Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Managerial Economics & Business Strategy

Chapter 8 Managing in Competitive,

Monopolistic, and Monopolistically

Competitive Markets

8-2

Overview

I. Perfect Competition –  Characteristics and profit outlook. –  Effect of new entrants.

II. Monopolies –  Sources of monopoly power. –  Maximizing monopoly profits. –  Pros and cons.

III. Monopolistic Competition –  Profit maximization. –  Long run equilibrium.

8-3

Perfect Competition Environment

§  Many buyers and sellers. §  Homogeneous (identical) product. §  Perfect information on both sides of market. §  No transaction costs. §  Free entry and exit.

8-4

Key Implications

§  Firms are “price takers” (P = MR). §  In the short-run, firms may earn profits or

losses. §  Entry and exit forces long-run profits to zero.

8-5

Unrealistic? Why Learn?

§  Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms.

§  It is a useful benchmark. §  Explains why governments oppose monopolies. §  Illuminates the “danger” to managers of competitive

environments. –  Importance of product differentiation. –  Sustainable advantage.

8-6

Managing a Perfectly Competitive Firm

(or Price-Taking Business)

8-7

Setting Price

Firm Qf

$

Df

Market QM

$

D

S

Pe

8-8

Profit-Maximizing Output Decision

§  MR = MC.

§  Since, MR = P,

§  Set P = MC to maximize profits.

8-9

Graphically: Representative Firm’s Output Decision

$

Qf

ATC

AVC

MC

Pe = Df = MR

Qf*

ATC

Pe

Profit = (Pe - ATC) × Qf*

8-10

A Numerical Example §  Given

–  P=$10 –  C(Q) = 5 + Q2

§  Optimal Price? –  P=$10

§  Optimal Output? –  MR = P = $10 and MC = 2Q –  10 = 2Q –  Q = 5 units

§  Maximum Profits? –  PQ - C(Q) = (10)(5) - (5 + 25) = $20

8-11

$

Qf

ATC

AVC

MC

Pe = Df = MR

Qf*

ATC Pe

Profit = (Pe - ATC) � Qf* < 0

Should this Firm Sustain Short Run Losses or Shut Down?

Loss

8-12

Shutdown Decision Rule

§  A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs. – Operating results in a smaller loss than ceasing

operations.

§  Decision rule: – A firm should shutdown when P < min AVC. – Continue operating as long as P ≥ min AVC.

8-13

$

Qf

ATC

AVC

MC

Qf*

P min AVC

Firm’s Short-Run Supply Curve: MC Above Min AVC

8-14

Entry and Exit Decision Rule §  In the long run, there is no fixed cost.

–  A profit-maximizing firm shall choose to exit whenever it is making an economic loss.

–  If any existing firm is making an economic profit in the short run, more firms will choose to enter the market.

§  Decision rule: – More and more firms exit when P < min ATC. – More and more new firms enter as long as P ≥ min

ATC. – Until P = ATC

8-15

Firm’s Long-run Equilibrium

S1

Profit

D1

D2

MC

ATC

P1

Market

Q

P

(market)

One firm

Q

P

(firm)

P2 P2

Q1 Q2

S2

Q3

A firm begins in long-run eq’m…

…but then an increase in demand raises P,… …leading to SR

profits for the firm. Over time, profits induce entry, shifting S to the right, reducing P…

…driving profits to zero and restoring long-run eq’m.

A

B

C

8-16

Long-run Supply Curve

MC Market

Q

P

(market)

One firm

Q

P

(firm)

In the long run, the typical firm earns zero profit.

LRATC

long-run supply

P = min. ATC

The LR market supply curve is horizontal at P = minimum ATC.

8-17

Long run Equilibrium – Example TC(q) = 40q – 6q2+q3/3 D(P) = 2200 -100P Find Q*, q*, P*, n*.

§  Decision rule: MC=MR=P=ATC §  Step 1: MC(q) = 40-12q +q2

§  Step 2: AC(q) = 40-6q+q2/3

§  Step 3: MC=AC

2q2/3=6q 2q/3=6 q*=9

8-18

Long run Equilibrium – Example TC(q) = 40q – 6q2+q3/3 D(P) = 2200 -100P Find Q*, q*, P*, n*.

§  Decision rule: MC=MR=P=ATC

§  Step 4: P*=AC(q) = 40-6q+q2/3=40-54+27=13=p*

§  Step 5: Q*=D(P) = 2200 -100P*=2200 – 100(13)=900 §  Step 6: n* = Q*/q*=100

8-19

Managing a Monopolist

§  Number of firms: one §  Barriers to entry or exit from the industry: extremely

great §  Type of product: unique, no close substitute §  Key characteristic: only one firm

§  Eg. Xcel

8-20

Marginal Revenue

Q Q

P TR

100

0 0 10 20 30 40 50 10 20 30 40 50

800

60 1200

40

20

Inelastic

Elastic

Elastic Inelastic

Unit elastic

Unit elastic

MR

8-21

Monopoly: Profit Maximization

§  Maximize profits – Produce output where MR = MC.

§  Inverse Elasticity Pricing Rule

MR = P + ∂P∂Q

Q = P + ∂P∂Q

QPP = P 1+ 1

∂Q∂P

⎛⎝⎜

⎞⎠⎟PQ

⎛⎝⎜

⎞⎠⎟

⎛

⎝

⎜⎜⎜

⎞

⎠

⎟⎟⎟= P 1+ 1

ε⎛⎝⎜

⎞⎠⎟

MC(Q*) = P * 1+ 1εQ,P

⎛

⎝⎜

⎞

⎠⎟

L = P *−MC *P *

= − 1εQ,P

8-22

Monopoly

$ ATC

MC

D

MR QM

PM

Profit

ATC

X

8-23

Managing a Monopolistically Competitive Firm

§  Like a monopoly, monopolistically competitive firms –  have market power that permits pricing above marginal cost. –  level of sales depends on the price it sets.

§  But … –  The presence of other brands in the market makes the demand for

your brand more elastic than if you were a monopolist. –  Free entry and exit impacts profitability.

§  Therefore, monopolistically competitive firms have limited market power.

8-24

Short-Run Monopolistic Competition

$ ATC

MC

D

MR QM

PM

Profit

ATC

Quantity of Brand X

8-25

Long Run Adjustments?

§  If the industry is truly monopolistically competitive, there is free entry. –  In this case other “greedy capitalists” enter, and their

new brands steal market share. – This reduces the demand for your product until

profits are ultimately zero.

8-26

$ AC

MC

D

MR

Q*

P*

Quantity of Brand X MR1

D1

Entry

P1

Q1

Long Run Equilibrium (P = AC, so zero profits)

Long-Run Monopolistic Competition

8-27

Monopolistic Competition

The Good (To Consumers) –  Product Variety

The Bad (To Society) –  P > MC –  Excess capacity

•  Unexploited economies of scale

The Ugly (To Managers) –  P = ATC > minimum of average costs.

•  Zero Profits (in the long run)!

8-28

Optimal Advertising Decisions §  Advertising is one way for firms with market power to

differentiate their products. §  But, how much should a firm spend on advertising?

–  Advertise to the point where the additional revenue generated from advertising equals the additional cost of advertising.

–  Equivalently, the profit-maximizing level of advertising occurs where the advertising-to-sales ratio equals the ratio of the advertising elasticity of demand to the own-price elasticity of demand.

PQ

AQ

EE

RA

,

,

−=

8-29

Maximizing Profits: A Synthesizing Example

§  C(Q) = 125 + 4Q2

§  Determine the profit-maximizing output and price, and discuss its implications, if –  You are a price taker and other firms charge $40 per unit; –  You are a monopolist and the inverse demand for your

product is P = 100 – Q; –  You are a monopolistically competitive firm and the

inverse demand for your brand is P = 100 – Q.

8-30

Marginal Cost

§  C(Q) = 125 + 4Q2,

§  So MC = 8Q.

§  This is independent of market structure.

8-31

Price Taker

§  MR = P = $40. §  Set MR = MC.

•  40 = 8Q. • Q = 5 units.

§  Cost of producing 5 units. • C(Q) = 125 + 4Q2 = 125 + 100 = $225.

§  Revenues: •  PQ = (40)(5) = $200.

§  Maximum profits of -$25. §  Implications: Expect exit in the long-run.

8-32

Monopoly/ Monopolistic Competition

§  MR = 100 - 2Q (since P = 100 - Q). §  Set MR = MC, or 100 - 2Q = 8Q.

–  Optimal output: Q = 10. –  Optimal price: P = 100 - (10) = $90. –  Maximal profits:

•  PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.

§  Implications –  Monopolist will not face entry (unless patent or other entry barriers

are eliminated). –  Monopolistically competitive firm should expect other firms to

clone, so profits will decline over time.

8-33

Conclusion

§  Firms operating in a perfectly competitive market take the market price as given. –  Produce output where P = MC. –  Firms may earn profits or losses in the short run. –  … but, in the long run, entry or exit forces profits to zero.

§  A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated.

§  A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.