Chapter 12: Managerial Decision for Firm with Market Power

Market Power Ability of a firm changing output level to influence the market price Any firm that faces downward sloping demand has market power Gives firm ability to charge price above marginal cost P > MC Dr. Chen’s notes: The best example to illustrate market power is OPEC in the world crude oil market. When OPEC cuts (raises) the production, crude oil market price increases (decreases). Price is well above the marginal cost.

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 Dr. Chen’s notes: A P.C. firm facing the horizontal demand (price line) has zero market power.

Measurement of Market Power Lerner index measures proportionate amount by which price exceeds marginal cost: Dr. Chen’s notes: Lerner index is one of the measures (the most common measure) for market power. It only requires the information of market price and a firm’s marginal cost. Given the definition, we can see that 0 ≤ Lerner index ≤ 1. If Firm A has a greater Lerner index than Firm B’s, then Firm A has a stronger market power. However, Lerner index doesn’t work well for some industries in which most firms’ marginal costs are pretty low. For example, the software industry, each firm’s marginal costs (additional cost per copy) are similar and close to zero. Lerner index cannot tell the difference significantly between two firms. In the case, some measures of market shares (e.g. Herfindahl index) will work better.

Measurement of Market Power Lerner index Equals zero under perfect competition Increases as market power increases Also equals –1/ED, 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 Dr. Chen’s notes: Lerner index = (P  MC)/P =  1/E which is derived from the result on Slide #19 in Chapter 6. It is worth to study the textbook pp. 457. The result allows us to compare firms’ market power through the price elasticity of demand on their products.

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 Dr. Chen’s notes: Monopoly is another polar market structure. Compared with a P.C. firm which has zero market power, a monopoly can charge a price much higher than its marginal cost. Due to the entry barrier, monopoly can maintain a positive profit in both short-run and long-run without competition.

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 Dr. Chen’s notes: Economies of scale is also known as a “natural” barrier. In the past, utility industry (e.g. telephone service, electricity…etc) and transportation industry (e.g. railroad, airline…etc), were defined as natural monopoly because their cost structures exhibited economies of scale. A single seller might benefit consumers more by providing lower price with lower average total costs. In order to control the price, the government set regulations (constraints) on the revenues for those natural monopolies. So, they were also called “regulated monopolies”.

Common Entry Barriers Barriers created by government Input barriers Licenses, exclusive franchises 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 Dr. Chen’s notes: The United State Postal Service (USPS) can open every household’s mailbox for mail delivery because it is granted the franchise of mailbox by the U.S. Government.

Common Entry Barriers Consumer lock-in Network externalities 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 Dr. Chen’s notes: The two barriers in the above are particularly applied in the 3C Industry (Computer, Communication and Consumer Electronic). With them, a successful firm can “tip” the whole market. So, is Facebook a monopoly?

Demand & Marginal Revenue for a Monopolist Market demand curve is the firm’s demand curve 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 Dr. Chen’s notes: Remember the marginal revenue (MR) curve in CH 6? We face it again here. If an inverse demand facing a firm is linear, say P = A + BQ (A > 0, B < 0), then the firm’s marginal revenue is also linear. MR bisects the distance between the vertical (price) axis and demand curve as MR = A + 2BQ

Demand & Marginal Revenue for a Monopolist (Figure 12.1)

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 Dr. Chen’s notes: MR=MC is the rule of thumb for all firms’ profit maximization. Monopoly will locate its optimal output Q* by MR=MC; then plug Q* into the market demand function to see what the price should be. Please check the graph on the next slide. Once the 200 units is determined by the intersection of SMC and MR, the monopoly will charge $7 as the unit price which is reflected by the demand curve. Therefore, there is NO SUPPLY CURVE for a monopoly! The monopoly price is determined by demand curve and optimal output rate.

Short-Run Profit Maximization for Monopoly (Figure 12.3)

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 Dr. Chen’s notes: The shutdown rule is the same as that for a P.C. firm.

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

Long-Run Profit Maximization for Monopoly (Figure 12.5)

Profit-Maximizing Input Usage Marginal revenue product (MRP) MRP is the additional revenue attributable to hiring one more unit of the input (labor or capital) MRPL = MR * MPL =TR / L MRPK = MR * MPK =TR / K Duality For a firm with market power, the profit-maximizing conditions MRP = input price in input and MR = MC in output are equivalent Dr. Chen’s notes: Recall Ch 11. A monopoly can also maximize the profit by MRPL = w (wage) and MRPL = r (interest rate). Compared with a P.C. firm’s MRP (i.e. MRP= P*MP ), a monopoly’s MRP = MR*MP < P*MP (i.e. price is higher than MR). So, an input (e.g. labor) is underpaid by a monopoly because its MRPL = w (wage) < P*MP in which wage is less than the value of production.

Monopolistic Competition Large number of firms; each firm has its local territory Differentiated product Pure monopoly in the short run Competitive in the long run Dr. Chen’s notes: Monopolistic competition (M.C. market) is the third market structure. We already learned the P.C. and monopoly. The four market characteristics in the above imply that any industry in which “location” serves as the most important factor in demand, can be qualified as a M.C. market. For example, shopping centers, restaurants, movie theaters, and convenient stores. The “convenience” of location makes the products differentiated to you. In the SR, a M.C. firm faces the whole local demand as a monopoly. If it is quite profitable, new firms will enter the territory to share profits in the long run.

Monopolistic Competition Short-run equilibrium is identical to monopoly Unrestricted entry/exit leads to long-run equilibrium (see the next slide) A firm’s demand will shrink (left shift) when new firms enter its territory Attained when demand curve for each producer is tangent to LAC At LR equilibrium output, P = LAC; that is, a M.C. firm only earns a normal profit; please see the next slide.

Long-Run Profit Maximization for Monopolistic Competition (Figure 12

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

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

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

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

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

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

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

Example: Maximizing Profit at Aztec Electronics (pp. 489-493) Solve for inverse demand

Maximizing Profit at Aztec Electronics: An Example Determine marginal revenue function Double coefficient 

Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)

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

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

Maximizing Profit at Aztec Electronics: An Example Output decision Solve for Q* using the quadratic formula * Dr. Chen’s notes: Remember the quadratic formula for solving y = f(x)= ax2 +bx +c = 0?

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

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

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