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Understanding Market Power and Profit Maximization for Monopolies

This chapter explores market power and monopolies, including measurement techniques, determinants of market power, entry barriers, demand and marginal revenue for monopolies, short-run and long-run profit maximization strategies, and profit-maximizing input usage.

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Understanding Market Power and Profit Maximization for Monopolies

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  1. Chapter 12 Managerial Decisions for Firms with Market Power

  2. 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)

  3. 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

  4. Measurement of Market Power • Degree of market power inversely related to price elasticity of demand • The less elastic the firm’s demand, the greater its degree of market power • The fewer close substitutes for a firm’s product, the smaller the elasticity of demand (in absolute value) & the greater the firm’s market power • When demand is perfectly elastic (demand is horizontal), the firm has no market power

  5. Measurement of Market Power • Lerner index measures proportionate amount by which price exceeds marginal cost:

  6. Measurement of Market Power • 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

  7. Measurement of Market Power • 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

  8. 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

  9. 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

  10. Common Entry Barriers • 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

  11. Common Entry Barriers • Consumer lock-in • Potential entrants can be deterred if they believe high switching costs will keep them from inducing many consumers to change brands • Network externalities • 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

  12. Demand & Marginal Revenue for a Monopolist • Market demand curve is the firm’s 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

  13. Demand & Marginal Revenue for a Monopolist (Figure 12.1)

  14. 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

  15. 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

  16. Short-Run Profit Maximization for Monopoly (Figure 12.3)

  17. Short-Run Loss Minimization for Monopoly (Figure 12.4)

  18. 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 profit-maximizing output level

  19. Long-Run Profit Maximization for Monopoly (Figure 12.5)

  20. Profit-Maximizing Input Usage • Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

  21. Profit-Maximizing Input Usage • Marginal revenue product (MRP) • MRP is the additional revenue attributable to hiring one more unit of the input • 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

  22. Monopoly Firm’s Demand for Labor (Figure 12.6)

  23. Profit-Maximizing Input Usage • 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

  24. Monopolistic Competition • Large number of firms sell a differentiated product • Products are close (not perfect) substitutes • Market is monopolistic • Product differentiation creates a degree of market power • Market is competitive • Large number of firms, easy entry

  25. 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

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

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

  28. Implementing the Profit-Maximizing Output & Pricing Decision • Step 1: Estimate demand equation • Use statistical techniques from Chapter 7 • Substitute forecasts of demand-shifting variables into estimated demand equation to get

  29. Implementing the Profit-Maximizing Output & Pricing Decision • Step 2: Find inverse demand equation • Solve for P

  30. Implementing the Profit-Maximizing Output & Pricing Decision • Step 3: Solve for marginal revenue • When demand is expressed as P = A + BQ, marginal revenue is

  31. Implementing the Profit-Maximizing Output & Pricing Decision • Step 4: Estimate AVC & SMC • Use statistical techniques from Chapter 10

  32. Implementing the Profit-Maximizing Output & Pricing Decision • 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

  33. Implementing the Profit-Maximizing Output & Pricing Decision • Step 7: Check shutdown rule • Substitute Q* into estimated AVC function • If P*AVC*, produce Q* units of output & sell each unit for P* • If P*< AVC*, shut down in short run

  34. Implementing the Profit-Maximizing Output & Pricing Decision • Step 8: Compute profit or loss • Profit = TR - TC • If P < AVC, firm shuts down & profit is -TFC

  35. Maximizing Profit at Aztec Electronics: An Example • Aztec possesses market power via patents • Sells advanced wireless stereo headphones

  36. Maximizing Profit at Aztec Electronics: An Example • Estimation of demand & marginal revenue

  37. Maximizing Profit at Aztec Electronics: An Example • Solve for inverse demand

  38. Maximizing Profit at Aztec Electronics: An Example • Determine marginal revenue function

  39. Demand & Marginal Revenue for Aztec Electronics(Figure 12.9)

  40. Maximizing Profit at Aztec Electronics: An Example • Estimation of average variable cost and marginal cost • Given the estimated AVC equation: • So,

  41. Maximizing Profit at Aztec Electronics: An Example • Output decision • Set MR = MC and solve for Q*

  42. * Maximizing Profit at Aztec Electronics: An Example • Output decision • Solve for Q*using the quadratic formula

  43. * Maximizing Profit at Aztec Electronics: An Example • Pricing decision • Substitute Q* into inverse demand

  44. * Maximizing Profit at Aztec Electronics: An Example • Shutdown decision • Compute AVC at 6,000 units:

  45. * * * * Maximizing Profit at Aztec Electronics: An Example • Computation of total profit

  46. Profit Maximization at Aztec Electronics(Figure 12.10)

  47. 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

  48. A Multiplant Firm (Figure 12.11)

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