1. Lecture 8-Managerial Decision for firms with Market Power
Previously we discussed firms with market power
What is market power?????

2. Managerial Decision for firms with Market Power
What is a Monopoly?????
What is Monopolistic Competition?????

3. Measurement of Market Power
One method of measurement is Elasticity of demand
The more elastic the demand the larger the% decrease in sales as price increases.
The less elastic the demand of the smaller % decrease in sales as price increases.

4. Measurement of Market Power
NB The degree to which a firm possess market power is inversely related to the elasticity of demand. The less elastic the firms demand the greater its degree of market power.
When demand is perfectly elastic the firm possess no market power e.g perfect competition

5. Measurement of Market Power
The Lerner Index
Learner Index = P – MC P
Price equals MC when firms are price takers so Learner Index = 0 under competition.

6. Measurement of Market Power
The higher Lerner Index the higher the degree of market power.
Lerners Index can be related to price elasticity of demand. At profit maximisation MR = MC this implies
Learner Index = P – MC= P- P(1+1/E)
P P

7. Measurement of Market Power
Learner Index = -1/E
Cross price elasticity is another measure of market power.
If consumers view two goods to be substitutes the cross price elasticity of demand Exy is positive. The higher the CPE the greater the perceived suitability and the smaller the degree of market power possessed

8. Measurement of Market Power
Determinants of market power
Strong barriers to entry
Economies of Scale
Barriers created by Government
Input Barriers
Brand loyalty
Consumer locked in

9. Profit Maximizations under Monopoly
A monopoly chooses a point on the market demand curve that maximizes profit. If marginal revenue exceeds marginal cost a profit maximizing monopolist increases output.

10. Monopoly
Pure monopoly – where only one producer exists in the industry
In reality, rarely exists – always some form of substitute available!
Monopoly exists, therefore, where one firm dominates the market
Firms may be investigated for examples of monopoly power when market share exceeds 25%
Use term ‘monopoly power’ with care!

11. Monopoly
Monopoly power – refers to cases where firms influence the market in some way through their behaviour – determined by the degree of concentration in the industry
Influencing prices
Influencing output
Erecting barriers to entry
Pricing strategies to prevent or stifle competition
May not pursue profit maximisation – encourages unwanted entrants to the market
Sometimes seen as a case of market failure

12. Monopoly Monopoly Profit MC AC AR MR Costs / Revenue Output / Sales
AR (D) curve for a monopolist likely to be relatively price inelastic. Output assumed to be at profit maximising output (note caution here – not all monopolists may aim for profit maximisation!)
This is both the short run and long run equilibrium position for a monopoly
Given the barriers to entry, the monopolist will be able to exploit abnormal profits in the long run as entry to the market is restricted. MC
£7.00
Monopoly
Profit AC
£3.00 AR MR
Output / Sales Q1

13. Profit Maximizations under Monopoly
The market demand curve is the demand curve for the monopolist.
The monopolist must lower price to sell more units making MR<P for all but the first unit sold.
When MR is positive demand is elastic and vice versa

14. Profit Maximizations under Monopoly in SR
Lets look at table 12.1 Page 321
In the SR a monopoly will produce a positive output if some price on the demand curve> AVC.
It maximizes profit by producing quantity for which MR = SMC.
The price of the output is given by the demand curve.

15. Profit Maximizations under Monopoly
If price>ATC the firm makes a pure economic profit
If price < ATC > AVC the firm suffers an economic loss but continues to produce in the SR.
If demand falls below AVC at every output the firm shuts down in the SR and loses only FC.

16. Profit Maximizations under Monopoly in LR
The manager of a monopoly maximises profit in the LR by choosing to produce the level output where MR = LMC.
If P < LAC firm exits market
In LR manager will adjust plant size to the optimal level.
The optimal plant is one with SAC is tangent to LAC at profit maximising output.

17. Profit Maximizations under Monopoly in LR
Π= PQ – LAC xQ = Q( P – LAC)
What is Marginal Revenue Product???
MRP = ΔTR/ ΔL= MR X MP

18. A monopoly firms Demand for labor
When producing with a single variable input a monopolist will maximize profit by employing that amount of input for which MRP = the price of the input when given.
Consequently MRP curve over the relevant range is the monopolist demand curve for the variable input.
The MRP is downward sloping

19. A monopoly firms Demand for labor
For a price taking firm MRP = w
For a monopolist MRP =w too
And MR = w/MP
w= MR x MP
So two profit maximising rules MR = MC and MRP = w
This means regardless of a manager chooses Q or L to maximise profit the level of price, output, profit etc will be same

20. Monopolistic Competition
Characteristics:
Large number of firms in the industry
May have some element of control over price due to the fact that they are able to differentiate their product in some way from their rivals – products are therefore close, but not perfect, substitutes
Entry and exit from the industry is relatively easy – few barriers to entry and exit
Consumer and producer knowledge imperfect

21. Monopolistic or Imperfect Competition
If the firm produces Q1 and sells each unit for £1.00 on average with the cost (on average) for each unit being 60p, the firm will make 40p x Q1 in abnormal profit.
Monopolistic or Imperfect Competition
Implications for the diagram: MC
Marginal Cost and Average Cost will be the same shape. However, because the products are differentiated in some way, the firm will only be able to sell extra output by lowering price.
Cost/Revenue AC
£1.00
Abnormal Profit
The demand curve facing the firm will be downward sloping and represents the AR earned from sales.
£0.60
We assume that the firm produces where MR = MC (profit maximising output). At this output level, AR>AC and the firm makes abnormal profit (the grey shaded area).
D (AR)
Since the additional revenue received from each unit sold falls, the MR curve lies under the AR curve. MR Q1
Output / Sales
This is a short run equilibrium position for a firm in a monopolistic market structure.

22. Monopolistic Competition
LR equilibrium in a monopolistically competitive market is attained when the demand curve for each producer is tangent to the LRAC.
Unrestricted entry and exit lead to this equilibrium
At equilibrium output price equals LRAC and MR = LRMC

23. Working profit maximising output for a firm with market power
Estimate the demand Q= a + bP + cM + dPr
Find the inverse demand equation
P =f(Q) P = -a ' /b + 1/bQ = A +BQ
Solve for MR P = A +BQ MR = A + 2BQ Using inverse function MR= -a ' /b + 2/bQ
Estimate AVC and MC

24. Working profit maximising output for a firm with market power
AVC = a + bQ + cQ²
SMC = a + 2bQ + cQ³
Find output where MR = SMC
MR = A + 2BQ + a + 2bQ + cQ³ = SMC
Find the optimal price
P* = A + BQ*

25. Working profit maximising output for a firm with market power
Check the shutdown rule
AVC* = a + bQ* + cQ*²
If P*> or = AVC monopolist produces at Q*
If P*< or = AVC monopolist shuts down
Calc Profit or Loss Π = TR – TC = { P* X Q*) – {AVC* x Q*} + TFC
If P < AVC the firm shuts down and Π= -TFC