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

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

Common Entry Barriers Essential input barriers Brand loyalties 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

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 benefit or utility 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 base or network of buyers

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)

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 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)