expanding production.
▪ All consumer surplus is captured by the firm.
▪ In practice perfect price discrimination is almost never possible.
▪ Firms may discriminate imperfectly by charging a few different prices based on
estimates of consumers’ reservation prices.

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PERFECT PRICE DISCRIMINATION
ADDITIONAL PROFIT FROM
PERFECT FIRST-DEGREE
PRICE DISCRIMINATION

Because the firm charges

each consumer her
reservation price, it is
profitable to expand output to
Q**.
When only a single price, P*,
is charged, the firm’s variable
profit is the area between the
marginal revenue and
marginal cost curves.
With perfect price
discrimination, this profit
expands to the area between
the demand curve and the
marginal cost curve. The additional profit from producing and selling an incremental
unit is the difference between demand and marginal cost.
IMPERFECT PRICE DISCRIMINATION

FIRST-DEGREE PRICE DISCRIMINATION

IN PRACTICE

Firms usually don’t know the reservation

price of every consumer, but sometimes
reservation prices can be roughly
identified.
Here, six different prices are charged.
The firm earns higher profits, but some
consumers may also benefit.
With a single price P4, there are fewer
consumers.
Some of the consumers who now pay P5
or P6 may enjoy a surplus.
 Second Degree Price Discrimination
▪ In some markets, as consumer purchases many units of a good over a given period,
his reservation price declines with the number of units purchased.
▪ In this case a firm can discriminate according to the quantity consumed
▪ Different prices are charged for different quantities of the same good
▪ Example: Quantity discounts
▪ Block Pricing is also an example of second degree price discrimination
▪ The consumer is charged different prices for different quantities or blocks of a
good.
▪ If scale economies causes average and marginal costs to decline, the govt agencies
controlling the rates may encourage block pricing
▪ It can increase consumer welfare while allowing for greater profit to the company

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Second-Degree Price Discrimination

Second-degree price discrimination Practice of charging different prices per

unit for different quantities of the same good or service.

Block pricing Practice of charging different prices for different quantities or

“blocks” of a good.

SECOND-DEGREE PRICE DISCRIMINATION

Different prices are charged for different

quantities, or “blocks,” of the same good. Here,
there are three blocks, with corresponding
prices P1, P2, and P3.
There are also economies of scale, and
average and marginal costs are declining.
Second-degree price discrimination can then
make consumers better off by expanding output
and lowering cost.
 Third-Degree Price Discrimination
▪ It is the practice of dividing consumers into two or more groups with separate
demand curves and charging different prices to each group.
▪ Most prevalent form of price discrimination. Examples: Regular versus special
airline fare, premium versus non premium brands of chocolates/liquor, discounts
to students and senior citizens, coupons
▪ The first step is CREATING CONSUMER GROUPS- vacationers versus business
travelers, students and senior citizens versus rest of the population

10 Papiya Ghosh
 What price for which group?
▪ How should the firm decide what price to charge each group of consumers?
1. However much is produced, total output should be divided between the groups
of customers so that marginal revenues for each group are equal.
2. Total output must be such that the marginal revenue for each group of
consumers is equal to the marginal cost of production. MR1=MR2=….=MC
𝑃1 1+1Τ𝑒2
3. Relative prices to be charged to each group of consumers: = .
𝑃2 1+1Τ𝑒1
4. Higher price will be charged to consumers with the lower absolute e.
✓ Check with e1=2 and e2=4.
✓ P1 must be 1.5 times higher than P2.

11 Papiya Ghosh
THIRD-DEGREE PRICE DISCRIMINATION

Consumers are divided into two groups,

with separate demand curves for each
group. The optimal prices and quantities
are such that the marginal revenue from
each group is the same and equal to
marginal cost.

Here group 1, with demand curve D1, is

charged P1, and group 2, with the more
elastic demand curve D2, is charged the
lower price P2.

Marginal cost depends on the total

quantity produced QT.

Note that Q1 and Q2 are chosen so that

MR1 = MR2 = MC.
Price Discrimination Applied to Different Groups of Buyers

P P
Pb Economic profit (a)

Economic profit (b)

Ps
MC = MC = ATC
Db ATC Ds
MRb MRs

0 Qb Q 0 Qs Q
(a) Businesses (b) Students
NO SALES TO SMALLER MARKETS
Even if third-degree price
discrimination is feasible, it may not
pay to sell to both groups of consumers
if marginal cost is rising.

Here the first group of consumers, with

demand D1, are not willing to pay much
for the product.

It is unprofitable to sell to them

because the price would have to be too
low to compensate for the resulting
increase in marginal cost.
EXAMPLE THE ECONOMICS OF COUPONS AND REBATES
Coupons are often issued to the customers to buy products at discounts. Why
do the firms issue coupons? Why not lower the price of the product?
TABLE PRICE ELASTICITIES OF DEMAND FOR USERS
VERSUS NONUSERS OF COUPONS
PRICE ELASTICITY
Coupons provide a means of price
PRODUCT NONUSERS USERS
discrimination.
Toilet tissue – 0.60 –0.66
Stuffing/dressing –0.71 –0.96
Studies show only about 20-30% of all
Shampoo –0.84 –1.04
consumers use coupons. They are more sensitive
Cooking/salad oil –1.22 –1.32
to price than those who ignore coupons.
Dry mix dinners –0.88 –1.09
Cake mix –0.21 –0.43
By issuing coupons the firm can separate its
Cat food –0.49 –1.13
customers into 2 or more groups and charge
Frozen entrees –0.60 –0.95
more price-sensitive customers a lower price
Gelatin –0.97 –1.25
than others
Spaghetti sauce –1.65 –1.81
Crème rinse/conditioner –0.82 –1.12
Soups –1.05 –1.22
Hot dogs –0.59 –0.77
 USING COUPONS AND REBATES FOR PRICE
DISCRIMINATION
▪ Pricing strategy:
P(1 – 1/|eR|) = (P – X)(1 – 1/|eS|) = MC

➢ P = market price
➢ X = discount from coupon or rebate
➢ eR = price elasticity of demand by those who don't use coupons or rebates
➢ eS = price elasticity of demand by those who do use coupons or rebates

16 Papiya Ghosh
 USING COUPONS AND REBATES FOR PRICE
DISCRIMINATION
▪ By estimating the elasticity of demand, managers can figure out how coupons
should be priced.
▪ Example: Barnegat Light Fish Company price crab cakes
▪ Two types of consumers exist, R and S; eR=-2, eS= -5
▪ Managers at the fish company choose a posted price (P) but then issue a coupon for $X
off in the newspaper local to the consumer types
▪ MC = 2
▪ What should the values of P and X be?
➢ For R, MR = MC => P = 4
➢ For S, MR = (4 – X)[1 – (1/|–5|)] = 2 = MC => X = 1.5

17 Papiya Ghosh
EXAMPLE AIRLINE FARES
Travellers are often amazed at the variety of fares available for round-trip
flights from New York to Los Angeles.
At some point, for example, the first-class fare was above $2000; the
regular (unrestricted) economy fare was about $1000, and special
discount fares (often requiring the purchase of a ticket two weeks in
advance and/or a Saturday night stayover) could be bought for as little as
$200. These fares provide a profitable form of price discrimination. The
gains from discriminating are large because different types of customers,
with very different elasticities of demand, purchase these different types
of tickets.
Airline price discrimination has become increasingly sophisticated. A wide
variety of fares is available.
TABLE ELASTICITIES OF DEMAND FOR AIR TRAVEL
FARE CATEGORY
ELASTICITY FIRST CLASS UNRESTRICTED COACH DISCOUNTED
Price –0.3 –0.4 –0.9
Income 1.2 1.2 1.8
19 Papiya Ghosh
 Practice Problems
1. Suppose Akshara Airlines (AA) flies only one route: Jammu-Kochi. The demand for each flight is Q
= 500 − P. AA’s cost of running each flight is $30,000 plus $100 per passenger.
a. What is the profit-maximizing price that AA will charge? How many people will be on each flight?
What is AA’s profit for each flight?
A: P=200, Q=300, Profit= 0
b. AA finds out that two different types of people fly to Kochi. Type A consists of business people with a
demand of QA = 260 − 0.4P. Type B consists of students whose total demand is QB = 240 −0.6P.
Because the students are easy to spot, AA decides to charge them different prices. What price does
AA charge the students? What price does it charge other customers? How many of each type are on
each flight?
c. Calculate the consumer surplus of each consumer group. What is the total consumer surplus?
d. Before AA started price discriminating, how much consumer surplus was the Type A demand getting
from air travel to Kochi? Type B?

20 Papiya Ghosh
 Intertemporal Price Discrimination and Peak-Load
Pricing
▪ Intertemporal price discrimination Separating consumers with different
demand functions into different groups by charging different prices at different
points in time.
▪ Peak-load pricing Charging higher prices during peak periods when capacity
constraints cause marginal costs to be high. Examples:
 Electricity generation
 Roadways
 Resort and hotel rooms

21 Papiya Ghosh
Intertemporal Price Discrimination

Consumers are divided into groups by

changing the price over time.
Initially, the price is high. The firm
captures surplus from consumers who
have a high demand for the good and
who are unwilling to wait to buy it.
Later the price is reduced to appeal to
the mass market.
EXAMPLE HOW TO PRICE A BEST-SELLING NOVEL

Publishing both hardbound and paperback editions

of a book allows publishers to price discriminate.
Some consumers want to buy a new book by bestseller
author as soon as it is released, even if the price is
Rs. 500. Other consumers, however, will wait a year until
the book is available in paperback for Rs.200.
The key is to divide consumers into two groups, so that those who are
willing to pay a high price do so and only those unwilling to pay a high
price wait and buy the paperback.
It is clear, however, that those consumers willing to wait for the paperback
edition have demands that are far more elastic than those of bibliophiles.
It is not surprising, then, that paperback editions sell for so much less than
hardbacks.
 Peak-Load Pricing
The objective is to increase economic efficiency by charging prices that are close to marginal cost.

Demands for some goods and services

increase sharply during particular times of the
day or year. Marginal cost is higher during
these peak periods because Plant capacity
is constant.
The firm sets MR equal to MC for each
period obtaining higher price P1 for the peak
period and P2 price for the nonpeak period.

Charging a higher price P1 during the peak

periods is more profitable for the firm than
charging a single price at all times.

It is also more efficient because prices are

equal to MCs in the respective periods.
 The Two-Part Tariff
Form of pricing in which consumers are charged both an entry fee upfront and a per unit
usage fee.

How to set the entry fee and the usage fee? Should the entry fee be high and usage fee low or the other
way round?

TWO-PART TARIFF WITH A SINGLE

CONSUMER
The consumer has demand curve D.

The firm maximizes profit by setting usage fee P equal

to marginal cost and entry fee T* equal to the entire
surplus of the consumer.
The firm thus captures all the consumer surplus as its
profit

Examples
Clubs (golf, health, discount, etc.) that charge a membership fee and a per use fee
Phone plans that charge a fixed fee and then additional fees per minute
Personal seat licenses (PSL) for sports stadiums—a fixed cost that gives the purchaser the right to buy tickets to
games.
TWO CONSUMERS

The firm can set only one entry fee and one usage fee

TWO-PART TARIFF WITH TWO

CONSUMERS
The profit-maximizing usage fee P* will
exceed marginal cost.

The entry fee T* is equal to the surplus of

the consumer with the smaller demand.

The resulting profit is 2T* + (P* − MC)(Q1 +

Q2). Note that this profit is larger than twice
the area of triangle ABC.
MANY CONSUMERS

TWO-PART TARIFF WITH MANY

DIFFERENT CONSUMERS
Total profit π is the sum of the profit from the
entry fee πa and the profit from sales πs. Both πa
and πs depend on T, the entry fee.
Therefore

π = πa + πs = n(T)T + (P − MC)Q(n)
where n is the number of entrants, which
depends on the entry fee T, and Q is the rate of
sales, which is greater the larger is n.
Here T* is the profit-maximizing entry fee, given
P. To calculate optimum values for P and T, we
can start with a number for P, find the optimum
T, and then estimate the resulting profit.
P is then changed and the corresponding T
recalculated, along with the new profit level.
Bundling
Practice of selling two or more products as a package.

To see how a film company can use customer heterogeneity to its advantage, Suppose
that there are two movie theaters and that their reservation prices for two films are as
follows:
Sitare Zameen Par Lal Singh Chaddha
Theater A $12,000 $3000
Theater B $10,000 $4000

If the films are rented separately, the maximum price that could be charged for Dangal is
$10,000 because charging more would exclude Theater B. Similarly, the maximum
price that could be charged for LSC is $3000. Total revenue=$26000

But suppose the films are bundled. Theater A values the pair of films at $15,000 ($12,000
+ $3000), and Theater B values the pair at $14,000 ($10,000 + $4000). Therefore, we
can charge each theater $14,000 for the pair of films and earn a total revenue of
$28,000.
CONSUMPTION DECISIONS
WHEN PRODUCTS ARE SOLD
SEPARATELY
The reservation prices (r1 and r2) of
consumers in region I exceed the
prices P1 and P2 for the two goods,
so these consumers buy both goods.
Consumers in regions II and IV buy
only one of the goods, and
consumers in region III buy neither
good.
CONSUMPTION DECISIONS WHEN
PRODUCTS ARE BUNDLED

Consumers compare the sum of their reservation

prices r1 + r2, with the price of the bundle PB.
They buy the bundle only if r1 + r2 is at least as
large as PB.

Depending on the prices, some of the consumers in

region II and IV might have bought one of the goods
if they had been sold separately. These consumers are
lost to the firm, however, when it sells the goods
only as a bundle.
The firm, then, must determine whether it can do
better by bundling.
 ▪ The effectiveness of bundling depends on the extent to which demands are
negatively correlated.
▪ It works best when consumers who have a high reservation price for good 1 have a
low reservation price for good 2, and vice versa.
▪ By charging the price PB the firm can capture all the consumer surplus.
▪ In the movie theatre example Theatre A will pay relatively more for the movie SZP
but Theatre B will pay relatively more for LSC. This makes it profitable to rent the
films as a bundle priced at $14000.

31 Papiya Ghosh
 Mixed Bundling
Selling two or more goods both as a package and individually.

Mixed bundling is often the ideal strategy when demands are only somewhat negatively correlated and/or
when marginal production costs are significant.

MIXED VERSUS PURE BUNDLING

With positive marginal costs, mixed bundling may be more
profitable than pure bundling.

Consumer A has a reservation price for good 1 that is below

marginal cost c1, and consumer D has a reservation price for good
2 that is below marginal cost c2.
With mixed bundling, consumer A may be induced to buy only
good 2, and consumer D is induced to buy only good 1, thus
reducing the firm’s cost.

Let us compare three strategies:

1. Selling the goods separately at prices P1 = $50 and P2 =
$90
2. Selling the goods only as a bundle at a price of $100
3. Mixed bundling, whereby the goods are offered
separately at prices P1 = P2 = $89.95, or as a bundle at a
price of $100.
When products are sold separately, the total profit is 3($50 - $20) + 1($90 - $30) = $150.

With pure bundling, all four consumers buy the bundle for $100, so that total profit is 4($100 - $20 - $30) =
$200.
With mixed bundling Consumer D buys only good 1 for $89.95, consumer A buys only good 2 for $89.95,
and consumers B and C buy the bundle for $100. Total profit is now ($89.95 - $20) + ($89.95 - $30) +
2($100 - $20 - $30) = $229.90

TABLE BUNDLING EXAMPLE

P1 P2 P3 PROFIT
Sold separately $50 $90 — $150
Pure bundling — — $100 $200
Mixed bundling $89.95 $89.95 $100 $229.90
EXAMPLE THE COMPLETE DINNER VERSUS À LA CARTE:
A RESTAURANT PRICING PROBLEM

For a restaurant, mixed bundling means offering

both platters (the appetizer, main
course, and dessert come as a package) and
an à la carte menu (the customer buys the
appetizer, main course, and dessert separately).

This strategy allows the à la carte menu to be

priced to capture consumer surplus from customers who value some
dishes much more highly than others.

At the same time, the complete dinner retains those customers who have
lower variations in their reservation prices for different dishes (e.g.,
customers who attach moderate values to both appetizers and desserts).
EXAMPLE THE COMPLETE DINNER VERSUS À LA CARTE: A
RESTAURANT PRICING PROBLEM

Successful restaurateurs know their customers’ demand characteristics and use

that knowledge to design a pricing strategy that extracts as much consumer
surplus as possible.

TABLE MIXED BUNDLING AT MCDONALD’S (2011)

MEAL (INCLUDES SODA UNBUNDLED PRICE OF
INDIVIDUAL ITEM PRICE AND FRIES) PRICE BUNDLE SAVINGS
Chicken Sandwich $5.49 Chicken Sandwich $10.07 $7.89 $2.18
Filet-O-Fish $4.39 Filet-O-Fish $8.97 $6.79 $2.18
Big Mac $4.69 Big Mac $9.27 $6.99 $2.28
Quarter Pounder $4.69 Quarter Pounder $9.27 $7.19 $2.08
Double Quarter
$6.09 Double Quarter Pounder $10.67 $8.39 $2.28
Pounder
10-piece Chicken 10-piece Chicken
$5.19 $9.77 $7.59 $2.18
McNuggets McNuggets
Large French Fries $2.59
Large Soda $1.99
Bundling in Practice

MIXED BUNDLING IN PRACTICE

The dots in this figure are estimates of
reservation prices for a representative
sample of consumers.
A company could first choose a price for
the bundle, PB, such that a diagonal line
connecting these prices passes roughly
midway through the dots.
The company could then try individual
prices P1 and P2.
Given P1, P2, and PB, profits can be
calculated for this sample of consumers.
Managers can then raise or lower P1, P2,
and PB and see whether the new pricing
leads to higher profits. This procedure is
repeated until total profit is roughly
maximized.
Tying

Practice of requiring a customer to purchase one good in order to purchase

another.

Why might firms use this kind of pricing practice?

▪ it often allows a firm to meter demand and thereby practice price discrimination more
effectively.

▪ Tying can also be used to extend a firm’s market power.

▪ Tying can have other uses. An important one is to protect customer goodwill
connected with a brand name.
➢ This is why franchises are often required to purchase inputs from the franchiser.

Pure bundling is a form of tying but tying can take other forms as well.
 Exercise
Your firm produces two products, the demands for which are independent. Both
products are produced at zero marginal [Link] face four consumers (or groups of
consumers) with the following reservation prices respectively: CONSUMERS A B C
D; GOOD 1($) 25 40 80 100; GOOD 2($) 100 80 40 25
a. Consider three alternative pricing strategies: (i) selling the goods separately; (ii)
pure bundling; (iii) mixed bundling. For each strategy, determine the optimal
prices to be charged and the resulting profits. Which strategy would be best?
b. Now suppose that the production of each good entails a marginal cost of $30.
How does this information change your answers to (a)? Why is the optimal
strategy now different?

38 Papiya Ghosh
 Monopolistic Competition

39 Papiya Ghosh
 Monopolistic Competition

▪ A monopolistically competitive market has two key characteristics:

▪ Firms compete by selling differentiated products that are highly substitutable for one
another but not perfect substitutes. In other words, the cross-price elasticities of
demand are large but not infinite.
▪ There is free entry and exit: It is relatively easy for new firms to enter the market with
their own brands and for existing firms to leave if their products become unprofitable.
▪ Monopolistic competitors advertise their products, often heavily.

40 Papiya Ghosh
Equilibrium in the Short Run and the Long Run
A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT RUN
Because the firm is the
only producer of its brand,
it faces a downward-
sloping demand curve.
Price exceeds marginal
cost and the firm has
monopoly power.
In the short run, price also
exceeds average cost,
and the firm earns profits
shown by the yellow-
shaded rectangle.
Equilibrium in the Short Run and the Long Run

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN

In the long run, these
profits attract new
firms with competing
brands. The firm’s
market share falls, and
its demand curve shifts
downward.
In long-run equilibrium,
described in part (b),
price equals average
cost, so the firm earns
zero profit even though
it has monopoly power.
Monopolistically Competitive Industries
▪ The degree of industry concentration—the extent to which the largest firms account
for the bulk of the industry’s output—is often measured to identify monopolistically
competitive (versus oligopolistic) industries.
Industry concentration
❑ 4-firm concentration ratio (CR): Percentage of sales by 4 largest firms
4-firm CR = Output of Four Largest Firms ÷ Total Output in the Industry
▪ If the largest four firms account for less than 40 percent, they are likely to be
monopolistically competitive
Limitation: Some markets with low national concentration ratios are highly localized. In such
localized markets, only two or three producers compete, not the numerous firms present in
monopolistic competition. Local oligopolies can exist even though national concentration ratios are
low.
❑ Herfindahl index (HI): Sum of squared market shares
HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2
▪ The lower the Herfindahl index, the greater is the likelihood that an industry is
monopolistically competitive rather than oligopolistic.
Low Concentration Industries
Percentage of Output Produced by Firms in Selected Low-Concentration U.S. Manufacturing Industries
(2)
Percentage of (2)
Industry Output (3) Percentage of (3)
Produced by the Herfindahl Industry Output Herfindahl
(1) Four Largest Index for the Top (1) Produces by the Index for the
Industry Firms 50 Firms Industry Four Largest Firms Top 50 Firms
Jewellery 32 550 Ready-mix concrete 14 89
Plastic pipe 31 303 Sawmills 14 93
Plastic bags 28 320 Textile bags 13 93
Asphalt paving 25 230 Wood pallets 12 55
Bolts, nuts, and rivets 23 198 Stone products 12 56
Women’s dresses 22 236 Textile machinery 10 58
Wood trusses 21 158 Metal stamping 10 52
Curtains and draperies 20 172 Signs 9 36
Metal windows and doors 17 143 Sheet metal work 8 29
Quick printing 17 108 Retail bakeries 5 12
Monopolistic Competition and Economic Efficiency
COMPARISON OF MONOPOLISTICALLY COMPETITIVE EQUILIBRIUM AND
PERFECTLY COMPETITIVE EQUILIBRIUM

FIGURE 1 of 2

Under perfect
competition, price
equals marginal cost.
The demand curve
facing the firm is
horizontal, so the
zero-profit point
occurs at the point of
minimum average
cost.
FIGURE (2 of 2)
COMPARISON OF MONOPOLISTICALLY COMPETITIVE EQUILIBRIUM AND PERFECTLY
COMPETITIVE EQUILIBRIUM

Under monopolistic competition,

price exceeds marginal cost.
Thus there is a deadweight loss, as
shown by the yellow-shaded area.
The demand curve is downward-
sloping, so the zero profit point is
to the left of the point of
minimum average cost.
In both types of markets, entry
occurs until profits are driven to
zero
In monopolistic competition, the gap between the minimum-ATC output and the profit-maximizing output
identifies excess capacity : plant and equipment that are underused because firms are producing less than the
minimum-ATC output. If each monopolistic competitor could profitably produce at the minimum-ATC
output, fewer firms could produce the same total output, and the product could be sold at a lower price.
Monopolistically competitive industries thus are overcrowded with firms, each operating below its optimal
capacity.
The Inefficiency of Monopolistic Competition

MC ATC MC
Price and costs

P3 = A 3
P3 = A 3 a
b ATC
A4
D3
c
d D
M4 MR = MC 3

MR
MR
0 Q3 Q4
Q3 Q4
Quantity
Excess capacity
Productive efficiency is not realized because production occurs where the average total cost (A3) exceeds the minimum average
total cost (A4). This firm’s excess production capacity is Q4 - Q3.
 Is monopolistic competition undesirable?
▪ Is monopolistic competition then a socially undesirable market structure that
should be regulated?
▪ The answer—for two reasons—is probably no:
✓ In most monopolistically competitive markets, monopoly power is small.
Usually enough firms compete, with brands that are sufficiently substitutable, so that no single firm has much
monopoly power. Any resulting deadweight loss will therefore be small. And because firms’ demand curves
will be fairly elastic, average cost will be close to the minimum.
✓ Any inefficiency must be balanced against an important benefit from monopolistic competition:
product diversity.
Most consumers value the ability to choose among a wide variety of competing products and brands that
differ in various ways. The gains from product diversity can be large and may easily outweigh the
inefficiency costs resulting from downward-sloping demand curves.

48 Papiya Ghosh
EXAMPLE MONOPOLISTIC COMPETITION IN THE MARKETS FOR
COLAS AND COFFEE

The markets for soft drinks and coffee illustrate the

characteristics of monopolistic competition. Each
market has a variety of brands that differ slightly
but are close substitutes for one another.

TABLE ELASTICITIES OF DEMAND FOR COLAS AND COFFEE

BRAND ELASTICITY OF DEMAND
Colas RC Cola –2.4
Coke –5.2 to –5.7
Ground coffee Folgers –6.4
Maxwell House –8.2
Chock Full o’ Nuts –3.6

With the exception of RC Cola and Chock Full o’ Nuts, all the colas and
coffees are quite price elastic. With elasticities in the order of −4 to −8,
each brand has only limited monopoly power. This is typical of
monopolistic competition.
 ADVERTISING EXPENDITURES: A SIMPLE RULE
▪ Managers in monopolistic competition, as well as in other market structures, spend
huge amounts on advertising
▪ How much should a profit-maximizing manager spend on advertising?
 Assume diminishing returns to advertising expenditures- beyond some point, successive
advertising outlays yield smaller increases in sales
 Assume that quantity demanded depends only on price and advertising expenditures

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 ADVERTISING EXPENDITURES: A SIMPLE RULE
▪ Gross profit from each additional unit of product sold due to advertising= P – MC
(omitting advertising expenditures)
▪ To obtain net profit managers must deduct additional advertising outlays from the gross
profit
▪ Advertising expenditures are optimal if the increase in gross profit from an additional
dollar spent on advertising is equal to one dollar plus the additional cost incurred due
to higher production.
▪ If Q is defined as the number of extra units sold as a result of an additional dollar of
advertising expenditures, then advertising expenditures are optimal when MRA=MCA
Q Q
P = 1+MC (full marginal cost of advertising)
ΔA ΔA
▪ Increased output because of advertising means increased production costs, and this must be taken into
account when comparing the costs and benefits of an extra dollar of advertising.

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 Thumb rule for advertising
▪ Therefore, (P-MC) Q/ΔA=1
P – MC A Q
[ . ]= A/PQ
P Q ΔA
▪ Recall (P – MC)/P = -1/ep
▪ A/PQ= -eA/ ep
▪ Managers should therefore increase advertising expenditures until the following
condition is reached: A/PQ=-eA/eP
▪ Rule of thumb:
To maximize profit the advertising to sales ratio should be equal to the (minus) ratio of
advertising to price elasticity of demand
▪ Given information (from, say, market research studies) on these two elasticities, the
firm can use this rule to check that its advertising budget is not too small or too large.

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 ▪ Firm should advertise a lot if
▪ the demand is sensitive to advertising or
▪ demand is not very price elastic

▪ Intuitive reason:
A small elasticity of demand would mean higher markup of price over MC.
Therefore, the marginal profit from each extra unit sold is large enough. Therefore, if
advertising can help sell few more extra units, it will be worth the cost.

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 Example
▪ Assume that a firm is generating sales revenue of $1 million per year while
allocating only $10,000 (1 percent of its revenues) to advertising. The firm knows
that its advertising elasticity of demand is 0.2, so that a doubling of its advertising
budget from $10,000 to $20,000 should increase sales by 20 percent. The firm also
knows that the price elasticity of demand for its product is −4.
Should it increase its advertising budget, knowing that with a price elasticity of
demand of −4, its markup of price over marginal cost is substantial?
▪ Answer: Yes; the equation tells us that the firm’s advertising-to-sales ratio should
be −(.2/−4)=5 percent, so the firm should increase its advertising budget from
$10,000 to $50,000.

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 ADVERTISING IN PRACTICE
 If we look at the use of markup pricing by supermarkets, convenience stores, and makers
of designer jeans, we would see in each case how the markup of price over marginal cost
depended on the firm’s price elasticity of demand. Now let’s see why these firms, as well
as producers of other goods, advertise as much (or as little) as they do.
 First, supermarkets. Several supermarkets usually serve most areas. As a result, the
price elasticity of demand for a typical supermarket is around −10. For most , markup is
indeed about 10 or 11 per cent. To determine the advertising-to-sales ratio, we also need
to know the advertising elasticity of demand. This number can vary considerably
depending on what part of the country the supermarket is located in and whether it is in a
city, suburb, or rural area. A reasonable range, however, would be 0.1 to 0.3. Substituting
these numbers into the equation, we find that the manager of a typical supermarket
should have an advertising budget of around 1 to 3 percent of sales—which is indeed what
many supermarkets spend on advertising.

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  Convenience stores have lower price elasticities of demand (around −5)
because they are open for longer hours, often 24 hrs a day and they typically charge
higher prices than supermarkets. But their advertising-to-sales ratios are usually
less than those for supermarkets (and are often zero). Why?
 Because convenience stores mostly serve customers who live nearby; they may
need a few items late at night or may simply not want to drive to the supermarket.
These customers already know about the convenience store and are unlikely to
change their buying habits if the store advertises. Thus EA is very small, and
advertising is not worthwhile.

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  Advertising is quite important for makers of designer jeans, who will have
advertising-to-sales ratios as high as 10 or 20 percent. Advertising helps to make
consumers aware of the label and gives it an aura and image. The price elasticities of
demand in the range of −3 to −4 are typical for the major labels, and advertising
elasticities of demand can range from .3 to as high as 1. So, these levels of advertising
would seem to make sense.
 Laundry detergents have among the highest advertising-to-sales ratios of all products,
sometimes exceeding 30 percent, even though demand for any one brand is at least as
price elastic as it is for designer jeans. What justifies all the advertising?
 A very large advertising elasticity. The demand for any one brand of laundry detergent
depends crucially on advertising; without it, consumers would have little basis for
selecting that particular brand.

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 Table 11.7 shows sales, advertising
expenditures, and the ratio of the two
for leading brands of over-the-counter
drugs. Observe that overall, the ratios
are quite high. As with laundry
detergents, the advertising elasticity for
name-brand drugs is very high. Alka-
Seltzer, Mylanta, and Tums, for instance,
are all antacids that do much the same
thing. Sales depend on consumer
identification with a particular brand,
which requires advertising.

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 ADVERTISING, PRICE ELASTICITY, AND BRAND EQUITY:
EVIDENCE ON MANAGERIAL BEHAVIOR
▪ Promotions and advertising tend to be two sides of the same coin.
▪ Promotions-use a price-oriented message
➢ Appeal to price sensitivity
➢ Price-oriented message
➢ Attempt to erode brand loyalty
➢ Attempt to increase price elasticity and limit the premiums consumers are willing to
pay for brand-name products
▪ Advertising-illuminates brand worth and does not mention price
➢ Attempts to build brand loyalty
➢ Loyalty is measured as the frequency of repeat purchases
➢ Product-quality oriented message

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 ADVERTISING, PRICE ELASTICITY, AND BRAND EQUITY:
EVIDENCE ON MANAGERIAL BEHAVIOR
▪ Evidence
➢ Promotions do increase the price elasticities of consumers.
➢ Promotions have less effect on brand loyalists.
➢ The effects of promotions decay over time.
➢ Price elasticity of non-loyalists was found to be four times that of loyalists in one study.
➢ The effects of advertising on brand loyalty erode over time and price becomes more
important to consumers.

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 Oligopoly

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 Oligopoly
▪ Oligopoly is a market dominated by a few large producers of a homogeneous or
differentiated product.
▪ Oligopolists have considerable control over their prices, but each must consider the
possible reaction of rivals to its own pricing and output decisions.
▪ In some oligopolistic markets, some or all firms earn substantial profits over the long run
because barriers to entry make it difficult or impossible for new firms to enter.
▪ Oligopoly is the most prevalent form of market structure. Examples of oligopolistic
industries include automobiles, electronics, petrochemicals, electrical equipment, and
cellular service.
▪ Managing an oligopolistic firm is complicated because pricing, output and investment
decisions involve important strategic considerations, which can be highly complex.

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 Identification of Oligopolistic Industry
▪ When the largest four firms in an industry control 40 percent or more of the market, that
industry is considered oligopolistic.
▪ Limitations: a. The four-firm concentration ratio do not account for the import
competition of foreign suppliers b. they disguise significant inter-industry
competition c. does not reveal the extent to which one or two firms dominate
an industry.
▪ Herfindahl Index is often considered to be a better measure. The larger the HI the greater
the market power within an industry.
▪ Notice that the 4-firm concentration ratios for the primary aluminium industry and the
tyre industry are similar: 74 and 73 percent. But the Herfindahl index of 2089 for the
aluminium industry suggests greater market power than the 1531 index for the tyre
industry

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 Percentage of Output Produced by Firms in Selected High-
Concentration U.S. Manufacturing Industries
(2) (2)
Percentage of (3) Percentage of (3)
Industry Output Herfindahl Industry Output Herfindahl
(1) Produced by the Index for the Top 50 (1) Produced by the Index for the
Industry Four Largest Firms Firms Industry Four Largest Firms Top 50 Firms

Household laundry equipment 100 ND︎ Primary aluminum 74 2,089

Household refrigerators and freezers 93 ND︎ Tires 73 1,531

Cigarettes 88 2,897 Bottled water 71 1,564
Beer 88 3,561 Gasoline pumps 70 1,611
Glass containers 86 ND Bar soaps 70 2,250
Phosphate fertilizers 85 3,152 Burial caskets 69 1,699
Small-arms ammunition 84 2,848 Printer toner cartridges 67 1,449
Electric light bulbs 84 3,395 Alcohol distilleries 65 1,394
Aircraft 80 3,287 Turbines and generators 61 1,263
Breakfast cereals 79 2,333 Motor vehicles 60 1,178
Aerosol cans 75 1,667 Primary copper 50 879
 Equilibrium in an Oligopolistic Market
▪ In an oligopolistic market a firm sets price or output based on strategic
considerations regarding the behavior of its competitors.
▪ Strategic managerial decisions: Characterized by interactive payoffs in which
managers must explicitly consider the actions likely to be taken by their rivals in
response to their decisions
▪ The study of how agents behave in strategic situations is called game theory. And
we will use simple game-theory models to analyze the decisions of the oligopolists.
▪ In general, there are no unconditional optimal strategies in game theory; the
optimal choices may change depending on managerial beliefs about others.

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 STRATEGY BASICS
All game theoretic models are defined by five parameters.
1. The players: A player is an entity that makes decisions; models describe the number
and identities of players.
2. The feasible strategy set: Actions with some possibility of occurring comprise the
feasible strategy set.
❑ It is important for managers to think carefully about the strategy set
3. The outcomes or consequences: The feasible strategies of all players intersect to
define an outcome matrix.
4. The payoffs: Every outcome has a defined payoff for every player. Players are assumed
to be rational, that is, to prefer a higher payoff to a lower one.
5. The order of play: Play may be simultaneous or sequential.

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 VISUAL REPRESENTATION
▪ The representation of the payoffs takes one of two forms: matrix or extensive
▪ Normal form (Matrix form): Form that summarizes all possible outcomes as a matrix

▪ Extensive form (Game trees ): Form that provides a road map of player decisions.

▪ The extensive form explicitly states the timing of choices among players unlike
normal form.
▪ Typically, a simultaneous move game is represented in matrix form and sequential-
move game is represented in tree form.

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 Example 1
▪ Managers at two firms, Allied and Barkley, discover they both are planning to
launch product development programs for competing products. They can
choose to either keep spending at the currently planned level or increase it in
hopes of speeding up product development and getting to the market first.
Expected profits are a function of the expected development costs and
revenues.
❑Figure 1: A Two-Person Simultaneous Game -Allied-Barkley Spending:
Simultaneous

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 Example 2
Managers at Allied and Barkley must choose a pricing policy for the new
product. They know the other will introduce a similar competing product.
Because Barkley is expected to enter the market slightly sooner than Allied,
Barkley managers announce their price first. Managers will choose one of three
prices: $1.00, $1.35, or $1.65. Allied managers will reveal their price later. Because
Allied is second to market, managers have possible price points of $0.95, $1.30, and
$1.55.
❑Figure 2: Allied-Barkley Pricing: Sequential (Barkley is expected to enter the market
slightly sooner than Allied)

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71 Papiya Ghosh
 ▪ The extensive form can also show simultaneous games. It does this with
information sets which represents the knowledge at the time it reveals its strategy.
❑Figure 3: Allied-Barkley Pricing: Simultaneous (shown as extensive form)
• Uses information sets (the dotted ellipse) to use the extensive form to represent
simultaneous version of the previous game. It represents Allied’s information set, or
knowledge at the time it reveals its strategy. The dotted line signifies that Allied
managers know they are at one of the three nodes—but not which one because Barkley
managers have not revealed their strategy.

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 Solution Concepts And Equilibria
▪ How does game theory let managers see the future?
➢ It anticipates (correctly) the behavior of others.
▪ Solution Concepts
❑Key to the solution of game theory problems is the anticipation of the behavior of
others.
▪ Equilibria
 Equilibrium: When no player has an incentive to unilaterally change his or her strategy

 That is, no player is able to improve his or her payoff by unilaterally changing strategy.

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 Dominant Strategies
▪ Can the managers act without regard to the actions of others?
▪ Yes, if they have a dominant strategy(ies)
▪ Dominant strategies: A strategy whose payoff in any outcome is higher
relative to all other feasible strategies
▪ A strategy that is optimal regardless of the strategies selected by rivals
▪ Although the strategy choices of others still affect managerial payoffs, thinking about
others will not change the managerial decision
▪ Managers should always choose a dominant strategy if it is available.
▪ Example: Dominant strategy
▪ Figure 1: A Two-Person Simultaneous Game
▪ Barkley has a dominant strategy, which is to maintain the current spending level.
▪ Allied has a dominant strategy, which is to increase spending.

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 Iterated Elimination of Strictly Dominated Strategies
(IESDS)
▪ In some games, only one player will have a dominant strategy.
▪ In such games the player who does not have a dominant strategy will know that his
opponent does have one and presumably will play that. So she chooses her best response
or equilibrium action accordingly.
▪ For games with three or more strategies available to a player, some of a player’s
strategies may be strictly dominated but there may still be no dominant strategy
▪ A strategy is strictly dominated for a player when the player has another strategy
that gives it a higher payoff no matter what the other player does.
▪ Equilibrium of such games can be found by removing strictly dominated strategies
from consideration as possible choices

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 ▪ Successive or iterated elimination of strictly dominated strategies may lead to a
point where no further elimination is possible
▪ Eliminate any dominated strategy from consideration and keep on
doing as many iterations as possible
▪ If this process leads to a unique equilibrium outcome, we say the game is
dominance solvable.
▪ However, the process may not yield such a unique outcome under all
circumstances.

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 Capacity Expansion Game between Toyota and Honda
Toyota
Build Large Build Small Do not build

Build Large 0,0 12,8 18,9

Honda
Build Small 8, 12 16,16 20,15

Do not build 9,18 15, 20 18, 18

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 Nash equilibrium
▪ Domination principles help make managerial life easier.
▪ But only few games have a dominant strategy equilibrium; interaction with others
is generally more complicated.
▪ How can managers anticipate behavior in games without a dominant strategy
equilibrium?
▪ Nash equilibrium Assuming that all players are rational, every player should
choose the best strategy conditional on all other players doing the same.
➢ NE is the set of strategies or actions in which each player does the best it can given its
competitors’ actions.

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 THE NASH EQUILIBRIUM
▪ Model
▪ Each of N players chooses a strategy si*, where i = 1, 2, 3,…., N.
▪ An outcome of the game is represented as an array of strategies s* = (s1*, s2*,…..,
sN*).
▪ The payoff to player i when s* is selected is Bi(s*).
▪ A Nash equilibrium is an array of strategies such that
Bi(s1*, s2*, sN*)  Bi(s1', s2*, sN*) for all players and all outcomes.
▪ There is no strategy better than si* for any player, given what others are doing.

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 Example 3
New Product Introduction-Both Barkley and Allied must now introduce new
products. Each can choose one product or several; but because of financial
constraints, only one can be supported. Managers at both firms understand
this. Their choice to introduce a product is conditional on how they think the
other will behave.
▪ Nash equilibrium is where Barkley produces product sigma and Allied produces
product alpha.

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THE PRISONERS’ DILEMMA
Game theory example in which two prisoners must decide separately whether to
confess to a crime; if a prisoner confesses, he will receive a lighter sentence and
his accomplice will receive a heavier one, but if neither confesses, sentences will
be lighter than if both confess.
TABLE PAYOFF MATRIX FOR PRISONERS’ DILEMMA
PRISONER B

CONFESS DON’T CONFESS

A
Prisoner
CONFESS –5, –5 –1, –10
DON’T –10, –1 –2, –2
CONFESS

If Prisoner A does not confess, he risks being taken advantage of by his former accomplice. After all,
no matter what Prisoner A does, Prisoner B comes out ahead by confessing. Likewise, Prisoner A always comes
out ahead by confessing, so Prisoner B must worry that by not confessing, she will be taken advantage
of. Therefore, both prisoners will probably confess and go to jail for five years.
Oligopolistic firms often find themselves in a prisoners’ dilemma.
 Prisoner’s Dilemma
▪ Suppose Allied and Barkley produce an identical product and have similar cost
structures.
▪ Each player must decide whether to price high or low.
▪ Figure 5: Pricing as a Prisoner's Dilemma
▪ Solution is for both to price low.
▪ Both would be better off if both priced high.

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 EXAMPLE A PRICING PROBLEM FOR PROCTER & GAMBLE
P&G, Kao Soap Ltd. and Unilever Ltd. Planned to enter the Japanese market for Gypsy Moth tape about the
same time. P&G’s demand curve for monthly sales: 𝑄 = 3375𝑃 −3.5 𝑃𝑈 .25 𝑃𝐾 .25

Assuming that P&G’s competitors face the same demand conditions, with what price should P&G enter the
market, and how much profit should it expect to earn?
TABLE P&G’S PROFIT (IN THOUSANDS OF DOLLARS PER MONTH)
COMPETITOR’S (EQUAL) PRICES ($)
P& G’s
Price ($) 1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80
1.10 –226 –215 –204 –194 –183 –174 –165 –155
1.20 –106 –89 –73 –58 –43 –28 –15 –2
1.30 –56 –37 –19 2 15 31 47 62
1.40 –44 –25 –6 12 29 46 62 78
1.50 –52 –32 –15 3 20 34 52 68
1.60 –70 –51 –34 –18 –1 14 30 44
1.70 –93 –76 –59 –44 –28 –13 1 15
1.80 –118 –102 –87 –72 –57 –44 –30 –17

$1.40 is the price at which P&G would be doing its best it can given its competitors’ prices. Its competitors are
also doing the best they can, so it is a Nash equilibrium. As the table shows, in this equilibrium P&G and its
competitors each make a profit of $12,000 per month. If it could collude with its competitors, it could make a
larger profit. They would all agree to charge $1.50, and each of them would earn $20,000.
EXAMPLE PROCTER & GAMBLE IN A PRISONERS’ DILEMMA

We argued that P&G should expect its competitors to charge a price of $1.40
and should do the same. But P&G would be better off if it and its competitors
all charged a price of $1.50.

TABLE PAYOFF MATRIX FOR PRICING PROBLEM

UNILEVER AND Kao
CHARGE $1.40 CHARGE $1.50

Charge $1.40 $12, $12 $29, $11

P&G
Charge $1.50 $3, $21 $20, $20

Since these firms are in a prisoners’ dilemma, it doesn’t matter what Unilever
and Kao do. P&G makes more money by charging $1.40.
 Example
▪ Suppose there are only two 2 pizza shops: Dominos and Pizza Hut
▪ Each is deciding on the price it should charge for its pizza. Let’s say the options are
limited-high, medium and low for both
▪ High price- the profit margin is $12 per pizza
▪ Medium price-the profit margin is $10 per pizza
▪ Low price- the profit margin is $5 per pizza
▪ Each store has a loyal captive customer base who will buy 3,000 pizza per week.
▪ There is also a floating demand of 4000 pizza per week which is price-sensitive and with
both stores charging same price, the demand will be split equally between them
▪ The following payoff table summarizes their payoffs (in thousands of dollars) under
various price choices:

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 Solution?

Pizza Hut
High Medium Low

High 60,60 36,70 36,35

Dominos Medium 70,36 50,50 30,35

Low 35,36 35,30 25,25

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 EXAMPLE
COMPETITION AND COLLUSION IN THE AIRLINE INDUSTRY

In March 1983, American Airlines proposed that all

airlines adopt a uniform fare schedule based on
mileage. This proposal would have done away with the
many different fares then available. Most other major
airlines reacted favorably to the plan and began to adopt
it.

Was it really to “help reduce fare confusion”?

No, the aim was to reduce price competition and achieve a collusive pricing arrangement. Prices had been
driven down by competitive undercutting, as airlines competed for market share. The plan failed, a victim of
the prisoners’ dilemma. Pan Am, dissatisfied with its small market share dropped its fares and triggered a
price competition.
Each airline has an incentive to lower fares in order to capture passengers from its competitors because the
MC of adding passengers is very low. In addition, the demand for air travel often fluctuates unpredictably.
Such factors as these stand in the way of implicit price cooperation.

Thus, aggressive competition has continued to be the rule in the airline industry. Discount airlines, reduction
in fares in order to attract customers, and “fare shopping” in the Internet have forced several major airlines
into bankruptcy and resulted in record losses for the industry.
 Illustration: Banning of Cigarette Advertising on TV
and Radio
 In America, President Richard Nixon signed the Public Health Cigarette Smoking Act,
which banned cigarette ads from airing on television and radio. Before 1971, you could
find a cigarette advertising.
 So let’s push ourselves a little back in time when these ads were a thing and try to analyse
the advertisement war.
 We now consider two major key players who dominated the field in the 1970’s; Philip
Morris (PM) and [Link] (RJR). And assuming the annual demand of 1,000,000,000
units and a profit of $ 0.1 per unit. For simplicity each of these firms can choose to spend
$ 5, $ 10 or $ 15 million on their product advertisement.
 The annual demand is considered independent of money poured in advertisement. We
assume a relation of direct proportionality between ‘market share’ and ‘cost on advertisement’.

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 R J Reynolds
Spend 5 Spend 10 Spend 15

Spend 5 45,45 28,57 20,60

Philip Morris
Spend 10 57,28 40,40 30,45

Spend 15 60,20 45,30 35,35

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  The strategy profile of spending 15 million stands the test of IESDS resulting in
payoff (35 million, 35 million).
 And just here we let “Nixon” happen eventually leading to Radio and TV
advertising hence making it impractical to spend 15 million.
 The only strategy bound to work is to spend 10 million resulting in an annual
money inflow of $ 40 million for each one of them.
 The ban actually helped the firms gather 40 million instead of 35!!

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 Implications of the Prisoners’ Dilemma for
Oligopolistic Pricing
▪ Does the prisoners’ dilemma doom oligopolistic firms to aggressive
competition and low profits?
▪ Not necessarily. Most firms set output and price over and over again, continually
observing their competitors’ behaviour and adjusting their own accordingly. This
allows firms to develop reputations from which trust can arise.
▪ As a result, oligopolistic coordination and cooperation can sometimes prevail.
▪ However, resolution of prisoner’s dilemma occurs in some industries and not in
others.
▪ Managers may not be content with moderately high profits resulting from implicit
collusion and prefer to compete aggressively to reach higher market share
▪ Sometimes implicit arrangements are difficult to reach because of different assessments
of market demand
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 ▪ And in some industries implicit collusion is short-lived.
▪ Sometimes cooperation breaks down or never begins because there are too many firms or
there is a mismatch in their expectations.
▪ Because implicit collusion tends to be fragile there is a strong desire for price stability by
the oligopolistic firms.
▪ This is why price rigidity can be a characteristic of oligopolistic industries.
▪ Price rigidity Characteristic of oligopolistic markets by which firms are reluctant to
change prices even if costs or demands change.
▪ Kinked demand curve model Oligopoly model in which each firm faces a demand
curve kinked at the currently prevailing price: at higher prices demand is very elastic,
whereas at lower prices it is inelastic.
▪ Price rigidity is the basis of the kinked demand curve model.

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THE KINKED DEMAND CURVE
Each firm believes that if it raises
its price above the current price
P*, none of its competitors will
follow suit, so it will lose most of
its sales.
Each firm also believes that if it
lowers price, everyone will follow
suit, and its sales will increase
only to the extent that market
demand increases.
As a result, the firm’s demand
curve D is kinked at price P*, and
its marginal revenue curve MR is
discontinuous at that point.
If marginal cost increases from
MC to MC’, the firm will still
produce the same output level Q*
and charge the same price P*.
 Price leadership
▪ A big impediment to implicit collusive pricing is the fact that it is difficult to agree
on the price
▪ Coordination is particularly difficult when cost and demand conditions are
changing
▪ Price signaling Form of implicit collusion in which a firm announces a price
increase in the hope that other firms will follow suit. If the competitors follow suit
then all the firms will earn higher profit.
▪ Sometimes a pattern is established whereby one firm regularly announces price
changes that other firms then match. This pattern of pricing is called price
leadership.
▪ An example is the US automobile industry where GM has traditionally been the
price leader.
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 ▪ In some industries, a large firm might naturally emerge as a leader, with the other
firms deciding that they are best off just matching the leader’s prices, rather than
trying to undercut the leader or each other.
▪ Price leadership can also serve as a way for oligopolistic firms to deal with the
reluctance to change prices, a reluctance that arises out of the fear of being
undercut or “rocking the boat.”

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Repeated Games
Repeated game Game in which actions are taken and payoffs received over and
over again.
TABLE PRICING PROBLEM
Firm 2
Low price High price

Low price 10, 10 100, –50

Firm 1
High price –50, 100 50, 50

Suppose this game is repeated over and over again—for example, you and your competitor
simultaneously announce your prices on the first day of every month. Should you then play the
game differently?
GRIM TRIGGER STRATEGY and TIT-FOR-TAT STRATEGY
In the pricing problem above, the repeated game strategy that works best is the grim
trigger strategy or tit-for-tat strategy.
Tit-for-tat strategy Repeated-game strategy in which a player responds in
kind to an opponent’s previous play, cooperating with cooperative opponents
and retaliating against uncooperative ones.
 REPEATED GAMES
▪ Repeated play can lead to cooperative behavior in a prisoner’s dilemma game.
➢ Trust, reputation, promises, threats, and reciprocity are relevant only if there is
repeated play.
➢ In repeated games strategies can become more complex
➢ Strategies like tit-for tat may induce competitors to behave cooperatively
➢ Cooperative behavior is more likely if there is an infinite time horizon than if there is
a finite time horizon.
➢ If there is a finite time horizon, then the value of cooperation, and hence its
likelihood, diminishes as the time horizon is approached. Backward induction implies
that cooperation will not take place in this case.
➢ Folk theorem: any type of behavior can be supported by an equilibrium (as long as
the players believe there is a high probability that future interaction will occur).

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 INFINITELY REPEATED GAME
▪ When the two competitors repeatedly set prices month after month, forever,
cooperative behavior (i.e., charging a high price) is then the rational response to a
tit-for-tat strategy. (This assumes that a firm’s competitor knows, or can figure out,
that it is using a tit-for-tat strategy.) It is not rational to undercut.
▪ In fact, with infinite repetition of the game, the competitor of a firm need not even
be sure that his competitor is playing tit-for tat strategy. Even if the competitor
believes there is some chance of his opponent playing tit-for tat, the expected gains
from cooperation will outweigh those from undercutting.
▪ This will be true even if the probability that a firm is playing tit-for-tat (and so will
continue cooperating) is small.

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 FINITE NUMBER OF REPETITIONS
▪ Now suppose the game is repeated a finite number of times—say, N months. (N can be
large as long as it is finite.)
▪ If my competitor (Firm 2) is rational and believes that I am rational, the following shall be his
reasoning: Because Firm 1 is playing tit-for tat, I (Firm 2) cannot undercut until the last month. I
should undercut last month because the game will be over soon after, so Firm 1 cannot retaliate.
▪ Since Firm 1 has figured this out, he also plans to charge low price in the last month. Firm 2 also
can figure out that Firm 1 will charge a low price in the last month.
▪ But then what about the next-to-last month? Because there will be no cooperation in the
last month, anyway, Firm 2 figures that it should undercut and charge a low price prior-
to-last month. But, of course, Firm 1 has figured this out too.
▪ In the end, the only rational outcome is for both the firms to charge a low price every
month.

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 TIT-FOR-TAT IN PRACTICE
▪ The tit-for-tat strategy can sometimes work and cooperation can prevail. There are two
primary reasons.
➢ First, most managers don’t know how long they will be competing with their rivals. The
unravelling argument that begins with a clear expectation of undercutting in the last month no
longer applies. As with an infinitely repeated game, it will be rational to play tit-for-tat.
➢ Second, my competitor might have some doubt about the extent of my rationality. “Perhaps,”
thinks my competitor, “Firm 1 will play tit-for-tat blindly, charging a high price as long as I
charge a high price.”-fails to work out logical implications of finite horizon
▪ Just the possibility can make cooperative behavior a good strategy (until near the end) if the
time horizon is long enough. Although my competitor’s conjecture about how I am
playing the game might be wrong, cooperative behavior is profitable in expected value terms.
With a long time horizon, the sum of current and future profits, weighted by the
probability that the conjecture is correct, can exceed the sum of profits from price
competition, even if my competitor is the first to undercut.
▪ Thus, in a repeated game, the prisoners’ dilemma can have a cooperative outcome.
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 Strategic Foresight: The use of BACKWARD
INDUCTION
▪ In many interesting games one player can move before others do.

▪ Such games involve strategic foresight and are analyzed using the principle of Backward
Induction.
▪ Good managers use strategic foresight.
▪ Strategic foresight: A manager's ability to make decisions today that are rational
given what is anticipated in the future.
➢ For example, a manager builds extra capacity today because she believes (correctly) that
demand will increase in the near future.
▪ Game theory formally models strategic foresight through what is called backward
induction.

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 Strategic Foresight: The use of BACKWARD
INDUCTION
▪ Backward induction: Used in game theory to solve games by looking to the future,
determining what strategy other players will choose (anticipation), and then
choosing an action that is rational, based on those beliefs
 In sequential games, backward induction involves starting with the last decisions in the sequence and
then working backward to the first decisions, identifying all optimal decisions.
▪ Example
 Allied-Barkley Expansion Decision: They must now decide whether to expand their
product lines
 Barkley is the market leader-so its managers will reach their decision first. After seeing
the decision of Barkley managers, those at Allied decide whether to expand
 How does a manager with strategic foresight use backward induction to solve this
game?

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 Backward Induction and the Centipede Game

▪ Centipede game: A sequential game involving a series of six decisions that shows the
usefulness of backward induction in strategic thinking- Player A moves first and can
choose either down (D) or right (R). If player A chooses D, the game is over and both
players receive a payoff of $1. If player A chooses R, then player B faces a similar choice.
The game continues, until one player chooses down or player B is asked to choose for a
third time.
▪ The optimal solution is for the first player to end the game immediately.

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 Strategic Foresight: The use OF BACKWARD INDUCTION

▪ Backward induction has many uses.

✓ One is to test the credibility of commitments.
▪ From threats to promises we want to know whether we should believe others.
▪ One must consider only credible commitments.
▪ Credibility of Commitments
▪ Credible: When the costs of falsely making a commitment are greater than the
associated benefits
▪ Example: Managers at a company who simply proclaim its product is best are not
credible. The managers can make that claim credible by offering a product warranty. A
warranty increases the commitment cost (if it is falsely sent)

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 STRATEGIC FORESIGHT: THE USE OF BACKWARD
INDUCTION
 Example- Recall that Barkley managers expanded their product line but Allied
managers have not. Allied’s managers decide to counter Barkley’s product line
extension by dropping the price of their product. However, they are concerned that if
they drop their price, Barkley managers will follow with a price cut of their own. In
fact, Barkley’s managers told a common supplier of both firms that if Allied drops its
price, they will drop theirs.
 What should Allied managers do?
 Figure : Does Barkley Have a Credible Threat?
 It is not in Barkley's interest to drop price in response to Allied's price cut. The threat
to do so is not credible.

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 Commitment and Credibility: Example
▪ Sometimes firms can make threats credible.
▪ Strategic moves that seemingly limit options can make a player better off. In other
words, inflexibility can have value.
▪ This is because a firm’s commitment can alter its competitor’s expectations about
how it will compete and this in turn will lead the competitors to make decisions
that benefit the committed firm.
▪ Consider the following example.
▪ Race Car Motors, Inc., produces cars, and Far Out Engines, Ltd., produces
specialty car engines. Far Out sells most of its engines to Race Car Motors, and a
few to a limited outside market. Therefore, it makes its production decisions in
response to Race Car’s production plans.

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 Commitment and Credibility
 Here we have a sequential game in which Race Car is
the “leader.” Race Car will do best by deciding to
produce small cars. It knows that in response to this
decision, Far Out will produce small engines, most of
which Race Car will then buy.
 Can Far Out induce Race Car to produce big cars
instead of small ones?
 Suppose Far Out threatens to produce big engines. If
Race Car believed Far Out’s threat, it would produce
big cars.
 But the threat is not credible.
 Far Out can make its threat credible by visibly and
irreversibly reducing some of its own payoffs in the
matrix, thereby constraining its own choices. It might
do this by shutting down or destroying some of its small
engine production capacity. This would result in the
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payoff matrix shown in the next Table
Commitment and Credibility

TABLE MODIFIED PRODUCTION CHOICE PROBLEM

Race Car Motors
Small cars Big Cars

Far Out Small engines 0, 6 0, 0

Engines Big engines 1, 1 8, 3

Now Race Car knows that whatever kind of car it produces, Far Out will produce big
engines. Now it is clearly in Race Car’s interest to produce large cars. By taking an
action that seemingly puts itself at a disadvantage, Far Out has improved its
outcome in the game.
Although strategic commitments of this kind can be effective, they are risky and depend
heavily on having accurate knowledge of the payoff matrix and the industry.

Suppose, for example, that Far Out commits itself to producing big engines but is
surprised to find that another firm can produce small engines at a low cost. The
commitment may then lead Far Out to bankruptcy rather than continued high profits.
  Mind it the game just discussed is a sequential game!
 The payoff matrix does not represent the game correctly. However, the payoffs
corresponding to each branch of the tree are written in the matrix.
 Form a game tree to find out the solution using backward induction.

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