1. Managerial Economics Market Structures
Aalto University
School of Science
Department of Industrial Engineering and Management
January 10 – 26, 2017
Dr. Arto Kovanen, Ph.D.
Visiting Lecturer

2. General considerations
Mankiw, Principles of Economics

3. General considerations
Firms face two type of constraints, which influence their ability to maximize profits
The first is technological: all types of production plans are not physically possible (also costs can be higher than desired)
The second constraint is the market environment:
A firm usually is not able to unilaterally decide at what price to sell its output (except, perhaps, a monopoly)
How firms determine the price for their outputs and what price they are willing to purchase inputs will be crucial for profitability
So, ability to influence markets is an important element

4. Forces that shape competition
Forces that shape competition (from firm’s point of view) are many and include the following:
Rivalry among existing companies in an industry (for their products)
Customers (e.g., how elastic is demand)
Suppliers (e.g., how much market power suppliers have)
Potential entrants (i.e., are there restrictions to entry)
Substitutability between products
These forces define industry’s structures and shape the nature of competition within an industry
Drivers of profitability are similar to all industries
See Michael E. Porter (2008), “The Five Competitive Forces That Shape Strategy”, Harvard Business Review

5. Chart (Porter) – Five Forces

6. Forces that shape … (cont.)
We will analyze these factors during this course and link them to behavior of consumer, producers, and market structures
The bottom line: when these forces are intense, it will be very difficult to ear an attractive return on investment
Average return on invested capital varies markedly from industry to industry (reflecting these forces)
From low rates in industries such as airlines and hotels
To high rates in industries such as pharmaceuticals and securities brokers
See chart (Porter): return on invested equity (1992 – 2006)

7. Chart (Porter) – Profitability

8. Forces that shape … (cont.)
Industry structures drive competition and profitability
Not whether an industry is emerging or mature, high or low tech, regulated or unregulated
Threat of entry and sources of barriers to entry:
Minimum economies of scale needed in the production
Demand-side benefits of scale (network effects)
Switching costs (when changing suppliers)
Capital requirements (so-called natural monopolies)
Incumbency advantages regardless of size (“the name everyone trust”)
Access to distribution channels

9. Pricing and output decisions
There are four basic market types:
Perfect competition
Monopolistic competition
Oligopoly
Monopoly
Each of them differ in terms of the number of firms in the market, differentiation between products, and the pricing power of buyers and/or seller
To understand the role of the markets in firm’s pricing and output decisions, it is helpful to begin with the one where the nobody has market power and thus cannot separate itself from other operators in the market

10. Market structures
Webster, Managerial Economics

11. Perfect competition
In a perfectly competitive market consumer and suppliers are price takers
It means that they cannot influence the price of the product because:
There are many others selling the same good
Goods are similar in the eyes of consumers (e.g., market place for strawberries)
Perfectly competitive markets in real life do exist
How does the demand curve facing the firm look like?
What is the price elasticity of demand

12. Perfect competition
The demand curve facing the firm is horizontal, hence demand is perfectly elastic
That means that at any price higher than set by the market will drive the firm out of the market since the consumers can buy the same good from another firm
On the other hand, there is no reason for the firm to sell its product at below market price, which will only reduce it profits and lead to infinite demand for its output
Hence the demand is given by Q(D) = P
What are total, average and marginal revenues?

13. Perfect competition
The firm chooses its output level by equating MR with MC, as discussed earlier, to maximize its profits
This condition applies regardless of competition in the market place
In the case of perfect competition, MR = P. Why?
Graphically, find the output level where P = MC
Graphically, find the area of total profits
π = TR – TC = P*Q* – AC*Q*
= Q* (P – AC)

14. Profit maximization
Mankiw, Principles of Economics

15. Perfect competition
The above means that if AC > P, the firm will incur a loss of (AC – P) per unit of output
The firm may still operate in the market in the short-run if its variable cost is below P
This, however, is not sustainable since the firm will not be able to cover its fixed costs
The shutdown point is the lowest price at which the firm would still produce where P = MC = AVC
If P < AVC, the firm will shut down

16. Perfect competition
In the long run, the price in the competitive market will settle at the point where firms earn a normal profit
Economic profit invites entry of new firms, which will shift the supply curve to the right, put downward pressure on the price and reduce profits
Economic loss has the opposite effect
In equilibrium, entry and exit ensure that profits are zero in the long run

17. Monopoly
Mankiw, Principles of Econommics

18. Monopoly
A monopoly market is the other extreme and consists of a single firm; that is, the firm is the market
Monopoly is often associated with limited market entry (either because of regulation or uniqueness of its product)
As a result, the firm has complete power to price its product
The only limitation to the firm’s pricing power comes from the demand (which is downward sloping) and its elasticity (elastic/inelastic)
How much should the firm produce to maximize its profits?

19. Monopoly As before, the optimal condition is MR = MC
Unlike in the case of perfect competition where MR = P, with monopoly MR is a declining function of the level of output
That is, MR = f(Q) where dMR/dQ < 0
A monopoly can move along the downward-facing demand curve and influence the price of its product
Monopoly maximizes it profits where MC ≠ AC, hence producing less than a firm in the competitive market (where MC = AC) CHECK!!!!

20. Monopoly’s optimum
Mankiw, Principles of Economics

21. Mark-up pricing
Mark-up pricing refers to the extent to which the price is higher than the marginal cost
(P – MC)/P = 1/εP (called Lerner index)
P = [1/(1 + 1/εP)]*MC
Mark-up is related to the price elasticity of demand (and hence pricing power of the firm)
When demand is perfectly elastic, then the elasticity is infinite and P = MC (perfect competition)
When demand is inelastic, P > MC (monopoly power)
Because -1 ≤ εP < - infinity, demand is price elastic and thus monopoly will produce on the part of demand curve that is elastic

22. Competition in the long run
This is determined by two factors:
The first is ease of entry and exit
If entry and exit is free in the industry, in the long run all firms zero economic profits
The second condition is technological advancement
If long-run average costs are constant and entry restricted, a fixed number of firms operate with a constant-return-to-scale technology
If long-run average costs are constant and entry is free, the number of firms vary (any number of firms is possible)
If long-run average costs are increasing and entry limited, firms can make positive profits (MC > AC); e.g., farming in which entry is limited by the fixed amount of land

23. Monopoly vs. perfect competition
For the society, perfect competition is preferable since it results in greater output and lower prices
Perfectly competitive firms are making only normal profits in the long run while monopoly is making an economic profit
Hence monopoly results in an inefficient allocation of resources
There are also welfare effects that are different for a monopoly compared to a competitive market

24. Monopoly vs. perfect competition
Consumer surplus is the difference between what consumers would be prepared to pay for a given quantity of good or service and the amount they actually pay
This is the area below the downward-sloping demand curve and above the setting price
Producer surplus is the difference between the total revenues earned from production and sale of output and what the firm would have been willing to accept for its output
This is the area above the upward-sloping supply curve and below the price in the market

25. Monopoly vs. perfect competition
Deadweight loss is the loss of consumption and production efficiency arising from monopolistic market structures
Total deadweight loss is the sum of the losses of consumer and producer surplus for which there are no offsetting gains
Examples of monopolies and perfect competition
Drug companies – patent protection creates a monopoly
Utilities – natural monopolies (high capital requirement)?
Is monopoly profit needed for innovation (e.g., Apple where high R&D costs and risks are typical)?

26. Monopolistic competition
An intermediate alternative between a monopoly and pure competition is monopolistic competition
There is limited number of producers who sell similar, but not identical products (few = oligopoly)
The demand facing the i-th firms is dependent on the demand for the products of other firms
In the long-run, the price charged by a producer must equal the average cost for each firm
That is, in the long-run, monopolistic competition leads to zero economic profit (i.e., P = AC)