Chapter 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

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1 Managerial Economics & Business Strategy Chapter 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2 I. Perfect Competition Overview 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. 8-2

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. 8-3

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. 8-4

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. 8-5

6 Managing a Perfectly Competitive Firm (or Price-Taking Business) 8-6

7 Setting Price $ S $ P e D f D Market Q M Firm Q f 8-7

8 Profit-Maximizing Output Decision MR = MC. Since, MR = P, Set P = MC to maximize profits. 8-8

9 Graphically: Representative Firm s Output Decision $ Profit = (P e - ATC) Q f* MC ATC P e AVC P e = D f = MR ATC Q f* Q f 8-9

10 Given P=$10 A Numerical Example C(Q) = 5 + Q 2 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) = $

11 Should this Firm Sustain Short Run Losses or Shut Down? $ Profit = (P e - ATC) Q f* < 0 MC ATC AVC ATC P e Loss P e = D f = MR Q f* Q f 8-11

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. 8-12

13 Firm s Short-Run Supply Curve: MC Above Min AVC $ MC AVC ATC P min AVC Q f* Q f 8-13

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 8-14

15 Firm s Long-run Equilibrium A firm begins in but then an increase in long-run leading eq m to driving SR profits Over time, to zero profits demand induce raises entry, P, profits for the and firm. restoring shifting long-run S to eq m. the right, reducing P P One firm MC P Market S 1 P 2 P 1 Profit ATC P 2 A B C S 2 Q (firm) Q 1 Q 2 Q 3 D 2 D 1 Q (market) 8-15

16 Long-run Supply Curve In the long run, the typical firm earns zero profit. The LR market supply curve is horizontal at P = minimum ATC. P One firm MC P Market P = min. ATC LRATC Q (firm) long-run supply Q (market) 8-16

17 Long run Equilibrium Example TC(q) = 40q 6q 2 +q 3 /3 D(P) = P Find Q*, q*, P*, n*. Decision rule: MC=MR=P=ATC Step 1: MC(q) = 40-12q +q 2 Step 2: AC(q) = 40-6q+q 2 /3 Step 3: MC=AC 2q 2 /3=6q 2q/3=6 q*=9 8-17

18 Long run Equilibrium Example TC(q) = 40q 6q 2 +q 3 /3 D(P) = P Find Q*, q*, P*, n*. Decision rule: MC=MR=P=ATC Step 4: P*=AC(q) = 40-6q+q 2 /3= =13=p* Step 5: Q*=D(P) = P*= (13)=900 Step 6: n* = Q*/q*=

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 8-19

20 Marginal Revenue P TR 100 Elastic Unit elastic Inelastic 40 Unit elastic Q Q MR Elastic Inelastic 8-20

21 Monopoly: Profit Maximization Maximize profits Produce output where MR = MC. Inverse Elasticity Pricing Rule MR = P + P Q Q = P + P Q MC( Q*) = P * 1+ 1 L = P * MC * P * ε Q,P = 1 ε Q,P Q P P = P 1+ 1 Q P P Q = P 1+ 1 ε 8-21

22 Monopoly $ Profit MC ATC P M ATC D Q M MR X 8-22

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. 8-23

24 Short-Run Monopolistic Competition $ Profit MC ATC P M ATC D Q M MR Quantity of Brand X 8-24

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. 8-25

26 Long-Run Monopolistic Competition $ Long Run Equilibrium (P = AC, so zero profits) MC AC P* P 1 Entry D MR D 1 Q 1 Q* MR 1 Quantity of Brand X 8-26

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)! 8-27

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. A R = E Q, A E Q, P 8-28

29 Maximizing Profits: A Synthesizing Example C(Q) = Q 2 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. 8-29

30 C(Q) = Q 2, Marginal Cost So MC = 8Q. This is independent of market structure. 8-30

31 MR = P = $40. Set MR = MC. 40 = 8Q. Q = 5 units. Price Taker Cost of producing 5 units. C(Q) = Q 2 = = $225. Revenues: PQ = (40)(5) = $200. Maximum profits of -$25. Implications: Expect exit in the long-run. 8-31

32 Monopoly/ Monopolistic Competition MR = 100-2Q (since P = Q). Set MR = MC, or 100-2Q = 8Q. Optimal output: Q = 10. Optimal price: P = (10) = $90. Maximal profits: PQ - C(Q) = (90)(10) -( (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. 8-32

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. 8-33

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