CHAPTER 8. Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

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

CHAPTER OUTLINE Perfect competition Demand at the market and firm levels Short-run output decisions Long-run decisions Monopoly Monopoly power Sources of monopoly power Maximizing profits Implications of entry barriers Monopolistic competition Conditions for monopolistic competition Profit maximization Long-run equilibrium Implications of product differentiation Chapter Overview 8-2

8.1 PERFECT COMPETITION 1) Characteristics: The number of firms in the industry: a large number of firms each firm is small relative to the market firms are price takers The degree of homogeneity of the product: homogeneous products no brand perfect substitutes The ease of entry and exit: free entry and exit Availability of information: full information

8.1 PERFECT COMPETITION 1) Characteristics: The number of firms in the industry: The degree of homogeneity of the product: The ease of entry and exit: free entry and exit no barriers Availability of information: full information

8.1 PERFECT COMPETITION 2) Price takers: firms take market price as given a market price is determined by the interaction of market demand and market supply market demand curve is derived by adding the quantity demanded of each buyer at different prices market supply curve is derived by adding the quantity supplied of each seller at different prices

8.1 PERFECT COMPETITION Perfect Competition Price Market Price Firm S PP ee DD ff = PP ee D 0 Market output Firm s output 8-6

SHORT-RUN PROFIT MAXIMIZATION: REVENUE-COST APPROACH $ Slope of RR = MMMM = PP A Maximum profits E B Costs CC QQ Perfect Competition Revenue RR = PP QQ Slope of CC QQ = MMCC 0 QQ Firm s output 8-7

8.1 PERFECT COMPETITION 3) The Profit maximizing rule Max profit=total revenue- Total cost Optimal output level (q*) Marginal Rule: MR(q)=MC(q) In P.C. MR(q)=P => P=MC(q) Optimal output level (q*)

8.1 PERFECT COMPETITION Perfect Competition The cost function for a firm is CC QQ = 5 + QQ 2 and marginal cost function is CC(QQ)=2QQ. If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, What price should the manager of this firm charge? What level of output should be produced to maximize profits? How much profit will be earned? Answer: Charge $20. Since marginal cost is 2QQ, equating price and marginal cost yields: $20 = 2QQ QQ = 10 units. Maximum profits are: ππ = 20 10 5 + 10 2 = $95. 8-9

8.1 PERFECT COMPETITION 4) Calculating profit from a graph: 1) use MR=MC to find q* 2) find TR(=pq*) 3) find TC(=ATCq*) 4) profit=tr-tc

Perfect Competition SHORT-RUN PROFIT MAXIMIZATION IN ACTION $ MMMM AAAAAA PP ee AAAAAA QQ Profit DD ff = PP ee = MMMM 0 QQ Firm s output 8-

8.1 PERFECT COMPETITION 5) Four scenarios 1) P>ATC firm makes a profit 2) P=ATC firm breaks even (TR=TC) 3) AVC<P<ATC experiences losses but continues to produce 4) P<AVC shuts down production in the short run

Perfect Competition 8.1 PERFECT COMPETITION To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where PP = MMMM, provided that PP AAAAAA. If PP < AAAAAA, the firm should shut down its plant to minimize it losses. 8-

Perfect Competition 8.1 PERFECT COMPETITION The short-run supply curve for a perfectly competitive firm is: its marginal cost curve above the minimum point of the AAAAAA curve. 8-

8.1 PERFECT COMPETITION PP 1 $ Short-run supply curve for individual firm Perfect Competition MMMM AAAAAA PP 0 0 QQ 0 QQ 1 Firm s output 8-

Perfect Competition 8.1 PERFECT COMPETITION P Individual firm s supply curve MMMM ii Market supply curve S $12 $10 0 1 500 Market outpu 8-

8.1 PERFECT COMPETITION 8) Long-run competitive equilibrium PP=MMCC PP=mmiinniimmuumm ooff AACC

8.1 LONG-RUN COMPETITIVE EQUILIBRIUM $ Perfect Competition MMMM Long-run competitive equilibrium AAAA PP ee DD ff = PP ee = MMMM 0 QQ Firm s output 8-

8.2 MONOPOLY Definition: A market structure in which a single firm serves an entire market for a good that has no close substitutes.

8.2 MONOPOLY 2) Characteristics: The number of firms in the industry: a single firm The degree of homogeneity of the product: unique product The ease of entry and exit: legal barrier (e.g. a patented drug) cost barrier (e.g. huge fixed cost) Availability of information: imperfect information

8.2 MONOPOLY 3) Monopolist s demand and marginal revenue curve: firms are price setters market demand curve is the monopolist s demand curve However, a monopolist does not have unlimited market power.

8.2 MONOPOLY Monopoly Price Monopolist s power is constrained by the demand curve. PP 0 A PP 1 B DD ff = DD MM 0 QQ 0 QQ 1 Output 8-

8.2 MONOPOLY

MARGINAL REVENUE IN ACTION Suppose the inverse demand function for a monopolist s product is given by PP = 10 2QQ. What is the maximum price per unit a monopolist can charge to be able to sell 3 units? What is marginal revenue when QQ = 3? Answer: The maximum price the monopolist can charge for 3 units is: PP = 10 2 3 = $4. The marginal revenue at 3 units for this inverse linear demand is: MMMM = 10 2 2 3 = $2. Monopoly 8-

8.2 MONOPOLY A profit-maximizing monopolist should produce the output, QQ MM, such that marginal revenue equals marginal cost: MMMM QQ MM = MMMM QQ MM Monopoly 8-

8.2 MONOPOLY 4) Calculating profit from a graph: 1) use MR=MC to find q* 2) find p (from demand curve) 3) find TR(=pq*) 4) find TC(=ATCq*) 5) profit=tr-tc

8.2 MONOPOLY Monopoly Price PPPPPPPPPPPPPP = PP MM AAAAAA QQ MM QQ MM MC ATC PP MM AAAAAA(QQ MM ) Profits QQ MM MR Demand Quantity 8-

8.2 MONOPOLY Suppose the inverse demand function for a monopolist s product is given by PP = 100 2QQ and the cost function is CC QQ = 10 + 2QQ and MC Q = 2. Determine the profitmaximizing price, quantity and maximum profits. Answer: Profit-maximizing output is found by solving: 100 4QQ = 2 QQ MM = 24.5. The profit-maximizing price is: PP MM = 100 2 24.5 = $51. Maximum profits are: ππ = $51 24.5 10 + 2 24.5 = $1,190.50. Monopoly 8-

ABSENCE OF A SUPPLY CURVE Monopoly Recall, firms operating in perfectly competitive markets determine how much output to produce based on price (PP = MMMM). Thus, a supply curve exists in perfectly competitive markets. A monopolist s market power implies PP > MMMM = MMMM. Thus, there is no supply curve for a monopolist, or in markets served by firms with market power. 8-

LONG-RUN PROFIT OF MONOPOLY A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits. Implication: monopoly profits will continue over time provided the monopoly maintains its market power. Monopoly Monopoly power, however, does not guarantee positive profits, so monopoly profit could be zero in the long run. 8-

8.2 MONOPOLY 5) Sources of Monopoly Power Economies of scale Ownership of a key resource Patents and other legal barriers Licenses Economies of scope Cost complementary

ECONOMIES OF SCALE As output increases, long run average costs go down Such industries are called natural monopolies because concentration of production in a single firm is socially desirable EX: electricity, water company It s natural in the sense that we really don t want to have more than one firm, and naturally want to have one firm in the market

8.2 MONOPOLY 5) Source of Monopoly Power Economies of scale Ownership of a key resource Patents and other legal barriers Licenses

EXCLUSIVE CONTROL OVER INPUTS ownership of a key resource De Beers diamonds, mineral water from a specific spring can disappear if a substitute appears

DE BEER De Beers is well known for its monopoly practices throughout the 20th century, whereby it used its dominant position to manipulate the international diamond market.

8.2 MONOPOLY 5) Source of Mon Economies of scale Economies of scale Ownership of a key resource Patents and other legal barriers Licenses

PATENTS Right to exclusive use of an invention ---- 17 years in US While granting a firm a monopoly results in a loss of social welfare, the benefits in terms of innovation are expected to outweigh the costs

8.2 MONOPOLY 5) Source of Mon Economies of scale Economies of scale Ownership of a key resource Patents and other legal barriers Licenses

LICENSES Authorities give permission to one firm to operate EX: airport vendors; exclusive rights to sell on campus PP245

LONG-RUN PROFIT OF MONOPOLY A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits. Implication: monopoly profits will continue over time provided the monopoly maintains its market power. Monopoly Monopoly power, however, does not guarantee positive profits, so monopoly profit could be zero in the long run. 8-

Multiple-Output Cost Function 5.2.4 MULTI-PRODUCT COST FUNCTION Economies of scope Exist when the total cost of producing QQ 1 and QQ 2 together is less than the total cost of producing each of the type of output separately. CC QQ 1, 0 + CC 0, QQ 2 > CC QQ 1, QQ 2 https://www.youtube.com/watch?v=dml7u0kcgwq Cost complementarity Exist when the marginal cost of producing one type of output decreases when the output of another good is increased. MMMM 1 QQ 1, QQ 2 < 0 QQ 2 5-41

MULTIPLANT DECISIONS Monopoly Often a monopolist produces output in different locations. Implications: manager has to determine how much output to produce at each plant. Consider a monopolist producing output at two plants: The cost of producing QQ 1 units at plant 1 is CC QQ 1, and the cost of producing QQ 2 at plant 2 is CC QQ 2. When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is PP QQ, where QQ = QQ 1 + QQ 2. 8-

MULTIPLANT OUTPUT RULE Monopoly Let MMMM QQ be the marginal revenue of producing a total of QQ = QQ 1 + QQ 2 units of output. Suppose the marginal cost of producing QQ 1 units of output in plant 1 is MMMM 1 QQ 1 and that of producing QQ 2 units in plant 2 is MMMM 2 QQ 2. The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that: MMMM QQ = MMMM 1 QQ 1 MMMM QQ = MMMM 2 QQ 2 MMMM 11 QQ 11 =MMMM 22 QQ 22 =MMMM QQ 11 + QQ 22 8-

8.3 MONOPOLISTIC COMPETITION 1) Characteristics: The number of firms in the industry: a large number of firms The degree of homogeneity of the product: slightly different Implication: Firms compete on product quality, price and marketing The ease of entry and exit: Availability of information:

8.3 MONOPOLISTIC COMPETITION 1) Characteristics: The number of firms in the industry: The degree of homogeneity of the product: Implication: Firms compete on product quality, price and marketing The ease of entry and exit: free to enter and exit the industry Implication: In the long run equilibrium, firm s profit is zero Availability of information: imperfect information

PHONE INDUSTRY

WOMEN S HANDBAG INDUSTRY

8.3 MONOPOLISTIC COMPETITION 2) The Short-run output and price decisions products are close, but not perfect substitutes firm s demand curve is downward sloping firm s marginal revenue curve is downward sloping Profit maximization quantity at which MR=MC Price is determined from the demand curve

8.3 MONOPOLISTIC COMPETITION 3) The Long-run equilibrium If firms in monopolistically competitive markets earn short-run profits, additional firms will enter in the long run to capture some of those profits. losses, some firms will exit the industry in the long run.

Monopolistic Competition 8.3 MONOPOLISTIC COMPETITION Price PPPPPPPPPPPPPP = PP AAAAAA QQ QQ MC ATC PP AAAAAA(QQ ) Profits QQ MR Demand Quantity 8-

8.3 MONOPOLISTIC COMPETITION Monopolistic Competition Price MC ATC PP Due to entry of new firms selling other brands Demand 1 Demand 0 QQ MR 1 MR 0 Quantity of Brand X 8-

Monopolistic Competition 8.3 MONOPOLISTIC COMPETITION Price MC Long-run monopolistically competitive equilibrium ATC PP Demand 1 QQ MR 1 Quantity of Brand X 8-

8.3 MONOPOLISTIC COMPETITION Long-Run Output and Price Decision Zero Economic Profit In the long run, economic profit induces entry Entry continues as long as firms in the industry earn an economic profit as long as (P>ATC) Demand falls with firm entry until P=ATC and firms earn zero economic profit P>MC and MR=MC

8.3 MONOPOLISTIC COMPETITION In the long run, monopolistically competitive firms produce a level of output such that: PP > MMMM markup Monopolistic Competition PP = AAAAAA > mmmmmmmmmmmmmm oooo aaaaaaaaaaaaaa cccccccccc excess capacity 8-

MONOPOLY VS. PERFECT COMPETITION Monopoly: Higher price Lower quantity Lower consumer surplus Higher producer surplus Lower total surplus Dead weight loss exists

CONCLUSION Firms operating in a perfectly competitive market take the market price as given. Produce output where PP = MMMM. Firms may earn profits or losses in the short run. but, in the long run, entry or exit forces economic profits to zero. A monopoly firm, in contrast, can earn persistent profits provided that the 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 in the long run. 8-