I have recently been showing my AP and IB Econ classes the following New Yorker interview with Columbia Professor Tim Wu, the man who coined the phrase “net neutrality”. Wu shares his views on the “cycles” of competition in the communications industry, from radio, telephone and television in the 20th century to the internet and the “mobile web” today.

I find it a useful video for starting discussions about the pros and cons of perfectly competitive markets (represented by the “chaotic” period of any new communications technology) and imperfectly, more monopolistic industries (represented by the period later in the cycle of any communications technology when market power becomes concentrated among a few large firms).

Watch the video and pause it along the way to discuss some of the questions below.

Currents: Tim Wu on Communication, Chaos, and Control : The New Yorker

Discussion Questions:

1. Why are new communications industries often characterized by “chaos” in their early years? How did the internet industry reflect the perfectly competitive characteristics in its early days, or even 10 years ago?
2. How are consumers affected as communications industries go from “chaos” to control under big companies like Apple and Google?
3. How does the behavior of firms like Google and Apple demonstrate the concept of non-price competition?
4. Would the technology industry be more efficient if it were more competitive?
5. Can you envision a world in which all of our online activities are done through one company, i.e. the “Googlenet” or the “Facebooknet” instead of the “Internet”? Would that world be better or worse than what we have now? Why?
6. How is the communications industry today similar to the telephone industry 30 years ago? How is it different?
7. Tim Wu suggest that in the future there will be no internet. Discuss as a class what you envision as a possible successor to the internet.
8. If you had a time machine and could travel back to 1970, how would you try to explain to someone on the stree how we communicate with one another in 2011. How would you have tried to explain the internet and smart phones? Do you think someone from 1970 would believe your descriptions of products like Skype, like Google, like a phone you could watch movies on, like video chat, like “Google goggles”, etc…?
9. If someone from 40 years in the future arrived in 2011 and tried to explain to you how humans are communicating in 2050, do you think you would believe them?
10. Economist Joseph Schumpeter referred to capitalism as a system driven by a system of “creative destruction”. How does the history of the communications industry demonstrate the concept of “creative destruction”?

Imperfect competition in the News: After watching the video and discussion the questions with your class, go to Welker’s Wikinomics Universe and follow the link to the “Econ News” tab.  Browse the headlines from the various news feeds and look for articles that you think may be about non-price competition between firms in a monopolistically competitive or an oligopolistic market.

When you’ve found one good article, open your Diigo toolbar and add highlights to the lines in the article that you think demonstrate non-price competition between the firms described. Add one or two sticky notes using the Diigo toolbar, and when you’ve added your own thoughts, bookmark the article. Be sure to share it to your class’s group before bookmarking it so your classmates can view your highlights and sticky notes online.

If there is time left in class, log into your Diigo account and visit our class group. Read some of the highlights from your classmates’ articles and discuss with the people around you the various types of non-price competition described.

What makes oligopolistic markets, which are characterized by a few large firms, so different from the other market structures we study in Microeconomics? Unlike in more competitive markets in which firms are of much smaller size and one firm’s behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists (non-collusive meaning a few firms that do NOT cooperate on output and price), economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

In the game above, both SF Coffee and Starbuck have what is called a dominant strategy. Regardless of what its competitor does, both companies would maximize their outcome by advertising. If SF coffee were to not advertise, Starbucks will earn more profits ($20 vs $10) by advertising. If SF coffee were to advertise, Starbucks will earn more profits ($12 vs $10) by advertising. The payoffs are the same given both options for SF Coffee. Since both firms will do best by advertising given the behavior of its competitor, both firms will advertise. Clearly, the total profits earned are less when both firms advertise than if they both did NOT advertise, but such an outcome is unstable because the incentive for both firms would be to advertise. We say that advertise/advertise is a “Nash Equilibrium” since neither firm has an incentive to vary its strategy at this point, since less profits will be earned by the firm that stops advertising.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful to firms deciding how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

Game theory as a mathematical tool can be applied in realms beyond oligopoly behavior in Economics.  In each of the videos below, game theory can be applied to predict the behavior of different “players”. None of the videos portray a Microeconomic scenario like the one above, but in each case a payoff matrix can be created and behavior can be predicted based on an analysis of the incentives given the player’s possible behaviors.

Assignment: Watch each of the five videos below. For each one, create a payoff matrix showing the possible “plays” and the possible “payoffs” of the game portrayed in the video. Predict the outcome of each game based on your understanding of incentives and the assumption that humans act rationally and in their own self-interest.

“Batman – the Dark Night” – the Joker’s ferry game:

“Princess Bride” – where’s the poison?:

“Murder by Numbers” – the interrogation:

“Golden Balls” – split or steal:

“The Trap” – the delicate balance of terror:

Discussion Questions:

1. Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?
2. What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?
3. Among the videos above, which games ended in the way that your payoff matrix and understanding of human behavior and rational decision making would have predicted?
4. How often did the equilibrium outcomes according to your analysis of the payoff matrices correspond with the socially optimal outcome (i.e. the one where total payoffs for all players are maximized or the total losses minimized)?

A few summers ago, my wife and I spent three weeks travelling around the island of Bali in Indonesia. For six of those days we rented a jeep and circumnavigated the island. Our first stop was for two days of scuba diving in the northeast region of Ahmed. As we drove along the seven beaches near Ahmed, we observed there were around ten dive operators offering packages for the local dive spots (including one of Asia’s most famous dives, the WWII-era USS Liberty wreck). Based on our Lonely Planet recommendation, we settled on Eco-Dive, where we paid $60 a day for two dives and all our gear rental. We felt good about this rate and agreed that $60 was a fair and competitive price for a day of diving.

Our next stop, Pemuteran, a remote and relatively undeveloped area on the northwest coast just across the straits from Java, is also known for its great diving. On our first morning in Pemuteran, my wife and I strolled along the beach and found that there were only three dive operators to choose from! And guess what, they all charged between $95-$105 for a day of diving. That’s around 60% more than the operators in Ahmed charged! In the end, we decided to do only one day of diving in Pemuteran, and elected to spend our second day there reading by the pool.

Discussion Questions:

1. What was the difference between the scuba diving markets in Ahmed and Pemuteran? Which market was more competitive? Which of the four market structures did the two markets most resemble: perfectly competitive, monopolistically competitive, oligopolistic or monopolistic?
2. How were the dive operators in Pemuteran able to charge 60% more than the operators in Ahmed?
3. What do you think is keeping one of the three dive operators in Pemuteran from lowering their price to, say, $60 for a day of diving? How would the other two operators respond? Would this be good or bad for the dive operators of Pemuteran? Would it be good or bad for scuba divers?
4. Assuming that the cost of opening a dive operation was relatively low, and there were no government or other barriers to doing so in Pemuteran, what do you suspect will happen in the Scuba diving market as the tourism industry continues to develop in the remote town of Pemuteran? Explain.
5. Which village’s dive operators do you think were more “efficient” in their use of resources? Explain.

The launch of the iPad earlier this year, heralded a new period of competition in the market for tablet and slate computers. The three videos below, suggest that although Apple may have seized the lead the in the growing market, many other competing firms will be launching new products to entice customers to part with their money.

From first impressions, the market seems to be oliogopolistic in nature, where a few large firms (Apple, HP, Lenovo/IBM) share a large portion of the total market. At the moment it appears that Apple has the lead, and has created a product with unique selling points such as touch capability and a book reader. You can envisage from the video that HP will closely follow developments and try introduce other selling points eg. USB ports, built-in camera.

Discussion Questions:

1. What are the key difference between an oligopoly and monopolistic market structure?
2. What do you think will happen to Apple’s profits once more and more firms begin releasing their own version of the iPad? What must Apple do to try to maintain its profits in the tablet PC market?
3. What are “barriers to entry”? What are some of the barriers to entry that exists in the market for tablet computers?
4. Do you think firms in the tablet market would opt for price competition or product differentiation strategies to gain market share? Explain the advantages of each.

Kiwifruit has been one of New Zealand’s niche exports for over the past forty years. New Zealand producers nearly 30% of the international traded kiwifruit. Kiwifruit is purchased by one large monopsony and then on sold to the international market by the large dominant buyer. During this period of time the value of kiwi exports has risen and fallen. Lately due to technological developments the fruit has undergone a process of product differentiation through cross-pollination of existing species and intensive marketing. Zespri a New Zealand company is attempting to extert dominance in the market to maximize profits.

Kiwifruit was originally known by its Chinese name, yáng táo (Sunny Peach) but was marketed as Kiwifruit in the 1950’s by the New Zealand export industry. This was to fit with the needs of the North American market. The name Kiwifruit was however never trade marked and thus other producers from Chile, Europe and China cashed in on the marketing and New Zealand producers lost their unique advantage and potential monopoly advantage.

In 1996 the New Zealand Kiwifruit industry undertook a new marketing venture to rebrand the humble kiwifruit as Zespri, a term that captured the zesty nature and vitality of the furry fruit. Overtime the New Zealand product again became noticeable in supermarkets in Europe and Asia and thus differentiated from the competition through branding. In 1987 the first yellow kiwifruit was developed by New Zealand horticulturists and last week the first red hulled fruit was developed for the export market. The NZ Herald reports here that

A variety of red-centred kiwifruit, called Hongyang, already exists but it doesn’t travel or store well so researchers are working on developing a more commercially useful version that can feed the huge export market.

The new red fruit is slightly smaller than the traditional green kiwifruit and has a sweet taste that resembles a tamarillo. Around the core is a deep red colour, which changes to yellow- green nearer the green skin.

Zespri has the largest kiwifruit species breeding programme in the world, keeping up to 50,000 seedlings in trial.
“We are trying to deliver the next generation of kiwifruit for the market to grow and increase the brand around the world,” said Rosstan Mazey, green produce category manager for Zespri.”

Globally the market for kiwi exporters potentially fits the assumptions of several market structures. The international market appears to fit the characteristics of an oligopoly. The barriers to produce and knowledge to export kiwifruit are significant. Nations or export focused companies such as Zespri are attempting to differentiate their products using new cross-pollination techniques to thus develop different varieties and to clearly distinguish their products from other exporters. The qualities of each variety may be very similar but customers will be willing to pay a little more for the uniqueness of the product. The costs of production for the different species of kiwifruit will likely be very similar in the long run thus firms can expect significantly higher profits.

These are some characteristics of market structures which can help us understand the Kiwifruit market.

Numbers: Although there are many producers in the international market for Kiwifruit it appears that a few firms or countries have a high concentration of the total global market share, Italy, New Zealand and Chile. The theory also suggests that each firm in an oligopolistic structure is interdependent on each other. You could argue that instead kiwifruit producers are independent and there is a high degree of competition and not collusion.

Ease of entry: There does exist some barriers to entry in the market due the high costs of setting up a fruit growing industry and then developing the channels to successfully export the product. But these barriers are also discouraging firms from exiting the industry. Farmers and the industry have large sunk costs, which would be hard to recover if they were forced to enter the market. A kiwifruit vine is a clear example of a sunk cost and is research and development. We could therefore assume that the industry is oligopolistic.

Product: Each firm or country in the Kiwifruit industry attempts to produce a branded product. There are becoming distinct differences in the products on offer as illustrated by the development of new species of yellow and red centered kiwifruit in New Zealand. Many economists believe that the main form of competition in oligopoly is non-price competition, and advertising in particular, to highlight the differences in the products. These differences such as country of origin increase the perceived value of the product.

This analysis perhaps explains how technological developments in cross-pollination are leading to a change in the global market structure for Kiwifruit as firms are able to produce significantly different products leading to technological barriers to entry and less contestability. Thus shifting the description of the market from monopolistic competition, which it may be been in the 1960’s to towards a perhaps oligopoly structure without the collusion, but with high barriers to entry and with greater competition.

For more reading on contestable markets, oligopolies and monopolistic competition the UK site here  S-Cool – Economics is a great start.

Discussion Questions:

1. Find examples from your local area of oligopolies, monopolistic and contestable markets?
2. What do the MR / AR curves look like for an oligopoly and monopolistic structure?
3. Compare and contrast the difference between an oligopoly and monopolistic competition?
4. How is a monopoly different from a monospony?
5. Find other examples of how technological change is altering a market structure. Does Apple have monopoly power in the portable music industry?

Teaching the Prisoners’ Dilemma Will Never Be the Same Again « Cheap Talk

Rarely does such a perfect illustration of the Prisoner’s Dilemma come along for Econ teachers to use in their classroom:

The payoffs are clear:

Each player has a weakly dominant strategy, which is to choose to steal. By choosing to steal, the player has a chance at maximizing his own payoff, but will do no worse than he would if his opponent also chooses to steal and at least will have the satisfaction of thwarting his opponent’s attempt to steal the money.

There are three Nash equilibria in the game, which are outcomes at which a player can not do better on his or her own by changing his or her strategy. The outcome Steve was hoping for by chosing “split” (50/50) was not a Nash equilibrium because Sarah knows she can do better if she chooses steal when Steve chooses split. Steve doomed himself by choosing split because he should know that Sarah’s dominant strategy is to choose steal. However, Sarah would also have doomed herself by choosing split because she should assume that Steve would also chose steal since steal is a dominant strategy for him too.

John Nash, who pioneered the field of Game Theory, assumed that humans were coldly rational, self-interested, deceptive creatures that would not hesitate to stab one another in the back to get what was best for themselves. His theory of human behavior is only partially proven correct in this game, in which Steve is shown to be the sucker and Sarah the coldly rational self-interested player. The best chance for Steve to go home with any money would have been for him to use the one minute of discussion time to convince Sarah that he would choose SPLIT, yet be willing to go home with something LESS THAN $50,000 and accept that Sarah was going to choose STEAL. He could have threatened to chose steal if she did not agree to share her winnings with him to some extent. Then again, any promise Sarah makes she could later break, thus further empowering the players to choose steal.

Discussion questions:

1. What in the world is going on here? Why did Sarah choose steal rather than collaborate with Steve and share the $100,000?
2. Was Steve totally wrong to choose split? What would you have done in his situation?
3. How do the choices faced by Steve and Sarah relate to the choices faced by firms in oligopolitic markets? Now that you’ve seen this video, can you explain why collusive agreements between oligopolists often fall apart? Why do cartels such as OPEC often fail to achieve the high price targets agreed upon in meetings of their leaders?

This week in AP Microeconomics students get to play online games, watch movies, and compete with their classmates in strategic competitions in which there are proud winners and sad losers. That’s right, we’re studying oligopoly!

What makes oligopolistic markets, which characterized by a few large firms, so different from the other market structures we study in Microeconomics? The answer is that unlike in more competitive markets in which firms are of much smaller size and one firm’s behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists, economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful in helping firms decide how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

While Game Theory can be useful in predicting firm behavior in oligopolistic markets, believe it or not that is not its most useful application developed. In fact, would you believe me if I told you that Game Theory may be precisely what saved the world from nuclear holocaust during the 20th Century? It’s true. The US government employed Game Theory to avert annihilation by nuclear attack from the Soviet Union during much of the 20th Century. This video tells the story!

Professor Preston McAfee on Price Discrimination

(you must have RealPlayer to view this video. Mac users can download it here)

CalTech Economics professor Preston McAfee is an expert on prices. His research spans three decades and examines the pricing behavior of firms in various market structures. In the lecture linked above the professor shares several examples of firms practicing price discrimination. I was surprised to see that many of the examples he discusses are ones that I have been using in my own lectures on price discrimination for the last few years.

McAfee presents a mathematical formula for monopoly pricing, which no AP or IB text that I’ve seen has included:

Monopoly Price = [PED/(1-PED)] x MC where PED is the price elasticity of demand of the customer and MC is the firm’s marginal cost of production.

The basic idea is that the more inelastic the customer’s demand, the higher price the monopolist should charge over its marginal cost. The implication, therefore, is that a monopolist prefers to charge higher prices to customer’s whose demand is inelastic and lower prices to customers who are “price sensitive” or whose demand is elastic. The charging of different prices to different consumers for the exact same product is what economists call price discrimination.

McAfee begins talking about price discrimination at minute 8:44 in the video. His examples include:

• Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
• Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
• Grocery stores: Offer coupons to price sensitive consumers (people whose demand is inelastic won’t bother to cut coupons, thus will pay more for the same products as price sensitive consumers who take the time to collect coupons).
• Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
• Dell Computers: Dell price discriminates based on customer answers to questions during the online shopping process. Dell charges higher prices to large business and government agencies than to households and small businesses for the exact same product!
• Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
• Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
• Damaged goods discounts: When a company creates  and sells two products that are essentially identical except one has fewer features and costs significantly less to capture more price-sensitive consumers.
• Book publishers: Some paperbacks cost more to manufacture but sell to consumers for significantly less than hard covers. Price sensitive consumers will buy the paperback while those with inelastic demand will pay more for the hard cover.
• Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a roundtrip ticket that departs and returns during the week.

McAfee also goes into a fascinating discussion of price dispersion which is essentially a theory of oligopoly pricing. All Econ teachers should watch this video and find examples of price discrimination and oligopoly pricing that they can incorporate into their own class.

If you’re up for a challenge, try deciphering some of the mathematics in McAfee’s free, downloadable intro to economics text, available here.

In  IB Economics, we are currently learning about how firms in imperfectly competitive markets differentiate their products in order to increase their market power and their price-making power.

In a market with a few large firms such as the laptop computer market, companies must do what they can to increase demand for their own products over those of their competitors. Apple Computer is an example of a company that has successfully differentiated its line of laptop computers in recent years, regularly improving the features of its line of MacBooks to attract consumers away from its competitors and into the world of Macs.

Last year Apple launched the MacBook Air, the lightest and thinnest laptop on the market, creating a huge buzz in the technology world and converting millions to Apple’s line of laptops. This year, Apple has launched yet another innovation in laptop computing, in the hope of once again increasing demand for its products, and making consumers think they cannot live without the sleek, shiny Apple computers. This year’s innovation? The “MacBook Wheel”… watch:

Apple Introduces Revolutionary New Laptop With No Keyboard

The goal of an imperfectly competitive firm like Apple is to increase its market power by increasing demand for its particular product through product differentiation, advertising, developing brand loyalty, and “hype”: all forms of non-price competition. If Apple were to simply charge a lower price than its competitors for its products, it would also succeed in increasing the amount of computers it sells to consumers, but may also end up accepting lower profits due to the lower prices it must sell for.

Through differentiation, which means making its products unique and attractive to consumers, Apple attempts to increase market demand for its computers, while simultaneously making demand less elastic. With higher, more inelastic demand, Apple gains price-making power over the laptop computer market, as can be seen in the graphs below, which show that after the successful launch of a new product like the MacBook wheel Apple is able to charge a higher price, produce a similar quantity, and earn greater economic profits.

In the video, one customer says that he’d buy “buy almost anything if it’s shiny and its made by Apple”. Such statements reflect that among loyal customers, demand for Apple’s products is highly inelastic. While the firm is certainly not a monopolist in the market for laptop computers, Apple has surely succeeded to increase its market power and thus its power over prices through product differentiation, brand loyalty, and the “hype” surrounding the launch of new products like the MacBook Wheel.

Discussion questions:

1. In the graphs above, the slopes of the demand curve increases after successful product differentiation by Apple. Why does this happen?
2. Assuming the market for laptop computers is monopolistically competitive, what will likely happen to Apples economic profits over time? What must Apple do if it wishes to maintain its profits in the long-run?
3. What are some real ways companies like Apple and its competitors have attempted to differentiate their products over the years? Would YOU buys a MacBook Wheel if it were real?