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For most of the twentieth century, a cup of coffee tasted about the same whether you ordered it at a restaurant or diner or brewed it at home using ground coffee out of a can. And the leading brands, such as Folgers, Maxwell House, and Hills Brothers, tasted about the same. Standard restaurant or home-brewed coffee is often called “first wave coffee.” Beginning in the 1980s, the popularity of Starbucks and competing coffeehouse chains, including Peet’s and Caribou Coffee, shook up the coffee market. Starbucks and its competitors offered a variety of coffees made from freshly roasted coffee beans and often added various flavors. Coffee served in coffeehouses is often called “second wave coffee.” In 1995, Emily Mange and Doug Zell helped launch “third wave coffee” when they opened Intelligentsia, a small chain of coffeehouses based in Chicago. Third wave coffee is usually directly sourced, which means that these coffeehouses buy coffee beans directly from coffee growers rather than from wholesalers. Intelligentsia explains, “Our commitment to direct trade allows us to cut out unneces-sary importers and exporters, and enables us to truly part-ner with our growers.” Direct trade provides a means for third wave coffeehouses to differentiate themselves from second wave chains such as Starbucks. Alyza Bohbot, who owns City Girl Coffee, headquartered in Duluth, Minne-sota, sources only from farms owned by women in the developing world. She argues that direct trade is particu-larly appealing to millennials: “As a group they’re much more conscientious about what they’re purchasing and from whom.” The owners of third wave coffeehouses argue that they make better-tasting coffee because they personally select the coffee beans and make sure the beans are roasted and served within a brief time after being harvested. Industry analysts refer to third wave coffeehouses as selling artisanal coffee. Generally these coffeehouses charge higher prices than do Starbucks and other larger chains. In Chapter 9, we saw that perfectly competitive mar-kets share three key characteristics: 1. There are many firms. 2. All firms sell identical products. 3. There are no barriers to new firms entering the industry. Intelligentsia and City Girl Coffee compete in a market that shares two of these characteristics: There are many cof-feehouses, and the barriers to entering the market are very low. But the products that coffeehouses sell are differenti-ated rather than identical. So, the market is monopolistically competitive rather than perfectly competitive. Some markets are even further removed from perfect competition because in these markets only a few firms com-pete. For example, the discount department store market is dominated by just a few firms, including Walmart and Target. An industry with only a few firms is an oligopoly. In an oligopoly, a firm’s profitability depends crucially on its interactions with other firms

Many markets in the U.S. economy are similar to the coffeehouse market: There are many buyers and sellers, and the barriers to entry are low, but the goods and services offered for sale are differentiated rather than identical. Examples of these markets include pizza restaurants, movie theaters, super-markets, and furniture stores. In fact, the majority of the firms you buy from are competing in monopolistically competitive markets. We have seen how perfect competition benefits consumers and results in economic efficiency. Will these same desirable outcomes also hold for monopolistically competitive markets? This question is important because monopolistically competitive markets are so common. In this chapter, we will also study oligopoly, a market structure in which a small num-ber of interdependent firms compete. The approach we use to analyze competition among oligopolists is called game theory. Game theory can be used to analyze any situation in which groups or individuals interact. In the context of economic analysis, game theory is the study of the decisions of firms in industries where the profits of each firm depend on its interac-tions with other firms. It has been applied to strategies for nuclear war, for international trade negotiations, and for political campaigns, among many other examples. In this chapter, we focus on how game theory can be used to analyze the business strategies of large firms.

Blue Bottle Coffee is a third wave coffeehouse chain that James Freeman started in 2002 in Oakland, California. In 2017, Nestlé, the Swiss food company, purchased Blue Bottle, and by 2019, the chain had opened coffeehouses in several other U.S. cities and in Japan. Suppose that a Blue Bottle coffeehouse is located a mile from where you live. One day, the manager decides to

raise the price of a cup of cappuccino from $3.50 to $4.00. As a result, some Blue Bottle customers will switch to buying cappuccinos at other coffeehouses, such as Starbucks. But other customers will be willing to pay the higher price for a variety of reasons: This coffeehouse may be closer to them, or they may prefer Blue Bottle’s cappuc-cinos to similar coffee at competing coffeehouses. So, a Blue Bottle coffee house will face a downward-sloping demand curve, unlike a wheat farmer, who will sell no wheat if he raises his price and who, therefore, faces a horizontal demand curve. The Demand Curve for a Monopolistically Competitive Firm ● Figure 11.1 shows how a change in price affects the quantity of cappuccinos a Blue Bottle coffeehouse sells. The increase in the price from $3.50 to $4.00 decreases the quantity of cappuccinos consumers demand from 3,000 per week to 2,400 per week. Marginal Revenue for a Firm with a Downward-Sloping Demand Curve ● For a firm in a perfectly competitive market, the demand curve and the marginal rev-enue curve are the same (see Chapter 9, Section 9.2). A perfectly competitive firm faces a horizontal demand curve and does not have to cut the price to sell a larger quantity. A monopolistically competitive firm, however, must cut the price to sell more, so its marginal revenue curve will slope downward and will be below its demand curve. ● The data in Table 11.1 illustrate this point. To keep the numbers simple, let’s assume that your local Blue Bottle coffeehouse is very small and sells at most 10 cappuccinos per week. If this Blue Bottle charges a price of $6.00 or more, all of its potential customers will buy their cappuccinos somewhere else. If it charges $5.50, it will sell 1 cappuccino per week. For each additional $0.50 this Blue Bottle reduces the price, it increases the number of cappuccinos it sells by 1. The third column in the table shows how the firm’s total revenue changes as it sells more cappuccinos. The fourth column shows the firm’s revenue per unit, or its average revenue. Average revenue is equal to total revenue divided by quantity. Because total revenue equals price multiplied by quantity, dividing by quantity leaves just price. Therefore, average revenue is always equal to price. This result will be true for firms selling in any of the four market structures we described at the beginning of Chapter 9. ● The last column in Table 11.1 shows the firm’s marginal revenue, or the change in total revenue as the firm sells 1 more cappuccino. For a perfectly competitive firm, the additional revenue received from selling 1 more unit is just equal to the price. That will not be true for this Blue Bottle coffeehouse because to sell another cappuccino, it has to reduce the price. When the firm cuts the price by $0.50, one good thing happens, and one bad thing happens: ○ • The good thing: It sells 1 more cappuccino; we can call this the output effect. ○ • The bad thing: It receives $0.50 less for each cappuccino that it could have sold at the higher price; we can call this the price effect. ● Figure 11.2 illustrates what happens when the firm cuts the price from $3.50 to $3.00. Selling the sixth cappuccino adds the $3.00 price to the firm’s revenue; this is the output effect. But this Blue Bottle coffeehouse now receives a price of $3.00, rather than $3.50 on the first 5 cappuccinos sold; this is the price effect. As a result of the price effect, the firm’s revenue on these 5 cappuccinos is $2.50 less than it would have been if the price had remained at $3.50. So, the firm has gained $3.00 in revenue on the sixth cappuccino and lost $2.50 in revenue on the first 5 cappuccinos, for a net change in revenue of $0.50. Marginal revenue is the change in total revenue from selling 1 more unit. Therefore, the marginal revenue of the sixth cappuccino is $0.50. Notice that the marginal revenue of the sixth cappuccino is far below its price of $3.00. In fact, for each additional cappuccino that this Blue Bottle coffeehouse sells, marginal revenue will be less than price. There is an important general point: Every firm that has the ability to affect the price of the good or service it sells will have a marginal revenue curve that is below its demand curve. Only firms in perfectly competitive markets, which can sell as many units as they want at the market price, have marginal revenue curves that are the same as their demand curves. Figure 11.3 plots the data from Table 11.1 and shows the relationship between the demand curve and the marginal revenue curve for your local Blue Bottle. Notice that after the sixth cappuccino, marginal revenue becomes negative because the additional revenue received from selling 1 more cappuccino is less than the rev-enue lost from receiving a lower price on the cappuccinos that could have been sold at the original price

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If a Blue Bottle coffeehouse increases the price of its cappuccinos, it will lose some, but not all, of its customers. In this case, raising the price from $3.50 to $4.00 reduces the quantity of cappuccinos con-sumers demand from 3,000 per week to 2,400. Therefore, unlike a perfect com-petitor, a Blue Bottle coffeehouse faces a downward-sloping demand curve

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If a local Blue Bottle coffeehouse reduces the price of a cappuccino from $3.50 to $3.00, the number of cappuccinos con-sumers demand per week will increase from 5 to 6. The coffeehouse’s marginal revenue from selling the sixth cappuc-cino will be $0.50, which is equal to the $3.00 additional revenue from selling 1 more cappuccino (the area of the green rectangle) minus the $2.50 loss in rev-enue from selling the first 5 cappuccinos for $0.50 less each (the area of the red rectangle)

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On the truncated graph, the X axis represents quantity in cappuccinos per week, and the Y axis represents price in dollars per cup. The demand line falls through points (5, 3.50), and (6, 3.00). The area between (0, 3.00), (0, 3.50), (5, 3.50), and (5, 3.00) is shaded red, and represents the loss of revenue from price cut = $0.50 times 5 cappuccinos = $2.50. The area between (5, 0), (5, 3.00), (6, 3.00), and (6, 0) is shaded green, and represents the gain in revenue from price cut = $3.00 times 1 cappuccino = $3.00.

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On the truncated graph, the X axis represents quantity in cappuccinos per week, and the Y axis represents price in dollars per cup. The demand line falls through points (5, 3.50), and (6, 3.00). The area between (0, 3.00), (0, 3.50), (5, 3.50), and (5, 3.00) is shaded red, and represents the loss of revenue from price cut = $0.50 times 5 cappuccinos = $2.50. The area between (5, 0), (5, 3.00), (6, 3.00), and (6, 0) is shaded green, and represents the gain in revenue from price cut = $3.00 times 1 cappuccino = $3.00.

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Any firm that has the ability to affect the price of the product it sells will have a marginal revenue curve that is below its demand curve. We plot the data from Table 11.1 to create the demand and marginal revenue curves for a Blue Bottle coffeehouse. After the sixth cap-puccino, marginal revenue becomes negative because the additional revenue received from selling 1 more cappuccino is less than the revenue lost from receiv-ing a lower price on the cappuccinos that could have been sold at the original price

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The X axis represents quantity in cappuccinos per week, and the Y axis represents price in dollars per cup. Demand line falls from (0, 6.00) to (10, 1.00). The Marginal revenue line falls from (1, 5.50), well beyond the X axis at 6.5.

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All firms use the same approach to maximize profit: They produce the quantity where marginal revenue is equal to marginal cost. So the local Blue Bottle will maximize profit by selling the quantity of cappuccinos for which the last one sold adds the same amount to the firm’s revenue as to its costs. (We want to keep this example simple in order to focus on the main points, so we are ignoring the other food and drinks, apart from cap-puccinos, that this Blue Bottle sells.) Let’s look more carefully at how monopolistically competitive firms maximize profit by considering the situation your local Blue Bottle faces in the short run. Recall that in the short run, at least one factor of production is fixed, and there is not enough time for new firms to enter the market (see Chapter 8, Section 8.2). A coffeehouse has many costs, including the cost of purchasing coffee beans and the ingredients for its other menu items, the electricity it uses, and the wages of its employees. Recall that a firm’s marginal cost is the increase in total cost resulting from producing one more unit of output. We have seen that for many firms, the marginal cost curve has a U shape, so we will assume that is true for this Blue Bottle. We combine the revenue data from Table 11.1 with cost data to create the table in Figure 11.4 and plot the data from the table in the two graphs. In panel (a), we see how this Blue Bottle can determine its profit-maximizing quantity and price. As long as the marginal cost of selling 1 more cappuccino is less than the marginal revenue, the firm should make and sell additional cappuccinos. For example, increasing the quantity of cappuccinos sold from 3 per week to 4 per week increases cost by $1.00 but increases revenue by $2.50. So, this Blue Bottle coffeehouse’s profit is increased by $1.50 as a result of selling the fourth cappuccino As this coffeehouse sells more cappuccinos, rising marginal cost eventually equals marginal revenue, and the firm sells the profit-maximizing quantity of cappuccinos. Marginal cost equals marginal revenue with the fifth cappuccino, which adds $1.50 to the firm’s costs and $1.50 to its revenues—point A in panel (a) of Figure 11.4. The demand curve tells us the price at which the firm is able to sell 5 cappuccinos per week. In Figure 11.4, if we draw a vertical line from 5 cappuccinos up to the demand curve, we can see that the price at which the firm can sell 5 cappuccinos per week is $3.50 (point B). We can conclude that for this Blue Bottle, the profit-maximizing quantity is 5 cappuccinos, and the profit-maximizing price is $3.50. If the firm sells more than 5 cappuccinos per week, its profit will fall. For example,

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selling a sixth cappuccino adds $2.00 to its costs and only $0.50 to its revenues. So, its profit will fall from $5.00 to $3.50. Panel (b) adds the average total cost curve for this Blue Bottle. The panel shows that the average total cost of selling 5 cappuccinos is $2.50. Recall from Chapter 9, Section 9.3 that: Profit = (P-ATC) x Q. In this case: Profit =($3.50-$2.50) x5=$5.00. The green rectangle in panel (b) of Figure 11.4 shows the amount of profit. The rectangle has a base equal to Q and a height equal to 1P-ATC2, so we know that its area equals profit Notice that, unlike a perfectly competitive firm, which produces where P=MC, a monopolistically competitive firm produces where P > MC. This Blue Bottle charges a price of $3.50, although marginal cost is $1.50. For a perfectly competitive firm price equals marginal revenue, P=MR. Therefore, to fulfill the MR=MC condition for profit maximization, a perfectly competitive firm will produce where P=MC. We know that P > MR for a monopolistically competitive firm because the firm’s marginal revenue curve is below its demand curve. Therefore, a monopolistically competitive firm will maximize profit by producing where P > MC.

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To maximize profit, a Blue Bottle coffeehouse needs to sell cappuccinos up to the point where the marginal revenue from selling the last cappuccino is just equal to its marginal cost. As the table shows, selling the fifth cappuccino— point A in panel (a)—adds $1.50 to the firm’s costs and $1.50 to its rev-enues. The firm then uses the demand curve to find the price that will lead consumers to buy this quantity of cappuccinos (point B). In panel (b), the green rectangle represents the firm’s profit. The rectangle has a height equal to $1.00, which is the $3.50 price minus the average total cost of $2.50, and it has a base equal to the quantity of 5 cappuccinos. So, for this coffeehouse, profit equals $1 x 5=$5.00

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A table has 11 rows and 6 columns. The columns have the following headings from left to right. Cappuccinos sold per week, Q, Price, P, Total revenue, T R, Marginal revenue, M R, Total cost, T C, Marginal cost, M C. The row entries are as follows. Row 1. Cappuccinos sold per week, Q, 0. Price, P, $6.00. Total revenue, T R, $0.00. Marginal revenue, M R, None. Total cost, T C, $5.00. Marginal cost, M C, None. Row 2. Cappuccinos sold per week, Q, 1. Price, P, 5.5. Total revenue, T R, 5.5. Marginal revenue, M R, $5.50. Total cost, T C, 8. Marginal cost, M C, $3.00. Row 3. Cappuccinos sold per week, Q, 2. Price, P, 5. Total revenue, T R, 10. Marginal revenue, M R, 4.5. Total cost, T C, 9.5. Marginal cost, M C, 1.5. Row 4. Cappuccinos sold per week, Q, 3. Price, P, 4.5. Total revenue, T R, 13.5. Marginal revenue, M R, 3.5. Total cost, T C, 10. Marginal cost, M C, 0.5. Row 5. Cappuccinos sold per week, Q, 4. Price, P, 4. Total revenue, T R, 16. Marginal revenue, M R, 2.5. Total cost, T C, 11. Marginal cost, M C, 1. Row 6. Cappuccinos sold per week, Q, 5. Price, P, 3.5. Total revenue, T R, 17.5. Marginal revenue, M R, 1.5. Total cost, T C, 12.5. Marginal cost, M C, 1.5. Row 7. Cappuccinos sold per week, Q, 6. Price, P, 3. Total revenue, T R, 18. Marginal revenue, M R, 0.5. Total cost, T C, 14.5. Marginal cost, M C, 2. Row 8. Cappuccinos sold per week, Q, 7. Price, P, 2.5. Total revenue, T R, 17.5. Marginal revenue, M R, -0.5. Total cost, T C, 17. Marginal cost, M C, 2.5. Row 9. Cappuccinos sold per week, Q, 8. Price, P, 2. Total revenue, T R, 16. Marginal revenue, M R, -1.5. Total cost, T C, 20. Marginal cost, M C, 3. Row 10. Cappuccinos sold per week, Q, 9. Price, P, 1.5. Total revenue, T R, 13.5. Marginal revenue, M R, -2.5. Total cost, T C, 23.5. Marginal cost, M C, 3.5. Row 11. Cappuccinos sold per week, Q, 10. Price, P, 1. Total revenue, T R, 10. Marginal revenue, M R, -3.5. Total cost, T C, 27.5. Marginal cost, M C, 4. Graph A , represents the X axis represents quantity in cappuccinos per week, and the Y axis represents price in dollars per cup. profit maximizing quantity and price for a monopolistic competitor. The M C curve intersects with the M R line at point A, 5, the profit maximizing quantity of cappuccinos, and 1.50. The M R line falls from (1, 5.50) to (10, negative 3.50). The demand line falls through point B, at 5 and 3.50, profit maximizing price.

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A table has 11 rows and 8 columns. The columns have the following headings from left to right. Cappuccinos sold per week, Q, Price, P, Total revenue, T R, Marginal revenue, M R, Total cost, T C, Marginal cost, M C, Average total cost, A T C, Profit. The row entries are as follows. Row 1. Cappuccinos sold per week, Q, 0. Price, P, 6. Total revenue, T R, 0. Marginal revenue, M R, None. Total cost, T C, 5. Marginal cost, M C, None. Average total cost, A T C, None. Profit, -5. Row 2. Cappuccinos sold per week, Q, 1. Price, P, 5.5. Total revenue, T R, 5.5. Marginal revenue, M R, 5.5. Total cost, T C, 8. Marginal cost, M C, 3. Average total cost, A T C, 8. Profit...