Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Managerial Economics & Business Strategy Chapter 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

8-2 Overview I. Perfect Competition –Characteristics and profit outlook. –Effect of new entrants. II. Monopolies –Sources of monopoly power. –Maximizing monopoly profits. –Pros and cons. III. Monopolistic Competition –Profit maximization. –Long run equilibrium.

8-3 Perfect Competition Environment  Many buyers and sellers.  Homogeneous (identical) product.  Perfect information on both sides of market.  No transaction costs.  Free entry and exit.

8-4 Key Implications  Firms are “price takers” (P = MR).  In the short-run, firms may earn profits or losses.  Entry and exit forces long-run profits to zero.

8-5 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.

8-6 Managing a Perfectly Competitive Firm (or Price-Taking Business)

8-7 Market and Individual Demand  Difference between Market demand and individual demand functions.  Perfectly elastic demand facing the firm implies no market power.  Charge the market price and determine what level of output to produce.

8-8 Setting Price Firm QfQf $ DfDf Market QMQM $ D S PePe

8-9 Profit-Maximizing Output Decision  MR = MC.  Since, MR = P,  Set P = MC to maximize profits.

8-10 Graphically: Representative Firm’s Output Decision $ QfQf ATC AVC MC P e = D f = MR Q f* ATC PePe Profit = (P e - ATC)  Q f*

8-11 A Numerical Example  Given –P=$10 –C(Q) = 5 + Q 2  Optimal Price? –P=$10  Optimal Output? –MR = P = $10 and MC = 2Q –10 = 2Q –Q = 5 units  Maximum Profits? –PQ - C(Q) = (10)(5) - (5 + 25) = $20

8-12 $ QfQf ATC AVC MC P e = D f = MR Q f* ATC PePe Profit = (P e - ATC)  Q f* < 0 Should this Firm Sustain Short Run Losses or Shut Down? Loss

8-13 Shutdown Decision Rule  A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs. –Operating results in a smaller loss than ceasing operations.  Decision rule: –A firm should shutdown when P < min AVC. –Continue operating as long as P ≥ min AVC.

8-14 $ QfQf ATC AVC MC Q f* P min AVC Firm’s Short-Run Supply Curve: MC Above Min AVC

8-15 Supply in the Long Run  Free entry and exit in the LR causes LRS curve to be horizontal at the market price.  All firms in the industry earn zero economic profits in equilibrium.  If costs increase due to input market pressures then LRS can be upward sloping.  P=MC where the industry is producing the socially efficient level of output.

8-16 Monopoly  A monopoly is a firm that is the sole seller of a product without close substitutes.  A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power.

8-17 Why Monopolies Arise The main cause of monopolies is barriers to entry – other firms cannot enter the market. Three sources of barriers to entry: 1.A single firm owns a key resource. E.g., DeBeers owns most of the world’s diamond mines 2.The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws

Natural monopoly: a single firm can produce the entire market Q at lower ATC than could several firms. Q Cost ATC 1000 $50 Example: 1000 homes need electricity. Electricity Economies of scale due to huge FC ATC is lower if one firm services all 1000 homes than if two firms each service 500 homes. 500 $80

8-19 Why Monopolies Arise  4. Economies of scale – the natural monopoly case.  5. Economies of scope – joint production of two outputs is cheaper in one production system than in two. Tends to encourage the growth of larger firms.

8-20 Monopoly vs. Competition: Demand Curves In a competitive market, the market demand curve slopes downward. but the demand curve for any individual firm’s product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the competitive firm. D P Q A competitive firm’s demand curve

8-21 Monopoly vs. Competition: Demand Curves A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P. Thus, MR ≠ P. D P Q A monopolist’s demand curve

8-22 A Monopoly’s Revenue Moonbucks is the only seller of cappuccinos in town. The table shows the market demand for cappuccinos. Fill in the missing spaces of the table. What is the relation between P and AR? Between P and MR? 22 QPTRARMR 0$ n.a.

8-23 A Monopoly’s Revenue Here, P = AR, same as for a competitive firm. Here, MR < P, whereas MR = P for a competitive firm $ n.a $ 0$4.500 MRARTRPQ – $4

8-24 Moonbuck’s D and MR Curves Q P, MR Demand curve (P) MR $

8-25 Understanding the Monopolist’s MR  Increasing Q has two effects on revenue: –The output effect: More output is sold, which raises revenue –The price effect: The price falls, which lowers revenue  To sell a larger Q, the monopolist must reduce the price on all the units it sells.  Hence, MR < P  MR could even be negative if the price effect exceeds the output effect (e.g., when Moonbucks increases Q from 5 to 6).

8-26 Profit-Maximization  Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC.  Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity.  It finds this price from the D curve.

8-27 Profit-Maximization 1.The profit- maximizing Q is where MR = MC. 2.Find P from the demand curve at this Q. Quantity Costs and Revenue MR D MC Profit-maximizing output P Q

8-28 A Monopoly Does Not Have an S Curve A competitive firm  takes P as given  has a supply curve that shows how its Q depends on P A monopoly firm  is a “price-maker,” not a “price-taker”  Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve. So there is no supply curve for monopoly.

8-29 Multi-Plant Monopoly  Profit max occurs when the monopoly produces in each plant such that the MC of producing in each plant equals the MR of total output.  If MR>MC in one plant then it pays to expand output in that plant and decrease output in the other plant.  As output expands MR declines until MR=MC.  Demonstration problem 8-6 page 290.

8-30 Case Study: Monopoly vs. Generic Drugs Patents on new drugs give a temporary monopoly to the seller. When the patent expires, the market becomes competitive, generics appear. MC Quantity Price D MR PMPM QMQM P C = QCQC The market for a typical drug

8-31 P = MC Deadweight loss P MC The Welfare Cost of Monopoly Competitive eq’m: quantity = Q E P = MC total surplus is maximized Monopoly eq’m: quantity = Q M P > MC deadweight loss Quantity Price D MR MC QMQM QEQE

8-32 Public Policy Toward Monopolies  Increasing competition with antitrust laws –Examples: Sherman Antitrust Act (1890), Clayton Act (1914) –Antitrust laws ban certain anticompetitive practices, allow govt to break up monopolies.  Regulation –Govt agencies set the monopolist’s price –For natural monopolies, MC < ATC at all Q, so marginal cost pricing would result in losses. –If so, regulators might subsidize the monopolist or set P = ATC for zero economic profit.

8-33 Public Policy Toward Monopolies  Public ownership –Example: U.S. Postal Service –Problem: Public ownership is usually less efficient since no profit motive to minimize costs  Doing nothing –The foregoing policies all have drawbacks, so the best policy may be no policy.

8-34 Managing a Monopolistically Competitive Firm  Like a monopoly, monopolistically competitive firms –have market power that permits pricing above marginal cost. –level of sales depends on the price it sets.  But … –The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. –Free entry and exit impacts profitability.  Therefore, monopolistically competitive firms have limited market power.

8-35 Marginal Revenue Like a Monopolist QQ P TR Inelastic Elastic Inelastic Unit elastic MR

8-36 Monopolistic Competition: Profit Maximization  Maximize profits like a monopolist –Produce output where MR = MC. –Charge the price on the demand curve that corresponds to that quantity.

8-37 Short-Run Monopolistic Competition $ ATC MC D MR QMQM PMPM Profit ATC Quantity of Brand X

8-38 Long Run Adjustments?  If the industry is truly monopolistically competitive, there is free entry. –In this case other “greedy capitalists” enter, and their new brands steal market share. –This reduces the demand for your product until profits are ultimately zero.

8-39 $ AC MC D MR Q* P* Quantity of Brand X MR 1 D1D1 Entry P1P1 Q1Q1 Long Run Equilibrium (P = AC, so zero profits) Long-Run Monopolistic Competition

8-40 Monopolistic Competition The Good (To Consumers) –Product Variety The Bad (To Society) –P > MC –Excess capacity Unexploited economies of scale The Ugly (To Managers) –P = ATC > minimum of average costs. Zero Profits (in the long run)!

8-41 Advertising  Comparative advertising – differentiating a brand  Brand equity - additional value added to a product because of a well known brand.  Niche marketing – targeting a specific group in the market

8-42 Optimal Advertising Decisions  Advertising is one way for firms with market power to differentiate their products.  But, how much should a firm spend on advertising? –Advertise to the point where the additional revenue generated from advertising equals the additional cost of advertising. –Equivalently, the profit-maximizing level of advertising occurs where the advertising-to-sales ratio equals the ratio of the advertising elasticity of demand to the own-price elasticity of demand. –Demonstration problem 8-8 page 301

8-43 Maximizing Profits: A Synthesizing Example  C(Q) = Q 2  Determine the profit-maximizing output and price, and discuss its implications, if –You are a price taker and other firms charge $40 per unit; –You are a monopolist and the inverse demand for your product is P = Q; –You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q.

8-44 Marginal Cost  C(Q) = Q 2,  So MC = 8Q.  This is independent of market structure.

8-45 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.

8-46 Monopoly/ Monopolistic Competition  MR = Q (since P = Q).  Set MR = MC, or Q = 8Q. –Optimal output: Q = 10. –Optimal price: P = (10) = $90. –Maximal profits: PQ - C(Q) = (90)(10) -( (100)) = $375.  Implications –Monopolist will not face entry (unless patent or other entry barriers are eliminated). –Monopolistically competitive firm should expect other firms to clone, so profits will decline over time.

8-47 Conclusion  Firms operating in a perfectly competitive market take the market price as given. –Produce output where P = MC. –Firms may earn profits or losses in the short run. –… but, in the long run, entry or exit forces profits to zero.  A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated.  A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.