Managerial Decisions For Firms With Market Power: Ninth Edition Ninth Edition

Managerial Economics
ninth edition
Thomas Maurice
Chapter 12
Managerial Decisions for Firms with Market Power
McGraw-Hill/Irwin McGraw-Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
Market Power
Ability of a firm to raise price without losing all its sales
Any firm that faces downward sloping demand has market power
Gives firm ability to raise price above average cost & earn economic profit (if demand & cost
conditions permit)
12-2
Monopoly
Single firm Produces & sells a good or service for which there are no good substitutes New firms are prevented from entering market because of a barrier to entry
12-3
Measurement of Market Power

Degree of market power inversely related to price elasticity of demand
The less elastic the firms demand, the greater its degree of market power The fewer close substitutes for a firms product, the smaller the elasticity of demand (in absolute value) & the greater the firms market power When demand is perfectly elastic (demand is horizontal), the firm has no market power
12-4

Lerner index measures proportionate amount by which price exceeds marginal cost:
P MC Lerner index P
12-5

Lerner index
Equals zero under perfect competition Increases as market power increases
Also equals 1/E, which shows that the index (& market power), vary inversely with elasticity The lower the elasticity of demand (absolute value), the greater the index & the degree of market power
12-6

If consumers view two goods as substitutes, cross-price elasticity of demand (EXY) is positive
The higher the positive cross-price elasticity, the greater the substitutability between two goods, & the smaller the degree of market power for the two firms
12-7
Determinants of Market Power

Entry of new firms into a market erodes market power of existing firms by increasing the number of substitutes A firm can possess a high degree of market power only when strong barriers to entry exist
Conditions that make it difficult for new firms to enter a market in which economic profits are being earned
12-8
Common Entry Barriers

Economies of scale
When long-run average cost declines over a wide range of output relative to demand for the product, there may not be room for another large producer to enter market
Barriers created by government

Licenses, exclusive franchises
12-9

Input barriers
One firm controls a crucial input in the production process
Brand loyalties
Strong customer allegiance to existing firms may keep new firms from finding enough buyers to make entry worthwhile
12-10

Consumer lock-in
Potential entrants can be deterred if they believe high switching costs will keep them from inducing many consumers to change brands
Occur when value of a product increases as more consumers buy & use it Make it difficult for new firms to enter markets where firms have established a large network of buyers
Network externalities
12-11
Demand & Marginal Revenue for a Monopolist

Market demand curve is the firms demand curve Monopolist must lower price to sell additional units of output
Marginal revenue is less than price for all but the first unit sold
When MR is positive (negative), demand is elastic (inelastic) For linear demand, MR is also linear, has the same vertical intercept as demand, & is twice as steep
12-12
Demand & Marginal Revenue for a Monopolist (Figure 12.1)
12-13
Short-Run Profit Maximization for Monopoly

Monopolist will produce a positive output if some price on the demand curve exceeds average variable cost Profit maximization or loss minimization occurs by producing quantity for which MR = MC
12-14
Short-Run Profit Maximization for Monopoly

If P > ATC, firm makes economic profit If ATC > P > AVC, firm incurs loss, but continues to produce in short run If demand falls below AVC at every level of output, firm shuts down & loses only fixed costs
12-15
Short-Run Profit Maximization for Monopoly (Figure 12.3)
12-16
Short-Run Loss Minimization for Monopoly (Figure 12.4)
12-17
Long-Run Profit Maximization for Monopoly

Monopolist maximizes profit by choosing to produce output where MR = LMC, as long as P LAC Will exit industry if P < LAC Monopolist will adjust plant size to the optimal level
Optimal plant is where the short-run average cost curve is tangent to the long-run average cost at the profitmaximizing output level
12-18
Long-Run Profit Maximization for Monopoly (Figure 12.5)
12-19
Profit-Maximizing Input Usage

Profit-maximizing level of input usage produces exactly that level of output that maximizes profit
12-20

Marginal revenue product (MRP)
MRP is the additional revenue attributable to
hiring one more unit of the input
TR MRP MR MP L
When producing with a single variable input:
Employ amount of input for which MRP = input
price
Relevant range of MRP curve is downward sloping, positive portion, for which ARP > MRP
12-21
Monopoly Firms Demand for Labor (Figure 12.6)
12-22

For a firm with market power, profit-maximizing conditions MRP = w and MR = MC are equivalent
Whether Q or L is chosen to maximize profit, resulting levels of input usage, output, price, & profit are the same
12-23
Monopolistic Competition
Large number of firms sell a differentiated product Market is monopolistic Market is competitive
12-24
Products are close (not perfect) substitutes Product differentiation creates a degree of market power Large number of firms, easy entry
Monopolistic Competition
Short-run equilibrium is identical to monopoly Unrestricted entry/exit leads to long-run equilibrium
Attained when demand curve for each producer is tangent to LAC At equilibrium output, P = LAC and
MR = LMC
12-25
Short-Run Profit Maximization for Monopolistic Competition (Figure 12.7)
12-26
Long-Run Profit Maximization for Monopolistic Competition (Figure 12.8)
12-27
Implementing the Profit-Maximizing Output & Pricing Decision

Step 1: Estimate demand equation
Use statistical techniques from Chapter 7 Substitute forecasts of demandshifting variables into estimated demand equation to get
Q a' bP
dP Where a' a cM R
12-28

Step 2: Find inverse demand equation
Solve for P
a' 1 P Q A BQ b b
1 Where a' a cM dPR , A a' b , and B b
12-29

Step 3: Solve for marginal revenue
When demand is expressed as P = A + BQ, marginal revenue is
a' 2 MR A 2 BQ Q b b
12-30

Step 4: Estimate AVC & SMC
Use statistical techniques from Chapter 10
AVC a bQ cQ 2 SMC a 2bQ 3cQ 2
12-31

Step 5: Find output where MR = SMC
Set equations equal & solve for Q* The larger of the two solutions is the profit-maximizing output level
Step 6: Find profit-maximizing price

Substitute Q* into inverse demand
P* = A + BQ*
Q* & P* are only optimal if P AVC
12-32

Step 7: Check shutdown rule
Substitute Q* into estimated AVC function
AVC a bQ cQ
* *
*2
If P* AVC*, produce Q* units of output & sell each unit for P* If P* < AVC*, shut down in short run
12-33

Step 8: Compute profit or loss Profit = TR - TC
P Q AVC Q TFC
* *
( P AVC )Q TFC
*
If P < AVC, firm shuts down & profit is -TFC

12-34
Maximizing Profit at Aztec Electronics: An Example

Aztec possesses market power via patents Sells advanced wireless stereo headphones
12-35

Estimation of demand & marginal revenue
Q 41, 000 500 P 0.6M 22.5PR
41,000 500P 0.6(45,000) 22.5(800) 50, 000 500 P
12-36

Solve for inverse demand Q 50,000 500P
Q 50, 000 500 P 500 500 Q 50, 000 P 500 500 1 P 100 Q 500 100 0.002Q
12-37

Determine marginal revenue function
P 100 0.002Q MR 100 0.004Q
12-38
Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)
12-39

Estimation of average variable cost and marginal cost
Given the estimated AVC equation:
AVC 28 0.005Q 0.000001Q

So,
SMC 28 (2 0.005)Q (3 0.000001)Q 28 0.01Q 0.000003Q

12-40

Output decision
Set MR = MC and solve for Q*
100 0.004Q 28 0.01Q 0.000003Q 2 0 (28 100) (0.01 0.004)Q 0.000003Q

2
72 0.006Q 0.000003Q
12-41

Output decision
Solve for Q* using the quadratic formula
(0.006) (0.006) 2 4(72)(0.000003) Q* * 2(0.000003)

0.036 6,000 0.000006
12-42

Pricing decision
Substitute Q* into inverse demand * 100 0.002(6, 000) P*
$88
12-43

Shutdown decision
Compute AVC at 6,000 units:
* 28 0.005(6, 000) 0.000001(6, 000) AVC*
2
$34
Because P $88 $34 AVC, Aztec should produce rather than shut down
12-44

Computation of total profit
TR TVC TFC
( P* * Q*) * Q*) * TFC * ( AVC * ($88 6,000) ($34 6,000) $270,000 $528,000 $204,000 $270,000 $54, 000
12-45
Profit Maximization at Aztec Electronics (Figure 12.10)
12-46
Multiple Plants
If a firm produces in 2 plants, A & B
Allocate production so MCA = MCB Optimal total output is that for which MR = MCT
For profit-maximization, allocate total output so that

MR = MCT = MCA = MCB
12-47
A Multiplant Firm
(Figure 12.11)
12-48

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Managerial Decisions For Firms With Market Power: Ninth Edition Ninth Edition

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Managerial Economics

Measurement of Market Power

Measurement of Market Power

Measurement of Market Power

Measurement of Market Power

Determinants of Market Power

Common Entry Barriers

Barriers created by government

Common Entry Barriers

Common Entry Barriers

Demand & Marginal Revenue for a Monopolist

Demand & Marginal Revenue for a Monopolist (Figure 12.1)

Short-Run Profit Maximization for Monopoly

Short-Run Profit Maximization for Monopoly

Short-Run Profit Maximization for Monopoly (Figure 12.3)

Short-Run Loss Minimization for Monopoly (Figure 12.4)

Long-Run Profit Maximization for Monopoly

Long-Run Profit Maximization for Monopoly (Figure 12.5)

Profit-Maximizing Input Usage

Profit-Maximizing Input Usage

Monopoly Firms Demand for Labor (Figure 12.6)

Profit-Maximizing Input Usage

Short-Run Profit Maximization for Monopolistic Competition (Figure 12.7)

Long-Run Profit Maximization for Monopolistic Competition (Figure 12.8)

Implementing the Profit-Maximizing Output & Pricing Decision

Implementing the Profit-Maximizing Output & Pricing Decision

Implementing the Profit-Maximizing Output & Pricing Decision

Implementing the Profit-Maximizing Output & Pricing Decision

AVC a bQ cQ 2 SMC a 2bQ 3cQ 2

Implementing the Profit-Maximizing Output & Pricing Decision

Step 6: Find profit-maximizing price

Implementing the Profit-Maximizing Output & Pricing Decision

Implementing the Profit-Maximizing Output & Pricing Decision

If P < AVC, firm shuts down & profit is -TFC

Maximizing Profit at Aztec Electronics: An Example

Maximizing Profit at Aztec Electronics: An Example

41,000 500P 0.6(45,000) 22.5(800) 50, 000 500 P

Maximizing Profit at Aztec Electronics: An Example

Maximizing Profit at Aztec Electronics: An Example

P 100 0.002Q MR 100 0.004Q

Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)

Maximizing Profit at Aztec Electronics: An Example

AVC 28 0.005Q 0.000001Q

SMC 28 (2 0.005)Q (3 0.000001)Q 28 0.01Q 0.000003Q

Maximizing Profit at Aztec Electronics: An Example

100 0.004Q 28 0.01Q 0.000003Q 2 0 (28 100) (0.01 0.004)Q 0.000003Q

Maximizing Profit at Aztec Electronics: An Example

(0.006) (0.006) 2 4(72)(0.000003) Q* * 2(0.000003)

Maximizing Profit at Aztec Electronics: An Example

Maximizing Profit at Aztec Electronics: An Example

Maximizing Profit at Aztec Electronics: An Example

Profit Maximization at Aztec Electronics (Figure 12.10)

For profit-maximization, allocate total output so that

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