1. Many industries in the United States, especially those in the world of technology, media, and communications, are becoming more oligopolistic.
II. Markets with Only a Few Sellers
A. A key feature of oligopoly is the tension between cooperation and self-interest.
1. The group of oligopolists is better off cooperating and acting like a monopolist, producing a small quantity of output and charging a price above marginal cost.
A duopoly is an oligopoly with only two members.
a. Definition of collusion: an agreement among firms in a market about quantities to produce or prices to charge.
b. Definition of cartel: a group of firms acting in unison.
Definition of Nash equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen.
The oligopoly price is less than the monopoly price but greater than the competitive price (which implies that it is greater than marginal cost).
. Game Theory and the Economics of Cooperation
A. Definition of game theory: the study of how people behave in strategic situations.
1. By strategic, we mean a situation in which each person, in deciding what actions to take, must consider how others might respond to that action.
2. Each firm in an oligopoly must act strategically, because its profit not only depends on how much output it produces, but also on how much other firms produce as well.
B. Definition of prisoners’ dilemma: a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.
C. The Prisoners’ Dilemma
1. Example: Bonnie and Clyde have been captured. The police have enough evidence to convict them on a weapons charge (sentence = one year) but suspect that they have been involved in a bank robbery. Because they lack hard evidence in the crime, they need at least one of them to confess.
2. The police lock the two in separate rooms and offer each of them a deal:
"We can lock you up for one year. However, if you confess to the bank robbery and implicate your partner, we will give you immunity. You will go free and your partner will get 20 years in jail. If you both confess, we won’t need your testimony and avoid the cost of a trial so you will both get an intermediate sentence of eight years."
3. The decision for both Bonnie and Clyde can be described using a payoff matrix:
4. Definition of dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players.
5. Bonnie’s dominant strategy is to confess.
a. If Clyde remains silent, Bonnie can go free by confessing.
b. If Clyde confesses, Bonnie can lower her sentence by confessing.
6. Clyde’s dominant strategy is to confess.
a. If Bonnie remains silent, Clyde can go free by confessing.
b. If Bonnie confesses, Clyde can lower his sentence by confessing.
7. If they had both remained silent, they would have been better off collectively (with a sentence of only one year instead of eight). But, by each pursuing his or her own self-interests, the two prisoners together reach an outcome that is worse for both of them.
8. Cooperation between the two prisoners is difficult to maintain, because cooperation is individually irrational.
D. Oligopolies as a Prisoners’ Dilemma
1. Example: Jack and Jill are trying to keep the sale of water low to keep the price high. After reaching an agreement, each person must decide whether to follow the agreement.
2. Suppose that they are faced with the following decision:
1. The firm must consider how the quantity of apples it can harvest and sell is affected by the number of apple pickers hired.
2. Definition of production function: the relationship between the quantity of inputs used to make a good and the quantity of output of that good.
3. Definition of marginal product of labor: the increase in the amount of output from an additional unit of labor.
(= P x MPL)
4. Definition of diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases.
D. The Value of Marginal Product and the Demand for Labor
1. When deciding how many workers to hire, the firm considers how much profit each worker would bring in.
2. Because profit equals total revenue minus total cost, the profit from an additional worker is the worker's contribution to revenue minus the worker's wage.
3. Definition of value of the marginal product: the marginal product of an input times the price of the output.
a. Economists sometimes refer to the value of marginal product as the firm’s marginal revenue product.
b. The value of the marginal product is the extra revenue a firm gets from hiring an additional unit of a factor of production.
4. If the wage for workers is $500 per week, the firm will only hire three workers.
a. For the first three workers, the value of the marginal product is greater than the wage, so the marginal profit from hiring these workers is positive.
b. For the fourth worker, the value of the marginal product is lower than the wage, so the marginal profit from hiring this worker would be negative.
5. We can show the firm's decision graphically.
a. The value of the marginal product curve will slope downward because of the diminishing marginal product of labor.
b. The wage is depicted by a horizontal line because the firm is a price taker in the labor market.
6. A competitive, profit-maximizing firm hires workers up to the point where the value of the marginal product of labor is equal to the wage.
7. Because the firm chooses the quantity of labor at which the value of the marginal product equals the wage, the value-of-marginal-product curve is the firm's labor demand curve.
3. When a competitive firm hires labor up to the point at which the value of the marginal product is equal to the wage, it also produces a level of output at which price equals marginal cost.
F. What Causes the Labor Demand Curve to Shift?
1. The Output Price
a. An increase in the price of the product raises the value of the marginal product of labor and therefore increases the demand for labor.
b. A decrease in the price of the product lowers the value of the marginal product of labor and therefore decreases the demand for labor.
a. Technological advance raises the marginal product of labor, which in turn raises the value of the marginal product of labor.
b. It is also possible for technological change to reduce labor demand. A labor-saving technological change (such as an industrial robot) could reduce the marginal product of labor and thus the value of the marginal product of labor.
c. History suggests that most technological progress has been labor augmenting.
d. FYI: The Luddite Revolt – This box describes the 19th-century revolt against technology that occurred in England. After reading this, students will understand why we use the term “Luddite” to refer to anyone who opposes technological progress.
3. The Supply of Other Factors
a. The quantity available of one factor can affect the marginal product of another.
b. Therefore, any change in the availability of another factor will likely affect the demand for labor.
III. The Supply of Labor
A. The Trade-off between Work and Leisure
1. Any hours spent working are hours that could be devoted to something else like studying or watching television. Economists refer to all time not spent working for pay as “leisure.”
2. The opportunity cost of an hour of leisure is the amount of money that would have been earned if that hour were spent at work.
3. Therefore, as the wage increases, so does the opportunity cost of leisure.
4. The labor supply curve shows how individuals respond to changes in the wage in terms of the labor–leisure trade-off.
a. An upward-sloping labor supply curve means that an increase in the wage induces workers to increase the quantity of labor they supply.
b. Note that, for some individuals, the labor supply curve may in fact be backward bending. This possibility is discussed in more detail in Chapter 21.
B. What Causes the Labor Supply Curve to Shift?
1. Changes in Tastes (for leisure vs. working)
2. Changes in Alternative Opportunities (other occupations)
IV. Equilibrium in the Labor Market
A. Marginal Product in Equilibrium
1. The wage adjusts to balance the supply and demand for labor.
2. The wage equals the value of the marginal product of labor.
3. At the labor market equilibrium, each firm has bought as much labor as it finds profitable at the equilibrium wage.
4. Thus, any event that changes the supply or demand for labor must change the equilibrium wage and the value of the marginal product by the same amount, because these must always be equal.
B. Shifts in Labor Supply
1. An increase in the supply of labor would shift the supply curve to the right, creating a surplus of workers at the original wage. This will put downward pressure on the equilibrium wage, causing the quantity of labor demanded to rise.
a. As the number of workers employed rises, the marginal product of labor falls due to the diminishing marginal product of labor.
b. Thus, both the wage and the value of the marginal product of labor are now lower.
2. A decrease in the supply of labor would shift the supply curve to the left, creating a shortage of workers at the original wage. This will put upward pressure on the equilibrium wage, causing the quantity of labor demanded to fall.
a. As the number of workers employed falls, the marginal product of labor rises due to the diminishing marginal product of labor.
b. Thus, both the wage and the value of the marginal product of labor are now higher.
C. Shifts in Labor Demand
1. An increase in the demand for labor will shift the labor demand curve to the right, creating a shortage at the original wage. This will put upward pressure on the equilibrium wage causing the quantity of labor supplied to increase.
a. The value of the marginal product rises because VMPL = P x MPL (and either P or MPL have risen to cause the demand for labor to rise).
b. This implies that both the wage and the value of the marginal product are now higher.
2. A decrease in the demand for labor will shift the labor demand curve to the left, creating a surplus at the original wage. This will put downward pressure on the equilibrium wage causing the quantity of labor supplied to decrease.
a. The value of the marginal product falls because VMPL = P x MPL (and either P or MPL have fallen to cause the demand for labor to decline).
b. This implies that both the wage and the value of the marginal product are now lower.
A. Example: two goods—meat and potatoes; and two people—a cattle rancher and a potato farmer (each of whom likes to consume both potatoes and meat).
1. The gains from trade are obvious if the farmer can only grow potatoes and the rancher can only raise cattle.
2. The gains from trade are also obvious if, instead, the farmer can raise cattle as well as grow potatoes, but he is not as good at it and the rancher can grow potatoes in addition to raising cattle, but her land is not well suited for it.
3. The gains from trade are not as clear if either the farmer or the rancher is better at producing both potatoes and meat.
B. Production Possibilities
1. The farmer and rancher both work eight hours per day and can use this time to grow potatoes, raise cattle, or both.
2. Table 1 shows the amount of time each takes to produce one ounce of either good:
Minutes Needed to Make One Ounce of:
Amount Produced in Eight Hours
3. The production possibilities frontiers can also be drawn.
a. These production possibilities frontiers are drawn linearly instead of being bowed out. This assumes that the farmer's and the rancher's technology for producing meat and potatoes allows them to switch between producing one good and the other at a constant rate.
We will assume that the farmer and rancher divide their time equally between raising cattle and growing potatoes.
a. The farmer produces (and consumes) at point A—16 ounces of potatoes and 4 ounces of meat.
b. The rancher produces (and consumes) at point B—24 ounces of potatoes and 12 ounces of meat.
C. Specialization and Trade
1. Suppose the rancher suggests that the farmer specialize in the production of potatoes and then trade with the rancher for meat.
a. The rancher will spend six hours a day producing meat (18 ounces) and two hours a week growing potatoes (12 ounces).
b. The farmer will spend eight hours a day growing potatoes (32 ounces).
c. The rancher will trade 5 ounces of meat for 15 ounces of potatoes.
2. End results:
a. The rancher produces 18 ounces of meat and trades 5 ounces, leaving him with 13 ounces of meat. He also grows 12 ounces of potatoes and receives 15 ounces in the trade, leaving him with 27 ounces of potatoes.
b. The farmer produces 32 ounces of potatoes and trades 15 ounces, leaving him with 17 ounces. He also receives 5 ounces of meat in the trade with the rancher.
3. In both cases, they are able to consume quantities of potatoes and meat after the trade that they could not reach before the trade.
II. Comparative Advantage: The Driving Force of Specialization
A. Absolute Advantage
1. Definition of absolute advantage: the ability to produce a good using fewer inputs than another producer does.
2. The rancher has an absolute advantage in the production of both potatoes and meat.
B. Opportunity Cost and Comparative Advantage
1. Definition of opportunity cost: whatever must be given up to obtain some item.
a. For the rancher, it takes ten minutes to produce one ounce of potatoes. Those same ten minutes could be used to produce one-half ounce of meat. Thus, the opportunity cost of producing an ounce of potatoes is one-half ounce of meat.
b. For the farmer, it takes 15 minutes to produce one ounce of potatoes. Those same 15 minutes could be used to produce one-fourth ounce of meat. Therefore, the opportunity cost of producing one ounce of potatoes is one-fourth ounce of meat.
c. The opportunity cost of producing one ounce of meat is the inverse of the opportunity cost of producing one ounce of potatoes.
2. Definition of comparative advantage: the ability to produce a good at a lower opportunity cost than another producer.
a. The farmer has a lower opportunity cost of producing potatoes and therefore has a comparative advantage in the production of potatoes.
b. The rancher has a lower opportunity cost of producing meat and therefore has a comparative advantage in the production of meat.
3. Because the opportunity cost of producing one good is the inverse of the opportunity cost of producing the other, it is impossible for a person to have a comparative advantage in the production of both goods.
C. Comparative Advantage and Trade
1. When specialization in a good occurs (assuming there is a comparative advantage), total output will grow.
2. As long as the opportunity cost of producing the goods differs across the two individuals, both can gain from specialization and trade.
a. The farmer buys 5 ounces of meat with 15 ounces of potatoes. This implies that the price of each ounce of meat is three ounces of potatoes, which is lower than the farmer's opportunity cost of four ounces of potatoes. Trade is beneficial to the farmer.
b. The rancher buys 15 ounces of potatoes for 5 ounces of meat. The price of each ounce of potatoes is one-third ounce of meat. This is lower than the rancher's opportunity cost of one-half ounce of meat. Trade also benefits the rancher.
I. FYI: The Legacy of Adam Smith and David Ricardo
A. In Adam Smith's 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, he writes of the ability of producers to benefit through specialization and trade.
B. In David Ricardo's 1817 book Principles of Political Economy and Taxation, Ricardo develops the theory of comparative advantage and argues against restrictions on free trade.
C. The benefits of free trade are an issue that is generally agreed upon by most economists, and the theories and arguments developed by these two individuals 200 years ago are still used today.
IV. Applications of Comparative Advantage
A. Should Tiger Woods Mow His Own Lawn?
1. Imagine that Woods can mow his lawn faster than anyone else can.
2. This implies that he has an absolute advantage.
3. Suppose that it takes him two hours to mow his lawn. In that same two hours, he could film a commercial for Nike for which he would earn $10,000. This means that the opportunity cost of mowing his lawn is $10,000.
4. It is likely that someone else would have a lower opportunity cost of mowing Woods’ lawn; this individual would have a comparative advantage.
5. Both he and the person hired will be better off as long as he pays the individual more than the individual's opportunity cost and less than $10,000.
B. Should the United States Trade with Other Countries?
1. Just as individuals can benefit from specialization and trade, so can the populations of different countries.
2. Definition of imports: goods produced abroad and sold domestically.
4. The principle of comparative advantage suggests that each good should be produced by the country with a comparative advantage in producing that good (smaller opportunity cost).
5. Through specialization and trade, countries can have more of all goods to consume.
6. Trade issues among nations are more complex. Some individuals can be made worse off even when the country as a whole is made better off.
The Arguments for Restricting Trade
A. The Jobs Argument
1. If a country imports a product, domestic producers of the product will have to lay off workers because they will decrease domestic output when the price decreases to the world price.
2. Free trade, however, will create job opportunities in other industries where the country enjoys a comparative advantage.
B. The National-Security Argument
1. Certain industries may produce key resources needed to produce products necessary for national security.
2. In many of the cases for which this argument is used, the role of the particular market in providing national security is exaggerated.
C. The Infant-Industry Argument
1. New industries need time to get established to be able to compete in world markets.
2. Even if this argument is legitimate, it is nearly impossible for the government to choose which industries will be profitable in the future and it is even more difficult to remove tariffs or quotas in an industry once they are in place.
D. The Unfair-Competition Argument
1. It is unfair if firms in one country are forced to comply with more regulations than firms in another country, or if another government subsidizes the production of a good.
2. Even if another country is subsidizing the production of a product so that it can be exported to a country at a lower price, the domestic consumers who import the product gain more than the domestic producers lose.
E. The Protection-As-A-Bargaining-Chip Argument
1. Threats of protectionism can make other countries more willing to reduce the amounts of protectionism they use.
2. If the threat does not work, the country has to decide if it would rather reduce the economic well-being of its citizens (by carrying out the threat) or lose credibility in negotiations (by reneging on its threat).
F. In the News: Trade Policy in India
1. Because of lobbying from its domestic poultry industry, the government of India increased the tariff on chicken legs from 33 percent to 100 percent.
G. Case Study: Trade Agreements and the World Trade Organization
1. Countries wanting to achieve freer trade can take two approaches to cutting trade restrictions: a unilateral approach or a multilateral approach.
2. A unilateral approach occurs when a country lowers its trade restrictions on its own. A multilateral approach occurs when a country reduces its trade restrictions while other countries do the same.
3. The North America Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT) are multilateral approaches to reducing trade barriers.
4. The rules established under GATT are now enforced by the World Trade Organization (WTO).
5. The functions of the WTO are to administer trade agreements, provide a forum for negotiation, and handle disputes that arise among member countries.