chapter 12 price and output determination under oligopoly gottheil — principles of economics, 7e...
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Chapter 12Chapter 12
PRICE AND OUTPUT PRICE AND OUTPUT DETERMINATION UNDER DETERMINATION UNDER OLIGOPOLYOLIGOPOLY
Gottheil — Principles of Economics, 7e© 2013 Cengage Learning1
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Economic PrinciplesEconomic Principles
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The concentration ratio and the Herfindahl-Hirschman Index (HHI)
Balanced and unbalanced oligopoly
Horizontal, vertical and conglomerate mergers
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Economic PrinciplesEconomic Principles
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Cartels
Game theory
Price leadership
Kinked demand
Brand multiplication
Price discrimination
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Concentration RatiosConcentration Ratios
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For a vast number of US manufacturing industries, the competition among firms in the industry is essentially competition among the few—oligopoly.
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Concentration RatiosConcentration Ratios
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An industry may consist of many firms, but if only a few of the many dominate the industry, then the industry is oligopolistic.
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Concentration RatiosConcentration Ratios
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Concentration ratio
• A measure of market power. It is the ratio of total sales of the leading firms in an industry (usually four) to the industry’s total sales.
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Concentration RatiosConcentration Ratios
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A criterion for determining whether an industry is an oligopoly:• If the leading four firms in an industry
account for 40 percent or more of total industry sales, then an industry is likely to be an oligopoly.
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Concentration RatiosConcentration Ratios
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Herfindahl-Hirschman index
• A measure of industry concentration, calculated as the sum of the squares of the market shares held by each of the firms in the industry.
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EXHIBIT 1 CONCENTRATION RATIOS—PERCENTAGE OF TOTAL INDUSTRY SALES PRODUCED BY THE LEADING FOUR FIRMS, AND HHI
Source: U.S. Bureau of the Census, 2002; Concentration Ratios in Manufacturing, 2004.
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Exhibit 1: Concentration Ratios— Exhibit 1: Concentration Ratios— Percentage of Total Industry Sales Percentage of Total Industry Sales
Produced by the Leading FourProduced by the Leading FourFirms, and HHIFirms, and HHI
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How many industries in Exhibit 1 have market shares greater than 50 percent at the four-firm level?• 13 of the 15 industries
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EXHIBIT 2 DISTRIBUTION OF MANUFACTURING INDUSTRIES BY FOUR-FIRM SALES CONCENTRATION
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission.
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Exhibit 2: Distribution of Exhibit 2: Distribution of Manufacturing Industries by Manufacturing Industries by
Four-Firm Sales ConcentrationFour-Firm Sales Concentration
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How many industries had four-firms controlling 40-59 percent of the industry sales in 1982? • 120 out of 448 total industries had four firms
controlling 40-59 percent of the total industry sales.
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Oligopoly and Concentration RatiosOligopoly and Concentration Ratios
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Contrary to many people’s intuition, there is no convincing evidence that the share of industry sales controlled by the four leading firms in the US manufacturing economy is growing.
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EXHIBIT 3 PERCENTAGE OF TOTAL INDUSTRIAL SALES PRODUCED BY INDUSTRIES WITH FOUR-FIRM SALES CONCENTRATION RATIOS OF 50 PERCENT OR MORE: 1895–1982
Source: F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, Third Edition, Copyright © 1990 by Houghton Mifflin Company, Adapted with permission.
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Exhibit 3: Percentage of Total Industrial Exhibit 3: Percentage of Total Industrial Sales Produced by Industries with Four-Sales Produced by Industries with Four-Firm Sales Concentration Ratios of 50 Firm Sales Concentration Ratios of 50
Percent or More: 1895–1982Percent or More: 1895–1982
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What is the trend in the percentage of industrial sales produced by the largest four firms since 1963? • There is a downward trend in the percentage
of industrial sales by the largest four firms from 1963 to 1982.
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Oligopoly and Concentration RatiosOligopoly and Concentration Ratios
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Market power
• A firm’s ability to select and control market price and output.
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Oligopoly and Concentration RatiosOligopoly and Concentration Ratios
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Unbalanced oligopoly
• An oligopoly in which the sales of the leading firms are distributed unevenly among them.
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Oligopoly and Concentration RatiosOligopoly and Concentration Ratios
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Balanced oligopoly
• An oligopoly in which the sales of the leading firms are distributed fairly evenly among them.
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EXHIBIT 4 BALANCED AND UNBALANCED OLIGOPOLY
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Exhibit 4: Balanced and Exhibit 4: Balanced and Unbalanced OligopolyUnbalanced Oligopoly
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1. What percentage of their industry’s total sales do the leading four firms in Industry A and B control?
• The leading four firms in both industry A and B control 80 percent of their industry’s sales.
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Exhibit 4: Balanced and Exhibit 4: Balanced and Unbalanced OligopolyUnbalanced Oligopoly
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2. Why is industry B considered an unbalanced oligopoly?
• The largest firm in industry B controls 50 percent of the industry’s sales. It’s market share is greater than the other three leading industries combined and more than four times greater than the next largest firm’s sales share.
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Oligopoly and Concentration Ratios Oligopoly and Concentration Ratios
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• The dominance of oligopolies in industry is not unique to the U.S.
• The concentration ratios for U.S. industries are similar to other modern industrialized economies.
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EXHIBIT 5 PRODUCTION CONCENTRATION RATIOS IN JAPANESE MANUFACTURING INDUSTRIES BY LEADING AND FIVE LEADING FIRMS
Source: Nippon, A Charted Survey of Japan, 1994/95, Yano, I., ed., The Tsuneta Yano Memorial Society, p. 162.
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Exhibit 5: Production Concentration Ratios Exhibit 5: Production Concentration Ratios in Japanese Manufacturing Industries by in Japanese Manufacturing Industries by
Leading and Five Leading FirmsLeading and Five Leading Firms
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In how many Japanese industries do the five leading firms have greater than a 90 percent production concentration ratio? • Four industries—beer, nylon, glass, and tires and
tubes—are controlled by the five leading firms at a concentration of 90 percent or greater.
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Concentrating the ConcentrationConcentrating the Concentration
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An oligopoly can build market power in two ways:• Reinvesting its profit and painstakingly
expanding its production capacity.
• Merging with and/or acquiring other firms.
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Concentrating the ConcentrationConcentrating the Concentration
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There are three reasons why firms merge:1. To exercise greater market control.
2. To increase control over the supplies of their inputs or the buyers of their goods.
3. To expand and diversify their asset holdings.
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Concentrating the ConcentrationConcentrating the Concentration
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There are three types of mergers:
1. Horizontal merger
2. Vertical merger
3. Conglomerate merger
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Concentrating the ConcentrationConcentrating the Concentration
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Horizontal merger
• A merger between firms producing the same good in the same industry.
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Concentrating the ConcentrationConcentrating the Concentration
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A number of high-profile horizontal mergers occurred in the 1990s.• Boeing and McDonnell Douglas in the aircraft
industry.
• Staples and Office Depot in the office supply industry.
• Union Pacific and Southern Pacific Rail in the railroad industry.
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Concentrating the ConcentrationConcentrating the Concentration
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Vertical merger
• A merger between firms that have a supplier-purchaser relationship.
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Concentrating the ConcentrationConcentrating the Concentration
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An example of vertical merging is that of Anheuser-Busch.
The firm has acquired malt plants, yeast plants, a corn-processing plant, beer can factories, and a railway that ships freight by rail and truck.
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Concentrating the ConcentrationConcentrating the Concentration
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Conglomerate merger
• A merger between firms in unrelated industries.
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Concentrating the ConcentrationConcentrating the Concentration
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The conglomerate merger is the most common type of merger.
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Concentrating the ConcentrationConcentrating the Concentration
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• One reason for conglomerate mergers is the desire to diversify operations.
• While horizontal and vertical mergers strengthen the firm’s position within the industry, the fate of the firm rests on the health of the industry.
• Acquiring unrelated firms insures the conglomerate against catastrophe if one industry faces severe problems.
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Concentrating the ConcentrationConcentrating the Concentration
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Cartel
• A group of firms that collude to limit competition in a market by negotiating and accepting agreed-upon price and market shares.
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Concentrating the ConcentrationConcentrating the Concentration
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Collusion
• The practice of firms to negotiate price and market share decision that limit competition in a market.
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Concentrating the ConcentrationConcentrating the Concentration
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Cartels are an example of a merger in which firms don’t have to actually buy each other’s assets, yet they enjoy the benefits of having market power.
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Concentrating the ConcentrationConcentrating the Concentration
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• While cartels are illegal in the United States, it is difficult to prove collusion.
• Some governments encourage cartels to form in their countries. OPEC is one example.
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Concentrating the ConcentrationConcentrating the Concentration
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Many studies support the contention that price and concentration ratios move in the same direction – an increase in one is associated with an increase in the other.
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Mergers without MergingMergers without Merging
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Firms don’t have to merge or acquire each other to gain the advantages of merging. They can remain independent by creating a joint venture or joining a cartel.
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Mergers without MergingMergers without Merging
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Joint venture
• A business arrangement in which two or more firms undertake a specific economic activity together.
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Mergers without MergingMergers without Merging
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Cartel
• A group of firms that collude to limit competition in a market by negotiating and accepting agreed upon price and market shares.
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Mergers without MergingMergers without Merging
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Collusion
• The practice of firms to negotiate price and market share decisions that limit competition in a market.
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Cartel PricingCartel Pricing
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• A cartel determines price by acting as if it is a monopoly.
• Price and quantity are determined using the MR = MC rule.
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EXHIBIT 6 CARTEL PRICING AND OUTPUT ALLOCATIONS
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Exhibit 6: Cartel Pricing and Exhibit 6: Cartel Pricing and Output AllocationsOutput Allocations
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Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?• The price and output decisions made by the
cartel are determined by the MR = MC rule.
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Exhibit 6: Cartel Pricing and Exhibit 6: Cartel Pricing and Output AllocationsOutput Allocations
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Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?• The price and quantity assigned to individual
firms within the cartel may not coincide with where the firm would maximize profit using its own MR and MC curves.
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Exhibit 6: Cartel Pricing and Exhibit 6: Cartel Pricing and Output AllocationsOutput Allocations
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Why is there an incentive for cartels to “cheat” and produce greater quantities than they are assigned?
• There is an incentive for the firm to try to secretly increase quantity and thereby increase its own profit.
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EXHIBIT 7 RELATIONSHIP BETWEEN THE CONCENTRATION RATIO AND PRICE
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Exhibit 7: Relationship Between the Exhibit 7: Relationship Between the Concentration Ratio and PriceConcentration Ratio and Price
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Where on the curve in Exhibit 7 does the concentration ratio have the strongest effect on price?
• The effect is the strongest in the middle of the S-shaped curve.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e51
In monopoly, monopolistic competition and perfect competition, firms react only to the demand and cost structures they face. Prices tend toward equilibrium.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e52
In oligopoly, firms are continually second guessing how the competition will respond to price decision they make. Prices are subject to fits of change.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e53
Game theory
• A theory of strategy ascribed to the firms’ behavior in oligopoly. The firms’ behavior is mutually interdependent.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e54
Nash equilibrium
• A set of pricing strategies adopted by firms in which none can improve its payoff outcome, given the price strategies of the other firm or firms.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e55
Payoff matrix
• A table that matches the sets of gains (or losses) for competing firms when they choose, independently, various pricing options.
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© 2013 Cengage Learning Gottheil — Principles of Economics, 7e56
EXHIBIT 8 FIRM PROFIT, GENERATED BY HIGH AND LOW PRICING
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© 2013 Cengage Learning Gottheil — Principles of Economics, 7e57
EXHIBIT 9 PAYOFF MATRIX
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Exhibits 8 & 9: Firm Profit Generated Exhibits 8 & 9: Firm Profit Generated by High and Low Pricingby High and Low Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e58
How does total profit change as Dell and Compaq change their prices?• When both firms price high, total profit is 20.
When one firm prices high and the other prices low, total profit is 18. When both firms price low, total profit is 12.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e59
Price leadership
• A firm whose price decisions are tacitly accepted and followed by other firms in the industry. The theory explains pricing in unbalanced oligopolies.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
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Tit-for-tat
• A pricing strategy in game theory in which a firm chooses a price and will change its price to match whatever price the competing firm chooses.
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© 2013 Cengage Learning Gottheil — Principles of Economics, 7e61
EXHIBIT 10 PRICE AND OUTPUT UNDER CONDITIONS OF GODFATHER OLIGOPOLY
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Exhibit 10: Price and Output Under Exhibit 10: Price and Output Under Conditions of Godfather OligopolyConditions of Godfather Oligopoly
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e62
How is the price of chocolate determined in Exhibit 10?• Hershey is the “godfather” in the chocolate
business. Hershey produces where its MR = MC. That is, 5 tons of chocolate at $5 per pound. The other firms in the chocolate industry accept the $5 per pound price.
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© 2013 Cengage Learning Gottheil — Principles of Economics, 7e63
EXHIBIT 11 CONSTRUCTING AN OLIGOPOLIST’S DEMAND CURVE
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Exhibit 11: Constructing an Exhibit 11: Constructing an Oligopolist’s Demand CurveOligopolist’s Demand Curve
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e64
1. If Lipton were to raise its price above $0.80 per box, what would its competitors do, according to the curve in panel b?• Lipton’s competitors would not follow suit.
Lipton’s demand curve above $0.80 (NK) is relatively elastic.
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Exhibit 11: Constructing an Exhibit 11: Constructing an Oligopolist’s Demand CurveOligopolist’s Demand Curve
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e65
2. If Lipton were to lower its price below $0.80 per box, then what would its competitors do?• Lipton’s competitors would feel compelled to
follow suit. Lipton’s demand curve below $0.80 (YK) is relatively inelastic.
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Theories of Oligopoly PricingTheories of Oligopoly Pricing
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e66
Kinked demand curve
• The demand curve facing a firm in oligopoly; the curve is more elastic when the firm raises price than when it lowers price.
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© 2013 Cengage Learning Gottheil — Principles of Economics, 7e67
EXHIBIT 12 PRICE RIGIDITY IN OLIGOPOLIES WITH KINKED DEMAND CURVES
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Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand Curves
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e68
The marginal revenue curve associated with a kinked demand curve is:i. Continuous
ii. Discontinuous
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Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand Curves
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e69
The marginal revenue curve associated with a kinked demand curve is:i. Continuous
ii. Discontinuous
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Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand Curves
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e70
As long as the MC curve crosses the gap created by the discontinuity in the MR curve, price will remain unchanged, as shown in panel b.
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Exhibit 12: Price Rigidity in Exhibit 12: Price Rigidity in Oligopolies with Kinked Oligopolies with Kinked
Demand CurvesDemand Curves
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e71
If the MC curve cuts the MR curve above the gap, output will decrease and price will increase. This scenario is depicted in panel c.
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Brand MultiplicationBrand Multiplication
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e72
Brand multiplication
• Variations on essentially one good that a firm produces in order to increase its market share.
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Brand MultiplicationBrand Multiplication
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e73
• A firm’s market share =
(Number of brands) × (Brand market share).
• As the number of brands in the industry increases, market share per brand diminishes.
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Price DiscriminationPrice Discrimination
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e74
Price discrimination
• The practice of offering a specific good or service at different prices to different segments of the market.
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Price DiscriminationPrice Discrimination
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e75
• Oligopolists sometimes segment the market in order to charge consumers what they are willing to pay for a good or service.
• Differences in airline ticket prices are a good example.
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© 2013 Cengage Learning Gottheil — Principles of Economics, 7e76
EXHIBIT 13 DEMAND SCHEDULE FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK
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Exhibit 13: Demand Schedule Exhibit 13: Demand Schedule for a United Airlines Round-Trip for a United Airlines Round-Trip
Flight Between LA and NYFlight Between LA and NY
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e77
If United chose not to segment its market in Exhibit 13, what would be its total revenue?• The maximum total revenue for United
would be achieved at a ticket price of $318 each, for a total of $119,250.
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EXHIBIT 14 DEMAND BY MARKET SEGMENT FOR A UNITED AIRLINES ROUND-TRIP FLIGHT BETWEEN LOS ANGELES AND NEW YORK
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Exhibit 14: Demand by Market Exhibit 14: Demand by Market Segment for a United Airlines Round-Segment for a United Airlines Round-
Trip Flight Between LA and NYTrip Flight Between LA and NY
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e79
What is United’s total revenue when it segments its market into a multiple-fare system?• United’s total revenue is $210,635. This
is an increase of $91,385 over the unsegmented market.
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Price DiscriminationPrice Discrimination
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e80
• Price discrimination exists in virtually every market.
• Some differences in price are not clear cases of price discrimination, however.
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Why Oligopolists Sometimes Why Oligopolists Sometimes DiscriminateDiscriminate
© 2013 Cengage Learning Gottheil — Principles of Economics, 7e81
• For example, many would argue that upper balcony seats are not the same as front row seats at a concert. If the goods are different, then it is not necessarily price discrimination to charge more for the front row seats.