Natural Monopoly

(1) AV= c(q)/q=m+(F/q). Gradient of AC= -F/q 2 which is smaller than 0, thus average cost is
always decreasing.

MC = m, since F>0, q>0, AC>MC. Thus, marginal cost is always below average cost.

(2) As no other firms were able to overtake the leading firm in the past one year, the new
firm is unlikely to survive the competition as this industry is likely to have a high barrier of
entry. If the competing firm starts a price war, the new firm will likely lose without
competitive technology.

(3) As the leading frim, Microsoft has most of the market share and its decision will influence
the market price. In addition, it has low variable cost leading to high profit margin unlike the
situation of perfect competition.

(4) In our theory, we assume that maximum demand is fixed as the market is stagnant.
However, in real life the market could be growing. As other firms launch new products, they
could induce more demand in the industry thus Microsoft cannot have absolute power of a
monopoly as proposed by the model.

In addition, the theory assumes that there is one single market clearing price, which is not
the case in real life. Due to product differentiation in the real market, different products
could be sold at different prices. Thus, Microsoft cannot be the sole decider of price.

Cost Function

(1) Let b be the point that MC and AC cross with each other, c be a point between (0,b), a be
a point between (c,b).

c (b)
When AC=MC, =c ' (b)
b

' c ( b) c ( b )−c( 0) c ( b) c ( b )
c ( b ) −c ' (c ) − −
c’’(a)= = b b = b b =0
b−c
b−c b−c
Gradient of MC at point a=0. Since MC is strictly decreasing then increasing, as a lies before
b, b must lie on the increasing part of the curve.

MC ( q )− AC (q )
(2) AC’(q)=
q
c (q)
When AC=MC, =c '(q) , AC’(q)=0.
q
'' ' 2 ' 3 '' ' 2 '
q · c ( q )−c ( q ) q · c ( q )−2 q · c (q) q · c ( q ) +2 q · c ( q )−2 q c (q)
AC’’(q) = 2
− 4
= 4
q q q
 3 '' 2 ' 2 '
q · c ( q ) +2 q · c ( q ) −2q c (q )
=
q4
3 ''
q · c ( q)
=
q4
Therefore, AC’(q)=0, AC’’(q) is positive, this point is the minimum point

(3) In a perfect competition market, all firm are price takers. When p<AC, firm is losing
money thus they will leave the market in long term, when p>AC, firm is making positive
profit thus new firms will enter and increase supply to move price down. Therefore, in the
long term, p=AC.

To maximise profit, solving max π= pq−c (q) , optimal quantity q takes place when p=MC.
Thus, as p=AC, p=MC, this point is the profit-maximising point.

Coding: Causality