Introduction to Industrial Organization

Perfect Competition, Monopoly, and Dominant Firm

Jian-Da Zhu
National Taiwan University

September 30, 2016

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September 30, 2016

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Outline
Perfect Competition
-

Assumptions
Shutdown decision for firms
Short-run and long-run equilibrium
Efficiency and welfare

Monopoly
- Assumptions
- Elasticity
- Welfare and deadweight loss

Dominant Firm
- Assumptions
- Equilibrium

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Perfect Competition
Assumptions:
- Homogeneous products (only one single good)
- Perfect information: All consumers and producers know the price and
utilities for each person.
- No transaction costs
- No externalities
- Many (infinite) buyers (consumers) and sellers (firms).
- All firms and buyers are price takers. Price is determined by the market.

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Perfect Competition
Profit maximization problems for a single firm:
max = max P q c(q)
q

First-order condition (F.O.C.):

c(q)
=0P
= 0 P = M C(q)
q
q
Given a price P0 , the firm produces at the quantity level q0 , where
P0 = M C(q0 ).

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Perfect Competition

profits

MC

P0

AC
AV C

Cost
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q0

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Perfect Competition
Total cost is C(q0 ) = q0 AC(q0 ).
Supply curve: As price increases, the firm increases the production
along the curve M C(q).
Review of cost theory:
- Cost function: C(q) = F + V C(q), where F are fixed costs, and
V C(q) are variable costs.
- What is sunk cost?
- Sunk cost: It should not affect the future decision.
- Not a sunk cost: Recoverable, so it should affect the decision.

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Shutdown Decision
The firm produces only if the revenues are higher than avoidable costs.
In the short run, avoidable costs are variable costs V C(q) if all fixed
costs are sunk. If P q < V C(q) P < AV C(q), then the firm will
shut down.
In the long run, avoidable costs are total costs C(q). If
P q < C(q) P < AC(q), then the firm will shut down.
In the short run, if proportion of fixed costs are not sunk, such as
refundable rent, then avoidable costs are V C(q) + F . The firm will
shut down if P q < V C(q) + F P < AV C(q) + F
q

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Shutdown Decisions
Short-run shutdown point Ps . (All the fixed costs are sunk.)
Long-run shutdown point Pl .
$

MC
AC
AV C

Pl
Ps

q
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Short-run Equilibrium
There are n identical firms.
Short-run market supply curve, S; Short-run equilibrium price, P0 , and
quantity, Q0 = nq0 . (Qs = nqs )
Firms are making a positive profit.
$

Supply, S

MC

AV C
P0

P0
Ps

Ps
Demand
qs q0

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Long-Run Equilibrium
Firms are free to enter into the market.
The equilibrium price, P = minimum of AC; the equilibrium number
replacements
of firms, n ; the equilibrium output Q = n q .
Firms make zero profit because of free entry.
$

M C AC
AV C

Long-Run Supply Curve

Demand

q
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Long-Run Equilibrium
Note: The long-run supply curve need not be flat. It may be
upward-sloping.
- Case 1: minimum of AC is rising in market demand.
- Case 2: A few firms can produce at low costs.
Example: Two types of firms: n1 low-cost, efficient firms with smaller
AC1 , and n2 high-cost firms with higher AC2 .

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Elasticities and the Residual Demand Curve

Definition: The demand curve facing a particular firm is called the
replacements
residual demand curve, Dr (p)
Dr (p) D(p) So (p); Dr (p) = 0 if So (p) > D(p),
where So (p) is the supply of other firms.
$

$
So

10
9

10

Residual demand

9
D
200

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300 Q

Dr
100

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Elasticities and the Residual Demand Curve

Price Elasticity of Demand/Supply
=

Q(P )
Q(P )
P
P

Q(P ) P
P Q(P )

Example:
- The slope of demand is very steep inelastic demand || < 1
- The slope of demand is very flat elastic demand || > 1

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Elasticities and the Residual Demand Curve

The elasticity of demand facing firm i is i .
Dr (p) = D(p) So (p)
dDr (P )
dD(P ) dSo (P )
=

dP
dP
dP
dDr (P ) P
dD(P ) P
dSo (P ) P

dP
q
dP q
dP q
dSo (P ) P Qo
dD(P ) P Q
dDr (P ) P

dP
q
dP Q q
dP Q q
| {z } | {z } |{z} | {z o} |{z}

n1

i = n (n 1)0 ,

where is the market elasticity of demand, and 0 is the elasticity of

supply of the other firm. (Qo = (n 1)q; Q = nq)
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Elasticities and the Residual Demand Curve

The residual demand curve facing the firm is much flatter than the
market demand curve.
The single firms demand elasticity is much higher than the market
elasticity.
i = n (n 1)0
Given the supply of other firms is completely inelastic (0 = 0),
i = n. For instance, if = 1 and n = 500, then i = 500. The
elasticity of demand facing a single firm is very large.
In a perfect competition market, n = . The elasticity of demand
facing a firm is infinite, so the demand curve facing a competitive firm
is horizontal at the market price. A competitive firm is a price taker.
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Efficiency and Welfare

Welfare = consumer surplus
(CS) + producer surplus (PS)

CS

In the competitive equilibrium

- Firms: P = M C(q). Profits
are maximized, so producer
surplus is maximized.
- Consumers: consumer surplus
is maximized.

PS
D
P

Deadweight loss is defined as

the welfare loss from the
competitive equilibrium.

Q
S

Deadweight Loss
D
Q

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Perfect Competition
Summary:
- Welfare is maximized under perfect competition.
- Free entry is a crucial factor for perfect competition market, so the
firms make zero profits in the long run.
- All the firms are price takers.

Questions:
- If there is a restriction on entry, whats the long-run equilibrium?
Discuss the profits and welfare.

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Monopoly
Assumptions:
- Only one firm in the market
- Facing the downward-sloping demand curve(P (Q))

Profit maximization problem:

First-order condition:

max = P (Q)Q C(Q)

| {z } | {z }
Q
Revenue Cost

C(Q)

P (Q)
=0
=0
Q + P (Q)
Q
Q
Q
{z
}
|
| {z }
Marginal revenue Marginal cost
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Monopoly
From F.O.C,
P (Q)
Q + P (Q) = M C(Q)
Q
P (Q) Q
P (Q) + P (Q) = M C(Q)

Q P (Q)

1
P (Q) 1 + Q P (Q) = M C(Q),
P

where

Q P (Q)
P Q

is the demand elasticity.

We obtain
P
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1
1+

= M C.

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Monopoly
Deciding the price for monopoly is equivalent to deciding the quantity.
There is no supply curve for monopoly.
Example:
- Inverse demand function: P = a bQ
- Cost function: cQ (constant marginal cost)
- Maximization problem:
max(a bQ)Q cQ = aQ bQ2 cQ
Q

- First-order condition:
c =0
a 2bQ |{z}
| {z }
MC
MR

- Marginal revenue: a 2bQ; marginal cost: c.

- Optimal output: Qm = ac
2b ; optimal price: Pm =
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a+c
2 .
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Monopoly
P

Pm

P = a bQ(Inverse demand function)

MC=c

profits
Qm
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Q
MR: P = a 2bQ

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Elasticity
From F.O.C:
1
P (1 + ) = M C

1
P MC
=

| {z }
|{z}
price-cost margin positive
The price-cost margin is also called the Lerner Index of market power.
If the demand is very elastic, = 100, then the price-cost margin is
P M C
1
0 P M C.
100 . As ,
P
If the demand is less elastic, = 2, then the price-cost margin is 21 .
The optimal price is much higher than the marginal cost.

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Elasticity
How about inelastic demand? 1 < < 0
Answer: Monopoly never operates on the inelastic portion of the
demand. If so, raise the price!
In actual markets, demand curves shift over time, so a rational
monopoly should change its price over time.

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Welfare and Comparison with Competitive Market

Price: Pm > Pc ; Quantity: Qm < Qc
Consumer surplus:
P

- Competitive market: ABC

- Monopoly: ADE

Producer surplus (profits):

Pm D

Pc C

- Competitive market: 0
- Monopoly:  DEFC

Demand

Qm

Total Welfare: Wc > Wm

MC
Q Q
c

- Competitive market:
Wc = ABC + 0
- Monopoly: Wm = ADE +  DEFC

Deadweight loss Wc Wm = EFB

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Dominant Firm
Assumptions:
- There is one firm (dominant firm) that is much larger than any other
firm (fringe firm).
- All firms, except the dominant firm, are price takers, determining their
output levels by setting P = M C.
- The number of firms is fixed (No-Entry Model); many fringe firms are
free to enter into the market (Free-Entry Model).
- Dominant firm knows the markets demand curve.
- Dominant firm can predict how much output the competitive fringe will
produce at any given price; that is, it knows fringes supply curve.

There is one dominant firm (d) and n fringe firms (f ) in the market.
Two types of models: free entry market / no entry market

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Dominant Firm
Reasons to be the dominant firm:
- More efficient than its rivals: better management or better technology.
- Early entrant: with lower costs, grow large optimally
- Government may favor the original firm. For instance, USPS does not
need to pay taxes or highway fees.
- Superior product in the market
- A group of firms may collectively act as a dominant firm (cartel)

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Dominant Firm (No Entry)

The residual demand faces the dominant firm
Dd (P ) = D(P ) So (P ):
M Cf
ACf

P
P

Demand
qf
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Dominant Firm (No Entry)

The residual demand faces the dominant firm
Dd (P ) = D(P ) So (P ):
M Cf

$
So (P )

P
P

Demand
qf

Qf

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Q
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Dominant Firm (No Entry)

The residual demand faces the dominant firm
Dd (P ) = D(P ) So (P ):
M Cf

$
So (P )

P
P
Dd (P )
Demand
qf

Qf

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Dominant Firm (No Entry)

Obtain the marginal revenue line M Rd from the residual demand
curve
$

M Cf

$
So (P )

P
P
Dd (P )
Demand

Demand

Q
M Rd

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Dominant Firm (No Entry)

Case 1: Optimal price and quantity for dominant firm: P and Qd ;
optimal quantity for each fringe firm: qf .
M Cf

$
So (P )
M Cd (Case 1)
ACd

Dd (P )
Demand
qf Qf

Demand
Qd

M Rd
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Dominant Firm (No Entry)

Case 2: Optimal price and quantity for dominant firm: P and Qd ;
optimal quantity for each fringe firm: qf = 0. (Monopoly case)
$

M Cf

$
So (P )

M Cd (Case 2)

Dd (P )
ACd
Demand

Demand
Q
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Qd
M Rd

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Dominant Firm (Free Entry)

If many fringe firms are free to enter into the market, then the
residual demand faces the dominant firm:
$

M Cf

So (P )
Dd (P )
Demand
Q

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Introduction to Industrial Organization

Demand
Q
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Dominant Firm (Free Entry)

Obtain the marginal revenue line M Rd from the residual demand
curve
$

M Cf

So (P )
Dd (P )
Demand

Demand

Q
M Rd

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Dominant Firm (Free Entry)

Case 1: Optimal price and quantity for dominant firm: P and Qd ;
optimal quantity for all the fringe firm: Qf = Q Qd .
$

M Cf

$
M Cd (Case 1)

ACd

So (P )

Dd (P )
Demand
Q

Demand
Qd Q

M Rd
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Dominant Firm (Free Entry)

Case 2: Optimal price and quantity for dominant firm: P and Qd ;
optimal quantity for each fringe firm: qf = 0. (Monopoly case)
$

M Cf

So (P )

M Cd (Case 2)

Dd (P )
ACd
Demand

Demand
Q
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Qd
M Rd

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