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Organization
Chapter 15
Slides by Pamela L. Hall
Western Washington University
2005, Southwestern
Introduction
Profits may be high because product coincidentally was offered in right place
at right time
Introduction
Provide scores indicating which strategy action yields most profit enhancement
Scores can be used by a firms management to allocate resources where largest
payoff in terms of profits will occur
Management will then attempt to equate marginal revenue with marginal cost in
marketing its output
Introduction
Introduction
Investigate how price, output, sales promotion, and product differentiation are determined under
various market conditions
Present a model to determine optimal level of product differentiation and advertising (selling
expenses)
Cournot model assumes firms do not realize that their individual output decisions affect output
decisions of their competitors
Stackelberg model--one firm realizes interdependence of output decisions and determines its
optimal output decision based on this
Also consider Stackelberg disequilibrium
Each firm realizes output interdependence but believes other firms do not
Bertrand model assumes firms compete in terms of price rather than through output
We contrast these with Cournot conditions
Product Differentiation
Convince consumers that its product is not sharply different from competing
products
Maximizing Profit
F.O.C.s are
Maximizing Profit
For profit maximization, marginal revenue from each activity must equal marginal
cost for that activity
For example, a firm will produce additional advertising messages up to point at which the
marginal revenue from additional demand generated by a message is equal to messages
marginal cost
Messages that spark greatest reaction from consumers will receive a larger share of expenditures
Indicates at least some positive increment to profit for these two activities
Advertising services is a major industry within U.S.
Accounts for 2% to 3% of GNP
Market for advertising messages is not separate from market for commodity
For example, beer is a joint product where beer and advertising for beer are both produced
Firms that do not account for joint production and contribute all of any increase in
revenue to advertising will overinvest in advertising
Maximizing Profit
By differentiating their products firms can possibly satisfy a market niche and
create monopoly power with potential of increasing profit
Instead, they offer products that are not too different from their competitors
products yet have some unique features
Better to be a half-step ahead and understood than a whole step ahead and ignored
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Assessing Advertising
But it may or may not have any effect on overall consumption choices
For example, cigarette advertising can have a major effect on consumers choice of
brands
However, there is little evidence that cigarette advertising has increased demand
for cigarettes among adults
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Assessing Advertising
Informational
Persuasive
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Assessing Advertising
Persuasive advertising
Firm is attempting to modify consumers preferences by creating wants
Little information concerning product is generally provided
Assessing Advertising
National Advertising Division of the Council of Better Business Bureaus was created by
advertising industry in 1971 to
Advertisers, advertising agencies, and consumers rely on this division to maintain high
standards of principles in advertising
By 2001, over 3200 advertising cases had been successfully handled through this selfregulatory process
A problem with any type of regulation is determining what is true and false in advertising
and who should determine it
Documentation supporting advertising claims and litigation costs associated with regulation
may increase product price
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Monopolistic Competition
Product differentiation
Relatively large number of firms
Easy entry into market
Examples include service stations, convenience stores, and fast-food franchises
Monopolistically competitive firms produce similar but not identical products with
relatively easy entry into industry
Products may be differentiated only by brand name, color of package, location of the seller,
customer service, or credit conditions
Results in each firm having a partial monopoly of its own differentiated product
Possible to have wide differences among firms in price, output, and firm profit
Because each firm has a partial monopoly, each firm has its own output demand curve
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Monopolistic Competition
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Monopolistic Competition
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At a particular price firm will not sell expected level of output based on Qd
demand curve
Instead, firm will sell lesser output associated with QD curve
At this tangency point, firm cannot vary output to enhance its profit
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However, as indicated in Figure 15.1, production is not at minimum of LAC, p > LMC
In Figure 15.1, QD demand curve cuts above short-run average total cost curve
Creates an area where a monopoly can earn a short-run pure profit by reducing output to within
this area
Thus, monopolistically competitive firms level of resource misallocation is less than if a monopoly
was sole supplier in industry
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Oligopoly
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Oligopoly
Economies of scale
May result where total market size permits only a few optimally-sized plants
Exclusive franchises
Present legal barriers to entry
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p q1 < 0, p q2 < 0
Assuming firms objectives are maximizing their own profit, profit for
each firm is
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This results in
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To solve F.O.C.s for optimal level of outputs, q1* and q2*, we require the
functional forms of
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Cournot Model
A firm, setting its own output, assumes other firms output will not change
For example, a firm may determine its output capacity without regard to capacity of other firms
Cournot duopoly solution implies that each firm equates its own MR to MC without regard to
any possible reaction by other firm
p(Q*) + [p(Q) Q]q*j = MC(q*j), j = 1, 2
Even with zero conjectural variations, solution for (q 1, q2) still involves simultaneous solution of each firms
F.O.C.
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Cournot Model
However, each individual firm does not consider effect on its total revenue of
other firms building office space
When additional office space becomes available, market is flooded and price drops
Result is magnified when high price for office space is during an economic
boom period in citys cyclical economy
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Factoring out p(Q*) from F.O.C. for profit maximization and multiplying
second term by 1 = Q*/Q*, yields
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With a greater than firms SAVC, they will each supply a positive level of
output
Since Cournot firms conjectural variations are both zero, Firm 1s F.O.C.
reduces to
q2 = (a c bq1)/2b
Reaction functions are illustrated in Figure 15.2
Cournot equilibrium level of outputs for firms 1 and 2 result at their intersection
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Isoprofit Curves
As firm 2 increases its output from zero, profit for firm 1 declines
Illustrated by isoprofit curves with lower levels of profit as q2 increases
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Isoprofit Curves
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Isoprofit Curves
Given these isoprofit and reaction curves, firm 1 will react to firm 2s
output level q2
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Stackelberg Model
Stackelberg model
Follower behaves exactly as Cournot firm, so its conjectural variation is still zero
Leader then takes advantage of assumption that other firm is behaving as a follower
A sequential game-theory problem where leader has advantage of moving
first
Industries with one dominant large firm and a number of smaller firms are
examples of markets with possible Stackelberg characteristics
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Stackelberg Model
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Stackelberg Model
Given firm 2s reaction function, we can determine subgame perfect Nash equilibrium
for Firm 1
Specifically
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Stackelberg Model
bq1 = bq2
q1 = q2
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Stackelberg Model
Results in firm 1 earning a higher profit and firm 2 earning a lower profit than at
Cournot equilibrium
Similarly, as illustrated in Figure 15.4, if firm 2 is the Stackelberg firm facing Cournot
firm 1
Equilibrium output and profit levels are reversed
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Stackelberg Disequilibrium
Collusion
F.O.C.s are
/q1 = /q2 = a b(q1 + q2) b(q1 + q2) c = 0
Solving for Q = (q1 + q2) gives
Q = (q1 + q2) = (a c)/2b
Firms set total output equal to the monopoly solution
Then determine how to divide this output among themselves
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Collusion
If they are not equal, joint profit could be increased by shifting production toward
firm with higher marginal profit
Equality of marginal profit is illustrated in Figure 15.4
Given that costs of two firms are the same, one possible division would be for total
output to be divided evenly
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Collusion
Firm can increase its individual profit if the other firm does not deviate from
agreed upon output limits
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Collusion
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Bertrand Model
Perfect Oligopoly
Any firm setting a price higher than marginal costs will be undercut by another firm offering a slightly lower price
Thus, perfectly competitive solution that yields a Pareto-efficient allocation will exist with
each firm setting price equal to marginal cost
With as few as two firms, result is a consequence of the firms setting their bid price equal to
marginal cost
Firms are in effect auctioning off their output in a first-bid common-value auction
Note that this Bertrand model Pareto-efficient solution for as few as two firms contrasts
with Cournot solution
Only when number of firms approach infinity will Cournot model yield a Pareto-efficient solution
Efficiency depends on how firms strategically interact
Bertrand, Cournot, and Stackelberg models illustrate how equilibrium outcomes and
efficiency in an oligopoly industry depend on type of strategic interaction engaged in by
firms
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Imperfect Oligopoly
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Imperfect Oligopoly
Imperfect Oligopoly
The F.O.C. is
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Imperfect Oligopoly
p1 = a/2b + d/2bp2
Similarly, maximizing profit for firm 2, holding firm 1s price constant, yields Firm 2s
reaction function
p2 = a/2b + d/2bp1
These reaction functions are illustrated in Figure 15.5 with Bertrand equilibrium corresponding
to where they intersect
Thus, equilibrium prices are determined by solving simultaneously the two reaction
functions
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Collusion
For example, Bertrand model in game theory yields the same results as
Prisoners Dilemma when it also is played repeatedly
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Collusion
No general agreement among economists that any existing oligopoly model is appropriate
for analyzing firm behavior in a specific industry
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Each member can cheat by defecting from cartel and increase its payoff
Thus, there is an incentive for both firms to cheat and defect
For this reason, it is generally thought that cartels are inherently unstable in the
absence of some binding constraints on participants
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Legal Provisions
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Legal Provisions
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