Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managerial Economics & Business Strategy Chapter 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Overview I. Perfectly Competition n Characteristics and profit outlook n Effect of new entrants II. Monopolies n Sources of monopoly power. n Maximizing monopoly profits. n Pros and cons III. Monopolistic Competition n Profit maximization n Long run equilibrium

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Perfect Competition Many buyers and sellers Homogeneous product Perfect information No transaction costs Free entry and exit

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Key Implications Firms are “price takers” (P = MR) In the short-run, firms may earn profits or losses Long-run profits are zero

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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 n Importance of product differentiation n Sustainable advantage

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managing a Perfectly Competitive Firm (or Price-Taking Business)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Setting Price Firm QfQf $ DfDf Market QMQM $ D S PePe

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Setting Output: MR = MC MR = P, therefore Set P = MC to maximize profits

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Graphically $ QfQf ATC AVC MC P e = D f = MR Q f* ATC PePe Profit = (P e - ATC)  Q f*

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 A Numerical Example Given n P=$10 n C(Q) = 5 + Q 2 Optimal Price? n P=$10 Optimal Output? n MR = P = $10 and MC = 2Q n 10 = 2Q n Q = 5 units Maximum Profits? n PQ - C(Q) = (10)(5) - (5 + 25) = $20

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Long Run Adjustments? If firms are price takers but there are barriers to entry, profits will persist If the industry is perfectly competitive, firms are not only price takers but there is free entry n Other “greedy capitalists” enter the market

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Effect of Entry on Price? Firm QfQf $ DfDf Market QMQM $ D S PePe S* P e* D f* Entry

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Effect of Entry on the Firm’s Output and Profits? $ Q AC MC QLQL PePe DfDf P e* D f* Qf*Qf*

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Summary of Logic Short run profits leads to entry Entry increases market supply, drives down the market price, increases the market quantity Demand for individual firm’s product shifts down Firm reduces output to maximize profit Long run profits are zero

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Features of Long Run Competitive Equilibrium P = MC n Socially efficient output P = minimum AC n Efficient plant size n Zero profits Firms are earning just enough to offset their opportunity cost

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Monopoly Single firm serves the “relevant market” Most monopolies are “local” monopolies The demand for the firm’s product is the market demand curve Firm has control over price n But the price charged affects the quantity demanded of the monopolist’s product

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 “Natural” Sources of Monopoly Power Economies of scale Economies of scope Cost complementarities

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 “Created” Sources of Monopoly Power Patents and other legal barriers (like licenses) Tying contracts Exclusive contracts Collusion Contract... I. II. III.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Legal Barriers to Monopoly Power Section 3 of the Clayton Act (1914) n Prohibits exclusive dealing and tying arrangements where the effect may be to “substantially lessen competition” Sections 1 and 2 of the Sherman Act (1890) n Prohibits price-fixing, market sharing, and other collusive practices designed to “monopolize, or attempt to monopolize” a market

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managing a Monopoly Market power permits you to price above MC Is the sky the limit? No. How much you sell depends on the price you set!

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 A Monopolist’s Marginal Revenue P Q Q Demand Elastic Inelastic Unitary MR Total Revenue ($)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Monopoly Profit Maximization $ Q ATC MC D MR QMQM PMPM Profit ATC Produce where MR = MC. Charge the price on the demand curve that corresponds to that quantity.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 A Useful Formula What’s the MR if a firm faces a linear demand curve for its product? P(Q) = a + bQ MR = a + 2bQ

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 A Numerical Example Given estimates of P = 10 - Q C(Q) = 6 + 2Q Optimal output? MR = Q MC = Q = 2 Q = 4 units Optimal price? P = 10 - (4) = $6 Maximum profits? PQ - C(Q) = (6)(4) - (6 + 8) = $10

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Long Run Adjustments? None, unless the source of monopoly power is eliminated.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Why Government Dislikes Monopoly? P > MC n Too little output, at too high a price Deadweight loss of monopoly

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 $ Q ATC MC D MR QMQM PMPM MC Deadweight Loss of Monopoly

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Arguments for Monopoly The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power Encourages innovation

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Monopolistic Competition Numerous buyers and sellers Differentiated products n Implication: Since products are differentiated, each firm faces a downward sloping demand curve. Firms have limited market power. Free entry and exit n Implication: Firms will earn zero profits in the long run.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Key Implications Since products are differentiated, each firm faces a downward sloping demand curve; firms have limited market power. Free entry and exit, so firms will earn zero profits in the long run.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managing a Monopolistically Competitive Firm Market power permits you to price above marginal cost, just like a monopolist. How much you sell depends on the price you set, just like a monopolist. But … The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. You have limited market power.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Marginal Revenue Like a Monopolist P Q Q Demand Elastic Inelastic Unitary MR Total Revenue ($)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Monopolistic Competition: Profit Maximization Maximize profits like a monopolist Produce where MR = MC Charge the price on the demand curve that corresponds to that quantity

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Graphically $ ATC MC D MR QMQM PMPM Profit ATC Quantity of Brand X

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Long Run Adjustments? In the absence of free entry, no adjustments occur. If the industry is truly monopolistically competitive, there is free entry. n In this case other “greedy capitalists” enter, and their new brands steal market share. n This reduces the demand for your product until profits are ultimately zero.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 $ AC MC D MR Q* P* Quantity of Brand X MR 1 D1D1 Entry P1P1 Q1Q1 Long Run Equilibrium (P = AC, so zero profits) Graphically

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Monopolistic Competition The Good (To Consumers) n Product Variety The Bad (To Society) n P > MC n Excess capacity Unexploited economies of scale The Ugly (To Managers) n Zero Profits

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Strategies to Avoid (or Delay) the Zero Profit Outcome Change; don’t let the long-run set in. Be the first to introduce new brands or to improve existing products and services. Seek out sustainable niches. Create barriers to entry. Guard “trade secrets” and “strategic plans” to increase the time it takes other firms to clone your brand.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Maximizing Profits: A Synthesizing Example C(Q) = Q 2 Determine the profit-maximizing output and price, and discuss its implications, if n You are a price taker and other firms charge $40 per unit; n You are a monopolist and the inverse demand for your product is P = Q; n You are a monopolistically competitive firm and the inverse demand for your brand is P = Q

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Marginal Cost C(Q) = Q 2, So MC = 8Q This is independent of market structure

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Taker MR = P = $40 Set MR = MC 40 = 8Q Q = 5 units Cost of producing 5 units C(Q) = Q 2 = = 225 Revenues: PQ = (40)(5) = 200 Maximum profits of -$25 Implications: Expect exit in the long-run

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Monopoly/Monopolistic Competition MR = Q (since P = Q) Set MR = MC, or Q = 8Q n Optimal output: Q = 10 n Optimal price: P = (10) = 90 n Maximal profits: PQ - C(Q) = (90)(10) -( (100)) = 375 Implications n Monopolist will not face entry (unless patent or other entry barriers are eliminated) n Monopolistically competitive firm should expect other firms to clone, so profits will decline over time