1. Imperfect Competition
Characteristics & Behavior of Firms With Market Power

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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.

10. 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

11. 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

12. 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

13. 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 = ( ) x 50 = - $250

14. 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

15. 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

16. 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

17. 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

18. 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

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

20. 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

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

22. 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

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

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

25. Demand & Marginal Revenue for Aztec Electronics

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

27. Find πMax Output for Aztec
Set MR = MC and put equation in general quadratic equation form
0 = Q Q2

28. Find πMax Output for Aztec
Plug coefficients into quadratic formula *

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

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

31. Total Profit at Aztec Electronics
Computation of total profit *

32. Profit Maximization at Aztec Electronics

33. 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