Managing in Perfectly Competitive and Monopolistic Markets

Perfect Competition Conditions: Large number of buyers and sellers Homogeneous product Perfect knowledge Free entry and exit No government intervention Key Implications: Flat firms’ demand determined by market equilibrium price Market participants are price takers without any market power to influence prices (have to charge MR = P = MC) In the short run firms earn profits or losses or shut down In the long run profit = normal = 0 (firms operate efficiently)

Monopoly Conditions: Large number of buyers and one sellers Product without close substitutes Perfect knowledge Barriers to entry No government intervention Key Implications: Downward sloping firm’s demand is market demand Firm has market power and determines market price (can charge P > MR = MC) In the short run monopoly earns profit or loss or shuts down In the long run profit > normal is sustainable indefinitely but even with profit = normal = 0 (monopoly does not operate efficiently)

Sources of Monopoly Power Natural: Economies of scale and excess capacity Economies of scope and cost complementarities Capital requirements, sales and distribution networks Differentiated products and brand loyalty Created: Patents and other legal barriers (licenses) Tying and exclusive contracts Collusion (tacit or open) Entry limit pricing (predatory pricing illegal)

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

Profit Maximization for Total Measures Industry D (TR) = Firm D (TR) T is maximized: Where the slope of T is 0 (TR and TC are parallel or their slopes are equal). dT / dQ = M = 0 2 such points (Q1, Q3) need additional condition: 2. d2T / dQ2 is negative or max TR - TC => Q* = Q3.

Profit Maximization for per Unit Measures T is maximized: At Q where MR = MC. 2 points, need additional condition MR < MC for any Q > Q* = Q3 (Q* is one of FONC candidates) or when MC is increasing. T = [(TR – TC)/Q]Q = (AR – AC)Q = (P – AC)Q Max T = area of the rectangle = (AR|Q* - AC|Q*)Q* = (P|Q* - AC|Q*)Q*

A Numerical Example Given estimates of Optimal output? Optimal price? P = 10 - Q C(Q) = 6 + 2Q Optimal output? MR = 10 - 2Q = 2 = MC Q = 4 units Optimal price? P = 10 - (4) = $6 Maximum profits? PQ - C(Q) = 6(4) - (6 + 8) = $10

= 0

Shut-Down Point In the long run all cost must be recovered. In the short run fixed cost incurred before production begins and do not change regardless of the level of production (even for Q = 0). Shut down only if: –TFC > T (total) AVC > P (per unit). TFC = AFC*Q = (SAC – AVC)*Q Operate with loss if: 0 > T  –TFC (total) SAC > P  AVC (per unit). This is the third T maximizing condition.

Setting Price $ TR Firm small part of industry: Industry D (TR) > Firm D (TR) Firm’s D small segment of upward slopping Industry D Qf(units) $ $ DM SM Df = Pf = AR = MR PM QM(106) Qf(units) Firm Market

Choosing Output To maximize total profit: T = TR - TC FONC: dT /dQ = M = MR - MC = 0 In general (including monopoly) MR = MC. In perfect competition MR = P = MC. To maximize profit increase output (Q) until 1) MR = P = MC (at Q*), and 2) for Q > Q* => MC > P (or MC is increasing) => M < 0 => TC < TR As long as: max T ≥ -TFC or P ≥ AVC

A Numerical Example Given estimates of Optimal Price? Optimal Output? C(Q) = 5 + Q2 Optimal Price? Optimal Output? MR = P = $10 = 2Q = MC Q = 5 units Maximum Profits? PQ - C(Q) = 10(5) - (5 + 25) = $20

Profit > Normal

Normal Profit Normal profit is necessary for the firm to produce over the long run and is considered a cost of production Normal profit is required because investors expect a return on their investment. Profit < normal leads to exit in the long run. Profit > normal leads to entry in the long run. Profit = normal maintains the # of firms in the industry.

Shutdown

Short-Run Supply Under Perfect Competition

Effect of Entry on Market Price & Quantity Firm Qf $ Df Market QM D S Pe S* Pe* Df* Entry Short run profits leads to entry Entry increases market supply, driving down the market price and increasing the market quantity

Effect of Entry on Firms Output & Profit $ Q LAC LMC QL Pe Df Pe* Df* Qf* Demand for individual firm’s product and hence its price shifts down Long run profits are driven to zero

Perfect Competition in the Long Run Socially efficient output and price: MR = P = MC (no dead weight loss) Efficient plant size: P = MC = min AC (all economies of scale exhausted) Optimal resource allocation: T = Normal  = 0 because P = min AC (because of no market power or free entry opportunity cost equals TR )

Perfect Competition S = MC > min AVC PPC D = P = MR QPC Price Consumer surplus Price S = MC > min AVC PPC Producer surplus Efficient quantity D = P = MR QPC Quantity 60

Inefficiency of Monopoly PA Consumer surplus Price S = MC > min AVC PM Deadweight loss Monopoly’s gain PPC Producer surplus MR D = P QM QPC Quantity 61

Monopoly in the Long Run with Greater than Normal and Normal Profit Socially inefficient: P > MR = MC (QM<QPC, PM>PPC, dead weight loss) Scale inefficient: P > MC = min AC (economies of scale still exist) Misallocated resources: even when T = normal  = 0, P is still > min AC (because of market power or barriers to entry opportunity cost < TR) Encouraged R&D, benefits from natural monopolies, economies of scope and cost complementarity might offset inefficiencies

Synthesizing Example C(Q) = 125 + 4Q2 => MC = 8Q is unaffected by market structure. What are profit maximizing output & price, and their implications if You are a price taker, other firms charge $40 per unit? P = MR = 40 = 8Q = MC => Q* = 5 and P* = 40 Max T = TR - C(Q*) = 40(5) - (125+4(5)2) = 200 - 225 = -$25 Expect exit in the long-run You are a monopolist with inverse demand P = 100 – Q? MR = 100 - 2Q = 8Q = MC => Q* = 10 and P* = 100 - Q = 100 - 10 = 90 Max T = TR - C(Q*) = 90(10) - (125+4(100)) = 900 - 525 = $375 No entry until barriers eliminated

Natural Monopoly LAC 5 10 15 1 2 3 4 D=P Economies of scale exist over the entire LAC curve. One firm distributes 4 million kWh at ¢5 a kWh. This same total output costs ¢10 a kWh with two and ¢15 a kWh with four firms. Natural monopoly: one firm meets the market demand at a lower cost than two or more firms. Public utility commission ensures that P = LAC (not P associated with MR = MC), eliminating monopoly rent. LAC Quantity (millions of kilowatt-hours) 5 10 15 1 2 3 4 D=P Price (cents per kilowatt-hour) 10

Break-Even Analysis Approximation in absence of detailed data on revenue & costs. Assume both TR & TC are linear. At the Break-even output: TR = TC = TVC + TFC P*QBE = AVC*QBE + TFC (P – AVC)*QBE = TFC QBE = TFC / (P – AVC) P = $6, AVC = $3.6, TFC = $60K QBE = 60,000 / (6 – 3.6) QBE = $25,000 (P – AVC) unit contribution margin. 1 – P/AVC contribution margin ratio (fraction of P to recover TFC)