ECON 202: Principles

of Microeconomics

Review Session for Exam 3

Chapters 11-15
Review Session 3
1. Perfect Competition.
2. Monopolistic Competition.
3. Oligopoly.
4. Monopoly.
5. Pricing Strategy.

ECON 202: Princ. of Microeconomics Review Session 3 2

Review Session 3

PERFECT MONOPOLISTIC
CHARACTERISTIC OLIGOPOLY MONOPOLY
COMPETITION COMPETITION

Number of firms Many Many Few One

Identical or
Type of product Identical Differentiated Unique
differentiated

Ease of entry High High Low Entry blocked

ECON 202: Princ. of Microeconomics Review Session 3 3

1. Perfect Competition
 Conditions for perfect competitive market:
 Many buyers and sellers, small relative to the market.
 Products are identical.
 No barriers to new firms entering the market.
 Prices are determined by the interaction of aggregate
demand and aggregate supply.
 Firms are so small that cannot affect the price in the
market.
 If raise prices, consumers switch to another firm.
 Price takers.
 Example: wheat farmers.
 Firms face perfectly elastic demand.

ECON 202: Princ. of Microeconomics Review Session 3 4

1. Perfect Competition

ECON 202: Princ. of Microeconomics Review Session 3 5

1. Perfect Competition
 In order to maximize profits is equivalent:
 To produce where difference between total revenue and total
cost is the greatest.
 To produce where marginal revenue is equal to marginal
cost.
 In the case of firms in perfectly competitive markets,
marginal revenue is equal to the price in the market.
 Condition for maximizing profit:
 Price = Marginal Cost

ECON 202: Princ. of Microeconomics Review Session 3 6

1. Perfect Competition
 Remember that:
 Total Revenue = Price x Quantity
 Total Cost = Average Total Cost x Quantity
Price and cost
(dollars per Marginal
bushel) Cost
Average
Total Cost

P
Profit

Total Revenue
Total Cost

Q Quantity
Profit Maximizing
level of output
ECON 202: Princ. of Microeconomics Review Session 3 7
1. Perfect Competition
 Shut-down decision in the short run.
Price and cost
(dollars per Supply Curve
bushel) for the firm in Marginal Cost
the short run
Average Total Cost

Average Variable Cost

P1

P2

PMIN

QSD Q2 Q1 Quantity

ECON 202: Princ. of Microeconomics Review Session 3 8

1. Perfect Competition
 In the long-run
 With economic profit, entry of new firms make price decrease
until firms are breaking even.
 With economic losses, exit of firms make price increase until
firms are breaking even.
 Resulting situation is Long-run competitive equilibrium.
 Long run competitive equilibrium price is at minimum
point of the Average Total Cost curve.
 Economic profits disappear in the long run.

ECON 202: Princ. of Microeconomics Review Session 3 9

1. Perfect Competition
 According to the slope of long-run supply curve
 Horizontal: constant-cost industries.
 Upward sloping: increasing-cost industries.
 Downward sloping: decreasing-cost industries.
 In the long-run, perfect competition results in productive
efficiency.
 When a good is produced at the lowest possible cost.
 Also, perfect competition achieves allocative efficiency.
 A state of the economy in which production represents consumer
preferences
 Every good is produced up to the point where the last unit
provides a marginal benefit to consumers equal to the marginal
cost of producing it.
ECON 202: Princ. of Microeconomics Review Session 3 10
2. Monopolistic Competition
 Monopolistic Competition is market structure where:
 Many firms.
 Barriers to entry are low.
 Products are similar, but not identical.

ECON 202: Princ. of Microeconomics Review Session 3 11

2. Monopolistic Competition

ECON 202: Princ. of Microeconomics Review Session 3 12

2. Monopolistic Competition

 Economic profits attract more firms:

 Shifts demand to the left.
 Makes demand more elastic.
ECON 202: Princ. of Microeconomics Review Session 3 13
2. Monopolistic Competition
 Monopolistic Competitive firms have excess capacity.
 By increasing output, average cost can be reduced.

 In monopolistic competition:
 Productive efficiency is not reached: products are not produced
at the lowest cost.
 Allocative efficiency is not reached: firms charge a price different
than marginal cost.
 However, consumers benefit from differentiated products
and more closed suited to their tastes.

ECON 202: Princ. of Microeconomics Review Session 3 14

3. Oligopoly
 Oligopoly is market structure where:
 Few competitors.
 Identical or differentiated products.
 Restrictions to entry.
 In case of oligopolistic markets, revenues of the firms
depend on actions of other competitors.
 Approach to analyze oligopolies: game theory.

ECON 202: Princ. of Microeconomics Review Session 3 15

3. Oligopoly
 More than 40% indicates 4-firm concentration ratios per
industry oligopolistic market.
 Herfindahl-Hirschman Index (HHI)
 Sum of squared shares: 302 + 302 + 202 + 202 = 2,600
 HHI > 1,800 : oligopolistic markets.
 Barriers to entry.
 Economies of scale.
 Ownership of a key input.
 Government-imposed barriers.

ECON 202: Princ. of Microeconomics Review Session 3 16

3. Oligopoly
 Duopoly: price competition between two firms.

 Firms would collude, but is against the law.

ECON 202: Princ. of Microeconomics Review Session 3 17

3. Oligopoly
 Dominant strategy
 The best strategy for a player, regardless of what the other
players decide.
 Nash equilibrium.
 A situation where each player is choosing its best strategy, given
the others players’ strategies.
 A situation where no player has an incentive to change of
strategy.
 In most business situations games are played
repeatedly.
 Firms can collude implicitly to reach the cooperative equilibrium.
 Example: “low price guaranteed”

ECON 202: Princ. of Microeconomics Review Session 3 18

3. Oligopoly
 Sequential games to analyze business strategies.

 Best strategy for WalMart is to build the large store, deterring entry
from Target.
ECON 202: Princ. of Microeconomics Review Session 3 19
3. Oligopoly
 Forces that determine the level of competition in an
industry.

ECON 202: Princ. of Microeconomics Review Session 3 20

4. Monopoly
 A monopoly is a firm that sells a good that does not
have close substitutes.
 In other words, a monopoly is a firm that can ignore the
actions of all other firms.
 If it can ignore them, they are not producing close enough
substitutes.
 Reasons for monopolies
 Entry Blocked by Government Action
 Patents and copyrights.
 Public franchises.
 Control of a Key Resource
 Network Externalities
 Natural Monopoly

ECON 202: Princ. of Microeconomics Review Session 3 21

4. Monopoly

ECON 202: Princ. of Microeconomics Review Session 3 22

4. Monopoly
 Monopoly reduces economic efficiency.

ECON 202: Princ. of Microeconomics Review Session 3 23

4. Monopoly
 At the present, mergers of large firms have to be
approved by:
 Antitrust Division of the US Department of Justice.
 Federal Trade Commission.
 Mergers guidelines
 Market definition
 Relevant market is the market where by rising the prices of all the
firms, profits increase.
 Measure of concentration: Herfindahl-Hirschman Index (HHI)
Moderately Highly
Not concentrated concentrated concentrated

0 1,000 1,800 10,000

Mergers not If HHI rises > 100: If HHI rises > 50: If HHI rises > 100:
challenged by mergers MAY be mergers MAY be mergers WILL be
FTC & DoJ challenged challenged challenged

ECON 202: Princ. of Microeconomics Review Session 3 24

4. Monopoly
 Regulating Natural Monopolies

ECON 202: Princ. of Microeconomics Review Session 3 25

5. Pricing Strategy
 Price discrimination:
 Charging different prices to different customers for the same
product.
 Price differences are not explained by differences in cost.
 Requirements for successful price discrimination:
 Market power.
 Different types of customers (willingness to pay).
 Ability to separate types of customers (no arbitrage).

ECON 202: Princ. of Microeconomics Review Session 3 26

5. Pricing Strategy

 Less elastic demand pays a higher price.

 More elastic demand pays a lower price.
ECON 202: Princ. of Microeconomics Review Session 3 27
5. Pricing Strategy
 Perfect price discrimination
 If monopolist know the willingness to pay of all the customers, it
can charge exactly this willingness to pay to them.

ECON 202: Princ. of Microeconomics Review Session 3 28

5. Pricing Strategy
 Two-part tariffs
 When consumers pay one price (or tariff) for the right to buy as
much of a related good as they want at a second price.
 Disneyland, Ipods.

ECON 202: Princ. of Microeconomics Review Session 3 29

5. Pricing Strategy
 Different types of customers and asymmetric information
 Firms know that customers have different willingness to pay for
goods, but their identification is difficult.
 They try to have customers reveal their type:
 High-value customers to order the higher priced pack.
 Low-value customers to order the lower priced pack.

ECON 202: Princ. of Microeconomics Review Session 3 30

5. Pricing Strategy

Packages offered Utility Cable

High-value Low-value company
Type Channels Price
customer customer profit
High-value 10 30 0 -15
Original 20
Low-value 5 15 6.25 0
High-value 10 23.75 6.25 -8.75
New 23.75
Low-value 5 15 6.25 0
High-value 10 26 4 -11
New-new 26
Low-value 4 14 4 0

ECON 202: Princ. of Microeconomics Review Session 3 31

5. Pricing Strategy
 Because of difficulty to identify each type of customer,
firm ends up:
 Giving some extra benefit to high-value customer in order to
make her reveal her identity.
 Selling a lower than efficient level of quantity to low-value
customer.
 Price per channel is higher for the low value customer
($14 / 4 = $3.5) than for the high value customer ($26 /
10 = $2.6).
 Quantity discounts are not only explained by differences
in cost, but also by pricing strategies of firms.

ECON 202: Princ. of Microeconomics Review Session 3 32

 Problems Given this information for a firm
in a perfect competitive market:
Price
 How much will produce at a
60 MC
price of $55?
ATC
55  What will be its profit?

45
 The firm will have economic
losses if the price goes below:
35
 If in the long-run equilibrium
25 there are 100 identical firms in
this market, what will be the
15
quantity supplied in the market?
5
 If in the long-run equilibrium
10 20 30 40 50 Quantity aggregate demand shifts to the
left, will firms enter or leave this
market?

ECON 202: Princ. of Microeconomics Review Session 3 33

 Problems

Price Given this information for a

60 MC firm in a monopolistic
55
ATC competitive market:
 What price maximizes profits
45
for the firm?
35  Will its profit be above or

25
below $700?
 What is the productively
15
efficient level of production?
Demand
5 MR

10 20 30 40 50 Quantity

ECON 202: Princ. of Microeconomics Review Session 3 34

Problems

 Suppose that at initial point, they keep the level of tuition, do any
school has incentives to change of strategy?
 What is the dominant strategy for Texas M&A?
 And for t.u.?
 What is the Nash equilibrium?

ECON 202: Princ. of Microeconomics Review Session 3 35

 Problems
 What is the quantity
produced by this monopolist?
Price
 What is his profit?
130 MC ATC  What is the Deadweight
Loss?
110
 What is the productively
90 efficient level of production?
70
Suppose that there is only one
consumer in this market and
Demand
50 that price in the demand
30
curve when quantity is 600 is
MR
$82.
10
 Would the monopolist make
100 300 500 700 900 Quantity more profit by charging a two-
part tariff?
 How much would be the entry
fee and the price per unit.
ECON 202: Princ. of Microeconomics Review Session 3 36
 Problems  What is the price and quantity that this
monopolist will choose?
 What is his profit?
 If a regulatory agency wants the
monopoly to produce the productively
Price efficient level of output, how much would
325 the monopolist produce?
275  What is the profit of the monopolist in this
case?
225
 What price and quantity should impose
175 the regulatory agency to make sustainable
the monopolist?
125
ATC Suppose that the monopolist is again free
75 to decide how much to charge and produce
MC
 How much will the monopolist collect
25 Demand
from entry fees if decides to charge a two-
100 300 500 700 900 Quantity part tariff?
MR
 How much will the monopolist charge per
unit of product?
 How much is his total profit in this case?

ECON 202: Princ. of Microeconomics Review Session 3 37

ECON 202: Principles
of Microeconomics

Review Session for Exam 3

Chapters 11-15