1. Managerial Decisions for Firms with Market Power
Chapter 12
Managerial Decisions for Firms with Market Power

2. 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)

3. 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

4. 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

5. Measurement of Market Power
Lerner index measures proportionate amount by which price exceeds marginal cost:

6. Measurement of Market Power
Lerner index
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. Determinants of Market Power
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

10. Common Entry Barriers 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

11. 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 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

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, & is twice as steep

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

14. Short-Run Profit Maximization for Monopoly
Monopolist will produce a positive output if some price on the demand curve exceeds average variable cost
Profit maximization or loss minimization occurs by producing quantity for which MR = MC

15. Short-Run Profit Maximization for Monopoly
If P > ATC, firm makes economic profit
If ATC > P > AVC, firm incurs loss, but continues to produce in short run
If demand falls below AVC at every level of output, firm shuts down & loses only fixed costs

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

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

18. 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

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

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

21. 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

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

23. 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

24. 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

25. 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

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

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

28. 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

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

30. Implementing the Profit-Maximizing Output & Pricing Decision
Step 3: Solve for marginal revenue
When demand is expressed as P = A + BQ, marginal revenue is

31. Implementing the Profit-Maximizing Output & Pricing Decision
Step 4: Estimate AVC & SMC
Use statistical techniques from Chapter 10

32. 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

33. Implementing the Profit-Maximizing Output & Pricing Decision
Step 7: Check shutdown rule
Substitute Q* into estimated AVC function
If P*  AVC*, produce Q* units of output & sell each unit for P*
If P* < AVC*, shut down in short run

34. Implementing the Profit-Maximizing Output & Pricing Decision
Step 8: Compute profit or loss
Profit = TR - TC
If P < AVC, firm shuts down & profit is -TFC

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

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

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

38. Maximizing Profit at Aztec Electronics: An Example
Determine marginal revenue function

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

40. Maximizing Profit at Aztec Electronics: An Example
Estimation of average variable cost and marginal cost
Given the estimated AVC equation:
So,

41. Maximizing Profit at Aztec Electronics: An Example
Output decision
Set MR = MC and solve for Q*

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

43. Maximizing Profit at Aztec Electronics: An Example
Pricing decision
Substitute Q* into inverse demand *

44. Maximizing Profit at Aztec Electronics: An Example
Shutdown decision
Compute AVC at 6,000 units: *

45. Maximizing Profit at Aztec Electronics: An Example
Computation of total profit *

46. Profit Maximization at Aztec Electronics (Figure 12.10)

47. 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

48. A Multiplant Firm (Figure 12.11)