# UNIT III: COMPETITIVE STRATEGY

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```					   UNIT III: COMPETITIVE STRATEGY

10/14   • Monopoly
• Oligopoly
• Strategic Behavior
Monopoly

•   Market Structure
•   Monopoly
•   Multiplant Monopoly: 1 Firm – 2 Plants
•   Price Discrimination: 1 Firm – 2 Markets
•   Next Time: Duopoly
Market Structure
So far, we have looked at how consumers and firms
make optimal decisions (maximize utility and profits)
under constraint. Then we looked at how those individual
decisions are coordinated via the market.

Under Perfect Competition, we assume an infinite
number of infinitely small price-takers, and we know that
the competitive market equilibrium is Pareto-efficiency.

Now want to consider other market structures (e.g.,
monopoly; duopoly) and characterize the corresponding
equilibria; what are the welfare consequences of these
market structures?
Market Structure
Market structure is related to market concentration and
competitiveness.     Perfect Competition is a polar case
(low conc; high comp), where rational decision-making at
the individual level (consumer; firm) adds up to optimal
outcomes at the social level – The Invisible Hand
Theorem of Welfare Economics.
Once we move away from perfect competition, firms can
exploit market power: their behavior can influence prices
(and profits). Monopoly is the case where a single firm
has market power. Later we will consider what happens
when several firms have power in the market (oligopoly).
Here, competitive strategy comes to the fore.
Market Structure
Perfect Comp    Oligopoly
POINT 1:       Monopoly

The number of
Under every
No. of Firms      infinite           (>)2
firms in the
market           1
market all
structure,is
determined by
firms attempt
Output         MR = MC = P            ???
entry
MR = MC < P
to maximize
conditions.
profits, s.t.,
Profit               0            MR = MC.
?            Yes

Efficiency        Yes                            ???
Market Structure
Perfect Comp    Oligopoly
POINT 1:            Monopoly

Profits signal
Under every
No. of Firms      infinite          (>)2
entry. For a
market              1
firm to remain
structure, all
profitable,
firms attempt
Output         MR = MC = P           ???
there must be
MR = MC < P
to maximize
barriers to
profits, s.t.,
MR ? the
(or
entry= MC.
Profit               0                               Yes
market is too
small for a
Efficiency        Yes          second firm).         ???
Market Structure
Perfect Comp   Oligopoly
POINT 2:            Monopoly

Under every
No. of Firms      infinite         (>)2
market              1
structure, all
firms attempt
Optimality     MR = MC = P          ???          MR = MC < P
to maximize
profits, s.t.,
Profit               0          MR = MC.
?             Yes

Efficiency        Yes                               ???
Market Structure
Perfect Comp   Oligopoly
POINT 2:       Monopoly

… but under
No. of Firms      infinite       (>)2
perfect          1
competition
P = MR
Optimality     MR = MC = P        ???       MR = MC < P
and under
monopoly
Profit               0          P >?MR.        Yes

Efficiency        Yes                          ???
Market Structure
Perfect Comp    Oligopoly
POINT 3:     Monopoly

No. of Firms      infinite         (>)2
market          1
structure
raises welfare
Optimality     MR = MC = P          ???
questions.
MR = MC < P
Perfect
Profit               No        competition
?          Yes
implies
efficiency.
Efficiency         Yes                         ???
Market Structure
Perfect Comp   Oligopoly
POINT 3:      Monopoly

What are the
No. of Firms      infinite         (>)2
welfare          1
implications of
other market
Optimality     MR = MC = P          ???
structures?
MR = MC < P

Profit               No            ?            Yes

Efficiency         Yes                          ???
Market Structure
Perfect Comp   Oligopoly     Monopoly

No. of Firms      infinite      (>)2           1

Optimality     MR = MC = P       ???      MR = MC < P

Profit               No           ?          Yes

Efficiency         Yes            ?           ???
Market Structure
Perfect Competition
• Firms are price-takers: can sell all the output they
want at P*; can sell nothing at any price > P*.
• Homogenous product: e.g., wheat, t-shirts, long-
distance phone minutes
• Perfect factor mobility: in the long run, factors can
move costlessly to where they are most productive
(highest w, r).
• Perfect Information: firms know everything about
costs,    consumer      demand,      other    profitable
opportunities, etc.
Market Structure
Perfect Competition
• Firms are price-takers: can sell all the output they
want at P*; can sell nothing at any price > P*.
• Homogenous product: e.g., wheat, t-shirts, long-
distance phone minutes
• Perfect factor mobility: in the long run, factors can
move costlessly to where they are most productive
(highest w, r).
• Perfect Information: firms know everything about
costs,    consumer      demand,      other    profitable
opportunities, etc.
Market Structure
Monopoly
• Firms are price-setters: one firm supplies entire
market, faces downward-sloping demand curve.
• Homogenous product: necessarily so for a single
firm.
• Barriers to entry: no perfect factor mobility. E.g.,
• Perfect Information: firms know everything about
costs,     consumer     demand,  other   profitable
opportunities, etc.
Monopoly
Barriers to Entry: The number of firms is determined
by Restricted Entry
As we have learned, profits are the incentive for entry.
The only way a firm can remain profitable (and a
monopoly) is if there are very strong barriers to entry,
or if the market is too small for a second firm.

•   Some of these barriers are natural (technology)
•   Some are created by regulators (franchise, license)
•   Some are created by the monopolist to deter entry
by potential rivals (competitive strategy)
Monopoly
Remember that a perfectly competitive firm can sell all it
wants at the market price. This means that any time it
wants to increase revenues, it needs only to produce
more output. For this reason in perfect competition
marginal revenue and price were equal,    MC = MR = P.

Since a monopolist necessarily faces the entire market
demand, it faces a downward sloping demand curve. This
means that, if the firm wishes to increase revenues it
must lower price. If it wishes to sell less it must raise
price. As it turns out this means that, for a monopolist
marginal revenue is different from market price,
MC = MR < P.
Monopoly
Marginal Revenue the additional revenue from a unit
increase in output.
Remember, the firm must sell it’s entire output at the
same price. Therefore, marginal revenue will be the price
of that extra unit minus the change in revenue on all
earlier (inframarginal) units
MR = dTR/dQ = d(PQ)/dQ          dP/dQ is neg, for downward
= P + Q(dP/dQ)           sloping demand curve
= P + P(Q/P)(dP/dQ)=

= P[1 + Q/P(dP/dQ)]
= P(1 + 1/E)
Monopoly
Marginal Revenue the additional revenue from a unit
increase in output.
Remember, the firm must sell it’s entire output at the
same price. Therefore, marginal revenue will be the price
of that extra unit minus the change in revenue on all
earlier (inframarginal) units
MR = dTR/dQ = d(PQ)/dQ
= P + Q(dP/dQ)
= P + P(Q/P)(dP/dQ)=   e = P/Q(dQ/dP)
price elasticity of demand
= P[1 + Q/P(dP/dQ)]
= P(1 + 1/e)
Monopoly
Marginal Revenue the additional revenue from a unit
increase in output.
Remember, the firm must sell it’s entire output at the
same price. Therefore, marginal revenue will be the price
of that extra unit minus the change in revenue on all
earlier (inframarginal) units
MR = dTR/dQ = d(PQ)/dQ
= P + Q(dP/dQ)
= P + P(Q/P)(dP/dQ)= 0 > e > -1; MR < 0 inelastic
e = -1; MR = 0 unit elasticity
= P[1 + Q/P(dP/dQ)] - < e < -1; MR > 0 elastic
8

= P(1 + 1/e)
Monopoly
Price-Taker                Price-Setter
\$

D: P = AR
= MR
D: P = AR
\$                  Q                          Q
TR
What does the TR
curve look like?

Q                          Q
Monopoly
Price-Taker                    Price-Setter
\$
P0

D      P1
P2

D: P = AR
\$                  Q                                Q
P1Q1
TR
P2Q2
TR = PQ
P0Q0

Q          Qo     Q1    Q2       Q
Monopoly
Price-Taker               Price-Setter
\$
What does the MR
D: P = AR             curve look like?

= MR
D: P = AR
\$                  Q                              Q
MR
TR
TR

Q                              Q
Monopoly
Price-Taker               Price-Setter
\$                              MR > 0 (Elastic; e < -1)

D: P = AR
MR < 0 (Inelastic;
= MR                    0 > e > -1)
D: P = AR
\$                  Q                              Q
MR
TR
TR

Q                              Q
Monopoly
\$                                MR > 0 (Elastic; e < -1)

D: P = AR
MR < 0 (Inelastic;
A monopolist will never
= MR                    0 > e > -1)
produce at an                       D: P = AR
\$                       Q                        Q
inelastic portion
TR
of the demand curve                    TR
AC

Q                        Q
Monopoly
Consider a monopolist characterized by the following
total cost and demand functions:

TC = 100 + Q2               QD = 1000 - 10P

Find the market equilibrium in the long-run.
Monopoly
Consider a monopolist characterized by the following
total cost and demand functions:

TC = 100 + Q2                       QD = 1000 - 10P demand function
Inverse

MC = 2Q                                      P = 100 - .1Q
\$                              TR = 100Q - .1Q2
MC
MR = 100 - .2Q
Pm = 47.72                                = MC = 2Q

Qm       =
45.45
D             Pm       =
47.72                                          Q
Qm = 45.45   MR
Multiplant Monopolist
Now consider a monopolist who operates several
plants.
Q = qa + qb

\$             mca             mcb

D

qa          q    qb         q                 Q
Plant A             Plant B         Market   MR
Multiplant Monopolist
Now consider a monopolist who operates several
plants.
MC(q)a = MC(q)b                  =     MR
\$                  mca             mcb                     MC

P                                                              D

qa            q    qb         q         Q           Q
Plant A                 Plant B             Market   MR

Not to scale
Perfect Competition
Competitive equilibrium. Firms are producing at the
efficient scale. P* = acmin; P = 0.
What would happen
\$                           \$          if a monopolist
mc                          owned all the
plants?
ac

P*                                                    LRS

D

q*             q                Q*            Q
Multiplant Monopolist
Monopoly in the short run.   Price rises, total market
quantity falls …

\$                           \$
mc

Pm                                             MCsr
ac

P*

D

q*           q          Qm    Q*              Q

Not to scale
Multiplant Monopolist
Monopoly in the short run. Plants are producing at less
than efficient scale. P* > ACmin; P > 0.
There is no
\$                            \$                 supply curve
mc                              (Q = f(P)) for
a monopolist
Pm
ac

P*

D

qm q*            q           Qm    Q*             Q
MR
Not to scale
Multiplant Monopolist
Monopoly in the short run. Plants are producing at less
than efficient scale. P* > ACmin; P > 0; P > 0.
\$                            \$
mc
Max SS – Actual SS

Pm                                                    MCsr
ac
Profit
DWL
P*

D

qm q*            q                 Qm    Q*              Q
MR
Not to scale
Monopoly
Monopoly in the long run. Plants are producing at their
efficient scale. P* > ACmin; P > 0.
\$                              \$
mc
Pm
ac
Profit
DWL
P*                                                            MClr

D

q*               q                Qm        Q*        Q
MR
Monopoly
Natural Monopoly.            Sometimes, one large firm can
produce more efficiently than many small ones.
\$                       tc = 100 + q2   \$    QD = 1000 – 10P
mc

ac

P*

D

q*                     q                Q*         Q
MR
Monopoly
Natural Monopoly. Sometimes, one large firm can
produce more efficiently than many small ones.
\$                 tcm = 1000 + 2q   \$        QD = 1000 – 10P
mc                                  P = 100 - .1Q
mcm = 2
TR = 100Q-.1Q2
Pm                ac                           MR = 100 - .2Q
= MC = 2
P*                                                   Qm = 490
acm
MC
D

qm q*                    q          Qm             Q*    Q
MR
Monopoly
Natural Monopoly. Sometimes, one large firm can
produce more efficiently than many small ones.
\$                 tcm = 1000 + 2q   \$
What are the welfare
mc
mcm = 2               implications?

Pm                ac

P*
acm
MC
D

qm q*                    q          Qm          Q*    Q
MR
Price Discrimination
When a firm has market power, it will attempt to capture
as much of the consumer surplus as it can.

Goods susceptible to price discrimination:

– Personal services (e.g., hair cuts)
– Utilities (e.g., water; electricity)
Price Discrimination
3rd Degree (Market Segmentation): Now consider a
monopolist who sells in several markets.
MRa = MRb                                    =   MC
Higher price in the less
\$                                      elastic market               MC

Pb
Pa

da                          db
qa   MRa        q           qb   MRb        q           Q       Q
MR
Market A                    Market B                    Firm
Price Discrimination
2nd Degree (Block Pricing): Firm charges different price
for different units; all consumers face the same price
schedule.
\$
0-100   \$10
CS
10                        101-150      8
8          CS                  151-    5
PS
PS
CS
5

D

100 150         Q
Price Discrimination
1st Degree (Perfect): Firm charges different price for to
different consumers and different price for different units
to the same consumer.
\$

What are the                         Entire area
welfare                    under demand
implications?                     curve capture
by producer

MC

D

Q
Market Structure
POINT 1: The number of firms in the market is
determined by entry conditions. Profits signal entry. For
a firm to remain profitable, there must be barriers to
entry (or the market is too small for a second firm).
POINT 2: Under every market structure, all firms attempt
to maximize profits, s.t., MR = MC. But under perfect
competition P = MR and under monopoly P > MR.
POINT 3: Thinking about market structure raises welfare
questions. Perfect competition implies efficiency. What
are the welfare implications of other market structures?
Next Time
Perfect Comp   Oligopoly     Monopoly

No. of Firms      infinite      (>)2            1

Output         MR = MC = P       ???      MR = MC < P

Profit               No           ?           Yes

Depends on
Efficiency         Yes            ?       cost ???
structure
Next Time

10/21   MIDTERM EXAM

10/28   Duopoly
Pindyck & Rubenfeld, Chapter 12.
Besanko, Chapter 13.

```
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