KEY FORMULAS ECON 315 New material (see older sheets also)

Measurements of Market Structure:

C4 = [S1 + S2 + S3 + S4] / ST where Si = sales value one of firm (top 4 firms here)
ST=total sales value all firms in industry
Herfindahl-Hirschman Index HHI = 10,000 * wi 2 where each wi = Si / ST
HHI < 1000 unconcentrated; HHI 1000-1800 moderately concentrated; HHI> 1800 highly
concentrated (mergers likely prevented by US Department of Justice)
Rothschild Index R = (ET) / (EF) where

ET = elasticity demand total market

EF = elasticity demand product from 1 firm

Lerner Index L = ( P MC)/ P

Mark-up factor as [1/(1-L)]

where P is price, MC is marginal cost

factor by which MC multiplied to get P

Profits = Total Revenue Total Costs

Unit Profits = P AC (average costs)
Profit Maximization: choose Q* where MC = MR (then check profits)
Shutdown rule: close if P < AVC or TR < TVC
Market structure:
1) Perfect Competition (P=MR=MC) price-taker, homogenous goods sold, long-run 0 profits
2) Monopolistic Competition: short-run monopoly since heterogenous goods and charges P>MR
(downward-sloping demand), long-run perfect competition so profits disappear
3) Oligopoly: few firms with market power generally; P > MR charged; interdependence often
seen through kinked demand curve or game theory
Normal form games: 2 competitors, 2+ actions, payoffs in boxes
4) Monopoly: most market power with product of no substitutes; P >MR; highest long-run
profits possible since no entry by other firms.
All firms generally follow 3-step SR profit mazimization process (1) find Q where MR=MC
(2) find profits there
(3) if profits < 0 apply
shutdown
analysis

Understanding oligopoly through graphs and game theory:

--interdependence key: two firms set different prices in response and split up fixed quantity (i.e.
Sweezy) or firms determine individual quantities and affect market price (i.e. OPEC). General
kinked demand curve four variations by whether or not rival matches initial firms price increase
or decrease. Sweezy model predicts price rigidity over time.
--(one-shot) game theory variation has two firms with knowledge of each others payoffs. This
will give discrete ideal action by each player and discrete outcomes (profits, quantities, etc..).
Steps:
1) examine payoffs with left-side player seeing first number in parentheses, top columns player
seeing second number in parentheses
2) determine dominant strategy for each player if each has dominant that is Nash equilibrium
3) if only one player has a dominant strategy, then other player puts self in rivals shoes and
assumes that first player will play dominant.
4) if neither player has a dominant straregy, each cell must be examined to determine if it is a
Nash equilibrium (each person has no incentive to move, given others strategy).
Firms with market power can do other pricing strategies:
1) Price Discrimination
a) 1st degree: charge each buyer maximum WTP (willingness-to-pay)
b) 2nd degree: set 2+ bundles and charge WTP for each bundle
c) 3rd degree: divide consumers into 2+ groups and charge different prices
2) Two-part pricing: find Q where MC=P (demand); determine consumer surplus there to
charge as entry fee, then charge unit price = MC
3) Block pricing: find Q where MC=P (demand); determine total willingness-to-pay there
4) Bundling: add up the willingness-to-pay for all components together for each buyer.
Charge the lowest bundled price so as to bring all consumers into market.
General mark-up rule using elasticity:
P= [Ef/(1+Ef)]*MC
Where constant unit marginal cost and own-price elasticity of demand for firm product