1. Chapter 12 Managerial Decisions for Firms with Market Power

2. Learning Objectives
Define market power and describe measurement of market power
Explain why entry barriers are necessary for long run market power and discuss major types of entry barriers
Find the profit‐maximizing output, price, and input usage for a monopolist and monopolistic competitor
Employ empirically estimated or forecasted demand, average variable cost, and marginal cost to calculate profit‐maximizing output and price for monopolistic or monopolistically competitive firms
Select production levels at multiple plants to minimize the total cost of producing a given total output for a firm

3. 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)

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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
Essential input barriers
One firm controls a crucial input in the production process

10. Common Entry Barriers Brand loyalties Consumer lock-in
Strong customer allegiance to existing firms may keep new firms from finding enough buyers to make entry worthwhile
Consumer lock-in
Potential entrants can be deterred if they believe high switching costs will keep them from inducing many consumers to change brands

11. Common Entry Barriers Network externalities Sunk costs
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
Sunk costs
Entry costs (which are sunk costs) can serve as a barrier if they are so high that the manager cannot expect to earn enough future profit to make entry worthwhile

12. 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, and is twice as steep

13. Demand & Marginal Revenue for a Monopolist (Figure 12.1)

14. 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

15. Short-Run Profit Maximization for Monopoly (Figure 12.3)

16. Short-Run Loss Minimization for Monopoly (Figure 12.4)

17. 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

18. Long-Run Profit Maximization for Monopoly (Figure 12.5)

19. Profit-Maximizing Input Usage
Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

20. 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

21. Monopoly Firm’s Demand for Labor (Figure 12.6)

22. 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

23. 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

24. 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

25. Short-Run Profit Maximization for Monopolistic Competition (Figure 12

26. Long-Run Profit Maximization for Monopolistic Competition (Figure 12

27. 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

28. Implementing the Profit-Maximizing Output & Pricing Decision
Step 2: Find inverse demand equation
Solve for P

29. 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

30. 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

31. 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

32. 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

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

34. Maximizing Profit at Aztec Electronics: An Example
Estimation of demand & marginal revenue

35. Maximizing Profit at Aztec Electronics: An Example
Solve for inverse demand

36. Maximizing Profit at Aztec Electronics: An Example
Determine marginal revenue function
P = 100 – 0.002Q
MR = 100 – 0.004Q

37. Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)

38. Maximizing Profit at Aztec Electronics: An Example
Estimation of average variable cost and marginal cost
Given the estimated AVC equation:
AVC = 28 – 0.005Q Q2
Then,
SMC = 28 – (2 x 0.005)Q + (3 x )Q2
= 28 – 0.01Q Q2

39. Maximizing Profit at Aztec Electronics: An Example
Output decision
Set MR = MC and solve for Q*
100 – 0.004Q = 28 – 0.01Q Q2
0 = (28 – 100) + ( )Q Q2
= -72 – 0.006Q Q2

40. Maximizing Profit at Aztec Electronics: An Example
Output decision
Solve for Q* using the quadratic formula

41. Maximizing Profit at Aztec Electronics: An Example
Pricing decision
Substitute Q* into inverse demand
P* = 100 – 0.002(6,000)
= $88

42. Maximizing Profit at Aztec Electronics: An Example
Shutdown decision
Compute AVC at 6,000 units:
AVC* = (6,000) (6,000)2
= $34
Because P = $88 > $34 = ATC, Aztec should produce rather than shut down

43. 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

44. Profit Maximization at Aztec Electronics (Figure 12.10)

45. 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

46. A Multiplant Firm (Figure 12.11)

47. Summary Price-setting firms possess market power
A monopoly exists when a single firm produces and sells a particular good or service for which there are no good substitutes and new firms are prevented from entering the market
Monopolistic competition arises when the market consists of a large number of relatively small firms that produce similar, but slightly differentiated, products and have some market power
A firm can possess a high degree of market power only when strong barriers to the entry of new firms exist
In the short run, the manager of a monopoly firm will choose to produce where MR = SMC, rather than shut down, as long as total revenue at least covers the firm’s total variable cost (TR ≥ TVC)

48. Summary
In the long run, the monopolist maximizes profit by choosing to produce where MR = LMC, unless price is less than long-run average cost (P < LAC), in which case the firm exits the industry
For firms with market power, marginal revenue product (MRP) is equal to marginal revenue times marginal product: MRP = MR × MP
Whether the manager chooses Q or L to maximize profit, the resulting levels of input usage, output, price, and profit are the same
Short-run equilibrium under monopolistic competition is exactly the same as for monopoly

49. Summary
Long-run equilibrium in a monopolistically competitive market is attained when the demand curve for each producer is tangent to the long-run average cost curve
Unrestricted entry and exit lead to this equilibrium
8 steps can be employed for profit-maximization for a monopoly or monopolistically competitive firm: (1) estimate demand equation, (2) find inverse demand equation, (3) solve for marginal revenue, (4) estimate average variable cost and marginal cost, (5) find output level where MR = SMC, (6) find profit-maximizing price, (7) check the shutdown rule, and (8) compute profit/loss
A firm producing in two plants, A and B, should allocate production between the two plants so that MCA = MCB