Econ 305E

Industrial Organization
Tolga Yuret
Cabral Chapter 6.

Acknowledgement: I prepare these slides by incorporating

Professor Murat Usman’s course slides that he cordially give
permission for us to use.
Solving the competitive model
Profit maximization and market equilibrium:
Perfect competition

A short run competitive equilibrium consists of a price p* and an output q*i for
each firm i such that,
given the price p*,
1. the amount each firm i wishes to supply is q*i
2. the sum of all q*i is equal to the total amount Qd(p*) demanded.
Profit maximization and market equilibrium:
Perfect competition

The competitive firm chooses q to max profits under the assumption that it can sell
as much as it wants at the constant market price P.
Profit = Total Revenue − Total Cost
Profit = π(q) = TR(q) − TC(q)
Total Revenue (TR) = price times quantity = Pxq
Total Cost (TC) = TC(q) (Example: TC(q) = F + cq + dq ; c, d, F are positive real numbers.)
2
A little bit of mathematics…

Choosing the output level q to maximize profits π = Pxq − TC(q)

Differentiate π(q) with respect to q and then set equal to 0.
P − MC(q) = 0
Rearrange to get P = MC(q*).
The competitive firm maximizes its profits by producing q* units of output such
that P = MC(q*).
A numerical example

TC(q) = F + q + 0.05q2
MC(q) = ?
A numerical example

TC(q) = F + q + 0.05q2
MC(q) = 1 + 0.1q

Warm up question:
Find the profit maximizing q when P = 11.
A numerical example

MC(q) = 1 + 0.1q
P = 11
“MC(q) = P” means 1 + 0.1q = 11, we solve this for q:  q* = 100.
The supply function of the single firm

The profit maxing q is the one at which P = MC(q)

Now we don’t put a numerical value for P but keep P in the “MC(q) = P” equation
as a “parameter”:
1 + 0.1q = P
We solve this for q 
qS(P) = 10P – 10
if P > 1, qS(P) = 0 if otherwise
Remember this?

A perfectly competitive firm's supply curve is that portion of its marginal cost curve
that lies above the minimum of the average variable cost curve.

How so?
MC(q) = 1 + 0.1q
qS(P)= 10P – 10 if P > 1, 0 if otherwise
The market supply function

Suppose there are 200 firms in the market.

We let QS(P) denote the market supply. Then
QS(P) = 200 x qS(P)
Remember qS(P)= 10P – 10 if P > 1, 0 if otherwise
QS(P) = 200 x [10P – 10]
= 2000P – 2000 if P > 1, 0 if otherwise.
The market equilibrium price and quantity

Suppose the market demand is QD = 10300 – 50P

The equilibrium price equates supply and demand
QS = 2000P – 2000
QD = 10300 – 50P

QS = QD means 2000P – 2000 = 10300 – 50P

Solve this for P:  The equilibrium price is P* = 6, the equilibrium quantity is Q* = 10,000.
Each firm produces 50 units in equilibrium. (Remember qS(P) = 10P – 10 )
Profit per firm: 125 − F. (Pxq = 300, TC(q) = F + 50 + 0.05x502 = 175, all evaluated at P = 6
and q = 50, TC(q) = F + q + 0.05q2)
Now, this was the so called short run equilibrium
The short-run equilibrium

In the short-run equilibrium the number of firms is fixed.

The long – run equilibrium

In the long-run equilibrium the number of firms is endogenously determined.

In the long run entry and exit is possible.

The competitive equilibrium in the long-run
In the long run

New firms will enter industry XYZ, if the profits in XYZ are higher
than other (“similar”) industries.

Existing firms that are not making a profit will exit.

In the long run firms can enter and exit the industry

A situation is a long run equilibrium if

1. no firm in the industry wants to leave
2. no potential firm wants to enter.

Implications: Given the definition of economic profit, the theory implies that in a long run equilibrium
3. no existing firm makes a loss
4. any potential firm that entered would make a loss

Assuming that all firm have the technology and hence the same cost functions, and ignoring the integer
value problem, the theory implies that
• in a long run equilibrium every firm's maximal profit is zero
or, equivalently,
• price is equal to minimum average cost.
The process of free entry and exit eliminates excess profits or
losses.
The long run equilibrium: Entry and exit

Adam Smith’s definition:

The natural price, or “the price of free competition”.
The natural price “(…), is the lowest which the sellers can commonly afford to take,
and at the same time continue their business.”
The Long-Run Competitive Equilibrium Price

MC
Price
60
AC
50
40
P* = 38
30
20
10
0 2 4 6 8 Quantity
So, how does the math work out?
Computing the long run equilibrium in 5 easy steps!

GIVEN: cost and demand functions

1. Use the firm’s cost function to compute the output level at which the AC is at its minimum. Call
this output level qLR.
2. Compute AC at q = qLR. This is the long-run equilibrium price.
3. Use the market demand and the long run equilibrium price to compute the long run
equilibrium quantity. Call this QLR.
4. Compute the number of firms by QLR/qLR.
If this number is not an integer, round it down to the nearest integer.

qLR QLR
Let’s use this method for the numerical example

All firms have TC(q) = F + q + 0.05q2, with MC = 1 + 0.1q

The market demand is QD = 10300 – 50P

Find q at which AC reaches its minimum.

To do that, first, compute the AC function, then use the condition AC = MC
This is why we are using AC = MC condition
TC(q) = F + q + 0.05q2, MC = 1 + 0.1q

AC = TC/q
= (F + q + 0.05q2)/q
= F/q + 1 + 0.05q

for F = 40, AC looks like this

Now, use AC = MC to find q at which AC reaches its minimum.

Some algebra for AC = MC

F/q + 1 + 0.05q = 1 + 0.1q
F/q + 0.05q = 0.1q
F/q = 0.05q
F = 0.05q2
q2 = F/0.05 F
qLR 
0.05
Finally, we have
AC(q) = F/q + 1 + 0.05q

F
Let F = 80, then q  0.05 tells us that
AC is reaches its minimum value at q = 40.
The minimum AC is 5. ACMIN = 5
This means that the long run equilibrium price must be 5.
The market demand is QD = 10300 – 50P.
With P = 5, the equilibrium quantity is 10050.
We have 10050/40 = 251.25, so, there will be 251 firms in the market.
P=5

q = 40
The long run competitive equilibrium when every firm's average cost curve is the
same, given by AC, is characterized by a price p*, an output q* for each firm, and a
number n* of firms such that
p* is the minimum of AC
q* is the minimizer of AC
Qd(p*) = n*q*.
These three conditions have a very simple structure: the first one determines p*,
the second determines q*, and the last determines n*, given p* and q*.
Some Empirical Facts
Profits=0 in the long-run?
• 600 U.S. firms from 1950 to 1972.

• Classified firms in groups of 100 according to average profits in the period from 1950 to 1952

• Computed average profit rates in the whole 23-year period for each of the groups.

• The hypothesis that profits converge to the competitive level in the long run would imply
that inter group differences are insignificant on average.

• However, the data reject that any pair of averages is equal. In other words, average
differences in profitability across the groups persist even after 23 years
Entry-Exit rates
• Firms either enter or exit from an industry in the standard theory. However:
Size of the firms
• Standard theory implies a single size firm. However:
Now something more complicated!
What happens if firms have different cost structures?
How does the long run equilibrium look like?
If firms have different cost structures then in a long run competitive equilibrium
(with many price-taking firms who are small relative to the overall market), the
least efficient firm (aka the marginal firm) will be the one for which p = AC holds.
Those firms that have cost advantages will be earning a positive profit, a profit we
refer to as a rent.
Firms earn rents in competitive markets when their cost function is better than
their rivals'.
Some firms that are better than others
See if you can answer the following…
All firms in the industry…

have the same total cost function TC(q) = M + 10q + wq2,

where M is the salary paid to the manager,
and w is the market wage rate for workers.
All firms face an output price of P = 30, and a wage rate of w = 2.

Merlin is like all other managers in this industry except in one respect:
Because of his great sense of humor, people are willing to work for him for half the
market wage rate. Merlin’s salary as a manager is also M.
a. How much output will Merlin’s firm produce? How much output will a regular
firm produce?
a. How much output will Merlin’s firm produce? How much output will a regular
firm produce?
b. The market demand is QD(P) = 80 – P. The market is in the short run equilibrium
at P = 30 with N regular firms and Merlin’s firm. Compute N.
a. How much output will Merlin’s firm produce? How much output will a regular
firm produce?
b. The market demand is QD(P) = 80 – P. The market is in the short run equilibrium
at P = 30 with N regular firms and Merlin’s firm. Compute N.
c. Compute the value of M so that the output price (P = 30) is the long run
equilibrium price.
Let’s do it!

TC(q) = M + 10q + wq2…

The marginal cost function is MC(q) = 10 + 2wq.
A regular firm pays w = 2, so it has MC = 10 + 2x2xq.
P = MC for that firm is 30 = 10 + 4xq  q* = 5.

Merlin’s firm pays w = 1,

so its MC is 10 + 2xq.
P = MC for Merlin’s firm is 30 = 10 + 2q  qM = 10.
Profit = revenue – cost

Profit of a regular firm

πR = 5x30 – M – 10x5 –2x52 = 50 – M.

Profit of Merlin’s firm

πM = 10x30 – M – 10x10 –1x102 = 100 – M
So, Merlin’s firm makes more profit than other firms
It also has a larger market share!
Finally part c:

What value of M will make this price the long-run equilibrium price? How many
firms will there be in the market?
In particular, will Merlin’s firm make 0 profit in the long-run equilibrium?

Let the market demand be QD(P) = 80 – P

The answer is…

M = 50.

When M = 50 and P = 30, the regular firms produce q= 5 and make 0 (economic)
profit.
Merlin’s firm will produce q = 10 and make a profit of 50.
At P = 30 quantity demanded is QD(P) = 80 – P = 50.
How many firms will there be in the market?
There will be 8 regular firms (each firm produces q = 5) + Merlin’s firm (produces q
= 10).
Now in the light of the new model:

• Long run profits? ✓

• Simultaneous entry and exit ✓

• Firms with different sizes ✓

A little bit of thought???

• What would happen to Merlin’s wage in the long run?

• What would happen to the long-run profit?

• Theorists always seek for better models to explain empirical facts.

Monopolistic Competition
• Always confused by monopoly! (because of the name)

• Actually it is closer to perfect competition in assumption and to monopoly in

analysis (graphs)

• Perfect Competition assumptions with only one change:

• Products are not homogeneous!

• e.g. hotels, restaurants, jeans, etc.

Short-run equilibrium
Analysis

• The only difference with this graph and monopoly graph is:

• Market demand and the demand faced by the firm is the same in
monopoly

• Market demand and the demand faced by the firm is very different in
monopolistic competition
Analysis

• Which one is more elastic? Market demand or the demand facing the
firm?

• In which market structure, the firm can charge more? Monopoly or

monopolistic competition?
In the long-run.

• Entry if profits are positive

• Exit if profits are negative

Long-run
Long-run

• Which market type produce more? Which market type has lower
prices? Perfect competition or monopolistic competition?

• DWL=0 in perfect competition. How about monopolistic competition?

• Which is better? (Hint: Do you want all your jeans the same???)