2:BasicMicroeconomics

ConsiderabletimepassedbeforeAdamSmith'soriginalandintuitiveinsightsregardingthenatureofmarket
behaviorandmarketoutcomesweretranslatedintoformalmodels.Itthentookevenmoretimeforthat
formalunderstandingtomakeitswayintoastandardprofessionalliterature.Yetbythelatenineteenth
century,arigorousunderstandingofthebenefitsofcompetitionversusmonopolyhadbeenestablishedas
evidencedinparticularbythepublicationofAlfredMarshall'sPrinciplesofEconomics,Vol.1(1890).
Whileweareultimatelyinterestedinmodelingthegrayareathatliesbetweencompetitionandmonopoly,a
soundunderstandingoftheperfectlycompetitiveandpuremonopolizedmarketsisneverthelessquite
insightful.Indeed,thesemodelscontinuetoprovideusefulstartingpointsforinterpretingmuchofwhatone
readsaboutinthedailybusinesspress.Theyalsorevealtheprimaryintellectualforcebehindpublicpolicies
designedtolimitmonopolypower.Forallthesereasons,weundertakeinthischapterabriefreviewofthe
basicmodelsofperfectcompetitionandmonopoly.

2.1COMPETITIONVERSUSMONOPOLY:THEPOLESOFMARKET
PERFORMANCE
Wefocusonfirmprofitmaximizingbehaviorandtheresultantmarketoutcomethatsuchbehaviorimplies.
Wetakeasgiventhederivationofanaggregateconsumerdemandfortheproductthatdefinesthemarket
ofinterest.Thismarketdemandcurvedescribestherelationshipbetweenhowmuchmoneyconsumersare
willingtopayperunitofthegoodandtheaggregatequantityofthegoodconsumed.Figure2.1showsan
exampleofamarketdemandcurvemorespecifically,alinearmarketdemandcurvethatcanbedescribed
bytheequationP=ABQ.Whenwewritethedemandcurveinthisfashionwithpriceonthelefthandside,
itisoftencalledaninversedemandcurve.1TheverticalinterceptAisthemaximumwillingnesstopay,or
maximumreservationdemandpricethatanyconsumeriswillingtopaytohavethisgood.Atamarketprice
greaterthanA,nooneinthismarketwantstobuyanyoftheproduct.AsthemarketpricefallsbelowA,
demandfortheproductincreases.Forexample,ifthemarketpriceofthegoodisP1,thenconsumerswill
desiretopurchaseaquantityQ1ofthegood.Alternatively,wemayviewP1asconsumerwillingnesstopay
atthemargin.Thatis,P1isthemostanyconsumerwouldpayforthelastortheQ1thunitofthegood.

Figure2.1Marketdemandcurve
ThepriceP 1isthemarginalconsumervaluationofanadditionalunitofoutputwhencurrentoutputisQ1.

Whenwedrawademandcurve,weareimplicitlythinkingofsomeperiodoftimeoverwhichthegoodis
consumed.Forexample,wemaywanttolookatconsumerdemandfortheproductperweek,perquarter,
orperyear.Similarly,whenwetalkaboutfirmsproducingthegood,wewanttoconsidertheircorresponding
weekly,quarterly,orannualproductionofthegood.Thetemporalperiodoverwhichwedefineconsumer
demandandfirmproductiontypicallyaffectswhatproductiontechnologiesareavailabletothefirmfor
producingthegood.Theshorterthetimeperiod,thefeweroptionsanyfirmhasforalteringitsproduction.
Followingthetraditioninmicroeconomics,wedistinguishbetweentwogeneraltimeperiods:theshortrun
andthelongrun.Theshortrunisasufficientlyshorttimeperiodfortheindustrysothatnonewproduction
facilitiesnonewplantandequipmentcanbebroughtonline.Intheshortrun,neitherthenumberoffirms
northefixedcapitalateachfirmcanbechanged.Bycontrast,thelongrunisaproductionperiodsufficiently
longsothatfirmscanbuildnewproductionfacilitiestomeetmarketdemand.
Foreithertheshortrunorthelongrunscenario,weareinterestedindeterminingwhenamarketisin
equilibrium.Bythiswemeanfindinganoutcomeatwhichthemarketisatrest.Ausefulinterpretationofa
marketequilibriumisasituationinwhichnoconsumerandnofirminthemarkethasanincentivetochange
itsdecisiononhowmuchtobuyorhowmuchtosell.Tobesure,theprecisemeaningofthisdefinitionmay
varydependingonwhetherweconsidertheshortrunorthelongrun.Yetineithercase,theessential
featureisthesame.Equilibriumrequiresthatnoonehasanincentivetochangehisorhertradingdecision.

2.1.1PerfectCompetition
Aperfectlycompetitivefirmisapricetaker.Thepriceofitsproductisnotsomethingthattheperfectly
competitivefirmchooses.Instead,thatpriceisdeterminedbytheinteractionofallthefirmsandconsumers
inthemarketforthisgood,anditisbeyondtheinfluenceofanyoneoftheperfectlycompetitivefirms.This
characterizationonlymakessenseifeachfirm'spotentialsupplyoftheproductissmallrelativetomarket
demandfortheproduct.Ifafirm'ssupplyofagoodwerelargerelativetothemarket,wewouldexpectthat
thatfirmcouldinfluencethepriceatwhichthegoodwassold.Anexampleofasmallfirmwouldbeawheat
farmerinKansasor,alternatively,abrokerontheNewYorkStockExchangetradingIBMstock.Eachisso
smallthatanyfeasiblechangeintheirbehaviorleavesthepricesofwheatandIBMstock,respectively,
unchanged.
Becauseaperfectlycompetitivefirmcannotinfluencethemarketpriceatwhichthegoodtrades,thefirm
perceivesthatitcansellasmuch,oraslittle,asitwantstoatthatprice.Ifthefirmcannotsellasmuchasit
wantstoatthemarketprice,thentheimplicationisthatsellingmorewouldrequireafallintheprice.
Becausethiswouldimplythatthefirmhassomepoweroverthemarketprice,suchafirmwouldnotbea
perfectcompetitor.Thefactthatthefirmcannotaffectthemarketpricealsomeansthatitsactionsdonot
affectotherproducers.Inturn,thismeansthatperfectlycompetitivefirmsdonotstrategicallyinteractwith
anyoftheirnumerousrivals.
Becausetheoutputdecisionofaperfectlycompetitivefirmdoesnotaffectthegoingprice,agraphofthe
inversedemandcurvefacingsuchafirmappearsasahorizontallineatthecurrentmarketprice.Nomatter
howmuchorhowlittlethefirmproduces,thatpriceremainsunchanged.Notethatthisisthecaseeven
thoughthemarketdemandcurvedescribingthedemandfacedbytheentireindustryisdownwardsloping.2
Thatmarketdemandcurveindicatesthatiftheaggregateoutputofallfirmsincreasesinanymaterialway,
themarketpricewillfall.Again,though,thedistinguishingfeatureofaperfectlycompetitivefirmisthatitis

sosmallthatitsoutputchoicehasnosuchmaterialimpactontotalindustryoutputorwheretheindustryis
onthemarketdemandcurve.
Likeallfirms,theperfectlycompetitiveoneswilleachchoosethatoutputlevelwhichmaximizestheir
individualprofit.Profitisdefinedasthedifferencebetweenthefirm'srevenueanditstotalcosts.Revenueis
justmarketprice,P,timesthefirm'soutput,q.Thefirm'stotalcostisassumedtorisewiththelevelofthe
firm'sproductionaccordingtosomefunction,C(q).Itisimportanttounderstandthatthefirm'scostsinclude
theamountnecessarytopaytheownersofthefirm'scapital(thatis,itsstockholders)anormalor
competitivereturn.Thisisawayofsayingthatinputcostsareproperlymeasuredasopportunitycosts.That
is,eachinputmustbepaidatleastwhatthatinputcouldearninitsnextbestalternativeemployment.Thisis
trueforthecapitalemployedbythefirmasmuchasitistrueforthelaborandrawmaterialsthatthefirm
alsouses.Generallyspeaking,theopportunitycostforthefirm'scapitalismeasuredastherateofreturn
thatthecapitalcouldearnifinvestedinotherindustries.Thiscostisthenincludedinourmeasureoftotal
cost,C(q).Inotherwords,theconceptofprofitweareusingisthatofeconomicprofit.Itreflectsnetrevenue
abovewhatisnecessarytopayallofthefirm'sinputsatleastwhattheycouldearninalternative
employment.Thispointisimportantbecauseitmakesclearthatwhenafirmearnsnoeconomicprofitit
doesnotmeanthatitsstockholdersgoawayemptyhanded.Itsimplymeansthatthosestockholdersdonot
earnmorethananormalreturnontheirinvestment.
Anecessaryfirstorderconditionforprofitmaximizationisthatthefirmchoosesanoutputlevelsuchthatthe
revenuereceivedforthelastunitproduced,orthemarginalrevenue,justequalsthecostincurredto
producethatlastunit,orthemarginalcost.Thisconditionforprofitmaximizationholdsfortheoutputchoice
ofanyfirm,beitaperfectlycompetitiveone,oramonopoly.Sincetotalrevenuedependsontheamount
produced,marginalrevenueisalsodependentonqasdescribedbythemarginalrevenuefunction,MR(q).
Becausetheperfectlycompetitivefirmcansellasmuchasitlikesatthegoingmarketprice,eachadditional
unitofoutputproducedandsoldgeneratesadditionalrevenueexactlyequaltothecurrentmarketprice.
Thatis,themarginalrevenuefunctionforacompetitivefirmisjustMR(q)=P.Similarly,becausetotalcostis
afunctionoftotaloutput,q,themarginalcostfunctionalsodependsonq,accordingtothefunctionMC(q).
Thisfunctiondescribestheadditionalcostincurredbythefirmforeachsuccessiveunitofoutputproduced.
DiagramslikethoseshowninFigures2.2(a)and2.2(b),respectively,areoftenusedtoillustratethe
standardtextbookmodeloftheperfectlycompetitivefirmandtheperfectlycompetitivemarketinwhichthe
firmsells.Foranymarkettobeinequilibrium,thenecessaryconditionmentionedearliermustholdforeach
firm.Foracompetitivemarket,thismeansthatforeachfirmthepricereceivedforaunitofoutputexactly
equalsthecostofproducingthatoutputatthemargin.ThisconditionisillustratedinFigures2.2(a)and
2.2(b).TheinitialindustrydemandcurveisD1andthemarketpriceisPC.AfirmproducingoutputqCincurs
amarginalcostofproductionMC(qC)justequaltothatprice.Producingonemoreunitwouldincuranextra
cost,asindicatedbythemarginalcostcurveMCthatexceedsthepriceatwhichthatunitwouldsell.
Conversely,producinglessthanqCwouldsavelessincostthanitwouldsacrificeinrevenue.Whenthefirm
producesqCandsellsitatmarketprice,PC,itismaximizingprofit.Itthereforehasnoincentivetochangeits
choiceofoutput.Hence,inacompetitiveequilibriumeachfirmmustproduceatapointwhereitsmarginal
costisjustequaltotheprice.
Totalmarketsupply,QC,isthesumofeachfirm'soutput,qC.Becauseeachfirmismaximizingprofit,the
conditionP=MC(qC),willholdforeachfirm.Ifdemandfortheproductincreasesandthemarketpricerises
tosayP1,eachfirmwillreviseitsproductiondecisionandincreaseoutputtoq1,whereP1=MC(q1).Thiswill

increasetotalproductiontoQ1.Indeed,becausethefirms'productiondecisionsaregovernedbycostsat
themargin,themarginalcostcurveofeachfirmprovidesthebasisfordeterminingthetotalindustrysupply
atanygivenmarketprice.Asthepricerises,weworkouthoweachfirmadjustsitsprofitmaximizingoutput
bymovingupitsmarginalcostfunctiontoapointwhereP=MC(q)atthisnewprice.Thenweaddupallthe
firms'reviseddecisionsandcomputethetotaloutputnowsupplied.Repeatingthisexerciseforvarious
pricesrevealstheindustrysupplyfunctionindicatingthetotaloutputsuppliedatanygivenmarketprice.Itis
illustratedbythecurveS1inFigure2.2(b).Becauseforeachfirmpriceisequaltoitsmarginalcost,itmust
bethecasethatateachpointonthesupplyfunctionforeveryfirmtheincrementalcostofthelastunit
producedisjustequaltothatprice.
Considerasimplelinearexamplewhereeachfirm'smarginalcostcurveislinearinsteadofcurved,as
showninFigure2.2(a).Specifically,letthemarginalcostofeachfirmbe:MC(q)=4q+8.Givenamarket
priceP,theoptimaloutputforanyonecompetitivefirmisthenqsuchthat4q+8=P,implyingthatthe
optimaloutputforeachsuchfirmsatisfiesq=

2.

Figure2.2Thelongruncompetitiveequilibrium
PriceP 1isconsistentwithashortrunequilibriuminwhicheachfirmproducesatapointwhereitsmarginalcostisequaltoP 1.However,atP 1price
exceedsaveragecostandeachfirmearnsapositiveeconomicprofit.Thiswillencourageentrybynewfirms,shiftingoutthesupplycurveasshown
in(b).ThelongruncompetitiveequilibriumoccursatpriceP C,inwhicheachfirmproducesoutputlevelq Candpriceequalsbothaverageand
marginalcost.

Ifthereare80suchfirms,totalindustryproductionQatpricePis80timesqorQS=20P160.Solvingfor
PwritestheresultantsupplycurveintheformimpliedbyFigures2.2(a)and2.2(b)inwhichpriceappears
ontheverticalaxis.ThisyieldsP=0.05QS+8.Atapriceof8orless,eachfirmwillproducezerooutput.
Industryoutputwillalsobezero.AriseinPto12willinduceeachfirmtoraiseitsoutputto1unit,increasing
industryoutputto80.AfurtherrisetoP=16willleadeveryfirmtoraiseitsoutputto2units,implyingatotal
supplyof160.Wecouldrepeatthisexercisemanytimesover,eachtimechoosingadifferentprice.Plotting
theindustryoutputagainsteachsuchpriceyieldstheindustrysupplycurve.Theimportantpointto
understandisthatthederivationofthatsupplycurvereflectstheunderlyingfirstorderconditionforprofit
maximizationthatis,eachcompetitivefirmchooseaprofitmaximizinglevelofoutputsuchthatP=MC(q).

IntheexampleshowninFigures2.2(a)and2.2(b),themarketinitiallyclearsattheprice,PC.Giventhe
demandcurveD1,thisequilibriumisconsistentwiththefirstorderconditionthateachfirmproduceanoutput
suchthatP=MC(q).Therequirementthateachfirmproduceswheremarginalcostequalsthemarketprice
isalmostallthatisrequiredforacompetitiveequilibriumintheshortrun.3However,thereisanadditional
conditionthatmustbemetinorderforthistobealongruncompetitiveequilibrium.Theconditionisthatina
longrunequilibrium,eachfirmearnszeroeconomicprofit.Thisconditionisalsometintheinitialequilibrium
illustratedinFigure2.2(a).
AtoutputqC,eachfirmisjustcoveringitscostofproduction,includingthecostofhiringcapitalaswellas
laborandotherinputs.Inotherwords,alongruncompetitiveequilibriumrequiresthatfirmsjustbreak
evenandnotearnanyeconomicprofitrevenueinexcessoftheamountrequiredtoattracttheproductive
inputsintotheindustry.Thisrequirementcanbestateddifferently.Inthelongrun,thepriceofthegood
mustjustequaltheaverageorperunitcostofproducingthegood.Again,boththiszeroprofitconditionand
thefurtherrequirementthatpriceequalmarginalcostaresatisfiedintheinitialequilibriuminwhichthe
industrydemandcurveisD1andthepriceisPC.
Ifdemandsuddenlyshiftstotheleveldescribedbythedemandcurve,D2,theexistingindustryfirmswill
respondbyincreasingoutput.Insodoing,thesefirmsmaximizeprofitbyagainsatisfyingthebasic
requirementthattheyeachproducewhereP=MC(q).ThisleadseachfirmtoexpanditsproductionfromqC
toq1,therebyraisingthemarketoutputtoQ1.However,thisshortrunresponsedoesnotsatisfythezero
profitconditionrequiredforalongruncompetitiveequilibrium.AtpriceP1,themarketpriceequalseach
firm'smarginalcostbutexceedseachfirm'saveragecost.Hence,eachfirmearnsapositiveeconomicprofit
ofP1AC(q1)oneachoftheq1unitsitsells.
Suchprofiteitherinducesnewfirmstoentertheindustryorexistingfirmstoexpandproduction.This
expansionshiftstheindustrysupplycurveoutwarduntiltheequilibriumpriceagainjustcoversaveragecost.
Figure2.2(b)illustratesthisbytheshiftintheindustrysupplycurvetoS2.Asdrawn,thisshiftreestablishes
theinitialprice,PC.EachfirmagainproducesoutputqCatwhichtheindustrypriceequalsboththefirm's
marginalcostanditsaveragecost.Ofcourse,totalindustryoutputisnowhigheratQC.Whileeachfirmis
producingtheoutputqC,therearenowmorefirms.Theseexamplesillustrateacentralelementinour
definitionofanequilibriumnamely,thatnofirmhastheincentivetochangeitsproductionplan.Inthelong
run,thisincludestheideathatnofirmwisheseithertoleaveortoenterthemarket.
2.1PracticeProblem
Assumethatthemanufacturingofcellularphonesisaperfectlycompetitiveindustry.Themarketdemandfor
cellularphonesisdescribedbyalineardemandfunction:QD=

.Therearefiftymanufacturersofcellularphones.Eachmanufacturerhasthesameproductioncosts.These
aredescribedbylongruntotalandmarginalcostfunctionsofTC(q)=100+q2+10q,andMC(q)=2q+10.
1.Showthatafirminthisindustrymaximizesprofitbyproducingq=

.
2.DerivetheindustrysupplycurveandshowthatitisQS=25P250.

3.Findthemarketpriceandaggregatequantitytradedinequilibrium.
4.Howmuchoutputdoeseachfirmproduce?Showthateachfirmearnszeroprofitinequilibrium.

2.1.2Monopoly
Inaperfectlycompetitivemarket,eachfirm'sproductionofthegoodistinyrelativetothemarkettotal.What
wouldhappen,though,ifallofthesetinysellersbecomeconsolidatedintoonefirm,i.e.,whatwouldhappen
ifthemarketweremonopolized?Becausethissinglefirmwouldbetheonlysupplierofthegood,itsdemand
curveisidenticalwiththemarketdemandcurve.Incompletecontrasttothecompetitivefirm,thismonopoly
firmcandecisivelyinfluencethepriceinthismarketbecauseitschoicesdecisivelyalterthetotalsupply.
Recognizingthiseffect,themonopolist'sprofitmaximizingbehaviorwilldifferfromthatofacompetitivefirm
andsowillchangethemarketequilibrium.

Figure2.3Themarginalrevenuefromincreasedproductionforamonopolist
AnincreaseinproductionfromQ1toQ2causesagaininrevenuesapproximatedbyareaG,andalossinrevenuesapproximatedbyareaL.The
netchangeormarginalrevenueisthereforeGL.Note,becausethefirmisamonopolist,thisisalsothenetrevenuegaingeneratedbycuttingthe
pricefromP 1toP 2.

Becausethemonopolist'sdemandcurveslopesdownward,anyincreasedproductionbythemonopolistwill
leadtoapricereduction.Consider,forinstance,Figure2.3.Here,amonopolistwhoisconsideringselling
eitherQ1orQ2unitsfacesthefollowingdilemma.IfproductionisrestrictedtoQ1units,themarketpricewill
beP1.IfinsteadproductionissetatQ2however,themarketpricewillfalltoP2.Accordingly,themonopolist
isverydifferentfromthecompetitivefirmthatreckonsthateveryadditionalunitsoldwillbringinrevenue
equaltothecurrentmarketprice.Instead,themonopolistknowsthateveryunitsoldwillbringinmarginal
revenuelessthantheexistingprice.Becausetheadditionaloutputcanbesoldonlyifthepricedeclines,the
marginalrevenuefromanadditionalunitsoldisnotmarketpricebutsomethingless.
InFigure2.3,thecomponentsofmarginalrevenueforamonopolistareillustratedbytheshadedareasG
andL.Theseareasreflectthetwoforcesaffectingthemonopolist'srevenuewhenthemonopolistincreases
outputfromQ1toQ2,andtherebycausesthepricetofallfromP1toP2.AreaGisequaltothenewpriceP2
timestheriseinoutput,Q2Q1.Itistherevenuegainthatcomesfromsellingmoreunits.AreaLequalsthe
amountbywhichthepricefalls,P1P2,timestheoriginaloutputlevel,Q1.Thisreflectstherevenueloston
theinitialQ1unitsasaresultofcuttingthepricetoP2.Thenetchangeinthemonopolist'srevenueisthe
differencebetweenthegainandtheloss,orGL.

Wecanbemorepreciseaboutthis.LetQ=Q2Q1,andP=P1P2.Theslopeofthemonopolist's
(inverse)demandcurvemaythenbeexpressedas

.Ifwedescribethisdemandcurve(whichofcourseisalsothemarketdemandcurve)asalinearrelation,P
=ABQ,thatslopeisalsoequaltotheterm,B,i.e.,

=B.Inotherwords,anincreaseinoutputQ4leadstoadeclineinpricePequaltoBQ.Becausetotal
revenueisdefinedaspriceperunittimesthenumberofunitssold,wecanwritetotalrevenueasafunction
ofthefirm'soutputdecision,orR(Q)=P(Q)Q=(ABQ)Q.AsjustshowninFigure2.3,thechangein
revenue,R(Q),duetotheincreaseinoutput,Q,isthesumoftwoeffects.Thefirstistherevenuegain,
P2Q.Thesecondistherevenueloss,Q1P.Hence,

wherewehaveusedthedemandcurvetosubstituteABQ2forP2inthefirsttermontherighthandside.
MR(Q)ismeasuredonaperunitbasis.Hence,wemustdividethechangeinrevenueshowninequation
(2.1)bythechangeinoutput,Q,toobtainmarginalrevenue.Thisyields

Herewehaveusedtheapproximation,B(Q1+Q2)2BQ.Thiswillbelegitimatesolongaswearetalking
aboutsmallchangesinoutput,i.e.,solongasQ2isfairlyclosetoQ1.
Equation(2.2)sometimesreferredtoasthetwiceassteepruleisveryimportant,andwewillmake
frequentreferencetoitthroughoutthetext.Itnotonlyillustratesthatthemonopolist'smarginalrevenueis
lessthanthecurrentpricebut,forthecaseoflineardemand,alsodemonstratesthepreciserelationship
betweenpriceandmarginalrevenue.Theequationforthemonopolist'smarginalrevenuefunction,MR(Q)=
A2BQ,hasthesamepriceinterceptAasthemonopolist'sdemandcurvebuttwicetheslope,2Bversus
justB.Inotherwords,whenthemarketdemandcurveislinear,themonopolist'smarginalrevenuecurve
startsfromthesameverticalinterceptasthatdemandcurve,butiseverywheretwiceassteeplysloped.It
followsthatthemonopolist'smarginalrevenuecurvemustthenlieeverywherebelowtheinversedemand
curve.
InFigure2.4,weshowboththemarketdemandcurveandthecorrespondingmarginalrevenuecurvefacing
themonopolist.Again,profitmaximizationrequiresthatafirmproduceuptothepointwherethemarginal
revenueassociatedwiththelastunitofoutputjustcoversthemarginalcostofproducingthatunit.Thisis
trueforthemonopolyfirmaswellasfortheperfectlycompetitivefirm.Thekeydifferencehereisthatforthe
monopolyfirm,marginalrevenueislessthanprice.Forthemonopolyfirm,theprofitmaximizingruleof
marginalrevenueequaltomarginalcost,orMR(Q)=MC(Q),holdsattheoutputQM.Themonopolist
thereforeproducesatthislevelandsellseachunitatthepricePM.Observethat,atthisoutputlevel,the
revenuereceivedfromsellingthelastunitofoutputMRislessthanthepriceatwhichthatoutputissold,
MR(QM)<PM.Itisthisfactthatleadsthemonopolisttoproduceanoutputbelowthe(shortrun)equilibrium
outputofacompetitiveindustry,QC.

WehavealsodrawntheaveragecostfunctionforthemonopolyfirminFigure2.4.Theperunitcostof
producingoutputQM,describedontheaveragecostcurvebyAC(QM),islessthanthepricePMatwhichthe
monopolistsellsthegood.Thismeans,ofcourse,thattotalrevenueexceedstotalcost,andthemonopolist
earnsapositiveeconomicprofit.ThisprofitisshownastherectanglePMabAC(QM).Furthermore,because
themonopolististheonlyfirminthismarket,andbecauseweassumethatnootherfirmcanenterand
supplythisgood,thismarketoutcomeisalongrunequilibrium.Eachconsumerbuysasmuchashewants
toatpricePMand,giventhesecostdemandconditions,themonopolisthasnoincentivetosellmoreorto
sellless.

Figure2.4Thetextbookmonopolycase
Themonopolistmaximizesprofitbychoosingtheoutput,QM,atwhichmarginalrevenueequalsmarginalcost.Thepriceatwhichthisoutputcanbe
soldisidentifiedbythedemandcurveasP M,whichexceedsmarginalcost.ProfitisP MabAC(QM).Thecompetitiveindustrywouldhaveinstead
producedQC,atwhichpointpriceequalsmarginalcost.

2.2PracticeProblem
SupposethatthecellularphonemarketdescribedinPracticeProblem2.1,ismonopolized.Themonopolist
has50identicalplantstorun,eachwiththesamecostfunctionasdescribedinthatproblem.Hence,the
marginalcostfunctionforthemultiplantmonopolist5isdescribedbyMC(Q)=10+Q/25.Themarket
demandisalsoassumedtobethesameasinPracticeProblem2.1.RecallQD=

1.Showthatthemonopolist'smarginalrevenuefunctionisMR(Q)=12018Q/50.
2.Showthatthemonopolist'sprofitmaximizingoutputlevelisQM=275.Whatpricedoesthemonopolist
settosellthislevelofoutput?
3.Whatistheprofitearnedateachoneofthemonopolist'splants?

2.2ECONOMICEFFICIENCYANDTHESOCIALSURPLUS
Nowthatwehavedescribedtheperfectlycompetitiveandpuremonopolymarketoutcomes,itistimetotry
tounderstandwhyperfectcompetitionisextolledandpuremonopolyisjudgedharshlybyeconomists.In
bothcasesfirmsaredrivenbyprofitmaximization.Also,inbothcasesthefirmsselltoconsumerswho
decidehowmuchtheywanttobuyatanygivenprice.Whatmakesonemarketgoodandtheothermarket
not?Theanswertothisquestiondoesnotreflectanyconcernabouttoomuchprofitorfirmsrippingoff

consumers.Theanswerinsteadliesintheeconomicconceptofefficiency.Ineconomics,efficiencyhasa
veryprecisemeaning.Brieflyspeaking,amarketoutcomeissaidtobeefficientwhenitisimpossibletofind
somesmallchangeintheallocationofcapital,labor,goods,orservicesthatwouldimprovethewellbeingof
oneindividualwithouthurtinganyothers.6Iftheonlywaywecanmakesomebodybetteroffisbymaking
someoneelseworseoff,thenthereisreallynoslackorinefficiencyinhowthemarketisworking.If,onthe
otherhand,wecanimaginechangesthatwouldsomehowallowonepersontohavemoregoodsand
serviceswhilenobodyelsehasless,thenthecurrentmarketoutcomeisnotefficient.Asitturnsout,thatis
preciselythecaseforamonopolizedmarket.Onecanthinkofchangestothemonopolyoutcomethatwould
yieldmoreforatleastoneindividualandnolessforanyother.
Itisreadilyapparentthattoimplementourefficiencycriterionweneedsomemeasureofhowwelloff
consumersandfirmsareinanymarketoutcome.Forthispurpose,weusethenotionsofconsumersurplus
andproducersurplus.Theconsumersurplusobtainedfromconsumingoneunitofthegoodisdefinedas
thedifferencebetweenthemaximumamountaconsumeriswillingtopayforthatunitandtheamountthe
consumeractuallydoespay.Totalconsumersurplusinamarketisthenmeasuredbysummingthis
differenceovereachunitofthegoodboughtinthemarket.Analogously,theproducersurplusobtainedfrom
producingasingleunitofthegoodisthedifferencebetweentheamountthesellerreceivesforthatunitof
thegoodandthecostofproducingit.Totalproducersurplusinamarketisthenmeasuredbysummingup
thisdifferenceovereachunitofthegoodsold.

2.2.1EconomicEfficiencyandSurplusinaCompetitiveMarket
WeillustratetheseconceptsinFigure2.5.Inthecompetitiveoutcome,QCunitsofthegoodareboughtand
sold.Themaximumamountaconsumeriswillingtopayforthelastunit,theQCthunit,isjusttheequilibrium
pricePC.However,themaximumamountaconsumeriswillingtopayforthefirst,thesecond,thethird,and
soon,uptotheQCthunitisgreaterthanPC.Weknowthisbecause,atagivensalesvolume,thedemand
curveisaprecisemeasureofthemaximumamountanyconsumeriswillingtopayforonemoreunit.
Hence,theareaunderthedemandcurvebutabovethemarketequilibriumpricePCissurplusto
consumers.Itisameasureofhowmuchtheywerewillingtopaylesswhattheyactuallydidpayinthe
competitiveoutcome.ThisisshowninFigure2.5asareaabc.

Figure2.5Competitionmaximizesthetotalsurplus
AtthecompetitivepriceP CandoutputQC,consumersenjoyasurplusequaltotriangleabc.Producersenjoyasurplusequaltotrianglecbd.Thisis
themaximum.Producinglesswouldlosesomeofthetotalsurplusgivenbytriangleabd.SubsidizingproductiontooutputQGreducesthepriceto
P G.Therequiredsubsidyisgfh.

Consumersgainadditionalsurpluscbge.However,thisamountrepresentsatransferofsurplusfromproducerstoconsumersandthus,nonetgain
intotalsurplus.Consumersalsogainthetrianglegbh,butthisismorethanoffsetbythefundsrequiredfortheneededsubsidy.Theremainingpart
ofthesubsidyequaltotrianglebfhisadeadweightlossasresourcesvaluedmorehighlyinalternativeusesaretransferredtotheindustryin
questionwherethemarginalvalueofoutputisonlyP G.

Forcompetitiveproducers,thesupplycurvetellsusthemarginalcostofproducingeachunit.7Similarto
consumersurplus,wecanconstructameasureofproducersurplus.Foreachunitofthegoodsold,
producersurplusismeasuredbythedifferencebetweenmarketpricePCandthecorrespondingreservation
supplypriceonthesupplycurve.Byaddingupthisdifferenceforeachvalueofoutputuptothecompetitive
output,weobtaintotalproducersurplus.ThisisillustratedbytheareacbdinFigure2.5.
Notethatwhentheequilibriumquantity,QC,ofthegoodisproducedandsoldatpricePC,thetotalsurplus
orwelfaretoconsumersandproducersisgivenbytheareaabd.8
SupposethatanoutputgreaterthanQC,sayQG,wasproducedinthismarket.Forconsumerstobuythis
quantityofthegood,thepricemustfalltoPG.Thisriseinproductionandsalesresultsinanincreasein
consumersurplus.Specifically,consumersurplusincreasestoaeh.Producersurplus,however,falls.
Moreover,itfallsbymorethantheincreaseinconsumersurplus.Muchoftheriseinconsumersurplusthat
resultsfrommovingtooutputQGinparticular,theshadedareacbgeisnotanincreaseintotalsurplus.It
simplyreflectsatransferofsurplusfromproducerstoconsumers.Asfortheadditionalincreaseinconsumer
surplusthetrianglegbhthisisclearlylessthantheadditionaldecreaseinproducersurplusthetriangle
gfh.ProducersnowreceiveapositivesurplusonlyonthefirstQ'unitsproduced.Becausethegainin
consumersurplusislessthanthelossinproducersurplus,theoverallsurplusatoutputQGislessthanthat
atoutputQC.ItiseasytorepeatthisanalysisforanyoutputgreaterthanQC.Inshort,wecannotincrease
totalsurplusbyraisingoutputbeyondthecompetitivelevelwecanonlydecreaseit.
AsimilarthoughtexperimentwillshowthatoutputlevelsbelowQCalsoreducethetotalsurplus(see
PracticeProblem2.3).ThisisbecauserestrictingoutputtobelessthanQCreducesconsumersurplusby
morethanitraisesproducersurplus.Accordingly,theoverallsurplusatanoutputbelowQCmustbesmaller
thanthesurplusunderperfectcompetition.Notethatsayingthatneitheranincreasenoradecreasein
outputfromQCcanincreasethetotalsurplusbutonlydecreaseitisequivalenttosayingthatthetotal
surplusismaximizedatQC.Yetifwecannotincreasethetotalsurplusthenwecannotmakeanyonebetter
offwithoutmakingsomeoneworseoff.Thatis,ifwecannotmakethesizeofthepiebigger,wecanonlygive
moretosomeindividualsbygivinglesstoothers.Becausethisisthecaseunderperfectcompetition,the
perfectlycompetitiveoutputisefficient.9
2.3PracticeProblem
Returntothecellularphoneindustrywhenitwasorganizedasaperfectlycompetitiveindustry.Usethe
informationinPracticeProblem2.1toworkoutconsumersurplusandproducersurplusinacompetitive
equilibrium.
1.ShowthatwhenQC=500unitsandPC=$30perunitthenconsumersurplusisequalto$22,500and
producersurplusisequalto$5,000.Thisresultsinatotalsurplusequalto$27,500.
2.Showthatwhenanoutputof275unitsisproducedinthisindustry,thesumofconsumerandproducer
surplusfallsto$21,931.25.

2.2.2TheMonopolistandtheSocialSurplus

Nowconsiderthemonopolyoutcome.Ifthisisinefficient,itmustbepossibletoshowthatbyproducingan
outputleveldifferentfromthemonopolyoutputQM,thetotalsurplusrises.Thewaytoshowthisissimilarto
thesolutiontoPracticeProblem2.3andisshowninFigure2.6.Thisfigureshowsthecompetitiveoutput
andprice,QCandPCrespectively,muchasinFigure2.5.However,inFigure2.6wealsoshowwhat
happenswhentheindustryismonopolized.ThemonopolistproducesoutputQMandsetspricePM.
Consumersurplusisthenthetrianglejax.Themonopolist'sprofitatQMismeasuredbyareajxzk.Thesum
ofthesetwosurplusesisaxzk.Thisisclearlysmallerthantheareaayk,whichmeasuresthetotalsurplus
obtainedintheperfectlycompetitiveoutcome.
Itisworthnotingthatwhilethetotalsurplusisgreaterunderperfectcompetitionthanitisundermonopoly,
theoppositeholdstrueforproducersurplus.True,amovefrommonopolytocompetitiongainstheproducer
surpluswyz.ButtoachievethisgainrequiressettingthecompetitivepricePCandtheconsequentlossofthe
firm'ssurplus,hjxw.Thelossisgreaterthanthegain.

Figure2.6Thedeadweightlossofmonopoly
ThemonopolistproducesQMunitsandsellseachatpriceP M.AcompetitiveindustryproducesQCunitsandeachsellsatapriceofP C.The
deadweightlosscausedbyamovefromcompetitiontomonopolyistrianglexyz.

Notethatthereductioninconsumersurplusthatmonopolycausesisnotpurelytheresultofanincreasein
themonopolist'ssurplus.Quitethecontrary,thedeclineintotalsurplusalertsustothefactthatthe
monopolist'sgainislessthantheconsumer'sloss.Inotherwords,asaresultofmovingfromacompetitive
industrytooneofmonopoly,consumerslosemorethantheprofitthatthemonopolistearns.Theyalsolose
anadditionalamounttheareaxwyinFigure2.6beyondthatpartoftheirsurplusthatistransferredtothe
monopolist.
Theareaoftheshadedtrianglexyzisanexactmeasureofinefficiencyundermonopoly.Theupper
boundaryofthistrianglecomprisespointsthatlieontheconsumers'demandcurve.Everypointonthis
boundaryindicatesthemarginalvaluethatconsumersplaceonsuccessiveincreasesinoutputbeyondQM.
Thelowerboundaryofthistriangletracesoutthemarginalcostofproducingthisadditionaloutput.The
trianglexyzthusreflectsallthetradesthatgenerateasurplusbutthatdonottakeplaceundermonopoly.
Withinthistriangle,thepricethatconsumerswouldwillinglypayexceedsthecostofproducingextraunits,
andthisdifferenceisthesurpluslostthatis,earnedbynooneduetomonopolizationoftheindustry.If
thisadditionaloutputwereproduced,therewouldbeawaytodistributeitandmakeonepersonbetteroff
withoutloweringtheprofitofthemonopolistorthewelfareofanyotherindividual.Thetrianglexyzisoften

referredtoasthedeadweightlossofmonopoly.Itisalsoagoodapproximationofthegainstobehadby
restructuringtheindustrytomakeitacompetitiveone.
Again,itisworthrepeatingthatthedeadweightlossinFigure2.6isnotduetotheexcessprofitofthe
monopolist.Fromtheviewpointofeconomicefficiency,wedonotcarewhetherthesurplusgeneratedina
marketgoestoconsumersasitdoesunderperfectcompetitionortoproducers.Thewelfaretrianglein
Figure2.6isalossbecauseitreflectsthepotentialsurplusthatwouldhavegonetosomeoneconsumers
orproducershadtheefficientoutputbeenproduced.Itisnotthedivisionofthesurplusbutitstotalamount
thatisaddressedbyeconomicefficiency.
Efficiencyisapowerfulconceptbothbecauseofitsunderlyinglogicandbecauseitisopentoexplicit
computation.Withappropriatestatisticaltechniques,economistscantrytocalculatethedeadweightlossof
Figure2.6foragivenindustry.Hence,theycanestimatethepotentialgainsfrommovingtoamore
competitivemarket.
2.4PracticeProblem
Waterisproducedandsoldbythegovernment.DemandforwaterisrepresentedbythelinearfunctionQ=
502P.Thetotalcostfunctionforwaterproductionisalsoalinearfunction:TC(Q)=100+10Q.Youwill
alsoneedtoworkoutboththeaveragecostofproduction,denotedbyAC(Q),equaltothetotalcostof
producingaquantityofoutputdividedbythatquantityofoutput,TC(Q)/Q,andthemarginalcostof
production,denotedbyMC(Q),whichistheadditionalcostincurredtoproduceonemoreunit.
1.Whatfeeshouldthegovernmentchargeperunitofwaterinordertoreachtheefficientallocation?
2.Howmuchshoulditchargeifitwishestomaximizeprofitfromthesaleofwater?
3.Whatisthevalueoftheefficiencylossthatresultsfromchargingthepriceinpartbratherthantheprice
determinedinparta?

2.3INTERTEMPORALCONSIDERATIONSANDCONSTRAINTSON
MONOPOLYPOWER
Boththecompetitionandthemonopolymodelsdescribedintheprevioussectionaresomewhatvaguewith
respecttotime.Whilesomedistinctionismadebetweentheshortrunandthelongrun,neitherconcept
explicitlyconfrontsthenotionofaunitoftimesuchasaday,aweek,amonth,orayear,orofhowmany
suchunitsconstitutesay,thelongrun.Tomaximizeprofitinthelongrunrequires,forexample,onlythatthe
firmmakeallnecessaryadjustmentstoitsinputsinordertoproduceattheoptimumlevel,andthen
repeatedlychoosethisinputoutputcombinationineveryindividualperiod.Fromthestandpointofdecision
makingthen,thelongrunisenvisionedasasinglemarketperiodandtheassumptionthatthefirmwillseek
tomaximizeprofitisunambiguousinitsmeaning.
However,therecognitionthatthelongrunisaseriesofindividual,finitetimeperiodsextendingfarintothe
futurealsoraisesthepossibilitythateachsuchperiodwillnotbethesame.Thechoicemaywellbebetween
takinganactionthatyieldsprofitimmediatelyversustakinganactionthatyieldsperhapsgreaterprofitbut
notuntilmanyperiodslater.Insuchasetting,themeaningofmaximizingprofitislessclear.Isitbetteror
worsetohavemoreprofitlaterandlessprofitnow?Howdoesonecompareprofitinoneperiodwithprofitin

another?Suchquestionsmustbeansweredifwearetoprovideausefulanalysisofthestrategicinteraction
amongfirmsovertime.
Sacrificingprofittodaymeansincurringacost.Hence,theproblemjustdescribedarisesanytimethatacost
isincurredinthepresentinreturnforbenefitstoberealizedmuchlater.Firmsoftenfacesuchatradeoff.A
classicexampleisthedecisiontobuildanewmanufacturingplant.Iftheplantisconstructednow,thefirm
willimmediatelyincurtheexpenseofhiringarchitectsandconstructionworkersandthebuyingofbuilding
materials,machinery,andequipment.Itwillonlybesometimelateraftertheplantisbuiltandrunning
smoothlythatthefirmwillactuallybegintoearnsomeprofitorreturnonthisinvestment.

2.3.1Discounting,PresentValue,andIntertemporalTrades
Inordertounderstandhowfirmsmakedecisionsinwhichthecostsandbenefitsareexperiencednotjustin
oneperiodbutinsteadovertime,weborrowsomeinsightsfromfinancialmarkets.Afterall,thecomparison
ofincomereceived(orforegone)atdifferentpointsintimeisreallywhatfinancialmarketsareallabout.
Thinkforamoment.Ifonebuyssomestockin,say,Microsoft,onehastogiveupsomefundstoday
namely,thepriceofashareinMicrosofttimesthenumberofsharesbought.Ofcourse,investorsdothis
everyday.ThousandsofMicrosoftsharesareboughteverydayoftheweek.Theseinvestorsarethus
sacrificingsomeoftheircurrentwealthwhichcouldalternativelybeusedtopurchaseaCaribbean
vacation,wardrobe,orotherconsumergoodstobuytheseshares.Whydoinvestorsdothis?Theanswer
isthattheydosointheexpectationthatthoseshareswillpaydividendsandwillalsoappreciateinvalue
overtime.Thatis,stockholdersbuysharesofstockandincurtheassociatedinvestmentexpensenow,in
thehopethattheownershipofthoseshareswillgenerateincomelaterintheformofdividendsandcapital
gains.
Inshort,thefinancialmarketsareexplicitlyinvolvedintradingcurrentforfutureincome.Accordingly,wecan
usethetechniquesofthosemarketstoevaluatesimilartradesofcurrentversusfutureprofitthatafirm
mightmake.Thekeyinsightthatweborrowfromfinancialmarketsisthenotionofpresentvalueor
discounting.Tounderstandtheconceptofdiscounting,imaginethatafriendhasaskedtoborrow$1,000for
twelvemonths.Supposefurtherthatforyoutolendhermoneyrequiresthatyouwithdraw$1,000fromyour
checkingaccount,anaccountthatpays3percentinterestperyear.Inotherwords,youwillhavetolose
about$30ofinterestincomebymakingthiswithdrawal.Althoughyoulikeyourfriendverymuch,youmay
notseepreciselywhyyoushouldmakeheragiftof$30.Therefore,youagreetolendherthe$1,000today
if,ayearfromnow,shepaysyounotonlythe$1,000ofprincipalbutalsoanadditional$30ininterest.Your
friendwilllikelyagree.Afterall,ifsheborrowedfromthebankdirectlyshewouldhavetopayatleastas
much.Thebankcannotaffordtopayyou3percentperyearifitdoesnotchargeaninterestrateatleastas
highwhenitloansthosefundsout.Infact,thebankwillprobablychargeaninterestrateabithighertocover
itsexpenses.Therefore,itmakessenseforyourfriendtoagreethatyougiveher$1,000todayandthatshe
giveyou$1,030intwelvemonths.
Quiteexplicitly,youandyourfriendhavejustnegotiatedatradeofpresentfundsforfuturefunds.Infact,
youhaveestablishedtheexacttermsatwhichsuchatradecantakeplace.Onethousanddollarstodaymay
beexchangedfor$1,030oneyearfromnow.Ofcourse,matterswouldhavebeenabitdifferentifthe
interestratethatyourbankpaidondepositshadbeen5percent.Inthatcase,youwouldhaveaskedyour
friendfor$50(5percentof$1,000)inrepaymentbeyondthe$1,000originallyborrowed.Thatwouldhave
beentheonlyrepaymentthatwouldtrulycompensateyouforyourlossoftheinterestonyourbankdeposit.

Ingeneral,ifwedenotetheinterestrateasr,thenwehavethat$1,000todayexchangesfor(1+r)times
$1,000inoneyear.Ifwenowbecomeevenmoregeneralandconsideraninitialloanamountdifferentfrom
$1,000,sayofY,wewillquicklyseethatthesamelogicimpliesthatYtodaytradesfor(1+r)Ypaidintwelve
months.
Thereis,however,analternativewaytoviewthetransactionsjustdescribed.Insteadofaskinghowmuch
moneyonewillreceiveinayearforgivingup$1,000(orY)now,wecanreversethequestion.Thatis,we
canaskinsteadhowmuchwehavetopaytodayinordertogetaparticularpaymentoneyearfromthe
present.Forexample,wecouldaskhowmuchitwouldcostrightnowtobuyacontractrequiringthatthe
otherpartytothedealpayus$1,030inayear.Iftheinterestrateis3percent,theansweriseasy.Itis
simply$1,000.Infact,thisisthecontractwithyourfriendthatwejustconsidered.Youessentiallypaid
$1,000topurchaseapromisefromyourfriendtopayyou$1,030inoneyear.Theintuitionisthatatan
interestrateof3percent,thebanksandthefinancialmarketsaresayingthatinreturnforadepositof
$1,000theypromisetopay$1,030inoneyear.Inotherwords,wecanbuythecontractwearethinking
aboutforexactly$1,000fromthebanks.There'snosenseinpayingmoreforitfromanyoneelse,andno
oneelseisgoingtoacceptless.Therefore,whentheinterestrateis3percent,themarketissayingthatthe
currentpriceofacontractpromisingtopay$1,030inoneyearisexactly$1,030/(1.03)or$1,000.Because
priceisjusttheeconomist'stermforvalue,wecallthisthepresentvalueor,morecompletely,thepresent
discountedvalueof$1,030dueintwelvemonths.
Moregenerally,thepresentvalueofapieceofpaper(e.g.,aloancontractorshareofstock)promisingits
ownerapaymentofZinoneperiodisjustZ/(1+r).Theterm1/(1+r)istypicallyreferredtoasthediscount
factorandisoftenpresentedjustasR.Inotherwords,R=1/(1+r).Hence,thepresentvalueofZdollars
oneyearfromnowisoftenwrittenasRZ.Thesourceoftheadjectivediscountshouldbeclear.Incomethat
doesnotarriveuntilayearfromnowisnotasvaluableasincomereceivedtoday.Instead,thevalueofsuch
futureincomeisdiscounted.Thishasnothingtodowithinflationandanypossiblecheapeningofthe
currencyovertime.Itsimplyreflectsthefactthatindividualsprefertohavetheirconsumptionnowandhave
tobepaidapremiumaninterestratereturninordertobepersuadedtowait.
Whatifthetermoftheloanhadbeenfortwoyears?Letusreturnagaintoouroriginalexampleofa$1,000
loanat3percentinterest.Ifyourfriendhadinitiallyaskedtoborrowthefundsfortwoyears,yourreasoning
mighthavegoneasfollows.MakingatwoyearloantomyfriendrequiresthatItake$1,000outofmy
checkingaccounttoday.Notmakingtheloanmeansthatthe$1,000staysinthebank.Inthiscase,Iwill
earn3percentoverthenexttwelvemonthsand,accordingly,startthenextyearwith$1,030inthebank.I
willthenearn3percentonthisamountoverthenextorsecondyear.Accordingly,byrefusingmyfriendand
keepingthefundsinthebank,Iwillhaveondeposit$1,030(1.03)=$1,060.90intwoyears.Therefore,Iwill
onlylendmyfriendthefundsfortwoyearsifsheinturnpromisestopayme$1,060.90thesameasIcould
haveearnedatthebankwhentheloanexpirestwentyfourmonthsfromnow.Notethattheamount
$1,060.90canbealternativelyexpressedas$1,000(1.03)(1.03)=$1,000(1.03)2.Ingeneral,aloantodayof
amountYwillyieldY(1+r)2orYR2intwoyears.Byextension,aloanofYdollarsfortyearswillyieldan
amountofY(1+r)torYRtwhenitmaturestyearsfromnow.
Asbefore,wecanturnthequestionaroundandaskhowmuchweneedtopaycurrentlyinordertoreceive
anamountofZdollarsatsomedatetperiodsintothefuture.Theanswerfollowsimmediatelyfromourwork
above.ItisRtZ.Howdoweknowthis?IfweputtheamountRtZdollarsinaninterestbearingaccounttoday,

thentheamountthatcanbewithdrawnintperiodsis,byourpreviouslogic,(RtZ)Rt=Z.So,clearly,the
presentdiscountedvalueofanamountZtobereceivedtperiodsinthefutureisjustRtZ.
Theonlyremainingquestionishowtovalueaclaimthatprovidesdifferentamountsatdifferentdatesinthe
future.Forexample,considertheconstructionofaplantthatwill,aftercompletioninoneyear,generateZ 1
innetrevenueanetrevenueofZ 2twoyearsfromnowZ 3threeyearsfromnowandsoon.Whatisthe
presentvalueofthisstreamoffuturenetrevenues?
ThepresentvalueofZ 1inoneperiodis,asweknow,RZ 1.Similarly,thepresentvalueoftheZ 2tobe
receivedintwoperiodsisR2Z 2.Ifwecontinueinthismanner,wewillworkoutthepresentvalueofthe
incomereceivedateachparticulardate.Thepresentvalueofthisentirestreamwillthensimplybethesum
ofalltheseindividualpresentvalues.Ingeneral,thepresentvaluePVofastreamofincomereceiptstobe
receivedatdifferentdatesextendingTperiodsintothefutureis:

Aspecialcaseofequation(2.3)occurswhentheincomereceivedineachperiodZ tisthesame,thatis,
whenZ 1=Z 2=...=Z T=

.Inthatcase,thepresentvalueofthetotalstreamis:

AnevenmorespecialcaseoccurswhennotonlyistheincomereceiptconstantatZ=

,butalsothestreampersistsintotheindefinitefuturesothattheterminalperiodTapproachesinfinity.In
thatcase,becausethediscountfactorRislessthanone,thetermRT+1inequation(2.4)goestozero.
Hence,whenthestreamisbothconstantandperpetual,thepresentvalueformulabecomes:

Thus,iftheinterestraterwere3percent,apromisetopayaconstant$30foreverwouldhaveapresent
valueofPV=$30/0.03=$1,000.Notethatforallourpresentvalueformulas,anincreaseintherealinterest
raterimpliesadecreaseinthediscountfactorR.Inturn,thismeansthatariseintheinterestrateimpliesa
decreaseinthepresentvalueofanygivenfutureincomestream.
Again,itisimportanttorememberthecontextinwhichtheseequationshavebeendeveloped.Oftenfirm
decisionmakinghasatemporaldimension.Indeed,ourfocusonlongrunequilibriaimpliesthatweare
consideringjustsuchdecisions.Hence,weneedtoconsidertradeoffsthataremadeovertime.Anexpense
mayneedtobeincurrednowinordertoreapadditionalprofitatsomefuturedateordates.Thesimple
dictummaximizeprofitdoesnothaveaclearmeaninginsuchcases.Theonlywayofevaluatingthe
desirabilityofsuchatradeoffovertimeistodiscount,thatis,translatethefuturedollarinflowsintoacurrent
orpresentvaluethatmaythenbecomparedwiththecurrentexpensenecessarytosecurethosefuture
receipts.Ifthepresentvalueofthefutureincomeisnotatleastasgreatasthevalueofthenecessary
expense,thenthetradeoffisnotfavorable.If,forinstance,aplantcosts$3milliontobuild,andwill

generatefutureprofitwithadiscountedpresentvalueofonly$2million,itisnotadesirableinvestment,and
wewouldnotexpectarationalfirmtoundertakeit.10Inshort,ourassumptionthatfirmsmaximizeprofit
mustnowbequalifiedtomeanthatfirmsmaximizethepresentvalueofallcurrentandfutureprofit.Of
course,foroneperiodproblems,thisisidenticalwiththeassumptionthatfirmssimplymaximizeprofit.
However,wewillneedtobefamiliarwiththeideaofdiscountingandthepresentvalueoffutureprofitsinthe
secondhalfofthebookwhenwetakeupsuchissuesascollusion,research,anddevelopment,whichoften
haveamultiperioddimension.
RealityCheckpoint
TicketDiscounts
ArecentstudybytheNationalHighwayTrafficSafetyAdministrationrevealsthatnearly80percentofdrivers
admittospeedingwithinthelastmonthand25percentadmittospeedingthatday.Givenattitudesregarding
whattrulyconstitutesspeedingandwillingnesstoadmittoillegalbehavior,aprudentguessisthat
somethinglike50percentofthedriversaredrivingabovethepostedspeedlimitsonmultilaneinterstate
highwaysatanytime.
Ofcourse,theprospectofbeingpulledoverandticketedbythepoliceisadeterrenttooverlyfastdriving.
Finesvarybystatebutafineof$200forthosegoing15milesoverthepostedlimitiscommon,andthatfine
isjustpartofthecost.Anothermajorpartistheimpactofaspeedingconvictiononone'sautoinsurance.In
Massachusetts,forexample,onespeedingticketadds30percenttothecostofinsuranceinfourareas:1)
bodilyinjury,2)propertydamage,3)personalinjury,and4)collisionforatotalof$300extrainannual
insurancecostforatleastthreeyears.AssumingadiscountfactorofR=0.97(aninterestrateofabout3
percent),thecostofaspeedingticketis:$200+$300+R$300+R2$300=$1073.
Notallspeedersarecaught.RoughevidencefromMassachusettsandVirginiasuggeststhatatypicaldriver
averaging1015milesoverthespeedlimithasabouta15percentchanceofbeingticketedeveryyear.
Hence,overathreeyearperiod,theaveragedriver,forwhomtheprobabilityofasecondspeedingticketis
basicallyzero,hasanexpectedspeedingcostof:0.15*$1073+0.15R$1073+0.15R2$1073=$469.This
costcanbeavoidedthoughbypurchasingahighqualityradar(andlidar)detectorsuchasEscort'sPassport
9500i,Cobra'sXR5R9G,ortheBeltronicsBelSTiDriver.Theseretailfor$450to$500andlastaboutthree
yearsbeforetheyeitherbecomeoverlysensitiveandgivesomanyfalsewarningsthatdriversturnthemoff
orpoliceupdatetheirtechnologiestomakethatgenerationofdetectorsobsolete.
So,thenetbenefitofbuyingadetectorforatypicaldriverissmall.Forthetruesuperspeeders,though,
whoregularlypushthepedaltothemetalandwhothereforefacesubstantiallyhigherprobabilitiesofgetting
aticket,purchasingadetectormaywellseemagoodinvestment...butslowingdownmaybecheaper.
Source:J.WelshNoRadarDetectorsGiveSpeedFreaksaRush,WallStreetJournal,January10,2008,
p.D1.NationalHighwayTrafficSafetyAdministration,NationalSurveyofSpeedingandUnsafeDriving
Attitudes&Behaviors,(2003).
2.5PracticeProblem
SuiteEnterprisesisalargerestaurantsupplyfirmthatdominatesthelocalmarket.Itdoes,however,have
onerival:LoewSupplies.Becauseofthiscompetition,Suiteearnsaprofitof$100,000peryear.Itcould,
however,cutitspricestocostanddriveoutLoew.Todothis,Suitewouldhavetoforegoallprofitforone

yearandearnzero.Afterthatyear,LoewwouldbegoneforeverandSuitecouldearn$110,000peryear.
TheinterestrateSuiteconfrontsis12percentperannum,andthusthediscountfactorR=0.8929.
1.IsdrivingLoewoutofthemarketagoodinvestmentforSuite?
2.ConsiderthealternativestrategyinwhichSuitebuysLoewfor$80,000todayandthenoperatesthe
newlycombinedfirm,Suite&Loew,asamonopolyearning$110,000inallsubsequentperiods.Isthisa
goodinvestment?

2.3.2TimeandtheEvolutionofIndustryStructure
Considerationsoftimealsointroducesomepotentialconstraintsontheexerciseofmonopolypowerand,
consequently,ontheamountofwelfarelossthataccompaniessuchpower.Onesuchmechanismreflects
thedynamicsofindustrialstructure.Inourtextbookanalysisabove,wesimplyassumedthatthemarkethad
eitheracompetitiveormonopolystructure.Wedidnotaskhowthatstructurewasachievedorwhetheritis
stable.Inthissense,theanalysisisshortrunincharacter.Thisisnottosaythatitisinaccurate.Thewelfare
lossassociatedwithmonopolypricingisreal.Theremaybesomequestion,though,astowhetheritwillbe
longlasting.Whetherornotthisisthecasedependsinpartonwhethertheeconomicprofitorsurplusthat
themonopolyfirmearnswillattractentryandcompetitionovertime.
Asnotedearlier,asensiblerequirementforalongrunequilibriumisthatthereisnoincentiveforthe
industrystructuretochange.Inotherwords,thereshouldbenoincentiveforanyfirmtoexitorenterthe
industry.Therearemanywaystoimposethiscondition.Themostcommononehoweveristoassumethatit
requiresthateachfirmintheindustryearnzeroeconomicprofit.11Inotherwords,foreachfirm,total
revenuePqiequalstotalcostC(qi).Dividingeachsidebythefirm'soutput,qi,revealsthatthisisequivalent
toimposingtheconstraintthatfirmsexitorenteruntilthemarketpriceequalsaveragecost,whereaverage
costisdefinedastheratiooftotalcosttototalproductionorcostperunit.
Wewillreturntoamorecompletediscussionofaverage(andmarginal)costagaininChapter4whenwe
discusstheproductiontechnologyanditsimplicationsforthefirm'scostsinsomedetail.Fornow,wesimply
notethatimposingthelongrunequilibriumconditionthatpriceequalsaveragecostprovidesawayto
determinetheequilibriumstructureoftheindustry.Totheextentthatthatstructurehasmorethanonefirm
init,thatis,totheextentthatthemarketpermitsentrybyrivalsovertime,themonopolist'sabilitytosustain
apricefarabovemarginalcostwillbelessened.Indeed,evenifthemarketonlyhasonefirm,theabilityof
thatfirmtopriceabovemarginalcostmaybesharplycurtailedbythethreatofpotentialentrantswhowould
comeintothemarketreadilyandundercutsuchpricing.Thisinfactisthefundamentalideabehindtheidea
ofcontestablemarkets.12
Atthesametime,itisimportanttorecognizethatafirmwithmonopolypowermaybeabletotakeactions
thatprotectthatpoweragainstrivalentrantsovertime,andthatpushtheevolutionofmarketstructure
towardthemonopolypole.Inshort,marketstructureatanypointintimemaynotbeanaccurategaugeof
theintensityofcompetitioninanindustry.Evenamonopolistcanbeconstrainedbytheprospectofactualor
potentialentry.Itisequallyimportanttorecognizethatbecausebothentryandentrydeterrencetypically
requirethatacostbeincurredtodayinreturnforhigherprofitsinthefuture,analysisoftheseissues
inevitablyinvolvescomparisonofprofitsatdifferentpointsoftimeandtheuseofthediscountingtechniques
justdiscussed.

2.3.3DurableGoodsandtheCoaseConjecture

Asecondwayinwhichattentiontotimeconsiderationsmayrevealaconstraintonmonopolypowerarisesin
connectionwithdurablegoods.Unlike,say,food,manygoodssuchashouseholdappliancesand
automobileslastanumberofyears.Inturn,thismeansthatamonopolisthastothinkcarefullyaboutthe
priceinitiallysetandthevolumesoldtoday.Thatsupplywillstillbearoundtoinfluencemarketoutcomes
oneortwoperiodslater.NobellaureateRonaldCoasearguednearly40yearsago(Coase1972)thatthis
durabilitymightgreatlyreduceifnoteliminatetheabilityofthemonopolisttosetpricesabovetheefficient
leveleveninthecurrentperiod.
Considerthefollowingexample.Thetimeframehastwodiscreteperiods.Amonopolisthastwounitsofa
durablegoodthatwillprovideservicestoanownerineachofthetwoperiodswithnolossdueto
depreciation.Therearetwosuchpotentialconsumers.Onevaluestheservicesofthegoodat$50per
period.Theothervaluestheseservicesat$30perperiod.Thus,forthehighvalueconsumerthepresent
valueofservicesfromthegoodis$50+R$50=(1+R)$50,whileforthelowvalueconsumeritis(1+
R)$30.Becausethemonopolisthasthetwounitsalready,marginalproductioncostiszero.Inturn,this
impliesthatthemaximumtotalsurplusavailableinthismarketis(1+R)$80.Anyoutcomethatyieldsthis
surplusisefficient,butanyoutcomethatyieldsatotalsurpluslessthan(1+R)$80isinefficient.
Ofcourse,themonopolistseekstomaximizehisownsurplus,notthetotalsurplus.Indoingso,hewill
recognizethefollowingconstraints.First,anyfirstperiodpricebelow(1+R)$30willresultinboth
consumerspurchasingthegoodinthefirstperiodandthemarketprocesswilleffectivelyend,i.e.,therewill
benomoresalesinperiod2.Themonopolisthasnothinglefttosellinthesecondperiodandboth
consumerscontinuetoenjoytheservicesofthegoodthenbecauseitisdurable.Second,anypriceabove
(1+R)$30willresultinthesaleofeitheroneunitinthefirstperiod,ifthepriceislessthan(1+R)$50,orno
unitsifitishigher.Inthefirstcase,themonopolistwillenterthesecondperiodwithoneunitleft,whichcan
thenbesoldtothelowvalueconsumerfor$30.Inthesecondcase,themonopolistwillfacethechoice
betweensellingeitherbothunitsatapriceof$30oroneunitatapriceof$50.Clearly,thebestoptioninthis
caseistosellbothat$30foratotalsecondperiodprofitof$60.
Animportantimplicationoftheforegoinganalysisisthatanyandallsecondperiodsalesmusttakeplaceat
apriceof$30.Thereissimplynowaythatthemonopolistcanmakeacrediblefirstperiodcommitmentto
anysecondperiodpriceabovethisamount.Giventhis,wecannowconsiderthestrategyofmakingone
firstperiodsaletothehighvalueconsumeratapriceof(1+R)$50fromtheviewpointofthatconsumer.
Thedifficultywiththisstrategyisthenimmediatelyapparent.Confrontedwithafirstperiodpriceof(1+
R)$50,thehighvalueconsumercaneitherbuyinthefirstperiodandearnzerosurplusordeferthe
purchasetothesecondperiodknowingthatthepricewillthenbe$30,andthattherewillthereforebea
surplusofR$20inpresentvalueterms.Thehighvalueconsumerwillobviouslychoosethelatter.Itfollows
thatthemonopolistcannothopetomakeafirstperiodsaleat(1+R)$50.Thefactthatthesecondperiod
pricemustbe$30makesthisimpossible.
Whataboutapricebelow(1+R)$50butabove(1+R)$30?Considerthefirstperiodprice,(1+R)$(30+

),where

isasmallpositiveconstant.Suchapricegivesthehighvalueconsumerasurplusof(1+R)$(20

).Iftheconsumerinsteadwaitsandpurchasesthegoodnextperiodat$30,therewillbeasurpluswith
presentvalueR$20.Thus,inorderforthemonopolisttoselltothisconsumerinthefirstperiod,itmustbe
thecasethatthemonopolistoffersapricesuchthat

Inotherwords,themaximumpricethatthemonopolistcansetinthefirstperiodinordertoselljustoneunit
is(1+R)

=(1+R)$30+$20.
Inlightoftheabove,wecannowgreatlysimplifythemonopolist'sproblem.Eitherselltwounitsinthefirst
periodeachatapriceof(1+R)$30oroneunitinthefirstperiodatapriceof(1+R)$30+$20anda
secondunitinthefollowingperiodatapriceof$30ornounitsinthefirstperiodbutbothunitsinthesecond
periodatapriceof$30.ThecorrespondingprofitsareshowninTable2.1.
AlittlealgebrawillconfirmthatthefirstrowoptioninTable2.1givesthegreatestprofitinpresentvalue
terms.Thatis,themonopolistwillmaximizeprofitbysettingafirstperiodpriceof(1+R)$30andselling
bothunitsimmediately,onetoeachconsumer.Themonopolistwillthenearnasurplusof2(1+R)$30.The
highvalueconsumerwillearnasurplusof(1+R)$20,whilethelowvalueconsumerwillearnzerosurplus.
Thetotalsurpluswillthusbe2(1+R)$30+(1+R)$20=(1+R)$80,themaximumamountpossible.In
otherwords,thedurablefeatureofthegoodhasconstrainedthemonopolisttosetefficientpricesones
thatmaximizethesurplus.ThisisCoase'sconjecture.Itisthesuppositionthatdurabilityconstrains
monopolypricingsoastoeliminateanydeadweightloss.
However,justastheefficacyofentryasadisciplineonmonopolybehaviorcanbeweakened,sotoocanthe
impactofdurability.Considerhowtheaboveexamplewouldhavebeenalteredhadthelowvalueconsumer
onlyvaluedtheservicesofthedurablegoodat$20perperiodor(1+R)$20intotal.Inthiscase,itisnow
nolongerthecasethatanyandallsecondperiodsalesmusttakeplaceatthemaximumpriceofthelow
valueconsumer,whichisnow$20.Ifthemonopolistsellsnounitsinthefirstperiodandentersthesecond
periodwithtwounitstosell,itwillbepreferabletoselljustoneunittothehighvalueconsumerat$50rather
thanbothunitsat$20apiece.Itfollowsthatthehighvalueconsumercannolongerbargainsoaggressively
inthefirstperiod.Thisconsumerwillnowpreferanypriceof(1+R)$(50

)inthefirstperiodthatprovidesasurplusof(1+R)$

toapriceof$50inthesecondperiodthatprovidesasurplusofzero.Thus,bymaking

arbitrarilysmall,themonopolistcaninducethehighvalueconsumertobuyinthefirstperiod,andthensell
atapriceof$20tothelowvalueconsumerinthesecondperiod.Neitherconsumerwillenjoyanysurplus,
whilethemonopolistwillearnaprofitof(1+R)$50+R$20.Ascanbeeasilyverified,themaximumsurplus
availableinthiscaseis(1+R)$70,whichis$20greaterthanthesurplusactuallyrealized.Here,durability
hasnoteliminatedthedeadweightlossofmonopoly.

Thedifferenceinthetwocasesreflectsthedistributionofconsumervaluations.Inbothcases,this
distributionisdiscrete.However,thejumpfromonevaluationtothenextismoresubstantialinthesecond
case.Heuristically,valuationsarelesscontinuousinthatsetting.Thispointstoageneralizationregarding
theCoaseconjecture.Themorethatconsumervaluationsarecontinuous,themorethatdurability
constrainsmonopolypricingofdurablegoodstobeefficient.Indeed,asthedistributionbecomesperfectly
continuous,themonopolistmaybeforcedtosetcompetitiveprices.Ingeneral,durabilitywill,likepotential
entry,imposesomelimitsontheexploitationofmonopolypowerandtheextentoftheassociatedwelfare
loss.13
Table2.1Priceoptionsandcorrespondingprofitforthedurablegoodsmonopolist

2.3.4TheNonsurplusApproachtoEconomicEfficiency 14
LetusreturntothesecondexampleinthediscussionoftheCoaseconjectureaboveinwhichtheCoase
conjecturefails.Recallthattheefficientfirstperiodpriceis(1+R)$20resultinginatotalsurplusof(1+
R)$70,butthatthemonopolistinsteadsetsaninitialpriceof(1+R)$50andasubsequentsecondperiod
priceof$20,resultinginadeadweightlossof$20.Wemayasknowhowmattersmightbedifferenthad
therebeenfiftyhighvalueconsumersandfiftylowvalueonesagainassumingthatthemonopolisthasjust
twounits.
Thefirstthingtonoteisthatthetotalsurplusnowavailableonthemarketis2(1+R)$50.Atafirstperiod
priceof(1+R)$50,twounitswillbesoldtotwoofthe50highvalueconsumersandallofthissurpluswillgo
tothemonopolist.Infact,nootherpriceispossible.Nonewouldbuyatahigherprice.Moreover,atany
lowerprice,thehighvalueconsumerswouldactivelycompetewithhigherbidsuntilagainthepriceroseto
(1+R)$50.Hereisanothercaseinwhichprofitmaximizationbythemonopolistisconsistentwithefficient
resourceallocation.
Whydoesthishappenhere?Whyisitthatnow,despitethesizeabledifferencesinconsumervaluations
betweenthetwogroups,monopolypricinginvolvesnodeadweightloss?Theanswerliesinconsidering
moredeeplyjustwhatthatdeadweightlossofmonopolysignifies.Thedeadweightlossofmonopolyisreally
justtheadditionalsurplusthatthemonopolistcouldgenerateifoutputwereincreasedtotheefficientlevel.
Theproblemforthemonopolistintheconventionalsetting,e.g.,Figure2.2(b),isthatthemonopolistcannot
appropriatethefullvalueofthismarginalsurplus.Astheadditionaloutputissoldandpricemovesdownthe
demandcurve,unitsaresoldatalowerprice.Evenifthemonopolistcapturesallthesurplusonthe
marginalunits,thenetgainislessthanthisbecauselessisnowearnedoninframarginalunits.
Itistheinabilityofthemonopolisttoappropriateallthesurplusthatproductiongeneratesthatliesatthe
heartofthewelfarelossofmonopoly.Whentherearefiftyhighvalueconsumers,however,andthe
monopolistonlyhastwounitstosell,thisproblemnolongerexists.Themonopolistcanselltheefficient
amountwithoutloweringthepricetoanyinframarginalconsumer.Withinthefeasiblerangeofsales,the
monopolistgenerates(1+R)$50ofsurplusforeachunitsoldandacquiresandkeepsallthissurplus.

Whentherearefiftyhighvalueconsumers,themonopolist'soutputpotentialissmallrelativetothetotal
market.Atthemargin,thedecisiontoincreaseordecreasesalesbyoneunitandsellitat(1+R)$50,
leavesthesurplusofallothermarketparticipantsunaffected.Themarginalconsumerearnsasurplusof
zeroineithercase.Notethatthisissimilartotheperfectlycompetitivecase.There,too,eachfirmis
sufficientlysmallrelativetothemarketthatithasnoeffectonthesurplusearnedbyallotherparticipants.
Theprofitofasinglecompetitivefirmatthemarginiszeroandthisispreciselythesameasthatfirm's
contributiontothesurplusorwelfarecreatedbymarkettrading.Thesamecanbetrueforamonopolistifit
issmallrelativetotheoverallmarket.
Theunderstandingthatthecrucialfactorgivingrisetoinefficientoutcomesisthattherearemarket
participantsable,atthemargin,toalterthesurplusofotherparticipantsisknownasthenonsurplus
approachtoeconomicanalysis.Forourpurposes,itmakestheimportantpointthatitisnotthenumberof
sellersbuttheirsizerelativetothemarketthatgivesrisetoawelfareloss.Inotherwords,itisnotthefact
thatthemonopolististheonlysellerbutthefactthatthemonopolistislargerelativetothemarketthatleads
toinefficientoutcomes.15

2.4EMPIRICALAPPLICATION:TESTINGTHECOASEDURABLE
GOODSMODEL
Coase'sargumentthatmonopolistssellingdurablegoodsmaystillfacemarketpressuretoprice
competitivelyrestsonaveryrationalmodelofconsumerbehaviorinwhichconsumersareassumedtobe
forwardlookingwhenmakingtoday'sbuyingdecisions.Whetherbuyersarereallythatrational,though,is
opentoquestion.JudithChevalierandAustanGoolsbee(2009)examinethisissuebyanalyzingthecollege
textbookmarket.Theirintuitionisstraightforward:Ifthestandardmodelaccuratelydescribesconsumer
behavior,thenstudentsbuyingatextbookshouldconsiderthelikelihoodthataneweditionwillcomeout
afterthestudentisdonewithitandwantstosellitbackontheusedbookmarket.Inparticular,theprospect
thataneweditionwillcomeoutsoonshoulddepressthestudentdemandforthebook,asthiswillmakeit
hardertosellausedversion.
Toinvestigatethisissue,ChevalierandGoolsbeecollecteddatafortextbooksinbiology,economics,and
psychologyfortheyears1997through2001bysemesterandbyclass.Foreachclass,theyknowthe
assignedtextbookandhowmanypeoplewereintheclass.Theyalsoknowtheaggregatenewbooksales
ofeachtextandalsothetotalsalesofusedversionsoftheassignedtextthroughcollegebookstores.For
anytextbookiinyeart,letNitbethenumberofstudentswhoboughtthetextnewandAitbethetotal
numberofstudentsinclassesinwhichthebookwasassigned.ThenS1it=Nit/Aitistheshareofthepotential
academicclassmarketthatboughtthebooknew.Similarly,letS2itbetheshareofstudentswhoboughta
usedversionatthecollegebookstore.Finally,letS3itbetheshareofstudentswhodidnotbuytheassigned
textatall.ThevariableS1it/S3itisthenameasureofthedemandforanew,unusedbookrelativetonot
buyingthebookinanyform.Itistemptingtorelatethislinearlytothepricepitofanewbookandsomeother
independentvariablesXit,togivethesimplelinear:

Here,isavectorofcoefficientsontheXitvariables,whichincludesuchthingsaswhetherthebookisan
introductoryoradvancedtext,whetheritcomesshrinkwrappedwithastudyguideandotherancillaries,and
thebook'slevelofdifficulty,while1measurestheeffectofthebookpriceonstudentpurchasesofnew,
unusedtexts.However,ChevalierandGoolsbeerecognizethatbecausebothS1itandS3itarepositive

fractions,theirratiomustalsoalwaysbepositive.Yetitispossiblethatthedatamaygiverisetoestimatesof
and1thatpredictvaluesbelowzero.Further,thesimplerelationshipexpressedinequation(2.7)allows
nodirecttestofwhetherstudentsareforwardlookingintheirtextbookpurchases.
ChevalierandGoolsbee(2009)thereforemaketwoalterationstothesimplemodelabove.First,theymake
whatisknownasalogittransformationbyusingthenaturallogofthedependentvariable,i.e.,byusing
ln(S1it/S3it)=ln(S1it)ln(S3it).Becauselogarithmscanbenegative,thisallowsthedatatospeakfreely.
Second,theyincludeasecondpricevariable=.5(1Dit)pit,whereDitisa1,0dummyvariablethattakes
thevalue1inanysemesterinwhichaneweditionofthebookiscomingoutonesemesterlater,andzero
otherwise.Theideabehindthissecondmodificationissimple.Thetruepriceofbuyinganewtextbookisthe
pricepaidforitinitially,pit,lessthediscountedpriceforwhichstudentscansellthebookbackattheendof
theterm.ChevalierandGoolsbeefindthatthisresalepriceistypicallyontheorderof50to75percentof
theinitialprice,or0.5pit,reflectingaruleofthumbforbuybacksthatalmostallbookstoresfollow.However,if
anewversionofthetextisabouttocomeout(Dit=1),thentheresalepricefallstozero.Thus,thetrue
priceofpurchasinganewbookisgivenby:pitR0.5(1Dit)pit.Here,Rreflectsthediscountfactorthat
studentsapplytothemoneytheywillreceiveinthefuturewhentheysellthebookavariablethatisnot
directlyobserved.
Withthesemodifications,equation(2.7)becomes:

or,moregenerally,

Notethatthevalueof2=10.5Randthatitindicateswhetherornotstudentsareforwardlooking.If2=
0,thenstudentsaremyopicandconsideronlytheinitialprice.However,if2isnotzero,thenstudentsdo
consideratext'sfutureresalevalueintheiroriginalpurchasedecision,exceptinyearswhenDit=1sothat
futureresalevalueiszero.Noteaswellthatwecandefinetheratio=2/1=0.5R.Hence,ifwehave
estimatesof1and2,wecaninferthetypicalstudent'sdiscountfactorR.
ChevalierandGoolsbee(2009)estimateequation(2.9)withalternativeregressiontechniques(OLSand
GMM)includingineachcaseseveraladditionalindependentvariables(Xit).Thesearetimedummiesto
capturegeneralshiftsintextbookdemandfromoneyeartothenext,fortheparticularfieldthatthetextisin,
whetheritisbundledwithadditionalsoftwarethefractionofthetimethatthebookwasrequiredforthe
classandnotjustassigned(whichisgreaterthan0.90forallofthebooksconsidered)theaverageSAT
scoreofstudentsassignedthebooktheageoftheeditionandwhetheritisapaperback.16Forthe
purposesoftestingtheCoaseviewand,specifically,theunderlyingassumptionthatstudentsareforward
looking,wepresentonlytheirbasicresultsforthepricevariables.TheseareshowninTable2.2.
Table2.2Estimatedeffectsofcurrentpriceandfutureresalepriceontextbookdemand(standarderrorsin
parentheses)

Theseresultsconfirmboththemodelandthehypothesisthatstudentsaredefinitelyforwardlooking.The
currentpricehasahighlysignificantandnegativeeffectonnewtextbookdemand,whiletheresalepricehas
asignificantlypositiveeffectjustasitshouldforforwardlookingconsumers.Indeed,theestimatesofimply
estimatedstudentdiscountfactorsthatexceed1.Ifthiswereliterallytrue,itwouldmeanthatfarfrombeing
myopic,studentscaremoreaboutthefutureresalevaluethantheinitialpurchasepriceinbuyingatext.
However,theestimateofisnotsoprecisethatonecanruleoutmorenormal,onesemesterdiscount
factorsofsayR=0.98.
Inshort,theChevalierandGoolsbee(2009)estimatesimplythatconsumers,oratleastcollegestudents
takingbiology,economics,andpsychologyclasses,areforwardlooking.Indeed,thedifferenceinprice
sensitivityofthesestudentsdiffersdramaticallyinyearsinwhichanewversionofthetextisnotanticipated
(Dit=0)andyearsinwhichoneis(Dit=1).Intheformercase,theestimatesinTable2.2implythata10
percentriseintheinitialpurchasepricewilldecreaseinitialsalesbyonly16.3percentbecausetheyplanon
gettinghalfofthatpriceincreasebackattheendoftheterm.Incontrast,forstudentsexpectingnoresale
becauseofananticipatednewedition,a10percentpriceriseontheinitialpurchaseleadstoanearly40
percentdeclineinsales.Perhapssomewhatparadoxically,then,thepresenceofaresalemarketleadsto
higherinitialpricesasstudentsaremorewillingtopaythosepricesiftheybelievethatcanresellthebook
later.
Asauthorsofatextbookourselves,weknowthatitiswidelybelievedamongstudentsthatneweditionsare
introducedtoraiseprofitsbyeliminatingcompetitionfromusedbooks.YetChevalierandGoolsbee(2009)
showthattheirestimatesimplythatthereisnosuchincentiveforeconomicstextbooksbecausegivenhow
forwardlookingstudentsareandhowsensitivetheyaretoabook'sexpectedresalevalue,theexpected
salesrevenueforeconomicstextsvarieslittlewiththefrequencyofrevision.Fasterrevisionsmeanslower
initialsalesinamannerthatbasicallycancelsoutanygainfromeliminatingusedbookcompetition.This
evidencethuslendsfairlystrongsupporttoCoase'sargumentregardingthepricingconstraintsfacinga
durablegoodsmonopolist.

Summary
Wehaveformallypresentedthebasicmicroeconomicanalysisofmarketscharacterizedbyeitherperfect
competitionorperfectmonopoly.Inbothcases,thegoalofanyfirmisassumedtobetomaximizeprofit.
Thenecessaryconditionforprofitmaximizationisthatthefirmproduceatalevelatwhichmarginalrevenue
equalsmarginalcost.Becausefirmsincompetitivemarketstakemarketpriceasagiven,priceequals
marginalrevenueforthecompetitivefirm.Asaresult,thecompetitivemarketequilibriumisoneinwhich
priceissetequaltomarginalcost.Inturn,thisimpliesthatthecompetitivemarketequilibriumisefficientin
thatitmaximizesthesumofproducerandconsumersurplus.
Thepuremonopolycasedoesnotyieldanefficientoutcome.Themonopolyfirmunderstandsthatitcan
affectthemarketpriceandthisimpliesthatmarginalrevenuewillbelessthanthepriceforamonopolyfirm.
Ifthemarketdemandcurveislinear,thisdifferenceisreflectedinthefactthatthemonopolist'smarginal
revenuecurvehasthesamepriceinterceptbutistwiceassteeplyslopedasitsdemandcurve.Amonopoly
firmequatingmarginalrevenuewithmarginalcost,asrequiredforprofitmaximization,yieldsanoutput
inefficientlybelowthatofthecompetitiveequilibrium.Resourcesaremisallocatedbecausetoofew
resourcesareemployedintheproductionofthemonopolizedcommodity.Theinefficiencythatresultsis
oftencalledthedeadweightorwelfarelossofmonopoly.

Thereare,however,somenaturallimitstomonopolypower.Tobeginwith,monopolyprofitswillattractentry
sothatfirmswithsubstantialmarketsharesmaybeforcedtopricerelativelyclosetocompetitivelevelsby
potentialentrantswhowillswoopinandstealcustomersaway(perhapspermanently)shouldtheincumbent
firmmateriallyabuseitsmarketpower.Inaddition,monopolistsofdurablegoodsfacecompetitionfromstill
survivingunitsoftheirownearlierproduction.Thiscreatesadifficultpricingtensionthatcanagaindiscipline
thefirm'spricingand,dependingonthedistributionofconsumerreservationprices,evenforceittocharge
perfectlycompetitiveprices.Tobesure,thisdisciplinerequiresthatconsumersareforwardlookingandthat
theyconsiderfutureusedgoodpriceswhentheymaketheirinitialpurchase.Evidencefromthemarketfor
studenttextbookstendstoconfirmthatthisisthecase.
Perfectcompetitionandmonopolyformthetwopolarcasesofmarketstructure.Thebehavioroffirmsand
thenatureofmarketoutcomesinthesetwocasesarefairlywellunderstood.Theremainingquestioniswhat
happensinthefarmorecommoncasesofsomethingbetweenthesetwoextremes.Beforewedirectly
addressthatissue,however,weneedtohaveamorerigorouswayofcharacterizingthemarketsettingand
adeeperunderstandingofthetechnologicalandcostfeaturesthatgiverisetoparticularmarketstructures.
Thesearethetopicstobeaddressedinthenexttwochapters.

Problems
1.SupposethattheannualdemandforprescriptionantidepressantssuchasProzac,Paxil,andZoloftis,in
inverseform,givenby:P=10000.025Q.Supposethatthecompetitivesupplycurveisgivenby:P=150
+0.033Q.
1.Calculatetheequilibriumpriceandannualquantityofantidepressants.
2.Calculatei)producersurplusandii)consumersurplusinthiscompetitiveequilibrium.
2.Assumethatthedairyindustryisinitiallyinaperfectlycompetitiveequilibrium.Assumethat,inthelong
run,thetechnologyissuchthataveragecostisconstantatalllevelsofoutput.Supposethatproducers
agreetoformanassociationandbehaveasaprofitmaximizingmonopolist.Explainclearlyinadiagram
theeffectson(a)marketprice,(b)equilibriumoutput,(c)economicprofit,(d)consumersurplus,and(e)
efficiency.
3.Supposethatthetotalcostofproducingpizzasforthetypicalfirminalocaltownisgivenby:C(q)=2q+
2q2.Inturn,marginalcostisgivenby:MC=2+4q.(Ifyouknowcalculus,youshouldbeabletoderive
thisexpressionformarginalcost.)
1.Showthatthecompetitivesupplybehaviorofthetypicalpizzafirmisdescribedby:q=

.
2.Ifthereare100firmsintheindustry,eachactingasaperfectcompetitor,showthatthemarketsupply
curveis,ininverseform,givenby:P=2+Q/25.
4.LetthemarketdemandforwidgetsbedescribedbyQ=100050P.Supposefurtherthatwidgetscanbe
producedataconstantaverageandmarginalcostof$10perunit.
1.Calculatethemarketoutputandpriceunderperfectcompetitionandundermonopoly.
2.Definethepointelasticityofdemand

D ataparticularpriceandquantitycombinationastheratioofpricetoquantitytimestheslopeofthe

demandcurve,Q/P,allmultipliedby1.Thatis,D=

.Whatistheelasticityofdemandinthecompetitiveequilibrium?Whatistheelasticityofdemandinthe
monopolyequilibrium?
3.DenotemarginalcostasMC.Showthatinthemonopolyequilibrium,thefollowingconditionissatisfied:

.
5.Supposethattheinversedemandforclotheshangersisgivenby:P=3Q/16,000.Supposefurtherthat
themarginalcostofproducinghangersisconstantat$1.
1.Whatistheequilibriumpriceandquantityofhangersifthemarketiscompetitive?
2.Whatistheequilibriumpriceandquantityofhangersifthemarketismonopolized?
3.Whatisthedeadweightorwelfarelossofmonopolyinthismarket?
6.Asinglefirmmonopolizestheentiremarketforsinglelever,balltypefaucetswhichitcanproduceata
constantaverageandmarginalcostofAC=MC=10.Originally,thefirmfacesamarketdemandcurve
givenbyQ=60P.
1.Calculatetheprofitmaximizingpriceandquantityforthefirm.Whatisthefirm'sprofit?
2.Supposethatthemarketdemandcurveshiftsoutwardandbecomessteeper.Marketdemandisnow
describedasQ=450.5P.Whatisthefirm'sprofitmaximizingpriceandquantitycombinationnow?
Whatisthefirm'sprofit?
3.Insteadofthedemandfunctionassumedinpartb,assumethatmarketdemandshiftsoutwardand
becomesflatter.ItisdescribedbyQ=1002P.Nowwhatisthefirm'sprofitmaximizingpriceand
quantitycombination?Whatisthefirm'sprofit?
4.Graphthethreedifferentsituationsinpartsa,b,andc.Basedonwhatyouobserve,explainwhythere
isnosupplycurveforafirmwithmonopolypower.

References
Baumol,W.J.,J.C.Panzar,andR.D.Willig.1982.ContestableMarketsandtheTheoryofMarket
Structure.NewYork:Harcourt,Brace,Jovanovich.
Brandenburger,A.,andB.Nalebuff.1996.Coopetition.Cambridge:HarvardUniversityPress.
Chevalier,J.,andA.Goolsbee.2009.AreDurableGoodsConsumersForwardLooking?Evidencefrom
CollegeTextbooks,QuarterlyJournalofEconomics124(November):185384.
Coase,R.L.1972.DurabilityandMonopoly,JournalofLaw&Economics15(April):14350.
Makowski,L.,andJ.Ostroy.1995.AppropriationandEfficiency:ARevisionoftheFirstTheoremofWelfare
Economics,AmericanEconomicReview85:80827.
Marshall,Alfred.1890.PrincipalsofEconomics,London:MacmillanPublishers.

Stokey,NancyL.1981.RationalExpectationsandDurableGoodsPricing,BellJournalofEconomics12
(Spring):11228.
Thepot,Jacques.1998.ADirectProofoftheCoaseConjecture,JournalofMathematicalEconomics29
(January):5766.
Appendix
TheCalculusofCompetition
Thecompetitivefirm'sproblemmaybesolvedbyfirstwritingthefirm'sprofitasafunctionofitsoutput,
(q)inturndefinedasrevenueR(q)lesscostC(q).PricetakingbehaviorimpliesR(q)=Pq.Hence:

Standardmaximizationthenyields:

P=marginalcostC(q)underperfectcompetition.
Forthemonopolyfirm,itsoutputisthesameasindustryoutputQ,thatgivesP(Q),viatheinversedemand
curve.Hence,themonopolist'sprofitmaximizationproblemistochooseoutputQsoastomaximize:

Again,standardmaximizationtechniquesyield:

P(Q)+QP(Q),isthefirm'smarginalrevenue.Themonopolistwillmaximizeprofitbyproducingwhere
marginalcostequalsmarginalrevenue.ForalineardemandcurveoftheformofP(Q)=ABQwehaveP
(Q)=B.Inthiscase,thefirm'smarginalrevenueisABQBQ,orA2BQ.Themonopolist'smarginal
revenuecurvehasthesameinterceptasitsdemandcurvetwicetheslope.
Notethattheprofitmaximizingconditionabovecanalsobewrittenas

DividingbothsidesbyP(Q),wethenhave

whereiswhateconomistscalltheelasticityofdemandameasureofhowresponsivethequantity
demandedistopricemovements.Itisformallydefinedas:

1Thereasonforthisterminologyisthattraditionallyinmicroeconomics,wethinkofquantitydemandedas

beingthedependentvariable,(lefthandsideoftheequation)andprice,theindependentvariable,(right
handsideoftheequation).However,whenfirmschoosequantitiesandpriceadjuststoclearthemarket,itis
preferabletoputmarketpriceonthelefthandside,hence,theinversedemandfunction.Ourdiscussion

shouldmakeclearthatthemarketdemandcurvecanbethoughtofasthehorizontalsummationofthe
individualdemandcurveofeachconsumer.Itisnot,however,thehorizontalsummationofthedemand
curvefacingeachfirm.
2Thisfollowsfromthedefinitionofaperfectcompetitor.Onemaywonderhoweachfirmcanfacea

horizontaldemandcurvewhileindustrydemandisdownwardsloped.Theansweristhatthedemandcurve
facingtheindustryreflectsthesummationoftheindividualdemandpresentedbyeachconsumernotthe
individualdemandfacingeachfirm.
3Wesayalmostbecausetheremaybeadistinctionbetweenaveragevariablecostandmarginalcost.No

productionwilloccuratallintheshortrunifthefirmcannotproduceatalevelthatwillcoveritsaverage
variablecost.
4Underperfectcompetition,firmoutputisdifferentfromindustryoutput.Soweusealowercaseqtorefer

tofirmoutputandanuppercaseQforindustryoutput.Undermonopoly,firmoutputisthemarketoutput
andsoweuseQtodescribeboth.
5Costminimizationforanymultiplantfirmrequiresthatthemarginalunitbeproducedattheplantwiththe

lowestmarginalcost.Withdivisibleoutput,thisimpliesthattheprofitmaximizingmonopolistwillwantto
allocatetotalproductionacrossthefiftyplantsinsuchawaythatthemarginalcostofproducingthelastunit
ofoutputisthesameineachplant.Therefore,themonopolistderivestheoverallmarginalcostfunctionina
mannersimilartohowweconstructedthesupplyfunctionforthecompetitiveindustry.SeeChapter4,
footnote3andtheAppendix.
6ThisnotionofefficiencyisoftenreferredtoasParetoOptimalityafterthegreatItaliansocialthinkerofthe

latenineteenthandearlytwentiethcenturies,VilfredoPareto.
7Again,rememberthatthemarketsupplycurveisthehorizontalsummationofeachcompetitivefirm's

marginalcostcurve,andsothesupplycurvetellsusexactlywhatistheopportunitycosttothefirmof
producingandsellingeachunitofthegood.
8Observethattheunitofmeasurementoftheareasofconsumerandproducersurplusisthedollar.To

workouttheareasyoumusttake$/unit,asmeasuredontheverticalaxis,timesunitsonthehorizontalaxis.
Thisgivesyouameasureindollars,whichisamoneymeasureofthewelfarecreatedbyhavingthisgood
producedatoutputlevelQCandsoldatpricePC.
9Wefocushereontheconceptofallocationalorstaticefficiency,inwhichweexaminethebestwayto

allocateresourcesfortheproductionofagivensetofgoodsandserviceswithagiventechnology.Dynamic
efficiency,whichconsiderstheallocationofresourcessoastopromotethedevelopmentofnewgoodsand
newproductiontechniques,isaddressedexplicitlyinChapter20.
10Wehavetreatedtheproblemasoneofcurrentexpensesversusfuturereceipts.Ofcourse,futurecosts

shouldbediscountedaswell.
11Analternativeapproachwouldbetorequirethateachfirmwithintheindustryearnsnonnegativeprofits

(andsohavenoincentivetoleave)whileanyfirmnotintheindustrywouldearnnonpositiveprofitifit
entered(andsohavenoincentivetodoso).

12See,forexample,Baumol,Panzar,andWillig(1982).
13Stokey(1981)offersaformalderivationoftheCoaseConjecture.SeealsoThepot(1998).
14Thissectionandthepreviousonemakeextensiveuseofthenonsurplusapproachdevelopedin

MakowskiandOstroy(1995).Ithashadanimportantinfluenceonourunderstandingofmarket
participation.ItalsoplaysacentralroleinthebusinessstrategiesadvocatedbyBrandenburgerandNalebuff
(1996).
15ThenonsurplusapproachisdevelopedinMakowskiandOstroy(1995).Ithashadanimportantinfluence

onourunderstandingofmarketparticipation.Italsoplaysacentralroleinthebusinessstrategiesadvocated
byBrandenburgerandNalebuff(1996).
16Studentswithaknowledgeofeconometricsmayrecognizethatthepricevariableisendogenousandthat

thereforeaninstrumentalvariables(IV)approachiswarranted.ChevalierandGoolsbeedoindeedadoptan
IVapproach,includingadummyvariableindicatingifabookispublishedbyanonprofitpublisher,theshare
ofnonprofitpublishersamongtextbooksdesignedforthesamecourse,andtheHerfindahlindexfor
publishersforthecourseintheyearinwhichthetextbookwaspublished.