1. 1 Welcome to EC 209: Managerial Economics- Group A By: Dr. Jacqueline Khorassani Week Nine

2. 2 Managerial Economics- Group A Week Nine- Class 1 Monday, October 29 11:10-12:00 Fottrell (AM) 11:10-12:00 Fottrell (AM) Bank Holiday- no class

3. 3 Chapter 8 of Baye Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

4. 4 What are the characteristics of a perfectly competition market? 1. Many buyers and sellers. 2. Homogeneous (identical) product. 3. Perfect information on both sides of market. 4. No transaction costs. 5. Free entry and exit.

5. 5 Key Implications? 1. Firms are “price takers”. 2. In the short-run, firms may earn profits or losses. 3. Long-run profits are zero.

6. 6 Unrealistic? Yes. So, why learn? 1. Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms. 2. It is a useful benchmark. 3. Explains why governments oppose monopolies. 4. Illuminates the “danger” to managers of competitive environments. –Importance of product differentiation. –Sustainable advantage.

7. 7 Managing a Perfectly Competitive Firm (or Price-Taking Business)

8. 8 Setting Price Firm QfQf $ D f = MR Market QMQM $ D S 10 Remember: MR = marginal revenue = the revenue of selling one more unit of output.

9. 9 Profit-Maximizing Output Decision General rule of profit maximization: General rule of profit maximization: –Choose the quantity of output where MR = MC. Why? If produce more  MC>MR  total profits _______. If produce more  MC>MR  total profits _______. If produce less  MC<MR  can increase total profits by selling _______. If produce less  MC<MR  can increase total profits by selling _______. Since, MR = P, Since, MR = P, Produce where P = MC Produce where P = MC decline more

10. 10 Graph of a Firm’s Output Decision € QfQf ATC AVC MC P e = D f = MR 5 ATC = 6 10 Profit = €20

11. 11 A Numerical Example Given Given –P=€10 –C(Q) = 5 + Q 2 Optimal Output? Optimal Output? –MR = P = €10 –and MC = 2Q –10 = 2Q –Q = 5 units How much are the profits? How much are the profits? –PQ - C(Q) = (10)*(5) - (5 + 25) = $20

12. 12 $ QfQf ATC AVC MC P e = D f = MR 2 € ATC= € 4.5 €€ 4€€ 4 € If operate  Profit = € -1 Should this Firm Sustain Short Run Losses or Shut Down? Loss € If shut down  loss = €5 = fixed cost € AVC= €2

13. 13 Shutdown Decision Rule firm should continue to operate if its operating loss is less than its fixed costs. firm should continue to operate if its operating loss is less than its fixed costs. Decision rule: Decision rule: –A firm should shutdown when P < min AVC. –Continue operating as long as P ≥ min AVC.

14. 14 $ QfQf ATC AVC MC Q f* P= min AVC Firm’s Short-Run Supply Curve: MC Above Min AVC Break even point Shut down point

15. 15 Short-Run Market Supply Curve The market supply curve is the summation of each individual firm’s supply at each price. The market supply curve is the summation of each individual firm’s supply at each price. Firm 1Firm 2 5 10 2030 Market Q QQ P PP 15 18 2543 S1S1 S2S2 SMSM

16. 16 Long Run Adjustments? If firms are price takers but there are barriers to entry, profits will persist. If firms are price takers but there are barriers to entry, profits will persist.

17. 17 But if the industry is perfectly competitive, firms are not only price takers but there is free entry. Firm QfQf $ DfDf Market QMQM $ D S PePe S* P e* D f* Entry As new firms enter the market price falls Other “greedy capitalists” enter the market.

18. 18 As price falls $ Q AC MC PePe DfDf P e* D f* Qf*Qf* QLQL Profits diminish and output of each firm goes down

19. 19 Features of Long Run Competitive Equilibrium P = MC P = MC –Socially efficient output. P = minimum AC P = minimum AC –Efficient plant size. –Zero profits Firms are earning just enough to offset their opportunity cost. Firms are earning just enough to offset their opportunity cost.

20. 20 Managerial Economics- Group A Week Nine- Class 2 Week Nine- Class 2 –Thursday, November 1 –Cairnes –15:10-16:00

21. 21 Monopoly Environment Single firm serves the “relevant market.” Single firm serves the “relevant market.” Most monopolies are “local” monopolies. E.g. petrol station in small town Most monopolies are “local” monopolies. E.g. petrol station in small town The demand for the firm’s product is the market demand curve. The demand for the firm’s product is the market demand curve. Firm has control over price. Firm has control over price. –But the price charges affects the quantity demanded of the monopolist’s product.

22. 22 “Natural” Sources of Monopoly Power Economies of scale Economies of scale Economies of scope Economies of scope Cost complementarities Cost complementarities

23. 23 “Created” Sources of Monopoly Power Patents and other legal barriers (like licenses) Patents and other legal barriers (like licenses) Exclusive contracts Exclusive contracts Collusion Collusion

24. 24 Managing a Monopoly Market power permits you to price above MC Market power permits you to price above MC Is the sky the limit? Is the sky the limit? No. How much you sell depends on the price you set! No. How much you sell depends on the price you set!

25. 25 A Monopolist’s Marginal Revenue QQ P TR 100 001020 3050 1020 3050 800 60 1200 40 Inelastic Elastic Inelastic Unit elastic MR 80

26. 26 Monopoly Profit Maximization $ Q ATC MC D MR QMQM PMPM Profit ATC Produce where MR = MC. Charge the price on the demand curve that corresponds to that quantity.

27. 27 Useful Formulae What’s the MR if a firm faces a linear demand curve for its product? What’s the MR if a firm faces a linear demand curve for its product? Alternatively, Alternatively,

28. 28 A Numerical Example Given estimates of Given estimates of P = 10 - Q P = 10 - Q C(Q) = 6 + 2Q C(Q) = 6 + 2Q Optimal output? Optimal output? MR = 10 - 2Q MR = 10 - 2Q MC = 2 MC = 2 10 - 2Q = 2 10 - 2Q = 2 Q = 4 units Q = 4 units Optimal price? Optimal price? P = 10 - (4) = $6 P = 10 - (4) = $6 Maximum profits? Maximum profits? PQ - C(Q) = (6)(4) - (6 + 8) = $10 PQ - C(Q) = (6)(4) - (6 + 8) = $10

29. 29 Long Run Adjustments? None, unless the source of monopoly power is eliminated. None, unless the source of monopoly power is eliminated.

30. 30 Why Government Dislikes Monopoly? P > MC P > MC –Too little output, at too high a price. Deadweight loss of monopoly-welfare loss (in terms of consumer and producer surplus) Deadweight loss of monopoly-welfare loss (in terms of consumer and producer surplus)

31. 31 $ Q ATC MC D MR QMQM PMPM MC Deadweight Loss of Monopoly

32. 32 Arguments for Monopoly The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power. The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power. Encourages innovation. Encourages innovation.

33. 33 Monopoly Multi-Plant Decisions Consider a monopoly that produces identical output at two production facilities (think of a firm that generates and distributes electricity from two facilities). Consider a monopoly that produces identical output at two production facilities (think of a firm that generates and distributes electricity from two facilities). –Let C 1 (Q 1 ) be the production cost at facility 1. –Let C 2 (Q 2 ) be the production cost at facility 2. Decision Rule: Produce output where Decision Rule: Produce output where MR(Q) = MC 1 (Q 1 ) and MR(Q) = MC 2 (Q 2 ) –Set price equal to P(Q), where Q = Q 1 + Q 2.

34. 34 Monopolistic Competition: Environment and Implications Numerous buyers and sellers Numerous buyers and sellers Differentiated products Differentiated products –Implication: Since products are differentiated, each firm faces a downward sloping demand curve. Consumers view differentiated products as close substitutes: there exists some willingness to substitute. Consumers view differentiated products as close substitutes: there exists some willingness to substitute. Free entry and exit Free entry and exit –Implication: Firms will earn zero profits in the long run.

35. 35 Managing a Monopolistically Competitive Firm Like a monopoly, monopolistically competitive firms Like a monopoly, monopolistically competitive firms –have market power that permits pricing above marginal cost. –level of sales depends on the price it sets. But … But … –The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. –Free entry and exit impacts profitability. Therefore, monopolistically competitive firms have limited market power. Therefore, monopolistically competitive firms have limited market power.

36. 36 Marginal Revenue Like a Monopolist QQ P TR 100 001020 304050 1020 304050 800 60 1200 40 20 Inelastic Elastic Inelastic Unit elastic MR

37. 37 Monopolistic Competition: Profit Maximization Maximize profits like a monopolist Maximize profits like a monopolist –Produce output where MR = MC. –Charge the price on the demand curve that corresponds to that quantity.

38. 38 Short-Run Monopolistic Competition $ ATC MC D MR QMQM PMPM Profit ATC Quantity of Brand X

39. 39 Long Run Adjustments? If the industry is truly monopolistically competitive, there is free entry. If the industry is truly monopolistically competitive, there is free entry. –In this case other “greedy capitalists” enter, and their new brands steal market share. –This reduces the demand for your product until profits are ultimately zero.

40. 40 $ AC MC D MR Q* P* Quantity of Brand X MR 1 D1D1 Entry P1P1 Q1Q1 Long Run Equilibrium (P = AC, so zero profits) Long-Run Monopolistic Competition

41. 41 Monopolistic Competition The Good (To Consumers) –Product Variety The Bad (To Society) P > MC –Excess capacity Unexploited economies of scale Unexploited economies of scale The Ugly (To Managers) P = ATC > minimum of average costs. Zero Profits (in LR) Zero Profits (in LR)

42. 42 Monopolistic Competition and the Welfare of Society There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost. There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost. However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming. However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming.

43. 43 Optimal Advertising Decisions Advertising is one way for firms with market power to differentiate their products. Advertising is one way for firms with market power to differentiate their products. But, how much should a firm spend on advertising? But, how much should a firm spend on advertising? –Advertise to the point where the additional revenue generated from advertising equals the additional cost of advertising. –Equivalently, the profit-maximizing level of advertising occurs where the advertising-to-sales ratio equals the ratio of the advertising elasticity of demand to the own-price elasticity of demand.

44. 44 Advertising (Read pp. 380-384 in Mankiw) Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising. Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising. Overall, about 2 percent of total revenue, or over $200 billion a year, is spent on advertising. See Table 7-6 in Baye for examples of A/TR ratios. High in pharmaceutical, cosmetics and food industries. Low in industrial products. Overall, about 2 percent of total revenue, or over $200 billion a year, is spent on advertising. See Table 7-6 in Baye for examples of A/TR ratios. High in pharmaceutical, cosmetics and food industries. Low in industrial products.

45. 45 Critique of Advertising Critics of advertising argue that firms advertise in order to manipulate people’s tastes. Critics of advertising argue that firms advertise in order to manipulate people’s tastes. They also argue that it impedes competition by implying that products are more different than they truly are. They also argue that it impedes competition by implying that products are more different than they truly are. Defenders argue that advertising provides information to consumers and that advertising increases competition by offering a greater variety of products and prices. Defenders argue that advertising provides information to consumers and that advertising increases competition by offering a greater variety of products and prices. The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered. The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered.

46. 46 Advertising and Competition Study in the U.S. found that the price of spectacles was about 20% lower in states where advertising by optometrists was allowed. Study in the U.S. found that the price of spectacles was about 20% lower in states where advertising by optometrists was allowed. Ireland – optometrists are one of the professions being examined by the Competition Authority. Ireland – optometrists are one of the professions being examined by the Competition Authority. Study by Indecon found that, while 75% of optometrists in Ireland said there was significant or extensive price competition, only 38% of the public agreed. 50% of the public said they would like more information about prices. Study by Indecon found that, while 75% of optometrists in Ireland said there was significant or extensive price competition, only 38% of the public agreed. 50% of the public said they would like more information about prices. Comparative advertising by optometrists is prohibited in Ireland. Indecon recommended that this restriction be removed. Comparative advertising by optometrists is prohibited in Ireland. Indecon recommended that this restriction be removed.

47. 47 Maximizing Profits: A Synthesizing Example C(Q) = 125 + 4Q 2 C(Q) = 125 + 4Q 2 Determine the profit-maximizing output and price, and discuss its implications, if Determine the profit-maximizing output and price, and discuss its implications, if –You are a price taker and other firms charge $40 per unit; –You are a monopolist and the inverse demand for your product is P = 100 - Q; –You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q.

48. 48 Marginal Cost C(Q) = 125 + 4Q 2, C(Q) = 125 + 4Q 2, So MC = 8Q. So MC = 8Q. This is independent of market structure. This is independent of market structure.

49. 49 Price Taker MR = P = $40. MR = P = $40. Set MR = MC. Set MR = MC. 40 = 8Q. 40 = 8Q. Q = 5 units. Q = 5 units. Cost of producing 5 units. Cost of producing 5 units. C(Q) = 125 + 4Q 2 = 125 + 100 = $225. C(Q) = 125 + 4Q 2 = 125 + 100 = $225. Revenues: Revenues: PQ = (40)(5) = $200. PQ = (40)(5) = $200. Maximum profits of -$25. Maximum profits of -$25. Implications: Expect exit in the long- run. Implications: Expect exit in the long- run.

50. 50 Monopoly/Monopolistic Competition MR = 100 - 2Q (since P = 100 - Q). MR = 100 - 2Q (since P = 100 - Q). Set MR = MC, or 100 - 2Q = 8Q. Set MR = MC, or 100 - 2Q = 8Q. –Optimal output: Q = 10. –Optimal price: P = 100 - (10) = $90. –Maximal profits: PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375. PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375. Implications Implications –Monopolist will not face entry (unless patent or other entry barriers are eliminated). –Monopolistically competitive firm should expect other firms to clone, so profits will decline over time.

51. 51 Conclusion Firms operating in a perfectly competitive market take the market price as given. Firms operating in a perfectly competitive market take the market price as given. –Produce output where P = MC. –Firms may earn profits or losses in the short run. –… but, in the long run, entry or exit forces profits to zero. A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated. A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated. A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time. A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time.