1. ECON 330 Lecture 9
Tuesday, October 16

2. 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)

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

4. 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

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

6. 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

7. 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.

8. 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.

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

10. 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.

11. 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.

12. 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

13. Examples
Intel was a dominant firm in market for general-purpose microprocessors with a 80% share between
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.

14. Long distance communication market in US (late 1980s)
AT&T was the monopoly until 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

15. 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

16. 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).

17. 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.

18. 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.

19. 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?

20. 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

21. The Dominant Firm equilibrium
Residual demand Pm Pd MC K

22. 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:

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

25. 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?

26. 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 = 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.