S
P
(P
, Q
P
Q
d
> 1 elastic,
d
= 1 unit elastic
d
< 1 inelastic
Of course, this is the market demand, not the resid
ual demand facing an individual rm if the number
of rms (N) is greater than one.
When writing up quantitative results, try to gure
out if you can express these as elasticities, rather
than a number like 23.23.
16
Lecture 2: Monopoly
Denition: A rm is a monopoly if it is the only
supplier of a product in a market.
A monopolists demand curve slopes down because
rm demand equals industry demand.
Four cases:
1. Base Case (One price, perishable good, nonIRS
Costs).
2. Natural Monopoly
3. Price Discrimination
4. Durable Goods
17
BASE CASE
Monopolists Prot Maximization Problem:
max
Q
= p(Q)QC(Q)
(Choosing P or Q makes no dierence because we
are selecting a single point on the demand curve.
This will not be true when we consider oligopoly
problems.) F.O.C. are:
d
dQ
= P(Q) +Q
dP
dQ
dC
dQ
= 0
P(Q) +Q
dP
dQ
=
dC
dQ
MR = MC
18
P
Q
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MR
MC
P
(P
, Q
) is protmaximizing choice.
19
The monopolist chooses output such that the markup
equals the inverse of the elasticity of demand:
P(Q)
dC(Q)
dQ
P(Q)
=
Q
dP(Q)
dQ
P(Q)
=
Q
P
dP(Q)
dQ
=
1

d

> 0
Dead Weight Loss exists because P > MC.
20
2. Natural Monopoly
Denition: Declining average cost over all mean
ingful quantities. The most ecient outcome is for
a single rm to produce all output.
Note: IRS is sucient but not necessary for a nat
ural monopoly.
21
P
Q
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D
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MR
MC
P
d
Q
d
AC
P
Natural Monopoly
Denition of natural monopoly: declining average
cost over all meaningful quantities. The most ef
cient outcome is for a single rm to produce all
output. (For example, public utilities)
22
Monopoly will maximize prots at (P
, Q
). (P
d
, Q
d
)
are welfare maximizing, but a rm would make a
loss in this case.
Raises the question of the rst best regulation for a
natural monopoly. Extensive literature on this that
may touch on in assymetric information / adverse
selection section.
23
3. Price Discrimination:
1. We distinguish between three types of price dis
crimination:
First degree (i.e., perfect price discrimination)
Second degree (i.e., nonlinear pricing such as
quantity discounts)
Third degree (i.e., market segmentation)
2. Price discrimination always increases prots (pro
ducer surplus), but its eects on consumer surplus
are ambiguous.
24
P
Q
D
1
MR
1
P
1
Q
1
Price Discrimination by the Monopolist:
Market 1
25
P
Q
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MR
2
P
2
Q
2
Price Discrimination by the Monopolist:
Market 2
26
P
Q









































D
MR
`
`
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`
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`
`
`
P
i
(q1, q2) = p(q
1
+q
2
)q
i
TC
i
(q
i
)
Now we need an equilibrium concept.
35
{p
c
, q
c
1
, q
c
2
} is a Cournot equilibrium (Nashinquantities
equilibrium) if:
1. a) given q
2
= q
c
2
, q
c
1
solves max
q
1
1
(q
1
, q
c
2
)
b) given q
1
= q
c
1
, q
c
2
solves max
q
2
2
(q
c
1
, q
2
)
2. p
c
= a b(q
c
1
+q
c
2
), for p
c
, q
c
1
, q
c
2
0.
No rm could increase its prot by changing its
output level, given that other rms produced the
Cournot output levels.
This is just the Nash Equilibrium concept applied to
our game. If you arent familiar with this concept,
go take a game theory course and then take this
course next year.
36
1
(q1, q2) = (a bq
1
bq
2
)q
1
c
1
q
1
F.O.C. (for rm 1):
1
(q
1
, q
2
)
q
1
= a 2bq
1
bq
2
c
1
= 0
Best response is:
q
1
= R
1
(q
2
) =
a c
1
2b
1
2
q
2
37
q
2
q
1
`
`
`
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R
1
(q
2
)
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`
`
``
R
2
(q
1
)
q
c
1
q
c
2
ac
1
2b
ac
2
2b
38
Note both bestresponse functions are downward
sloping. For each rm: if the rivals output in
creases, I lower my output level. (i.e., an increase
in a rivals output shifts the residual demand facing
my rm inward, leading me to produce less.)
Now we can compute Cournot equilibrium output
levels.
q
c
1
=
a 2c
1
+c
2
3b
q
c
2
=
a 2c
2
+c
1
3b
Equilibrium quantity supplied on the market is
Q
c
= q
c
1
+q
c
2
=
2a c
1
c
2
3b
39
We can also nd equilibrium price.
p
c
= a bQ
c
=
a +c
1
+c
2
3
What are the payo functions in equilibrium?
c
i
= [(a bQ
c
) c
i
](q
c
i
)
= (p
c
c
i
)(q
c
i
) = b(q
c
i
)
2
40
Extending this to N rms.
Its harder to see the reaction functions, but the
story is exactly the same.
Now each rm maximizes prots according to:
i
(q
1
, q
2
, ...q
N
) = p(Q)q
i
TC
i
(q
i
)
We would derive the best response function for all
N rms. For rm 1,
q
1
= R
1
(q
2
, ..., q
N
) =
a c
1
2b
1
2
(
N
j=2
q
j
)
41
We need N of these equations. However, if we as
sume that rms costs are the same (TC
i
(q
i
) = ci),
its a lot easier. Each rm has the same reaction
function, which is
q
i
= R
i
(q
i
) =
a c
2b
1
2
(
N
j=i
q
j
)
42
Back to the reaction function.
q
i
= R
i
(q
i
) =
a c
2b
1
2
(
N
j=i
q
j
)
q =
a c
2b
1
2
(N 1)q
Thus,
q
c
=
(a c)
(N +1)b
Q
c
=
N(a c)
(N +1)b
Now it is straightforward to solve for p
c
(the market
price) and
c
i
(prots for each rm).
43
Sanity checks. . .
Do we get the monopoly result for N = 1?
Do we get the duopoly result for N = 2?
What is the Cournot solution for N = ?
Take the limit as N for q
c
and Q
c
and p
c
. They
are:
lim
N
q
c
= 0
lim
N
Q
c
=
a c
b
lim
N
p
c
= c
44
Under the assumption of Cournot competition, mar
ket supply approaches the competitive supply as
N .
Note that market supply depends on the slope and
intercept of demand, and the (common) marginal
cost. Individual rms output levels approach zero
as N .
45
Take a look at the results when rms have dierent
levels of marginal cost.
Let marginal cost of rm i be c
i
. The F.O.C. is
only a slight modication from before.
i
= [(a bq
i
bq
i
) c
i
](q
i
)
i
q
i
= a 2bq
i
b
i=j
q
j
c
i
= 0
46
Rewrite the F.O.C. as
a bQ
bq
i
= c
i
Substitute in for price:
p c
i
= bq
i
Q
Rearrange...
p c
i
p
=
bq
i
Q
p
p c
i
p
=
p
Q
q
i
Q
p
The term
q
i
Q
d
And note that for perfectly competitive markets:
p c
i
p
=
0
d
And for monpolistic markets:
p c
i
p
=
1
d
48
Cournot with Sequential Moves:
We could also think about this in a game where rm
1 moves rst, rm 2 moves second, etc. We call
this a leaderfollower market structure, or a Stack
elberg game. The sequential moves game is a very
reducedform way to think about situations with in
cumbent rms and potential entrants.
Work backwards: Suppose rm 1 sets output
level to q
1
. What would rm 2 do?
R
2
(q
1
) =
ac
2b
1
2
q
1
Firm 1 can gure this out. What will Firm 1
do in response?
max
q
1
p(q
1
+R
2
(q
1
))q
1
cq
1
49
Whats dierent between this prot function and a
Cournot prot function?
Turns out leader output level is: q
S
1
=
ac
2b
=
3
2
q
C
.
Follower output level is: q
S
2
=
ac
4b
=
3
4
q
C
Equilibrium price is lower than Cournot, output
is larger than Cournot hence more consumer
surplus.
Firstmover advantage: leader makes more
prot than follower. Leader is better o
than in Cournot.
50
Bertrand (Nash in Prices)
When do you think price setting makes more sense
than setting quantity?
In general, economists may believe that dierent as
sumptions hold for dierent settings. Then we have
to argue about which one is more consistent with
the data.
Bertrand reviewed Cournots work 45 years later.
Go through a tworm example again. Now rms
set prices. We need two assumptions.
1. Consumers always purchase from the cheapest
seller (recall defn of homogeneous goods).
2. If two sellers charge the same price, consumers
are split 50/50.
51
The second assumption is that q
i
takes the values:
0 if p
i
> a
0 if p
i
> p
j
ap
2b
if p
i
= p
j
= p < a
ap
i
b
if p
i
< min(a, p
j
)
Do you see a dierence between Cournot and Bertrand?
Bertrand has an important discontinuity in the game
(more specically, there is a discontinuity in the pay
o functions.)
Solving for the equilibrium required us to say some
thing about costs.
52
1. If costs are the same, a Bertrand equilibrium is
price = marginal cost, with quantity supplied on the
market equal to the perfectly competitive outcome
(equally split between the two rms).
2. If costs dier, (say rm 1 has cost = c
1
where
c
1
< c
2
), then the rm with the lower cost charges
p
1
= c
2
, rm 2 sells zero quantity, and rm 1
sells quantity given by q
b
1
=
(ac
2
+)
b
.
Intuition:
If costs are the same, undercutting reduces price to
marginal cost. If costs dier, undercutting reduces
price to just below the cost of the highcost rm.
53
An important aspect of bertrand is that equilibrium
may not exist if marginal costs are not constant.
This has lead to various models, the most sucess
ful of which is the Supply function equilibrium of
Klemperer and Meyer (1989) Econometrica.
54
Bertrand under capacity constraints (keep the as
sumption that costs are the same):
Note that if rms choose capacity then prices, you
can get outcomes more like Cournot. This depends
crucially on the rationing protocol via which con
sumer match to transactions. Tirole is quite good
on this. This model is called KrepsScheinkman
(1983).
55
Comparison of Equilibrium in Models Covered So
Far:
Monopoly (M), Cournot (C), Stackelberg (S), Per
fect competition and Bertrand (PC)
CS
M
< CS
C
< CS
S
< CS
PC
PS
M
> PS
C
> PS
S
> PS
PC
= 0
DWL
M
> DWL
C
> DWL
S
> DWL
PC
= 0
56
Dierentiated Products
We now nally drop the assumption that rms oer
homogeneous products.
Dierentiated product models are among the most
realistic and useful of all models in IO.
If you understand the basic elements of product
dierentiation theories, then you should have an
awareness of the economics underlying:
1. product placement
2. niche markets
3. product design to target certain types of con
sumers
4. brand proliferation, etc.
57
There are two aspects of product dierentiation:
1. Horizontal dierentiation: if all products were
the same price, consumers disagree on which prod
uct is most preferred
Eg. lms, cars, clothes, books, cereals, icecream
avors, Starbucks (by geographic location), ...
58
2. Vertical dierentiation: if all products were the
same price, all consumers agree on the preference
ranking of products, but dier in their willingness to
pay for the top ranked versus lesser ranked products
Eg. computers, airline tickets, dierent quantities,
car packages, ...
59
Dierentiated Products Betrand Equilibrium
Now we examine a pricing equilibrium with dier
entiated products. It should be no surprise that we
solve for a Nashinprices equilibrium.
There a several cute models of pricing in dieren
tiated products Bertrand where people set up the
crosselasticities so that there is enough structure
and symmetry to give analytical results. Basically,
these models are not that useful for applied work
however. Which is a shame because dierentiated
Bertand is hyperhelpful way to conceptualize many
industries.
Key things to realize: The discontinuity in homoge
nous products Bertrand goes away.
Things look more like Cournot (in the sense of pos
itive margins etc)
(p
i
c)d
i
(p
i
, p
j
)
First order condition as expected. The extent to
which best response slopes away from 45 degree
line depends on crosseasticities (see next slide for
diagram of what I mean). This in turn aects the
extent to which things start to look somewhat sim
ilar to cournot.
60
Best Response Function, 2 rms, Bertrand
p
1
p
2
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
p
b
2
R
2
(p
1
)
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>>
R
1
(p
2
)
a
2b
61
Industry structure refers to the number of rms in
an industry and the size distribution of those rms,
among other things.
Many policy issues revolve around the concentration
and number of rms in a particular industry and how
competitive we think the industry is.
i.e., Why do some markets have a small number of
rms while other markets have a large number of
rms?
Weve already seen that the number of rms in an
industry can have a big impact on the supply equi
librium in the market, but we have not discussed
how the number of rms might arise endogenously
in the industry.
62
Notation:
N is number of rms
Q is total industry output
q
i
is output of rm i, so Q =
N
i=1
q
i
s
i
is % share of rm i (ie., s
i
= 100
q
i
Q
)
Two Measures of Concentration:
1) Fourrm Concentration Ratio:
I
4
=
4
i=1
s
i
Examples (1992, 2digit SIC classications):
Tobacco: 91.8
Furniture: 29.3
Department stores: 53.8
Legal services: 1.4
Problems with this or any other linear measure:
No dierence between (80,2,2,2) and (20,20,20,26)
(ie, cant distinguish concentration between the top
4.)
63
2) HerndahlHirshman Index (HHI)
I
HH
=
N
i=1
(s
i
)
2
Solves the linearity problem. Notice:
Monopoly: I
HH
= 10, 000
10 identical rms: I
HH
= 1, 000
DOJ Merger Guidelines use I
HH
. If I
HH
> 1, 800,
then mergers come under scrutiny.
64
Problems with Using Concentration Measures Gen
erally:
Market Denition: How should we dene markets
and industries when products are dierentiated?
Does not get to central issue about how rms be
have. For example, consider the case with 2 equal
sized rms, but in one industry, they compete Cournot,
and in another, they compete Bertrand. The I
HH
=
2, 500, but we only worry about the Cournot indus
try.
This is why sticking HHIs into a crossindustry re
gression to take care of competition is not going
to get a warm welcome from an IO guy.
65
Entry
We will focus on entry in two dierent contexts.
1. Nonstrategic Eects on Entry (Entry Barriers)
These are features of rms costs or production
technologies that aect how many rms can e
ciently serve a market. For example, natural mo
nopolies, generally the m.e.s. compared to the mar
ket size. Other features could include absolute cost
advantages, regulatory restrictions (licensing, etc.),
capital requirements...
2. Strategic Eects on Entry (Entry Deterrence)
These are costs of entry borne by entrants (or po
tential entrants) that are a result of strategic behav
ior by incumbent rms. Some examples are capac
ity commitment, spatial preemption, limit pricing,
longterm contracts, and other actions that an in
cumbent rm might take in the presence of an entry
threat that he would not take otherwise. (Possibly
also tying or other arrangements that have been
discussed in the Microsoft case.)
66
Usually barriers to entry can be expressed in terms
of sunk costs.
1. Exogenous Sunk Costs
Costs that are embedded in the underlying condi
tions of the market and not determined by rms
actions.
2. Endogenous Sunk Costs
Conditions and strategic actions that rms within
the industry can change. These are entry costs for
which the rm has choice over how large they will
be.
67
Examples:
1. Exogenous Sunk Costs or Barriers to Entry:
Capital requirements
Scale economies
Absolute cost advantages
Asset specicity
Regulatory restrictions (licensing)
2. Endogenous Sunk Costs or Barriers to Entry:
R&D
Patents
Excess capacity
Control over strategic resources
Contracts
Advertising?
68
Why advertising?
There is debate about this. The argument for think
ing of advertising as a barrier to entry is:
It does not depend on the level of output
The eect of advertising is to increases consumers
willingness to pay for that product
There are no spillovers that benet other rms (usu
ally)
All consumers in the market are aected
The opposing side of the debate says:
If capital markets are ecient, a new entrant will
just borrow the money necessary to do his own (pos
sibly higher) level of advertising.
Both sides have a point: perhaps it depends on the
market. (i.e., pepsi and coke vs. kitchen appliances)
69
Usual form of these types of models
Timing of events:
1) Each rm decides whether to enter an indus
try/market
2) There are some exogenous sunk costs (ie., the
acquisition of a plant of minimum ecient size)
3) Each rm then chooses some endogenous sunk
costs (ie., advertising or R&D)
4) Finally, rms in the market engage in some form
of competition
Stages 3 and 4 can be pretty complicated, depend
ing on the model. Eg Reputation models (gang of
4 etc), some of Whinstons exclusion papers etc
70
Lecture 11: Vertical Control (Part 1)
Manufacturers rarely supply nal consumers directly.
Instead, most industries are vertically separated. We
often refer to rms verticallyseparated markets
as upstream and downstream rms.
In these settings, downstream rms are the cus
tomers of the upstream rms, and many of the is
sues that we have reviewed already still apply. For
example, the upstream rm may want to price dis
criminate across the downstream rms.
71
However, things can also get more complicated in
vertical relationships between rms. In particular,
downstream rms often do not simply consume the
good, but typically make further decisions regarding
the product.
Examples of activites of downstream rms:
1) determination of nal price
2) promotional eort
3) placement of product on store shelves
4) promotion and placement of competing products
5) technological inputs
72
Unlike the consumption activities of nal consumers,
the activities of the downstream rms may aect
the prots of the upstream rm. This is why up
stream rms care about the activities of the down
stream rms, and why we study vertical control/restraints
between rms in these settings. IO research has
tended to focus on the incentives for vertical control
when the market for the intermediate good is im
perfectly competitive because this is where antitrust
concerns are most apparent. This leaves fairly open
the question of why they do it in other contexts
(although read Williamson, The Economic Institu
tions of Capitalism)
A common benchmark for what rms can achieve
through vertical control is the vertically integrated
prot. This is the maximum industry or aggregate
(manufacturer plus retailer) prot. If rms use ver
tical restraints eciently, they should achieve the
vertically integrated prot.
73
Often vertical restraints used by rms in vertically
separated markets are grouped into 5 classes:
Exclusive Territories: a dealer/ distributor/ retailer is
assigned a (usually geographic) territory by the manu
facturer/ upstream rm and given monopoly rights to
sell in that area.
Exclusive Dealing: a dealer/ distributor/ retailer is not
allowed to carry the brands of a competing upstream
rm.
Fullline forcing: a dealer is committed to sell all vari
eties of a manufacturers products rather than a limited
selection. (the upstream rm ties all products when sell
ing to the downstream rm).
Resale Price Maintenance: a dealer commits to a retail
price or a range of retail prices for the product. This
can take the form of either minimum resale price main
tenance or maximum resale price maintenance.
Contractual arrangements: upstream and downstream
rms write contracts to provide greater exibility in the
transfer of the product. Prot sharing and revenue shar
ing are the most common, which well see soon. Also,
quantity forcing and quantity rationing and franchise fees.
74
The typical outline of vertical control is as follows:
1) Basic Framework
2) The need for control because of externalities be
tween downstream and upstream rms, or among
downstream rms themselves.
3) Intrabrand competition
4) Interbrand competition
Think of exclusive territories as a form of vertical
control to restrain intrabrand competition, and ex
clusive dealing as a way of restraining interbrand
competition.
75
Basic Framework: Double Marginalization
Simple model: homogeneous good with (inverse)
linear demand given by
p = a Q
(ie. Im keeping things super simple to show you
avor fast)
Suppose we have a monopolistic manufacturer and
we have given exclusive rights to a dealer to sell the
product of the manufacturer, so both the upstream
and downstream rms are monopolistic. The down
stream rm has marginal cost of selling the product
of d which is equal to the wholesale cost of pur
chasing the product from the manufacturer, and
the manufacturer has marginal cost of producing
the good equal to c.
76
Dealer maximizes his prot given by
d
= p(Q)QdQ = (a Q)QdQ
F.O.C.:
d
Q
= 0 = a 2Qd
Q
=
a d
2
p
=
a +d
2
d
=
(a d)
2
4
Now, how should the upstream rm set d?
Check: what are the strategies of the two players
in this game? What does each rm choose?
77
Manufacturer maximizes prot given by
m
= (d c)Q = (d c)
a d
2
F.O.C.:
m
d
= 0 = a 2d +c
d
=
a +c
2
m
=
(a c)
2
8
Note that we can now substitute into the dealers
solutions (for d) and get:
Q
=
a c
4
p
=
3a +c
4
d
=
(a c)
2
16
78
Results:
1. The manufacturer earns a higher prot than the
dealer
2. The manufacturer could earn a higher prot if
he does the selling himself. Total industry prot
in this case is lower than the vertically integrated
prot. Shown here:
V I
=
(a c)
2
4
> (
d
+
m
) =
3(a c)
2
16
The presence of two markups screws things up for
the rms. This basic fact is called:
doublemonopoly markup problem, successive mo
nopolies problem, or double marginalization.
79
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80
As mentioned earlier, there are many ways around
these problems, including RPM, contracts, etc. There
are also other problems that arise, and sometimes
we might even create a successive monopoly prob
lem in order to solve other incentive problems in the
vertical channel.
81
Resale Price Maintenance:
Requires retailers to maintain a minimum price, a
maximum price, or a xed price. Examples: Win
dows 98, Windows XP, books, many many retail
products.
Two goals:
1) Partially solve the double marginalization prob
lem
2) Can induce dealers or retailers to allocate re
sources for promoting the product, or exerting other
forms of eort in distributing the product. (Exam
ples: perfume, Coors beer)
82
Consider the example of promotions or advertising.
Assume (inverse) demand is given by
p =
AQ
The manufacturer sells to two dealers who compete
in price. Denote the wholesale price as d and adver
tising expenditures as A
1
and A
2
, where A = A
1
+A
2
.
First result:
For any given d, no dealer will engage in adverits
ing and demand would shrink to zero, with no sales.
83
Why?
Firms compete in price, and they sell a homoge
neous product. What does p equal in this case??
84
What can Resale Price Maintenance do?
Minimum Resale Price Maintenance: p = p
f
d
Now demand is
Q =
(A
1
+A
2
) p
f
Assume that quantity demanded is split evenly be
tween the two retailers. The only strategic variable
for the retailers is A. Thus, writing prots as a
function of A and nding the F.O.C. yields:
i
=
(A
i
+A
j
) p
f
2
(p
f
d) A
i
85
F.O.C.:
0 =
i
A
i
=
p
f
d
4
(A
i
+A
j
)
1
Note that we can only identify the sum of A
1
+A
2
and not A
1
and A
2
individually. But the idea is
that retailers will compete on promotion now. As
long as p
f
> d then at least one retailer has an
incentive to advertise, and the total dollars spent
on ads increases with the markup.
86
Note that one problem in the last example was that
competition between the retailers initially resulted
in too much competition downstream, so that rms
could not aord to advertise as a verticallyintegrated
rm would choose to do.
One way around that: Exclusive Territories or Ter
ritorial Dealerships
87
Legal Issues
There are a lot of ambiguities in legal treatment
of vertical contracts.
Until 1970s,
RPM and E. Territories were per se ille
gal under Sherman Act.
But many states passed fair trade laws that were
interpreted to cover some of these cases.
Thus, although price xing remains per se illegal,
its not always applied in vertical settings b/c it
conicts with freetrade notions between mfgs and
their distributors.
Nonprice issues have been generally accepted to
be ok by the courts
Exclusive territories
Refusal to deal
. . . Foreclosure?
88
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