I.

Review of Demand, Costs, Revenues, Firm theory, Market Structures, Perfect

Competition, Monopoly

Market Structures:

The two extreme models of a market are perfect competition (large number of buyers and sellers
+ homogeneous goods + perfect information) and monopoly (single seller). In between there
could be Oligopoly (small number of sellers) of which Duopoly is a special case of only two sellers,
or Monopolistic Competition (large number of sellers + differentiated products).

Single seller One product Monopoly

Few sellers One product / Differentiated Oligopoly (Duopoly)
products
Many sellers Differentiated products Monopolistic competition
Many sellers One product Perfect competition

If a seller sells a particular product alone, it faces the entire market demand curve for that
product. If rivals also sell the same identical product, then a firm’s demand curve is the residual
demand curve ; i.e. the market demand minus rivals’ captive sales.

Strategic play between firms applies really to the Oligopoly model where firms are few enough
to realize their strategic importance in the market.

Demand and price elasticity:

𝑄𝑑 = 𝑓 −1 (𝑝) which can also be written in the inverse form as the inverse demand curve
(function), 𝑝 = 𝑓(𝑄𝑑 ). Examples & Illustrations.
𝑝
𝑝 = 100 − 2𝑄𝑑 ; or 𝑄𝑑 = 50 − 2

What would the Law of Demand say about the marginal (slope) as below?
′ 𝑑𝑄𝑑 𝑑𝑝
𝑓 −1 (𝑝) = or 𝑓 ′ (𝑄𝑑 ) = 𝑑𝑄
𝑑𝑝 𝑑

Both are negative. As price charged increases, 𝑄𝑑 falls; and in order to be able to sell a higher
𝑄𝑑 , the price must decrease.
𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 ∆ 𝑖𝑛 𝑄
Price elasticity of demand = | 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑎𝑙 ∆ 𝑖𝑛 𝑝𝑑 | ∈ [0, ∞] .

∆𝑄𝑑
𝑄𝑑 𝑝 𝑑𝑄𝑑
Calculated as 𝜀 = − lim ∆𝑝 = 𝑄 (− ),
∆𝑝→0 𝑑 𝑑𝑝
𝑝
such that the result is always a positive measure (the absolute value of price elasticity).

What is the unit of measurement of price elasticity of demand?

Independent of units of measurement, as it is the ratio of two ratios.

Average and Marginal revenues:

What measure of revenue does the demand curve represent?

Average revenue or price. An additional unit sold will bring revenue per unit equal to the new
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑅
price. 𝐴𝑅 = =
𝑄 𝑠𝑜𝑙𝑑 𝑄

What is marginal revenue?

∆𝑇𝑅 𝑑𝑇𝑅
The change in total revenue for a marginal increase in quantity sold. 𝑀𝑅 = =
∆𝑄 𝑑𝑄

𝑀𝑅 ≤ 𝐴𝑅 = 𝑝
𝑑𝑇𝑅 𝑑𝑝(𝑄)𝑄 𝑑𝑝
𝑀𝑅 = = = 𝑝 + 𝑄 𝑑𝑄 ≤ 𝑝
𝑑𝑄 𝑑𝑄

In trying to sell additional quantity, the price must be decreased. Therefore, although more is
sold in quantity which adds to total revenue, each unit is now sold at a lower price than before.
Therefore the addition to TR is less than the price or AR of each unit.

We can also write the above as

𝑑𝑝 𝑄 𝑑𝑝 1
𝑀𝑅 = 𝑝 + 𝑄 = 𝑝 [1 + ] = 𝑝 [1 − ]
𝑑𝑄 𝑝 𝑑𝑄 𝜀

For linear demand curves, the marginal revenue curve has twice the (negative) slope of the
demand (AR or price) curve.

𝑑𝑀𝑅 𝑑𝑝 𝑑𝑝 𝑑2 𝑝
= 𝑑𝑄 + 𝑑𝑄 + 𝑄 𝑑𝑄2
𝑑𝑄

𝑑2 𝑝 𝑑𝑀𝑅 𝑑𝑝
A linear demand curve implies 𝑑𝑄2 = 0. Therefore, = 2 𝑑𝑄 .
𝑑𝑄

Q. Some typical demand or inverse demand curves. Compute the price elasticity of demand, and
marginal revenue functions for each.

1. 𝑝 = 𝑎 − 𝑄
2. 𝑝 = 𝑎 − 𝑏𝑄

3. 𝑄 = 𝑝−𝑎

Ans.
𝑑𝑝 (𝑎−𝑏𝑄) 1 𝑎−𝑏𝑄
1&2. 𝑝 = 𝑎 − 𝑏𝑄 => 𝑑𝑄 = −𝑏 . Therefore, 𝜖 = = ;
𝑄 𝑏 𝑏𝑄

𝑏𝑄
and 𝑀𝑅 = 𝑝 [1 − ] = 𝑝 − 𝑏𝑄 = 𝑎 − 2𝑏𝑄.
𝑎−𝑏𝑄

when 𝑏 = 1, as in 1), 𝑀𝑅 = 𝑝 − 𝑄 = 𝑎 − 2𝑄.

𝑑𝑄 𝑝
3. 𝑄 = 𝑝−𝑎 => 𝑑𝑝 = −𝑎𝑝−𝑎−1 . Therefore, 𝜀 = 𝑝−𝑎 𝑎𝑝−𝑎−1 = 𝑎;

𝑄 𝑝 −𝑎 1
and 𝑀𝑅 = 𝑝 − 𝑎𝑝−𝑎−1 = 𝑝 − 𝑎𝑝−𝑎−1 = 𝑝 [1 − 𝑎] .

Perfect competition:

i. Large numbers of buyers and sellers

ii. Homogeneous product: perfect substitutes
iii. Free market entry and exit
iv. Complete and perfect information

The above conditions create a market where no seller or buyer has influence over the price at
which trade occurs, or the quantity of the good traded. An absence of market power such that
each buyer and seller acts like a price taker in the market and simply decides how much to buy
or sell individually (negligible quantities compared to the entire market).

 No market power.
 Agents are price takers; seek to maximize own profit.
 Each unit of the good is bought and sold at the market price, because no seller has
incentive to sell cheaper than that (given that each sells as much as he wants at market
price), and no buyer has the incentive to pay any price higher.

Social welfare or total surplus (CS+PS) is maximum in the perfect competition market equilibrium.
Explain.

Cost curves and optimal decisions (SR and LR):

𝐶 (𝑞 ) = 𝐹 + 𝑐(𝑞).
That is, total cost is the sum of fixed cost and variable cost. Draw.

𝑇𝐶 𝑉𝐶 𝑑𝑇𝐶
𝐴𝐶 = ; 𝐴𝑉𝐶 = ; 𝑀𝐶 =
𝑞 𝑞 𝑑𝑞

Q. Compute the AC, AVC, MC functions for the following TC curves:

i. 𝐶 (𝑞 ) = 𝑎 + 𝑏𝑞;
𝑎
Ans. + 𝑏; 𝑏; 𝑏
𝑞

ii. 𝐶 (𝑞 ) = 𝑎 + 𝑏𝑞 + 𝑐𝑞 2 + 𝑑𝑞 3 ;
𝑎
Ans. + 𝑏 + 𝑐𝑞 + 𝑑𝑞 2 ; 𝑏 + 𝑐𝑞 + 𝑞 2 ; 𝑏 + 2𝑐𝑞 + 3𝑑𝑞 2
𝑞

Maximizing profit is equivalent to equating marginal revenue and marginal cost, as follows.

𝜋 = 𝑇𝑅 − 𝐶 (𝑞 ) = 𝑝𝑞 − 𝐶(𝑞).

How do we maximize a function?

𝑑𝑇𝑅 𝑑𝐶(𝑞)
Taking the first order condition of the profit condition, gives = ; which is 𝑀𝑅 = 𝑀𝐶.
𝑑𝑞 𝑑𝑞

For a firm in a perfectly competitive market, market price 𝑝 is not a function of 𝑞, as the firm is a
price taker.
𝑑𝐶(𝑞)
Therefore 𝑀𝑅 = 𝑝. Profit maximization then implies, 𝑝 = = 𝑀𝐶; i.e. supplying the 𝑞 that
𝑑𝑞
satisfies this FOC, as long as 𝑝 ≥ 𝐴𝑉𝐶 for the firm. Otherwise, the firm prefers to supply zero
units, and shutdown.

 A firm’s supply function in the short run (when exit is not possible) in a perfectly
competitive market is its MC curve, above its AVC curve.
Illustrate on whiteboard.

NOTE: just like 𝑇𝐶 and 𝐶 are used interchangeably to denote Total Cost, we often use 𝐴𝑇𝐶 and
𝐴𝐶 interchangeably to denote Average (Total) Cost.

In the long run, entry and exit from the industry are possible. Positive profit in the industry (𝑝 >
𝐴𝑇𝐶) invite entry, and losses (𝑝 < 𝐴𝑇𝐶) force firms to exit; assuming all firms in the market are
identical. Therefore, long run equilibrium is attained, when each (identical) firm earns zero
economic profit; i.e. 𝑝 = 𝐴𝑇𝐶.

 𝑀𝑅 = 𝑝 = 𝑀𝐶 = 𝐴𝑇𝐶 for each identical firm in long run market equilibrium.

  𝑄 is given by demand curve at the market price

Perfect competition diagram with market and firm alongside. Short run and long run equilibria.

`
Q. Suppose in a perfectly competitive market there are 𝑁 identical firms, and the market
equilibrium price and quantity are Rs. 30 and 4,500 respectively.

Hint: For identical firms in a perfectly competitive market, 𝑁𝑞 = 𝑄.

a) What is the MR for each firm?

b) If the costs of each firm are given by 𝐶 (𝑞 ) = 𝑞 2, and each firm maximizes its profit, then how
many firms are there such that the market equilibrium quantity is being produced; i.e. find 𝑁.

c) Is this market in LR equilibrium? Why or why not?

Ans. a) MR = 30.

Each firm max profit is at 𝑀𝑅 = 𝑀𝐶 => 30 = 2𝑞 => 𝑞 ∗ = 15. And therefore,

4500
b) 𝑁 = = 300.
15

c) Because each firm is making profit equal to 𝑇𝑅 − 𝑇𝐶 = 30 ∗ 15 − 152 = 225 > 0, the market
is not in LR equilibrium.

Price controls:

Markets with price controls; price floors (minimum wages, minimum support prices) and price ceilings
(rent control). Whiteboard.

https://www.moneycontrol.com/news/india/price-war-in-the-sky-airfares-tumble-as-govt-
removes-price-caps-9133981.html

How do you think an imposed price band effectively constrains the market price?

https://www.nobelprize.org/uploads/2021/10/fig3_ek_en_21_effectIncreasingMinimunWage.pdf

https://davidcard.berkeley.edu/papers/njmin-aer.pdf

Their explanations: nonwage offsets; recoup in higher prices; deter potential new entry; teenage
employment rose while adult employment fell; restaurants need not be price takers in the labor market;
…

Monopoly:

- Single firm supplying to the entire market, such that there is some barrier to entry.
- Presence of market power; monopolist can choose his price; 𝑝 = 𝑝(𝑞) because 𝑞 = 𝑄.
- In other words, because the monopolist faces the entire market demand curve alone, its
𝑀𝑅 < 𝑝.
𝑑(𝑝𝑄) 𝑑𝑝
𝑀𝑅 = = 𝑝 + 𝑄 𝑑𝑄
𝑑𝑄
Profit maximization: max 𝜋 = 𝑝(𝑄)𝑄 − 𝐶(𝑄), which is equivalent to setting 𝑀𝑅 = 𝑀𝐶.
𝑄/𝑝

The monopoly optimal decision diagram showing profit, CS, PS, deadweight loss; market efficient
price that maximizes total surplus; and the cause of the deadweight loss or inefficiency due to
the market being a monopoly. Take inverse demand curve, 𝑝 = 100 − 𝑄. Do it for constant
marginal cost, 𝑐 = 10, and for an increasing MC curve, assuming FC=0.

On whiteboard.

Find Monopolist’s profit max price if 𝑝 = 100 − 𝑄; 𝑀𝐶 = 10

 max 𝜋 = (100 − 𝑄 − 10)𝑄

𝑄
 FOC: 100 − 2𝑄 = 10
90
 𝑄∗ = = 45
2
 𝑝∗ = 100 − 45 = 55
 𝜋 ∗ = (55 − 10)45
𝑎2
Another example: 𝐶 (𝑄) = 𝐹 + 𝑐𝑄2 ; 𝑝(𝑄) = 𝑎 − 𝑏𝑄; assume 𝐹 ≤ 4(𝑏+𝑐)

max 𝜋 = 𝑝(𝑄)𝑄 − 𝐶 (𝑄) = 𝑎𝑄 − 𝑏𝑄2 − 𝑐𝑄2

Q

FOC: 𝑎 − 2𝑏𝑄 − 2𝑐𝑄 = 0

𝑎
 𝑄∗ = 2(𝑏+𝑐) .

What price will this monopolist charge?

𝑎𝑏 2𝑎𝑏+2𝑎𝑐−𝑎𝑏 𝑎(𝑏+2𝑐)
Ans. 𝑝(𝑄∗ ) = 𝑎 − 𝑏𝑄∗ = 𝑎 − 2(𝑏+𝑐) = = .
2(𝑏+𝑐) 2(𝑏+𝑐)

There may be natural monopolies such that ownership of resource is in the hands of a single
seller, and/or production by more than one seller is inefficient given market demand. In that case,
a monopoly market is not necessarily bad.

https://ilsr.org/report-most-americans-have-no-real-choice-in-internet-providers/

But when a seller invests/spends unnecessary funds to maintain monopoly status, or to deter or
threaten further entry into the market, the social cost of a monopoly is great.

Richard Posner – the social cost of a monopoly is much higher than the deadweight loss, as a
monopoly wastes resources in pursuit of rents and its monopoly status; i.e. in creating barriers
to entry. For example,
 - Persuasive advertising (Purdue Pharma)
- Excessive or large capital investment to make entry unattractive
- Lobbying
- Patent race and wasted R&D
- Predatory pricing (Amazon books?)

https://www.theguardian.com/books/2014/aug/08/authors-ad-new-york-times-petition-amazon

The last can be difficult to classify as predatory or simply competitive. And R&D may benefit
innovation and add to social welfare.

https://www.npr.org/2022/09/14/1122995430/california-sues-amazon

Also often it may be difficult to classify a market as being a monopoly or not. There may be a high
degree of concentration and yet there may be some marginal competitors present. Therefore,
courts focus on abuses of monopoly power rather than the status of being a monopoly, and on
the intent and practices to maintain monopoly status.

https://www.statista.com/statistics/575207/air-carrier-india-domestic-market-share/

Would you call the Indian airlines market a near monopoly, a competitive market, or something in
between?

Lerner index (of market power): is the proportional difference between existing price and
𝑝−𝑐
competitive (efficient) price. 𝐿𝑒𝑟𝑛𝑒𝑟 𝑖𝑛𝑑𝑒𝑥 = .
𝑝

Remember for a monopoly maximizing profit, 𝑀𝑅 = 𝑀𝐶 = 𝑐. The 𝑀𝑅 of a monopoly is also

1
written in the form 𝑀𝑅 = 𝑝 (1 − 𝜀 ).

1
 𝑝 (1 − 𝜀 ) = 𝑐
1 𝑝
[𝑝−𝑝(1− )] 1
 Lerner index = 𝜀
= 𝜀
=𝜀.
𝑝 𝑝

That is, the inverse of the (absolute value of) price elasticity of demand, measures the market
power a monopolist has.

The price elasticity of demand is the only constraint on the monopoly’s pricing ability. The more
elastic the demand is to changes in price, the less the monopolist is able to charge a high price
for the good, because a high price then suggests a large fall in sales which would reduce profit as
well. The smaller the elasticity of demand to changes in price, the smaller the proportional fall in
sales for a high price; a high price would therefore result in higher profit.
Advertising: Advertising, if successful, can affect the demand that a firm faces. It can increase
demand for the firm’s output, and/or it can make the demand less price elastic.
Intuition/examples.

Q: If advertising is expensive, then which firm – a monopoly or a firm in a perfectly competitive

market – is more likely to undertake advertising? Why?

Laboratory evidence (Perfect competition and Monopoly): Martin, pgs 40-51.

Theoretical market equilibria do not always prevail in real markets. Understanding of how
markets reach equilibria is still scarce.

1. Chamberlin (1948) is believed to have conducted the first market experiment. A

classroom of students divided into buyers and sellers were given values and costs
respectively for the good, and allowed to move around and strike deals to buy and sell.
Prices were observed to be below, and trade exceeded competitive market equilibrium
levels. Notice that moving around a room does not guarantee being informed of the
values/costs of all traders willing to trade with one. It does not achieve the kind of perfect
information that perfect competition assumes; which can be achieved either after a long
haggling and bargaining between all agents (Marshall) or with a publicly observable
auctioneer who equates market demand and supply (Walras).

2. Vernon Smith (1962): Potential buyers were given different redemption values
(redeemable in money at the end of the experiment) if they happened to have a unit of
the good at the end of the experiment. This constructs the demand curve for the
classroom market.
Possible sellers were given marginal costs for units that they had (each seller had exactly
one unit to sell). This gives the supply curve.
Smith modeled the experiment on the lines of an organized commodity market, using the
double auction mechanism in which both buyers and sellers post bids and offers,
simultaneously.
Comparing with Chamberlin’s experiment, Smith’s changed the one-on-one bargaining
and made bids and offers public knowledge. Also repeat announcements of bids and
offers, allow for buyers and sellers to learn from experience.
Prices and quantities converge to the competitive equilibrium levels. A number of
economists have recreated the experiment, and have confirmed the results.

3. Simulating retail market (posted-offers) was done by Ketcham et al. (1984). All buyers and
sellers know each seller’s posted price, but buyers’ valuations are private information.
 Prices converge to the competitive equilibrium level, but from above, and take longer
(more periods of learning) to do so.

4. Double auction monopoly experiments were done by Smith (1981a). One seller could sell
upto 10 units of the good, with an experimentally set MC curve. Five buyers, could each
buy upto 2 units of the good that could be redeemed at the end of the experiment for the
reservation values.
Prices were observed to be above or near the monopoly price for the first few periods, then
fell toward, and eventually below the competitive market equilibrium price. In a second
experiment they fell, but remained slightly above the competitive market equilibrium
price. “buyers appear to have a capacity for tacit collusion against the seller that has not
appeared before in non-monopolistic experiments.”

5. Smith (1981a) also conducted posted-offer monopoly experiments. These resemble the
theoretical monopoly setting best. However, consumers could wait for lower prices in
future and reserve purchase, as suggested by Coase. Coase proposed that price of non-
perishable (durable) good would fall down to marginal cost level because consumers’
strategic wait would erase monopoly’s market power.
Observations showed convergence to the monopoly price; buyers failed to strategically
withhold demand in order to evoke lower prices in future.
Finite number of periods could have caused the absence of the Coase conjecture to show
up.

There might be concerns of external validity in taking experimental results to represent real
world/market behavior.