Ch 6 - ECON 4697 IO & Regulation Part II. Monopoly...

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ECON 4697 IO & Regulation Part II. Monopoly & Regulation Topic 6. DFCF model Objectives. 1. Use calculus to solve the DFCF model. 2. Examine the predictions of the model. 3. Apply the model to international telephone markets. 4. Contrast to oligopoly models where all firms can affect prices. 6.1 Introduction In topic 5 we noted that the existence of pure monopolies is rare. What we are more likely to observe is a market where a dominant firm has a large share of total industry output (> 40 percent market share) and several relatively small “fringe” firms supply the remaining output. Some examples include: US Steel in the steel industry in the early part of the 20 th century; Alcoa in the aluminum industry in the early part of the 20 th century AT&T in the long-distance telephone market from 1984 to 1996; Cable providers in the delivery of multi-channel subscription TV from 1993- 2000; and Incumbent local-exchange carriers [e.g., US West (now Qwest), Bell South (now AT&T Inc.), Bell Atlantic (now Verizon)] in local telephone markets after 1996. The dominant firm, competitive fringe (DFCF) model is used to examine firm behavior in markets that have monopoly aspects, in particular, one dominant firm with a very large market share. This topic presents the DFCF model and compares model predictions with the pure monopoly case to see how well the pure monopoly model approximates firm behavior in markets with a dominant firm. For applications, the DFCF model is applied to multi- channel subscription TV and long-distance telephone markets to examine questions about pricing and market power. 6.2 DFCF model 6.2.1 Model assumptions Suppose a market for a homogenous good is comprised of a single dominant firm (> 40 percent market share), and several smaller fringe firms.
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Copyright © 2008 Scott J Savage ALL RIGHTS RESERVED 2 The dominant firm (dom) is a “price leader” and sets industry price p. 1 The fringe (f) take p as given, and follow the dominant firm by setting the same p or a price slightly lower than p. In effect, the fringe are price takers and maximize profits by adjusting their output so that p = MC f . 2 The dominant firm recognizes the fringe behave in the manner described above and must therefore choose p to maximize profit with the knowledge that the fringe can sell as much output as they want to (according to P = MC f ) at that chosen price p. 6.2.2 Multi-channel subscription TV market The DFCF model is best explained by way of a worked example, here the delivery of multi-channel subscription TV to the city of Boulder. 3 A cable operator is the dominant firm with a large share of the market for a standard digital TV package. Two identical direct broadcast satellite (DBS) operators are the fringe. The fringe have a steeper MC curve due to the higher costs of home installation and customer acquisition (i.e., costs incurred in acquiring each additional customer). Assume the fringe accept the cable
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Ch 6 - ECON 4697 IO & Regulation Part II. Monopoly...

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