Memory tricks for market structures

Q: Compare perfect competition and monopoly on efficiency, output, price, and profit.

A: Perfect Competition: many identical sellers, price takers facing a horizontal demand curve, produce where P = MR = MC = minimum ATC in long run, zero economic profit, allocatively efficient because P = MC, productively efficient because output is at minimum ATC, no deadweight loss. Monopoly: single seller with no close substitutes, significant barriers to entry, price setter facing downward-sloping market demand, MR lies below the demand curve because selling one more unit requires lowering price on all units. Monopolist sets MR = MC to find profit-maximizing quantity, then reads the price off the demand curve above that quantity. Result: P greater than MC, quantity lower than competitive, persistent economic profit because barriers prevent entry, and a deadweight loss triangle because some consumers willing to pay above MC do not buy. The dynamic trade-off: monopoly profits can fund R&D — pharmaceutical patents justify temporary monopoly to incentivize innovation.

Q: Explain game theory and the Prisoner's Dilemma applied to oligopoly.

A: Game theory studies strategic decision-making where outcomes depend on choices of multiple players. A dominant strategy is the best choice regardless of what opponents do. Nash equilibrium is a stable outcome where no player can improve their payoff by changing strategy unilaterally. The Prisoner's Dilemma: both players have a dominant strategy to defect (confess, undercut, cheat on cartel) even though mutual cooperation would produce better outcomes for both. Applied to oligopoly: each firm has an incentive to produce more than its cartel quota and undercut the cartel price, even though if all firms cheat the price falls toward the competitive level. Repeated games: if firms interact repeatedly and can credibly threaten retaliation, cooperation can emerge as a Nash equilibrium. Tit-for-tat — cooperate initially then mirror the opponent's last move — is remarkably successful in repeated prisoner's dilemmas and explains why some cartels are more stable than game theory predicts.

Q: What is price discrimination and when can a firm practice it profitably?

A: Price discrimination means charging different prices to different customers for the same product based on extracting more consumer surplus rather than cost differences. Three conditions are required: market power (the firm must be a price setter, not a price taker), ability to identify and separate customer groups with different price elasticities of demand, and prevention of resale between groups (otherwise low-price buyers would resell to high-price buyers, eliminating the price difference). First-degree perfect price discrimination: charge each buyer their exact maximum willingness to pay, captures all consumer surplus, no deadweight loss, but only theoretical. Second-degree: price varies with quantity (bulk discounts, utility pricing tiers). Third-degree: charge different prices to identifiable groups based on elasticity — airlines charge more to business travelers (inelastic), colleges charge wealthy families more through financial aid, pharmaceutical companies charge different prices in different countries. Compared to single-price monopoly, price discrimination generally increases output toward the efficient level.

Q: Explain natural monopoly and the regulatory dilemma it creates.

A: A natural monopoly arises when economies of scale are so large that one firm can supply the entire market at lower average total cost than any combination of multiple competing firms. ATC decreases continuously over the relevant output range, meaning a second firm cannot enter profitably because it would face higher average costs. Examples: electricity transmission grids, water and sewage systems, natural gas pipelines, and broadband infrastructure in many areas. The regulatory dilemma has three options. Marginal cost pricing achieves allocative efficiency since P = MC, but since MC is below ATC the firm loses money at every output level and requires a government subsidy to survive. Average cost pricing (fair rate of return regulation) allows the firm to earn a normal accounting profit, is self-sustaining without subsidy, but creates some deadweight loss since P is above MC — this is the most common approach for regulated utilities. Unregulated monopoly pricing produces maximum profit but the largest deadweight loss and is generally unacceptable for essential services.

Q: Explain the HHI and how antitrust authorities evaluate mergers.

A: The Herfindahl-Hirschman Index measures market concentration as the sum of squared market shares of all firms in the industry. Three firms with shares of 50, 30, and 20 percent produce an HHI of 2500 + 900 + 400 = 3800. Below 1500 is competitive or unconcentrated. Between 1500 and 2500 is moderately concentrated. Above 2500 is highly concentrated, and mergers that raise the HHI by 200 or more points in this range are presumptively anticompetitive. The Sherman Antitrust Act of 1890 prohibits price-fixing cartels and bid-rigging (per se illegal — no justification accepted) and prohibits monopolization. The Clayton Act of 1914 addresses mergers that substantially lessen competition. The DOJ and FTC review proposed mergers by defining the relevant product and geographic market, calculating the HHI before and after the merger, assessing the likelihood of entry by new firms, and evaluating likely effects on prices. Remedies include blocking the merger entirely, requiring the merging firms to divest overlapping businesses, or imposing behavioral conditions such as licensing requirements.