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Managerial Economics & Business Strategy. Chapter 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets. Overview. I. Perfectly Competition II. Monopolies III. Monopolistic Competition. Perfect Competition. Many buyers and sellers Homogeneous product

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Managerial economics business strategy

Managerial Economics & Business Strategy

Chapter 8

Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets


Overview

Overview

I. Perfectly Competition

II. Monopolies

III. Monopolistic Competition


Perfect competition

Perfect Competition

Many buyers and sellers

Homogeneous product

Perfect information

No transaction costs (mobility)

Free entry and exit

PRICE-TAKERS


Key implications

Key Implications

Firms are “price takers” (price determined by interaction of buyers and sellers)

P = MR

In the short-run, firms may earn profits or losses

Long-run economic profits are zero (accounting profits  0)


Unrealistic why learn

Unrealistic? Why Learn?

  • Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms

  • It is a useful benchmark

  • Explains why governments oppose monopolies

  • Illuminates the “danger” to managers of competitive environments

    • Importance of product differentiation

    • Sustainable advantage


Setting price

Setting Price

$

$

S

Pe

MR=Df

D

QM

Qf

Firm

Market


Setting output

Setting Output:

$

C(Q), R

C(Q)

R=PQ

Slope of revenue curve is MR (linear, so constant)

Slope of tangent line to C(Q) is MC (nonlinear so MC constantly changing).

Output (Q)

Q0

AT Q0 , MC=MR.

Q1

Q2


Setting output1

Setting Output:

MR = MC

MR = P, therefore

To max , choose Q when

P = MC

where


Managerial economics business strategy

MC

$

ATC

AVC

Qf

Graphically (recall cost curves from Chapter 5)

Profit = (Pe - ATC)  Qf*

Pe

Pe = Df = MR

ATC

Qf*


A numerical example

A Numerical Example

  • Given

    • P=$80 and C(Q) = 40 + 8Q + 2Q2

  • (Q) = PQ – C(Q)

    • (Q) = 80Q – [40 + 8Q + 2Q2]

  • Optimal Q: set MR = MC and solve for Q; or find d /dQ, set equal to zero and solve for Q.

    • MR = P = $80 and MC = 8 + 4Q

    • d  /dQ = 80 – 8 – 4Q = 0.

    • Solving for Q in either case, Q = 18 units.

  • Max Profits? To ensure maximum, find 2nd derivative of  function. If 2nd derivative is negative (concave down), then indeed a maximum.

    • d2 /dQ2 = - 4, therefore concave down.

    • PQ - C(Q) = (80)(18) – [40 + 8(18) + 2(182)] = $608


Long run adjustments

Long Run Adjustments?

  • If firms are price takers but there are barriers to entry, profits will persist

  • If the industry is perfectly competitive, firms are not only price takers but there is free entry

    • Other “greedy capitalists” enter the market


Effect of entry on price

$

$

S

Pe

Df

D

QM

Qf

Firm

Market

Effect of Entry on Price?

S*

Entry

Pe*

Df*


Managerial economics business strategy

MC

$

AC

Pe

Df

Df*

Pe*

Q

QL

Qf*

Effect of Entry on the Firm’s Output and Profits?


Summary of logic

Summary of Logic

  • Short run profits leads to entry

  • Entry increases market supply, drives down the market price, increases the market quantity

  • Demand for individual firm’s product shifts down

  • Firm reduces output to maximize profit

  • Long run profits are zero


Managerial economics business strategy

Negative economic profits, but less than paying FC

MC

$

ATC

AVC

ATC

FC

AVC

Revenues

VC

Quantity

Qf

Negative Profits in the SR (AVC<P<ATC):

Pe

Df = MR


Summary negative economic profits

Summary: Negative Economic Profits

  • In SR, if AVC<P<ATC, OPERATE to cover portion of FC (look at 8-5)

  • In LR, EXIT. As firms exit, supply falls and price rises.

  • In SR, if P=AVC, DON’T OPERATE and pay FC. This is referred to as the

    • SHUTDOWN RULE

      • Supply curve is MC above minimum of AVC.


Managerial economics business strategy

MC

$

ATC

AVC

Quantity

Negative Profits in the SR (P = minimum of AVC)

Supply

Df = MR

Pe=AVC

Qf


Features of long run competitive equilibrium

Features of Long Run Competitive Equilibrium

  • P = MC

    • Socially efficient output

  • P = minimum ATC

    • Zero profits

      • Firms are earning just enough to offset their opportunity cost


Monopoly

Monopoly

Single firm serves the “relevant market”

Most monopolies are “local” monopolies (can exist even if size of firm small)

The demand for the firm’s product is the market demand curve

Firm has control over price

But the price charged affects the quantity demanded of the monopolist’s product (don’t have unlimited P-setting power)


Sources of monopoly power

Sources of Monopoly Power

  • Economies of scale

  • Patents and other legal barriers (licenses)

  • Exclusive Contracts

  • Collusion

  • Ownership or control of a scarce resource

  • Government restrictions (e.g., Utah State Liquor Stores)

  • Product Proliferation (Microsoft)


A monopolist s marginal revenue

A Monopolist’s Marginal Revenue

P

Elastic

Unitary

Inelastic

Demand

Q

Total

Revenue

($)

MR

Q


Managerial economics business strategy

MC

$

ATC

Q

Monopoly Profit Maximization

Produce where MR = MC.

Charge the price on the demand curve that corresponds to that quantity.

Profit

PM

ATC

D

QM

MR


Useful formulas

Useful Formulas

  • What’s the MR if a firm faces a linear demand curve for its product?

  • P(Q) = a + bQ (inverse D function & b<0)

  • MR = a + 2bQ

Math Note:

R(Q) = P(Q)Q = (a + bQ)Q = aQ + bQ2

MR = R(Q) = a + 2bQ!

With a little algebra, we could show that

MR = P[(1+E)/E], E is elasticity of D


Useful formulas1

Useful Formulas

Math Note:

MR = P[(1+E)/E]

Because MR=MC at profit-maximizing output then

MC = P[(1+E)/E]

Rearranging terms:

(P-MC)/P = -1/E

(i.e., the Lerner Index)


Example

Example

Using, MR = P[(1+E)/E]

{Note: Don’t take |E| when solving.}

Price = $1.25, MC = $0.25, and E = -2.5.

Based on this information, what should the firm do to boost profits?


A numerical example1

A Numerical Example

  • Given estimates of

    • P = 10 - Q

    • C(Q) = 6 + 2Q

  • Optimal output? Set MR = MC or find derivative of profit function and set equal to zero.

    • MR = 10 - 2Q

    • MC = 2

    • 10 - 2Q = 2

    • Q = 4 units

  • Optimal price? Plug Q into inverse demand function

    • P = 10 - (4) = $6

  • Maximum profits?

    • PQ - C(Q) = (6)(4) - (6 + 8) = $10


  • Long run adjustments1

    Long Run Adjustments?

    • None, unless the source of monopoly power is eliminated.


    Why government dislikes monopoly

    Why Government Dislikes Monopoly?

    • P > MC

      • Too little output, at too high a price

    • Deadweight loss of monopoly


    Deadweight loss of monopoly

    MC

    $

    ATC

    Q

    Deadweight Loss of Monopoly

    Deadweight Loss of Monopoly

    Recall:

    D represents WTP, thus it is a MB curve.

    PM

    D

    MR=MC

    QM

    MR


    Arguments for monopoly

    Arguments for Monopoly

    • The beneficial effects of economies of scale or economies of scope on price and output may outweigh the negative effects of market power

    • Encourages innovation


    Monopolistic competition

    Monopolistic Competition

    Numerous buyers and sellers

    Differentiated products

    Implication: Since products are differentiated, each firm faces a downward sloping demand curve.

    Firms have limited market power.

    Free entry and exit

    Implication: Firms will earn zero profits in the long run.


    Managing a monopolistically competitive firm

    Managing a Monopolistically Competitive Firm

    Market power permits you to price above marginal cost, just like a monopolist.

    How much you sell depends on the price you set, just like a monopolist. But …

    The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist.

    You have limited market power.


    Marginal revenue like a monopolist

    Marginal Revenue Like a Monopolist

    P

    Elastic

    Unitary

    Inelastic

    Demand

    Q

    Total

    Revenue

    ($)

    MR

    Q


    Monopolistic competition profit maximization

    Monopolistic Competition: Profit Maximization

    • Maximize profits like a monopolist

      • Produce where MR = MC

    • Charge the price on the demand curve that corresponds to that quantity


    Managerial economics business strategy

    MC

    $

    ATC

    Graphically

    Profit

    PM

    ATC

    D

    Quantity of Brand X

    QM

    MR


    Long run adjustments2

    Long Run Adjustments?

    • In the absence of free entry, no adjustments occur.

    • 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.


    Graphically

    MC

    $

    AC

    Graphically

    Long Run Equilibrium

    (P = AC, so zero profits)

    P*

    P1

    Entry

    D

    D1

    MR

    Quantity of Brand X

    Q*

    Q1

    MR1


    Monopolistic competition1

    Monopolistic Competition

    The Good (To Consumers)

    • Product Variety

      The Bad (To Society)

    • P > MC (MB>MC)

    • Excess capacity

      • Unexploited economies of scale because P>min AC.

        The Ugly (To Managers)

    • Zero Profits


    Strategies to avoid or delay the zero profit outcome

    Strategies to Avoid (or Delay) the Zero Profit Outcome

    • Comparative Advertisements

    • Be the first to introduce new brands or to improve existing products and services, “New Improved…”

    • Seek out sustainable niches.

    • Create barriers to entry.

    • Guard “trade secrets” and “strategic plans” to increase the time it takes other firms to clone your brand.


    Maximizing profits a synthesizing example

    Maximizing Profits: A Synthesizing Example

    • C(Q) = 125 + 4Q2

    • 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.


    Marginal cost

    Marginal Cost

    • C(Q) = 125 + 4Q2,

    • So MC = 8Q

    • This is independent of market structure


    Price taker

    Price Taker

    • MR = P = $40

    • Set MR = MC

      • 40 = 8Q

      • Q = 5 units

  • Cost of producing 5 units

    • C(Q) = 125 + 4Q2 = 125 + 100 = 225

  • Revenues:

    • PQ = (40)(5) = 200

  • Maximum profits of -$25

  • Implications: Expect exit in the long-run


  • Monopoly monopolistic competition

    Monopoly/Monopolistic Competition

    • MR = 100 - 2Q (since P = 100 - Q)

    • Set MR = MC, or 100 - 2Q = 8Q

      • Optimal output: Q = 10

      • Optimal price: P = 100 - (10) = 90

      • Maximum profits:

        • PQ - C(Q) = (90)(10) -(125 + 4(100)) = 375

    • 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


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