ECON 330 Lecture 9 Tuesday, October 16

HWKs Please turn in your HWK #2. Usual remarks HWKs are NOT part of your course grade. They are a small part of your bonus. Don’t do them if you are busy. Don’t feel bad. Working in groups is fine but please write your own answers. NO direct COPYING from friends. A quick survey: Who will not be at school during the Bayram week (Oct 22 and 23)

Now Solution to the in-class exercise from the last lecture: DWL of monopoly

Demand structure: Costs Three groups of consumers AC = MC = $5 Group 1 10,000, willingness to pay $20 Group 2 30,000, willingness to pay $15 Group 3 50,000, willingness to pay $9 Costs AC = MC = $5

Profit = (P–AC)xQ Three candidates for the profit max price P = 20  Profit = (20–5)x10,000 = 150,000 P = 15  Profit = (15–5)x(10,000+30,000) = 400,000 P = 9  Profit = (9–5)x(10,000+30,000+50,000) = 320,000

The profit maximizing price is 15, the first two groups will buy, the third group will not. CS = 10,000x(20 – 15) + 30,000x(15 – 15) = 50,000 PS ≡ revenue – variable cost = (15 – 5)x40,000 = 400,000 Social welfare = 450,000

Deadweight Loss of Monopoly DWL = 50,000x(9 – 5) = 200,000 This is the surplus that could be realized by selling the book to the third group at any price between 5 and 9.

Find the price at which you sell to all consumers and still make a profit of 5% on total cost Sell 90,000 books. Cost = 90,000x$5+$150,000 = $600,000. With 5% profit this means you need $630,000 in revenues, which means that you should sell the book for $7.

On to the Dominant Firm Model Now… On to the Dominant Firm Model

Not a MONOPOLY but a very large firm The dominant firm model also… How to estimate the inefficiency (DWL) of market power using real industry/firm data.

What is it? The dominant firm model is used to study industries with one large firm with 70-90% market share and many small competitive firms (also known as the fringe firms). The dominant firm is not a monopoly, but acts as a price setter/maker. The small firms behave competitively (they are price takers). Given the price set by the dominant firm each small firm chooses its quantity to max profits.

What makes a firm dominant? Lower costs – efficiency/technology, first-mover advantage from learning Superior product or reputation (advertising) Collusion by a group of firms

Examples Intel was a dominant firm in market for general-purpose microprocessors with a 80% share between 1993 - 98 In the low-end market segment it was “only” 75%, In the high-end segment it was over 95%.22 The Competitive Fringe - “small” producers including IBM, Sun, Hewlett-Packard, and Silicon Graphics.

Long distance communication market in US (late 1980s) AT&T was the monopoly until 1984. Then small competitors (MCI, Sprint) entered. The small competitors had lower capacities. AT&T acted as a price leader. See the table 5.1 on page 71 of the book

AT&T MCI SPRINT Date Rate Changed New Rate Months After Jan 87 .298 2 .289 Jan 88 .265 .256 .259 Jan 89 .254 .244 .250 Jan 90 .233 1 .223 .228 Jan 91 .222 5 July 91 .227 Jan 92 .224 June 92 .225 Feb 93 Aug 93 .229 Sept 93 .235 .234 Jan 94 .255

Solving the dominant firm model The set-up, the simplified version Both the small firms and the dominant firm have AC = MC = c. The small firms have a combined production capacity of K units. The market demand is given by QM(P).

Assumptions The dominant firm sets its price The small firms take that price as the market price (they behave as price takers) and they assume that they can sell as much as they want subject to their capacity constraint.

The residual demand for the dominant firm The dominant firm is a residual claimant, which means that for any p: QR(p) = QM(p) – SF(p) where QR(p) = dominant firm demand, SF(p)= supply of the fringe, QM(p) = market demand. In our set-up SF(p)= K if p ≥ c, 0 if p < c.

Example with Q = 20 – 2P Q P 10 2 9 4 8 6 7 5 12 14 3 16 Small firms K = 2, MC = AC = 4 The large firm MC = AC = 1 Residual demand at P = 9? P = 6? P = 3,99?

Find the profit maximizing price for the dominant firm Residual demand: QR = market demand – K Corresponding to QR we find the MR(residual) Profit maximization: MR(residual) = MC

The Dominant Firm equilibrium Residual demand Pm Pd MC K

Use some mathematics to show that High K  the dominant firm will set a lower price The profits of the dominant firm is π(P) = [QM(P) − K]∙P – c∙[QM(P) − K] Differentiate π with respect to P set equal to 0:

π(P) = [QM(P) − K]∙P – c∙[QM(P) − K] EP

In class exercise DEMAND Q P 10 2 9 4 8 6 7 5 12 14 3 16 The dominant firm has AC = MC = 1, and unlimited production capacity. Each of the small firms has AC = MC = 4, and a combined production capacity of K = 2. You are the owner of the dominant firm. What price will you set to max profits?

Solution P profit Q QR 10 9 2 8 14 4 7 24 6 30 5 32 12 3,99 35,9 3 28 16 Do the math: The residual demand is QR = 20 – 2P – 2 for P ≥ 4 QR = 20 – 2P for P < 4. If P < 4 the best price is P = 3.99. The profits are 35,9 (almost 36). If P ≥ 4, to find the best price: QR = 20 – 2P – 2 = 18 – 2P. The inverse residual demand P = 9 –0.5QR. MRR = 9 – QR  Use the condition MRR = MC 9 – QR = 1  Q* = 8, P* = 5, profits are 32. SO the profit maximizing price is 3.99.