Managerial Economics & Business Strategy

1. Managerial Economics & Business Strategy Chapter 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

2. Overview I. Perfectly Competition II. Monopolies III. Monopolistic Competition

3. Perfect Competition Many buyers and sellers Homogeneous product Perfect information No transaction costs (mobility) Free entry and exit PRICE-TAKERS

4. 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)

5. 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

6. Setting Price $ $ S Pe MR=Df D QM Qf Firm Market

7. 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

8. Setting Output: MR = MC MR = P, therefore To max , choose Q when P = MC where

9. MC $ ATC AVC Qf Graphically (recall cost curves from Chapter 5) Profit = (Pe - ATC)  Qf* Pe Pe = Df = MR ATC Qf*

10. 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

11. 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

12. $ $ S Pe Df D QM Qf Firm Market Effect of Entry on Price? S* Entry Pe* Df*

13. MC $ AC Pe Df Df* Pe* Q QL Qf* Effect of Entry on the Firm’s Output and Profits?

14. 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

15. 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

16. 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.

17. MC $ ATC AVC Quantity Negative Profits in the SR (P = minimum of AVC) Supply Df = MR Pe=AVC Qf

18. 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

19. 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)

20. 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)

21. A Monopolist’s Marginal Revenue P Elastic Unitary Inelastic Demand Q Total Revenue ($) MR Q

22. 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

23. 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

24. 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)

25. 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?

26. 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

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

28. Why Government Dislikes Monopoly? • P > MC • Too little output, at too high a price • Deadweight loss of monopoly

29. 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

30. 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

31. 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.

32. 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.

33. Marginal Revenue Like a Monopolist P Elastic Unitary Inelastic Demand Q Total Revenue ($) MR Q

34. 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

35. MC $ ATC Graphically Profit PM ATC D Quantity of Brand X QM MR

36. 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.

37. MC $ AC Graphically Long Run Equilibrium (P = AC, so zero profits) P* P1 Entry D D1 MR Quantity of Brand X Q* Q1 MR1

38. 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

39. 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.

40. 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.

41. Marginal Cost • C(Q) = 125 + 4Q2, • So MC = 8Q • This is independent of market structure

42. 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

43. 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