Chapter 12--Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12

8/19/2019 Chapter 12--Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12

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Copyright © 2008 by the McGraw-Hill Companies, Inc. All

McGraw-Hill"IrwinManagerial #conomics,

Managerial Economics ThomaMaurininth edition

Copyright © 2008 by the McGraw-Hill Companies, Inc. AllMcGraw-Hill"IrwinManagerial #conomics,

Managerial Economics ThomaMaurininth edition

Chapter 12

Managerial Decisions forFirms with Market Power


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Managerial EconomicsManagerial Economics

12-2

Market Power

• Ability of a firm to raise price

without losing all its sales

• Any firm that faces downward slopingdemand has market power

• Gives firm ability to raise price

above average cost & earn

economic profit (if demand & costconditions permit)


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12-3

Monopoly

• Single firm

• Produces & sells a good or service

for which there are no goodsubstitutes

• New firms are prevented from

entering market because of abarrier to entry


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12-5

Measurement of Market Power

• !erner inde" measures

proportionate amount by which

price e"ceeds marginal cost#

P MC

P

="erner inde#


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12-6


• !erner inde"

• $%uals !ero under perfect competition

• ncreases as market power increases• Also e%uals –1/E , which shows that theinde# (& market power), vary inverselywith elasticity

• The lower the elasticity of demand(absolute value), the greater the inde#& the degree of market power


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12-7


• $f consumers view two goods as

substitutes% crossprice elasticity

of demand (E XY ) is positive

• The higher the positive cross'priceelasticity, the greater thesubstitutability between two goods, &

the smaller the degree of marketpower for the two firms

ll


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12-8

Determinants of Market Power

• 'ntry of new firms into a marketerodes market power of e"istingfirms by increasing the number of

substitutes• A firm can possess a high degree of

market power only when strongbarriers to entry e"ist

• onditions that make it difficult fornew firms to enter a market in whicheconomic profits are being earned

M i l E iM i l E i


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12-9

Common Entry Barriers

• 'conomies of scale

• hen long'run average cost declines overa wide range of output relative to

demand for the product, there may notbe room for another large producer toenter market

•arriers created by government• "icenses, e#clusive franchises

M i l E iM i l E i


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12-


• $nput barriers

• ne firm controls a crucial input in theproduction process

• rand loyalties

• *trong customer allegiance to e#istingfirms may keep new firms from finding

enough buyers to make entry worthwhile

M i l E iM i l E i


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12-


• onsumer lockin

• +otential entrants can be deterred ifthey believe high switching costs will

keep them from inducing many consumersto change brands

• Network e"ternalities

• ccur when value of a product increases

as more consumers buy & use it• ake it difficult for new firms to enter

markets where firms have established alarge network of buyers

M i l E iM i l E i


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12-

Demand Marginal !e"enue for a

Monopolist • *arket demand curve is the firm+s demand

curve

• *onopolist must lower price to sell

additional units of output• arginal revenue is less than price for all butthe first unit sold

• ,hen MR is positive (negative)% demand is

elastic (inelastic)• -or linear demand% MR is also linear% has

the same vertical intercept as demand% & istwice as steep

M i l E iM i l E i


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12-

Demand Marginal !e"enue for a

Monopolist #Figure 12$1%

M i l E iM i l E i


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12-

&hort'!un Profit Ma(imi)ation for

Monopoly • *onopolist will produce a positive

output if some price on the demand

curve e"ceeds average variable cost

• Profit ma"imi.ation or loss

minimi.ation occurs by producing

/uantity for which MR = MC

M i l E iM i l E i


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12-


Monopoly • $f P > ATC % firm makes economicprofit

• $f ATC > P > AVC % firm incurs loss% but

continues to produce in short run

• $f demand falls below A0 at every

level of output% firm shuts down &

loses only fi"ed costs



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12-


Monopoly#Figure 12$*%


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12-

+ong'!un Profit Ma(imi)ation for

Monopoly • *onopolist ma"imi.es profit by

choosing to produce output where MR = LMC % as long as P ≥ LAC

• ,ill e"it industry if P


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12-


Monopoly #Figure 12$-%



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12-

Profit'Ma(imi)ing .nput /sage

• Profitma"imi.ing level of input

usage produces e"actly that level

of output that ma"imi.es profit



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12-


• *arginal revenue product (MRP)

• MRP is the additional revenue attributable tohiring one more unit of the input

• ,hen producing with a single variable input#

• $mploy amount of input for which MRP = inputprice

• -elevant range of MRP curve is downward sloping,positive portion, for which ARP > MRP

TR MRP MR MP L

∆ ×∆

= =



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12-

Monopoly Firm0s Demand for

+abor #Figure 12$%



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12-


• -or a firm with market power%

profitma"imi.ing conditions MRP

= w and MR = MC are e/uivalent

• hether . or " is chosen to ma#imi!eprofit, resulting levels of input usage,output, price, & profit are the same



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12-

Monopolistic Competition

• !arge number of firms sell adifferentiated product

• +roducts are close (not perfect)

substitutes• *arket is monopolistic

• +roduct differentiation creates a

degree of market power• *arket is competitive

• "arge number of firms, easy entry



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12-

Monopolistic Competition

• Shortrun e/uilibrium is identical to

monopoly

•

2nrestricted entry3e"it leads tolongrun e/uilibrium

• Attained when demand curve for each

producer is tangent to LAC

• At e%uilibrium output, P = LAC and MR = LMC



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12-


Monopolistic Competition #Figure 12$%



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12-


Monopolistic Competition #Figure 12$3%



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12-

.mplementing the Profit'Ma(imi)ing

4utput Pricing Decision• Step 4# 'stimate demand e/uation

• /se statistical techni%ues fromhapter 0

• *ubstitute forecasts of demand'shifting variables into estimateddemand e%uation to get

Q a' bP

Rˆ ˆ a' a cM dP

here



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12-


4utput Pricing Decision• Step 5# -ind inverse demand

e/uation

• *olve for P

a' P Q A BQ

b b

= =

1

Rˆ ˆ a' a cM dP , A a' b , B

b= = =

1here and



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12-


4utput Pricing Decision• Step 6# Solve for marginal revenue

• hen demand is e#pressed as P = A + BQ, marginal revenue is

a' MR A BQ Q

b b

= =

22



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12-


4utput Pricing Decision• Step 7# 'stimate AVC & SMC

• /se statistical techni%ues fromhapter 12

SMC a bQ cQ2

2 3

AVC a bQ cQ2

=



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12-

• Step 8# -ind output where MR = SMC

• *et e%uations e%ual & solve for Q5

• The larger of the two solutions is the

profit'ma#imi!ing output level• Step 9# -ind profitma"imi.ing price

• *ubstitute Q5 into inverse demand

P 5 = A + BQ5

Q5 & P 5 are only optimal if P ≥ AVC


4utput Pricing Decision



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12-


4utput Pricing Decision• Step :# heck shutdown rule

• *ubstitute Q5 into estimated AVCfunction

• f P 5 ≥

AVC 5 , produce Q5 units ofoutput & sell each unit for P 5

• f P 5


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12-


4utput Pricing Decision• Step ;# ompute profit or loss

• +rofit = TR TC

• f P ! AVC , firm shuts down & profitis 'T"C

* *

P Q AVC Q T"C × ×

* ( P AVC )Q T"C



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12-

Ma(imi)ing Profit at 6)tecElectronics7 6n E(ample

• A.tec possesses market power via

patents

• Sells advanced wireless stereo

headphones



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12-


• 'stimation of demand & marginal

revenue

41, 000 500 0.6 22.5= − + − RQ P M P

41, 000 500 0.6(45, 000) 22.5(800)= − + − P

50, 000 500= − P



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12-


• Solve for inverse demand

50, 000 500

500 500

Q P − −=

− −

50,000

500 500

Q P

−+ =

− − 1100

500 P Q= −

50, 000 500Q P − = −

100 0.002Q= −



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a age a co o csa age a co o cs

12-


• etermine marginal revenue

function

100 0.002 P Q= −

100 0.004 MR Q= −



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gg

12-

Demand Marginal !e"enue for

6)tec Electronics #Figure 12$8%



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gg

12-


• 'stimation of average variable cost

and marginal cost

• 3iven the estimated AVC e%uation4228 0.005 0.000001 AVC Q Q= − +

• *o,

228 (2 0.005) (3 0.000001)SMC Q Q= − × + ×

228 0.01 0.000003Q Q= − +



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gg

12-


•


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gg

12-


• Pricing decision

• *ubstitute Q* into inverse demand

$88=

* 100 0.002(6, 000) P = −*



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gg

12-


• Shutdown decision

• ompute AVC at 5,222 units4

$34=

$88 $34 P AVC = > =6ecause , A!tec shouldproduce rather than shut down

2* 28 0.005(6, 000) 0.000001(6, 000) AVC = − +*



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gg

12-


• omputation of total profit

TR TVC TFC π = − −

($88 6, 000) ($34 6, 000) $270, 000= × − × −

$528, 000 $204, 000 $270, 000= − −

$54,000=

( * *) ( * *) P Q AVC Q TFC = × − × −* * * *



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gg

12-

Profit Ma(imi)ation at 6)tec

Electronics #Figure 12$19%



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gg

12-

Multiple Plants

• $f a firm produces in 5 plants% 6 & B

• Allocate production so MC A = MC B

• ptimal total output is that for which MR = MC T

• -or profitma"imi.ation% allocate

total output so that

MR = MC T = MC A = MC B



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6 Multiplant Firm #Figure 12$11%

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Chapter 12--Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12Chapter 12