Imperfect Competition Characteristics & Behavior of Firms With Market Power

Objectives of Discussion Consider what it means for a firm to have “market power” Examine some measures of market power Consider some of the factors that will create market power for a firm Examine the optimizing behavior of a monopoly firm Examine the monopoly firm’s short-run & long-run equilibrium Examine the monopoly firm’s optimal resource utilization behavior Examine Output decisions for multi-plant firms

Market Power A firm has “Market Power” (MP) if it can raise its price without losing all of its sales Consider case of firm in perfect competition--what happens when it tries to raise price Implications of market power Firm’s demand curve is downward sloping No perfect substitutes for its products Gives firm ability to raise price above average cost & earn economic profit (if demand & cost conditions permit) Almost all firms have some degree of market power Degree of market power varies greatly from industry to industry Local gas/convenience stores have market power based on location Major department stores have market power based on location and advertising induced name recognition

Measures of Market Power Most direct measure of firm’s MP is the price elasticity of demand for its product: The more inelastic the firm’s demand, the greater its MP Note the emphasize on the firm as opposed to the industry elasticity A secondary set of measures of MP is the cross-elasticity of firm’s product with respect to “possible substitutes” Relatively high positive cross-elasticity coefficients indicates that there are close substitutes and firm’s MP is limited Cross-elasticity is frequently used in anti-trust cases to determine if products are viewed as competitors Lerner Index—based on how much a firm can raise its price above its MC

Lerner Index Lerner index measures proportionate amount by which price exceeds marginal cost: Equals zero under perfect competition because Q is chosen where P = MC 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

Determinants of Market Power Ease of entry Entry of new firms erodes market power of existing firms Excessive economic profits by existing firms provides incentive for new firms to enter More firms means more substitutes Strong barriers to entry must exist to sustain a high degree of market power

Barriers to Entry & Market Power “Barriers to Entry” (BtoE) are technical, governmental or economic factors that impede entry of firms into a market Limits potential substitutes Large Minimum Efficient Economies of Scale Capacity of firm required to achieve lowest point on LAC curve is large relative to total market demand Large capital investment required to achieve competitive cost level Significant cost disadvantages for smaller firms Number of firms required to satisfy total market demand is small

Other Barriers to Entry Government created BtoE’s: Licensing & franchises--e.g. local telephone companies, trash collection, toll roads, etc Federally granted patents on products & processes Control of, or limited access to, resource markets Classic case was ALCOA’s control of bauxite before WWII Walmart is frequently accused of controlling suppliers’ interactions with competitors Advertising & Brand Loyalties Soft drinks & chewing gum are classic examples Beauty products and cosmetics are other examples Cost of entry for a new firm is an overwhelming advertising budget

Other 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 Cell phone contracts, internet contracts, etc. Network externalities Occur when value 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 network of buyers Cell phones, internet access, computer software, etc.

Profit Maximization in 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

Monopoly Firm’s Demand & MR Firm’s demand curve is the downward sloping market demand curve Firm must accept a reduction in price if it desires to sell more Point of unitary E Firm’s MR curve deviates from its demand & AR curve For linear demand, MR declines twice as fast as demand MR becomes zero at quantity at which demand elasticity is unitary MR is only positive when |E| > 1

Profit Maximization for Monopoly Firm Short-run cost curves for monopoly firm are same u-shaped curves as PC Like firm in PC, monopolist chooses Q where its MR = MC Set P based on demand curve WTP Profit = $1,400 Firm then sets price that market will bear for that quantity πMax Q is where MR = MC πMax Firm’s profits are (P - ATC) x Q Profits represented by rectangle ABCD & equal $1,400

Losses in Short-run Monopolist not always guaranteed profit Loss = ABCD = (P – ATC)Q = (75 – 80) x 50 = -$ 250 Monopolist not always guaranteed profit Like firm in PC, monopolist will operate with loss in SR as long as can cover all of AVC Firm chooses Q where MR = MC & sets price along demand In this case, firm suffers loss represented by ABCD Loss = (P - ATC) x Q Loss = (75 - 80) x 50 = - $250

Long-run Equilibrium for Monopoly Firm Monopolist does not have to maximize profits to survive In LR, monopoly firm will not operate with loss Firm’s LR cost curves are similar to those of PC firm Once LR plant size is chosen, firm will operate along its SR cost curves At LR equilibrium, firm will choose Q where MR=LMC=SMC Firm may make profits, or break even, but will not suffer a loss

Optimal Hiring Decision for Monopolist As was true in PC Shut down if w > ARPMax Monopolist’s optimal hiring rule is similar to that of PC firm Expand use of factor as long as its MRP ≥ MC Main difference between Monopolist & PC is way MRP is determined For monopolist MRP = MR x MP whereas for PC firm MRP = P x MP Monopolist must reduce P to sell the additional MPL MRP for monopolist declines faster than MRP for PC

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 Choose Q where MR = MC Set price on basis of willingness to pay as reflected by the demand curve Long-run equilibrium Excessive economic profits provide incentive for entry Unrestricted entry/exit reduces each existing firm’s demand and increases cost Long-run equilibrium attained when demand curve for each producer is tangent to its LAC At equilibrium output, P = LAC and MR = LMC However, does operate at minimum LAC and P > LMC

Short-Run Profit Maximization for Monopolistic Competition Π = PABC πMax Q: MR = MC

Long-Run Profit Maximization for Monopolistic Competition Firm’s Initial Demand Curve Firm’s Demand Shifts left as firms enter LR equilibrium occurs when D shifts to left so that P = LAC At LR equilibrium P = LAC & MR = LMC & Π = Zero

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

Estimate Aztec Electronics Demand Function Assume the following demand function was estimated where P is price, M is income and PR is the price of a related good: Substituting for M & PR: The direct demand function is: Q = 50,000 – 500P

Inverse Demand for Aztec Electronics: Start with direct demand function: Divide all terms by -500: Solve for P: Inverse demand function is: P = 100 - .002Q

Determine MR Function: Multiple Inverse Demand by Q to find TR: MR is 1st Derivative of TR

Demand & Marginal Revenue for Aztec Electronics

Estimating AVC & MC Given the estimated AVC equation: Find TVC: Find SMC:

Find πMax Output for Aztec Set MR = MC and put equation in general quadratic equation form 0 = -72 - 0.006Q + 0.000003Q2

Find πMax Output for Aztec Plug coefficients into quadratic formula *

Finding P* P * = $88 Pricing decision * Substitute Q* into inverse demand * P * = $88

Aztec’s Shut-Down Point Shutdown decision Compute AVC at 6,000 units: *

Total Profit at Aztec Electronics Computation of total profit *

Profit Maximization at Aztec Electronics

A Multiplant Firm Firm produces in 2 plants A & B Determine total MC: MCT = MCA + MCB Set each plant’s Q where MR = MCT = MCA = MCB Find total Q* by setting MCT = MR