Mankiw.2003.Principles.of.Economics

CHAPTER 16 OLIGOPOLY 361

Iraq's Decision Figure 16-3

High Production Low Production AN OLIGOPOLY GAME. In this
game between members of an
Iraq gets $40 billion Iraq gets $30 billion oligopoly, the profit that each
earns depends on both its
High production decision and the
Production production decision of the other
oligopolist.

Iran's Iran gets $40 billion Iran gets $60 billion
Decision
Iraq gets $60 billion Iraq gets $50 billion

Low
Production

Iran gets $30 billion Iran gets $50 billion

result is the inferior outcome (from Iran and Iraq’s standpoint) with low profits for
each country.

This example illustrates why oligopolies have trouble maintaining monopoly
profits. The monopoly outcome is jointly rational for the oligopoly, but each oli-
gopolist has an incentive to cheat. Just as self-interest drives the prisoners in the
prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to
maintain the cooperative outcome with low production, high prices, and monop-
oly profits.

OTHER EXAMPLES OF THE PRISONERS’ DILEMMA

We have seen how the prisoners’ dilemma can be used to understand the problem
facing oligopolies. The same logic applies to many other situations as well. Here
we consider three examples in which self-interest prevents cooperation and leads
to an inferior outcome for the parties involved.

A r m s R a c e s An arms race is much like the prisoners’ dilemma. To see this,
consider the decisions of two countries—the United States and the Soviet Union—
about whether to build new weapons or to disarm. Each country prefers to have
more arms than the other because a larger arsenal gives it more influence in world
affairs. But each country also prefers to live in a world safe from the other coun-
try’s weapons.

Figure 16-4 shows the deadly game. If the Soviet Union chooses to arm, the
United States is better off doing the same to prevent the loss of power. If the Soviet
Union chooses to disarm, the United States is better off arming because doing so
would make it more powerful. For each country, arming is a dominant strategy.
Thus, each country chooses to continue the arms race, resulting in the inferior out-
come in which both countries are at risk.

362 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Figure 16-4 Decision of the United States (U.S.)

AN ARMS-RACE GAME. In this Arm Disarm
game between two countries, the
safety and power of each country U.S. at risk U.S. at risk and weak
depends on both its decision
whether to arm and the decision Arm
made by the other country.
Decision
of the USSR at risk USSR safe and powerful
Soviet Union
(USSR) U.S. safe and powerful U.S. safe

Disarm

USSR at risk and weak USSR safe

Throughout the era of the Cold War, the United States and the Soviet Union
attempted to solve this problem through negotiation and agreements over arms
control. The problems that the two countries faced were similar to those that oli-
gopolists encounter in trying to maintain a cartel. Just as oligopolists argue over
production levels, the United States and the Soviet Union argued over the amount
of arms that each country would be allowed. And just as cartels have trouble en-
forcing production levels, the United States and the Soviet Union each feared that
the other country would cheat on any agreement. In both arms races and oligopo-
lies, the relentless logic of self-interest drives the participants toward a noncoop-
erative outcome that is worse for each party.

A d v e r t i s i n g When two firms advertise to attract the same customers, they
face a problem similar to the prisoners’ dilemma. For example, consider the deci-
sions facing two cigarette companies, Marlboro and Camel. If neither company ad-
vertises, the two companies split the market. If both advertise, they again split the
market, but profits are lower, since each company must bear the cost of advertis-
ing. Yet if one company advertises while the other does not, the one that advertises
attracts customers from the other.

Figure 16-5 shows how the profits of the two companies depend on their ac-
tions. You can see that advertising is a dominant strategy for each firm. Thus, both
firms choose to advertise, even though both firms would be better off if neither
firm advertised.

A test of this theory of advertising occurred in 1971, when Congress passed a
law banning cigarette advertisements on television. To the surprise of many ob-
servers, cigarette companies did not use their considerable political clout to op-
pose the law. When the law went into effect, cigarette advertising fell, and the
profits of cigarette companies rose. The law did for the cigarette companies what
they could not do on their own: It solved the prisoners’ dilemma by enforcing the
cooperative outcome with low advertising and high profit.

CHAPTER 16 OLIGOPOLY 363

Marlboro's Decision Figure 16-5

Advertise Don't Advertise AN ADVERTISING GAME. In this
game between firms selling
Marlboro gets $3 Marlboro gets $2 similar products, the profit that
billion profit billion profit each earns depends on both its
own advertising decision and the
Advertise Camel gets $3 Camel gets $5 advertising decision of the other
billion profit billion profit firm.
Camel's
Decision Marlboro gets $5 Marlboro gets $4
billion profit billion profit
Don't
Advertise

Camel gets $2 Camel gets $4
billion profit billion profit

C o m m o n R e s o u r c e s In Chapter 11 we saw that people tend to overuse
common resources. One can view this problem as an example of the prisoners’
dilemma.

Imagine that two oil companies—Exxon and Arco—own adjacent oil fields.
Under the fields is a common pool of oil worth $12 million. Drilling a well to re-
cover the oil costs $1 million. If each company drills one well, each will get half of
the oil and earn a $5 million profit ($6 million in revenue minus $1 million in
costs).

Because the pool of oil is a common resource, the companies will not use it ef-
ficiently. Suppose that either company could drill a second well. If one company
has two of the three wells, that company gets two-thirds of the oil, which yields a
profit of $6 million. Yet if each company drills a second well, the two companies
again split the oil. In this case, each bears the cost of a second well, so profit is only
$4 million for each company.

Figure 16-6 shows the game. Drilling two wells is a dominant strategy for each
company. Once again, the self-interest of the two players leads them to an inferior
outcome.

THE PRISONERS’ DILEMMA AND
THE WELFARE OF SOCIETY

The prisoners’ dilemma describes many of life’s situations, and it shows that co-
operation can be difficult to maintain, even when cooperation would make both
players in the game better off. Clearly, this lack of cooperation is a problem for
those involved in these situations. But is lack of cooperation a problem from the
standpoint of society as a whole? The answer depends on the circumstances.

In some cases, the noncooperative equilibrium is bad for society as well as
the players. In the arms-race game in Figure 16-4, both the United States and the

364 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Figure 16-6 Exxon's Decision

A COMMON-RESOURCES GAME. Drill Two Wells Drill One Well
In this game between firms
pumping oil from a common Exxon gets $4 Exxon gets $3
pool, the profit that each earns million profit million profit
depends on both the number of
wells it drills and the number of Drill Two Arco gets $4 Arco gets $6
wells drilled by the other firm. Wells million profit million profit

Arco's Exxon gets $6 Exxon gets $5
Decision million profit million profit

Drill One
Well

Arco gets $3 Arco gets $5
million profit million profit

Soviet Union end up at risk. In the common-resources game in Figure 16-6, the ex-
tra wells dug by Arco and Exxon are pure waste. In both cases, society would be
better off if the two players could reach the cooperative outcome.

By contrast, in the case of oligopolists trying to maintain monopoly profits,
lack of cooperation is desirable from the standpoint of society as a whole. The mo-
nopoly outcome is good for the oligopolists, but it is bad for the consumers of the
product. As we first saw in Chapter 7, the competitive outcome is best for society
because it maximizes total surplus. When oligopolists fail to cooperate, the quan-
tity they produce is closer to this optimal level. Put differently, the invisible hand
guides markets to allocate resources efficiently only when markets are competi-
tive, and markets are competitive only when firms in the market fail to cooperate
with one another.

Similarly, consider the case of the police questioning two suspects. Lack of co-
operation between the suspects is desirable, for it allows the police to convict more
criminals. The prisoners’ dilemma is a dilemma for the prisoners, but it can be a
boon to everyone else.

WHY PEOPLE SOMETIMES COOPERATE

The prisoners’ dilemma shows that cooperation is difficult. But is it impossible?
Not all prisoners, when questioned by the police, decide to turn in their partners
in crime. Cartels sometimes do manage to maintain collusive arrangements, de-
spite the incentive for individual members to defect. Very often, the reason that
players can solve the prisoners’ dilemma is that they play the game not once but
many times.

To see why cooperation is easier to enforce in repeated games, let’s return to
our duopolists, Jack and Jill. Recall that Jack and Jill would like to maintain the
monopoly outcome in which each produces 30 gallons, but self-interest drives

CHAPTER 16 OLIGOPOLY 365

Jack's Decision Figure 16-7

Sell 40 Gallons Sell 30 Gallons JACK AND JILL’S OLIGOPOLY
GAME. In this game between
Jack gets Jack gets Jack and Jill, the profit that each
$1,600 profit $1,500 profit earns from selling water depends
on both the quantity he or she
Sell 40 Jill gets Jill gets chooses to sell and the quantity
Gallons $1,600 profit $2,000 profit the other chooses to sell.

Jill's Jack gets Jack gets
Decision $2,000 profit $1,800 profit

Sell 30
Gallons

Jill gets Jill gets
$1,500 profit $1,800 profit

them to an equilibrium in which each produces 40 gallons. Figure 16-7 shows the
game they play. Producing 40 gallons is a dominant strategy for each player in this
game.

Imagine that Jack and Jill try to form a cartel. To maximize total profit, they
would agree to the cooperative outcome in which each produces 30 gallons. Yet, if
Jack and Jill are to play this game only once, neither has any incentive to live up to
this agreement. Self-interest drives each of them to renege and produce 40 gallons.

Now suppose that Jack and Jill know that they will play the same game every
week. When they make their initial agreement to keep production low, they can
also specify what happens if one party reneges. They might agree, for instance,
that once one of them reneges and produces 40 gallons, both of them will produce
40 gallons forever after. This penalty is easy to enforce, for if one party is produc-
ing at a high level, the other has every reason to do the same.

The threat of this penalty may be all that is needed to maintain cooperation.
Each person knows that defecting would raise his or her profit from $1,800 to
$2,000. But this benefit would last for only one week. Thereafter, profit would fall
to $1,600 and stay there. As long as the players care enough about future profits,
they will choose to forgo the one-time gain from defection. Thus, in a game of re-
peated prisoners’ dilemma, the two players may well be able to reach the cooper-
ative outcome.

C A S E S T U D Y THE PRISONERS’ DILEMMA TOURNAMENT

Imagine that you are playing a game of prisoners’ dilemma with a person being
“questioned” in a separate room. Moreover, imagine that you are going to play
not once but many times. Your score at the end of the game is the total number
of years in jail. You would like to make this score as small as possible. What
strategy would you play? Would you begin by confessing or remaining silent?

366 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

How would the other player’s actions affect your subsequent decisions about
confessing?

Repeated prisoners’ dilemma is quite a complicated game. To encourage
cooperation, players must penalize each other for not cooperating. Yet the strat-
egy described earlier for Jack and Jill’s water cartel—defect forever as soon as
the other player defects—is not very forgiving. In a game repeated many times,
a strategy that allows players to return to the cooperative outcome after a pe-
riod of noncooperation may be preferable.

To see what strategies work best, political scientist Robert Axelrod held a
tournament. People entered by sending computer programs designed to play
repeated prisoners’ dilemma. Each program then played the game against all
the other programs. The “winner” was the program that received the fewest
total years in jail.

The winner turned out to be a simple strategy called tit-for-tat. According to
tit-for-tat, a player should start by cooperating and then do whatever the other
player did last time. Thus, a tit-for-tat player cooperates until the other player
defects; he then defects until the other player cooperates again. In other words,
this strategy starts out friendly, penalizes unfriendly players, and forgives them
if warranted. To Axelrod’s surprise, this simple strategy did better than all the
more complicated strategies that people had sent in.

The tit-for-tat strategy has a long history. It is essentially the biblical strat-
egy of “an eye for an eye, a tooth for a tooth.” The prisoners’ dilemma tourna-
ment suggests that this may be a good rule of thumb for playing some of the
games of life.

Q U I C K Q U I Z : Tell the story of the prisoners’ dilemma. Write down a table
showing the prisoners’ choices and explain what outcome is likely. N What
does the prisoners’ dilemma teach us about oligopolies?

PUBLIC POLICY TOWARD OLIGOPOLIES

One of the Ten Principles of Economics in Chapter 1 is that governments can some-
times improve market outcomes. The application of this principle to oligopolistic
markets is, as a general matter, straightforward. As we have seen, cooperation
among oligopolists is undesirable from the standpoint of society as a whole, be-
cause it leads to production that is too low and prices that are too high. To move
the allocation of resources closer to the social optimum, policymakers should try
to induce firms in an oligopoly to compete rather than cooperate. Let’s consider
how policymakers do this and then examine the controversies that arise in this
area of public policy.

RESTRAINT OF TRADE AND THE ANTITRUST LAWS

One way that policy discourages cooperation is through the common law. Nor-
mally, freedom of contract is an essential part of a market economy. Businesses and
households use contracts to arrange mutually advantageous trades. In doing this,

CHAPTER 16 OLIGOPOLY 367

they rely on the court system to enforce contracts. Yet, for many centuries, judges
in England and the United States have deemed agreements among competitors to
reduce quantities and raise prices to be contrary to the public good. They therefore
refused to enforce such agreements.

The Sherman Antitrust Act of 1890 codified and reinforced this policy:

Every contract, combination in the form of trust or otherwise, or conspiracy, in
restraint of trade or commerce among the several States, or with foreign nations,
is declared to be illegal. . . . Every person who shall monopolize, or attempt to
monopolize, or combine or conspire with any person or persons to monopolize
any part of the trade or commerce among the several States, or with foreign
nations, shall be deemed guilty of a misdemeanor, and on conviction therefor,
shall be punished by fine not exceeding fifty thousand dollars, or by
imprisonment not exceeding one year, or by both said punishments, in the
discretion of the court.

The Sherman Act elevated agreements among oligopolists from an unenforceable
contract to a criminal conspiracy.

The Clayton Act of 1914 further strengthened the antitrust laws. According to
this law, if a person could prove that he was damaged by an illegal arrangement to
restrain trade, that person could sue and recover three times the damages he sus-
tained. The purpose of this unusual rule of triple damages is to encourage private
lawsuits against conspiring oligopolists.

Today, both the U.S. Justice Department and private parties have the authority
to bring legal suits to enforce the antitrust laws. As we discussed in Chapter 15,
these laws are used to prevent mergers that would lead to excessive market power
in any single firm. In addition, these laws are used to prevent oligopolists from act-
ing together in ways that would make their markets less competitive.

C A S E S T U D Y AN ILLEGAL PHONE CALL

Firms in oligopolies have a strong incentive to collude in order to reduce pro-
duction, raise price, and increase profit. The great eighteenth-century economist
Adam Smith was well aware of this potential market failure. In The Wealth of
Nations he wrote, “People of the same trade seldom meet together, but the con-
versation ends in a conspiracy against the public, or in some diversion to raise
prices.”

To see a modern example of Smith’s observation, consider the following ex-
cerpt of a phone conversation between two airline executives in the early 1980s.
The call was reported in The New York Times on February 24, 1983. Robert Cran-
dall was president of American Airlines, and Howard Putnam was president of
Braniff Airways.

CRANDALL: I think it’s dumb as hell . . . to sit here and pound the @#$% out
of each other and neither one of us making a #$%& dime.
PUTNAM:
CRANDALL: Do you have a suggestion for me?

PUTNAM: Yes, I have a suggestion for you. Raise your $%*& fares
CRANDALL: 20 percent. I’ll raise mine the next morning.

Robert, we . . .

You’ll make more money, and I will, too.

368 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

IN THE NEWS Daniels-Midland Co. executives guilty in annually as the No. 2 executive at
The Short Step from a landmark price-fixing case. ADM and was being groomed to suc-
Millionaire Executive ceed his 80-year-old father, Dwayne
to Convicted Felon The unanimous decision by the six- Andreas. . . .
woman, six-man jury, reached here after
BUSINESS EXECUTIVES ARE SUPPOSED TO a week of deliberations in the two-month The most prominent American exec-
maximize their company’s profits, but trial, is a blow to the Andreas family, utive ever convicted for international
as the following article makes clear, whose decades-long control of the De- price-fixing, the younger Mr. Andreas
they have to play within the rules es- catur, Ill., grain-processing giant has faces sentencing on Jan. 7. Prosecutors
tablished by the antitrust laws. made it one of the Midwest’s wealthiest said they will seek the maximum sen-
and most politically influential families. tence of three years in prison for violat-
Jury Convicts Ex-Executives ing the Sherman Antitrust Act. The jury
in ADM Case The verdicts also give the Justice determined that Mr. Andreas helped or-
Department its biggest convictions in a ganize a cartel with four Asian compa-
BY SCOTT KILMAN push against illegal global cartels. The nies to rig the $650 million world-wide
CHICAGO—A federal jury found Michael department has 30 grand juries around market for lysine, a fast-selling livestock-
D. Andreas and two other former Archer- the country considering international feed additive that hastens the growth
price-fixing cases, and more are of chickens and hogs. [Author’s note:
expected. . . . Andreas was eventually sentenced to
spend two years in prison.]
Mr. Andreas, who didn’t take the
stand in his defense, sat stone-faced as SOURCE: The Wall Street Journal, September 18,
U.S. District Judge Blanche M. Manning 1998, p. A3.
read the verdict to the packed court-
room. Before the scandal, Mr. Andreas,
49 years old, was earning $1.3 million

PUTNAM: We can’t talk about pricing!
CRANDALL:
Oh @#$%, Howard. We can talk about any &*#@ thing we want
to talk about.

Putnam was right: The Sherman Antitrust Act prohibits competing executives
from even talking about fixing prices. When Howard Putnam gave a tape of this
conversation to the Justice Department, the Justice Department filed suit against
Robert Crandall.

Two years later, Crandall and the Justice Department reached a settlement
in which Crandall agreed to various restrictions on his business activities, in-
cluding his contacts with officials at other airlines. The Justice Department said
that the terms of settlement would “protect competition in the airline industry,
by preventing American and Crandall from any further attempts to monopolize
passenger airline service on any route through discussions with competitors
about the prices of airline services.”

CONTROVERSIES OVER ANTITRUST POLICY

Over time, much controversy has centered on the question of what kinds of
behavior the antitrust laws should prohibit. Most commentators agree that price-
fixing agreements among competing firms should be illegal. Yet the antitrust laws

CHAPTER 16 OLIGOPOLY 369

have been used to condemn some business practices whose effects are not obvious.
Here we consider three examples.

R e s a l e P r i c e M a i n t e n a n c e One example of a controversial business
practice is resale price maintenance, also called fair trade. Imagine that Superduper
Electronics sells VCRs to retail stores for $300. If Superduper requires the retailers
to charge customers $350, it is said to engage in resale price maintenance. Any
retailer that charged less than $350 would have violated its contract with
Superduper.

At first, resale price maintenance might seem anticompetitive and, therefore,
detrimental to society. Like an agreement among members of a cartel, it prevents
the retailers from competing on price. For this reason, the courts have often
viewed resale price maintenance as a violation of the antitrust laws.

Yet some economists defend resale price maintenance on two grounds. First,
they deny that it is aimed at reducing competition. To the extent that Superduper
Electronics has any market power, it can exert that power through the wholesale
price, rather than through resale price maintenance. Moreover, Superduper has no
incentive to discourage competition among its retailers. Indeed, because a cartel of
retailers sells less than a group of competitive retailers, Superduper would be
worse off if its retailers were a cartel.

Second, economists believe that resale price maintenance has a legitimate goal.
Superduper may want its retailers to provide customers a pleasant showroom and
a knowledgeable sales force. Yet, without resale price maintenance, some cus-
tomers would take advantage of one store’s service to learn about the VCR’s spe-
cial features and then buy the VCR at a discount retailer that does not provide this
service. To some extent, good service is a public good among the retailers that sell
Superduper VCRs. As we discussed in Chapter 11, when one person provides a
public good, others are able to enjoy it without paying for it. In this case, discount
retailers would free ride on the service provided by other retailers, leading to less
service than is desirable. Resale price maintenance is one way for Superduper to
solve this free-rider problem.

The example of resale price maintenance illustrates an important principle:
Business practices that appear to reduce competition may in fact have legitimate purposes.
This principle makes the application of the antitrust laws all the more difficult. The
economists, lawyers, and judges in charge of enforcing these laws must determine
what kinds of behavior public policy should prohibit as impeding competition and
reducing economic well-being. Often that job is not easy.

P r e d a t o r y P r i c i n g Firms with market power normally use that power to
raise prices above the competitive level. But should policymakers ever be con-
cerned that firms with market power might charge prices that are too low? This
question is at the heart of a second debate over antitrust policy.

Imagine that a large airline, call it Coyote Air, has a monopoly on some route.
Then Roadrunner Express enters and takes 20 percent of the market, leaving Coy-
ote with 80 percent. In response to this competition, Coyote starts slashing its fares.
Some antitrust analysts argue that Coyote’s move could be anticompetitive: The
price cuts may be intended to drive Roadrunner out of the market so Coyote can
recapture its monopoly and raise prices again. Such behavior is called predatory
pricing.

Although predatory pricing is a common claim in antitrust suits, some econo-
mists are skeptical of this argument and believe that predatory pricing is rarely,

370 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

and perhaps never, a profitable business strategy. Why? For a price war to drive
out a rival, prices have to be driven below cost. Yet if Coyote starts selling cheap
tickets at a loss, it had better be ready to fly more planes, because low fares will at-
tract more customers. Roadrunner, meanwhile, can respond to Coyote’s predatory
move by cutting back on flights. As a result, Coyote ends up bearing more than
80 percent of the losses, putting Roadrunner in a good position to survive the price
war. As in the old Roadrunner–Coyote cartoons, the predator suffers more than
the prey.

Economists continue to debate whether predatory pricing should be a concern
for antitrust policymakers. Various questions remain unresolved. Is predatory
pricing ever a profitable business strategy? If so, when? Are the courts capable of
telling which price cuts are competitive and thus good for consumers and which
are predatory? There are no easy answers.

T y i n g A third example of a controversial business practice is tying. Suppose
that Makemoney Movies produces two new films—Star Wars and Hamlet. If
Makemoney offers theaters the two films together at a single price, rather than
separately, the studio is said to be tying its two products.

When the practice of tying movies was challenged in the courts, the U.S.
Supreme Court banned the practice. The Court reasoned as follows: Imagine that
Star Wars is a blockbuster, whereas Hamlet is an unprofitable art film. Then the
studio could use the high demand for Star Wars to force theaters to buy Hamlet. It
seemed that the studio could use tying as a mechanism for expanding its market
power.

Many economists, however, are skeptical of this argument. Imagine that the-
aters are willing to pay $20,000 for Star Wars and nothing for Hamlet. Then the
most that a theater would pay for the two movies together is $20,000—the same as
it would pay for Star Wars by itself. Forcing the theater to accept a worthless movie
as part of the deal does not increase the theater’s willingness to pay. Makemoney
cannot increase its market power simply by bundling the two movies together.

Why, then, does tying exist? One possibility is that it is a form of price dis-
crimination. Suppose there are two theaters. City Theater is willing to pay $15,000
for Star Wars and $5,000 for Hamlet. Country Theater is just the opposite: It is will-
ing to pay $5,000 for Star Wars and $15,000 for Hamlet. If Makemoney charges sep-
arate prices for the two films, its best strategy is to charge $15,000 for each film,
and each theater chooses to show only one film. Yet if Makemoney offers the two
movies as a bundle, it can charge each theater $20,000 for the movies. Thus, if dif-
ferent theaters value the films differently, tying may allow the studio to increase
profit by charging a combined price closer to the buyers’ total willingness to pay.

Tying remains a controversial business practice. The Supreme Court’s argu-
ment that tying allows a firm to extend its market power to other goods is not well
founded, at least in its simplest form. Yet economists have proposed more elabo-
rate theories for how tying can impede competition. Given our current economic
knowledge, it is unclear whether tying has adverse effects for society as a whole.

C A S E S T U D Y THE MICROSOFT CASE

The most important and controversial antitrust case in recent years has been the
U.S. government’s suit against the Microsoft Corporation, filed in 1998. Cer-
tainly, the case did not lack drama. It pitted one of the world’s richest men (Bill
Gates) against one of the world’s most powerful regulatory agencies (the U.S.

CHAPTER 16 OLIGOPOLY 371

Justice Department). Testifying for the government was a prominent economist “ME? A MONOPOLIST? NOW JUST WAIT A
(MIT professor Franklin Fisher). Testifying for Microsoft was an equally promi- MINUTE . . .”
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.

Q U I C K Q U I Z : What kind of agreement is illegal for businesses to make?
N 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

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.

Summary

N Oligopolists maximize their total profits by forming a of the prisoners’ dilemma applies in many situations,
cartel and acting like a monopolist. Yet, if oligopolists including arms races, advertising, common-resource
make decisions about production levels individually, the problems, and oligopolies.
result is a greater quantity and a lower price than under
the monopoly outcome. The larger the number of firms N Policymakers use the antitrust laws to prevent
in the oligopoly, the closer the quantity and price will be oligopolies from engaging in behavior that reduces
to the levels that would prevail under competition. competition. The application of these laws can be
controversial, because some behavior that may seem to
N The prisoners’ dilemma shows that self-interest can reduce competition may in fact have legitimate business
prevent people from maintaining cooperation, even purposes.
when cooperation is in their mutual interest. The logic

oligopoly, p. 350 Key Concepts prisoners’ dilemma, p. 359
monopolistic competition, p. 350 dominant strategy, p. 360
collusion, p. 353 cartel, p. 353
Nash equilibrium, p. 355
game theory, p. 358

Questions for Review

1. If a group of sellers could form a cartel, what quantity 5. What is the prisoners’ dilemma, and what does it have
and price would they try to set? to do with oligopoly?

2. Compare the quantity and price of an oligopoly to those 6. Give two examples other than oligopoly to show how
of a monopoly. the prisoners’ dilemma helps to explain behavior.

3. Compare the quantity and price of an oligopoly to those 7. What kinds of behavior do the antitrust laws prohibit?
of a competitive market.
8. What is resale price maintenance, and why is it
4. How does the number of firms in an oligopoly affect the controversial?
outcome in its market?

CHAPTER 16 OLIGOPOLY 373

Problems and Applications

1. The New York Times (Nov. 30, 1993) reported that “the ideas apply to companies that are oligopolists in the
inability of OPEC to agree last week to cut production market for the inputs they buy.
has sent the oil market into turmoil . . . [leading to] the a. If sellers who are oligopolists try to increase the
lowest price for domestic crude oil since June 1990.”
a. Why were the members of OPEC trying to agree to price of goods they sell, what is the goal of buyers
cut production? who are oligopolists?
b. Why do you suppose OPEC was unable to agree on b. Major league baseball team owners have an
cutting production? Why did the oil market go into oligopoly in the market for baseball players. What
“turmoil” as a result? is the owners’ goal regarding players’ salaries?
c. The newspaper also noted OPEC’s view “that Why is this goal difficult to achieve?
producing nations outside the organization, like c. Baseball players went on strike in 1994 because
Norway and Britain, should do their share and cut they would not accept the salary cap that the
production.” What does the phrase “do their share” owners wanted to impose. If the owners were
suggest about OPEC’s desired relationship with already colluding over salaries, why did the owners
Norway and Britain? feel the need for a salary cap?

2. A large share of the world supply of diamonds comes 4. Describe several activities in your life in which game
from Russia and South Africa. Suppose that the theory could be useful. What is the common link among
marginal cost of mining diamonds is constant at $1,000 these activities?
per diamond, and the demand for diamonds is
described by the following schedule: 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:

PRICE QUANTITY United States' Decision

$8,000 5,000 Low Tariffs High Tariffs
7,000 6,000
6,000 7,000 U.S. gains U.S. gains
5,000 8,000 $25 billion $30 billion
4,000 9,000
3,000 10,000 Low Mexico gains Mexico gains
2,000 11,000 Tariffs $25 billion $10 billion
1,000 12,000
Mexico's U.S. gains U.S. gains
Decision $10 billion $20 billion

High
Tarrifs

Mexico gains Mexico gains
$30 billion $20 billion

a. If there were many suppliers of diamonds, what a. What is the dominant strategy for the United
would be the price and quantity? States? For Mexico? Explain.

b. If there were only one supplier of diamonds, what b. Define Nash equilibrium. What is the Nash
would be the price and quantity? equilibrium for trade policy?

c. If Russia and South Africa formed a cartel, what c. In 1993 the U.S. Congress ratified the North
would be the price and quantity? If the countries American Free Trade Agreement (NAFTA), in
split the market evenly, what would be South which the United States and Mexico agreed to
Africa’s production and profit? What would reduce trade barriers simultaneously. Do the
happen to South Africa’s profit if it increased its perceived payoffs as shown here justify this
production by 1,000 while Russia stuck to the cartel approach to trade policy?
agreement?
d. Based on your understanding of the gains from
d. Use your answer to part (c) to explain why cartel trade (discussed in Chapters 3 and 9), do you think
agreements are often not successful. that these payoffs actually reflect a nation’s welfare
under the four possible outcomes?
3. This chapter discusses companies that are oligopolists in
the market for the goods they sell. Many of the same

374 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

6. Suppose that you and a classmate are assigned a project 9. Farmer Jones and Farmer Smith graze their cattle on
on which you will receive one combined grade. You the same field. If there are 20 cows grazing in the
each want to receive a good grade, but you also want to field, each cow produces $4,000 of milk over its
do as little work as possible. The decision box and lifetime. If there are more cows in the field, then each
payoffs are as follows: cow can eat less grass, and its milk production falls.
With 30 cows on the field, each produces $3,000 of milk;
Your Decision Shirk with 40 cows, each produces $2,000 of milk. Cows cost
$1,000 apiece.
Work You get B grade, a. Assume that Farmer Jones and Farmer Smith can
fun each purchase either 10 or 20 cows, but that neither
You get A grade, knows how many the other is buying when she
no fun makes her purchase. Calculate the payoffs of each
outcome.
Work Classmate gets Classmate gets B b. What is the likely outcome of this game? What
A grade, no fun grade, no fun would be the best outcome? Explain.
Classmate's c. There used to be more common fields than there are
Decision You get B grade, You get D grade, today. Why? (For more discussion of this topic,
no fun fun reread Chapter 11.)
Shirk
10. Little Kona is a small coffee company that is considering
Classmate gets Classmate gets entering a market dominated by Big Brew. Each
B grade, fun D grade, fun company’s profit depends on whether Little Kona
enters and whether Big Brew sets a high price or a low
Assume that having fun is your normal state, but price:
having no fun is as unpleasant as receiving a grade that
is two letters lower. Big Brew Low Price
a. Write out the decision box that combines the letter
High Price Brew makes
grade and the amount of fun you have into a single $1 million
payoff for each outcome. Brew makes
b. If neither you nor your classmate knows how much $3 million
work the other person is doing, what is the likely
outcome? Does it matter whether you are likely to Enter Kona makes Kona loses
work with this person again? Explain your answer. $2 million $1 million
Little
7. The chapter states that the ban on cigarette advertising Kona Brew makes Brew makes
on television in 1971 increased the profits of cigarette $7 million $2 million
companies. Could the ban still be good public policy? Don't
Explain your answer. Enter Kona makes Kona makes
zero zero
8. A case study in the chapter describes a phone
conversation between the presidents of American Big Brew threatens Little Kona by saying, “If you enter,
Airlines and Braniff Airways. Let’s analyze the game we’re going to set a low price, so you had better stay
between the two companies. Suppose that each out.” Do you think Little Kona should believe the
company can charge either a high price for tickets or a threat? Why or why not? What do you think Little Kona
low price. If one company charges $100, it earns low should do?
profits if the other company charges $100 also, and high
profits if the other company charges $200. On the other 11. Jeff and Steve are playing tennis. Every point comes
hand, if the company charges $200, it earns very low down to whether Steve guesses correctly whether
profits if the other company charges $100, and medium Jeff will hit the ball to Steve’s left or right. The
profits if the other company charges $200 also. outcomes are:
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?

CHAPTER 16 OLIGOPOLY 375

Steve Guesses Does either player have a dominant strategy? If Jeff
Left Right chooses a particular strategy (Left or Right) and sticks
with it, what will Steve do? So, can you think of a better
Steve wins Steve loses strategy for Jeff to follow?
point point
Left
Jeff loses Jeff wins
Jeff point point
Hits
Steve loses Steve wins
Right point point

Jeff wins Jeff loses
point point



IN THIS CHAPTER
YOU WILL . . .

MONOPOLISTIC COMPETITION Analyze competition
among firms that
You walk into a bookstore to buy a book to read during your next vacation. On the sell differentiated
store’s shelves you find a John Grisham mystery, a Stephen King thriller, a Danielle products
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? Compare the
outcome under
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 monopolistic
for your attention. A buyer in this market has thousands of competing products competition and
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 under perfect
novelist, there are hundreds of struggling ones. competition

On the other hand, the market for books seems monopolistic. Because each Consider the
book is unique, publishers have some latitude in choosing what price to charge. desirability of
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 outcomes in
monopolistically
377
competitive
markets

Examine the debate
over the effects of

advertising

Examine the debate
over the role of
brand names

378 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

monopolistic competition novel, for instance, is about $25, whereas the cost of printing one additional copy
a market structure in which many of the novel is less than $5.
firms sell products that are similar
but not identical 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:

N Many sellers: There are many firms competing for the same group of
customers.

N 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.

N 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

CHAPTER 17 MONOPOLISTIC COMPETITION 379

Price (a) Firm Makes Profit Price (b) Firm Makes Losses
Losses
MC MC
ATC ATC

Price Average
total cost
Average
total cost Price

Profit Demand

MR MR Demand

0 Profit- Quantity 0 Loss- Quantity
maximizing minimizing
quantity quantity

MONOPOLISTIC COMPETITORS IN THE SHORT RUN. Monopolistic competitors, like Figure 17-1
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.

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

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.

CHAPTER 17 MONOPOLISTIC COMPETITION 381

Price MC Figure 17-2
ATC
P = ATC A MONOPOLISTIC COMPETITOR
Demand IN THE LONG RUN. In a
MR monopolistically competitive
0 Quantity market, if firms are making
profit, new firms enter, and the
Profit-maximizing demand curves for the incumbent
quantity firms shift to the left. Similarly, if
firms are making losses, old firms
exit, and the demand curves of
the remaining firms shift to the
right. Because of these shifts in
demand, a monopolistically
competitive firm eventually finds
itself in the long-run equilibrium
shown here. In this long-run
equilibrium, price equals average
total cost, and the firm earns zero
profit.

To sum up, two characteristics describe the long-run equilibrium in a monop-
olistically competitive market:

N As in a monopoly market, price exceeds marginal cost. This conclusion arises
because profit maximization requires marginal revenue to equal marginal
cost and because the downward sloping demand curve makes marginal
revenue less than the price.

N As in a competitive market, price equals average total cost. This conclusion
arises because free entry and exit drive economic profit to zero.

The second characteristic shows how monopolistic competition differs from mo-
nopoly. Because a monopoly is the sole seller of a product without close substi-
tutes, it can earn positive economic profit, even in the long run. By contrast,
because there is free entry into a monopolistically competitive market, the eco-
nomic profit of a firm in this type of market is driven to zero.

MONOPOLISTIC VERSUS PERFECT COMPETITION

Figure 17-3 compares the long-run equilibrium under monopolistic competition to
the long-run equilibrium under perfect competition. (Chapter 14 discussed the
equilibrium with perfect competition.) There are two noteworthy differences be-
tween monopolistic and perfect competition: excess capacity and the markup.

E x c e s s C a p a c i t y As we have just seen, entry and exit drive each firm in a
monopolistically competitive market to a point of tangency between its demand

382 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Price (a) Monopolistically Competitive Firm Price (b) Perfectly Competitive Firm
MC P = MC
Markup ATC MC
ATC
P MR Demand
P = MR
Marginal (demand
cost
curve)

0 Quantity Efficient Quantity 0 Quantity produced = Quantity
produced scale Efficient scale

Excess capacity

Figure 17-3 MONOPOLISTIC VERSUS PERFECT COMPETITION. Panel (a) shows the long-run
equilibrium in a monopolistically competitive market, and panel (b) shows the long-run
equilibrium in a perfectly competitive market. Two differences are notable. (1) The
perfectly competitive firm produces at the efficient scale, where average total cost is
minimized. By contrast, the monopolistically competitive firm produces at less than the
efficient scale. (2) Price equals marginal cost under perfect competition, but price is above
marginal cost under monopolistic competition.

and average-total-cost curves. Panel (a) of Figure 17-3 shows that the quantity of
output at this point is smaller than the quantity that minimizes average total cost.
Thus, under monopolistic competition, firms produce on the downward-sloping
portion of their average-total-cost curves. In this way, monopolistic competition
contrasts starkly with perfect competition. As panel (b) of Figure 17-3 shows, free
entry in competitive markets drives firms to produce at the minimum of average
total cost.

The quantity that minimizes average total cost is called the efficient scale of the
firm. In the long run, perfectly competitive firms produce at the efficient scale,
whereas monopolistically competitive firms produce below this level. Firms are
said to have excess capacity under monopolistic competition. In other words, a mo-
nopolistically competitive firm, unlike a perfectly competitive firm, could increase
the quantity it produces and lower the average total cost of production.

M a r k u p o v e r M a r g i n a l C o s t A second difference between perfect com-
petition and monopolistic competition is the relationship between price and mar-
ginal cost. For a competitive firm, such as that shown in panel (b) of Figure 17-3,
price equals marginal cost. For a monopolistically competitive firm, such as that
shown in panel (a), price exceeds marginal cost, because the firm always has some
market power.

CHAPTER 17 MONOPOLISTIC COMPETITION 383

How is this markup over marginal cost consistent with free entry and zero
profit? The zero-profit condition ensures only that price equals average total
cost. It does not ensure that price equals marginal cost. Indeed, in the long-run
equilibrium, monopolistically competitive firms operate on the declining por-
tion of their average-total-cost curves, so marginal cost is below average to-
tal cost. Thus, for price to equal average total cost, price must be above marginal
cost.

In this relationship between price and marginal cost, we see a key behavioral
difference between perfect competitors and monopolistic competitors. Imagine
that you were to ask a firm the following question: “Would you like to see another
customer come through your door ready to buy from you at your current price?”
A perfectly competitive firm would answer that it didn’t care. Because price ex-
actly equals marginal cost, the profit from an extra unit sold is zero. By contrast, a
monopolistically competitive firm is always eager to get another customer. Be-
cause its price exceeds marginal cost, an extra unit sold at the posted price means
more profit. According to an old quip, monopolistically competitive markets are
those in which sellers send Christmas cards to the buyers.

MONOPOLISTIC COMPETITION AND
THE WELFARE OF SOCIETY

Is the outcome in a monopolistically competitive market desirable from the stand-
point of society as a whole? Can policymakers improve on the market outcome?
There are no simple answers to these questions.

One source of inefficiency is the markup of price over marginal cost. Because
of the markup, some consumers who value the good at more than the marginal
cost of production (but less than the price) will be deterred from buying it. Thus, a
monopolistically competitive market has the normal deadweight loss of monopoly
pricing. We first saw this type of inefficiency when we discussed monopoly in
Chapter 15.

Although this outcome is clearly undesirable compared to the first-best out-
come of price equal to marginal cost, there is no easy way for policymakers to fix
the problem. To enforce marginal-cost pricing, policymakers would need to regu-
late all firms that produce differentiated products. Because such products are so
common in the economy, the administrative burden of such regulation would be
overwhelming.

Moreover, regulating monopolistic competitors would entail all the problems
of regulating natural monopolies. In particular, because monopolistic competitors
are making zero profits already, requiring them to lower their prices to equal mar-
ginal cost would cause them to make losses. To keep these firms in business, the
government would need to help them cover these losses. Rather than raising taxes
to pay for these subsidies, policymakers may decide it is better to live with the
inefficiency of monopolistic pricing.

Another way in which monopolistic competition may be socially inefficient is
that the number of firms in the market may not be the “ideal” one. That is, there
may be too much or too little entry. One way to think about this problem is in
terms of the externalities associated with entry. Whenever a new firm considers en-
tering the market with a new product, it considers only the profit it would make.
Yet its entry would also have two external effects:

384 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

N The product-variety externality: Because consumers get some consumer surplus
from the introduction of a new product, entry of a new firm conveys a
positive externality on consumers.

N The business-stealing externality: Because other firms lose customers and
profits from the entry of a new competitor, entry of a new firm imposes a
negative externality on existing firms.

Thus, in a monopolistically competitive market, there are both positive and nega-
tive externalities associated with the entry of new firms. Depending on which ex-
ternality is larger, a monopolistically competitive market could have either too few
or too many products.

Both of these externalities are closely related to the conditions for monopolis-
tic competition. The product-variety externality arises because a new firm would
offer a product different from those of the existing firms. The business-stealing ex-
ternality arises because firms post a price above marginal cost and, therefore, are
always eager to sell additional units. Conversely, because perfectly competitive
firms produce identical goods and charge a price equal to marginal cost, neither of
these externalities exists under perfect competition.

In the end, we can conclude only that monopolistically competitive markets
do not have all the desirable welfare properties of perfectly competitive markets.
That is, the invisible hand does not ensure that total surplus is maximized under
monopolistic competition. Yet because the inefficiencies are subtle, hard to mea-
sure, and hard to fix, there is no easy way for public policy to improve the market
outcome.

Q U I C K Q U I Z : List the three key attributes of monopolistic competition.
N Draw and explain a diagram to show the long-run equilibrium in a
monopolistically competitive market. How does this equilibrium differ from
that in a perfectly competitive market?

FYI

Is Excess As we have seen, monopolisti- evaluating economic welfare. There is no reason that soci-
Capacity a cally competitive firms produce ety should want all firms to produce at the minimum of
Social Problem? a quantity of output below the average total cost. For example, consider a publishing firm.
level that minimizes average to- Producing a novel might take a fixed cost of $50,000 (the
tal cost. By contrast, firms in author’s time) and variable costs of $5 per book (the cost of
perfectly competitive markets printing). In this case, the average total cost of a book de-
are driven to produce at the clines as the number of books increases because the fixed
quantity that minimizes average cost gets spread over more and more units. The average to-
tal cost is minimized by printing an infinite number of books.
total cost. This comparison be- But in no sense is infinity the right number of books for so-
tween perfect and monopolistic ciety to produce.

competition has led some In short, monopolistic competitors do have excess ca-
economists in the past to ar- pacity, but this fact tells us little about the desirability of the
gue that the excess capacity of market outcome.
monopolistic competitors was a source of inefficiency.
Today economists understand that the excess capac-
ity of monopolistic competitors is not directly relevant for

CHAPTER 17 MONOPOLISTIC COMPETITION 385

ADVERTISING

It is nearly impossible to go through a typical day in a modern economy without
being bombarded with advertising. Whether you are reading a newspaper, watch-
ing television, or driving down the highway, some firm will try to convince you to
buy its product. Such behavior is a natural feature of monopolistic competition.
When firms sell differentiated products and charge prices above marginal cost,
each firm has an incentive to advertise in order to attract more buyers to its partic-
ular product.

The amount of advertising varies substantially across products. Firms that sell
highly differentiated consumer goods, such as over-the-counter drugs, perfumes,
soft drinks, razor blades, breakfast cereals, and dog food, typically spend between
10 and 20 percent of revenue for advertising. Firms that sell industrial products,
such as drill presses and communications satellites, typically spend very little on
advertising. And firms that sell homogeneous products, such as wheat, peanuts, or
crude oil, spend nothing at all. For the economy as a whole, spending on advertis-
ing comprises about 2 percent of total firm revenue, or more than $100 billion.

Advertising takes many forms. About one-half of advertising spending is for
space in newspapers and magazines, and about one-third is for commercials on
television and radio. The rest is spent on various other ways of reaching cus-
tomers, such as direct mail, billboards, and the Goodyear blimp.

THE DEBATE OVER ADVERTISING

Is society wasting the resources it devotes to advertising? Or does advertising
serve a valuable purpose? Assessing the social value of advertising is difficult and
often generates heated argument among economists. Let’s consider both sides of
the debate.

T h e C r i t i q u e o f A d v e r t i s i n g Critics of advertising argue that firms ad-
vertise in order to manipulate people’s tastes. Much advertising is psychological
rather than informational. Consider, for example, the typical television commercial
for some brand of soft drink. The commercial most likely does not tell the viewer
about the product’s price or quality. Instead, it might show a group of happy peo-
ple at a party on a beach on a beautiful sunny day. In their hands are cans of the
soft drink. The goal of the commercial is to convey a subconscious (if not subtle)
message: “You too can have many friends and be happy, if only you drink our
product.” Critics of advertising argue that such a commercial creates a desire that
otherwise might not exist.

Critics also argue that advertising impedes competition. Advertising often
tries to convince consumers that products are more different than they truly are.
By increasing the perception of product differentiation and fostering brand loyalty,
advertising makes buyers less concerned with price differences among similar
goods. With a less elastic demand curve, each firm charges a larger markup over
marginal cost.

T h e D e f e n s e o f A d v e r t i s i n g Defenders of advertising argue that firms
use advertising to provide information to customers. Advertising conveys the

386 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

prices of the goods being offered for sale, the existence of new products, and the
locations of retail outlets. This information allows customers to make better
choices about what to buy and, thus, enhances the ability of markets to allocate re-
sources efficiently.

Defenders also argue that advertising fosters competition. Because advertising
allows customers to be more fully informed about all the firms in the market, cus-
tomers can more easily take advantage of price differences. Thus, each firm has
less market power. In addition, advertising allows new firms to enter more easily,
because it gives entrants a means to attract customers from existing firms.

Over time, policymakers have come to accept the view that advertising can
make markets more competitive. One important example is the regulation of cer-
tain professions, such as lawyers, doctors, and pharmacists. In the past, these
groups succeeded in getting state governments to prohibit advertising in their
fields on the grounds that advertising was “unprofessional.” In recent years, how-
ever, the courts have concluded that the primary effect of these restrictions on ad-
vertising was to curtail competition. They have, therefore, overturned many of the
laws that prohibit advertising by members of these professions.

C A S E S T U D Y ADVERTISING AND THE PRICE OF EYEGLASSES

What effect does advertising have on the price of a good? On the one hand, ad-
vertising might make consumers view products as being more different than
they otherwise would. If so, it would make markets less competitive and firms’
demand curves less elastic, and this would lead firms to charge higher prices.
On the other hand, advertising might make it easier for consumers to find the
firms offering the best prices. In this case, it would make markets more com-
petitive and firms’ demand curves more elastic, and this would lead to lower
prices.

In an article published in the Journal of Law and Economics in 1972, economist
Lee Benham tested these two views of advertising. In the United States during
the 1960s, the various state governments had vastly different rules about adver-
tising by optometrists. Some states allowed advertising for eyeglasses and eye
examinations. Many states, however, prohibited it. For example, the Florida law
read as follows:

It is unlawful for any person, firm, or corporation to . . . advertise either
directly or indirectly by any means whatsoever any definite or indefinite price
or credit terms on prescriptive or corrective lens, frames, complete
prescriptive or corrective glasses, or any optometric service. . . . This section is
passed in the interest of public health, safety, and welfare, and its provisions
shall be liberally construed to carry out its objects and purposes.

Professional optometrists enthusiastically endorsed these restrictions on
advertising.

Benham used the differences in state law as a natural experiment to test
the two views of advertising. The results were striking. In those states that pro-
hibited advertising, the average price paid for a pair of eyeglasses was $33.
(This number is not as low as it seems, for this price is from 1963, when all
prices were much lower than they are today. To convert 1963 prices into to-
day’s dollars, you can multiply them by 5.) In those states that did not restrict

CHAPTER 17 MONOPOLISTIC COMPETITION 387

advertising, the average price was $26. Thus, advertising reduced average
prices by more than 20 percent. In the market for eyeglasses, and probably in
many other markets as well, advertising fosters competition and leads to lower
prices for consumers.

ADVERTISING AS A SIGNAL OF QUALITY

Many types of advertising contain little apparent information about the product
being advertised. Consider a firm introducing a new breakfast cereal. A typical ad-
vertisement might have some highly paid actor eating the cereal and exclaiming
how wonderful it tastes. How much information does the advertisement really
provide?

The answer is: more than you might think. Defenders of advertising argue that
even advertising that appears to contain little hard information may in fact tell
consumers something about product quality. The willingness of the firm to spend
a large amount of money on advertising can itself be a signal to consumers about
the quality of the product being offered.

Consider the problem facing two firms—Post and Kellogg. Each company has
just come up with a recipe for a new cereal, which it would sell for $3 a box. To
keep things simple, let’s assume that the marginal cost of making cereal is zero, so
the $3 is all profit. Each company knows that if it spends $10 million on advertis-
ing, it will get 1 million consumers to try its new cereal. And each company knows
that if consumers like the cereal, they will buy it not once but many times.

First consider Post’s decision. Based on market research, Post knows that its
cereal is only mediocre. Although advertising would sell one box to each of 1 mil-
lion consumers, the consumers would quickly learn that the cereal is not very
good and stop buying it. Post decides it is not worth paying $10 million in adver-
tising to get only $3 million in sales. So it does not bother to advertise. It sends its
cooks back to the drawing board to find another recipe.

Kellogg, on the other hand, knows that its cereal is great. Each person who
tries it will buy a box a month for the next year. Thus, the $10 million in advertis-
ing will bring in $36 million in sales. Advertising is profitable here because Kellogg
has a good product that consumers will buy repeatedly. Thus, Kellogg chooses to
advertise.

Now that we have considered the behavior of the two firms, let’s consider the
behavior of consumers. We began by asserting that consumers are inclined to try a
new cereal that they see advertised. But is this behavior rational? Should a con-
sumer try a new cereal just because the seller has chosen to advertise it?

In fact, it may be completely rational for consumers to try new products that
they see advertised. In our story, consumers decide to try Kellogg’s new cereal be-
cause Kellogg advertises. Kellogg chooses to advertise because it knows that its ce-
real is quite good, while Post chooses not to advertise because it knows that its
cereal is only mediocre. By its willingness to spend money on advertising, Kellogg
signals to consumers the quality of its cereal. Each consumer thinks, quite sensibly,
“Boy, if the Kellogg Company is willing to spend so much money advertising this
new cereal, it must be really good.”

What is most surprising about this theory of advertising is that the content of
the advertisement is irrelevant. Kellogg signals the quality of its product by its
willingness to spend money on advertising. What the advertisements say is not as

388 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

important as the fact that consumers know ads are expensive. By contrast, cheap
advertising cannot be effective at signaling quality to consumers. In our example,
if an advertising campaign cost less than $3 million, both Post and Kellogg would
use it to market their new cereals. Because both good and mediocre cereals would
be advertised, consumers could not infer the quality of a new cereal from the
fact that it is advertised. Over time, consumers would learn to ignore such cheap
advertising.

This theory can explain why firms pay famous actors large amounts of money
to make advertisements that, on the surface, appear to convey no information at
all. The information is not in the advertisement’s content, but simply in its exis-
tence and expense.

BRAND NAMES

Advertising is closely related to the existence of brand names. In many markets,
there are two types of firms. Some firms sell products with widely recognized
brand names, while other firms sell generic substitutes. For example, in a typical
drugstore, you can find Bayer aspirin on the shelf next to a generic aspirin. In a
typical grocery store, you can find Pepsi next to less familiar colas. Most often, the
firm with the brand name spends more on advertising and charges a higher price
for its product.

Just as there is disagreement about the economics of advertising, there is dis-
agreement about the economics of brand names. Let’s consider both sides of the
debate.

Critics of brand names argue that brand names cause consumers to perceive
differences that do not really exist. In many cases, the generic good is almost in-
distinguishable from the brand-name good. Consumers’ willingness to pay more
for the brand-name good, these critics assert, is a form of irrationality fostered by
advertising. Economist Edward Chamberlin, one of the early developers of the
theory of monopolistic competition, concluded from this argument that brand
names were bad for the economy. He proposed that the government discourage

CHAPTER 17 MONOPOLISTIC COMPETITION 389

their use by refusing to enforce the exclusive trademarks that companies use to
identify their products.

More recently, economists have defended brand names as a useful way for
consumers to ensure that the goods they buy are of high quality. There are two re-
lated arguments. First, brand names provide consumers information about quality
when quality cannot be easily judged in advance of purchase. Second, brand
names give firms an incentive to maintain high quality, because firms have a finan-
cial stake in maintaining the reputation of their brand names.

To see how these arguments work in practice, consider a famous brand name:
McDonald’s hamburgers. Imagine that you are driving through an unfamiliar
town and want to stop for lunch. You see a McDonald’s and a local restaurant next
to it. Which do you choose? The local restaurant may in fact offer better food at
lower prices, but you have no way of knowing that. By contrast, McDonald’s of-
fers a consistent product across many cities. Its brand name is useful to you as a
way of judging the quality of what you are about to buy.

The McDonald’s brand name also ensures that the company has an incentive
to maintain quality. For example, if some customers were to become ill from bad
food sold at a McDonald’s, the news would be disastrous for the company.
McDonald’s would lose much of the valuable reputation that it has built up with
years of expensive advertising. As a result, it would lose sales and profit not just in
the outlet that sold the bad food but in its many outlets throughout the country.
By contrast, if some customers were to become ill from bad food at a local restau-
rant, that restaurant might have to close down, but the lost profits would be
much smaller. Hence, McDonald’s has a greater incentive to ensure that its food
is safe.

The debate over brand names thus centers on the question of whether con-
sumers are rational in preferring brand names over generic substitutes. Critics of
brand names argue that brand names are the result of an irrational consumer re-
sponse to advertising. Defenders of brand names argue that consumers have good
reason to pay more for brand-name products because they can be more confident
in the quality of these products.

C A S E S T U D Y BRAND NAMES UNDER COMMUNISM

Defenders of brand names get some support for their view from experiences in
the former Soviet Union. When the Soviet Union adhered to the principles of
communism, central planners in the government replaced the invisible hand of
the marketplace. Yet, just like consumers living in an economy with free mar-
kets, Soviet central planners learned that brand names were useful in helping to
ensure product quality.

In an article published in the Journal of Political Economy in 1960, Marshall
Goldman, an expert on the Soviet economy, described the Soviet experience:

In the Soviet Union, production goals have been set almost solely in
quantitative or value terms, with the result that, in order to meet the plan,
quality is often sacrificed. . . . Among the methods adopted by the Soviets to
deal with this problem, one is of particular interest to us—intentional product
differentiation. . . . In order to distinguish one firm from similar firms in the
same industry or ministry, each firm has its own name. Whenever it is

390 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

IN THE NEWS which officially began this week, viewers AN ATTITUDE, NOT JUST A FROG
TV Networks as have been swamped by the torrent of
Brand Names teasing practically since the 1995–96 an overall packaging of the network to
season ended in May. build a relationship with viewers, so they
BRAND NAMES CONVEY INFORMATION TO will come to expect certain things from
consumers about the goods that firms At the center of those efforts is the us,” said Alan Cohen, executive vice
are offering. Establishing a brand most ambitious push ever by the broad- president for the ABC-TV unit of the
name—and ensuring that it conveys cast networks to brand themselves and Walt Disney Company in New York.
the right information—is an important many of the blocks of programming they
strategy for many businesses, including offer—a marked departure from the That, he said, means defining the
TV networks. past, when they would promote only network so that “when you’re watching
specific shows. ABC, you’ll know you’re watching
A TV Season When ABC”—and to accomplish it in a way
Image Is Everything “The perception was that people that appeals to the primary ABC audi-
watched shows, not networks,” said ence of youngish urbanites and families
BY STUART ELLIOTT Bob Bibb, who with Lewis Goldstein with children.
A marketing blitz to promote fall tele- jointly heads marketing for WB, a fledg-
vision programming, estimated at a rec- ling network owned by Time Warner, Inc., SOURCE: The New York Times, September 20, 1996,
ord $400 million to $500 million, has and based in Burbank, California. p. D1.
been inundating America with a barrage
of branding. “But that was when there were only
three networks, three choices,” Mr. Bibb
Branding is a shorthand term along added, “and it was easy to find the
Madison Avenue for attempts to create shows you liked.”
or burnish an identity or image, just as
Coca-Cola seeks to distinguish itself WB has been presenting a sassy
from Pepsi-Cola. For the 1996–97 singing cartoon character named Michi-
prime-time broadcast television season, gan J. Frog as its “spokesphibian,” per-
sonifying the entire lineup of the
“Dubba-dubba-WB”—as he insists upon
calling the network.

“It’s not a frog, it’s an attitude,” Mr.
Bibb said, “a consistency from show to
show.”

In television, an intrinsic part of
branding is selecting shows that seem
related and might appeal to a certain au-
dience segment. It means “developing

physically possible, it is obligatory that the firm identify itself on the good or
packaging with a “production mark.”

Goldman quotes the analysis of a Soviet marketing expert:

This [trademark] makes it easy to establish the actual producer of the product
in case it is necessary to call him to account for the poor quality of his goods.
For this reason, it is one of the most effective weapons in the battle for the
quality of products. . . . The trademark makes it possible for the consumer to
select the good which he likes. . . . This forces other firms to undertake
measures to improve the quality of their own product in harmony with the
demands of the consumer.

CHAPTER 17 MONOPOLISTIC COMPETITION 391

Goldman notes that “these arguments are clear enough and sound as if they
might have been written by a bourgeois apologist.”

Q U I C K Q U I Z : How might advertising make markets less competitive?
How might it make markets more competitive? N Give the arguments for
and against brand names.

CONCLUSION

Monopolistic competition is true to its name: It is a hybrid of monopoly and com-
petition. Like a monopoly, each monopolistic competitor faces a downward-
sloping demand curve and, as a result, charges a price above marginal cost. As in
a competitive market, however, there are many firms, and entry and exit drive the
profit of each monopolistic competitor toward zero. Because monopolistically
competitive firms produce differentiated products, each firm advertises in order to
attract customers to its own brand. To some extent, advertising manipulates con-
sumers’ tastes, promotes irrational brand loyalty, and impedes competition. To a
larger extent, advertising provides information, establishes brand names of reli-
able quality, and fosters competition.

The theory of monopolistic competition seems to describe many markets in
the economy. It is somewhat disappointing, therefore, that the theory does not
yield simple and compelling advice for public policy. From the standpoint of the
economic theorist, the allocation of resources in monopolistically competitive mar-
kets is not perfect. Yet, from the standpoint of a practical policymaker, there may
be little that can be done to improve it.

Summary

N A monopolistically competitive market is characterized markup of price over marginal cost. In addition, the
by three attributes: many firms, differentiated products, number of firms (and thus the variety of products) can
and free entry. be too large or too small. In practice, the ability of
policymakers to correct these inefficiencies is limited.
N The equilibrium in a monopolistically competitive
market differs from that in a perfectly competitive N The product differentiation inherent in monopolistic
market in two related ways. First, each firm has excess competition leads to the use of advertising and brand
capacity. That is, it operates on the downward-sloping names. Critics of advertising and brand names argue
portion of the average-total-cost curve. Second, each that firms use them to take advantage of consumer
firm charges a price above marginal cost. irrationality and to reduce competition. Defenders of
advertising and brand names argue that firms use them
N Monopolistic competition does not have all the to inform consumers and to compete more vigorously
desirable properties of perfect competition. There is the on price and product quality.
standard deadweight loss of monopoly caused by the

Key Concepts

monopolistic competition, p. 378

392 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Questions for Review

1. Describe the three attributes of monopolistic 4. Does a monopolistic competitor produce too much or
competition. How is monopolistic competition like too little output compared to the most efficient level?
monopoly? How is it like perfect competition? What practical considerations make it difficult for
policymakers to solve this problem?
2. Draw a diagram depicting a firm in a monopolistically
competitive market that is making profits. Now show 5. How might advertising reduce economic well-being?
what happens to this firm as new firms enter the How might advertising increase economic well-being?
industry.
6. How might advertising with no apparent informational
3. Draw a diagram of the long-run equilibrium in a content in fact convey information to consumers?
monopolistically competitive market. How is price
related to average total cost? How is price related to 7. Explain two benefits that might arise from the existence
marginal cost? of brand names.

Problems and Applications

1. Classify the following markets as perfectly competitive, a. Draw a diagram showing Sparkle’s demand curve,
monopolistic, or monopolistically competitive, and marginal-revenue curve, average-total-cost curve,
explain your answers. and marginal-cost curve. Label Sparkle’s profit-
a. wooden #2 pencils maximizing output and price.
b. bottled water
c. copper b. What is Sparkle’s profit? Explain.
d. local telephone service c. On your diagram, show the consumer surplus
e. peanut butter
f. lipstick derived from the purchase of Sparkle toothpaste.
Also show the deadweight loss relative to the
2. What feature of the product being sold distinguishes a efficient level of output.
monopolistically competitive firm from a monopolistic d. If the government forced Sparkle to produce
firm? the efficient level of output, what would happen
to the firm? What would happen to Sparkle’s
3. The chapter states that monopolistically competitive customers?
firms could increase the quantity they produce and
lower the average total cost of production. Why don’t 5. Do monopolistically competitive markets typically have
they do so? the optimal number of products? Explain.

4. Sparkle is one firm of many in the market for 6. Complete the table below by filling in YES, NO, or
toothpaste, which is in long-run equilibrium. MAYBE for each type of market structure.

DO FIRMS: PERFECT MONOPOLISTIC MONOPOLY
COMPETITION COMPETITION
Make differentiated products?
Have excess capacity?
Advertise?
Pick Q so that MR ϭ MC?
Pick Q so that P ϭ MC?
Earn economic profits in long-run equilibrium?
Face a downward-sloping demand curve?
Have MR less than price?
Face the entry of other firms?
Exit in the long run if profits are less than zero?

CHAPTER 17 MONOPOLISTIC COMPETITION 393

7. The chapter says that monopolistically competitive 11. Twenty years ago the market for chicken was perfectly
firms may send Christmas cards to their customers. competitive. Then Frank Perdue began marketing
What do they accomplish by this? Explain in words and chicken under his name.
with a diagram. a. How do you suppose Perdue created a brand name
for chicken? What did he gain from doing so?
8. If you were thinking of entering the ice-cream business, b. What did society gain from having brand-name
would you try to make ice cream that is just like one of chicken? What did society lose?
the existing brands? Explain your decision using the
ideas of this chapter. 12. The makers of Tylenol pain reliever do a lot of
advertising and have very loyal customers. In contrast,
9. Describe three commercials that you have seen on TV. the makers of generic acetaminophen do no advertising,
In what ways, if any, were each of these commercials and their customers shop only for the lowest price.
socially useful? In what ways were they socially Assume that the marginal costs of Tylenol and generic
wasteful? Did the commercials affect the likelihood of acetaminophen are the same and constant.
your buying the product, and why? a. Draw a diagram showing Tylenol’s demand,
marginal-revenue, and marginal-cost curves. Label
10. For each of the following pairs of firms, explain which Tylenol’s price and markup over marginal cost.
firm would be more likely to engage in advertising. b. Repeat part (a) for a producer of generic
a. a family-owned farm or a family-owned restaurant acetaminophen. How do the diagrams differ?
b. a manufacturer of forklifts or a manufacturer Which company has the bigger markup? Explain.
of cars c. Which company has the bigger incentive for careful
c. a company that invented a very reliable watch or a quality control? Why?
company that invented a less reliable watch that
costs the same amount to make



IN THIS CHAPTER
YOU WILL . . .

Analyze the labor
demand of

competitive, profit-
maximizing firms

Consider the
household decisions

that lie behind
labor supply

THE MARKETS FOR THE Learn why
equilibrium wages
FACTORS OF PRODUCTION equal the value of

When you finish school, your income will be determined largely by what kind of the marginal
job you take. If you become a computer programmer, you will earn more than if product of labor
you become a gas station attendant. This fact is not surprising, but it is not obvious
why it is true. No law requires that computer programmers be paid more than gas Consider how the
station attendants. No ethical principle says that programmers are more deserv- other factors of
ing. What then determines which job will pay you the higher wage? production—land
and capital—are
Your income, of course, is a small piece of a larger economic picture. In 1999
the total income of all U.S. residents was about $8 trillion. People earned this in- compensated
come in various ways. Workers earned about three-fourths of it in the form of
wages and fringe benefits. The rest went to landowners and to the owners of capi- Examine how a
tal—the economy’s stock of equipment and structures—in the form of rent, profit, change in the
and interest. What determines how much goes to workers? To landowners? To the supply of one factor
owners of capital? Why do some workers earn higher wages than others, some alters the earnings
of all the factors
397

398 PART SIX THE ECONOMICS OF LABOR MARKETS

factors of production landowners higher rental income than others, and some capital owners greater
the inputs used to produce goods and profit than others? Why, in particular, do computer programmers earn more than
services gas station attendants?

The answers to these questions, like most in economics, hinge on supply and
demand. The supply and demand for labor, land, and capital determine the prices
paid to workers, landowners, and capital owners. To understand why some peo-
ple have higher incomes than others, therefore, we need to look more deeply at
the markets for the services they provide. That is our job in this and the next two
chapters.

This chapter provides the basic theory for the analysis of factor markets. As
you may recall from Chapter 2, the factors of production are the inputs used to
produce goods and services. Labor, land, and capital are the three most important
factors of production. When a computer firm produces a new software program, it
uses programmers’ time (labor), the physical space on which its offices sit (land),
and an office building and computer equipment (capital). Similarly, when a gas
station sells gas, it uses attendants’ time (labor), the physical space (land), and the
gas tanks and pumps (capital).

Although in many ways factor markets resemble the goods markets we have
analyzed in previous chapters, they are different in one important way: The de-
mand for a factor of production is a derived demand. That is, a firm’s demand for a
factor of production is derived from its decision to supply a good in another mar-
ket. The demand for computer programmers is inextricably tied to the supply of
computer software, and the demand for gas station attendants is inextricably tied
to the supply of gasoline.

In this chapter we analyze factor demand by considering how a competitive,
profit-maximizing firm decides how much of any factor to buy. We begin our
analysis by examining the demand for labor. Labor is the most important factor of
production, for workers receive most of the total income earned in the U.S. econ-
omy. Later in the chapter, we see that the lessons we learn about the labor market
apply directly to the markets for the other factors of production.

The basic theory of factor markets developed in this chapter takes a large step
toward explaining how the income of the U.S. economy is distributed among
workers, landowners, and owners of capital. Chapter 19 will build on this analysis
to examine in more detail why some workers earn more than others. Chapter 20
will examine how much inequality results from this process and then consider
what role the government should and does play in altering the distribution of
income.

THE DEMAND FOR LABOR

Labor markets, like other markets in the economy, are governed by the forces of
supply and demand. This is illustrated in Figure 18-1. In panel (a) the supply and
demand for apples determine the price of apples. In panel (b) the supply and de-
mand for apple pickers determine the price, or wage, of apple pickers.

As we have already noted, labor markets are different from most other mar-
kets because labor demand is a derived demand. Most labor services, rather than

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 399

Price of (a) The Market for Apples Wage of (b) The Market for Apple Pickers
Apples Supply Apple Supply

Pickers

PW

Demand Demand

0 Q Quantity of 0 L Quantity of
Apple Pickers
Apples
Figure 18-1
THE VERSATILITY OF SUPPLY AND DEMAND. The basic tools of supply and demand
apply to goods and to labor services. Panel (a) shows how the supply and demand
for apples determine the price of apples. Panel (b) shows how the supply and demand for
apple pickers determine the wage of apple pickers.

being final goods ready to be enjoyed by consumers, are inputs into the produc-
tion of other goods. To understand labor demand, we need to focus on the firms
that hire the labor and use it to produce goods for sale. By examining the link be-
tween the production of goods and the demand for labor, we gain insight into the
determination of equilibrium wages.

THE COMPETITIVE PROFIT-MAXIMIZING FIRM

Let’s look at how a typical firm, such as an apple producer, decides the quantity of
labor to demand. The firm owns an apple orchard and each week must decide
how many apple pickers to hire to harvest its crop. After the firm makes its hiring
decision, the workers pick as many apples as they can. The firm then sells the ap-
ples, pays the workers, and keeps what is left as profit.

We make two assumptions about our firm. First, we assume that our firm is
competitive both in the market for apples (where the firm is a seller) and in the
market for apple pickers (where the firm is a buyer). Recall from Chapter 14 that a
competitive firm is a price taker. Because there are many other firms selling apples
and hiring apple pickers, a single firm has little influence over the price it gets for
apples or the wage it pays apple pickers. The firm takes the price and the wage as
given by market conditions. It only has to decide how many workers to hire and
how many apples to sell.

Second, we assume that the firm is profit-maximizing. Thus, the firm does not
directly care about the number of workers it has or the number of apples it pro-
duces. It cares only about profit, which equals the total revenue from the sale of

400 PART SIX THE ECONOMICS OF LABOR MARKETS

LABOR OUTPUT MARGINAL PRODUCT VALUE OF THE WAGE MARGINAL
OF LABOR MARGINAL PRODUCT PROFIT
L
(NUMBER OF WORKERS) OF LABOR

0 Q MPL ‫∆ ؍‬Q/∆L VMPL ‫ ؍‬P ؋ MPL ∆PROFIT ‫؍‬
1 (BUSHELS PER WEEK) (BUSHELS PER WEEK) W VMPL ؊ W
2
3 0 100 $1,000 $500 $500
4 100 80 800 500 300
5 180 60 600 500 100
240 40 400 500 Ϫ100
280 20 200 500 Ϫ300
300

Table 18-1 HOW THE COMPETITIVE FIRM DECIDES HOW MUCH LABOR TO HIRE

apples minus the total cost of producing them. The firm’s supply of apples and its
demand for workers are derived from its primary goal of maximizing profit.

THE PRODUCTION FUNCTION AND THE
MARGINAL PRODUCT OF LABOR

production function To make its hiring decision, the firm must consider how the size of its workforce
the relationship between the quantity affects the amount of output produced. In other words, it must consider how the
of inputs used to make a good and number of apple pickers affects the quantity of apples it can harvest and sell. Ta-
the quantity of output of that good ble 18-1 gives a numerical example. In the first column is the number of workers.
In the second column is the quantity of apples the workers harvest each week.
marginal product
of labor These two columns of numbers describe the firm’s ability to produce. As we
the increase in the amount of output noted in Chapter 13, economists use the term production function to describe the
from an additional unit of labor relationship between the quantity of the inputs used in production and the quan-
tity of output from production. Here the “input” is the apple pickers and the “out-
put” is the apples. The other inputs—the trees themselves, the land, the firm’s
trucks and tractors, and so on—are held fixed for now. This firm’s production
function shows that if the firm hires 1 worker, that worker will pick 100 bushels
of apples per week. If the firm hires 2 workers, the two workers together will pick
180 bushels per week, and so on.

Figure 18-2 graphs the data on labor and output presented in Table 18-1. The
number of workers is on the horizontal axis, and the amount of output is on the
vertical axis. This figure illustrates the production function.

One of the Ten Principles of Economics introduced in Chapter 1 is that rational
people think at the margin. This idea is the key to understanding how firms decide
what quantity of labor to hire. To take a step toward this decision, the third column
in Table 18-1 gives the marginal product of labor, the increase in the amount of
output from an additional unit of labor. When the firm increases the number of
workers from 1 to 2, for example, the amount of apples produced rises from 100 to
180 bushels. Therefore, the marginal product of the second worker is 80 bushels.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 401

Quantity Production Figure 18-2
of Apples function
THE PRODUCTION FUNCTION.
300 The production function is the
280 relationship between the inputs
240 into production (apple pickers)
and the output from production
180 (apples). As the quantity of the
input increases, the production
100 function gets flatter, reflecting the
property of diminishing marginal
product.

0 12 345 Quantity of

Apple Pickers

Notice that as the number of workers increases, the marginal product of labor diminishing marginal
declines. As you may recall from Chapter 13, this property is called diminishing
marginal product. At first, when only a few workers are hired, they pick apples product
from the best trees in the orchard. As the number of workers increases, additional the property whereby the marginal
workers have to pick from the trees with fewer apples. Hence, as more and more product of an input declines as the
workers are hired, each additional worker contributes less to the production of quantity of the input increases
apples. For this reason, the production function in Figure 18-2 becomes flatter as
the number of workers rises.

THE VALUE OF THE MARGINAL PRODUCT
AND THE DEMAND FOR LABOR

Our profit-maximizing firm is concerned more with money than with apples. As a value of the marginal
result, when deciding how many workers to hire, the firm considers how much product
profit each worker would bring in. Because profit is total revenue minus total cost, the marginal product of an input
the profit from an additional worker is the worker’s contribution to revenue minus times the price of the output
the worker’s wage.

To find the worker’s contribution to revenue, we must convert the marginal
product of labor (which is measured in bushels of apples) into the value of the mar-
ginal product (which is measured in dollars). We do this using the price of apples.
To continue our example, if a bushel of apples sells for $10 and if an additional
worker produces 80 bushels of apples, then the worker produces $800 of revenue.

The value of the marginal product of any input is the marginal product of
that input multiplied by the market price of the output. The fourth column in Ta-
ble 18-1 shows the value of the marginal product of labor in our example, assum-
ing the price of apples is $10 per bushel. Because the market price is constant for a
competitive firm, the value of the marginal product (like the marginal product it-
self) diminishes as the number of workers rises.

402 PART SIX THE ECONOMICS OF LABOR MARKETS

Figure 18-3 Value Value of marginal product
of the (demand curve for labor)
THE VALUE OF THE MARGINAL Marginal
PRODUCT OF LABOR. This figure Product
shows how the value of the
marginal product (the marginal Market
product times the price of the wage
output) depends on the number
of workers. The curve slopes 0
downward because of
diminishing marginal product.
For a competitive, profit-
maximizing firm, this value-of-
marginal-product curve is also
the firm’s labor demand curve.

Profit-maximizing quantity Quantity of
Apple Pickers

Now consider how many workers the firm will hire. Suppose that the market
wage for apple pickers is $500 per week. In this case, the first worker that the firm
hires is profitable: The first worker yields $1,000 in revenue, or $500 in profit. Sim-
ilarly, the second worker yields $800 in additional revenue, or $300 in profit. The
third worker produces $600 in additional revenue, or $100 in profit. After the third
worker, however, hiring workers is unprofitable. The fourth worker would yield
only $400 of additional revenue. Because the worker’s wage is $500, hiring the
fourth worker would mean a $100 reduction in profit. Thus, the firm hires only
three workers.

It is instructive to consider the firm’s decision graphically. Figure 18-3 graphs
the value of the marginal product. This curve slopes downward because the mar-
ginal product of labor diminishes as the number of workers rises. The figure also
includes a horizontal line at the market wage. To maximize profit, the firm hires
workers up to the point where these two curves cross. Below this level of employ-
ment, the value of the marginal product exceeds the wage, so hiring another
worker would increase profit. Above this level of employment, the value of the
marginal product is less than the wage, so the marginal worker is unprofitable.
Thus, a competitive, profit-maximizing firm hires workers up to the point where the value
of the marginal product of labor equals the wage.

Having explained the profit-maximizing hiring strategy for a competitive
firm, we can now offer a theory of labor demand. Recall that a firm’s labor demand
curve tells us the quantity of labor that a firm demands at any given wage. We
have just seen in Figure 18-3 that the firm makes that decision by choosing the
quantity of labor at which the value of the marginal product equals the wage. As a
result, the value-of-marginal-product curve is the labor demand curve for a competitive,
profit-maximizing firm.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 403

FYI

Input Demand In Chapter 14 we saw how worker adds less to the production of apples (MPL falls).
Similarly, when the apple firm is producing a large quantity
and Output a competitive, profit-maximizing of apples, the orchard is already crowded with workers, so it
is more costly to produce an additional bushel of apples
Supply: Two firm decides how much of its (MC rises).
Sides of the output to sell: It chooses the
Same Coin quantity of output at which the Now consider our criterion for profit maximization. We
price of the good equals the determined earlier that a profit-maximizing firm chooses the
quantity of labor so that the value of the marginal product
marginal cost of production. We (P ϫ MPL) equals the wage (W). We can write this mathe-
matically as
have just seen how such a firm
P ϫ MPL ϭ W.
decides how much labor to
If we divide both sides of this equation by MPL, we obtain
hire: It chooses the quantity of
P ϭ W/MPL.
labor at which the wage equals
We just noted that W/MPL equals marginal cost MC. There-
the value of the marginal prod- fore, we can substitute to obtain

uct. Because the production P ϭ MC.

function links the quantity of inputs to the quantity of output, This equation states that the price of the firm’s output is
equal to the marginal cost of producing a unit of output.
you should not be surprised to learn that the firm’s decision Thus, when a competitive firm hires labor up to the point at
which the value of the marginal product equals the wage, it
about input demand is closely linked to its decision about also produces up to the point at which the price equals mar-
ginal cost. Our analysis of labor demand in this chapter is
output supply. In fact, these two decisions are two sides of just another way of looking at the production decision we
first saw in Chapter 14.
the same coin.

To see this relationship more fully, let’s consider how

the marginal product of labor (MPL) and marginal cost (MC)

are related. Suppose an additional worker costs $500 and

has a marginal product of 50 bushels of apples. In this

case, producing 50 more bushels costs $500; the marginal

cost of a bushel is $500/50, or $10. More generally, if W

is the wage, and an extra unit of labor produces MPL units

of output, then the marginal cost of a unit of output is

MC ϭ W/MPL.

This analysis shows that diminishing marginal product

is closely related to increasing marginal cost. When our ap-

ple orchard grows crowded with workers, each additional

WHAT CAUSES THE LABOR DEMAND CURVE TO SHIFT?

We now understand the labor demand curve: It is nothing more than a reflection
of the value of marginal product of labor. With this insight in mind, let’s consider
a few of the things that might cause the labor demand curve to shift.

T h e O u t p u t P r i c e The value of the marginal product is marginal product
times the price of the firm’s output. Thus, when the output price changes, the
value of the marginal product changes, and the labor demand curve shifts. An in-
crease in the price of apples, for instance, raises the value of the marginal product
of each worker that picks apples and, therefore, increases labor demand from the
firms that supply apples. Conversely, a decrease in the price of apples reduces the
value of the marginal product and decreases labor demand.

Te c h n o l o g i c a l C h a n g e Between 1968 and 1998, the amount of output
a typical U.S. worker produced in an hour rose by 57 percent. Why? The most

404 PART SIX THE ECONOMICS OF LABOR MARKETS

important reason is technological progress: Scientists and engineers are constantly
figuring out new and better ways of doing things. This has profound implications
for the labor market. Technological advance raises the marginal product of labor,
which in turn increases the demand for labor. Such technological advance explains
persistently rising employment in face of rising wages: Even though wages (ad-
justed for inflation) increased by 62 percent over these three decades, firms
nonetheless increased by 72 percent the number of workers they employed.

T h e S u p p l y o f O t h e r F a c t o r s The quantity available of one factor of
production can affect the marginal product of other factors. A fall in the supply of
ladders, for instance, will reduce the marginal product of apple pickers and thus
the demand for apple pickers. We consider this linkage among the factors of pro-
duction more fully later in the chapter.

Q U I C K Q U I Z : Define marginal product of labor and value of the marginal
product of labor. N Describe how a competitive, profit-maximizing firm
decides how many workers to hire.

THE SUPPLY OF LABOR

Having analyzed labor demand in detail, let’s turn to the other side of the market
and consider labor supply. A formal model of labor supply is included in Chapter
21, where we develop the theory of household decisionmaking. Here we discuss
briefly and informally the decisions that lie behind the labor supply curve.

THE TRADEOFF BETWEEN WORK AND LEISURE

One of the Ten Principles of Economics in Chapter 1 is that people face tradeoffs.
Probably no tradeoff is more obvious or more important in a person’s life than the
tradeoff between work and leisure. The more hours you spend working, the fewer
hours you have to watch TV, have dinner with friends, or pursue your favorite
hobby. The tradeoff between labor and leisure lies behind the labor supply curve.

Another one of the Ten Principles of Economics is that the cost of something is
what you give up to get it. What do you give up to get an hour of leisure? You give
up an hour of work, which in turn means an hour of wages. Thus, if your wage is
$15 per hour, the opportunity cost of an hour of leisure is $15. And when you get a
raise to $20 per hour, the opportunity cost of enjoying leisure goes up.

The labor supply curve reflects how workers’ decisions about the labor–leisure
tradeoff respond to a change in that opportunity cost. An upward-sloping labor
supply curve means that an increase in the wage induces workers to increase the
quantity of labor they supply. Because time is limited, more hours of work means
that workers are enjoying less leisure. That is, workers respond to the increase in
the opportunity cost of leisure by taking less of it.

It is worth noting that the labor supply curve need not be upward sloping.
Imagine you got that raise from $15 to $20 per hour. The opportunity cost of

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 405

leisure is now greater, but you are also richer than you were before. You might
decide that with your extra wealth you can now afford to enjoy more leisure;
in this case, your labor supply curve would slope backwards. In Chapter 21, we
discuss this possibility in terms of conflicting effects on your labor-supply deci-
sion (called income and substitution effects). For now, we ignore the possibility of
backward-sloping labor supply and assume that the labor supply curve is upward
sloping.

WHAT CAUSES THE LABOR SUPPLY CURVE TO SHIFT?

The labor supply curve shifts whenever people change the amount they want to
work at a given wage. Let’s now consider some of the events that might cause such
a shift.

C h a n g e s i n Ta s t e s In 1950, 34 percent of women were employed at paid
jobs or looking for work. In 1998, the number had risen to 60 percent. There are, of
course, many explanations for this development, but one of them is changing
tastes, or attitudes toward work. A generation or two ago, it was the norm for
women to stay at home while raising children. Today, family sizes are smaller, and
more mothers choose to work. The result is an increase in the supply of labor.

C h a n g e s i n A l t e r n a t i v e O p p o r t u n i t i e s The supply of labor in any
one labor market depends on the opportunities available in other labor markets. If
the wage earned by pear pickers suddenly rises, some apple pickers may choose to
switch occupations. The supply of labor in the market for apple pickers falls.

I m m i g r a t i o n Movements of workers from region to region, or country to
country, is an obvious and often important source of shifts in labor supply. When
immigrants come to the United States, for instance, the supply of labor in the
United States increases and the supply of labor in the immigrants’ home countries
contracts. In fact, much of the policy debate about immigration centers on its effect
on labor supply and, thereby, equilibrium in the labor market.

Q U I C K Q U I Z : Who has a greater opportunity cost of enjoying leisure—a
janitor or a brain surgeon? Explain. Can this help explain why doctors work
such long hours?

EQUILIBRIUM IN THE LABOR MARKET

So far we have established two facts about how wages are determined in compet-
itive labor markets:
N The wage adjusts to balance the supply and demand for labor.
N The wage equals the value of the marginal product of labor.

406 PART SIX THE ECONOMICS OF LABOR MARKETS

Figure 18-4 Wage Supply
(price of
EQUILIBRIUM IN A LABOR Demand
MARKET. Like all prices, the labor) Quantity of
price of labor (the wage) depends Labor
on supply and demand. Because Equilibrium
the demand curve reflects the wage, W
value of the marginal product of
labor, in equilibrium workers
receive the value of their
marginal contribution to the
production of goods and services.

0 Equilibrium
employment, L

At first, it might seem surprising that the wage can do both these things at once. In
fact, there is no real puzzle here, but understanding why there is no puzzle is an
important step to understanding wage determination.

Figure 18-4 shows the labor market in equilibrium. The wage and the quantity
of labor have adjusted to balance supply and demand. When the market is in this
equilibrium, each firm has bought as much labor as it finds profitable at the equi-
librium wage. That is, each firm has followed the rule for profit maximization: It
has hired workers until the value of the marginal product equals the wage. Hence,
the wage must equal the value of marginal product of labor once it has brought
supply and demand into equilibrium.

This brings us to an important lesson: Any event that changes the supply or de-
mand for labor must change the equilibrium wage and the value of the marginal product by
the same amount, because these must always be equal. To see how this works, let’s con-
sider some events that shift these curves.

SHIFTS IN LABOR SUPPLY

Suppose that immigration increases the number of workers willing to pick apples.
As Figure 18-5 shows, the supply of labor shifts to the right from S1 to S2. At the
initial wage W1, the quantity of labor supplied now exceeds the quantity de-
manded. This surplus of labor puts downward pressure on the wage of apple pick-
ers, and the fall in the wage from W1 to W2 in turn makes it profitable for firms to
hire more workers. As the number of workers employed in each apple orchard
rises, the marginal product of a worker falls, and so does the value of the marginal
product. In the new equilibrium, both the wage and the value of the marginal
product of labor are lower than they were before the influx of new workers.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 407

Wage Supply, S1 1. An increase in Figure 18-5
(price of labor supply . . .
A SHIFT IN LABOR SUPPLY.
labor) S2 When labor supply increases
from S1 to S2, perhaps because of
W1 Demand an immigration of new workers,
W2 the equilibrium wage falls from
2. . . . reduces W1 to W2. At this lower wage,
the wage . . . firms hire more labor, so
employment rises from L1 to L2.
0 The change in the wage reflects a
change in the value of the
marginal product of labor: With
more workers, the added output
from an extra worker is smaller.

L1 L2 Quantity of

Labor

3. . . . and raises employment.

An episode from Israel illustrates how a shift in labor supply can alter the
equilibrium in a labor market. During most of the 1980s, many thousands of Pale-
stinians regularly commuted from their homes in the Israeli-occupied West Bank
and Gaza Strip to jobs in Israel, primarily in the construction and agriculture
industries. In 1988, however, political unrest in these occupied areas induced the
Israeli government to take steps that, as a by-product, reduced this supply of
workers. Curfews were imposed, work permits were checked more thoroughly,
and a ban on overnight stays of Palestinians in Israel was enforced more rigor-
ously. The economic impact of these steps was exactly as theory predicts: The
number of Palestinians with jobs in Israel fell by half, while those who continued
to work in Israel enjoyed wage increases of about 50 percent. With a reduced num-
ber of Palestinian workers in Israel, the value of the marginal product of the re-
maining workers was much higher.

SHIFTS IN LABOR DEMAND

Now suppose that an increase in the popularity of apples causes their price to rise.
This price increase does not change the marginal product of labor for any given
number of workers, but it does raise the value of the marginal product. With a
higher price of apples, hiring more apple pickers is now profitable. As Figure 18-6
shows, when the demand for labor shifts to the right from D1 to D2, the equilib-
rium wage rises from W1 to W2, and equilibrium employment rises from L1 to L2.
Once again, the wage and the value of the marginal product of labor move
together.

This analysis shows that prosperity for firms in an industry is often linked
to prosperity for workers in that industry. When the price of apples rises, apple

408 PART SIX THE ECONOMICS OF LABOR MARKETS

Figure 18-6 Wage Supply
(price of
A SHIFT IN LABOR DEMAND. 1. An increase in
When labor demand increases labor) labor demand . . .
from D1 to D2, perhaps because of
an increase in the price of the W2 D2
firms’ output, the equilibrium
wage rises from W1 to W2, and W1
employment rises from L1 to L2. 2. . . . increases
Again, the change in the wage the wage . . .
reflects a change in the value of
the marginal product of labor: 0
With a higher output price, the
added output from an extra
worker is more valuable.

Demand, D1

L1 L2 Quantity of

Labor

3. . . . and increases employment.

producers make greater profit, and apple pickers earn higher wages. When the
price of apples falls, apple producers earn smaller profit, and apple pickers earn
lower wages. This lesson is well known to workers in industries with highly
volatile prices. Workers in oil fields, for instance, know from experience that their
earnings are closely linked to the world price of crude oil.

From these examples, you should now have a good understanding of how
wages are set in competitive labor markets. Labor supply and labor demand to-
gether determine the equilibrium wage, and shifts in the supply or demand curve
for labor cause the equilibrium wage to change. At the same time, profit maxi-
mization by the firms that demand labor ensures that the equilibrium wage always
equals the value of the marginal product of labor.

C A S E S T U D Y PRODUCTIVITY AND WAGES

One of the Ten Principles of Economics in Chapter 1 is that our standard of living
depends on our ability to produce goods and services. We can now see how this
principle works in the market for labor. In particular, our analysis of labor de-
mand shows that wages equal productivity as measured by the value of the
marginal product of labor. Put simply, highly productive workers are highly
paid, and less productive workers are less highly paid.

This lesson is key to understanding why workers today are better off than
workers in previous generations. Table 18-2 presents some data on growth in
productivity and growth in wages (adjusted for inflation). From 1959 to 1997,
productivity as measured by output per hour of work grew about 1.8 percent
per year; at this rate, productivity doubles about every 40 years. Over this pe-
riod, wages grew at a similar rate of 1.7 percent per year.

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 409

TIME PERIOD GROWTH RATE GROWTH RATE Table 18-2
OF PRODUCTIVITY OF REAL WAGES
1959–1997 PRODUCTIVITY AND WAGE
1.8 1.7 GROWTH IN THE UNITED STATES
1959–1973
1973–1997 2.9 2.9
1.1 1.0

SOURCE: Economic Report of the President 1999, table B-49, p. 384. Growth in productivity is measured here
as the annualized rate of change in output per hour in the nonfarm business sector. Growth in real
wages is measured as the annualized change in compensation per hour in the nonfarm business sector
divided by the implicit price deflator for that sector. These productivity data measure average
productivity—the quantity of output divided by the quantity of labor—rather than marginal
productivity, but average and marginal productivity are thought to move closely together.

Table 18-2 also shows that, beginning around 1973, growth in productivity
slowed from 2.9 to 1.1 percent per year. This 1.8 percentage-point slowdown in
productivity coincided with a slowdown in wage growth of 1.9 percentage
points. Because of this productivity slowdown, workers in the 1980s and 1990s
did not experience the same rapid growth in living standards that their parents
enjoyed. A slowdown of 1.8 percentage points might not seem large, but accu-
mulated over many years, even a small change in a growth rate is significant. If
productivity and wages had grown at the same rate since 1973 as they did pre-
viously, workers’ earnings would now be about 50 percent higher than they are.

The link between productivity and wages also sheds light on international
experience. Table 18-3 presents some data on productivity growth and wage
growth for a representative group of countries, ranked in order of their produc-
tivity growth. Although these international data are far from precise, a close link
between the two variables is apparent. In South Korea, Hong Kong, and Singa-
pore, productivity has grown rapidly, and so have wages. In Mexico, Argentina,
and Iran, productivity has fallen, and so have wages. The United States falls
about in the middle of the distribution: By international standards, U.S. pro-
ductivity growth and wage growth have been neither exceptionally bad nor ex-
ceptionally good.

What causes productivity and wages to vary so much over time and across
countries? A complete answer to this question requires an analysis of long-run
economic growth, a topic beyond the scope of this chapter. We can, however,
briefly note three key determinants of productivity:

N Physical capital: When workers work with a larger quantity of equipment
and structures, they produce more.

N Human capital: When workers are more educated, they produce more.

N Technological knowledge: When workers have access to more sophisticated
technologies, they produce more.

Physical capital, human capital, and technological knowledge are the ulti-
mate sources of most of the differences in productivity, wages, and standards of
living.

410 PART SIX THE ECONOMICS OF LABOR MARKETS

Table 18-3 COUNTRY GROWTH RATE GROWTH RATE
OF PRODUCTIVITY OF REAL WAGES
PRODUCTIVITY AND WAGE South Korea
GROWTH AROUND THE WORLD Hong Kong 8.5 7.9
Singapore 5.5 4.9
Indonesia 5.3 5.0
Japan 4.0 4.4
India 3.6 2.0
United Kingdom 3.1 3.4
United States 2.4 2.4
Brazil 1.7 0.5
Mexico 0.4 Ϫ2.4
Argentina Ϫ0.2 Ϫ3.0
Iran Ϫ0.9 Ϫ1.3
Ϫ1.4 Ϫ7.9

SOURCE: World Development Report 1994, table 1, pp. 162–163, and table 7, pp. 174–175. Growth in
productivity is measured here as the annualized rate of change in gross national product per person
from 1980 to 1992. Growth in wages is measured as the annualized change in earnings per employee in
manufacturing from 1980 to 1991.

Q U I C K Q U I Z : How does an immigration of workers affect labor supply,
labor demand, the marginal product of labor, and the equilibrium wage?

THE OTHER FACTORS OF PRODUCTION:
LAND AND CAPITAL

capital We have seen how firms decide how much labor to hire and how these decisions
the equipment and structures used to determine workers’ wages. At the same time that firms are hiring workers, they
produce goods and services are also deciding about other inputs to production. For example, our apple-
producing firm might have to choose the size of its apple orchard and the number
of ladders to make available to its apple pickers. We can think of the firm’s factors
of production as falling into three categories: labor, land, and capital.

The meaning of the terms labor and land is clear, but the definition of capital is
somewhat tricky. Economists use the term capital to refer to the stock of equip-
ment and structures used for production. That is, the economy’s capital represents
the accumulation of goods produced in the past that are being used in the present
to produce new goods and services. For our apple firm, the capital stock includes
the ladders used to climb the trees, the trucks used to transport the apples, the
buildings used to store the apples, and even the trees themselves.

EQUILIBRIUM IN THE MARKETS FOR LAND AND CAPITAL

What determines how much the owners of land and capital earn for their con-
tribution to the production process? Before answering this question, we need to

CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 411

Rental (a) The Market for Land Rental (b) The Market for Capital
Price of Supply Price of Supply
Capital
Land

PP

Demand Demand

0 Q Quantity of 0 Q Quantity of
Capital
Land
Figure 18-7
THE MARKETS FOR LAND AND CAPITAL. Supply and demand determine the
compensation paid to the owners of land, as shown in panel (a), and the compensation
paid to the owners of capital, as shown in panel (b). The demand for each factor, in turn,
depends on the value of the marginal product of that factor.

distinguish between two prices: the purchase price and the rental price. The pur-
chase price of land or capital is the price a person pays to own that factor of pro-
duction indefinitely. The rental price is the price a person pays to use that factor for
a limited period of time. It is important to keep this distinction in mind because, as
we will see, these prices are determined by somewhat different economic forces.

Having defined these terms, we can now apply the theory of factor demand
we developed for the labor market to the markets for land and capital. The wage
is, after all, simply the rental price of labor. Therefore, much of what we have
learned about wage determination applies also to the rental prices of land and cap-
ital. As Figure 18-7 illustrates, the rental price of land, shown in panel (a), and the
rental price of capital, shown in panel (b), are determined by supply and demand.
Moreover, the demand for land and capital is determined just like the demand for
labor. That is, when our apple-producing firm is deciding how much land and
how many ladders to rent, it follows the same logic as when deciding how many
workers to hire. For both land and capital, the firm increases the quantity hired un-
til the value of the factor’s marginal product equals the factor’s price. Thus, the de-
mand curve for each factor reflects the marginal productivity of that factor.

We can now explain how much income goes to labor, how much goes to
landowners, and how much goes to the owners of capital. As long as the firms
using the factors of production are competitive and profit-maximizing, each fac-
tor’s rental price must equal the value of the marginal product for that factor.
Labor, land, and capital each earn the value of their marginal contribution to the produc-
tion process.

Now consider the purchase price of land and capital. The rental price and the
purchase price are obviously related: Buyers are willing to pay more to buy a piece
of land or capital if it produces a valuable stream of rental income. And, as we

412 PART SIX THE ECONOMICS OF LABOR MARKETS

FYI Labor income is an easy con- est on your bank account, that income is part of the econ-
omy’s capital income.
What Is cept to understand: It is the
Capital Income? paycheck that workers get from In addition, some of the earnings from capital are paid
their employers. The income to households in the form of dividends. Dividends are pay-
ments by a firm to the firm’s stockholders. A stockholder is
earned by capital, however, is a person who has bought a share in the ownership of the
firm and, therefore, is entitled to share in the firm’s profits.
less obvious.
A firm does not have to pay out all of its earnings to
In our analysis, we have households in the form of interest and dividends. Instead, it
can retain some earnings within the firm and use these
been implicitly assuming that earnings to buy additional capital. Although these retained
earnings do not get paid to the firm’s stockholders, the
households own the economy’s stockholders benefit from them nonetheless. Because re-
tained earnings increase the amount of capital the firm
stock of capital—ladders, drill owns, they tend to increase future earnings and, thereby,
the value of the firm’s stock.
presses, warehouses, etc.—
These institutional details are interesting and impor-
and rent it to the firms that use tant, but they do not alter our conclusion about the income
earned by the owners of capital. Capital is paid according to
it. Capital income, in this case, the value of its marginal product, regardless of whether this
income gets transmitted to households in the form of inter-
is the rent that households receive for the use of their capi- est or dividends or whether it is kept within firms as re-
tained earnings.
tal. This assumption simplified our analysis of how capital

owners are compensated, but it is not entirely realistic. In

fact, firms usually own the capital they use and, therefore,

they receive the earnings from this capital.

These earnings from capital, however, eventually get

paid to households. Some of the earnings are paid in the

form of interest to those households who have lent money

to firms. Bondholders and bank depositors are two exam-

ples of recipients of interest. Thus, when you receive inter-

have just seen, the equilibrium rental income at any point in time equals the value
of that factor’s marginal product. Therefore, the equilibrium purchase price of a
piece of land or capital depends on both the current value of the marginal product
and the value of the marginal product expected to prevail in the future.

LINKAGES AMONG THE FACTORS OF PRODUCTION

We have seen that the price paid to any factor of production—labor, land, or capi-
tal—equals the value of the marginal product of that factor. The marginal product
of any factor, in turn, depends on the quantity of that factor that is available. Be-
cause of diminishing returns, a factor in abundant supply has a low marginal
product and thus a low price, and a factor in scarce supply has a high marginal
product and a high price. As a result, when the supply of a factor falls, its equilib-
rium factor price rises.

When the supply of any factor changes, however, the effects are not limited to
the market for that factor. In most situations, factors of production are used to-
gether in a way that makes the productivity of each factor dependent on the quan-
tities of the other factors available to be used in the production process. As a result,
a change in the supply of any one factor alters the earnings of all the factors.

For example, suppose that a hurricane destroys many of the ladders that
workers use to pick apples from the orchards. What happens to the earnings of the
various factors of production? Most obviously, the supply of ladders falls and,