1. Managerial Economics Market Structures Aalto University School of Science Department of Industrial Engineering and Management January 12 – 28, 2016 Dr. Arto Kovanen, Ph.D. Visiting Lecturer

2. General considerations Mankiw, Principles of Economics

3.  Firms face two type of constraints, which influence the profit maximization  The first is technological: all types of production plans are not physically possible (also costs differ)  The second constraint is the market environment  A firm usually is not able to unilaterally to decide at what price to sell its output  How firms determine the price for their outputs and what price they are willing to purchase inputs General considerations

4.  Forces that shape competition (from firm’s point of view)  Rivalry among existing companies in an industry  Customers  Suppliers  Potential entrants  Substitute products  These forces define industry’s structures and shape the nature of competition within an industry  Drivers of profitability are similar to all industries  See Michael E. Porter (2008), “The Five Competitive Forces That Shape Strategy”, Harvard Business Review Forces that shape competition

5. Chart (Porter) – Five Forces

6.  We will analyze these factors during this course and link them to behavior of consumer, producers, and market structures  The bottom line: when these forces are intense, it will be very difficult to ear attractive returns on investments  Average return on invested capital varies markedly from industry to industry  From low rates in industries such as airlines and hotels  To high rates in industries such as pharmaceuticals and securities brokers  See chart (Porter): return on invested equity (1992 – 2006) Forces that shape … (cont.)

7. Chart (Porter) – Profitability

8.  Industry structures drive competition and profitability, not whether an industry is emerging or mature, high or low tech, regulated or unregulated  Threat of entry and sources of barriers to entry:  Economies of scale in the production  Demand-side benefits of scale (network effects)  Switching costs (when changing suppliers)  Capital requirements  Incumbency advantages regardless of size  Access to distribution channels Forces that shape … (cont.)

9.  There are four basic market types  Percent competition  Monopolistic competition  Oligopoly  Monopoly  Each of them differ in terms of the number of firms in the market, differentiation between products, and the pricing power of buyers and/or seller  To understand the role of the markets in firm’s pricing and output decisions, it is helpful to begin with the one where the nobody has any market power and cannot separate itself from the operators in the market Pricing and output decisions

10. Market structures Webster, Managerial Economics

11.  In a perfectly competitive market consumer and suppliers are price takers, which means that they cannot influence the price of the product  Were do we see perfectly competitive markets in real life? Or are they non-existing?  How does the demand curve of the firm product look like? What is the price elasticity of demand?  The objective of the firm is to maximize its profits Perfect competition

12.  The demand curve facing the firm is horizontal, hence demand is perfectly elastic  That means that at any price higher that that set by the market there will be no demand for firm’s output  In the opposite case where the firm offers to sell its output at below market price, it will face infinite demand for its output  Demand is given by Q(D) = P  What are total, average and marginal revenues? Perfect competition

13.  The firm chooses its output level by equating MR with MC, as discussed earlier, to maximize its profits  In the case of perfect competition, MR = P. Why?  Graphically, find the output level where P = MC  Graphically, find the area of total profits π = TR – TC = P*Q* – AC*Q* = Q* (P – AC) Perfect competition

14. Profit maximization Mankiw, Principles of Economics

15.  The above means that if AC > P, the firm will incur a loss of (AC – P) per unit of output  The firm may still operate in the market in the short- run if its variable cost is below P  This, however, is not sustainable since the firm will not be able to cover its fixed costs  The shutdown point is the lowest price at which the firm would still produce where P = MC = AVC  If P < AVC, the firm will shut down Perfect competition

16.  In the long run, the price in the competitive market will settle at the point where firms earn a normal profit  Economic profit invites entry of new firms, which will shift the supply curve to the right, put downward pressure on the price and reduce profits  Economic loss has the opposite effect  In equilibrium, entry and exit ensure that profits are zero in the long run Perfect competition

17. Monopoly Mankiw, Principles of Econommics

18.  A monopoly market is the other extreme and consists of a single firm; that is, the firm is the market  Monopoly is often associated with limited market entry (either because of regulation or uniqueness of product)  As a result, the firm has complete power to price its product  The only limitation to the firm’s pricing power comes from the demand (which is downward sloping) and its elasticity (elastic/inelastic)  How much should the firm produce to maximize its profits? Monopoly

19.  As before, the optimal condition is MR = MC  Unlike in the case of perfect competition where MR = P, with monopoly MR is a declining function of the level of output  That is, MR = f(Q) where dMR/dQ < 0  Monopoly maximizes it profits where MC ≠ AC, hence producing less than a firm in the competitive market (where MC = AC) CHECK!!!! Monopoly

20. Monopoly’s optimum Mankiw, Principles of Economics

21.  Mark-up pricing refers to the extent to which the price is higher than the marginal cost (P – MC)/P = 1/ε P (called Lerner index) P = [1/(1 + 1/ε P )]*MC  Mark-up is related to the price elasticity of demand (and hence pricing power of the firm)  When demand is perfectly elastic, then the elasticity is infinite and P = MC (perfect competition)  When demand is inelastic, P > MC (monopoly power)  Because -1 ≤ ε P < - infinity, demand is price elastic and thus monopoly will produce on the part of demand curve that is elastic Mark-up pricing

22.  This is determined by two effects:  The first is ease of entry and exit  If entry and exit is free in the industry, in the long run all firms zero economic profits  The second condition is technological advancement  If long-run average costs are constant and entry restricted, a fixed number of firms operate with a constant-return-to-scale technology  If long-run average costs are constant and entry is free, the number of firms vary (any number of firms is possible)  If long-run average costs are increasing and entry limited, firms can make positive profits (MC > AC); e.g., farming in which entry is limited by the fixed amount of land Competition in the long run

23.  For the society, perfect competition is preferable since it results in greater output and lower prices  Perfectly competitive firms are making only normal profits in the long run while monopoly is making an economic profit  Hence monopoly results in an inefficient allocation of resources  There are also welfare effects that are different for a monopoly compared to a competitive market Monopoly vs. perfect competition

24.  Consumer surplus is the difference between what consumers would be prepared to pay for a given quantity of good or service and the amount they actually pay  This is the area below the downward-sloping demand curve and above the setting price  Producer surplus is the difference between the total revenues earned from production and sale of output and what the firm would have been willing to accept for its output  This is the area above the upward-sloping supply curve and below the price in the market Monopoly vs. perfect competition

25.  Deadweight loss is the loss of consumption and production efficiency arising from monopolistic market structures  Total deadweight loss is the sum of the losses of consumer and producer surplus for which there are no offsetting gains  Examples of monopolies and perfect competition  Drug companies – patent protection creates a monopoly  Utilities – natural monopolies (high capital requirement)?  Is monopoly profit needed for innovation (e.g., Apple)? Monopoly vs. perfect competition

26.  An intermediate alternative between a monopoly and pure competition  There is limited number of producers who sell similar, but not identical products (few = oligopoly)  The demand facing the i-th firms is dependent on the demand for the products of other firms  In the long-run, the price charged by a producer must equal the average cost for each firm  That is, in the long-run, monopolistic competition leads to zero economic profit (i.e., P = AC) Monopolistic competition