Market Structures: Perfect and Imperfect Competition, Profit Maximization, and Pricing Strategy

5.1 Perfect & Imperfect Competition Summary Market Structures: Perfect and Imperfect Competition, Profit Maximization, and Pricing Strategy 5.1 Perfect & Imperfect Competition Summary 5.2 Market Power & Imperfect Competition 5.3 Compare Perfect Competition & Imperfect Competition 5.4 Monopolistic Competition as a Form of Imperfect Competition

5.1 Perfect & Imperfect Competition Summary Market Structures: Perfect and Imperfect Competition, Profit Maximization, and Pricing Strategy 5.1 Perfect & Imperfect Competition Summary See class notes.

Perfect Competition Characterized by A large number of firms in the market An undifferentiated product Ease of entry into the market Complete information available to all market participants

Perfect Competition Distinguished between behavior of individual firms and outcomes for entire market No single firm has any influence on the price of a product Price-taker: a firm cannot influence the price of its product, thus it can sell any amount of output at that price

Perfectly Competitive Figure 5.1 Industry/Market Individual Firm Q P Q1 MC Q2 ATC D=P=MR B A PE Q QE D S

Profit Maximization = TR - TC where = profit TR = total revenue TC = total cost Profit-maximization rule: to maximize profits, a firm should produce the level of output where marginal revenue equals marginal cost

Marginal Revenue Price equals marginal revenue for a perfectly competitive firm because the firm does not have to lower the price to sell more units of output The profit-maximizing level of output occurs where marginal revenue equals marginal cost because any other level of output will result in smaller profit

Determining the Amount of Profit Earned If you know total revenue and total cost, you can calculate amount of profit Using TR and TC function graphs, you can calculate level of profit-maximizing by finding the greatest distance between the two curves and calculate the profit at that point

The Shutdown Point The shutdown point for perfectly competitive firm: the price, which just equals AVC, below which it is more profitable for the perfectly competitive firm to shut down than to continue to produce The supply curve is that portion of its marginal cost curve above minimum AVC

Supply Curve for Perfectly Competitive Industry The supply curve shows the output produced by all perfectly competitive firms in the industry at different prices.

Long-run Adjustment Two factors: Entry and exit by new and existing firms Changes in the scale of operations by all firms These factors can occur simultaneously

Long-run Adjustment Equilibrium point for the perfectly competitive firm: the point where price equals ATC since the firm earns zero economic profit at this point Economic profit incorporates all implicit costs of production including normal rate of return on investment

Long-run Adjustment: Entry and Exit Figure 5.2 Industry/Market Individual Firm D2 PE2 QE2 QE1 D1 S1 S2 QE3 PE1 MC ATC D1=P1=MR1 P Q1 Q2 A B D2=P2=MR2

Long-run Adjustment Firm is a price-taker; therefore, it must accept new equilibrium price and determine appropriate level of output All firms know the positive economic profits Other firms are able to enter the market

Optimum Scale of Production Figure 5.3 SMC1 LRAC SATC1 SMC2 $ Q1 Q2 Q P1=MR1 SATC2 P2=MR2

Optimum Scale of Production In Figure 5.3, LRAC incorporates both economies of scale and diseconomies of scale Large-scale production will give managers competitive edge by decreasing production costs Cannot influence price of product

Managerial Rule of Thumb: Competition Means Little Control Over Price Managers have little or no control over product price They compete on basis of lowering costs of production Perfectly competitive firms earn zero economic profit because entry of other firms compete away excess profit

Managerial Rule of Thumb: Strategies to Gain Market Power Managers in competitive industries can gain market power by Merging with other companies Differentiating products Forming producer association to change consumer preferences and increase demand for output of the entire industry

5.2 Market Power & Imperfect Competition Market power: ability of a firm to influence the prices of its products and develop strategies to earn profits over longer periods of time Monopoly: single firm producing product with no close substitutes Price-searchers: firms in imperfect competition

Imperfect Competition Model with Positive Economic Profit Q $ ATCM QM PM Figure 5.4 D MR MC A ATC B

Imperfect Competition with Negative Economic Profit Q $ ATCM QM PM Figure 5.5 MR D MC B ATC A

Imperfect Competition Monopolist maximizes profits by producing where MR = MC and earns positive economic profit due to barriers to entry The monopolist could suffer losses if ATC is greater than price at the profit-maximizing level of output (previous slide)

Comparing Imperfect and Perfect Competition Figure 5.6 MC ATC D=P=MR $ QPC Q QM MC Q1 ATC MR $ P1 P2

5.3 Comparing Imperfect and Perfect Competition Monopolistic firm must seek out optimal price, which depends on demand and cost conditions Firms with market power might pursue other profit goals Price is higher and output lower under monopoly than under perfect competition

Barriers to Entry Economies of scale and mergers Barriers created by government Input barriers Brand loyalties Consumer lock-in and switching costs

Economies of Scale and Mergers Exist when a firm’s LRAC slopes downward or when lower production costs are associated with larger scale of operation Can act as a barrier to entry in different industries Mergers are particularly important in technology, media, and telecommunications

Barriers Created by Government Licenses Patents and copyrights

Input Barriers Control over raw materials Barriers in financial capital markets Larger firms can get lower interest rates Smaller firms need more collateral for loans Smaller firms are perceived as riskier

Consumer Lock-In and Switching Costs When consumers become locked into certain types or brands and would incur substantial switching costs if they changed Although lock-in types are dominant, they represent managerial strategies that can be used elsewhere to gain market power

Measures of Market Power Managers can use measures to better understand the markets Lerner Index: measure of market power that focuses on the difference between a firm’s product price and marginal cost of production L = (P – MC) P

Antitrust Issues Federal legislation that limits market power of firms and regulates how firms use their market power to compete Major components of antitrust law: Sherman Act of 1890 Clayton Act of 1914 Federal Trade Commission Act of 1914

Managerial Rule of Thumb: Understanding Antitrust Laws Managers must work within antitrust constraints Because of generalities and ambiguities, managers may not know whether their actions are illegal unless the government initiates litigation

5.4 Monopolistic Competition as a form of Imperfect Competition Product differentiation exists among firms Large number of firms exist No interdependence exists among these firms Entry by new firms is relatively easy

Monopolistic Competition, Long Run and Short run Figure 5.7 $ Q1 Q P1 $ Q2 Q P2 D MR MC D MR MC ATC ATC