Transcript Dominant Firm with a Competitive Fringe

Dominant Firm with a
Competitive Fringe
/supplement to Topic 3 Monopoly/
Dominant Firm with Competitive Fringe
• This supplement answers the last question of Topic 3,
namely:
What happens to a monopoly if
smaller price-taking firms enter
its market?
• It describes an alternative outcome of the situation
when a firm has a knowledge advantage.
• Particularly, though present the advantage of the firm
does not allow it to decrease its marginal cost so
much to prevent the entry of the high-cost firms.
Based on Carlton and Perloff (2000)
Dominant Firm with Competitive Fringe
• This supplement answers the last question of Topic 3,
namely:
What happens to a monopoly if
smaller price-taking firms enter
its market?
• It describes an alternative outcome of the situation
when a firm has a knowledge advantage.
• Particularly, though present the advantage of the
firm is not big enough to allow it to decrease its
marginal cost so much to prevent the entry of the
high-cost firms.
Based on Carlton and Perloff (2000)
Dominant Firm with Competitive Fringe
• If one firm is a price setter and faces smaller,
price-taking firms, it is called a dominant firm.
– The dominant firm typically has a large
market share.
• The smaller, price-taking firms are called
fringe firms.
– Fringe firms each have a very small share of the
market, even though together they may have a
substantial share of the market.
Based on Carlton and Perloff (2000)
Examples of Dominant Firms
• Industries in which one firm has a large share
of the industry are common (Pascale, 1984):
– Photographic business: Kodak, 60%
– Mainframe computer business: IBM, 68%
– Commercial Jet Aircraft Business: Boeing, 60%;
– Energy Sector: General Electric, 61%
– Computer chips ceramics: Kyocera, 70-75%
– Printer sales: Hewlett-Packard, 59%
Based on Carlton and Perloff (2000)
Why Some Firms are Dominant?
• Three possible reasons are sufficient to
create a dominant firm-competitive fringe
market structure:
– A dominant firm may have lower cost than fringe
firms.
– A dominant firm may have a superior product in a
market with product differentiation.
– A group of firms may collectively act as a
dominant firm.
Based on Carlton and Perloff (2000)
Causes of lower costs
• There are at least four major causes of lower
costs:
– A firm might be more efficient than its rivals due to
better management and/or patented technology.
– An early entrant might have learned by
experience how to produce more efficiently.
– An early entrant may have had time to grow large
optimally (in the presence of adjustment costs) so
as to benefit from economies of scale.
– The government may favor the original firm.
Based on Carlton and Perloff (2000)
Causes of superior quality
• There are at least four major causes of lower
costs:
– A firm might have better quality due to patented
technology.
– The quality superiority may be due to a reputation
achieved through advertising.
– Or through goodwill generated by its having been
in the market longer.
Based on Carlton and Perloff (2000)
Causes of collusion of firms
• Groups of firms in a market have an incentive
to coordinate their activities to increase their
profits.
– A firm might have better quality due to patented
technology.
– The quality superiority may be due to a reputation
achieved through advertising.
– Or through goodwill generated by the firm having
been in the market longer.
Based on Carlton and Perloff (2000)
Dominant Firm’s Behavior in the Long Run
• Whether a dominant firm can exercise market
power in the long run depends crucially on:
– the number of firms that can enter the market
– how their production costs compare to those of
the dominant firm and
– how fast they can enter.
• The dominant firm-competitive fringe model
could be examined under two alternative
extreme assumptions – with and without free
entry.
Based on Carlton and Perloff (2000)
The Fixed Entry Model
• Two key results emerge from an analysis of
this model:
(1) It is more profitable to be dominant than mere
fringe firm.
(2) The existence of the fringe limits the dominant
firm’s market power i.e. it is better to be a
monopoly than dominant firm with competitive
fringe.
Based on Carlton and Perloff (2000)
The Fixed Entry Model - Assumptions
• Five crucial assumptions underlie the no-entry model:
1. There is one firm that is much larger than any other firm
because of its lower production costs.
2. All firms, except the dominant firm, are price-takers,
determining their output levels by setting marginal cost
equal the market price p.
3. The number of firms in the competitive fringe is fixed – no
new entry could occur.
4. The dominant firm knows the market’s demand curve,
D(p).
5. The dominant firm can predict how much output the
competitive fringe can produce at any given price i.e. the
competitive fringe supply curve S(p)
Based on Carlton and Perloff (2000)
The Fixed Entry Model
• The dominant firm’s problem is much more
complex than that of a monopoly:
(1) The fringe supply curve, S(p), is increasing in p.
(2) As dominant firm lowers its output and price
rises, the competitive fringe output increases.
(3) The dominant firm must consider how the
competitive fringe responds to its actions.
Based on Carlton and Perloff (2000)
The Fixed Entry Model
$
$
MC f
AC f
D(p)
S(p)
p
f
p
p
p
MC d
AC d
Dd(p)

d
p*
D(p)
MCd
MR d
qf
Qf
Fringe firm and total supply, q, Q
Qd
Based on Carlton and Perloff (2000)
Q
Qf
Qd
Market quantity, Q
The Fixed Entry Model
• The market demand curve D(p) is above the residual
demand curve Dd(p) at prices above p and equal to it
at prices below p .
– The fringe firms meet some or all of the demand if price is
above p.
– They drop out of the market and leave all of the demand
to the dominant firm if price falls below p .
• The dominant firm’s marginal revenue curve (MRd) is
derived from its residual demand curve and has two
distinct sections.
– If the competitive fringe produces positive levels of output,
Dd(p) lies below D(p), and MRd is flatter.
– Where the two demand curves coincide MRd is steeper.
Based on Carlton and Perloff (2000)
The Fixed Entry Model - Solution
• The optimal output of the dominant firm is
determined by the following 2-step procedure:
(1) Determine the residual demand curve of the
dominant firm.
–
It is given by the horizontal difference between the
market demand curve and the competitive fringe’s
supply curve: Dd ( p)  D( p)  S ( p)
(2) Act like a monopoly with respect to the residual
demand.
–
The dominant firm maximizes its profits by picking a
price (or output level) so that MR=MC.
Based on Carlton and Perloff (2000)
The Fixed Entry Model - Equilibrium
• Because the marginal revenue curve has two
sections, there are two possible types of
equilibria:
(1) The dominant firm charges a high price, so that
it makes economic profits and the fringe firms
also make profits or break even.
(2) The dominant firm sets a price so low that the
fringe firms shut down to avoid making losses
and the dominant firm becomes a monopoly.
Based on Carlton and Perloff (2000)
The Dominant Firm-Competitive Fringe
Equilibrium
• This type of equilibrium occurs if the dominant firm’s
costs are not substantially less than those of the fringe
firms.
– MCd crosses the upper downward sloping segment of
MRd.
– Respectively, the dominant firm chooses to produce Qd
level of output at price p.
– Since no new entrants are able to enter, fringe firms each
makes a positive profit d.
– The dominant firm’s average cost is lower than that of the
fringe firms, so it makes more total profits as well.
– Still the dominant firm makes lower profits than if it were a
monopoly. So, the fringe hurts the dominant firm and
benefit consumers.
Based on Carlton and Perloff (2000)
The Dominant Firm as a Monopoly
Equilibrium
• This type of equilibrium occurs if the dominant firm’s
costs are extremely low compared to the fringe firms.
– MC*d crosses the lower downward sloping segment of
MRd.
– Respectively, the dominant firm chooses to produce Q*d
level of output at price p*.
– Because p* is below the fringe firm’s shutdown point p ,
the fringe firms drop out the market.
– As a result, market output, Q*, equals the dominant firm’s
output Q*d.
– Still the dominant firm makes lower profits than if it were a
monopoly. So, the fringe hurts the dominant firm and
benefit consumers.Based on Carlton and Perloff (2000)
The Free Entry Model
• This model retains all the assumptions made for
the preceding model,
except that now an unlimited number of
competitive fringe firms may enter the market.
– Fringe firms cannot make profits in the long run: they
either break even or are driven out of business.
– As long as the dominant firm has some cost or other
advantage, it can gain and hold indefinitely a large
share of the market.
– This is an industry with easy entry, and yet one firm
has the lion’s share of the market, presumably
because it has superior products, a superior sales
force, or has generated goodwill with buyers.
Based on Carlton and Perloff (2000)
The Free Entry Model
$
$
D(p)
MC d
p
S(p)
Dd(p)
MR d
p
p*
Dd(p)
MCd
D(p)
MR d
Quantity, Q
Q Qd
Qd
Based on Carlton and Perloff (2000)
Qf
Quantity, Q
The Free Entry Model
• As the number of firms grows large, the
fringe’s supply curve becomes horizontal.
• The residual demand curve facing the
dominant firm is also horizontal at p , so it
coincides with the MR curve.
• Below p, both curves slope downward. Again
the MR curve jumps at the quantity where the
kink in the residual demand curve occurs.
Based on Carlton and Perloff (2000)
The Free Entry Model - Equilibrium
• As in the model with fixed entry because the marginal
revenue curve has two sections, there are two
possible types of equilibria:
(1) If the dominant firm’s marginal cost is relatively high, so
that it intersects the horizontal portion of the MRd curve.
–
The equilibrium price is . pA dominant firm can make
positive profits, competitive firms just break even.
(2) If the dominant firm’s marginal cost is lower, so that it hits
the downward-sloping portion of the MRd curve.
–
The equilibrium is the same as in the second fixed-entry
equilibrium. The dominant firm is a monopoly, and the
potential supply of fringe firms is irrelevant.
Based on Carlton and Perloff (2000)
Summary
• A low-cost dominant firm has market power even
though it competes with other firms.
• A profit-maximizing dominant firm does not attempt to
drive out fringe firms at all costs.
• Its behavior depends on how great its cost advantage
over fringe firms is and on how easily other firms can
enter.
• If a large number of price-taking firms can enter the
market whenever a profit opportunity occurs, the
dominant firm is unable to charge prices substantially
above the competitive price.
• Even if fringe firms do not enter a market, the threat of
their entry may cause a monopoly to set a lower price
than it would in the Based
absence
of the fringe.
on Carlton and Perloff (2000)