Dominant Firm with a Competitive Fringe

1
Dominant Firm with a Competitive Fringe

• /supplement to Topic 3 Monopoly/

2
Dominant Firm with Competitive Fringe

• This supplement answers the last question of
  Topic 3, namely
• What happens to a monopoly if smaller
  price-taking firms enter its market?
• It describes an alternative outcome of the
  situation when a firm has a knowledge advantage.
• Particularly, though present the advantage of the
  firm does not allow it to decrease its marginal
  cost so much to prevent the entry of the
  high-cost firms.

3
Dominant Firm with Competitive Fringe

• This supplement answers the last question of
  Topic 3, namely
• What happens to a monopoly if smaller
  price-taking firms enter its market?
• It describes an alternative outcome of the
  situation when a firm has a knowledge advantage.
• Particularly, though present the advantage of the
  firm is not big enough to allow it to decrease
  its marginal cost so much to prevent the entry of
  the high-cost firms.

4
Dominant Firm with Competitive Fringe

• If one firm is a price setter and faces smaller,
  price-taking firms, it is called a dominant firm.
• The dominant firm typically has a large market
  share.
• The smaller, price-taking firms are called fringe
  firms.
• Fringe firms each have a very small share of the
  market, even though together they may have a
  substantial share of the market.

5
Examples of Dominant Firms

• Industries in which one firm has a large share of
  the industry are common (Pascale, 1984)
• Photographic business Kodak, 60
• Mainframe computer business IBM, 68
• Commercial Jet Aircraft Business Boeing, 60
• Energy Sector General Electric, 61
• Computer chips ceramics Kyocera, 70-75
• Printer sales Hewlett-Packard, 59

6
Why Some Firms are Dominant?

• Three possible reasons are sufficient to create a
  dominant firm-competitive fringe market
  structure
• A dominant firm may have lower cost than fringe
  firms.
• A dominant firm may have a superior product in a
  market with product differentiation.
• A group of firms may collectively act as a
  dominant firm.

7
Causes of lower costs

• There are at least four major causes of lower
  costs
• A firm might be more efficient than its rivals
  due to better management and/or patented
  technology.
• An early entrant might have learned by experience
  how to produce more efficiently.
• An early entrant may have had time to grow large
  optimally (in the presence of adjustment costs)
  so as to benefit from economies of scale.
• The government may favor the original firm.

8
Causes of superior quality

• There are at least four major causes of lower
  costs
• A firm might have better quality due to patented
  technology.
• The quality superiority may be due to a
  reputation achieved through advertising.
• Or through goodwill generated by its having been
  in the market longer.

9
Causes of collusion of firms

• Groups of firms in a market have an incentive to
  coordinate their activities to increase their
  profits.
• A firm might have better quality due to patented
  technology.
• The quality superiority may be due to a
  reputation achieved through advertising.
• Or through goodwill generated by the firm having
  been in the market longer.

10
Dominant Firms Behavior in the Long Run

• Whether a dominant firm can exercise market power
  in the long run depends crucially on
• the number of firms that can enter the market
• how their production costs compare to those of
  the dominant firm and
• how fast they can enter.
• The dominant firm-competitive fringe model could
  be examined under two alternative extreme
  assumptions with and without free entry.

11
The Fixed Entry Model

• Two key results emerge from an analysis of this
  model
• It is more profitable to be dominant than mere
  fringe firm.
• (2) The existence of the fringe limits the
  dominant firms market power i.e. it is better to
  be a monopoly than dominant firm with competitive
  fringe.

12
The Fixed Entry Model - Assumptions

• Five crucial assumptions underlie the no-entry
  model
• 1. There is one firm that is much larger than any
  other firm because of its lower production costs.
• 2. All firms, except the dominant firm, are
  price-takers, determining their output levels by
  setting marginal cost equal the market price p.
• 3. The number of firms in the competitive fringe
  is fixed no new entry could occur.
• 4. The dominant firm knows the markets demand
  curve, D(p).
• 5. The dominant firm can predict how much output
  the competitive fringe can produce at any given
  price i.e. the competitive fringe supply curve
  S(p)

13
The Fixed Entry Model

• The dominant firms problem is much more complex
  than that of a monopoly
• The fringe supply curve, S(p), is increasing in
  p.
• (2) As dominant firm lowers its output and price
  rises, the competitive fringe output increases.
• (3) The dominant firm must consider how the
  competitive fringe responds to its actions.

14
The Fixed Entry Model

15
The Fixed Entry Model

• The market demand curve D(p) is above the
  residual demand curve Dd(p) at prices above
  and equal to it at prices below .
• The fringe firms meet some or all of the demand
  if price is above .
• They drop out of the market and leave all of the
  demand to the dominant firm if price falls below
  .
• The dominant firms marginal revenue curve (MRd)
  is derived from its residual demand curve and has
  two distinct sections.
• If the competitive fringe produces positive
  levels of output, Dd(p) lies below D(p), and MRd
  is flatter.
• Where the two demand curves coincide MRd is
  steeper.

16
The Fixed Entry Model - Solution

• The optimal output of the dominant firm is
  determined by the following 2-step procedure
• Determine the residual demand curve of the
  dominant firm.
• It is given by the horizontal difference between
  the market demand curve and the competitive
  fringes supply curve
• (2) Act like a monopoly with respect to the
  residual demand.
• The dominant firm maximizes its profits by
  picking a price (or output level) so that MRMC.

17
The Fixed Entry Model - Equilibrium

• Because the marginal revenue curve has two
  sections, there are two possible types of
  equilibria
• The dominant firm charges a high price, so that
  it makes economic profits and the fringe firms
  also make profits or break even.
• (2) The dominant firm sets a price so low that
  the fringe firms shut down to avoid making losses
  and the dominant firm becomes a monopoly.

18
The Dominant Firm-Competitive Fringe Equilibrium

• This type of equilibrium occurs if the dominant
  firms costs are not substantially less than
  those of the fringe firms.
• MCd crosses the upper downward sloping segment of
  MRd.
• Respectively, the dominant firm chooses to
  produce Qd level of output at price p.
• Since no new entrants are able to enter, fringe
  firms each makes a positive profit ?d.
• The dominant firms average cost is lower than
  that of the fringe firms, so it makes more total
  profits as well.
• Still the dominant firm makes lower profits than
  if it were a monopoly. So, the fringe hurts the
  dominant firm and benefit consumers.

19
The Dominant Firm as a Monopoly Equilibrium

• This type of equilibrium occurs if the dominant
  firms costs are extremely low compared to the
  fringe firms.
• MCd crosses the lower downward sloping segment
  of MRd.
• Respectively, the dominant firm chooses to
  produce Qd level of output at price p.
• Because p is below the fringe firms shutdown
  point , the fringe firms drop out the market.
• As a result, market output, Q, equals the
  dominant firms output Qd.
• Still the dominant firm makes lower profits than
  if it were a monopoly. So, the fringe hurts the
  dominant firm and benefit consumers.

20
The Free Entry Model

• This model retains all the assumptions made for
  the preceding model,
• except that now an unlimited number of
  competitive fringe firms may enter the market.
• Fringe firms cannot make profits in the long run
  they either break even or are driven out of
  business.
• As long as the dominant firm has some cost or
  other advantage, it can gain and hold
  indefinitely a large share of the market.
• This is an industry with easy entry, and yet one
  firm has the lions share of the market,
  presumably because it has superior products, a
  superior sales force, or has generated goodwill
  with buyers.

21
The Free Entry Model

22
The Free Entry Model

• As the number of firms grows large, the fringes
  supply curve becomes horizontal.
• The residual demand curve facing the dominant
  firm is also horizontal at , so it coincides
  with the MR curve.
• Below , both curves slope downward. Again the
  MR curve jumps at the quantity where the kink in
  the residual demand curve occurs.

23
The Free Entry Model - Equilibrium

• As in the model with fixed entry because the
  marginal revenue curve has two sections, there
  are two possible types of equilibria
• If the dominant firms marginal cost is
  relatively high, so that it intersects the
  horizontal portion of the MRd curve.
• The equilibrium price is . A dominant firm can
  make positive profits, competitive firms just
  break even.
• (2) If the dominant firms marginal cost is
  lower, so that it hits the downward-sloping
  portion of the MRd curve.
• The equilibrium is the same as in the second
  fixed-entry equilibrium. The dominant firm is a
  monopoly, and the potential supply of fringe
  firms is irrelevant.

24
Summary

• A low-cost dominant firm has market power even
  though it competes with other firms.
• A profit-maximizing dominant firm does not
  attempt to drive out fringe firms at all costs.
• Its behavior depends on how great its cost
  advantage over fringe firms is and on how easily
  other firms can enter.
• If a large number of price-taking firms can enter
  the market whenever a profit opportunity occurs,
  the dominant firm is unable to charge prices
  substantially above the competitive price.
• Even if fringe firms do not enter a market, the
  threat of their entry may cause a monopoly to set
  a lower price than it would in the absence of the
  fringe.