MARKET

ANALYSIS:
COMPETITION
PROFIT-MAXIMIZING
PRICES AND QUANTITIES

 A firm’s profit, P, is equal to its revenue R less its cost C

 P=R–C
 Maximizing profit is another example of finding a best choice
by balancing benefits and costs
 Benefit of selling output is firm’s revenue, R(Q) = P(Q).Q
 Cost of selling that quantity is the firm’s cost of production, C(Q)
 Overall,
 P = R(Q) – C(Q) = P(Q).Q – C(Q)

March 21, 2024 2

PROFIT-MAXIMIZATION: AN EXAMPLE OF
GARDEN BENCHES
 Dieter faces a weekly inverse demand function:

P(Q) = 200 - Q

for his garden benches

 Weekly cost function is: C(Q)=Q2

 Suppose that he produces in batches of 10

 To maximize profit, he needs to find the production level with

the greatest difference between revenue and cost

March 21, 2024 3

Profits from Garden Benches Sales
Q P R C 
0 $200 $0 $0 $0
10 190 1,900 100 1,800
20 180 3,600 400 3,200
30 170 5,100 900 4,200
40 160 6,400 1,600 4,800
50 150 7,500 2,500 5,000
60 140 8,400 3,600 4,800
70 130 9,100 4,900 4,200
80 120 9,600 6,400 3,200
90 110 9,900 8,100 1,800
100 100 10,000 10,000 0

March 21, 2024 4

A PROFIT-MAXIMIZATION EXAMPLE

March 21, 2024 5

MARGINAL REVENUE (MR)
 Here the firm’s marginal benefit is its marginal revenue: the

extra revenue produced by the Q marginal units sold,

measured on a per unit basis

R R (Q)  R (Q  Q)
MR  
Q Q

March 21, 2024 6

MR AND PRICE (P)
 An increase in sales quantity (DQ) changes revenue in two
ways: DR = P1(Q1-Q0) + Q0(P1-P0) (Why?)
Let’s assume that at price P0, the producer sells Q0, and at
price P1, the producer sells Q1.
The revenue in the respective cases are:
R0 = P0*Q0, and R1 = P1*Q1.

R = R1-R0 = P1*Q1 - P0*Q0

= P1*Q1 - P1*Q0 + P1*Q0 - P0*Q0
= P1(Q1-Q0) + Q0(P1 - P0)
= output expansion effect + price reduction effect
 Price-taking firm faces a horizontal demand curve and is not subject to the price
reduction effect

March 21, 2024 7

MR AND P

March 21, 2024 8

 PROFIT-MAXIMIZING SALES
QUANTITY

 Two-step procedure for finding the profit-maximizing sales quantity

 Step 1: Quantity Rule

 Identify positive sales quantities at which MR=MC

 If more than one, find one with highest P

 Step 2: Shut-Down Rule

 Check whether the quantity from Step 1 yields higher profit than shutting down

March 21, 2024 9

 SUPPLY DECISIONS
 Price takers are firms that can sell as much as they want at some price P but nothing at
any higher price
 Face a perfectly horizontal demand curve
 Firms in perfectly competitive markets, e.g.
 MR = P for price takers
 Use P=MC in the quantity rule to find the profit-maximizing sales quantity for a price-
taking firm
 Shut-Down Rule:

 If P > ACmin, the best positive sales quantity maximizes profit.

 If P < ACmin, shutting down maximizes profit.

 If P = ACmin, then both shutting down and the best positive sales quantity yield zero
profit, which is the best the firm can do.
 Note: Economist argue to be in business if firm is able to recover just variable
cost. (Depends on the nature of Fixed Cost) March 21, 2024 10
 NATURE OF FIXED COST
 Avoidable
 Salary of security personnels
 Electricity to run all weather AC
 Electricity to run computers/ light
 Note that these fixed costs don’t vary with level of output. Otherwise, they
will become part of variable cost
 Sunk Cost
 Already bought shop
 Already contracted security personnels for entire year

March 21, 2024 11

PROFIT-MAXIMIZING QUANTITY OF A PRICE-TAKING FIRM

March 21, 2024 12

CONSIDER THE FOLLOWING PROBLEM:
 Daniel loves pizza. His firm makes frozen pizzas. The market price
of pizza is $10, and Daniel is a price taker. His daily cost of
making pizzas is C(Q) = 5Q+(Q2/80). How many pizzas should
Daniel sell each day? What if he also has an avoidable fixed of
$845 per day?

P = MC
 10 = 5 + (Q/40)
 Q = 200
Therefore,  = 10*200 – [5*200+(2002/80)] = $500
March 21, 2024 15
AC = C/Q = 5 + (Q/80)
= 5 + (200/80)
= $7.50

If Daniel also has an avoidable fixed cost of $845 per day, his
profit would be - $345 ($500-$845), and the shut-down rule
would tell us that he should stop selling frozen pizzas
altogether.

Alternatively, we could see that the price ($10) is now less than
the AC at 200 pizzas, which is $11.73 (i.e., 7.50 + 845/200).

March 21, 2024 16

 SUPPLY FUNCTION OF A PRICE-TAKING FIRM

 A firm’s supply function shows how much it wants to sell at each possible price:
Quantity supplied = S(Price)
 To find a firm’s supply function, apply the quantity and shut-down rules
 At each price above ACmin, the firm’s profit-maximizing quantity is positive and satisfies P = MC

 At each price below ACmin, the firm supplies nothing

 When price equals ACmin, the firm is indifferent between producing nothing and producing at its
efficient scale

March 21, 2024 17

SUPPLY CURVE OF A PRICE-TAKING
FIRM

March 21, 2024 22

DERIVING SUPPLY FUNCTION FROM COST FUNCTION
 Consider Daniel’s cost function: C(Q) = 5Q+(Q2/80). What is Daniel’s
supply function if he has no avoidable fixed cost? What if his avoidable
fixed cost is $845 per day?
 Step I: P = MC

P = 5 + (Q/40)
 Q = 40P – 200
 Step II: Find out min AC if he has no avoidable fixed cost.

AC = 5 + (Q/80). Therefore, min AC is 5 when Q = 0

 40P - 200 if P  5
S(P)  
0 if P  5
March 21, 2024 23
 When Daniel has an avoidable fixed cost of $845, we need to find out min AC,
which can be obtained by equating AC with MC, i.e.,

Q 845 Q
MC  5   5  AC
40 Q 80
 Solving this yields Q = 260

845 260
ACmin  5  $11 .50
260 80

 40P - 200 if P  11.50

S(P)  
0 if P  11.50

March 21, 2024 24

 CHANGE IN INPUT PRICE AND THE SUPPLY FUNCTION

 How does a change in an input price affect a firm’s supply function?

 Increase in price of an input that raises the per unit cost of production
 AC, MC curves shift up
 Supply curve shifts up

 Increase in an unavoidable fixed cost

 AC shifts upward
 MC unaffected
 Supply curve does not shift

March 21, 2024 25

CHANGE IN INPUT PRICE AND THE SUPPLY FUNCTION

March 21, 2024 26

CHANGE IN AVOIDABLE FIXED COST

March 21, 2024 27

SHORT-RUN AND LONG-RUN COST FUNCTIONS
 Suppose that Douglas runs a home remodeling business. The number of
square feet he can remodel in a week is described by Q = 10L 0.5K0.5. Let w =
$1,000 per week and r = $250 per week. What are his short-run and long-
run cost functions?
 Assume that in the short run K is fixed at 20, then

Q  10.L0.5 (20) 0.5

 This means that L  Q 2 / 2,000

 So the short-run cost function is:

Q2
C (Q)  (250)( 20)  (1,000)
100
SR
2,000
Q2
 5,000 
2
 The long-run cost function is: CLR(Q)= 100Q (why?)
March 21, 2024 32
 MPL w
Long - run cost minimizing equlibrium condition : 
MPK r
Q
MPL   0.5 10 L0.5 K 0.5  5L0.5 K 0.5
L
Q
MPK   0.5 10 L0.5 K 0.5  5 L0.5 K 0.5
K

MPL 5 L0.5 K 0.5 1000

 0.5 0.5  C (Q)  wL  rK
MPK 5L K 250
 1000 L  250(4 L)
K
 4  K  4L  2000 L
L
Q
Q  2000 
Q  10 L0.5 (4 L) 0.5  L  20
20  100Q
March 21, 2024 33
MARKET POWER
 In many situations, competition is not intense

 A firm has market power when it can profitably charge a price that is above its marginal
cost
 Most firms have some market power, though it may vary

 Depends on whether their competitors’ products are close substitutes

 Two market structures in which firms have market power:

 A monopoly market has a single seller

BCCI provides international-level cricket games involving the Indian team. It

generates revenues from the public, sales of TV rights, and commercial sponsorships.
 An oligopoly market has a few, but not many, producers

 Determining what is and is not a monopoly market can be trickier than simple definitions
might suggest
March 21, 2024 34
HOW DO FIRMS BECOME MONOPOLISTS?
 Firms get to be monopolists in various ways:
 Government grants a monopoly position to a firm (cable TV companies
in local communities, drug patents)
 Economies of scale (concrete supply in a small town)
 Being first to produce a new product.
E.g., Apple introduced its iPod in 2001, grabbing the lion’s share
(around 90%) of the portable music hard-drive business by being the
first to design and produce a portable hard-drive music player.
 Owning all of an essential input
E.g., South African diamond producer De Beers controlled more than
80% of the world’s diamond production, which gave it a near
monopoly position in the world diamond market)
 Many of these ways of initially capturing market power tend to erode
over time March 21, 2024 35
MARGINAL REVENUE FOR A
MONOPOLIST
 An increase in sales quantity (DQ) changes revenue in two ways
 Firm sells DQ additional units of output, each at a price of P(Q), the output
expansion effect
 Firm also has to lower price as dictated by the demand curve; reduces
revenue earned from the original (Q-DQ) units of output, the price reduction
effect
 The overall effect on marginal revenue is:

 P 
MR  PQ    Q
 Q 

So the price reduction effect makes the monopolist’s marginal revenue

less than price
MONOPOLY PROFIT MAXIMIZATION
 When a monopolist maximizes its profit by selling a positive amount, its
marginal revenue must equal its marginal cost at that quantity
 If marginal revenue exceeded marginal cost the firm would be better off
selling more
 If marginal revenue were less than marginal cost the firm would be better off
selling less
 Two-step procedure for finding the profit-maximizing sales quantity

 Step 1: Quantity Rule

 Identify positive sales quantities at which MR=MC

 If more than one, find one with highest profit

 Step 2: Shut-Down Rule

 Check whether the quantity from Step 1 yields higher profit than shutting
down
March 21, 2024 37
MONOPOLY PROFIT MAXIMIZATION

March 21, 2024 38

 NUMERICAL EXAMPLE:
Consider a monopolist who faces a demand curve: P = 100 – 4Q, and his total cost function is: C = 50 +
20Q. What are the profit maximizing price and quantity of the monopolist?

R  P  Q  100Q  4Q 2
π  R - C  (100Q  4Q 2 )  (50  20Q)
 80Q - 4Q 2  50
MR  MC

100  8Q  20  Q  10 P  60
π  60 * 10  (50  20 * 10)
 600 - 50 - 200
 $350
March 21, 2024 39
 If a monopolist behaves like a competitive firm, then the equilibrium condition for profit
maximization:

P = MC

100  4Q  20
 Q  20 and P  20

π  20 * 20  (50  20 * 20)
 400 - 50 - 400
 - $50

March 21, 2024 40

MARKUP

 A Rule of Thumb for Pricing

We want to translate the condition that marginal revenue should

equal marginal cost into a rule of thumb that can be more easily
applied in practice.
To do this, we first write the expression for marginal revenue:
MARKUP

 A Rule of Thumb for Pricing

Note that the extra revenue from an incremental unit of quantity,

Δ(PQ)/ΔQ, has two components:
1. Producing one extra unit and selling it at price P brings in
revenue (1)(P) = P.
2. But because the firm faces a downward-sloping demand
curve, producing and selling this extra unit also results in a
small drop in price ΔP/ΔQ, which reduces the revenue
from all units sold (i.e., a change in revenue Q[ΔP/ΔQ]).
Thus,
MARKUP
 A Rule of Thumb for Pricing

(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand,

1/Ed, measured at the profit-maximizing output, and

Now, because the firm’s objective is to maximize profit, we

can set marginal revenue equal to marginal cost:

which can be rearranged to give us

(10.1)

Equivalently, we can rearrange this equation to express

price directly as a markup over marginal cost:

(10.2)
MARKUP
 A monopolist facing a downward sloping demand curve will set its price
above marginal cost
 Firm in a perfectly competitive market sets price equal to marginal cost,
meaning that the firm has no market power

 Extent to which price exceeds marginal cost is a measure of monopolist’s

market power
 A firm’s markup, price-cost margin, or Lerner index equals the difference
between its price and its marginal cost, as a percentage of its price

P− MC 1
=
P |ε 𝑑|
March 21, 2024 46
MARKUP
 A monopolist’s markup at its profit-maximizing price always equals the reciprocal of
the elasticity of demand
 The less elastic the demand curve, the greater the firm’s markup over its marginal
cost
 When demand is less elastic, raising the price is more attractive because fewer sales
are lost
 This also implies that demand must be elastic at the profit-maximizing price

March 21, 2024 47

WELFARE EFFECTS OF MONOPOLY PRICING
 By charging a price above marginal cost, the monopolist makes consumers
worse off than under perfect competition
 Consumers who buy the product pay more for it
 Some who would have bought it under perfect competition will not buy
it at the higher price
 Welfare effects of monopoly pricing:
 Firm gains
 Consumers lose
 Deadweight loss incurred
 Deadweight loss from monopoly pricing is the amount by which aggregate
surplus falls short of its maximum possible level, which is attained in a
competitive market

March 21, 2024 49

WELFARE EFFECTS OF MONOPOLY PRICING

MR

March 21, 2024 50

WELFARE EFFECTS OF MONOPOLY PRICING

MR

March 21, 2024 51

WELFARE EFFECTS OF MONOPOLY PRICING

MR

March 21, 2024 52

REGULATION OF
MONOPOLIES
 Deadweight loss from monopoly pricing provides a justification for
government intervention
 Government actions that keep prices closer to marginal cost can protect
consumers and increase economic efficiency
 Intervention can take many forms
 Antitrust legislation (that seeks to keep prices low by ensuring that market is as
competitive as possible)
 Direct regulation of prices (electricity, natural gas, etc.)

March 21, 2024 53

WHY ARE SOME MONOPOLIES REGULATED?
 Regulation arises out of political pressure and economic concern about
market dominance
 When governments create monopolies they may then regulate them to deal
with the negative consequences. The reasons are:
 as a reward for successful innovation. Govt. patents do exactly that.
 to ensure that goods is produced at least cost.
 A market is a natural monopoly when a good is produced most
economically through a single firm
 Average cost falls as quantity increases
 Second firm may enter but this would cause costs to rise
 Government can designate one firm to be the provider
 Institute price regulation to protect consumers

March 21, 2024 54

MONOPOLISTIC COMPETITION AND OLIGOPOLY

● monopolistic competition Market in which firms can

enter freely, each producing its own brand or version of a
differentiated product.

● oligopoly Market in which only a few firms compete

with one another, and entry by new firms is impeded.

● cartel Market in which some or all firms explicitly

collude, coordinating prices and output levels to
maximize joint profits.
 MONOPOLISTIC COMPETITION
 The Makings of Monopolistic Competition

A monopolistically competitive market has two key characteristics:

1. Firms compete by selling differentiated products that are highly

substitutable for one another but not perfect substitutes. In other
words, the cross-price elasticities of demand are large but not
infinite.

2. There is free entry and exit: it is relatively easy for new firms to
enter the market with their own brands and for existing firms to
leave if their products become unprofitable.
 MONOPOLISTIC COMPETITION
 Equilibrium in the Short Run and the Long Run

A Monopolistically
Competitive Firm in the
Short and Long Run
Because the firm is the
only producer of its
brand, it faces a
downward-sloping
demand curve.
Price exceeds marginal
cost and the firm has
monopoly power.
In the short run,
described in part (a),
price also exceeds
average cost, and the
firm earns profits
shown by the yellow-
shaded rectangle.
 MONOPOLISTIC COMPETITION
 Equilibrium in the Short Run and the Long Run

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, and its demand
curve shifts downward.
In long-run equilibrium,
described in part (b),
price equals average
cost, so the firm earns
zero profit even though
it has monopoly power.
 MONOPOLISTIC COMPETITION
 Monopolistic Competition and Economic Efficiency

Comparison of
Monopolistically
Competitive Equilibrium
and Perfectly Competitive
Equilibrium
Under perfect
competition, price
equals marginal cost.
The demand curve
facing the firm is
horizontal, so the zero-
profit point occurs at
the point of minimum
average cost.
 TOPICS TO BE COVERED

1. Conditions for Oligopoly?

2. Role of Strategic Interdependence

3. Profit Maximization in Four Oligopoly Settings

 Sweezy (Kinked-Demand) Model
 Cournot Model
 Stackelberg Model
 Bertrand Model

March 21, 2024 61

 CONDITIONS FOR
OLIGOPOLY

 Relatively few firms, usually less than 10.

 Duopoly - two firms

 Triopoly - three firms

 The products firms offer can be either differentiated or homogeneous.

March 21, 2024 62

ROLE OF STRATEGIC INTERACTION
 What you do affects the profits of your rivals

 What your rival does affects your profits

March 21, 2024 63

 AN EXAMPLE

 You and another firm sell differentiated products

 How does the quantity demanded for your product change when you change your price?

March 21, 2024 64

P D2 (Rival matches your price change)

PH

P0

PL
D1
(Rival holds its
price constant)

Q0 Q

March 21, 2024 65

P D2 (Rival matches your price change)

Demand if Rivals Match Price

Reductions but not Price Increases

P0

D1
(Rival holds its
price constant)
D
Q0 Q

March 21, 2024 66

KEY INSIGHT

 The effect of a price reduction on the quantity demanded of your product depends upon whether
your rivals respond by cutting their prices too!
 The effect of a price increase on the quantity demanded of your product depends upon whether
your rivals respond by raising their prices too!
 Strategic interdependence: You aren’t in complete control of your own destiny!

March 21, 2024 67

 SWEEZY (KINKED-DEMAND)
MODEL

 Few firms in the market

 Each producing differentiated products.

 Barriers to entry

 Each firm believes rivals will match (or follow) price reductions, but won’t match (or follow) price increases.

 Key feature of Sweezy Model

 Price-Rigidity

March 21, 2024 68

SWEEZY MARGINAL
REVENUE
P
D2 (Rival matches your price change)

P0

D1
MR2 (Rival holds its
price constant)
MR1
D

Q0 MR Q

March 21, 2024 69

SWEEZY PROFIT-
MAXIMIZATION
P
MCH
MC
MCL
P0

Q0 MR Q

March 21, 2024 70

LIMITATION OF SWEEZY OLIGOPOLY

 The model does not explain the position of the kink on the demand curve. It starts with an arbitrarily
given output-price combination and then argues that it is the profit maximization combination.

March 21, 2024 71

COURNOT MODEL

 A few firms produce goods that are either perfect substitutes (homogeneous) or imperfect
substitutes (differentiated)
 Firms set output, as opposed to price

 Each firm believes their rivals will hold output constant if it changes its own output (The
output of rivals is viewed as given or “fixed”)
 Barriers to entry exist

March 21, 2024 72

 REACTION FUNCTIONS

 Suppose two firms produce homogeneous products.

 Firm 1’s reaction (or best-response) function is a schedule summarizing the amount of Q 1 firm 1 should produce
in order to maximize its profits for each quantity of Q 2 produced by firm 2.

 Since the products are substitutes, an increase in firm 2’s output leads to a decrease in the profit-maximizing
amount of firm 1’s product.

March 21, 2024 73

GRAPHICALLY
Q2

Q2 *

r1 (Firm 1’s Reaction Function)

Q1 * Q1 M Q1

March 21, 2024 74

HOW TO FIND RFS FOR COURNOT DUOPOLY
 The inverse market demand function in a homogeneous-product
Cournot duopoly is:
P  a  b(Q1  Q 2 )
where a and b are some positive constants.

and the respective cost functions of the two firms are:

C1 (Q1 )  c1Q1
C 2 (Q 2 )  c 2 Q 2
 The reaction functions of these two firms are (MR i = MCi):

a - c1 1 a - c2 1
Q1  r1 (Q 2 )   Q2 Q 2  r2 (Q1 )   Q1
2b 2 2b 2
March 21, 2024 75
COURNOT EQUILIBRIUM

 Situation where each firm produces the output that maximizes its profits, given the the output
of rival firms
 No firm can gain by unilaterally changing its own output

March 21, 2024 76

COURNOT EQUILIBRIUM
Q2

r1

Cournot Equilibrium
Q2 M

Q2 *

r2
Q1
Q1 M
Q1 *

March 21, 2024 77

SOLUTION OF COURNOT EQUILIBRIUM
a - c1 1
Q1   Q2 Let’s assume: a = 1,000, b = 1,
2b 2
a - c1 1  a - c 2 1  and c1 = c2 = 4
    Q1  1,000  4 - 2 * 4
2b 2  2b 2  Q1* 
3 *1
a - c1 a - c 2 1 996
   Q1   332
2b 4b 4 3
a  c 2 - 2c1 1 Q*2  332
  Q1
4b 4
a  c 2 - 2c1 The reactions functions are
Q1*  1,000 - 4 1 1
3b Q1  r1 (Q 2 )   Q 2  498  Q 2
2 *1 2 2
a  c1 - 2c 2 1,000 - 4 1 1
Q2*  Q 2  r2 (Q1 )   Q1  498  Q1
3b 2 *1 2 2
March 21, 2024 78
FINDING PROFIT AT
COURNOT EQUILIBRIUM
 P = 1,000 – (332+332) = 1,000 – 664 = $336

 C1 = C2 = 4*332 = 1328

 Π1 = Π2 = 336*332 -4*332 = 332(336-4)=332 2=$110,224

Under Collusion:
 MR = MC
 P = 1,000 – Q
 MR = 1,000 -2Q
 1,000 -2Q = 4  Q = 498 and P = $502 [=1,000 – 498 ]
 Π1 = Π2 = (502*249)- (4*249) = $124,002

March 21, 2024 79

PRICE LEADERSHIP
 A firm can effectively determine the price of goods or services for the entire market: Price Leader

 Rivals of the price leader with little choice but to follow its lead and match the prices if they are to hold onto
their market share.
 Economic Conditions for price leadership:
 Small no. of companies

 Entry to industry restricted

 Products are homogeneous

 Demand is less elastic

 Similar long run average costs for the firms

BAROMETRIC PRICE LEADERSHIP

 A company good at predicting market trends initiates a price change

 Can be a small company

 Price leadership can be short lived if market power of the firm is low
COLLUSIVE PRICE LEADERSHIP

 Some firms with high collective market power collude with each other to set prices

 Smaller firms follow these price changes

DOMINANT PRICE LEADERSHIP

 A firm with huge market share is the price leader

 Partial monopoly

 Predatory pricing
GAME THEORY

 Game theory is the study of the ways in which interacting choices of economic
agents produce outcomes with respect to the preferences (or utilities) of those agents, where the
outcomes in question might have been intended by none of the agents
DOMINANT STRATEGY
 Consider two people, Chris and Kim. They both enjoy each other's company, but neither can
communicate with the other before deciding whether to stay at home (where they would not see each
other) or go to the beach this afternoon (where they could see each other). Each prefers going to the
beach to being at home, and prefers being with the other person rather than being apart.
NASH EQUILIBRIUM

 Now consider Betty and John. John likes Betty, but Betty doesn't like John that much. Each knows
this, and neither wants to call the other before deciding what to do this afternoon: stay at their
respective homes or go to the neighborhood swimming pool. Here is the normal form:
Thank you
for your patience

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