Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

1. Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

2. Learning Objectives • Describe the key characteristics of the four basic market types used in economic analysis. • Compare and contrast the degree of price competition among the four market types. • Provide specific actual examples of the four types of markets. • Explain why the P=MC rule leads firms to the optimal level of production.

3. Learning Objectives • Describe what happens in the long run in markets where firms that are either incurring economic losses or are making economic profits. Explain why this happens with particular attention to the key assumptions used in this analysis. • Explain how and why the MR=MC rule helps a monopoly to determine the optimal level of price and output. • Explain the relationship between the MR=MC rule and the P=MC rule.

4. Learning Objectives • Cite the main differences between monopolistic competition and oligopoly • Describe the role that mutual interdependence plays in setting prices in oligopolistic markets • Illustrate price rigidity in oligopoly markets using the “kinked demand curve” • Elaborate on how non-price factors help firms in monopolistic competition and oligopoly to differentiate their products and services • Cite and briefly describe the five forces in Porter’s model of competition

5. Four Basic Market Types 1. Perfect Competition (no market power) • Large number of relatively small buyers and sellers • Standardized product • Very easy market entry and exit • Nonprice competition not possible

6. 2. Monopoly (absolute market power subject to government regulation) • One firm, firm is the industry • Unique product or no close substitutes • Market entry and exit difficult or legally impossible • Nonprice competition not necessary

7. 3. Monopolistic Competition (market power based on product differentiation) • Large number of relatively small firms acting independently • Differentiated product • Market entry and exit relatively easy • Nonprice competition very important

8. Oligopoly (market power based on product differentiation and/or the firm’s dominance of the market) • Small number of relatively large firms that are mutually interdependent • Differentiated or standardized product • Market entry and exit difficult • Nonprice competition very important among firms selling differentiated products

10. Pricing and Output Decisions in Perfect Competition • The Basic Business Decision: entering a market on the basis of the following questions: • How much should we produce? • If we produce such an amount, how much profit will we earn? • If a loss rather than a profit is incurred, will it be worthwhile to continue in this market in the long run (in hopes that we will eventually earn a profit) or should we exit?

11. 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.

12. Key assumptions of the perfectly competitive market • The firm operates in a perfectly competitive market and therefore is a price taker. • The firm makes the distinction between the short run and the long run. • The firm’s objective is to maximize its profit in the short run. If it cannot earn a profit, then it seeks to minimize its loss. • The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.

13. Setting Price $ $ S Pe Df D QM Qf Firm Market

14. Profit-Maximizing Output Decision MR = MC. Since, MR = P, Set P = MC to maximize profits.

15. MC $ ATC AVC Qf Graphically: Representative Firm’s Output Decision Profit = (Pe - ATC)  Qf* Pe Pe = Df = MR ATC Qf*

16. A Numerical Example • Given • P=$10 • C(Q) = 5 + Q2 • Optimal Price? • P=$10 • Optimal Output? • MR = P = $10 and MC = 2Q • 10 = 2Q • Q = 5 units • Maximum Profits? • PQ - C(Q) = (10)(5) - (5 + 25) = $20

17. The firm incurs a loss. At the optimum output level price is below average cost. • However, since price is greater than average variable cost, the firm is better off producing in the short run, because it will still incur fixed costs greater than the loss.

18. MC $ AVC Loss Qf Should this Firm Sustain Short Run Losses or Shut Down? Profit = (Pe - ATC)  Qf* < 0 ATC ATC Pe = Df = MR Pe Qf*

19. Shutdown Decision Rule • A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs. • Operating results in a smaller loss than ceasing operations. • Decision rule: • A firm should shutdown when P < min AVC. • Continue operating as long as P ≥ min AVC.

20. Contribution Margin (CM): the amount by which total revenue exceeds total variable cost. • CM = TR – TVC • If the contribution margin is positive, the firm should continue to produce in the short run in order to defray some of the fixed cost.

21. Shutdown Point: the lowest price at which the firm would still produce. • At the shutdown point, the price is equal to the minimum point on the AVC. This is where selling at the price results in zero contribution margin. • If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs.

22. MC $ ATC AVC Qf Firm’s Short-Run Supply Curve: MC Above Min AVC P min AVC Qf*

23. S1 S2 SM 25 43 18 20 30 10 Short-Run Market Supply Curve • The market supply curve is the summation of each individual firm’s supply at each price. Market Firm 1 Firm 2 P P P 15 5 Q Q Q

24. 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.

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

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

27. 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.

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

29. 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 shifts the supply curve to the right, puts downward pressure on price and reduces profits. • Economic loss causes exit of firms which shifts the supply curve to the left, puts upward pressure on price and increases profits.

30. Observations in perfectly competitive markets: • The earlier the firm enters a market, the better its chances of earning above-normal profit (assuming a strong demand in the market). • As new firms enter the market, firms that want to survive and perhaps thrive must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors. • Firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation instead.

31. Monopoly Environment Single firm serves the “relevant market.” Most monopolies are “local” monopolies. 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.

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

33. “Created” Sources of Monopoly Power Patents and other legal barriers (like licenses) Tying contracts Exclusive contracts Collusion Contract... I. II. III.

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

35. A Monopolist’s Marginal Revenue P TR Unit elastic 100 Elastic Unit elastic 1200 60 Inelastic 40 800 20 30 40 50 30 40 50 Q Q 0 10 20 0 10 20 MR Elastic Inelastic

36. 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

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

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

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

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

41. MC $ ATC PM QM Q Deadweight Loss of Monopoly Deadweight Loss of Monopoly D MC MR

42. 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. • Encourages innovation.

43. 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). • Let C1(Q2) be the production cost at facility 1. • Let C2(Q2) be the production cost at facility 2. • Decision Rule: Produce output where MR(Q) = MC1(Q1) and MR(Q) = MC2(Q2) • Set price equal to P(Q), where Q = Q1 + Q2.

44. Monopolistic Competition: Environment and Implications Numerous buyers and sellers 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. Free entry and exit Implication: Firms will earn zero profits in the long run.

45. Managing a Monopolistically Competitive Firm 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 … 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.

46. Competing in ImperfectlyCompetitive Markets • Non-price variables: any factor that managers can control, influence, or explicitly consider in making decisions affecting the demand for their goods and services. • Advertising • Promotion • Location and distribution channels • Market segmentation • Loyalty programs • Product extensions and new product development • Special customer services • Product “lock-in” or “tie-in” • Pre-emptive new product announcements

47. Marginal Revenue Like a Monopolist P TR Unit elastic 100 Elastic Unit elastic 1200 60 Inelastic 40 800 20 30 40 50 30 40 50 Q Q 0 10 20 0 10 20 MR Elastic Inelastic

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

49. MC $ ATC Short-Run Monopolistic Competition Profit PM ATC D Quantity of Brand X QM MR

50. Long Run Adjustments? • 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.