Profit

Maximization

chapter 9
In our pursuit to develop a market supply curve, we started from conceptualizing production, and then developing the idea
of Cost function, and now, have reached our final destination in this chapter where we shall develop the individual firm
supply curve.

•
 Perfectly Competitive Markets – Underlying assumptions
PRICE TAKING - both consumers and firms accept price as an exogenous parameter that they are
incapable of influencing. Both sides of market are “PRICE TAKER”
• Individual firms must believe that whatever they produce will get sold at the going market
price value which they presume during taking output decisions.
• So essentially, “market clears”, that is, market equilibrium OCCURS when (i) their
prediction/assumption of market price is a perfect match with the realized market price,
and (ii) all produced output gets sold.
• In reality, the market (real) price over time continue to fluctuate over a period of time unless firms
and consumers arrive at this conceptual match.
• Because each individual firm sells a sufficiently small proportion of total market output, its
decisions have no impact on market price – internet market place, fish auctions?

PRODUCT HOMOGENEITY - Products of all of the firms in a market are perfectly substitutable
with one another—that is, they are homogeneous. Hence, no firm can raise the price of its product above
the price of other firms without losing most or all of its business. Example: world market for wheat!!!
• In contrast, when products are heterogeneous, each firm has the opportunity to raise its price
above that of its competitors without losing all of its sales. Hence, the need for advertising!!
• The assumption of product homogeneity is important because it ensures that there is a
single market price, consistent with supply-demand analysis.

FREE ENTRY AND EXIT - With free entry and exit, buyers can easily switch from one supplier to
another, and suppliers can easily enter or exit a market. So there can be no special costs that make it
difficult for a firm to enter (or exit) an industry.

NO TRANSACTION COST - Sellers and buyers can easily locate each other and engage in a
meaningful discussion or negotiations of prices without fear or barriers.
 Do Firms Maximize Profit?

The assumption of profit maximization is frequently used in microeconomics because it

predicts business behavior reasonably accurately and avoids unnecessary analytical
complications.

Firms that do not care about maximizing profit are not likely to survive (their brand
names may survive though). The firms that do survive make long-run profit
maximization one of their highest priorities: [Case in point: Masayoshi Son issued a
call for profit maximization after his huge investment in WeWork went bust as the
company shut down due to immense losses.]
 PROFIT MAXIMIZATON

● profit := Difference between total revenue and total cost.

π(q) = R(q) − C(q) = P.q – C(q) if the firm is a price taker
● marginal revenue:= Change in revenue resulting from an infinitesmal
increase in output – slope of the revenue function.

● marginal cost:= Change in cost function resulting from an infinitesmal

increase in output – slope of the cost function.
A firm chooses output q*, so that
profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope
of the cost curve).
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0

MR(q) = MC(q)

A SHORT RUN EXAMPLE – BUT THE PRINCIPLE HOLDS IN

LONG RUN TOO!
 Demand and Marginal Revenue for a Competitive Firm

(firm’s perceived/assumed demand curve) (actual market demand curve)

MR(q) = Price for a competitive curve at all values of q = P

A competitive firm supplies only a small portion of the total output of all the firms in an industry.
Therefore, the firm BELIEVES (takes) the market price revealed by the supreme AI AND THAT
SHE CAN SELL AS MUCH SHE WANTS AT THIS PRICE – hence, choosing its output on the
assumption that the price will be unaffected by the output choice.

Hence (a) the demand curve perceived by the firm is perfectly elastic, even though the actual market
demand curve in (b) is downward sloping.
 • Along the perceived horizontal demand curve, marginal revenue, average
revenue (= R(q)/q), and price are all equal.

• Hence, the perfectly competitive structure of the market leaves firms to decide
only one question: HOW MUCH TO PRODUCE? (unlike a monopolist who –
not being a price taker – may ask a different question : “how much to charge?”

A perfectly competitive profit maximizing firm should choose to produce an

output q* so that marginal cost equals price:

MC(q*) = P and […….]

 Short-Run Profit Maximization by a Competitive Firm
In the short run, the
competitive firm maximizes its
profit by choosing an output q*
at which its marginal cost MC
is equal to the price P (or
marginal revenue MR) of its
product.

The profit of the firm is

measured by the rectangle
ABCD.

Any change in output, whether

lower at q1 or higher at q2, will
lead to lower profit.

Output Rule: If a firm is producing any positive

output, it should produce at the level at which price
equals marginal cost, and marginal cost curve is NON
- DECREASING.
 When should the firm “shut down” , that is, cease production in short
run?

A competitive firm should shut down

if price is below AVC.

Note shutting down in this sense is

not equivalent to exiting the market
– since by definition of short run, the
firm cannot reduce its fixed input to
zero.

A firm should shut down, that is, cease production in

short run (when it cannot exit
the market, if its profit by producing positive output is
weakly lesser than that from
producing no output. This is equivalent to Price being
greater than minimum possible value of average
variable cost (AVC).
 A Competitive Firm‟s Short-run Supply Curve
The firm‟s supply curve is the portion of the marginal cost curve for which marginal cost is
greater than minimum possible average variable cost. It tells us how much a profit
maximizing firm is willing to supply at each possible price level P, provided it believes P to be
the (future) market equilibrium price at which she can sell as much she wants.

NOTE THAT ANY FIRM BEHAVING IN SUCH AN IDEALIZED MANNER ENGAGES IN WHAT IS KNOWN AS
„MARGINAL COST PRICING”, THAT IS, THEY SELL EACH UNIT OF TOTAL OUTPUT Q* AT THE
MARGINAL COST MC(Q*).

In the short run, the firm

chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.
The short-run supply curve is
given by the crosshatched
portion of the marginal cost
curve.

AS WE SHALL SEE LATER, SUPPLY CURVE CAN EXIST AS MATHEMATICAL/CONCEPTUAL ENTITY ONLY IF THE FIRMS IN MARKET ARE PERFECTLY COMPETITIVE. MORE
IMPORTANTLY, THIS MEANS THE MARKET DEMAND-SUPPLY ANALYSIS IS INVALID FOR MARKETS WHERE FIRMS AND CUSTOMERS DO NOT BEHAVE IN A PERFECTLY
COMPETITIVE MANNER (OR A PRICE TAKER).
 The Short-Run Market/Industry Supply Curve

(horizontal summation)
The short-run industry
supply curve is the
summation of the supply
curves of the individual
firms.
Because the third firm has
a lower average variable
cost curve than the first two
firms, the market supply
curve S begins at price P1
and follows the marginal
cost curve of the third firm
MC3 until price equals P2,
when there is a kink.
Elasticity of Market Supply
For P2 and all prices above
it, the industry quantity Es = (ΔQ/Q)/(ΔP/P)
supplied is the sum of the
quantities supplied by each
of the three firms.
 Producer Surplus in the Short Run

producer surplus:= Sum over all units produced by a firm of differences between the
market price of a good and the marginal cost of production.

PRODUCER SURPLUS FOR A FIRM

The producer surplus for a firm is

measured by the yellow area below the
market price and above the marginal
cost curve, between outputs 0 and q*,
the profit-maximizing output.
 PRODUCER SURPLUS VERSUS PROFIT IN SHORT RUN

Short run producer surplus = PS = R − VC

Short run profit = π = R − VC − FC

PRODUCER SURPLUS FOR A MARKET

The producer surplus for a market is the

area below the market price and above
the market supply curve, between 0 and
output Q*.

Therefore in long run, that is, when C(0)=0, producer surplus is same as profit.
The Short Run Effects of a „per unit‟ Tax on an Individual Firm‟s Supply.

EFFECT OF AN OUTPUT TAX

ON A COMPETITIVE FIRM‟S
OUTPUT (in short run)
An output tax raises the firm’s
marginal cost curve by the
amount of the tax.
The firm will reduce its output
to the point at which the
marginal cost plus the tax is
equal to the price of the
product.
 The Short Run Effects of a „per unit‟ Tax on Industry/Market supply

An output tax placed on all

firms in a competitive market
shifts the supply curve for the
industry upward by the
amount of the tax.

This shift raises the market

price of the product and
lowers the total output of the
industry.

Note how the industry supply

curve is flatter than individual
supply curve. This is primarily
due to the horizontal
summation exercise.
 Profit Maximiziation in the Long Run
Interpret LAC as essentially an algorithm such that once you enter your chosen target output – it
will tell the optimum SAC (corresponding to the optimum number of planes/fixed capita input that
need to be procured), which you should operate on.
It is easy to see that if I believe that I can sell as much output as the going price P (say, the most
recent recorded trading price P), then I would choose the target output Q* such that P= LMC (Q*).

In this diagram, the aforementioned

output Q* =q3.

Note that at this output level q3, price

equals long-run marginal cost LMC

In the diagram, if initially the firm was

stuck at a fixed capital stock
corresponding to SAC, then when
she enters long run, she can choose
to increase production to q3 and
increases its profit from ABCD to
EFGD.
BUT AS ARGUED IN THE NEXT SLIDE, THIS LONG RUN CHOICE WOULD BE FUTILE AS IN THE LONG RUN, A PERFECTLY COMPETITIVE
PROFIT MAXIMIZING FIRM EITHER EXITS THE MARKET, OR ELSE PRODUCES q2 - in either case earning a zero economic profit.
 Long-Run Competitive Industry Equilibrium
In long run, firms have the option to sell (buy) off her capital assets and exit (enter) the
industry. When a firm earns zero economic profit, it has no incentive to exit the industry.
Likewise, other firms have no special incentive to enter. (Recall that in a perfectly competitive
market there are NO barriers to entry or exits)

BUT IF A FIRM EARNS POSITIVE ECONOMIC PROFIT, NEW FIRMS WILL STEADILY ENTER THE MARKET,
SHIFTING THE INDUSTRY SUPPLY CURVE TO THE RIGHT WITHOUT AFFECTING THE INDUSTRY
DEMAND CURVE. THIS WOULD LEAD TO REDUCTION IN MARKET PRICE, WHICH WOULD REDUCE
ECONOMIC PROFITS OF ALL INDIVIDUAL FIRMS. THIS PHENOMENON WOULD CONTINUE UNTILL ALL
FIRMS IN THE MARKET EARN ZERO ECONOMIC PROFITS.

Therefore, a long-run competitive market equilibrium with profit maximizing firms

occurs if and only if following two conditions hold:
1. No firm has an incentive either to enter or exit the industry because all firms are
earning zero economic profit (or else new firms would enter/exit and price would fall/rise).
• THIS IMPLIES THAT THE FIRMS THAT REMAIN IN OPERATION IN LONG RUN MUST HAVE
IDENTICAL LAC CURVES – PRODUCE IDENTICAL OUTPUT LEVEL Q* THAT MINIMIZE THIS
COMMON LAC CURVE.
• So if there are N firms that remain in the market in a long run competitive equilibrium, the
total sales in the market that happen must be equal to NxQ* .
• The equilibrium price P* must equal the LAC(Q*)= minimum possible value of LAC,
implying ZERO (economic) profits.
3. At price LAC(Q*), the quantity supplied by the industry is equal to the quantity
demanded by consumers.
(THIS IS THE INFERENCE DRAWN FROM THE MOST BASIC IDEALIZED MODEL IN AN INTRODUCTORY CLASS. FOR MOST
REALISTIC DESCRIPTION, ONE NEEDS TO SEE ADVANCED BOOKS.)
Hence each individual price taking profit maximizing firm that chooses to not exit in long
run – makes ZERO economic profit. This brings us the following distinction:

ACCOUNTING PROFIT vs ECONOMIC PROFIT

π = R − wL − rK

zero economic profit:= A firm is earning a normal return on its investment—i.e., it is

doing as well as it could by investing its money elsewhere. Note that the accounting
profit may well be very high.
Using competitive
Equilibrium and
market to estimate
Social Welfare
Efficiency
chapter 14
PLEASE READ CHAPTER 14 ONLY FROM SLIDES
 Market Demand
• Market demand: sum of the demands of all the
individual consumers
• Market demand curve: horizontal sum of the
individual demand curves
Individual and Market Demand
Curves
E E+ J
J
 Market Supply
• Market supply: sum of the supply of all the
individual sellers
• Market supply curve: horizontal sum of the
individual supply curves
Short run individual and Market Supply Curves
A A + R
R
 Aggregate Surplus/Social Welfare
• Aggregate surplus/Social Welfare : captures the net benefit
created by the production and consumption of a good
• Social Welfare = Total benefit from consumption (total
willingness to pay) – Total variable cost of production
• Note how the variable cost of production needs to be
considered as the firms, whenever producing positive
output must be operating in short run.
Recall - Willingness to pay
Emily’s WTP = $6.75
Juan’s WTP = $8
Variable (Short run) Cost of Production
Anitra’s ACP = $5
Robert’s ACP = $3
Measuring Consumer and Producer
Surplus
14-9
 Consumer and Producer Surplus
• Consumer surplus: sum of consumers’ total
willingness to pay minus their total expenditure
• Producer surplus: sum of firms’ revenue minus their
variable costs (because at any given point in time the
production must occur at a specific short run)
• Social Welfare = Consumer surplus + Producer
surplus
 Looking Forward
Next we will analyze what happens when
governments intervene in competitive markets
using taxes, subsidies, price controls, tariffs, or
other types of market intervention
 Market
Interventions
chapter 15
 Learning Objectives
• Describe the effects of a tax or subsidy in a competitive
market.
• Explain what determines who bears the burden of tax and
the difference between the statutory and economic
incidence of the tax.
• Compare the results of price floors, price supports,
production quotas.
• Show the effects of a price ceiling.
• Define domestic aggregate surplus (SOCIAL WELFARE) and
determine the effects of import tariffs and quotas.
 Overview
• Government interventions usually alter market
outcomes. We will focus on:
– Taxes and subsidies
– Policies designed to raise or decrease prices
– Import tariffs and quotas
 Taxes
• Governments tax goods to raise the revenue needed to pay
public expenditures
• There are typically two different kinds of taxes.
– Specific tax: a fixed dollar amount that must be paid on each unit
bought or sold
• If it is consumer who pays money to Government – tax is said to be applied
on consumer.
• If it is the seller who pays money to Government- tax is said to be applied
on seller.
– Ad valorem tax: a tax that is stated as a percentage on the good’s
price
• We shall focus on specific tax.
 Effects of a Specific Tax applied on seller
(upward shift in supply curve)
• Point A shows the initial
market equilibrium
• Point B shows the new
Price paid by buyers ($/gallon)

S1
market equilibrium.
Increase in
consumers’ cost
• Note the increased price per gallon S
Pb paid by consumers due P0 + T
to the tax.
Pb B
P0
• Note the price pocketed by A
sellers for each unit sold is PS = Pb - T C
Ps (shown by Point C). Decrease in
gas stations’
receipts per
gallon
• Note how imposition of
tax drives a WEDGE D
between price paid by
buyer and that RECEIVED QT Q0
by seller. Gallons of gas per month
15-16
 “Incidence” of a Specific Tax
• Incidence: how much of the tax burden is borne by
various market participants
 Incidence of a Specific Tax applied on seller
• Sellers bear the entire burden of the tax in both the
following extreme cases.
15-18
 Incidence of a Specific Tax applied on seller
• Buyers bear the entire burden of the tax in the
following two extreme cases.
15-19
 Incidence of a Specific Tax
• The more elastic demand is, and the less
elastic supply is, more of the tax is borne by
seller
• For small values of taxes - roughly:
– Es
Buyers ' share =
Es Ed
 Effects of a Specific Tax applied on buyer
(downward shift in demand curve)
• Point A shows the
market equilibrium
• Point B shows the
Price paid by buyers ($/gallon)

increase in the Increase in

consumer’s cost due to consumers’ cost
the tax per gallon
S
• Point C shows the B
decrease in the Pb = PS - T
producer’s profit due
to the tax A
P0
• Regardless of on whom PS C
the tax is applied, given T
Decrease in
the amount of specific
tax, its incidence
gas stations’ P0 + T
receipts per
remains the same gallon
DT D
QT Q0
Gallons of gas per month
15-21
 Welfare Effects of a Specific Tax
(irrespective on whom is it applied)
• Deadweight loss of
taxation: lost aggregate
surplus due to a tax
• Note that DWL DWL
computation remains
unchanged no matter on
whom tax is applied.
Market clearing conditions:
QD(Pb) = QS(Ps) and Ps = Pb –T
So if we have linear demand and supply
curves it is very easy to compute the
Deadweight loss by
½ (Q0 - QT )T.
15-22
Welfare Effects of a Specific Tax
15-23
Which Goods should the Government
Tax?
• Tax goods for which the deadweight loss of taxation
will be low
• Deadweight loss of taxation will be low if either the
demand or the supply curve is very inelastic
Taxation with No Deadweight Loss
15-25
 Subsidies
• Subsidy: payment that reduces the amount that
buyers pay for a good or increases the amount that
sellers receive.
• SEE THE DIAGRAM ON CLASS ROOM BLACK BOARD
• In competitive markets, subsidies create
deadweight loss
Market clearing conditions:
QD(Pb) = QS(Ps) and Ps = Pb + S
So if we have linear demand and supply curves - it is very easy to compute the
Deadweight loss by
½ (QS –Q0)S.
15-26
Interventions that AFFECT Prices directly
Recall the concept of price ceiling which ensured that price
in a market does not increase beyond a level.
In this chapter we see a few similar kinds of Govt.
intervention in markets..
• Price floors: government legislation banning trade at a price lower than a
certain level (eg: minimum wage regulations)
• Price supports: government PURCHASE (but no legislation) to enhance
market demand to support a certain price in the market (eg: wheat market in US)
 Price Floors
• Price floor: establishes
a minimum price that
Quantity traded
sellers can charge
• A particular feature during
Price floor
excess supply is the
competition for limited
consumers leads to black
market profiteering –
where eventually prices
collapse, often much
beyond the competitive
level P0.
15-28
 Price Supports
• Price support: raises the
market price by making
Quantity traded
purchases of the good,
thereby increasing
demand
• In diagram, this is
represented by rightward
shift of demand curve as
G buys up Q2 – Q1.
• No black market can exist
in this case.
15-29
 SUPPORTING THE PRICE OF WHEAT IN THE US
1981 Supply: QS = 1800 + 240P
1981 Demand: QD = 3550 266P
THE WHEAT MARKET
IN 1981
To increase the price to
$3.70, the government
must buy a quantity of
wheat Qg.
By buying 122 million
1981 Total demand: QD = 3550 266P + Qg
bushels of wheat, the
government increased the Qg= 506P 1750
market-clearing price from Qg= (506)(3.70) 1750 = 112 million bushels
$3.46 per bushel to $3.70. Loss to consumers = −A − B = $624 million
Cost to the government = $3.70 x 112 million = $451.4 million
Total cost of the program = $624 million + $451.4 million = $1075 million
Gain to producers = A + B + C = $638 million
 Production Quota
• Production quota: imposes
limits on the quantity that
individual firms can
produce
Quantity traded
• Limits black marketing
while producing the same
price change as price floor.
• But producers as well as
consumers be even more worse
off than before – there is no
option of trading goods in a
black market – as these goods
never get produced if quotas are
administered in a forthright
manner.
15-31
 WHY CAN’T ONE FIND A TAXI IN NEW YORK?
The city of New York limits the number of taxis by requiring each taxi to have a
medallion (essentially a permit), and then limiting the number of medallions. In 2011
there were 13,150 medallions in New York—roughly the same number as in 1937. Why
not just issue more medallions? The reason is simple. Doing so would incur the wrath
of the current owners of medallions. Medallions can be bought and sold by the
companies that own them.
In 1937, there were plenty of medallions to go around, so they had little value. By
1947, the value of a medallion had increased to $2,500, by 1980 to $55,000, and by
2011 to $880,000. That’s right—because New York City won’t issue more medallions,
the value of a taxi medallion is approaching $1 million!
But of course that value would drop sharply if the city starting issuing more
medallions. So the New York taxi companies that collectively own the 13,150 available
medallions have done everything possible to prevent the city from issuing any more—
and have succeeded in their efforts.
If the city were to issue another 7,000 medallions for a total of about 20,000, demand
and supply would equilibrate at a price of about $350,000 per medallion– still a lot,
but just enough to lease cabs, run a taxi business, and still make a profit.
 WHY CAN’T ONE FIND A TAXI IN NEW YORK?
The demand curve D
shows the quantity of
medallions demanded by
taxi companies as a
function of the price of a
medallion.
The supply curve S shows
the number of medallions
that would be sold by
current owners as a
function of price.
New York limits the
quantity to 13,150, so the
supply curve becomes
vertical and intersects
demand at $880,000, the
market price of a medallion
in 2011.
Policies that Raise Prices and their
Welfare Effects
Ignore
this
column
as we
Have
not
studied
it.
15-34
 Price ceiling
• Price ceiling: Quantity traded
establishes a
maximum price that
sellers can charge Price ceiling
through legal
legislation.
15-35
 THE MARKET FOR HUMAN KIDNEYS
Even at a price of zero (the effective price under the law), donors supply about 16,000
kidneys per year. It has been estimated that 8000 more kidneys would be supplied if the price
were $20,000.
We can fit a linear supply curve to this data—i.e., a supply curve of the form Q = a + bP.
When P = 0, Q = 16,000, so a = 16,000. If P = $20,000, Q = 24,000, so b = (24,000
16,000)/20,000 = 0.4.
Thus the supply curve is Supply: QS = 16,000 + 0.4P
Like supply, demand is relatively price inelastic; a reasonable estimate for the price elasticity
of demand at the $20,000 price is −0.33. One can estimate (we ignore the techniques of how
to do this) :
Demand: QD = 32,000 0.4P
 MARKET FOR KIDNEYS AND THE US NATIONAL ORGAN TRANSPLANTATION ACT
The market-clearing price is $20,000; at
this price, about 24,000 kidneys per year
would be supplied.
The law effectively makes the price zero.
About 16,000 kidneys per year are still
donated; this constrained supply is shown
as S’.
The loss to suppliers, due to this law, is
given by rectangle A and triangle C.
The loss to consumers, due to this law, is
triangle B (due to less availability without
law) less rectangle A (due to higher prices
without law).
The aggregate loss to social welfare due
to this law is B+C.
Economics, the dismal science, shows us that human organs have economic value that
cannot be ignored, and prohibiting their sale imposes a cost on society that must be
weighed against the benefits.
 Monopoly
chapter 17
From the idealistic extreme of market participants being price takers, to the other extreme (and much more realistic)
setting of one participant who can behave as price SETTER.
 Overview
• Unlike competitive markets, some other market
structures allow firms to charge a price above its
marginal cost (market power)
• Monopolists determine prices differently than
competitive firms, and they also choose their
products’ quality, and engage in research and
development (compete to form monopoly) to
maximize their profits
• To prevent the welfare loss that accompanies
monopoly pricing, governments sometimes regulate
the price a monopolist can charge
 Some Notions
Market power of a firm: when a firm can profitably charge a (uniform)
price per unit that is above its marginal cost of producing the
corresponding amount of demand (that is not possible in a perfectly
competitive market. HENCE, FIRM IS NOT A PRICE TAKER.
Examples of markets where sellers have market power:-
• Monopoly market: a market with a single seller
• Oligopoly market: a market with a few sellers
Sometimes the buyer also may have market power :-
• Monopsony market: a market with a single buyer
UNLESS MENTIONED OTHERWISE, WE ASSUME IN THIS CHAPTER THAT OUR
MONOPOLIST CHANRGES THE SAME PRICE FOR EACH UNIT THAT SHE SELLS
17-3
 How to become a monopolist
• Government awards and patents (example:
PHARMA)
• Other firms do not find the market profitable
(example: we will see later)
• Innovation and cost cutting (example: LAPTOP)
• Ownership of all of an essential input (example: OIL,
DIAMONDS)
 Price not equal to Marginal Revenue
(unlike Perfect Competition)
WHAT DOES THE MONOPOLIST FIRM BELIEVE/ EXPECT TO HAPPEN, WHEN IT
REDUCES ITS SALES BY A LITTLE AMOUNT? DOES IT EXPECT TO CONTINUE
GETTING THE SAME UNIFORM PRICE FOR EACH UNIT SOLD?
Price INCREASE
effect
Output REDUCTION effect
NOTE THAT THIS LOGIC WORKS ONLY BECAUSE WE ASSUME UNIFORM PRICING, THAT
IS, ALL CONSUMERS PAY THE PRICE PER UNIT OF PRODUCT PURCHASED FROM THE
17-5
MONOPOLIST.
 Marginal Revenue for a Monopolist
(NOTE THE UNDERLYING ASSUMPTION OF UNIFORM PRICING – WE SHALL RELAX IT LATER)
TR (Q ) TR (Q Q)
MR (Q )
Q
P (Q ) P (Q Q)
P (Q Q) .Q
Q
P When monopolist’s output is
MR (Q) P(Q) ( )Q finely divisible, the term Q –
Q ΔQ becomes approximately
equal to Q as ΔQ goes to
zero.
Output Price
Reduction Increase
Effect Effect
 Marginal Revenue and Elasticity
1
MR (Q ) P (Q )(1 )
| Ed |
• Elasticity of demand E d is a negative number
(typically), formula shows that marginal revenue is
less than price
• The more elastic the demand, the closer is marginal
revenue at output level Q to the price P(Q).
 Monopoly Profit Maximization
• Step 1: Quantity rule
– Identify positive sales quantities at which MR=MC and slope of
MC curve should be at least as great as the slope of MR curve. If
more than one positive sales satisfies the conditions, identify the
one that produces the highest profit. (Recall that for perfectly
competitive market MR(q)=P for all q>0)
• Step 2: Short run shut-down rule
– Check whether the most profitable positive sales quantity from
Step 1 is greater profit than shutting down (without exiting of
course). If it is, that is the profit maximizing choice. If not, then
selling nothing by ceasing production is the best option.
Profit Maximizing Price and Sales Quantity
MR = MC Profits
Markup: A Measure of Market Power
• The degree of a monopolist’s market power is
measured by the extent to which its price exceeds its
marginal cost, typically measured as a percentage:
P - MC 1
=-
P Ed
• Ratio is known as the markup, the price-cost margin,
and the Lerner index
 ASTRA-MERCK PRICES PRILOSEC
In 1995, Prilosec, represented a new generation of antiulcer medication. Prilosec was
based on a very different biochemical mechanism and was much more effective than
earlier drugs.
By 1996, it had become the best-selling drug in the world and faced no major competitor.
Astra-Merck was pricing Prilosec at about $3.50 per daily dose.
The marginal cost of producing and packaging Prilosec is only about 30 to 40 cents per
daily dose. The price elasticity of demand, ED, was estimated to be in the range of
roughly −1.0 to −1.2.
Check if the monopolist her Astra-Merck is profit maximizing or not?
 NO SUPPLY CURVE IN A MARKET THAT IS MONOPOLY
• A monopolistic market has no supply curve. In other words, there is no one-to-one
relationship between price and the quantity produced.
• The reason is that the monopolist’s output decision depends not only on marginal
cost but also on the shape of the demand curve – because she is no longer a price
taker driven by a naïve belief; instead she is PRICE SETTER.
• As a result, shifts in demand do not trace out the series of prices and quantities
that correspond to a competitive supply curve. Instead, shifts in demand can lead
to changes in price with no change in output, changes in output with no change in
price, or changes in both price and output. (See example in next slide.)
• Shifts in demand usually cause changes in both price and quantity in a
competitive industry. A competitive industry supplies a specific quantity at every
price. No such relationship exists for a monopolist, which, depending on how
demand shifts, might supply several different quantities at the same price, or the
same quantity at different prices.
 SHIFTS IN DEMAND THAT DO NOT AFFECT (a) OUTPUT SOLD, & (b) MARKET PRICE
This is possible because a
monopolistic market has no supply
curve—i.e., there is no one-to-one
relationship between price and
quantity produced.
• In (a), the demand curve D1 shifts
to new demand curve D2. But the
new marginal revenue curve MR2
intersects marginal cost at the
same point as the old marginal
revenue curve MR1.The profit-
maximizing output therefore
remains the same, although price
falls from P1 to P2.
• In (b), the new marginal revenue
curve MR2 intersects marginal cost
at a higher output level Q2. But
because demand is now more
elastic, price remains the same.
 Welfare Effects of Monopoly Pricing
Please remember unlike in book – we have defined producer surplus to be profit + fixed
costs (if they exist). We ignore sunk costs while computing economic profit – as it does/
should not AFFECT any of firm’s OPERATIONAL decisions. It is up to the ACCOUNTANTS
(not ECONOMISTS) to window dress profits by including/ amortizing such sunk costs.
Monopoly price and quantity
Competitive equilibrium
- Fixed - Fixed
cost cost
- Fixed - Fixed
cost cost
DWL
MONOPOLY LEADS TO WASTAGE VIZ-A-VIZ PERFECTLY COMPETITIVE OUTCOME, AND THIS
WASTAGE IS CAPTURED BY THE DEAD WEIGHT LOSS. THIS LOSS OF POTENTIAL EFFICIENCY IS
KNOWN AS MARKET FAILURE.
 A CRITICAL CONCEPT ABOUT ECONOMIC MARKETS
• In a market where both sellers and buyers are price takers – we get to have a supply
curve and a demand curve.
• In a market where sellers are not price taker (for any reason) but all buyers are – we
do NOT have a supply curve, but get to HAVE demand curve. (Ex - MONOPOLY).
• In a market where buyers are NOT price taker (for any reason) but all sellers are – we
we get to have a supply curve but not demand curve.
• In a market where neither buyers nor sellers are price takers, there can be no
demand curve or supply curve. These are bargaining markets – matter of advanced
game theory.
17-15
 Monopsony
(inverse of monopoly)
A market with a single buyer
Example: A small city with only one hospital where
nurses may work. As offered wages increase supply of Marginal expenditure curve
labour as nurses increases (remember the labour supply
curve) – this creates the upward sloping labour supply
curve (we ignore the backward bending part as it exists at
really high wages).
On the other, there is only one buyer of nurses in the city
– hence has inverse monopoly power where there is only DWL
ONE buyer – but many sellers. This buyer has a marginal
benefit (MB) curve that depicts the incremental benefit (as
profit or utility) from buying a little extra nurse hour at
different levels of current employment of nurses.
Typically this is downward sloping. (Also note that this
curve would be called the Demand curve iff the market Competitive equilibrium
became perfectly competitive - just like the marginal cost
curve in a Monopoly would depict a supply curve if the
market were perfectly competitive.)
Since all nurses must be paid the same wage the marginal
cost/expenditure of hiring one extra nurse is (i) the Monopsonist
(higher) wage that needs to be paid to this extra nurse (or
else she will not) and (ii) the extra wage that needs to be price and quantity
paid to all earlier hired nurses.
Hence marginal expenditure of hiring nurses when Q
nurses are working is
W The hospital decides to hire Q* nurses where
ME (Q) W (Q) ( )Q ME(Q*)=MB(Q*).
Q
 Marginal Expenditure
• Marginal Expenditure (ME): the extra cost incurred
to hire or purchase the marginal units of an input
W
ME (Q) W (Q) ( )Q
Q
Input Price
Input Reduction
Decrease Effect
Effect
• Same as the Marginal revenue concept:
P
MR (Q) P(Q) ( )Q
Q
 Monopsony Profit Maximization
• Profit-maximizing choice q* is when the
monopsony’s willingness to pay (marginal benefit)
equals its marginal expenditure (marginal cost):
MB (q*) ME (q*)
 Welfare Effects of Monopsony Pricing
• Just as with monopoly, monopsony price setting creates
deadweight loss. This because:
– The monopsonist uses too little of the input, meaning
that some potential net benefits from the input are
lost.
– The deadweight loss is the area between the
monopsonist’s marginal benefit and market supply
curves (Try to figure out yourself).
IGNORE THIS SLIDE AS WE DID NOT DISCUSS IN CLASS
 Natural Monopoly
The monopolist firm faces a long run average cost curve is continuously downward
sloping. This typically occurs due to technical peculiarity of the underlying
PRODUCTION function.
HIGH STARTUP COST OF A BUSINESS IS NEITHER NECESSARY NOR SUFFICIENT
FOR SUCH FIRMS TO EXIST.
REGULATING A NATURAL MONOPOLY
MARKET
A firm is a natural monopoly because it has
economies of scale (declining average and
marginal costs) over its entire output range.
They cannot afford to price competitively.
If price were regulated by Government to be Pc
the firm would lose money and go out of
business. (First best regulation doesn’t work)
Setting the price at Pr yields the largest
possible output consistent with the firm’s
remaining in business; excess profit is zero.
(Second best regulation)
 Government action to curb market power
Excessive market power harms potential purchasers and raises problems of equity
and fairness. In addition, market power reduces output, which leads to a deadweight
loss.
In theory, a firm’s excess profits could be taxed away, but very difficult to implement.
To limit the market power of a natural monopoly such as an electric utility company,
direct price regulation is the answer.
For other monopoly markets, an useful option is legal framework of checks and
balances like:
Antitrust laws: Rules and regulations prohibiting actions that restrain, or are likely to
restrain, competition. Such laws typically prohibit:
parallel conduct: Form of implicit collusion in which one
firm consistently follows actions of another, and
predatory pricing: Practice of pricing to drive current
competitors out of business and to discourage new
entrants in a market so that a firm can enjoy higher
future profits.
Antitrust in US
The antitrust laws in US are enforced in three ways:
1. Through the Antitrust Division of the Department of Justice.
2. Through the administrative procedures of the Federal Trade Commission.
3. Through private proceedings.
Antitrust in Europe
At first glance, the antitrust laws of the European Union are quite similar to those of the
United States. Article 101 of the Treaty of the European Community concerns restraints
of trade, much like Section 1 of the Sherman Act. Article 102, which focuses on abuses
of market power by dominant firms, is similar in many ways to Section 2 of the Sherman
Act. Finally, with respect to mergers, the European Merger Control Act is similar in spirit
to Section 7 of the Clayton Act.
Nevertheless, there remain a number of procedural and substantive differences
between antitrust laws in Europe and the United States. Merger evaluations typically
are conducted more quickly in Europe.
Antitrust enforcement has grown rapidly through the world in the past decade.
 IDENTIFYING A MONPOLY IS DIFFICULT – HIDDEN CARTELS
* We saw in earlier classes that perfectly competitive markets perform well, in the sense that
they maximize aggregate surplus.
*In contrast, we saw that monopolized markets fail to achieve this ideal, as there is DWL. This is
known as market failure.
*Unfortunately, the existence of more than one firm in a market doesn’t necessarily guarantee
competition. Even if there are five or six firms in a given market they may collude and behave as if
they a (secret) SINGLE FIRM!!
*How can we identify whether firms behave like price takers in a perfectly competitive market or are
instead colluding and behaving like a monopolist? This is a question that government agencies
might pose in deciding whether to intervene in the market or penalize the firms
* One way to answer is if firms' marginal costs are well known. But these are hidden information not
publicly verifiable (accounting statements, even if true, ignore opportunity costs).
*So 'AN' option is to note changes in firm's price response to changes in demand curve
such that level of demand does not change but elasticity will change (advanced statistical
methods are available to do so). A competitive firm's price would not change but a
monopolist's price would change.
 Jail time for business executives
If you become a successful business executive, think twice before picking up the
phone. And if your company happens to be located in Europe or Asia, don’t think that
will keep you out of a U.S. justice department.
For example:
In 1996 Archer Daniels Midland (ADM) and two other producers of lysine (an animal
feed additive) pled guilty to charges of price fixing. In 1999 three ADM executives
were sentenced to prison terms of two to three years.
In 1999 four of the world’s largest drug and chemical companies—Hoffman-La Roche
of Switzerland, BASF of Germany, Rhone Poulenc of France, and Takeda of Japan—
pled guilty to fixing the prices of vitamins sold in the U.S. and Europe. The
companies paid about $1.5 billion in penalties to the U.S. Department of Justice
(DOJ), $1 billion to the European Commission, and over $4 billion to settle civil suits.
Executives from each of the companies did prison time in the U.S.
 Jail time for business executives...
Few more examples:
During 2002 to 2009, Horizon Lines engaged in price fixing with Sea Star Lines (Puerto
Rico-based shipping companies). Five executives got prison terms ranging from one
to four years.
Eight companies, mostly in Korea and Japan, fixed DRAM (memory chip) prices from
1998 to 2002. In 2007, 18 executives from these companies were sentenced to
prison terms in the United States.
In 2009, five companies pled guilty to fixing prices of LCD displays during 2001 to
2006. 22 executives received prison sentences in the United States (on top of $1
billion in fines).
In 2011, two companies were convicted of fixing prices and rigging bids for ready-mix
concrete in Iowa. One executive was sentenced to one year in prison, another to
four years.
 THE UNITED STATES AND THE EUROPEAN UNION VERSUS MICROSOFT
Over the past two decades Microsoft has grown to become the largest computer software
company in the world, and has dominated the office productivity market.
Under the antitrust laws of the United States and the European Union, efforts by firms to
restrain trade or to engage in activities that inappropriately maintain monopolies are illegal.
Did Microsoft engage in anticompetitive, illegal practices? In 1998, the U.S. government said
yes; Microsoft disagreed. The Antitrust Division of the U.S. DOJ filed suit, claiming that
Microsoft had illegally bundled its Internet browser, Internet Explorer, with its operating
system for the purpose of maintaining its dominant operating system monopoly.
Following an eight-month trial that was hard-fought on a range of economic issues, the
District Court found that Microsoft did have monopoly power in the market for PC operating
systems, which it had maintained illegally in violation of Section 2 of the Sherman Act.
The U.S. case was ultimately settled in 2004, with (among other things) Microsoft agreeing
to give computer manufacturers (1) the ability to offer an operating system without Internet
Explorer and (2) the option of loading competing browser Programs on the PCs that they
sell. (THUS CAME THE season of MOZILLA AND CHROME)
 THE UNITED STATES AND THE EUROPEAN UNION VERSUS MICROSOFT
Microsoft’s problems did not end with the U.S. settlement, however. In 2004, the European
Commission ordered Microsoft to pay $794 million in fines for its anticompetitive practices, to
produce a version of Windows without the Windows Media Player to be sold alongside its
standard editions. (HENCE CAME THE TIME OF VLC PLAYER)
In 2008, the European Commission levied an additional fine of $1.44 billion, claiming that
Microsoft had not complied with the earlier decision. Even more recently, in response to a
concern relating to the bundling of browsers, Microsoft agreed to offer customers a choice of
browsers when first booting up their new operating system.
As of 2011, the European case against Microsoft remains on appeal. There is strong evidence
that the European-imposed remedies have had little impact on the market for media players or
browsers. However, Microsoft is facing an even stronger threat than U.S. or E.U. enforcement,
such as competition from the powerful Google search engine and social media sites such as
Facebook.
 Looking Forward
• In this chapter we implicitly assumed that a
monopolist charges a unique price for all units of
the same product irrespective of the consumer
identity.
• In reality, a firm with market power can increase its
profit by charging different prices for different units
of the same good.
• Next, we will focus on this practice, called price
discrimination.
 chapter 18
In this chapter we tread into the field of non-uniform pricing by a monopolist. Typically such pricing
strategies, if legal, then lead to expansion in profits.
 Overview
• This chapter studies the practice of NON-UNIFORM PRICING, better
known as price discrimination.

• We will focus on such pricing for a monopolist – but these same pricing
scheme are also useful in markets with “FEW” sellers, better known as
Oligopoly (we study this at a later stage).

• Identify the conditions required for successful price discrimination, and

discuss different ways that a firm can price discriminate.

• Study the firm’s profit-maximizing pricing strategy and consider the

consequences for consumer and aggregate welfare

• Observe how self-selection can increase a firm’s profit

• Consider the practice of selling goods together as a bundle.

 Price Discrimination
• Price discrimination: a firm charges either different (NET) prices for
different units of the same good, or different (NET) prices to
different consumer identities.
• BASICALLY ENSURES THAT THE TOTAL COST OF BUYING q UNITS, EITHER CHANGES NON-LINEARLY AS q
CHANGES OR CHANGES AS CONSUMER IDENTITY CHANGES OR BOTH
• NOTE THAT OFTEN PRICES ARE MENTIONED TO BE SAME ON RECEIPT – BUT WITH FREE DOORSTEP
DELIVERY, PEOPLE AT DIFFERENT LOCATIONS END UP PAYING DIFFERENT AMOUNT FOR THE SAME
QUANTITY

• In order to price discriminate a firm must have some market power –

mathematically, price should not be a parameter for her when she is
calculating the profit maximizing output.

• Unless stated explicitly, we will assume that monopolists or seller in

this chapter have complete and accurate knowledge of the market
demand curve (perhaps, because they excellent statistical
departments).
 The three pre-conditions to price discrimination
1. The firm must have some market power, either as a monopolist or
as a part of oligopoly (to be studied later).
2. The firm must have the ability to sort or conceptualize (may not be
able to identify physically) her customers into different groups with
respect to willingness to pay.
3. The firm must have the ability to stop resale of her produce.

So if you can sell a product at a mark up from her marginal cost of production, you
can very likely do better by price discriminating. Some products suitable for price
discrimination:
– Electricity [difficult to resale by nature].
– Books [publishers use tariffs and non-tariff/ legal barriers to sell the same edition at different prices
in different countries].
– Computer software [two options: (i) provide student discounts for full version while legally
restricting resale, or (ii) alter the product at zero cost and sell to students a limited version, thus
automatically making resale immaterial]
 BCG consults on Price discrimination – so stay awake

In this chapter we will see how to “AVOID AVERAGE PRICING” without the additional complication of
“ALTERNATIVE SUPPLIERS”. For the latter part, I plan to float a dedicated elective in Term 5 – but its
uncertain.
Perfect (First degree) Price Discrimination
(almost impossible in real life)
A monopolist can engage in perfect price discrimination if he
knows a customer’s willingness to pay for each unit he sells, and
can charge a different price for each unit to each customer.
 ADDITIONAL PROFIT FROM PERFECT FIRST-DEGREE PRICE DISCRIMINATION

Because the firm charges each consumer

her reservation price or maximum
willingness to pay, it is profitable to expand
output to Q**.

When only a single price, P*, is charged, the

firm’s producer surplus is the area between
the marginal revenue and marginal cost
curves.

With perfect price discrimination, this profit

expands to the area between the demand
curve and the marginal cost curve.

Also the profit maximizing firm would produce

the competitive level of output Q** where
demand curve intersects the MC curve, and MC
curve is not downward sloping.(This last
statement is true if all consumers have quasi-
linear utilities in money and other goods. In
general, this may not be true.)
Two-Part Tariffs – a practical version of 1st degree price discrimination
(assume a single consumer.)

• Two-part tariff: consumers pay a

fixed fee if they buy anything at all,
plus a separate UNIFORM price for
each unit they buy

• With a per-unit price of $1.50, the

demand will be for 3 units. This
leaves a consumer surplus of $2.25
(light-green/gray triangle), so they
would be willing to pay a weekly fee
of $2.25, and no more

• So if the monopolist knows the

demand curve with a high degree of
statistical certainty, this is a better
pricing scheme than the standard
uniform pricing of the last chapter.
 Optimal Two-Part Tariff
(assume a single consumer)

By lowering its per-minute

charge from 20 to 10 cents,
equal to its marginal cost, and
raising its fixed fee, the firm can
increase its profit to the
maximum possible

A monopolist will sells an output

where P(q*) = MC(q*), that
produces as much as a
competitive firms
 TYPICAL TWO PART TARIFF WITH TWO DIFFERENT CONSUMERS
The (typical) profit-maximizing usage fee
P* will exceed marginal cost.

The (typical) entry fee T* is equal to the

surplus of the consumer with the smaller
demand.
Assumption: AB /3= P*B
The resulting profit is 2T* + (P* − MC)(Q1 +
Q2). Note that this profit is larger than twice
the area of triangle ABC.

Mathematically firm chooses entry fee T,

and per unit price P to maximize n(T,P)T+[P-
MC(Q)].Q where
𝑛(𝑇,𝑃)
Q = 𝑖=1 𝑄 i , and n(T,P) is the number of
agents who choose to buy the product.
NOTE THAT TWO PART TARIFF EFFECTIVELY CONVERTS ONE PRODUCT INTO
An algorithmic way of to do this is for all TWO DERIVED GOODS WHENEVER SOCIOLOGICALLY POSSIBLE.
positive values of T, figure out a P*(T) that ONE DERIVED GOOD IS THE ACCESS TO THE PRODUCT, AND THE OTHER IS
maximizes the above expression – and then ACTUAL CONSUMPTION OF THE PRODUCT. CONSUMER MUST PROCURE THE
choose the T* that maximizes the value: FIRST GOOD TO CONSUME THE SECOND GOOD – BUT NOT VICE-VERSA.

n(T,P*(T))T+[P*(T)-MC(Q)].Q THEN BOTH DERIVED GOODS ARE SOLD VIA UNIFORM PRICING.
 Second degree price discrimination
(Each consumer faces the same price schedule – but price schedule is such that the cost of
purchasing q units changes non-linearly as q changes.)
One such method is ―block pricing‖ which is practice of charging different prices for different
quantities or ―blocks‖ of a good. Another method could be practice of giving volume subsidies of bulk
discount were per unit consumption is cheaper only when aggregate consumptions exceeds some
threshold.

BLOCK PRICING IN NATURAL MONOPOLY

Different prices are charged for different quantities,
or “blocks,” of the same good. Here, there are three
blocks, with corresponding prices P1, P2, and P3. So
for any amount C that is consumed – if Q3 > C> Q2,
then the price she pays is P1 Q1 + P2 [C – Q1].

In this example, such pricing is motivated by

economies of scale, and average and marginal costs
are declining. Second-degree price discrimination
can then make consumers better off by expanding
output and lowering cost.

Monopolists also use this technique when the consumer have extreme desire/willingness to pay for the product up till a certain threshold
level - after which it declines sharply. For example: a certain amount of electricity is essential to running a household (to run
TV/AC/refrigerator etc.) – but beyond that level, conservation of energy becomes easier (leading to a fall in willingness to pay).
 CUSTOMER SEGMENTATION
Three scenarios:
(1) Observable consumer groups (that is, customers are differentiable in eyes of seller) and there
are no legal barriers to price discrimination.
(2) Observable consumer groups but there are legal barriers to price discrimination.
(3) Unobservable consumer groups.

CASE (1):
• firm can distinguish consumers by their socio-economic characteristics
which are easy to verify, which in turn, reveal the EXTENT of their
willingness to pay for a product.
• essentially, based on these characteristics the monopolist may divide the
market in two separate markets, and charge different profit maximizing
prices in each market - example: railway tickets

Note that we continue to assume that: not only can the seller segregate customers into different markets but it
ALSO KNOWS THEIR RESPECTIVE DEMAND curves for sure.
 Third-Degree Price Discrimination: Case (1)
Definition: Practice of dividing consumers into two or more groups with separate demand
curves and charging different prices to each group (UNIFORM PRICE WITHIN EACH
GROUP), when customer characteristics are observable and no legal barriers to doing
so.

If third-degree price discrimination is feasible, how should the firm decide what price to
charge each group of consumers?

1. Total output should be sold in the two markets in such a way that marginal revenues
for each group are equal.

2. Total output must be such that marginal revenue for each group of consumers is
equal to the marginal cost of production.
 Let P1 be the price charged to the first group of consumers, P2 the
price charged to the second group, and C(QT) the total cost of
producing output QT = Q1 + Q2. Total profit is then

𝜋 = 𝑃1 𝑄1 + 𝑃2 𝑄2 − 𝐶 𝑄𝑇

∆𝜋 ∆ 𝑃1 𝑄1 ∆𝐶
= − =0
∆𝑄1 ∆𝑄1 ∆𝑄1

MR1 = MC

MR 2 = MC

MR1 (𝑄1 ) = MR 2 (𝑄2 ) = MC (Q1 + Q2)

And since for all q>0, 𝑀𝑅 𝑞 = 𝑃 𝑞 1 − 1 𝐸𝑑 𝑞 , we can say that:

𝑃1 1 − 1 |𝐸𝑑 𝑄2 |
=
𝑃2 1 − 1 |𝐸𝑑 𝑄1 |
 Profit with 3rd degree price discrimination across to two
groups of consumers

PRODUCER SURPLUS/ PROFIT = 3x300 + 7x700 = 900+ 4900= 5800$

 Profit without 3rd degree discrimination across two groups of
consumers.

PRODUCER SURPLUS/ PROFIT

= $5,000

Graphically, at least in this example, we can see that price discriminating producer surplus/
profit is GREATER than when not discriminating. MUST BE TRUE IF POSITIVE OUTPUT SOLD IN
EACH MARKET.

WHAT IF I CANNOT PHYSICALLY IDENTIFY CUSTOMERS FROM DIFFERENT GROUPS FOR SURE? WHAT IF I CAN DO SO BUT
AM LEGALLY MANDATED TO NOT DISCRIMINATE?
Changes in Consumer Surplus with 3rd degree discrimination
across two groups of consumers.

Adults lose $1,600

Students gain $400

[Decrease in consumer surplus = $1,200, Increase in profit = $800, ]====> [Decrease in

aggregate surplus in our example]
 Welfare Effects of 3rd Degree Price Discrimination

• Price discrimination has two main effects on aggregate

surplus
– Different consumers pay different prices. As a result, a
consumer with a low willingness to pay but facing a low
price may decide to buy the good while a consumer with a
higher willingness to pay may decide to not buy the good
when faced with a higher price, resulting in inefficiency.

– Price discrimination may encourage the monopolist to sell

more tickets by selling to both low demand as well as high
demand markets.

• The two opposing effects can combine to either raise or lower

aggregate surplus.
 Third-Degree Price Discrimination: Cases (2) & (3)
– Either because monopolist cannot segregate customers based
on their observable characteristics

– Or because monopolist cannot LEGALLY segregate customers

based on socio-economic characteristics. (MORE NATURAL CASE)

SOLUTION:
Self-selection: when the firm offers a menu of alternatives,
designed so that different customers will make different
choices based on their willingness to pay.

Sometimes these menu will ensure that cost of purchase of q units

changes non-linearly with q. In these cases, the boundaries of 3rd and
2nd degree PD become fuzzy, and we resort to PD that is mixture of the
all three kinds of PD.
 Mixture of 1st, 2nd, and 3rd degree using Self-Selection
• Two customer segments – one with high demand, the other with low
demand. But the firm cannot identify them.

• Self-selection would requires choosing a price schedule that makes

the low-demand plan less a attractive to high-demand consumers.

• Can be easily done by limiting the number of minutes a consumer

can purchase in the low-demand plan to the amount number that
low-demand consumers demand as per the price offered in the low-
demand plan. This

– Will have no effect on value that a low-demand consumer derives

– Makes the plan less attractive to high-demand customers

1st and 3rd degree price discrimination without capping to induce self-selection
in mobile tariff plan
Suppose a price of 20 cents is offered to low demand consumer, and a price of 10 cents is offered to the high demand
consumer. To appropriate all consumer surplus a fixed fee equal to upper triangle on the left diagram is charged along
with per unit price 20 cents. The high demand plan is designed to have a fixed fee such that (i) it is greater than CS for
low customer if she chooses the high plan, and (ii) CS of high demand person from high plan is same as that from low
plan [INCENTIVE CONSTRAINT].

Producer surplus = $7.50 Producer surplus = $13

$4.50 = high plan fixed fee part I

$4.50 = low plan fixed fee $8 = high plan fixed fee
part II

$3 = producer surplus $0.5 = high plan

fixed fee part III

CS of low demander from low plan =0, CS of high demander from high plan = blue area
ASSUMPTION: DEMAND CURVES OF BOTH SEGMENTS ARE KNOWN – BUT INDENTIFICATION OF A CONSUMER AS HIGH
DEMAND OR LOW DEMAND IS NOT POSSIBLE
 Capping Minutes In the Low-Demand Plan

Producer surplus from

High demand plan = $ 25.5
Producer surplus = $7.5

Fix one plan for low demand consumers where fixed fee is 4.5$ and 20 cents per minute of usage with
maximum usage available is 30 units. This ensures that the low demand buyer has no consumer
surplus. Fix another plan for high demand customer, and charge a fixed fee X$ and (same uniform price)
10 cents per minute without any LIMIT on usage. Define Y$ to be the possible consumer surplus of high
demand person IF she were to consume her demand at price of 20 cents per unit without any fixed fee.

For self-selection choose X$ such that Y-X = the consumer surplus of high demand customer if she
consumes only 30 minutes of cellular service at 20 cents per minute and fixed fee 4.5$ = BLUE AREA. That is
X= (Y - BLUE AREA).
 Combination of third degree price discrimination with two part tariff with
second degree price discrimination to induce self-selection.

• Note that this plan leads to self selection. But the profit earned is
lesser in the 1st application case that we saw.

• That is because in the current (that is, 2nd application) case, my high
demand plan DOES NOT allow high demand consumer to get ‘a lot
of’ surplus so as to ensure SELF SELECTION where she can be
indifferent between choosing high demand plan and the low
demand plan.
– That is, restrict consumption of low plan up to 30 which is less
than what high demander wants to consume as low plan price of
20 cents.
– This reduces the area of CS she can get achieve by choosing low
plan, and so, allows me to charge even greater amount of fixed
fee in my high plan.
So, its more profitable to ensure self selection along with quantity
capping in low demand plan. Also it may be profitable to price NO
markup to the high demand persons
 COUPONS AND REBATES
(special application of 3rd degree price discrimination in presence of unobservable customer
segmentation)
Coupons offer discount to carriers of these. But why waste money printing and circulating
coupons when one could simply lower prices? Because coupons provide a means of price
discrimination so offer lower prices to only those who really want then..
NUSERS OF COUPONS
PRICE ELASTICITIES OF DEMAND FOR USERS VERSUS NO

PRICE ELASTICITY
PRODUCT NONUSERS USERS
Toilet supplies – 0.60 –0.66
Stuffing/dressing –0.71 –0.96
Shampoo –0.84 –1.04
Detailed analysis can be found in a paper by Cooking/salad oil –1.22 –1.32
Chakravarthy Narasimhan in journal MARKETING Dry mix dinners –0.88 –1.09
SCIENCE in 1984. He estimates price elasticity
Cake mix –0.21 –0.43
differences between coupon users of different
commodities, and finds that users have greater Cat food –0.49 –1.13
elasticity on average. Frozen entrees –0.60 –0.95
Gelatin –0.97 –1.25
Spaghetti sauce –1.65 –1.81
Crème
–0.82 –1.12
rinse/conditioner
Soups –1.05 –1.22
Hot dogs –0.59 –0.77
 AIRLINE FARES
Travelers are often amazed at the variety of fares available for round-trip flights from
New York to Los Angeles.
A few years ago, the first-class fare was above $2000; the regular (unrestricted)
economy fare was about $1000, and special discount fares (often requiring the
purchase of a ticket two weeks in advance and/or a Saturday night stayover) could be
bought for as little as $200. These fares provide a profitable form of price discrimination.
The gains from discriminating are large because different types of customers, with very
different elasticities of demand, purchase these different types of tickets.
Airline price discrimination has become increasingly sophisticated. A wide variety of
fares is available.

FARE CATEGORY
ELASTICITY FIRST CLASS UNRESTRICTED COACH DISCOUNTED
Price –0.3 –0.4 –0.9
Income 1.2 1.2 1.8

Note the high price elasticity of demand for discounted fares which are typically bought by families well in
advance or leisure travellers. Demand for first class typically comes from business travellers who have less
flexibility on dates of travel and so have less price elasticity of demand.

Of course airlines also employ dynamic pricing in a major way!!

 PRICING CELLULAR PHONE SERVICE
Most telephone service is priced using a two-part tariff: a monthly access fee, which
may include some free minutes, plus a per-minute charge for additional minutes. This is
also true for cellular phone service, which has grown explosively, both in the United
States
and around the world.

In the case of cellular service, providers have taken the two-part tariff and turned it
into an art form.

In most parts of the United States, consumers can choose among four national
network providers—Verizon, T-Mobile, AT&T, and Sprint. These providers compete
among themselves for customers, but each has some market power. Market power
arises in part from oligopolistic pricing and output decisions (WE WILL STUDY LATER),
but also because consumers face switching costs (in India government has tried to
make this zero by ensuring number portability): Most service providers impose a
penalty upwards of $200 for early termination. Because providers have market power,
they must think carefully about profit-maximizing pricing strategies. The two-part tariff
provides an ideal means by which cellular providers can capture consumer surplus and
turn it into profit.
 CELLULAR PLANS EXAMPLE - US

CELLULAR RATE PLANS (2011)n

ANYTIME PER-MINUTE RATE
MINUNTES NIGHT & WEEKEND AFTER ANYTIME
ALLOTTED IN A MONTHLY RENTAL MINUTES (when MINUTES ARE
MONTH CHARGES demand is low) EXHAUSTED
A. VERIZON: AMERICA’S CHOICE BASIC
450 $39.99 Unlimited $0.45
900 $59.99 Unlimited $0.40
Unlimited $69.99 Unlimited Included
B. SPRINT: BASIC TALK PLANS
200 $29.99 Unlimited $0.45
450 $39.99 Unlimited $0.45
900 $59.99 Unlimited $0.40
C. AT&T INDIVIDUAL PLANS
450 $39.99 5000 $0.45
900 $59.99 Unlimited $0.40
Unlimited $69.99 Unlimited Included

QUESTION: Why don’t the firms offer a simple common two part tariff price for their
products that is easier to administer, and account for?

ANSWER: Now you know!

 ADDITIONAL SLIDE – NOT NEEDED FOR EXAM AS NOT DISCUSSED IN CLASS

• We now know basics of price discrimination to use heterogeneity in

willingness to pay across consumer group to maximize profits for a
monopolist.

• On a practical level, you must try to force customers to segment into

such group by introducing in slight variations in your product across
dimensions like time, spatial location, or quality.

• Another important method of psychologically creating such

segmentation is advertising – for example, : organic versus inorganic
agricultural produce.

• The idea is not to be unscrupulous – but create variations in product

that allows you to charge different markups over marginal costs from
different customer segments.
 MILLION DOLLAR QUESTION

FOR A MONOPOLIST SELLING A SINGLE OBJECT:

“What is the best selling strategy for a monopolist? Non-discriminatory uniform
monopoly pricing, or two part tariff, or decreasing / non-decreasing price schedules that
price discriminate in the second degree, or third degree price discrimination?”

THE ANSWER VARIES FROM CASE TO CASE DEPENDING ON ECONOMIC & LEGAL CONDITIONS
OF THE SETTINGS YOU ARE ANALYZING.

(THAT IS WHY YOU WOULD BE PAID THE BIG BUCKS)

And if that weren’t enough, you still have to advise your client on
optimality of breaking down their product into multiple separate ones.
This is know as Bundling – and we shall study it now.
 Bundling
Practice of selling two or more products as a package. Typically, makes sense
when customers are segmented/heterogeneous and identifiable - but
monopolist CANNOT price discriminate (why – maybe government bans it?)
To see how a film company can use customer heterogeneity to its advantage, suppose that there
are two movie theaters and that their reservation prices for our two films (made by the same
company/ distributor) as follows:

AVENGER EXTRACTION
Theater A $12,000 $3000
Theater B $10,000 $4000

Suppose the films cost the same amount of money to make (say, $ 1K). If the films are rented
separately, the maximum price that could be charged for AVENGER is $10,000 because charging
more would exclude Theater B. Similarly, the maximum price that could be charged for
EXTRACTION is $3000.

But suppose the films are bundled. Theater A values the pair of films at $15,000 ($12,000 +
$3000), and Theater B values the pair at $14,000 ($10,000 + $4000). Therefore, we can charge
each theater $14,000 for the pair of films and earn a total revenue of $28,000.
 Relative Valuations

Why is bundling more profitable than selling the films separately? Because the relative
valuations of the two films are reversed. That is, the demands are negatively correlated—the
customer willing to pay the most for Avenger is willing to pay the least for Extraction.
Suppose INSTEAD that demands are positively correlated—that is, Theater A would pay more for
each film than Theatre B.

AVENGER EXTRACTION
Theater A $12,000 $4000
Theater B $10,000 $3000

If we bundled the films, the maximum price that could be charged for the package is
$13,000, yielding a total revenue of $26,000, the same as by renting the films
separately.

In general, effectiveness of bundling depends to the extent demands for two products
(of a single firm) are negatively correlated – that is, customer with high WTP for a
company’s product X have low WTP for the same company’s other product Y.
 A MORE GENERAL ANALYSIS IN TERMS OF RESERVATION PRICES

DEPICTION OF CUSTOMERS IN THE

RESERVATION PRICE SPACE FOR TWO
GOODS

Fix any two goods G1 and G2.

Reservation prices r1 and r2 for two goods

are shown for three consumers, labeled A, B,
and C.
Consumer A is willing to pay up to $3.25 for
good 1 and up to $6 for good 2.
 CONSUMPTION DECISIONS WHEN PRODUCTS ARE BUNDLED AND SOLD AT PRICE PB

Consumers compare the sum

of their reservation prices r1 +
r2, with the price of the bundle
PB.
They buy the bundle only if r1 +
r2 is at least as large as PB.
CONSUMPTION DECISIONS WHEN PRODUCTS ARE SOLD SEPARATELY (AT PRICES P1 and
P2)

The reservation prices of consumers

in region I exceed the prices P1 and P2
for the two goods, so these
consumers buy both goods.
Consumers in regions II and IV buy
only one of the goods,
and consumers in region III buy
neither good.
 The two extremes

In (a), because demands are perfectly positively correlated, the firm does not gain by bundling: It
would earn the same profit (as bundling) by selling the goods separately.
In (b), demands are perfectly negatively correlated. Bundling is the ideal strategy—all the
consumer surplus can be extracted.
 Mixed vs Pure Bundling
mixed bundling: Selling two or more goods both as a package and individually.

pure bundling: Selling products only as a package.

With positive constant marginal costs,

mixed bundling may be more profitable
than pure bundling.

Compare pricing schemes: (A) PB = 100, P1 =

P2= 80, and (B) PB = 100.
Consumer A has a reservation price for
good 1 that is below marginal cost c1,
and consumer D has a reservation price for
good 2 that is below marginal cost c2.
With mixed bundling, consumer A is
induced to buy only good 2, and consumer
D is induced to buy only good 1, thus
reducing the firm’s cost. So when setting up price, you must choose
carefully whether to sell separately, or as pure
bundle or as mixed bundle.
A potential algorithm for “Mixed Bundling” in Practice assuming non-zero marginal
costs!
The dots in this figure are estimates of
reservation prices for a representative
sample of consumers.
A company could first choose a price for
the bundle, PB, such that a diagonal line
connecting these prices passes roughly
midway through the dots (fit a linear
downward sloping line by choosing the
intercept, that is, price of bundle suitably
to minimize the sum of distances from of
the dots from the fitted line).

In case, there are dense clusters at the

two ends of the fitted line - the company
could then try individual prices P1 and P2.

Given P1, P2, and PB, profits can be calculated for

this sample of consumers. Managers can then raise
or lower P1, P2, and PB and see whether the new
pricing leads to higher profits. This procedure is
repeated until total profit is roughly maximized.
 THE COMPLETE DINNER VERSUS À LA CARTE:
(A RESTAURANT PRICING PROBLEM)

For a restaurant, mixed bundling means offering both complete dinners (the
appetizer, main course, and dessert come as a package) and an à la carte
menu (the customer buys the appetizer, main course, and dessert separately).

This strategy allows the à la carte menu to be priced to capture consumer

surplus from customers who value some dishes much more highly than
others but have sharp contrast among themselves in terms of their
favourite foods.

At the same time, the complete dinner package (that is, bundle) retains those
customers who have lesser variations in their reservation prices (willingness to
pay) for different dishes (e.g., customers who attach moderate values to both
appetizers and desserts).
 THE COMPLETE DINNER VERSUS À LA CARTE:
(A RESTAURANT PRICING PROBLEM)
For a restaurant, mixed bundling means offering complete dinners and an à la carte
menu. This strategy allows the à la carte menu to be priced to capture consumer
surplus from customers who value some dishes much more highly than others.
Bundling makes sense. Successful restaurateurs know their customers’ demand
characteristics and use that knowledge to design a pricing strategy that extracts as
much consumer surplus as possible.
MC DONALD’S MENU IN US (2011?)

MEAL (INCLUDES SODA A la carte PRICE PRICE OF

INDIVIDUAL ITEM PRICE AND FRIES) of the bundle BUNDLE SAVINGS
Chicken Sandwich $5.49 Chicken Sandwich $10.07 $7.89 $2.18
Filet-O-Fish $4.39 Filet-O-Fish $8.97 $6.79 $2.18
Big Mac $4.69 Big Mac $9.27 $6.99 $2.28
Quarter Pounder $4.69 Quarter Pounder $9.27 $7.19 $2.08
Double Quarter
$6.09 Double Quarter Pounder $10.67 $8.39 $2.28
Pounder
10-piece Chicken 10-piece Chicken
$5.19 $9.77 $7.59 $2.18
McNuggets McNuggets
Large French Fries $2.59
Large Soda $1.99
 Looking Forward
• Next we will focus on another type of market—
oligopoly—where firms still have market power,
though not as much as a monopolist

• For the purposes of this 101 course, consider an

oligopoly market which is characterized by free entry
and exit in long run as a monopolistically competitive
market.

• But before that we need to see some Game Theory.

 chapter 19
The most realistic model that we will see in this course. The buyers are price takers but the finite number of sellers are
price setters. Note that we are going back to uniform pricing. Price discrimination can still be practiced – but that is beyond
the current course.
 Learning Objectives
• Discuss how economists use game theory to understand oligopolies and
describe the concept of Nash equilibrium.

• Describe the Bertrand model and the Cournot model, and identify the
Nash equilibrium in each model.

• Explain why product differentiation makes price competition less intense

and identify the Nash equilibrium in a market with product differentiation.

• Analyze whether collusion is sustainable in a setting with repeated price

competition.

• Determine the number of firms that will enter a market and discuss the
factors that affect this number.

• Describe the main U.S. antitrust statutes and discuss their rationales.
 Overview
• Analyze what a firm’s best actions are in oligopolies using
game theory

• Contrast models of oligopoly: Bertrand and Cournot model

• Examine the factors that determine the number of firms

that enter an oligopolistic market

• Observe strategic decisions shaping long-term competition

with rivals, along with collusion when firms compete
repeatedly
 Oligopoly and Game Theory
• Economists determine/predict/ explain the outcome
of oligopolistic competition by applying game theory.

• In particular, they focus on the Nash equilibrium.

• In a Nash equilibrium of an oligopoly market, each

firm is making a profit-maximizing choice given/
under a specific belief about the choices of its rivals
 Bertrand Model
• Suppose Duopoly, that is, two sellers in the market
• Can be trivially generalized to multiple sellers, in
which case, we shall call it an Oligopoly
• Homogeneous goods: firms sell identical products

Defining feature of Bertrand model:

Identical firms set their prices simultaneously. So in this
game the players are the firms, and their strategies are
the price which are chosen simultaneously.
 Market Demand and Residual (firm level) Demand Curves
Assumption: Say customers choose between Joe and Rebecca when they charge identical prices
by tossing an unbiased coin.
 Nash Equilibrium in the Bertrand Model
When sellers are identical, both (all) sellers charge an identical price equal to their
COMMON marginal cost earning zero profits in pure strategy NE.

Or else there will be a different NE, the seller with lower marginal costs – under
some assumption of suitable discrete pricing – will charge the largest possible
price less than marginal cost of the high cost firm and sell to the whole market,
while the high cost firm will produce zero.
 Cournot Model of Oligopoly
(a model of quantity competition)
Firms choose how much to produce
simultaneously (more importantly, without any
knowledge of what the other is choosing), and the
price clears the market given the total
quantity produced.

Compared to Bertrand’s model,

everything is same except for the
choice variable for both firms is
quantity of output.

This may be more realistic in markets

where no single firm can cater to
WHOLE MARKET at all prices.
In this case, firms while deciding on
strategy focus on quantities as choice
variable since price competition can never
eliminate your rival even you have cost
advantage.
 Residual Demand Curves

As before shows the relationship between a firm’s output and

the market price given the outputs of the firm’s rivals

Joe’s residual demand

Joe’s residual demand when Rebecca
when Rebecca produces produces 4,000
2,000

Market demand Market demand

Best Responses in the Cournot Duopoly Model
(without loss of generality assume that there are two players)

P = 60
Q = 2,000 MR = MC
P = 50, Q = 1,000
Joe behaves like a
monopolist given his
MR = MC
residual demand
 Best-Response/Reaction Curves in the Cournot Duopoly

REACTION CURVE: shows a firms best choice in response to

each possible action by its rival.
Nash Equilibrium in the Cournot Duopoly

• Each chooses its

profit-maximizing
output level given
its rival’s output
• Neither firm has
an incentive to
deviate from
(2,000, 2,000)
 MATHEMATICL EXPOSITION OF COURNOT DUOPOLY

• 2 firms
• Identical products
• Output choice competition
• Simultaneous choice of production amount: that is, one does not know
the choice of the other while making own choice

For simplicity of exposition in class, assume identical CONSTANT marginal

costs ‘C’.
 Cournot Duopoly - A Linear Demand Curve

Two identical firms face the following market demand curve 𝑃 = 30 − 𝑄

Also, MC1 = MC2 = 𝐶 and total output 𝑄= 𝑄1 + 𝑄2

Total REVENUE for firm 1: 𝑅1 = 𝑃𝑄1 = 30 − 𝑄 𝑄1 = 30𝑄1 − 𝑄12 − 𝑄2 𝑄1

then MR1 = ∆𝑅1 ∆𝑄1 = 30 − 2𝑄1 − 𝑄2

To solve for the Nash equilibrium (Q*1, Q*2) , we set MR1 = C (the firm’s marginal cost)
∗ ∗
and we find that Firm 1’s reaction curve: 2Q 1 = 30 − Q 2 - C
∗
By the same calculation, Firm 2’s reaction curve: 2Q 2 = 30 − 𝑄 1- C
∗

Cournot equilibrium strategies:: 𝑸 ∗𝟏 = 𝑸 ∗𝟐 = (𝟑𝟎 − 𝑪)/𝟑

Total quantity produced in equilibrium: 𝟐(𝟑𝟎 − 𝑪)/𝟑
Equilibrium price: (30+2C)/3

Note the demand by Hyundai chairman to reduce GST to help tide over the current auto
industry crisis. So what he is saying is that auto sales are down (for very
specific political and economic reasons beyond the scope of this course) so that the value
’30’ in demand curve has now become ‘20‘ leading to reduction in output produced and
hence, labour employed. If taxes are reduced sufficiently, then the output will increase again
as ‘C’ will reduce to say, ‘C-10’, and the initial output and employment levels would be
regained – albeit at a significant loss of Government revenue.
 Stackelberg duopoly model
The two firms choose their outputs sequentially – lets assume for the sake of this example, Rebecca’s firms is already
functional where as Joe’s firm is potentially getting ready to open his firm too. His startup cost is $15000.
REBECCA CAN NOW CONTROL HOW MUCH JOE WILL PRODUCE IF HE ENTERS – AND SO SHE CAN CONTROL WHETHER HE
ENTER AT ALL

Rebecca will choose to produce (or CREDIBLY commit to produce) 4000 units, which will
deter Joe from entering (as post entry profits would be 10000$, and thus, yield Rebecca
a profit of 80000$. 19-16
 Strategic Pre-commitment to ensure “Detrrence”
When a firm “commits to certain actions” or “takes certain actions”
before rivals take theirs, with the aim of affecting rivals’ later
choices.

• Examples
– Stackelberg competition, or equivalently, output choice by a
first-mover (by signing a big labour contract in advance or setting up a
large plant whose technology requires it to run at almost full capacity – like
alumina refining plants)
– Spanish Conquistador (CORTES’) in 1519 burning ships to
eliminate option retreat while invading Aztec city of
Tenochtitlan
– Entry deterrence (making a large enough output choice, in the manner
mentioned above which makes profits consequent to entry so low for the
competitor that she does not enter)
19-17
 Entry Deterrence
(OUT PUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)

(credible) commitment versus flexibility: Though a firm can sometimes

gain by pre-committing to future actions, there is a potential downside to the strategy
if market conditions are uncertain.

Put simply, pre-committing limits the firm’s ability to respond to changing market conditions.
For example, DuPont once tried to deter rivals from producing titanium dioxide (a whitener
used in paints and plastics) by committing to an extensive expansion of its facilities.
Unfortunately for DuPont, an unexpected recession struck, and market demand turned out to
be much lower than DuPont forecasted, causing the firm’s clever strategy to yield a
disappointing loss.

HENCE THE NEED FOR PROFESSIONAL STATISITICIANS/ ECONOMISTS WHO CAN PREDICT
BUSINESS CYCLES.

19-18
 Entry Deterrence via threats only
(OUTPUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)

• However, often firms prefer to set up the excess capacity (by signing a
labour contract or setting up a plant) but not actually increase
production prior to possible entry of competitor.

• Effectively, the existing firms are threatening the entrant that they
will render this decision to enter a financially COSTLY decision if they
DARE to enter.

• Such THREATS increase output and cause losses to a potential entrant

will only have an effect if the threat is credible. The exact meaning of
this credibility in terms of COMMITMENT is beyond the current course
and will be dealt with in Game theory course.
19-19
 Bertrand Competition with Differentiated Products

Differentiated products: when consumers view similar products as close

substitutes

Coke’s residual demand

Coke’s residual demand
Bertrand Competition with Differentiated Products
 Oligopoly - Raising Rival’s Costs

Options range from lobbying, to buying critical input in bulk, to fomenting labour trouble at
competitors’ plant. There is much documentary and punishment evidence in US itself. 19-22
 Collusion
Competing firms could merge become monopoly and earn monopoly profits that are
divided equally among shareholders of all firms. The is formation of CARTEL such as
OPEC. However, in domestic markets most countries have made such HORIZONTAL
MERGERS to be ILLEGAL.

So firms, if they want to collude in a domestic market must do so without any legal or
public declaration. This causes a problem because two separate production
technologies not integrated to each other need to agree to charge HIGH price – that
is, not cheat each other by charging LOW price while the other charges HIGH price.

Unfortunately, they can view their interaction to be an infinitely repeated game so use
special NE strategies (as the GRIM strategies) to sustain cooperation. That is, firms
may adopt a strategy in which they charge the monopoly price if no one has yet
undercut that price; otherwise they charge a price near or at their marginal cost.
Example: (OPEC and Russia)

OF COURSE, FOR THIS COLLUSIVE/COOPERTATIVE OUTCOME TO BE EQUILIBRIUM EACH FIRM MUST BE

ABLE TO VERIFY THE PRICES CHARGED BY OTHER FIRM SO AS TO ENSURE SHE HAS BEEN CHEATED OR
NOT. In that case, collusion will work if firms value the future highly enough (that is, if the
interest rate is low enough) EVEN when regulatory framework is robust and efficient.
 Imperfect Price Observation
(A STRATEGIC OBSTACLE TO COLLUSION)

In many real-world settings a firm observes its rivals’ prices imperfectly,

if at all. This makes collusion harder to sustain because a firm will
doubt whether its rivals have abided by the collusive agreement.

The Matt Damon movie called “Informant” actually documents such an

example “TACIT COLLUSION” between lysine manufacturers in US from
1992-95.
Interestingly, they start by fixing prices together – imperfect price observation led to
failure.

So the next step was for them to fix market share to each firm – if any firm sold
more leading to less sales from other fellow cartel members, she had to buy lysine
from them at the cartel decided price. Thus, they move from price coordination
(opposite of competition) to quantity coordination (opposite of competition).

This eliminated the incentive to cheat among members and led to sustaining of
cooperation until FBI arrested all CEOs.
 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)

• Markets where firms sell differentiated products at a markup,

that is, such that price of these products is greater than the
marginal cost of producing total sales.

• In spite of that each firm makes almost negligible zero

economic profit in long run.

• It occurs in a market with free entry when there is a large

number of firms – maybe the sunk cost to entry are very less.

• In long run, each firm produces a level of output that is NOT

minimum of LAC curve level.

• Example: petrol pumps or supermarkets.

 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT RUN

Suppose that the Nash

equilibrium price of the
competitor firm 2 at any value
P*2.
Because the firm is the only
producer of its brand, it faces a
downward-sloping demand
curve.
Then, given the fixed P*2, the
profit maximizing (and hence,
Nash equilibrium) price of firm
1 must be PSR:= P*1.

Suppose that PSR exceeds

average cost at the output sold
QSR . That is, in the short run,
the firm earns profits shown by
the yellow-shaded rectangle.
 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN

In the long run, these profits
attract new firms with competing
brands. The firm’s market share
falls in the new Nash equilibria
with larger number of firms, and
this is gets reflected in a
downward shift of its product’s
demand curve.
In long-run equilibrium,
described in figure (b), price
equals average cost, so the firm
earns zero profit even though it
has monopoly power.

So free entry and exit in

market eliminates any
monopoly profits in long run.
 COMPARISON OF MONOPOLISTICALLY COMPETITIVE LONG RUN EQUILIBRIUM AND
PERFECTLY COMPETITIVE LONG RUN EQUILIBRIUM

Under monopolistic
competition, price exceeds
marginal cost, and
production is carried out at
an inefficient level where
costs are not minimized.
Thus there is a deadweight
loss, as shown by the
yellow-shaded area.
The demand curve is
downward-sloping, so the
zero profit point is to the left In both types of markets, entry occurs until profits are driven to
of the point of minimum zero.
average cost.
 FOR THE SAKE OF EXAMINATION, READING
THIS CHAPTER FROM SLIDES IS ENOUGH.

Chapter 21
Markets with asymmetric information about quality/ value of the good being traded.
 Quality Uncertainty and the Market for Lemons
asymmetric information is typically found in situation in which a buyer and a seller possess
different information about a transaction (perhaps about the quality of produce being exchanged).
• Used cars sell (NO MATTER HOW YOUNG) for much LESS than new cars because
there is asymmetric information about their quality:

• REASON: The seller of a used car knows much more about the car than the prospective buyer
does as he has much more research on who was the original owner, how many kilometers did
the car run - in general being in the business of selling cars day in and day out gives the seller
a greater expertise to GAUGE quality of a car.

Thus, a prospective buyer is suspicious of the seller because she cannot sure of its
quality or believe seller‘s statement about its quality (who is going to make more
money by selling a low quality car as high quality product) - BECAUSE NICER THE CAR
LOOKS, MORE WILL SHE WONDER WHETHER THERE IS SOMETHING MAJORLY WRONG WITH THIS
CAR - OR ELSE WHY DID THE USER DECIDE SELL THIS NEW LOOKING CAR!!

The implications of asymmetric information about product quality were first analyzed
by George Akerlof and go far beyond the market for used cars.

The markets for insurance, financial credit, and even employment are also
characterized by asymmetric information about product quality.
THE MARKET FOR USED CARS
When sellers of products have better information about product quality than buyers, a
LEMONS PROBLEM may arise in which low-quality goods drive out high quality goods.
In (a) the demand curve for high-quality cars is DH.
However, as buyers lower their expectations about the average quality of cars on the
market, their perceived demand shifts to DM.
 THE MARKET FOR USED CARS
Likewise, in (b) the perceived demand curve for low-quality cars shifts from DL to DM.
As a result, the quantity of high-quality cars sold falls from 50,000 to 25,000,
and the quantity of low-quality cars sold increases from 50,000 to 75,000.
Eventually, only low quality cars are sold.

LEMONS MARKET/PROBLEM: Low- quality goods driving out high-quality goods out of
the market. Occurs due to information asymmetry.
 MARKET FAILURE DUE TO ADVERSE SELECTION
Consumers cannot in fact easily determine the quality of a used car until after they
purchase it. As a result, the price of used cars falls, and high-quality cars are driven out
of the market.

Market failure arises, therefore, because there are owners of high-quality cars who value
their cars less than potential buyers of high-quality cars. Both parties could enjoy gains
from trade, but, unfortunately, buyers‘ lack of information prevents this mutually
beneficial trade from occurring.

adverse selection: Form of market failure resulting when products of different qualities
GET sold at a single price because of asymmetric information, so that too much of the
low-quality product and too little of the high-quality product are sold.

SOLUTION: If as a seller, you are convinced of a high quality car – offer HUGE
WARRANTIES or FREE REPAIRS FOR 5 YEARS. Applying such warranties to a bad
quality car would create HUGE losses to you. Since the buyers realize this logic, they
will rely on your rationality to AVOIDING such huge losses and BELIEVE that the car
that you are trying to sell them is actually a high quality car which will NOT BREAK
DOWN TOO MUCH in coming 5 years.

THUS WARRANTIES CONVINCE BUYERS OF THE QUALITY OF PRODUCE

 Guarantees and Warranties

• Consider the markets for such durable goods as televisions, stereos,

cameras, and refrigerators.
• Many firms produce these items, but some brands are more dependable than others.
If consumers could not tell which brands tend to be more dependable, the better
brands could not be sold for higher prices.
• Firms that produce a higher-quality, more dependable product must therefore make
consumers aware of this difference. But how can they do it in a convincing way?
• The answer is guarantees and warranties.

• Guarantees and warranties effectively signal product quality because an extensive

warranty is more costly for the producer of a low-quality item than for the producer of
a high-quality item.
• The low-quality item is more likely to require servicing under the warranty, for which
the producer will have to pay.
• In their own self-interest, therefore, producers of low-quality items will not offer
extensive warranties.
• Thus consumers can correctly view extensive warranties as signals of high quality
and will pay more for products that offer them.
 THE MARKET FOR INSURANCE
• People who buy insurance know much more about their OWN general health than
any insurance company. As a result, adverse selection arises, much as it does in
the market for used cars.
• Because insurance company BELIEVES THAT unhealthy people are more likely to
want insurance, so there is HIGH proportion of unhealthy people in the pool of
insured people increases.
• This forces the PRICE of insurance to RISE, so that more healthy people, aware of
their LOW RISKS, elect not to BUY INSURANCE CONFIRMING THE BELIEFS OF
INSURERS.
• This further INCREASES the proportion of unhealthy people among the insured,
thus forcing the price of insurance UP MORE. The process continues until most
people who want to buy insurance are unhealthy.
• At that point, insurance becomes very expensive, or in the extreme, the
insurance companies stop selling insurance.

SOLUTION: “Pool risks”. For health insurance, the government might take on this role, as
it does with the MEDICARE (in US) program. By providing insurance for all people over
age 65, the government eliminates the problem of adverse selection.

Likewise, insurance companies PREFER TO offer group health insurance

policies at places of employment. By covering all workers in a firm, whether
healthy or sick, the insurance company spreads risks and thereby reduces the
RISK that MOST CUSTOMERS WILL BE HIGH RISK.
 MEDICARE

Health care reform has been at the forefront of policy debates in the United States and
worldwide for years. A core issue in the United States is whether everyone should have
health insurance, and whether participation in some kind of public or private insurance
program should be mandatory.

Indeed, mandatory participation is what makes Medicare work. Remember that

there is asymmetric information: people know much more about their health, than
insurance companies can possibly know. Those seniors who have chronic diseases are
much more likely to buy the insurance than those who are in excellent health and thus
expect lower costs. This creates an adverse selection problem.

All people over 65 participate in Medicare—those expecting low health care costs along
with those who expect high costs.

Of course, the low-cost participants are subsidizing those with high costs. But because
adverse selection is not a problem with a mandatory program, the overall cost of
Medicare is lower than the cost of most private insurance systems.

Indeed, Medicare has earned a reputation as one of the most successful and efficient
public programs in the United States.
 Market Signaling
(A SOLUTION TO ADVERSE SELECTION)
● market signaling: Process by which sellers send signals to buyers conveying
information about product quality.
• What characteristics can a firm examine to obtain information about people‘s
productivity before it hires them? Can potential employees convey information about
their productivity?

• Dressing well for the job interview might convey some information, but even
unproductive people can dress well. Dressing well is thus a weak signal—it doesn‘t
do much to distinguish high-productivity from low-productivity people.

• To be strong, a signal must be easier for high-productivity people to give than for low-
productivity people to give, so that high-productivity people are more likely to give it.
(example: LONG UNREASONABLE WARRANTIES)

• For example, education is a strong signal in labor markets. More productive

people are more likely to BE ABLE TO attain high levels of education in order to
signal their productivity to firms and thereby obtain better-paying jobs. Thus, firms are
correct in considering education a signal of productivity.

High-productivity people will excel at top college education/ IIT BTech to signal their
productivity; firms will read this signal and offer them a high wage.
 MARKET SCREENING
(another solution to ADVERSE SELECTION)
Take the example of labour market. Faced with two type of workers: high and low type;
the firm may ask them to take a test which only a high type can ace.

Of course, the knowledge being tested in such an exam MAY not be relevant to the
Production technology of the firm but still it can solve the adverse selection problem
caused by information asymmetry. (example: IAS exam in math?)

This kind of devices are called SCREENING.

Screening is different from signalling because the uninformed party makes the first
move – in this case, invite people for the test, fix the question paper etc. In contrast, in
case of signalling, the informed party makes the first move by sending a signal – that is
opt for high grades from a top college.

A humorous example of screening: a couple (A & B) in a romantic live-in relationship.

Say both live in A‘s apartment, while B‘s apartment is put out on lease. Suppose B wants
to know whether A is serious enough about their relationship for it to culminate in
legal marriage. Instead of feeling anxious, irritable, and insecure – all of which will
lead to LOWER quality of relationship – B can use a simple screening device:
―MENTION TO ‗A‘ THAT A BUYER IS INTERESTED IN B‘s FLAT AND THE PRICE IS
GOOD. SHOULD B SELL IT?‖
 Moral Hazard

moral hazard: When an economic agent‘s action are unobservable to some other
agent who is supposed to make payments contingent upon these actions.

• The possibility that an individual who has FULLY insured against theft of her vehicle
will now TAKE LESS CARE to protect her vehicle is logical – since such protection is
costly (car theft alarm or other kinds of steering lock).

• So for the insurance company, being able to sell the insurance increases probability
of the theft happening leading to higher chance of financial payout.

SOLUTION: As an insurance company, never agree to fully insure an object

against future losses. Always provide PARTIAL INSURANCE (maybe 70-80%).

The concept of moral hazard applies not only to problems of insurance, but also
to problems of workers who perform below their capabilities when employers
cannot monitor their behavior (“job shirking”).
 The Principal–Agent Problem
(a crucial moral hazard issue)

principal–agent problem = Problem arising when agents (e.g., a firm‘s managers)

decide to pursue their own goals that conflict with the goals of principals (e.g., the
firm‘s owners).

Principal Individual who employs one or more agents to achieve an objective.

agent Individual employed by a principal to achieve the principal‘s objective.

 The Principal–Agent Problem in Private Enterprises

• Managers can often pursue their own objectives (such as increase in stock prices),
rather than pursuing the objective of the shareholders which is to maximize the value
of the firm (why? Since their compensations may have stock options).
• Because shareholders cannot observe every daily action taken by the manager.
They will only focus on final profits which depend not only upon manager’s
actions – but also upon random event in world economy.
• Hence, the problem of hidden action/ moral hazard appears. Managers may not
work hard enough leading to loss in profits – but later claim that bad results were
due to external random factors.
• Hence, compensation schemes of CEOs and CFOs need to be designed
carefully.
• Economists have warned about this a long time but it took ENRON and the Sub-
prime crisis in the world financial community to start standardizing carefully
designed compensation schemes and mandatory disclosure rules (some of
which has been captured as BASEL III regulations).
• Still goes on – check out the documentary on WeWork which is a company that
lost 47 billion in valuation (by analysts) and 4 billion in hard cash - in six months.

This sub-area of Economics often studied in Business Schools under

“Corporate Finance”.
 CEO SALARIES
• CEO compensation has increased sharply over the past few decades.

• The average annual compensation (not just salary) for PRODUCTION WORKERS in
the U.S. went from $18,187 in 1990 to $32,093 in 2009. But in constant dollar terms,
the 2009 average salary was only $19,552 (in 1990 dollars), which represents only a
7.5% increase in real terms.

• At the same time, the average annual compensation (not just salary) for CEOs has
grown from $2.9 million to $8.5 million, or about $5.2 million (in 1990 dollars) – that is,
in constant dollars, CEO compensation has risen nearly 80% in real terms.

Why?
Have top managers become more productive, or are CEOs simply becoming more
effective at extracting economic rents from their companies – due to their
monopoly power and a pretention that a good CEO is as rare as a diamond?

The answer lies in the principal–agent problem, which is at the heart of CEO salary
determination. Lets see the problem in a bit more detail.
 chapter 8
In the last class, we saw a description of all efficient production methods that a firm may use. Now we will see how
a producer must accommodate this efficiency with the constraint of a limited amount of money available to carry out
production.
 Main Topics
• Types of cost
• What do economic costs include?
• Short-run cost: one variable input
• Long-run cost: cost minimization with two
variable inputs
• Average and marginal costs
• Effects of input price changes
• Economies and diseconomies of scale
 Critical concept in firm operation
• A firm can choose to produce zero output in a short run – kind of hibernating but not
out of the business.

• To really stop being in business, the firm must wait till the current short run is over,
after which it can reduce all its inputs to zero (that is necessary for quitting the
business).

• The firm may choose to produce a positive output in the next short run, after
choosing to produce zero output in current short run (wealthy small scale MSMEs
after demonetization).

Example: a carpenter entering a contract with owner of garage to operate a furniture

shop there. Such contracts are, typically, have a notice period of two months. So the
input of garage space is the Capital input, and the workers hours are labour inputs.
• To get a new garage space, the carpenter must look around for some months
(typically, the same time as the notice period) – hence, that duration is short
run.
• To quit business, she must wait for two months, during which even if she stops
production, she must continue to pay the rent for the garage space, that is, the
cost of capital for the next two months.

8-3
*Variable cost: costs of VARIABLE inputs that vary with the firm’s
output level.
*Fixed cost: costs of FIXED inputs whose use does not vary with the
firm’s output level if the firm operates in SHORT RUN and is zero other
wise.
*Sunk costs: costs incurred by the firm irrespective of the level at
which firm operates or whether it shuts down (irrespective of short or
long run – like bribes, lobbying expenditure etc.).
– Fixed: firm does not have to incur this cost if it chooses to produce zero output
but not exit the market. Hence, it can termed AVOIDABLE
– Sunk: firm has to incur this cost EVEN if it decides to exit the market. Hence,
can be termed UNAVOIDABLE (example, the non-refunded security deposit paid
the carpenter in the last slide)
– So to differentiate between the two, we must think in terms of a thought
experiment where the firm chooses to EXIT the business in long run
– So conceptually, in LONG RUN, a firm may consider itself incurring a sunk cost, but
cannot consider itself incurring a fixed cost !!
 Fixed vs Sunk- bit more nuance
• The amount of non-variable cost of setting up and carrying out
production, that can be recovered upon exiting the business – IS
FIXED COST WHILE THE REST IS SUNK COST.

• Cost of a New York taxi medallion is fixed cost if there is resale

market for it, or else it is a sunk cost.

• Level of both fixed and sunk costs are invariant to the positive
levels of output chosen to be produced.
• So fixed cost does not influence the decision on how much to
produce or how to price. It ONLY influences the decision to shut
down operations (produce zero output) in short run (BUT NOT
EXIT).

And sunk cost does not affect ANY operational or shutting down or
exit decisions in short or long run.
 Fixed versus Sunk: continued
ESSENTIALLY, SUNK COST PLAYS NO ROLE IN DETERMINING THE OPTIMAL OPERATIONAL
output or product mix DECISIONS. It may, however, be amortized to compute profits for an
accounting period. This would be mere window dressing of the realized profits.

HENCEFORTH, UNLESS MENTIONED OTHERWISE, SUNK COST IS ASSUMED TO BE ZERO in the

course.
 Fixed cost: Short vs Long run
Consider, for example, a problem that Delta Air Lines faced.

Delta wanted to know how its costs would change if it reduced the number of its
scheduled flights by 10 percent.

The answer depends on whether we are considering the short run planning horizon or
the long run planning horizon.

Over the short run - say six months - schedules are fixed and it is difficult to lay off or
discharge workers. As a result, most of Delta’s short-run costs are fixed and won’t be
reduced significantly with the flight reduction.

In the long run - say five years or more - the situation is quite different as Delta has
sufficient time to sell or lease planes that are not needed and to discharge un-needed
workers. In this case, most of Delta’s costs are variable and thus can be reduced
significantly if a 10-percent flight reduction is put in place.

SINCE THERE ARE NO FIXED INPUTS IN LONG RUN, THERE ARE NO FIXED
COSTS IN LONG RUN.
 Opportunity Cost and Economic Cost
• Some economic costs are hidden, such as lost
opportunities to use inputs in other ways
– Example: Using time to run your own firm means giving up the
chance to earn a salary in another job
• Opportunity Cost: the cost associated with an INPUT
forgoing the opportunity to employ it in its best
POSSIBLE/FEASIBLE alternative use.
– In practical usage, one needs a well functioning market for the
input in question to exist to appropriately evaluate the
opportunity cost.
• A firm’s true economic costs of production in any accounting
period, consists of BOTH out of pocket expenditures for that
period as well as the opportunity costs that can be estimated
`REASONABLY’ for that period.
 CHOOSING THE LOCATION FOR A NEW LAW SCHOOL BUILDING
The Northwestern University Law School has long been located in Chicago, along the
shores of Lake Michigan. However, the main campus of the university is located in the
suburb of Evanston. In the mid-1970s, the law school began planning the construction of
a new building.

The downtown (city center) location had many prominent supporters. They argued in
part that it was cost-effective to locate the new building in the city because the university
already owned the land. A large parcel of land would have to be purchased in Evanston
if the building were to be built there.

Does this argument make economic sense? No. It makes the common mistake of failing
to appreciate opportunity cost. From an economic point of view, it is very expensive to
locate downtown because the opportunity cost of the valuable lakeshore location is high:
That property could have been sold for enough money to buy the Evanston land with
substantial funds left over. THAT IS, THERE IS A POSITIVE COST OF USING DOWNTOWN LAND
EVEN THOUR THE UNIVERSITY LEGALLY OWNS IT, AND THIS COST IS VERY HIGH.

In the end, Northwestern decided to keep the law school in Chicago. This was a costly
decision. It may have been appropriate if the Chicago location was
commensurately HIGHLY valuable to the law school, but it was inappropriate if it
was made on the presumption that the downtown land had no cost.
 The concept of a Cost Function

1. Fix any output level Q.

2. Solve the optimization problem of minimum cost that needs to be incurred to

produce output level Q.

3. This optimization will take different forms depending on whether we are in the long
run planning horizon where all input usage levels are variable and hence,
legitimate choice variables – or whether we are in short run planning horizon
where at least of the input usage level must be treated as parameter.

4. The value function or the minimized cost obtained by solving this problem must be
a function of Q.

5. We call this value function of Q to be a (short run or long run) COST FUNCTION:
C(Q).

6. In what follows in the rest of the slides, we drop the word function, and merely refer
to C(Q) as cost to save time. However, you must remember that we are always
talking about value function of a optimization problem.
 Short run cost with one Variable input
• Suppose a firm has production function Q=f(K,L) = 2KL.
• Say in the short run, the capital input, say garage space, is fixed at level K*.

• We ask the question: what is the least amount of cost to be incurred in producing
X units of benches or output, when cost of a unit of capital is ‘r’, and cost of a unit
of labour is ‘w?.

• Given the production function we can easily see that Q=x if and only if L = x/2K*,
that is, we need to hire x/2K* units of labour hours to produce X benches in the
cheapest possible manner. That is, we need to incur the MINIMUM cost of labour
equal to {wx}/{2K*} produce X benches.

• Thus, the VARIABLE COST FUNCTION: VC(x) = {wx}/{2K*}.

• The fixed cost of producing x units of output is cost of the fixed input capital giving
us the FIXED COST FUNCTION, FC(x)= rK*

• Thus the SHORT RUN COST FUNCTION is given by:

C(x) = FC(x)+VC(x)= rK*+ {wx}/{2K*} 8-11
Types of short run cost
Deriving Variable Cost from single
input Production Function
 Fixed cost, short run Variable,
and short run Total Cost
Short run cost
curve is equal to
the variable cost
plus the fixed cost
curves.
Remember that -
given the scope of
a beginner’s
economics course -
fixed costs do not
exist in long run.
 Short run Costs: Definitions
• Apply idea of average cost to firm’s variable and fixed
costs to find average variable cost and average fixed cost:
VC (Q) FC
AVC(Q) AFC(Q)
Q Q

• Since total cost is the sum of variable and fixed costs,

short run average cost is the sum of AVC and AFC:
C (Q) VC (Q) FC VC (Q) FC
AC AVC(Q) AFC(Q)
Q Q Q Q

• Short run marginal cost is the slope of the cost function

provided it is smooth:
VC (Q dq) VC (Q)
MC (Q)
dq
Typical Short run Average Cost Curves
• Fixed costs are constant so AFC is always
downward sloping
• At each level of output the AC curve is the
vertical sum of the AVC and AFC curves
– Average cost curve lies above both AVC and AFC at
every output level
– Efficient scale of production exceeds output level
where AVC is lowest
 Typical short run AC, AVC, and
AFC Curves

TYPICALLY, AVERAGE VARIABLE COSTS ARE U SHAPED. THIS FOLLOWS FROM OUR EMPIRICALLY
OBSERVED TYPICAL PRODUCTION FUNCTION WHERE AVERAGE PRODUCT OF LABOUR CURVE IS
AN INVERTED U SHAPED.
 Short run AC, AVC, and
MC Curves

Note that, for the purposes of this class, the marginal cost curve is a U shaped curve
that always cuts the U shaped AVC curve and the U shaped AC curve at their minimum
points. Also, MC curve and AVC curve always have the same intercept.
 Graphical Analysis of Long run Cost Minimization
• For simplicity of graphical exposition, assume two inputs – both
of which are variable.
• Objective, as before, is to find out the least possible cost
needed to be incurred to produce a target level of output (Q).

• That is, we need to find the cheapest combination of inputs to

produce a given output, we will need a new tool.
• Isocost line: contains all the input combinations with the same
cost (these are level sets for rising cone in three dimensions)
• Isocost lines in combination with isoquants will allow the firm
to pick the least-cost combination of inputs to produce a
certain level of output (or the largest possible output given a
certain cost).
Isocost Lines
 Isocost Lines

The standard trick of optimization is to depict or visualize or analyze LEVEL

CURVE/SETS of the objective function (a surface in three dimensions if there are
only two choice variables) over the Euclidean plane containing the feasible set of
choice variables.
For maximization choose the highest level curve touching this feasible set (set of
choices that satisfy all constraints). For minimization choose the LOWEST curve
touching the feasible set.
 Least-Cost Method
• To find the least-cost
input combination
for an output of 140,
we look for the point
in that isoquant that
lies on the lowest
isocost line (point D)
Long run cost Minimization with
Fixed Proportions
Interior Solutions
 Boundary Solutions
Boundary solution:
the least-cost input
combination
excludes some
inputs
Output Expansion Path and Long run Total
Cost Curve
Long run Average and Marginal
Costs
Long run cost, average cost, and
marginal cost
From Long run Total Cost to Long
run Average Cost

Efficient
scale of
production
From long run Total Cost to long
run Marginal Cost
 Relationship between long run Average
and Marginal Cost
• When output is finely
divisible, the AC curve is
upward sloping at Q if
MC > AC, downward
sloping if MC < AC, and
neither rising nor falling
if MC = AC
 Effects of Input Price Changes
• After an increase in the
price of an input, a
cost-minimizing firm
never uses more of that
input to produce a
given amount of
output, and usually
employs less.
• Point B reflects a
higher cost of capital
than in point A
 Relation between Short-Run and Long-Run Cost - A Sociological Reality
Note that because there are economies and diseconomies of scale (assuming away
learning effects for simplicity) THE MINIMUM POINTS OF SAC curves corresponding to
ALL possible ‘FIXED CAPITAL’ levels DO NOT LIE on LAC curve. This property holds only
at a unique specific point where LAC curve is minimized.

The long-run average cost

curve LAC is the envelope
of the short-run average
cost curves SAC1, SAC2,
and SAC3.
Due to economies and
diseconomies of scale that
is typically observed for
almost production
technologies: the LAC
curve turns out to be U-
shaped.

Long run average cost curve is the LOWER ENVELOPE of all possible short run
average cost curves. In other words, choosing to operate at a point P on LAC,
implies choosing to procure X number of planes (or X amount of capital inputs)
such that – the SAC curve corresponding ‘fixed capital’ input at level X; touches
the LAC curve at point P.
 A new way of connection between short run and long run
• At any given point in time period, say T, a firm producing positive output is operating
in a short run, because there is at least one input that can not varied for some time in
future.

• This is an unequivocal sociological regularity that characterizes human economy.

• Long run cost minimization with respect to a target output Q, therefore, becomes an
exercise in choice of the CORRECT short run to produce Q in a least cost manner.

• That is, if the long run cost minimization tells you to hire K*(Q) and L*(Q) to produce
Q in a least cost manner, then it tells you to operate in the short run where capita
input is fixed at a level equal to K*(Q).

Thus, the long run average cost curve is a collection of single points from the infinite possible short run
average cost curves. So for any target output Q, the corresponding LAC(Q) is same as the SAC(Q)
corresponding to the fixed capital input level K*(Q) - where K*(Q) is long run cost minimizing amount of
capital input.
 Economies and Diseconomies of Scale
(An implication of very commonly observed U-shaped Long run AC curve)

• Economies of scale: least cost of production increases LESS than

proportionately as firm’s target output increases.

• Diseconomies of scale: least cost of production increases MORE than

proportionately as firm’s target output increases.

• It is generally observed that long run cost function exhibits economies of

scale at lower levels of target/planned output production; and beyond a
THRESHOLD output level, it exhibits diseconomies of scale.

• This statistical regularity leads to the LAC being U-shaped.

• This MAY or MAY NOT be caused by increasing returns to scale at low output
levels, followed by decreasing returns to scale at high output levels.

• It relates change in costs of production to change in target outputs to be

produced. Hence, conceptually, it is independent of the concept of returns to
scale (which relates change in output produced to amount of factors used).
“Learning” vs “Economies of Scale”
(SHIFT OF LAC CURVE DOWNWARD) (DOWNWARD MOVEMENT ALONG LAC CURVE)

A firm’s average cost of production

can decline over time because of
growth of sales when increasing
returns are present (a move from A
to B on curve long run AC1),
or it can decline because there is a
learning curve (a move from A on
curve AC1 to C on curve long run
AC2).

Essentially, economies of scale

depicts the change in costs
ALONG the long run average
cost curve – while learning
refers to change due to
downward SHIFT of long run
average cost curve.

In this beginner’s course we

ignore such learning effects.
 COST FUNCTIONS FOR ELECTRIC POWER
SHORT RUN AVERAGE
COST OF PRODUCTION IN
THE ELECTRIC POWER
INDUSTRY IN 1955 AND 1970

The average cost of electric

power in 1955 achieved a
minimum at approximately
20 billion kilowatt-hours.

By 1970 the average cost of

production had fallen
sharply and achieved a
minimum at an output of
more than 33 billion kilowatt-
hours.

Both learning effect and

economies of scale can be
seen here.
 Looking Forward
• Until now, we have focused on production and costs.
• Next, we will incorporate sales and revenue into our
analysis, and we will analyze how firms maximize
profits.
 Profit
Maximization

chapter 9

•
 Perfectly Competitive Markets – Underlying assumptions
PRICE TAKING - both consumers and firms accept price as an exogenous parameter that they are
incapable of influencing. Both sides of market are “PRICE TAKER”
• Individual firms must believe that whatever they produce will get sold at the going market
price value which they presume during taking output decisions.
• So essentially, “market clears”, that is, market equilibrium OCCURS when (i) their
prediction/assumption of market price is a perfect match with the realized market price,
and (ii) all produced output gets sold.
• That is, market (real) price over time continue to fluctuate over a period of time unless firms and
consumers arrive at this conceptual match.
• Because each individual firm sells a sufficiently small proportion of total market output, its
decisions have no impact on market price – internet market place?

PRODUCT HOMOGENEITY - Products of all of the firms in a market are perfectly substitutable
with one another—that is, they are homogeneous. Hence, no firm can raise the price of its product above
the price of other firms without losing most or all of its business. Example: world market for wheat!!!
• In contrast, when products are heterogeneous, each firm has the opportunity to raise its price
above that of its competitors without losing all of its sales. Hence, the need for advertising!!
• The assumption of product homogeneity is important because it ensures that there is a
single market price, consistent with supply-demand analysis.

FREE ENTRY AND EXIT - With free entry and exit, buyers can easily switch from one supplier to
another, and suppliers can easily enter or exit a market. So there can be no special costs that make it
difficult for a firm to enter (or exit) an industry.

NO TRANSACTION COST - Sellers and buyers can easily locate each other and engage in a
meaningful discussion or negotiations of prices without fear or barriers.
 Do Firms Maximize Profit?

The assumption of profit maximization is frequently used in microeconomics because it

predicts business behavior reasonably accurately and avoids unnecessary analytical
complications.

Firms that do not come close to maximizing profit are not likely to survive. The
firms that do survive make long-run profit maximization one of their highest
priorities: [Case in point: Masayoshi Son issued a call for profit maximization after his
huge investment in WeWork went bust as the company shut down due to immense
losses.]
 PROFIT MAXIMIZATON

● profit Difference between total revenue and total cost.

π(q) = R(q) − C(q)
● marginal revenue Change in revenue resulting from an infinitesmal
increase in output – slope of the revenue function.

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope
of the cost curve).

Δπ/Δq = ΔR/Δq − ΔC/Δq = 0

MR(q) = MC(q)

A SH ORT RUN EXAMPLE – BUT TH E

PRIN CIPLE H OLDS IN LON G RUN TOO!
 Demand and Marginal Revenue for a Competitive Firm

(firm ’s p erceived / assu m ed d em and cu rve) (actu al market d emand curve)

MR(q) = Price for a competitive curve at all values of q = P(q)

A competitive firm supplies only a small portion of the total output of all the firms in an industry.
Therefore, the firm takes (BELIEVES) the market price of the product as given AND THAT SHE
CAN SELL AS MUCH SHE WANTS AT THIS PRICE) – hence, choosing its output on the
assumption that the price will be unaffected by the output choice.

In (a) the demand curve facing the firm is (believed to be) perfectly elastic, even though the
market demand curve in (b) is downward sloping.
 • The demand curve d facing an individual firm in a competitive market is both
its average revenue curve and its marginal revenue curve.

• Along this demand curve, marginal revenue, average revenue (= R(q)/q), and
price are all equal.

• Hence, the perfectly competitive structure of the market leaves firms to decide
only one question: HOW MUCH TO PRODUCE?

A perfectly competitive profit maximizing firm should choose to produce an

output q* so that marginal cost equals price:

MC(q*) = MR(q*) = P
 Short-Run Profit Maximization by a Competitive Firm
In the short run, the
competitive firm maximizes its
profit by choosing an output q*
at which its marginal cost MC
is equal to the price P (or
marginal revenue MR) of its
product.

The profit of the firm is

measured by the rectangle
ABCD.

Any change in output, whether

lower at q1 or higher at q2, will
lead to lower profit.

Output Rule: If a firm is producing any positive

output, it should produce at the level at which marginal
revenue equals marginal cost, and marginal cost
curve is NON_DECREASING.
 When should the firm “shut down” , that is, cease production in short
run?

A competitive firm should

shut down if price is below
AVC.
The firm may produce in
the short run if price is
greater than average
variable cost.

Note shutting down in this

sense is not equivalent to
exiting the market – since
by definition of short run,
the firm cannot reduce its
fixed input to zero.

A firm should shut d ow n, that is, cease prod uction in short run (w hen it cannot exit
the m arket, if its profit by prod ucing positive output is w eakly lesser than that from
prod ucing no output. This is equivalent to Price being greater than m inim um possible
value of average variable cost (AVC).
 A Competitive Firm’s Short-run Supply Curve
The firm’s supply curve is the portion of the marginal cost curve for which marginal cost is
greater than average variable cost. It tells us how much a profit maximizing firm is willing
to supply at each possible price level P, provided it believes P to be the (future) market equilibrium
price at which she can sell as much she wants.

NOTE THAT ANY FIRM BEHAVING IN SUCH AN IDEALIZED MANNER ENGAGES IN WHAT IS KNOWN AS
‘MARGINAL COST PRICING”, THAT IS, THEY SELL EACH UNIT OF TOTAL OUTPUT Q* AT THE
MARGINAL COST MC(Q*).

In the short run, the firm

chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.
The short-run supply curve is
given by the crosshatched
portion of the marginal cost
curve.

AS WE SHALL SEE LATER, SUPPLY CURVE CAN EXIST AS MATHEMATICAL/CON CEPTUAL EN TITY ON LY IF THE
FIRMS IN MARKET ARE PERFECTLY COMPETITIVE. MORE IMPORTAN TLY, THIS MEAN S THE MARKET D EMAN D -
SUPPLY AN ALYSIS IS IN VALID FOR MARKETS WHERE FIRMS D O N OT BEHAVE IN A PERFECTLY COMPETITIVE
MAN N ER (OR A PRICE TAKER).
The Firm’s Response In Short run to an Input Price Change

Say labour becomes costlier

– implying that MC curve will
shift upward.

When the marginal cost of

production for a firm
increases (from MC1 to MC2),
the level of output that
maximizes profit falls (from q1
to q2).

The upward shift of MC curve

of this individual firm would
lead to an upward shift of the
market supply curve that we
had seen in the first class
(because it is the horizontal
summation of supply/MC
curves of each firm.) This
show in the next slide.
 The Short-Run Market/Industry Supply Curve

(horizontal summation)
The short-run industry
supply curve is the
summation of the supply
curves of the individual
firms.
Because the third firm has
a lower average variable
cost curve than the first two
firms, the market supply
curve S begins at price P1
and follows the marginal
cost curve of the third firm
MC3 until price equals P2,
when there is a kink.
Elasticity of Market Supply
For P2 and all prices above
it, the industry quantity Es = (ΔQ/Q)/(ΔP/P)
supplied is the sum of the
quantities supplied by each
of the three firms.
 Producer Surplus in the Short Run

● producer surplus Sum over all units produced by a firm of

differences between the market price of a good and the marginal cost of
production.

PRODUCER SURPLUS FOR

A FIRM
The producer surplus for a
firm is measured by the
yellow area below the market
price and above the marginal
cost curve, between outputs 0
and q*, the profit-maximizing
output.
Alternatively, it is equal to
rectangle ABCD because the
sum of all marginal costs up
to q* is equal to the variable
costs of producing q*.
 PRODUCER SURPLUS VERSUS PROFIT IN SHORT RUN

Producer surplus = PS = R − VC

Profit = π = R − VC − FC

PRODUCER SURPLUS FOR

A MARKET
The producer surplus for a
market is the area below the
market price and above the
market supply curve, between
0 and output Q*.

Therefore in long run, that is, w hen C(0)=0, producer surplus is same as profit.
The Short Run Effects of a ‘per unit’ Tax on an Individual Firm’s Supply.

EFFECT OF AN OUTPUT TAX

ON A COMPETITIVE FIRM’S
OUTPUT (in short run)
An output tax raises the firm’s
marginal cost curve by the
amount of the tax.
The firm will reduce its output
to the point at which the
marginal cost plus the tax is
equal to the price of the
product.
 The Short Run Effects of a ‘per unit’ Tax on Industry/Market supply

An output tax placed on all

firms in a competitive market
shifts the supply curve for the
industry upward by the
amount of the tax.

This shift raises the market

price of the product and
lowers the total output of the
industry.

Note how the industry supply

curve is flatter than individual
supply curve. This is primarily
due to the horizontal
summation exercise.
 Profit Maximiziation in the Long Run
Interpret LAC as essentially an algorithm such that once you enter your chosen target output – it
will tell the optimum SAC (corresponding to the optimum number of planes/fixed capita input that
need to be procured), which you should operate on.
It is easy to see that if I believe that I can sell as much output as the going price P (say, the most
recent recorded trading price P), then I would choose the target output Q* such that P= LMC (Q*).

In this diagram, the aforementioned

output Q* =q3.

Note that at this output level q3, price

equals long-run marginal cost LMC

In the diagram, if initially the firm was

stuck at a fixed capital stock
corresponding to SAC, then when
she enters long run, she can choose
to increase production to q3 and
increases its profit from ABCD to
EFGD.
BUT AS ARGUED IN THE NEXT SLIDE, THIS LO NG RUN CHO ICE W O ULD BE FUTILE AS IN
THE LO NG RUN, A PERFECTLY CO MPETITIVE PRO FIT MAXIMIZING FIRM EITHER EXITS
THE MARKET, O R ELSE PRO DUCES q2.
 Long-Run Competitive Industry Equilibrium
In long run, firms have the option to sell (buy) off her capital assets and exit (enter) the
industry. When a firm earns zero economic profit, it has no incentive to exit the industry.
Likewise, other firms have no special incentive to enter. (Recall that in a perfectly competitive
market there are NO barriers to entry or exits)

BUT IF A FIRM EARNS POSITIVE ECONOMIC PROFIT, NEW FIRMS WILL STEADILY ENTER THE MARKET,
SHIFTING THE INDUSTRY SUPPLY CURVE TO THE RIGHT WITHOUT AFFECTING THE INDUSTRY
DEMAND CURVE. THIS WOULD LEAD TO REDUCTION IN MARKET PRICE, WHICH WOULD REDUCE
ECONOMIC PROFITS OF ALL INDIVIDUAL FIRMS. THIS PHENOMENON WOULD CONTINUE UNTILL ALL
FIRMS IN THE MARKET EARN ZERO ECONOMIC PROFITS.

Therefore, a long-run competitive market equilibrium with profit maximizing firms

occurs if and only if following two conditions hold:
1. No firm has an incentive either to enter or exit the industry because all firms are
earning zero economic profit (or else new firms would enter/exit and price would fall/rise).
• THIS IMPLIES THAT THE FIRMS THAT REMAIN IN OPERATION IN LONG RUN MUST HAVE
IDENTICAL LAC CURVES – PRODUCE IDENTICAL OUTPUT LEVEL Q* THAT MINIMIZE THIS
COMMON LAC CURVE.
• So if there are N firms that remain in the market in a long run competitive equilibrium, the
total sales in the market that happen must be equal to NQ* .
• The equilibrium price P* must equal the LAC(Q*) value implying ZERO (economic) profits.
3. At price LAC(Q*), the quantity supplied by the industry is equal to the quantity
demanded by consumers.

(THIS IS THE INFERENCE DRAWN FROM THE MOST BASIC IDEALIZED MODEL IN AN INTRODUCTORY CLASS. FOR MOST
REALISTIC DESCRIPTION, ONE NEEDS TO SEE ADVANCED BOOKS.)
H ence each ind ivid ual price taking profit m axim izing firm that chooses to not exit in long
run – makes ZERO economic profit. This brings u s the follow ing d istinction:

ACCOUNTING PROFIT vs ECONOMIC PROFIT

Economic profit takes into account opportunity costs.

One such opportunity cost is the return to the firm’s owners if their capital/ labour/ other inputs were used
elsewhere.

For example: Accounting profit may equal revenues R minus labor cost wL (minus depreciation) which is likely
to be positive, if I bought capital stock in the last accounting cycle. Economic profit 𝜋 for the current cycle,
however, equals revenues R minus labor cost wL minus the capital cost, rk that is foregone by not renting out
the capital stock. That is, .
π = R − wL − rK

● zero economic profit A firm is earning a normal return on its investment—

i.e., it is doing as well as it could by investing its money elsewhere. Note that
the accounting profit may well be very high.
 chapter 12
Multi-person decision making, needed for analyzing imperfect competition where
there are finite sellers who are NOT price takers, but all buyers are price takers.
• Strategic decisions play a role when the effects of your
actions depend on the actions and reactions of other
people
• Game theory is the tool economists use to analyze
strategic situations
• Roughly speaking strategic situations can be
1. over after one set of decisions taken SIMULTANEOUSLY (or
equivalently, taken without any information on the chosen
decisions by others) by multiple players (one-stage games).
2. or may involve a sequence of decisions (multiple-stage games
– where a stage may describe a decision taken by a SINGLE
player)
• Sometimes all participants (players) in a game have access
to the same information, but sometimes different people
have different information (asymmetric information)
 What is a Game?
• Game: a situation in which a number of individuals
make decisions, and each cares both about his own
choice and about others’ choices
• Example: game theory provides the foundation for
understanding competition in industries with only a
few producers
• Example: every negotiation is a game
 Two Types of Games
• One-stage game: each participant makes ALL of their
choices before observing/knowing any choice by any
other participant (effectively they make
SIMULTANEOUS MOVE)

• Multiple-stage game: at least ONE participant

observes a choice by another participant before
making some decision (AT LEAST ONE of the PLAYERS
MOVES SEQUENTIALLY)
 Describing a Game
• One-stage games:
1) Identify the players and list the strategies available to
each
2) Identify each player’s payoff for every possible
combination of strategies
 Idea of best response to a strategy
that you expect.

Best response: a strategy that provides player with the highest possible
payoff, assuming other players behave in a specified way

Consider two friends Oscar and Roger caught with stolen goods guaranteeing
2 months in prison. If any one turns court approver giving testimony that the
other has stolen the goods – he will be rewarded by reduction from 2 to 1
month jail, while the other will be convicted for stealing as well as obstruction
of justice implying an increased jail time of 6 months. Of course if both turn
approvers against each other, they both go to jail for 5 months each (to
reward them for NOT obstructing justice).

They are taken to two separate interrogation rooms (they cannot contact
each other in any manner) and presented with these possibilities. What will
they do?
Prisoners’ Dilemma
Best Responses in the Prisoners’
Dilemma

12-8
Equilibrium in the Prisoner’s Dilemma

-2
 Nash Equilibrium
Nash equilibrium: the
strategy played by each
individual is a best
response to the strategies
played by everyone else.

In this case of Prisoners’

dilemma, NE prediction is
(SQUEAL, SQUEAL).

Nash equilibrium payoffs

12-10
 NO NASH EQUILIBRIUM IN PURE STRATEGY IN “MATCHING COINS” GAME

MATCHING COINS
Player B
Heads Tails
Heads 1, –1 –1, 1
Player A
Tails –1, 1 1, –1

In this game, each player CHOOSES heads or tails and the two players reveal their coins
at the same time. If the coins match Player A wins and receives a dollar from Player B. If
the coins do not match, Player B wins and receives a dollar from Player A.
Note that there is no Nash equilibrium in pure strategies for this game. No combination
of heads or tails leaves both players satisfied—one player or the other will always want
to change strategies.

There appears a Nash equilibrium IF WE ALLOW randomization in choosing strategies. For

example, A can use a machine that plays instead of A playing in person, and is programmed to
play Head with some probability pA . Similarly for B.
Then strategies become the programmed probabilities – and are called MIXED STRATEGIES. In
almost all games a Nash equilibrium exists in mixed strategies – even when it may not exist in
pure strategies. Here: p*A = p*B = ½.
 EXAMPLE OF A ONE STAGE GAME : BEACH LOCATION GAME

You (Y) and a competitor (C) plan to sell IDENTICAL soft drinks on a beach at
IDENTICAL price.

If vacationers are spread evenly across the beach and will walk to the closest vendor,
the two of you will locate next to each other at the center of the beach. This is the only
Nash equilibrium. If your competitor located at point A, you would want to move until
you were just to the left, where you could capture three-fourths of all sales. But your
competitor would then want to move back to the center, and you would do the same.
 Game with Perfect Information
(A special type of multi stage game)
In the pre-mobile times, Tony and
Maria decide go on a movie date –
but say Tony manages to reach the
theatre first. Tony decides to go
ahead and buy tickets for himself –
they have a pact of going Dutch on
every date. This is the story of his
decision on which movie ticket to
buy.

It is a multi-stage game where every

player makes her ever choice
KNOWING everything that happened
before. The gender stereotyping here is a thing of
past, and no longer applicable today. This
game was originally developed as “Battle
Equivalently, a perfect information of Sexes” in 1950s, and was an important
game is a multi-stage game that companion of the Prisoner’s Dilemma
consists of sequentially occurring game. Hence, we study a modified version
peculiar stage games that have a of it here.
SINGLE player choosing an action. 12-13
 Thinking Strategically in a Game with
Perfect Information

• Backward induction: the process of solving a

strategic problem by reasoning in reverse, starting at
the end of the tree diagram that represents the
game, and working back to the beginning
Solving by Backward Induction
 Backward induction and Nash Equilibrium
In terms of the earlier example:
• Tony’s NE strategy: choose the action-adventure film
• Maria’s NE strategy:
– if Tony chooses the action-adventure film, then choose
the action-adventure film
– if Tony chooses the romantic comedy, then choose the
romantic comedy

Note how a perfect information game MUST involve sequential moves,

and so, leads to a distinction in concept of strategy and action
(example: Maria).
 chapter 19
The most realistic model that we will see in this course. The buyers are price takers but the finite number of sellers are
price setters.
 Learning Objectives
• Discuss how economists use game theory to understand oligopolies and
describe the concept of Nash equilibrium.

• Describe the Bertrand model and the Cournot model, and identify the
Nash equilibrium in each model.

• Explain why product differentiation makes price competition less intense

and identify the Nash equilibrium in a market with product differentiation.

• Analyze whether collusion is sustainable in a setting with repeated price

competition.

• Determine the number of firms that will enter a market and discuss the
factors that affect this number.

• Describe the main U.S. antitrust statutes and discuss their rationales.
 Overview
• Analyze what a firm’s best actions are in oligopolies using
game theory

• Contrast models of oligopoly: Bertrand and Cournot model

• Examine the factors that determine the number of firms

that enter an oligopolistic market

• Observe strategic decisions shaping long-term competition

with rivals, along with collusion when firms compete
repeatedly
 Oligopoly and Game Theory
• Economists determine/predict/ explain the outcome
of oligopolistic competition by applying game theory.

• In particular, they focus on the Nash equilibrium.

• In a Nash equilibrium of an oligopoly market, each

firm is making a profit-maximizing choice given/
under a specific belief about the choices of its rivals
 Bertrand Model
• Suppose Duopoly, that is, two sellers in the market
• Can be trivially generalized to multiple sellers, in
which case, we shall call it an Oligopoly
• Homogeneous goods: firms sell identical products

Defining feature of Bertrand model:

Identical firms set their prices simultaneously. So in this
game the players are the firms, and their strategies are
the price which are chosen simultaneously.
 Market Demand and Firm Demand Curves
Assumption: Say customers choose between Joe and Rebecca when they charge identical prices
by tossing an unbiased coin.
 Nash Equilibrium in the Bertrand Model
When sellers are identical, both (all) sellers charge an identical price equal to their
COMMON marginal cost earning zero profits in pure strategy NE.

Or else there will be a different NE, the seller with lower marginal costs – under
some assumption of suitable discrete pricing – will charge the largest possible
price less than marginal cost of the high cost firm and sell to the whole market,
while the high cost firm will produce zero.
 Cournot Model of Oligopoly
(a model of quantity competition)
• Firms choose how much to
produce simultaneously (more
importantly, without any knowledge of
what the other is choosing),
and the
price clears the market given
the total quantity produced.

• Compared to Bertrand’s
model, everything is same
except for the choice
variable for both firms is
quantity of output. This may
be more realistic in markets
where no single firm can
cater to WHOLE MARKET at
all prices
 Residual Demand Curves
Residual demand curve: shows the relationship between a
firm’s output and the market price given the outputs of the
firm’s rivals
Joe’s residual demand
Joe’s residual demand when Rebecca
when Rebecca produces produces 4,000
2,000

Market demand Market demand

Best Responses in the Cournot Duopoly Model
(without loss of generality assume that there are two players)

P = 60
Q = 2,000 MR = MC
P = 50, Q = 1,000
Joe behaves like a
monopolist given his
MR = MC
residual demand
 Best-Response/Reaction Curves in the Cournot Duopoly

REACTION CURVE: shows a firms best choice in response to

each possible action by its rival.
Nash Equilibrium in the Cournot Duopoly

• Each chooses its

profit-maximizing
output level given
its rival’s output
• Neither firm has
an incentive to
deviate from
(2,000, 2,000)
 MATHEMATICL EXPOSITION OF COURNOT DUOPOLY

• 2 firms
• Identical products
• Output choice competition
• Simultaneous choice of production amount: that is, one does not know
the choice of the other w hile making ow n choice

For simplicit y of exposit ion in class, assume ident ical CO NSTANT marginal
cost s ‘C’.
 Cournot Duopoly - A Linear Demand Curve

Two identical firms face the following market demand curve 𝑃 = 30 − 𝑄

Also, MC1 = MC2 = 𝐶 and total output 𝑄= 𝑄1 + 𝑄2

Total REVENUE for firm 1: 𝑅1 = 𝑃𝑄1 = 30 − 𝑄 𝑄1 = 30𝑄1 − 𝑄12 − 𝑄2 𝑄1

then MR1 = ∆𝑅1 ∆𝑄1 = 30 − 2𝑄1 − 𝑄2

To solve for the Nash equilibrium (Q*1, Q*2) , we set MR1 = C (the firm’s marginal cost)
∗ ∗
and we find that Firm 1’s reaction curve: 2Q 1 = 30 − Q 2 - C
∗
By the same calculation, Firm 2’s reaction curve: 2Q 2 = 30 − 𝑄∗ 1- C

Cournot equilibrium strategies:: 𝑸 ∗𝟏 = 𝑸 ∗𝟐 = (𝟑𝟎 − 𝑪)/𝟑

Total quantity produced in equilibrium: 𝟐(𝟑𝟎 − 𝑪)/𝟑
Equilibrium price: (30+2C)/3

Note the demand by Hyundai chairman to reduce GST to help tide over the current auto
industry crisis. So what he is saying is that auto sales are down (for very
specific political and economic reasons beyond the scope of this course) so that the value
’30’ in demand curve has now become ‘20‘ leading to reduction in output produced and
hence, labour employed. If taxes are reduced sufficiently, then the output will increase again
as ‘C’ will reduce to say, ‘C-10’, and the initial output and employment levels would be
regained – albeit at a significant loss of Government revenue.
Deadweight Loss from Duopoly versus
Monopoly
• The deadweight loss
of monopoly is
larger because the
monopoly price is
further above
marginal cost than is
the oligopoly price
Price Competition with Differentiated
Products
• Differentiated products: when consumers do not
view similar products as perfect substitutes
 Bertrand Competition with
Differentiated Products
Coke’s Best Responses

Coke’s residual demand

Coke’s residual demand
Bertrand Competition with
Differentiated Products
 Collusion
Competing firms could merge become monopoly and earn monopoly profits that are
divided equally among shareholders of all firms. The is formation of CARTEL such as
OPEC. However, in domestic markets most countries have made such HORIZONTAL
MERGERS to be ILLEGAL.

So firms, if they want to collude in a domestic market must do so without any legal or
public declaration. This causes a problem because two separate production
technologies not integrated to each other need to agree to charge HIGH price – that
is, not cheat each other by charging LOW price while the other charges HIGH price.

Unfortunately, they can view their interaction to be an infinitely repeated game so use
special NE strategies (as the GRIM strategies) to sustain cooperation. That is, firms
may adopt a strategy in which they charge the monopoly price if no one has yet
undercut that price; otherwise they charge a price near or at their marginal cost.

OF COURSE, FOR THIS COLLUSIVE/COOPERTATIVE OUTCOME TO BE EQUILIBRIUM EACH FIRM MUST BE

ABLE TO VERIFY THE PRICES CHARGED BY OTHER FIRM SO AS TO ENSURE SHE HAS BEEN CHEATED OR
NOT. In that case, collusion will work if firms value the future highly enough (that is, if the
interest rate is low enough) EVEN when regulatory framework is robust and efficient.
 Imperfect Price Observation
(A STRATEGIC OBSTACLE TO COLLUSION)

In many real-world settings a firm observes its rivals’ prices imperfectly,

if at all. This makes collusion harder to sustain because a firm will
doubt whether its rivals have abided by the collusive agreement.

The Matt Damon movie called “Informant” actually documents such an

example “TACIT COLLUSION” between lysine manufacturers in US from
1992-95.
Interestingly, they start by fixing prices together – imperfect price observation led to
failure.

So the next step was for them to fix market share to each firm – if any firm sold
more leading to less sales from other fellow cartel members, she had to buy lysine
from them at the cartel decided price.

This eliminated the incentive to cheat among members and led to sustaining of
cooperation until FBI arrested all CEOs.
 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY or NOMINAL ENTRY COSTS)

• Markets where firms sell differentiated products at a markup,

that is, such that price of these products is greater than the
marginal cost of producing total sales.

• In spite of that each firm makes almost negligible (almost zero)

economic profit in long run.

• It occurs in a market with free entry when there is a large

number of firms – sunk cost to entry are very less.

• In long run, each firm produces a level of output that is NOT

minimum of LAC curve level.

• Example: petrol pumps or supermarkets.

 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT RUN

Suppose that the Nash

equilibrium price of the
competitor firm 2 at any value
P*2.
Because the firm is the only
producer of its brand, it faces a
downward-sloping demand
curve.
Then, given the fixed P*2, the
profit maximizing (and hence,
Nash equilibrium) price of firm
1 must be PSR:= P*1.

Suppose that PSR exceeds

average cost at the output sold
QSR . That is, in the short run,
the firm earns profits shown by
the yellow-shaded rectangle.
 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN

In the long run, these profits
attract new firms with competing
brands. The firm’s market share
falls in the new Nash equilibria
with larger number of firms, and
this is gets reflected in a
downward shift of its product’s
demand curve.
In long-run equilibrium,
described in figure (b), price
equals average cost, so the firm
earns zero profit even though it
has monopoly power.

So free entry and exit in

market eliminates any
monopoly profits in long run.
 COMPARISON OF MONOPOLISTICALLY COMPETITIVE LONG RUN EQUILIBRIUM AND
PERFECTLY COMPETITIVE LONG RUN EQUILIBRIUM

Under monopolistic
competition, price exceeds
marginal cost, and
production is carried out at
an inefficient level where
costs are not minimized.
Thus there is a deadweight
loss, as shown by the
yellow-shaded area.
The demand curve is
downward-sloping, so the
zero profit point is to the left In both types of markets, entry occurs until profits are driven to
of the point of minimum zero.
average cost.
 Back to Oligopoly - Raising Rival’s
Costs

Options range from lobbying, to buying critical input in bulk, to fomenting labour trouble at
competitors’ plant. There is much documentary and punishment evidence in US itself.
 How to Raise a Rival Firm’s Marginal
Cost
• Lobbying
– Imposing stringent environmental regulations
– Imposing a tariff
• Increasing the cost of a rival’s inputs

• Buying a lot of the supply of a critical input and not

supplying it to rivals (example: De Beers)
 Strategic Precommitment in Oligopoly
When a firm commits to certain actions before rivals take
theirs, with the aim of affecting rivals’ later choices

• Examples
– Output choice by a first-mover (by signing a big labour contract
in advance or setting up a large plant whose technology requires it to
run at almost full capacity – like alumina refining plants)
– Spanish Conquistador (CORTES’) in 1519 burning ships to
eliminate option retreat while invading Aztec city of
Tenochtitlan
– Entry deterrence (making a large enough output choice, in the
manner mentioned above which makes profits consequent to entry so
low for the competitor that she does not enter)
 Output Choice by a First-Mover
(UNDER THE ASSUMPTION THAT SECOND MOVER ENTERS THE MARKET AT A LATER DATE)

• Stackelberg model of quantity competition: two

firms choose their outputs sequentially

If the entry cost of Joe is 15000$, then Rebecca will choose to produce (or commit to
produce) 4000 units, which will deter Joe from entering (as post entry profits would be
10000$, and thus, yield Rebecca a profit of 80000$. 19-29
 Entry Deterrence
(OUT PUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)

Commitment versus flexibility: Though a firm can sometimes gain by pre-

committing to future actions, there is a potential downside to the strategy if market
conditions are uncertain.

Put simply, pre-committing limits the firm’s ability to respond to changing market conditions.
For example, DuPont once tried to deter rivals from producing titanium dioxide (a whitener
used in paints and plastics) by committing to an extensive expansion of its facilities.
Unfortunately for DuPont, an unexpected recession struck, and market demand turned out to
be much lower than DuPont forecasted, causing the firm’s clever strategy to yield a
disappointing loss. HENCE THE NEED FOR PROFESSIONAL STATISITICIANS/ ECONOMISTS WHO
CAN PREDICT BUSINESS CYCLES.

19-30
 Entry Deterrence
(OUTPUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)
• By expanding one’s output sufficiently, a firm may reduce the profit
its rival foresees enough to deter them from entering the market.

• However, often firms prefer to set up the excess capacity (by signing a
labour contract or setting up a plant) but not actually increase
production prior to possible entry of competitor.

• Effectively, the existing firms are threatening the entrant that they
will render this decision to enter a financially COSTLY decision if they
DARE to enter.

• Such THREATS increase output and cause losses to a potential entrant

will only have an effect if the threat is credible. The exact meaning of
this credibility in terms of COMMITMENT is beyond the current course 19-31
 Profit
Maximization
chapter 9
In our pursuit to develop a market supply curve, we started from conceptualizing production, and then developing the idea
of Cost function, and now, have reached our final destination in this chapter where we shall develop the individual firm
supply curve.
•
 Perfectly Competitive Markets – Underlying assumptions
PRICE TAKING - both consumers and firms accept price as an exogenous parameter that they are
incapable of influencing. Both sides of market are “PRICE TAKER”
• Individual firms must believe that whatever they produce will get sold at the going market
price value which they presume during taking output decisions.
• So essentially, “market clears”, that is, market equilibrium OCCURS when (i) their
prediction/assumption of market price is a perfect match with the realized market price,
and (ii) all produced output gets sold.
• In reality, the market (real) price over time continue to fluctuate over a period of time unless firms
and consumers arrive at this conceptual match.
• Because each individual firm sells a sufficiently small proportion of total market output, its
decisions have no impact on market price – internet market place, fish auctions?
PRODUCT HOMOGENEITY - Products of all of the firms in a market are perfectly substitutable
with one another—that is, they are homogeneous. Hence, no firm can raise the price of its product above
the price of other firms without losing most or all of its business. Example: world market for wheat!!!
• In contrast, when products are heterogeneous, each firm has the opportunity to raise its price
above that of its competitors without losing all of its sales. Hence, the need for advertising!!
• The assumption of product homogeneity is important because it ensures that there is a
single market price, consistent with supply-demand analysis.
FREE ENTRY AND EXIT - With free entry and exit, buyers can easily switch from one supplier to
another, and suppliers can easily enter or exit a market. So there can be no special costs that make it
difficult for a firm to enter (or exit) an industry.
NO TRANSACTION COST - Sellers and buyers can easily locate each other and engage in a
meaningful discussion or negotiations of prices without fear or barriers.
 Do Firms Maximize Profit?
The assumption of profit maximization is frequently used in microeconomics because it
predicts business behavior reasonably accurately and avoids unnecessary analytical
complications.
Firms that do not care about maximizing profit are not likely to survive (their brand
names may survive though). The firms that do survive make long-run profit
maximization one of their highest priorities: [Case in point: Masayoshi Son issued a
call for profit maximization after his huge investment in WeWork went bust as the
company shut down due to immense losses.]
 PROFIT MAXIMIZATON
● profit := Difference between total revenue and total cost.
π(q) = R(q) − C(q) = P.q – C(q) if the firm is a price taker
● marginal revenue:= Change in revenue resulting from an infinitesmal
increase in output – slope of the revenue function.
● marginal cost:= Change in cost function resulting from an infinitesmal
increase in output – slope of the cost function.
A firm chooses output q*, so that
profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope
of the cost curve).
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q)
A SHORT RUN EXAMPLE – BUT THE PRINCIPLE HOLDS IN
LONG RUN TOO!
 Demand and Marginal Revenue for a Competitive Firm
(firm’s perceived/assumed demand curve) (actual market demand curve)
MR(q) = Price for a competitive curve at all values of q = P
A competitive firm supplies only a small portion of the total output of all the firms in an industry.
Therefore, the firm BELIEVES (takes) the market price revealed by the supreme AI AND THAT
SHE CAN SELL AS MUCH SHE WANTS AT THIS PRICE – hence, choosing its output on the
assumption that the price will be unaffected by the output choice.
Hence (a) the demand curve perceived by the firm is perfectly elastic, even though the actual market
demand curve in (b) is downward sloping.
 • Along the perceived horizontal demand curve, marginal revenue, average
revenue (= R(q)/q), and price are all equal.
• Hence, the perfectly competitive structure of the market leaves firms to decide
only one question: HOW MUCH TO PRODUCE? (unlike a monopolist who –
not being a price taker – may ask a different question : “how much to charge?”
A perfectly competitive profit maximizing firm should choose to produce an
output q* so that marginal cost equals price:
MC(q*) = P and […….]
 Short-Run Profit Maximization by a Competitive Firm
In the short run, the
competitive firm maximizes its
profit by choosing an output q*
at which its marginal cost MC
is equal to the price P (or
marginal revenue MR) of its
product.
The profit of the firm is
measured by the rectangle
ABCD.
Any change in output, whether
lower at q1 or higher at q2, will
lead to lower profit.
Output Rule: If a firm is producing any positive
output, it should produce at the level at which price
equals marginal cost, and marginal cost curve is NON
- DECREASING.
 When should the firm “shut down” , that is, cease production in short
run?
A competitive firm should shut down
if price is below AVC.
Note shutting down in this sense is
not equivalent to exiting the market
– since by definition of short run, the
firm cannot reduce its fixed input to
zero.
A firm should shut down, that is, cease production in
short run (when it cannot exit
the market, if its profit by producing positive output is
weakly lesser than that from
producing no output. This is equivalent to Price being
greater than minimum possible value of average
variable cost (AVC).
 A Competitive Firm‟s Short-run Supply Curve
The firm‟s supply curve is the portion of the marginal cost curve for which marginal cost is
greater than minimum possible average variable cost. It tells us how much a profit
maximizing firm is willing to supply at each possible price level P, provided it believes P to be
the (future) market equilibrium price at which she can sell as much she wants.
NOTE THAT ANY FIRM BEHAVING IN SUCH AN IDEALIZED MANNER ENGAGES IN WHAT IS KNOWN AS
„MARGINAL COST PRICING”, THAT IS, THEY SELL EACH UNIT OF TOTAL OUTPUT Q* AT THE
MARGINAL COST MC(Q*).
In the short run, the firm
chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.
The short-run supply curve is
given by the crosshatched
portion of the marginal cost
curve.
AS WE SHALL SEE LATER, SUPPLY CURVE CAN EXIST AS MATHEMATICAL/CONCEPTUAL ENTITY ONLY IF THE FIRMS IN MARKET ARE PERFECTLY COMPETITIVE. MORE
IMPORTANTLY, THIS MEANS THE MARKET DEMAND-SUPPLY ANALYSIS IS INVALID FOR MARKETS WHERE FIRMS AND CUSTOMERS DO NOT BEHAVE IN A PERFECTLY
COMPETITIVE MANNER (OR A PRICE TAKER).
 The Short-Run Market/Industry Supply Curve
(horizontal summation)
The short-run industry
supply curve is the
summation of the supply
curves of the individual
firms.
Because the third firm has
a lower average variable
cost curve than the first two
firms, the market supply
curve S begins at price P1
and follows the marginal
cost curve of the third firm
MC3 until price equals P2,
when there is a kink.
Elasticity of Market Supply
For P2 and all prices above
it, the industry quantity Es = (ΔQ/Q)/(ΔP/P)
supplied is the sum of the
quantities supplied by each
of the three firms.
 Producer Surplus in the Short Run
producer surplus:= Sum over all units produced by a firm of differences between the
market price of a good and the marginal cost of production.
PRODUCER SURPLUS FOR A FIRM
The producer surplus for a firm is
measured by the yellow area below the
market price and above the marginal
cost curve, between outputs 0 and q*,
the profit-maximizing output.
 PRODUCER SURPLUS VERSUS PROFIT IN SHORT RUN
Short run producer surplus = PS = R − VC
Short run profit = π = R − VC − FC
PRODUCER SURPLUS FOR A MARKET
The producer surplus for a market is the
area below the market price and above
the market supply curve, between 0 and
output Q*.
Therefore in long run, that is, when C(0)=0, producer surplus is same as profit.
The Short Run Effects of a „per unit‟ Tax on an Individual Firm‟s Supply.
EFFECT OF AN OUTPUT TAX
ON A COMPETITIVE FIRM‟S
OUTPUT (in short run)
An output tax raises the firm’s
marginal cost curve by the
amount of the tax.
The firm will reduce its output
to the point at which the
marginal cost plus the tax is
equal to the price of the
product.
 The Short Run Effects of a „per unit‟ Tax on Industry/Market supply
An output tax placed on all
firms in a competitive market
shifts the supply curve for the
industry upward by the
amount of the tax.
This shift raises the market
price of the product and
lowers the total output of the
industry.
Note how the industry supply
curve is flatter than individual
supply curve. This is primarily
due to the horizontal
summation exercise.
 Profit Maximiziation in the Long Run
Interpret LAC as essentially an algorithm such that once you enter your chosen target output – it
will tell the optimum SAC (corresponding to the optimum number of planes/fixed capita input that
need to be procured), which you should operate on.
It is easy to see that if I believe that I can sell as much output as the going price P (say, the most
recent recorded trading price P), then I would choose the target output Q* such that P= LMC (Q*).
In this diagram, the aforementioned
output Q* =q3.
Note that at this output level q3, price
equals long-run marginal cost LMC
In the diagram, if initially the firm was
stuck at a fixed capital stock
corresponding to SAC, then when
she enters long run, she can choose
to increase production to q3 and
increases its profit from ABCD to
EFGD.
BUT AS ARGUED IN THE NEXT SLIDE, THIS LONG RUN CHOICE WOULD BE FUTILE AS IN THE LONG RUN, A PERFECTLY COMPETITIVE
PROFIT MAXIMIZING FIRM EITHER EXITS THE MARKET, OR ELSE PRODUCES q2 - in either case earning a zero economic profit.
 Long-Run Competitive Industry Equilibrium
In long run, firms have the option to sell (buy) off her capital assets and exit (enter) the
industry. When a firm earns zero economic profit, it has no incentive to exit the industry.
Likewise, other firms have no special incentive to enter. (Recall that in a perfectly competitive
market there are NO barriers to entry or exits)
BUT IF A FIRM EARNS POSITIVE ECONOMIC PROFIT, NEW FIRMS WILL STEADILY ENTER THE MARKET,
SHIFTING THE INDUSTRY SUPPLY CURVE TO THE RIGHT WITHOUT AFFECTING THE INDUSTRY
DEMAND CURVE. THIS WOULD LEAD TO REDUCTION IN MARKET PRICE, WHICH WOULD REDUCE
ECONOMIC PROFITS OF ALL INDIVIDUAL FIRMS. THIS PHENOMENON WOULD CONTINUE UNTILL ALL
FIRMS IN THE MARKET EARN ZERO ECONOMIC PROFITS.
Therefore, a long-run competitive market equilibrium with profit maximizing firms
occurs if and only if following two conditions hold:
1. No firm has an incentive either to enter or exit the industry because all firms are
earning zero economic profit (or else new firms would enter/exit and price would fall/rise).
• THIS IMPLIES THAT THE FIRMS THAT REMAIN IN OPERATION IN LONG RUN MUST HAVE
IDENTICAL LAC CURVES – PRODUCE IDENTICAL OUTPUT LEVEL Q* THAT MINIMIZE THIS
COMMON LAC CURVE.
• So if there are N firms that remain in the market in a long run competitive equilibrium, the
total sales in the market that happen must be equal to NxQ* .
• The equilibrium price P* must equal the LAC(Q*)= minimum possible value of LAC,
implying ZERO (economic) profits.
3. At price LAC(Q*), the quantity supplied by the industry is equal to the quantity
demanded by consumers.
(THIS IS THE INFERENCE DRAWN FROM THE MOST BASIC IDEALIZED MODEL IN AN INTRODUCTORY CLASS. FOR MOST
REALISTIC DESCRIPTION, ONE NEEDS TO SEE ADVANCED BOOKS.)
Hence each individual price taking profit maximizing firm that chooses to not exit in long
run – makes ZERO economic profit. This brings us the following distinction:
ACCOUNTING PROFIT vs ECONOMIC PROFIT
π = R − wL − rK
zero economic profit:= A firm is earning a normal return on its investment—i.e., it is
doing as well as it could by investing its money elsewhere. Note that the accounting
profit may well be very high.