Chapter 12 Managerial Decisions for Firms with Market Power

1. Chapter 12Managerial Decisions for Firms with Market Power

2. Learning Objectives • Define market power and describe measurement of market power • Explain why entry barriers are necessary for long run market power and discuss major types of entry barriers • Find the profit‐maximizing output, price, and input usage for a monopolist and monopolistic competitor • Employ empirically estimated or forecasted demand, average variable cost, and marginal cost to calculate profit‐maximizing output and price for monopolistic or monopolistically competitive firms • Select production levels at multiple plants to minimize the total cost of producing a given total output for a firm

3. 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)

4. 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

5. 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

6. Measurement of Market Power • Lerner index measures proportionate amount by which price exceeds marginal cost: • 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. Barriers to Entry • 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 • Essential input barriers • One firm controls a crucial input in the production process

10. Common Entry Barriers • Brand loyalties • Strong customer allegiance to existing firms may keep new firms from finding enough buyers to make entry worthwhile • Consumer lock-in • Potential entrants can be deterred if they believe high switching costs will keep them from inducing many consumers to change brands

11. Common Entry Barriers • Network externalities • Occur when benefit or utility 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 base or network of buyers • Sunk costs • Entry costs (which are sunk costs) can serve as a barrier if they are so high that the manager cannot expect to earn enough future profit to make entry worthwhile

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, and is twice as steep

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

14. Short-Run Profit Maximization for Monopoly • Monopolist will produce where MR = SMC as long as TR at least covers the firm’s total avoidable cost (TR ≥ TVC) • Price for this output is given by the demand curve • If TR < TVC (or, equivalently, P < AVC) the firm shuts down & loses only fixed costs • If P > ATC, firm makes economic profit • If ATC > P > AVC, firm incurs a loss, but continues to produce in short run

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

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

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 profit-maximizing output level

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

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

20. 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

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

22. Profit-Maximizing Input Usage • For a firm with market power, profit-maximizing conditions MRP = wand MR = MCare equivalent • Whether Q or L is chosen to maximize profit, resulting levels of input usage, output, price, & profit are the same

23. 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

24. 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

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

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

27. 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 Q = a′ + bP

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

29. Implementing the Profit-Maximizing Output & Pricing Decision • Step 3: Solve for marginal revenue • When demand is expressed as P = A + BQ, marginal revenue is • Step 4: Estimate AVC & SMC • Use statistical techniques from Chapter 10 AVC = a + bQ + cQ2 SMC = a + 2bQ + 3cQ2

30. 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

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

32. Implementing the Profit-Maximizing Output & Pricing Decision • Step 8: Compute profit or loss • Profit = TR – TC = P x Q* - AVC x Q* - TFC = (P – AVC)Q* - TFC • If P < AVC, firm shuts down & profit is -TFC

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

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

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

36. Maximizing Profit at Aztec Electronics: An Example • Determine marginal revenue function P = 100 – 0.002Q MR = 100 – 0.004Q

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

38. Maximizing Profit at Aztec Electronics: An Example • Estimation of average variable cost and marginal cost • Given the estimated AVC equation: AVC = 28 – 0.005Q + 0.000001Q2 • Then, SMC = 28 – (2 x 0.005)Q + (3 x 0.000001)Q2 = 28 – 0.01Q + 0.000003Q2

39. Maximizing Profit at Aztec Electronics: An Example • Output decision • Set MR = MC and solve for Q* 100 – 0.004Q = 28 – 0.01Q + 0.000003Q2 0 = (28 – 100) + (-0.01 + 0.004)Q + 0.000003Q2 = -72 – 0.006Q + 0.000003Q2

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

41. Maximizing Profit at Aztec Electronics: An Example • Pricing decision • Substitute Q* into inverse demand P* = 100 – 0.002(6,000) = $88

42. Maximizing Profit at Aztec Electronics: An Example • Shutdown decision • Compute AVC at 6,000 units: AVC* = 28 - 0.005(6,000) + 0.000001(6,000)2 = $34 • Because P = $88 > $34 = ATC, Aztec should produce rather than shut down

43. Maximizing Profit at Aztec Electronics: An Example • Computation of total profit π= TR – TVC – TFC =(P*x Q*) – (AVC*x Q*) – TFC = ($88 x 6,000) – ($34 x 6,000) - $270,000 = $528,000 - $204,000 - $270,000 = $54,000

44. Profit Maximization at Aztec Electronics (Figure 12.10)

45. 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

46. A Multiplant Firm (Figure 12.11)

47. Summary • Price-setting firms possess market power • A monopoly exists when a single firm produces and sells a particular good or service for which there are no good substitutes and new firms are prevented from entering the market • Monopolistic competition arises when the market consists of a large number of relatively small firms that produce similar, but slightly differentiated, products and have some market power • A firm can possess a high degree of market power only when strong barriers to the entry of new firms exist • In the short run, the manager of a monopoly firm will choose to produce where MR = SMC, rather than shut down, as long as total revenue at least covers the firm’s total variable cost (TR ≥ TVC)

48. Summary • In the long run, the monopolist maximizes profit by choosing to produce where MR = LMC, unless price is less than long-run average cost (P < LAC), in which case the firm exits the industry • For firms with market power, marginal revenue product (MRP) is equal to marginal revenue times marginal product: MRP = MR × MP • Whether the manager chooses Q or Lto maximize profit, the resulting levels of input usage, output, price, and profit are the same • Short-run equilibrium under monopolistic competition is exactly the same as for monopoly

49. Summary • Long-run equilibrium in a monopolistically competitive market is attained when the demand curve for each producer is tangent to the long-run average cost curve • Unrestricted entry and exit lead to this equilibrium • 8 steps can be employed for profit-maximization for a monopoly or monopolistically competitive firm: (1) estimate demand equation, (2) find inverse demand equation, (3) solve for marginal revenue, (4) estimate average variable cost and marginal cost, (5) find output level where MR = SMC, (6) find profit-maximizing price, (7) check the shutdown rule, and (8) compute profit/loss • A firm producing in two plants, Aand B, should allocate production between the two plants so that MCA = MCB