CHAPTER 9 PRICING AND OUTPUT DECISIONS: MONOPOLISTIC COMPETITION AND OLIGOPOLY QUESTIONS 1. The key difference is “product differentiation.” 2. a. In a pure monopoly, no one else can enter the market. Thus, the monopolist will enjoy above- normal profits as long as the demand is high relative to its cost structure. (Instructors may wish to discuss how realistic this is in the real world, i.e., how feasible is it for any non-regulated company to enjoy a monopoly over a long period of time.) b. Oligopolists may enjoy above-normal profits as long as their dominance in the market discourages companies from entering. However, as the PC market illustrates, even the giants (IBM, Apple, and Compaq) could not keep out the upstarts (AST, Leading Edge, NEC, Dell, and Northgate). c. Because of the ease of entry in this market, we expect any above-normal profits to eventually disappear. d. Because of ease of entry into the market, any above-normal profits (economic profits) will disappear. 3. Perhaps one of the most publicized examples of this is the bank credit card. In effect, the funds borrowed in the money market are the “input.” Its price is the cost of these funds. The price of the “output” is the interest rate charged by the companies for the card holder’s use of these funds. While money market interest rates (i.e., the cost of funds) have been falling, the interest rate charged to card holders have not. Thus, their profits on this operation have greatly increased. The reason this happens is because the money market is more “competitive” in the economic sense, while the market for credit cards is not (it is dominated by large banks such as Citibank). 4. Students should agree with this statement. A profit-maximizing firm will set a price according to the “MR=MC” rule. Firms that wish to maximize market share will.ry to increase their revenue. Thus, they will price their product at or near the point where MR=0. By implication, this price is lower that the one based on the MR=MC rule. 5. One of the main reasons why firms might not be able to set a price according to this rule is the difficulty and/or cost of obtaining the data on MR and MC. Indeed, firms might have to consider the trade-off between the added cost of obtaining the needed data and the added benefit of being able to maximize one’s profit by following the MR=MC rule. Also, in actual business situations, volatile market conditions (demand changes, costs of certain inputs change) can change a firm’s MR and MC relationships. Thus, a firm may not be able or willing to constantly adjust its price relative to the changing MR and MC. 6. Interdependence in a market means that each firm sets a price with the explicit consideration of the reactions of its competitor. Thus, in this situation, it is possible that all firms would continue to 88 Pricing and Output Decisions: Monopolistic Competition and Oligopoly charge the same price as everyone else for fear of either starting a price war or pricing itself out of the market. 7. A price leader provides a mechanism for everyone to begin raising prices in a more orderly and predictable fashion. 8. The usual concentration ratios could be used. Also, pricing tactics of competitors could be traced to monitor the extent of “mutual interdependence.” Managers should recognize the existence of oligopoly in order to anticipate reaction by competitors to any price action that they (the managers) take. 9. a. Oligopoly in the national (or worldwide) fast food market, but monopolistic competition in local or perhaps regional markets. b. Oligopoly in the national (or worldwide) oil refinery market; monopolistic competition at the local retail market (i.e., neighborhood gas stations). c. Monopolistic competition. The top five computer manufacturers (Dell, Compaq, IBM, Hewlett- Packard, and Gateway 2000) have less than 50% of the PC market in the United States, as well as in the world market. d. Oligopoly (almost a duopoly if you think about Heinz and Del Monte essentially dominating the ketchup market). e. Oligopoly (main competitor to Procter’s “Pampers” is Kimberly-Clark’s “Huggies”). However, private label disposable diapers are increasing their market share. f. Oligopoly (there is, of course, the green box, and private store labels are also increasing in importance). g. Monopolistic competition. Starbucks may be alone as a national chain, but in local markets there are numerous gourmet coffee establishments. h. Oligopoly in national pizza chains. Monopolistic competition at the local level. i. Oligopoly, but because of Intel’s dominance in this market, it could be called “near monopoly.” 10. The S-C-P paradigm says that industry structure determines industry conduct, which in turn determines industry performance. Structure is determined by the prevailing supply and demand conditions. This influences the industry’s conduct—its pricing strategies, advertising, product development, etc. The industry’s performance is measured in terms of how close it comes to achieving the goal of maximizing society’s welfare. A concentrated industry will be less likely to arrive at this norm than an industry where competition rules. Pricing and Output Decisions: Monopolistic Competition and Oligopoly 89 11. (1) Threat of new entrants: relates to number of sellers in perfect and monopolistic competition. (2) To some extent, substitute products could also be considered a form of new competition. (3) Intra-market rivalry refers to the “mutual interdependence” of the oligopoly market. (4) Buyer and supplier power have no direct relation to the characteristics of the four market types in economic theory, but are certainly important factors to consider. 12. a. The beer industry in the United States is already oligopolistic. One of the main reasons why South African Breweries (SAB) bought Miller is to have greater access to the U.S. market, the one market in that it has very little presence. (Interestingly enough, SAB began in the 1800s to help quench the thirst of diamond mine workers.) If SAB can combine its skills in producing and marketing beer around the world with Miller’s U.S. distribution channels, it may really start to give Anheuser-Busch (A-B) a “run for its money.” This could in effect result in a “duopolistic” market, with Coors a distant third. As far as world markets are concerned, this may put SAB into genuine contention with Heineken and Interbrew, the two brewery giants mentioned in the chapter. b. As mentioned above, one of SAB’s main reasons for buying Miller is to gain direct access to the U.S. market. This automatically expands the potential demand for its products. Moreover, once it starts to invest in Miller and also bring in its own brands, it can begin to reach a size closer to A-B and perhaps match A-B in terms of economies of scale and scope. Looking at the deal from Philip Morris’ point of view, Miller’s sales made up less than 5% of its annual total revenue from all its businesses. Consequently, it could never get the kind of focus and resources that it required from top management to compete effectively against A-B. 90 Pricing and Output Decisions: Monopolistic Competition and Oligopoly PROBLEMS 1. a. Note to Instructors: We found this problem to be a good application of the concepts. We also found that this makes a good in-class assignment. If your class size allows for this, divide the class into groups of 4 to 6 students and have each be prepared to report to the class their recommendation. Please be aware that students may not realize at first that this problem assumes a constant MC (which therefore equals AVC). You may wish to provide this hint. However, it is interesting to let the students discover on their own about the nature of a linear total cost function. It is interesting to note the different approaches that students use to solve this problem. Some use the more cumbersome “TR/TC Approach,” while others go right to the marginal analysis and begin comparing MR with (the constant) MC or AVC. PR PW Q TR MR E 12.50 10.00 6,000 60,000 12.00 9.60 6,500 62,400 4.80 -1.96 11.50 9.20 7,000 64,400 4.00 -1.74 11.00 8.80 7,500 66,000 3.20 -1.55 10.50 8.40 8,000 67,200 2.40 -1.38 10.00 8.00 8,500 68,000 1.60 -1.24 9.50 7.60 9,000 68,400 0.80 -1.11 9.00 7.20 9,500 68,400 0.00 -1.00 8.50 6.80 10,000 68,000 -0.80 -0.90 8.00 6.40 10,500 67,200 -1.60 -0.80 b. $8.75 is definitely a “sub-optimal” price as far as the students are concerned, because at that price MR < MC. In fact, this price actually falls in the inelastic portion of the demand curve. Thus, it would not even yield maximum total revenue. (The elasticity of demand between $12.50 and $8.00 is -1.24, indicating that demand is elastic over this price range. However, dividing up this range into smaller intervals of $.50 reveals that $8.75 actually falls in the inelastic position of the demand curve.) In order to determine the profit maximizing price, we must first determine the firm’s marginal cost of production. We shall assume the following costs to be variable: Paper $12,000 Repro Services 8,000 Binding 3,000 Shipping 2,000 Total Variable Cost $25,000 (Total fixed cost = $20,000) AVC = $4.16. Because it is constant, we can also state that it is equal to MC. Based on the demand schedule above, an MC of $4.16 would fall somewhere between the retail price of $12.00 and 11.50. Pricing and Output Decisions: Monopolistic Competition and Oligopoly 91 c. Let us assume that the retail price is set at $12.00 (a nice round number). At this level, total cost would be $47,040 (TFC = $20,000 and TVC = $4.16 x 6500). Total profit would be $15,360. Although this venture looks profitable, it does not seem to provide the students with economic profit. In fact, from an economic standpoint, each student would incur a loss because each student’s assumed share in the profits of $3072 is not enough to cover the assumed opportunity cost of $4000. Unless the students want the experience of running their own business, the “economics” of this venture dictate that they not start this company. d. Given the bookstore’s costs (which we do not know), $8.75 may very well be its optimal price. Moreover, the store manager may want to consider the book as a “loss leader” or at least an item whose low price might attract customers into the store. 2. a. The main difference is that the inclusion or exclusion of miscellaneous cost affects the MC, thereby affecting the point at which MC = MR. When miscellaneous cost is considered to be variable, MC = $5.00. The optimal price would be about $12.75. When it is not included, MC = $4.16. Thus, the optimal price would be about $11.75. b. In this problem, it is not likely that the law of diminishing returns would be important. However, AVC and MC could rise if for some reason factor costs rose (e.g., increase in wage rates of printers due to overtime compensation). c. AVC and MC would probably not decrease in the short run. In the long run, they might if the students increase their operations and cut costs from economies of scale (e.g., printing and paper costs are reduced if the printer cuts the price because of higher production runs). 3. a. and b. Firm’s Demand Curve Industry Demand Curve Total Marginal Total Marginal Price Quantity Revenue Revenue Price Quantity Revenue Revenue 10.00 2 20 10.00 14 140 9.00 10 90 8.75 9.00 17 153 4.33 8.00 18 144 6.75 8.00 20 160 2.33 7.00 26 182 4.75 7.00 23 161 0.33 6.00 34 204 2.75 6.00 26 156 -1.67 5.00 42 210 0.75 5.00 29 145 -3.67 4.00 50 200 -1.25 4.00 32 128 -5.67 3.00 58 174 -3.25 3.00 35 105 -7.67 12 10 8 P 6 4 D Ind. D Firm 2 0 0 10 20 30 40 50 60 70 Q Figure 9.1 92 Pricing and Output Decisions: Monopolistic Competition and Oligopoly c., d., e. 12 10 8 P 6 MR D 4 2 0 0 10 20 30 40 50 60 70 Q Figure 9.2 The range of changes in marginal costs without impact on price is shown on above graph. It is the vertical distance between the two marginal cost curves vertically below the kink. 4. a. FALSE Not if its loss is less than its fixed cost. See explanation of problem 1. b. FALSE Even a pure monopoly has to consider the possibility of demand falling below the level sufficient to earn a profit. (For example, even if Polaroid continues to have a monopoly on cameras that use instant developing film, can they stop the erosion in demand due to the one-hour photo developing machines and cameras that record images electronically on discs?) c. TRUE Other factors held constant, the entry or exit of firms will theoretically lead to this condition. d. TRUE In order to maximize revenue, a firm will price its product at the point where MR=0. By implication, this must be a lower price than the point where MR=MC. e. FALSE Although this is often the case, it is not always so. f. TRUE Economists consider this to be true because the more opportunities for substitution that a consumer has, the more elastic the demand for a particular product tends to be. In a monopolistically competitive market, there are many more firms for consumers to choose from. 5. a. Their unit cost of goods sold might be lower because they could buy directly from the manufacturer. Also, if consumers are not brand-loyal, stores might be able to increase revenues by lowering price. Thus, private label products could be (and often are) more profitable to sell than national brands. b. Selling to stores could help to reduce excess capacity. If they then produce at maximum capacity, their unit costs would be minimized. 6. a. Regardless of their cost structure, all three would be earning less money because the demand is price inelastic over this range of prices. Pricing and Output Decisions: Monopolistic Competition and Oligopoly 93 b. Perhaps, depending on their respective marginal costs. 7. a. P = $22 (TR = $1980, TC = $760) b. As new competitors enter the market, economic profit would decrease, eventually reaching zero. c. P = $12 At this best price, the firm would be losing money. However, it would still have a positive contribution, and, therefore, it should continue to operate in the short run. 8. a. Firms 1 and 2 should charge $15, Firm 3 should charge $16. Calculate MR: 40P = 1.000 - Q P = 25 - 0.025Q 2 TR = 25Q - 0.025Q MR = 25 - 0.05Q Firms 1 and 2 MC = 5 MR = MC: 25 - 0.05Q = 5 400 = Q P = 25 - 0.025 (400) = 15 Firm 3 MC = 7 MR = MC: 25 - 0.05Q = 7 360 = Q P = 25 - 0.025 (360) = 16 b. Firm 3’s MC is higher. c. In the short run, probably Firm 1 because it has the highest fixed cost. We believe that this is a very good problem for students to tackle because the answer is not as obvious as it appears. To be sure, Firm #1 has the highest “overhead” and, therefore, one would immediately assume that this would leave it most vulnerable to a price war. But this would be true as long as the price stays above about $13. As it starts to fall below this, the higher average variable cost of Firm #3 starts to have a relatively greater impact on its profit and loss statement compared to Firm #1. For example, if the price is $13 and assuming that both Firm #1 and Firm #3 follow the MR = MC rule, Firm #1 loses $160 while #3 loses $120. But when the price falls to $12, #1 loses $360 while #3 loses $400. 94 Pricing and Output Decisions: Monopolistic Competition and Oligopoly 9. “Low-Cost Approach” P MC P1 AC D Q Q1 MR Figure 9.3 Monopolistic competitor is able to keep AC low enough so that it is able to earn an economic profit given its demand. “Differentiation Approach” P MC P1 AC D Q Q1 MR Figure 9.4 Differentiation causes D to become less elastic, thereby enabling the firm to earn an economic profit, regardless of cost structure.