Chapter 12: Managerial Decisions for Firms with Market Power McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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)

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

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

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

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

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

Barriers to entry: 2 definitions “[A]nything which creates a disadvantage for potential entrants vis à vis established firms. The height of the barriers is measured by the extent to which, in the long run, established firms can elevate their selling prices above minimal average cost . . . without inducing potential entrants to enter” [Joe Bain, Industrial Organization, 2nd ed., p. 252]. Barriers to entry into a market . . . can be defined to be socially undesirable limitations to entry of resources which are due to protection of resource owners already in the market” [Christian von Weizsäcker, Barriers to Entry, p. 13].

Examples of barriers to entry Absolute cost advantages Examples: Alcoa had access to low cost hydroelectric power in Pacific NW; Weyerhauser procured extraction rights to tracts of Douglas fir in 1901; International petroleum majors (Texaco, SOCAL, BP, et al) formed a pipeline consortium in California. Economies of scale: Dominant firm may enjoy cost advantages due to realization of scale economies in production, distribution, capital raising, or sales promotion.

Barriers due to control of wholesale, retail distribution systems Examples: Control of wholesale diamond distribution by DeBeers; Control of advantageous retail shelf space by Proctor and Gamble, Kellogs. Barriers due to patents, copyrights, trademarks, and other legal barriers Examples: Xerox’s patent on xerography; Polaroid’s patent on instamatic photography Barriers due to product differentiation/brand power Examples: Cigarettes, pain relievers, designer jeans, athletic wear, batteries, soft drinks

Strategic Barriers Alcoa’s restrictive covenants with hydroelectric suppliers. Standard Oil’s “secret rebate” policy with the railroad companies. “Lease-only” policy of IBM, United Shoe Machinery, International Salt IBM’s continual design modification was designed to forestall entry of firms such as Calcomp that marketed plug-compatible peripherals—e.g.,tapes and line printers. Microsoft charges PC makers a royalty for every computer shipped—regardless of whether the machine has a Windows operating system installed. Microsoft requires that Explorer icon appear on desktop in initial boot up sequence.

The Microsoft case Microsoft Corporation v. U.S. 530 U.S. 1301 (2000) The Antitrust Division of the DOJ won Sherman section 1 and section 2 convictions against the software giant. The key element in the case was the so-called “applications barrier to entry.”                                                

The applications barrier in the Microsoft case Hear audio explanation (wav) Judge Jackson stated in his Finding of Fact: “[T]he applications barrier would prevent an aspiring entrant into the relevant market from drawing a significant number of customers away from a dominant incumbent even if the incumbent priced its products substantially above competitive levels for a significant period of time.”

Proprietary control of “application program interfaces” keeps software developers in the Microsoft tent. “These are synapses at which the developer of an application can connect to invoke pre-fabricated blocks of code in the operating system. These blocks of code in turn perform crucial tasks, such as displaying text on the computer screen. Because it supports applications while interacting more closely with the PC system's hardware, the operating system is said to serve as a ‘platform.’” Judge Jackson’s Finding of Fact

The middleware threat Mr. Gates viewed middleware (the Java programming language and Netscape browser software) as rival platforms for ISV’s. Gates feared middleware would bring down the applications barrier. Hear Brown’s comments (wav)

Evidence of ‘willful acquisition and maintenance . . . “ The government alleged that Microsoft designed its licensing agreements with OEM’s and IAP’s so as to preserve the applications barrier. This was also its objective in giving away Internet Explorer for free.

The OEM Channel Licensing agreements with Original Equipment Makers (OEM’s) stipulated pre-installation of Internet explorer. Internet Explorer icon must appear on the desktop after the initial boot-up sequence. OEM’s prohibited from pre-installing Netscape browser software.

The IAP Channel Microsoft offered IAP’s valuable “real estate” on the Windows desktop in exchange for their agreement to distribute Internet Explorer exclusively. Hear audio explanation (wav) If an IAP was already under contract to pay Netscape a certain amount for browser licenses, Microsoft offered to compensate the IAP the amount it owed Netscape. Microsoft also reduced the referral fees that IAPs paid when users signed up for their services using the Internet Referral Server in Windows in exchange for the IAPs' efforts to convert their installed bases of subscribers from Navigator to Internet Explorer.

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

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, & is twice as steep

Demand & Marginal Revenue for a Monopolist (Figure 12.1)

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

Short-Run Profit Maximization for Monopoly (Figure 12.3)

Short-Run Loss Minimization for Monopoly (Figure 12.4) Shut-down rule

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 Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

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

Monopoly Firm’s Demand for Labor (Figure 12.6)

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

Monopolistic Competition A market structure featuring a relatively large number of sellers and a differentiated product/service Examples: Women’s shoes, snack foods, furniture, carpet, bathroom fixtures, men’s suits, cold cuts.

The monopolistic competitor faces a downward sloping, but very elastic, demand curve.

Short run equilibrium in monopolistic competition 5 5 5

Long Run Equilibrium in Monopolistic Competition D o l l a r s p e r U n i t o f O u t p u t A C M C P E M R D F F Q E O u t p u t ( b ) L o n g - R u n E q u i l i b r i u m: t h e F i r m E a r n s Z e r o E c o n o m i c P r o f i t 6 6 6

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

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

Short-Run Profit Maximization for Monopolistic Competition (Figure 12

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 Q = a′ + bP

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 Step 4: Estimate AVC & SMC Use statistical techniques from Chapter 10 AVC = a + bQ + cQ2 SMC = a + 2bQ + 3cQ2

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 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

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

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

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

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

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

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: AVC = 28 – 0.005Q + 0.000001Q2 Then, SMC = 28 – (2 x 0.005)Q + (3 x 0.000001)Q2 = 28 – 0.01Q + 0.000003Q2

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

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

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

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

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

Profit Maximization at Aztec Electronics (Figure 12.10)

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

A Multiplant Firm (Figure 12.11)