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Managerial Economics & Business Strategy

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### Managerial Economics & Business Strategy

Chapter 8

Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

Perfect Competition

Many buyers and sellers

Homogeneous product

Perfect information

No transaction costs (mobility)

Free entry and exit

PRICE-TAKERS

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?

- 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 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

$

ATC

AVC

Qf

Graphically (recall cost curves from Chapter 5)

Profit = (Pe - ATC) Qf*

Pe

Pe = Df = MR

ATC

Qf*

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?

- 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

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

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

- 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.

- SHUTDOWN RULE

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

- Zero profits

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

- 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)

$

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

- 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 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

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 Example Optimal output? Set MR = MC or find derivative of profit function and set equal to zero. Optimal price? Plug Q into inverse demand function Maximum profits?

- Given estimates of
- P = 10 - Q
- C(Q) = 6 + 2Q

- MR = 10 - 2Q
- MC = 2
- 10 - 2Q = 2
- Q = 4 units

- P = 10 - (4) = $6

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

Long Run Adjustments?

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

Why Government Dislikes Monopoly?

- P > MC
- Too little output, at too high a price

- Deadweight loss of monopoly

$

ATC

Q

Deadweight Loss of MonopolyDeadweight Loss of Monopoly

Recall:

D represents WTP, thus it is a MB curve.

PM

D

MR=MC

QM

MR

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

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

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.

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

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.

$

AC

GraphicallyLong Run Equilibrium

(P = AC, so zero profits)

P*

P1

Entry

D

D1

MR

Quantity of Brand X

Q*

Q1

MR1

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)

- Unexploited economies of scale because P>min AC.
- Zero Profits

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

- 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

- C(Q) = 125 + 4Q2,
- So MC = 8Q
- This is independent of market structure

Price Taker Cost of producing 5 units Revenues: Maximum profits of -$25 Implications: Expect exit in the long-run

- MR = P = $40
- Set MR = MC
- 40 = 8Q
- Q = 5 units

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

- PQ = (40)(5) = 200

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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