The Dominant Firm Model

Evolution of a Dominant Firm

The typical cost structure for digital products is
necessary, but not sufficient, for the emergence of
a dominant firm.
Declining average cost (together with the absence of capacity
constraints) will permit a single firm to supply the whole market.
This cost structure does not preclude many firms from serving the
market however, as long as each individual firm can cover the
interest costs (or opportunity costs) associated with the sunk fixed
cost of its product.

Evolution of a Dominant Firm

What additional conditions must be satisfied for a firm to
become dominant?
Barriers to entry
Technical barriers
Large fixed costs ( large opportunity cost to entry)
Network externalities and lock-in

Legal barriers
Patents on technology ( control of standards)
Trademarks and copyright

Artificial barries
Advertising and marketing costs

Evolution of a Dominant Firm

Network Externalities
The value of the network to any individual connected to
it increases as the total number of connections increase.
Effect is an externality because the benefit occurs to a
connected individual independently of that individuals
actions.
Presence of externalities implies that many basic
economics results dont hold:
Generally cant have a perfectly competitive equilibrium
Competitive equilibrium will generally not be efficient

Evolution of a Dominant Firm

Market Tipping
Markets with network externalities generate positive feedback in
the sense that as the network grows, so does the incentive to join
the network.
Markets with positive feedback network externalities are
competitively unstable, in the sense that regardless of how
competitive the markets starts out, if one firm starts to gain market
share, customers will face strong incentives to switch to the large
network, leading to an upward cycle of growth by this firm which
culminates in market dominance.
Classic example: Microsofts growth from garage-based upstart to
dominance of the PC market.

Evolution of a Dominant Firm

Lock-In
Lock-in is the flip-side of positive feedback network
externalities.
Just as positive feedback makes joining the dominant network
valuable, it also makes leaving it costly.
Network members can face significant switching costs should
they wish to opt out of the network, and these costs give the
dominant firm leverage to maintain market share.

Monopoly Pricing
Dominant firms are price setters
Unlike competitive firms, a monopolist needs to be concerned with
the fact that reducing prices to sell more also reduces revenues on
all previous units sold.

Single firm, homogeneous product model

Profit maximization: =pq-C(q)
Prices are determined by inverse demand function p=p(q).
First-order conditions are standard: Choose output so that
marginal revenue from selling an additional unit is equal to the
marginal cost of producing the additional unit.

Monopoly Pricing
Mathematics of monopoly pricing
0 q MR q MC q
p q q p q C q

dp q
p q 1
C q

dq p

p q

1
1
C q
qp

Monopoly Pricing
Interpretation
is the elasticity of demand with respect to price and measures
qp

the %-change in quantity demanded given a 1% increase in price.

- If we make our standard assumption that marginal cost is zero, the
first-order condition states that we should produce and sell to the
point where demand just becomes inelastic (i.e. where qp=1).
- Note: With MC=0, the monopoly price need not be large. Indeed,
if demand is given by
then the elasticity is just ; clearly,
if this is greater than one, the firm will produce (and
price to sell) a

q p p
large amount of its product.

Monopoly Pricing
Heterogeneous Product Monopoly
More realistic case
Example: Microsoft Windows and Office Suite
Profit maximization problem (assuming zero marginal cost) now
becomes
pi qi p C
i

p pis1 ,...,
Here
thepvector
of prices for each of the firms
n
products. Note that the demand for each product will generally
depend on all prices.

Monopoly Pricing
First-order conditions for profit maximization

q j
qi
qi pi p p j p 0
j i
i
i

Monopoly Pricing
With some algebraic manipulation, this can be put in the
form
p jq j
1 ii
ij
j i pi qi
Here ii is good is own price elasticity of demand, and ij is
good js demand elasticity respect to a change in the price
of good i.

Monopoly Pricing
Application to Microsoft: Windows and Office
First-Order Conditions become

1 ww

po qo

wo
pw qw

and
1 oo

pw qw

ow
po qo

Durable Goods Monopoly

A second application of multi-product monopoly
Indestructibility and durability of digital products mean that a firm like Microsoft will find itself competing with its own earlier products.
Durable goods are, therefore, substitutes, though not perfect substitutes, since they are available at different points of time.
Example: Books -- Hardcover or Paperback?
Difference in production costs is small
Price differences are large
Form of price discrimination, separating patient from impatient.
Why does this occur?

Durable Goods Monopoly

Durable goods monopolist faces the question of whether to
lease the good or sell it.
A simple model of the lease-or-sell decision.
Two periods t=1,2 (good is obsolete after second period of use, replaced
by a new product).
MC=0 in both periods (without loss of generality, let C=0 in both
periods).
Demand in each period given by q(p)=1-p.
Both firm and customers discount future value by the discount factor
(with r = interest rate)

1
1 r

Durable Goods Monopoly

Leasing
Monopolist chooses outputs q1 and q2 to maximize ptq(pt) in each
period (i.e. the monopoly price in each period). From our
specification of demand, this yields p1=p2=1/2.
Since demand at these prices is q=1/2, and the good is durable, it
follows that the monopolists optimal output sequence is q 1=1/2
and q2=0.
The present discounted value of the firms profit is then

1 1
1
1
4 4
4
l

Durable Goods Monopoly

Selling
Backward Induction:
Period 2
When the monopolist produces and sells q 1 in the first period, we
assume that this amount is re-offered on the market in the
second period.
Monopolist chooses q2 to maximize second-period profit. Given
q2, the price the monopolist gets in period 2 is determined by
market-clearing: p2=1-q1-q2. Hence, the monopolist will choose q2
to maximize q2(1-q1-q2). This maximization has solution q2= (1q1). The second period profit is then 2=(1-q1)2.

Durable Goods Monopoly

Period 1
The rental cost in period 1 for using q1 units of the good is (from
the demand function for period1) (1-q1). The purchase price of the
good, however, depends on both the rental cost, and on the
anticipated future price p2a. Given the anticipated second period
price, the period one price will be p1=(1-q1)+p2a.
To close the model, we assume that agents correctly anticipate the
future price, so that p2a=p2. From the calculation for period 2,
agents know the monopolists output in terms of q1, and hence the
second period price in terms of q1: p2=(1-q1).

Durable Goods Monopoly

Period 1, continued.
Given this, the price in period 1 is
p1=(1-q1)+(1-q1) or
p1=(1-q1)(1+ )

Note that the quantity demanded in period one at any price p 1 is

lower than it would have been if the monopolist could commit not
to produce in period 2
In particular, if monopolist can commit to q2=0, then
p1=(1-q1)(1+ )
Question: Why cant the monopolist commit not produce?

The implied shift in demand in period one means that the

monopolist will not be able to sell as much in period 1 as he would
if he could commit to q2=0.

Durable Goods Monopoly

Period one, continued
The monopolists profit function is then given by
s=q1(1-q1)(1+/2)+ (1+q1)2.

Maximizing profit with respect to q 1 yields

2
1
q1

4 2
and
2

2
1
p1

.
In particular, it is easy
to2verify
4 that
2< and the monopolist
s

would prefer to lease.

Durable Goods Monopoly

Conclusion
Coase conjecture: The durability of a good erodes a monopolists market
power since the monopolist cannot credibly commit not to compete with
himself for future sales.
Mechanism: When the monopolist sells, there will be some residual
demand for the good in period 2 which can be supplied by the monopolist
or by individuals who purchase the good in period 1. The monopolist
therefore has an incentive to supply the market in period 2 at a lower price
than he charged for the same good in period 1. Consumers with marginal
valuations will benefit, in this case, from waiting and purchasing in period
2. This reduces demand in period 1, forcing the monopolist to reduce
prices in period.

Durable Goods Monopoly

Conclusion, cont.
Intertemporal Price Discrimination: Note the price discrimination
implicit in this result. The monopolist who cannot lease his product will
sell first to high-valuation buyers at a higher price than he subsequently
sells to lower-valuation buyers, who wait to make their purchases.
Limit Results: Economists who have studied the Coase conjecture have
been able to show that as the length of the period over which the
monopolist can credibly commit not to change his prices gets shorter, the
profit maximizing price gets closer to the competitive price (i.e. to
marginal cost).