CHAPTER 16 OLIGOPOLY 371 Justice Department). Testifying for the government was a prominent economist (MIT professor Franklin Fisher). Testifying for Microsoft was an equally promi- nent economist (MIT professor Richard Schmalensee). At stake was the future of one of the world’s most valuable companies (Microsoft) in one of the econ- omy’s fastest growing industries (computer software). A central issue in the Microsoft case involved tying—in particular, whether Microsoft should be allowed to integrate its Internet browser into its Windows operating system. The government claimed that Microsoft was bundling these two products together to expand the market power it had in the market for computer operating systems into an unrelated market (for Internet browsers). Allowing Microsoft to incorporate such products into its operating system, the government argued, would deter new software companies such as Netscape from entering the market and offering new products. Microsoft responded by pointing out that putting new features into old products is a natural part of technological progress. Cars today include stereos and air-conditioners, which were once sold separately, and cameras come with built-in flashes. The same is true with operating systems. Over time, Microsoft has added many features to Windows that were previously stand-alone prod- ucts. This has made computers more reliable and easier to use because con- sumers can be confident that the pieces work together. The integration of Internet technology, Microsoft argued, was the natural next step. One point of disagreement concerned the extent of Microsoft’s market power. Noting that more than 80 percent of new personal computers used a Microsoft operating system, the government argued that the company had sub- stantial monopoly power, which it was trying to expand. Microsoft replied that the software market is always changing and that Microsoft’s Windows was constantly being challenged by competitors, such as the Apple Mac and Linux operating systems. It also argued that the low price it charged for Windows— about $50, or only 3 percent of the price of a typical computer—was evidence that its market power was severely limited. As this book was going to press, the final outcome of the Microsoft case was yet to be resolved. In November 1999 the trial judge issued a ruling in which he found that Microsoft had great monopoly power and that it had illegally abused that power. But many questions were still unanswered. Would the trial court’s decision hold up on appeal? If so, what remedy would the government seek? Would it try to regulate future design changes in the Windows operating sys- tem? Would it try to break up Microsoft into a group of smaller, more com- petitive companies? The answers to these questions will shape the software industry for years to come. QUICK QUIZ: What kind of agreement is illegal for businesses to make? ◆ Why are the antitrust laws controversial? CONCLUSION Oligopolies would like to act like monopolies, but self-interest drives them closer to competition. Thus, oligopolies can end up looking either more like monopolies or more like competitive markets, depending on the number of firms in the “ME? A MONOPOLIST? NOW JUST WAIT A MINUTE . . .” 372 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY oligopoly and how cooperative the firms are. The story of the prisoners’ dilemma shows why oligopolies can fail to maintain cooperation, even when cooperation is in their best interest. Policymakers regulate the behavior of oligopolists through the antitrust laws. The proper scope of these laws is the subject of ongoing controversy. Although price fixing among competing firms clearly reduces economic welfare and should be illegal, some business practices that appear to reduce competition may have le- gitimate if subtle purposes. As a result, policymakers need to be careful when they use the substantial powers of the antitrust laws to place limits on firm behavior. ◆ Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. Yet, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. The larger the number of firms in the oligopoly, the closer the quantity and price will be to the levels that would prevail under competition. ◆ The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual interest. The logic of the prisoners’ dilemma applies in many situations, including arms races, advertising, common-resource problems, and oligopolies. ◆ Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition. The application of these laws can be controversial, because some behavior that may seem to reduce competition may in fact have legitimate business purposes. Summary oligopoly, p. 350 monopolistic competition, p. 350 collusion, p. 353 cartel, p. 353 Nash equilibrium, p. 355 game theory, p. 358 prisoners’ dilemma, p. 359 dominant strategy, p. 360 Key Concepts 1. If a group of sellers could form a cartel, what quantity and price would they try to set? 2. Compare the quantity and price of an oligopoly to those of a monopoly. 3. Compare the quantity and price of an oligopoly to those of a competitive market. 4. How does the number of firms in an oligopoly affect the outcome in its market? 5. What is the prisoners’ dilemma, and what does it have to do with oligopoly? 6. Give two examples other than oligopoly to show how the prisoners’ dilemma helps to explain behavior. 7. What kinds of behavior do the antitrust laws prohibit? 8. What is resale price maintenance, and why is it controversial? Questions for Review CHAPTER 16 OLIGOPOLY 373 1. The New York Times (Nov. 30, 1993) reported that “the inability of OPEC to agree last week to cut production has sent the oil market into turmoil . . . [leading to] the lowest price for domestic crude oil since June 1990.” a. Why were the members of OPEC trying to agree to cut production? b. Why do you suppose OPEC was unable to agree on cutting production? Why did the oil market go into “turmoil” as a result? c. The newspaper also noted OPEC’s view “that producing nations outside the organization, like Norway and Britain, should do their share and cut production.” What does the phrase “do their share” suggest about OPEC’s desired relationship with Norway and Britain? 2. A large share of the world supply of diamonds comes from Russia and South Africa. Suppose that the marginal cost of mining diamonds is constant at $1,000 per diamond, and the demand for diamonds is described by the following schedule: PRICE QUANTITY $8,000 5,000 7,000 6,000 6,000 7,000 5,000 8,000 4,000 9,000 3,000 10,000 2,000 11,000 1,000 12,000 a. If there were many suppliers of diamonds, what would be the price and quantity? b. If there were only one supplier of diamonds, what would be the price and quantity? c. If Russia and South Africa formed a cartel, what would be the price and quantity? If the countries split the market evenly, what would be South Africa’s production and profit? What would happen to South Africa’s profit if it increased its production by 1,000 while Russia stuck to the cartel agreement? d. Use your answer to part (c) to explain why cartel agreements are often not successful. 3. This chapter discusses companies that are oligopolists in the market for the goods they sell. Many of the same ideas apply to companies that are oligopolists in the market for the inputs they buy. a. If sellers who are oligopolists try to increase the price of goods they sell, what is the goal of buyers who are oligopolists? b. Major league baseball team owners have an oligopoly in the market for baseball players. What is the owners’ goal regarding players’ salaries? Why is this goal difficult to achieve? c. Baseball players went on strike in 1994 because they would not accept the salary cap that the owners wanted to impose. If the owners were already colluding over salaries, why did the owners feel the need for a salary cap? 4. Describe several activities in your life in which game theory could be useful. What is the common link among these activities? 5. Consider trade relations between the United States and Mexico. Assume that the leaders of the two countries believe the payoffs to alternative trade policies are as follows: a. What is the dominant strategy for the United States? For Mexico? Explain. b. Define Nash equilibrium. What is the Nash equilibrium for trade policy? c. In 1993 the U.S. Congress ratified the North American Free Trade Agreement (NAFTA), in which the United States and Mexico agreed to reduce trade barriers simultaneously. Do the perceived payoffs as shown here justify this approach to trade policy? d. Based on your understanding of the gains from trade (discussed in Chapters 3 and 9), do you think that these payoffs actually reflect a nation’s welfare under the four possible outcomes? United States Decision Low Tariffs Low Tariffs U.S. gains $25 billion Mexico gains $25 billion Mexico gains $10 billion Mexico gains $30 billion Mexico gains $20 billion U.S. gains $30 billion U.S. gains $10 billion U.S. gains $20 billion High Tariffs High Tarrifs Mexico's Decision ' Problems and Applications 374 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY 6. Suppose that you and a classmate are assigned a project on which you will receive one combined grade. You each want to receive a good grade, but you also want to do as little work as possible. The decision box and payoffs are as follows: Assume that having fun is your normal state, but having no fun is as unpleasant as receiving a grade that is two letters lower. a. Write out the decision box that combines the letter grade and the amount of fun you have into a single payoff for each outcome. b. If neither you nor your classmate knows how much work the other person is doing, what is the likely outcome? Does it matter whether you are likely to work with this person again? Explain your answer. 7. The chapter states that the ban on cigarette advertising on television in 1971 increased the profits of cigarette companies. Could the ban still be good public policy? Explain your answer. 8. A case study in the chapter describes a phone conversation between the presidents of American Airlines and Braniff Airways. Let’s analyze the game between the two companies. Suppose that each company can charge either a high price for tickets or a low price. If one company charges $100, it earns low profits if the other company charges $100 also, and high profits if the other company charges $200. On the other hand, if the company charges $200, it earns very low profits if the other company charges $100, and medium profits if the other company charges $200 also. a. Draw the decision box for this game. b. What is the Nash equilibrium in this game? Explain. c. Is there an outcome that would be better than the Nash equilibrium for both airlines? How could it be achieved? Who would lose if it were achieved? 9. Farmer Jones and Farmer Smith graze their cattle on the same field. If there are 20 cows grazing in the field, each cow produces $4,000 of milk over its lifetime. If there are more cows in the field, then each cow can eat less grass, and its milk production falls. With 30 cows on the field, each produces $3,000 of milk; with 40 cows, each produces $2,000 of milk. Cows cost $1,000 apiece. a. Assume that Farmer Jones and Farmer Smith can each purchase either 10 or 20 cows, but that neither knows how many the other is buying when she makes her purchase. Calculate the payoffs of each outcome. b. What is the likely outcome of this game? What would be the best outcome? Explain. c. There used to be more common fields than there are today. Why? (For more discussion of this topic, reread Chapter 11.) 10. Little Kona is a small coffee company that is considering entering a market dominated by Big Brew. Each company’s profit depends on whether Little Kona enters and whether Big Brew sets a high price or a low price: Big Brew threatens Little Kona by saying, “If you enter, we’re going to set a low price, so you had better stay out.” Do you think Little Kona should believe the threat? Why or why not? What do you think Little Kona should do? 11. Jeff and Steve are playing tennis. Every point comes down to whether Steve guesses correctly whether Jeff will hit the ball to Steve’s left or right. The outcomes are: Big Brew Enter High Price Brew makes $3 million Kona makes $2 million Kona loses $1 million Kona makes zero Kona makes zero Brew makes $1 million Brew makes $7 million Brew makes $2 million Low Price Don't Enter Little Kona Your Decision Work Work You get A grade, no fun Classmate gets A grade, no fun Classmate gets B grade, no fun Classmate gets B grade, fun Classmate gets D grade, fun You get B grade, fun You get B grade, no fun You get D grade, fun Shirk Shirk Classmate's Decision CHAPTER 16 OLIGOPOLY 375 Does either player have a dominant strategy? If Jeff chooses a particular strategy (Left or Right) and sticks with it, what will Steve do? So, can you think of a better strategy for Jeff to follow? Steve Guesses Left Left Steve wins point Jeff wins point Jeff wins point Steve wins point Right Right Jeff Hits Jeff loses point Steve loses point Steve loses point Jeff loses point IN THIS CHAPTER YOU WILL . . . Examine the debate over the role of brand names Consider the desirability of outcomes in monopolistically competitive markets Analyze competition among firms that sell differentiated products Compare the outcome under monopolistic competition and under perfect competition Examine the debate over the effects of advertising You walk into a bookstore to buy a book to read during your next vacation. On the store’s shelves you find a John Grisham mystery, a Stephen King thriller, a Danielle Steel romance, a Frank McCourt memoir, and many other choices. When you pick out a book and buy it, what kind of market are you participating in? On the one hand, the market for books seems competitive. As you look over the shelves at your bookstore, you find many authors and many publishers vying for your attention. A buyer in this market has thousands of competing products from which to choose. And because anyone can enter the industry by writing and publishing a book, the book business is not very profitable. For every highly paid novelist, there are hundreds of struggling ones. On the other hand, the market for books seems monopolistic. Because each book is unique, publishers have some latitude in choosing what price to charge. The sellers in this market are price makers rather than price takers. And, indeed, the price of books greatly exceeds marginal cost. The price of a typical hardcover MONOPOLISTIC COMPETITION 377 378 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY novel, for instance, is about $25, whereas the cost of printing one additional copy of the novel is less than $5. In this chapter we examine markets that have some features of competi- tion and some features of monopoly. This market structure is called monopolistic competition. Monopolistic competition describes a market with the following attributes: ◆ Many sellers: There are many firms competing for the same group of customers. ◆ Product differentiation: Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve. ◆ Free entry: Firms can enter (or exit) the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero. A moment’s thought reveals a long list of markets with these attributes: books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, and so on. Monopolistic competition, like oligopoly, is a market structure that lies be- tween the extreme cases of competition and monopoly. But oligopoly and monop- olistic competition are quite different. Oligopoly departs from the perfectly competitive ideal of Chapter 14 because there are only a few sellers in the market. The small number of sellers makes rigorous competition less likely, and it makes strategic interactions among them vitally important. By contrast, under monopo- listic competition, there are many sellers, each of which is small compared to the market. A monopolistically competitive market departs from the perfectly com- petitive ideal because each of the sellers offers a somewhat different product. COMPETITION WITH DIFFERENTIATED PRODUCTS To understand monopolistically competitive markets, we first consider the de- cisions facing an individual firm. We then examine what happens in the long run as firms enter and exit the industry. Next, we compare the equilibrium un- der monopolistic competition to the equilibrium under perfect competition that we examined in Chapter 14. Finally, we consider whether the outcome in a mo- nopolistically competitive market is desirable from the standpoint of society as a whole. THE MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT RUN Each firm in a monopolistically competitive market is, in many ways, like a mo- nopoly. Because its product is different from those offered by other firms, it faces a monopolistic competition a market structure in which many firms sell products that are similar but not identical CHAPTER 17 MONOPOLISTIC COMPETITION 379 downward-sloping demand curve. (By contrast, a perfectly competitive firm faces a horizontal demand curve at the market price.) Thus, the monopolistically com- petitive firm follows a monopolist’s rule for profit maximization: It chooses the quantity at which marginal revenue equals marginal cost and then uses its de- mand curve to find the price consistent with that quantity. Figure 17-1 shows the cost, demand, and marginal-revenue curves for two typical firms, each in a different monopolistically competitive industry. In both panels of this figure, the profit-maximizing quantity is found at the intersection of the marginal-revenue and marginal-cost curves. The two panels in this figure show different outcomes for the firm’s profit. In panel (a), price exceeds average total cost, so the firm makes a profit. In panel (b), price is below average total cost. In this case, the firm is unable to make a positive profit, so the best the firm can do is to minimize its losses. All this should seem familiar. A monopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar. THE LONG-RUN EQUILIBRIUM The situations depicted in Figure 17-1 do not last long. When firms are mak- ing profits, as in panel (a), new firms have an incentive to enter the market. This QuantityProfit- maximizing quantity Loss- minimizing quantity 0 Price Price Demand Demand MR ATC (a) Firm Makes Profit Quantity0 Price Price Average total cost Average total cost (b) Firm Makes Losses MR Profit Losses MC ATC MC Figure 17-1 MONOPOLISTIC COMPETITORS IN THE SHORT RUN. Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal revenue equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is above average total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost. 380 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products falls, these firms experience declining profit. Conversely, when firms are making losses, as in panel (b), firms in the market have an incentive to exit. As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. In other words, losses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms’ products rises, these firms experience rising profit (that is, de- clining losses). This process of entry and exit continues until the firms in the market are mak- ing exactly zero economic profit. Figure 17-2 depicts the long-run equilibrium. Once the market reaches this equilibrium, new firms have no incentive to enter, and existing firms have no incentive to exit. Notice that the demand curve in this figure just barely touches the average- total-cost curve. Mathematically, we say the two curves are tangent to each other. These two curves must be tangent once entry and exit have driven profit to zero. Because profit per unit sold is the difference between price (found on the demand curve) and average total cost, the maximum profit is zero only if these two curves touch each other without crossing. . promi- nent economist (MIT professor Richard Schmalensee). At stake was the future of one of the world’s most valuable companies (Microsoft) in one of the. The integration of Internet technology, Microsoft argued, was the natural next step. One point of disagreement concerned the extent of Microsoft’s market power.