Managerial Decisions for Firms with Market Power

BEC 30325Managerial Economics

Market Power• Ability of a firm to raise price without losing all

its sales– Any firm that faces downward sloping demand has

market power• Gives firm ability to raise price above average

cost & earn economic profit (if demand & cost conditions permit)

Monopoly

• Single firm• Produces & sells a good or service for which

there are no close substitutes• New firms are prevented from entering

market because of a barrier to entry

Measurement of Market Power• Degree of market power inversely related to price

elasticity of demand– The less elastic the firm’s demand, the greater its

degree of market power– The fewer close substitutes for a firm’s product, the

smaller the elasticity of demand (in absolute value) & the greater the firm’s market power

– When demand is perfectly elastic (demand is horizontal), the firm has no market power

• Lerner index measures proportionate amount by which price exceeds marginal cost:– Equals zero under perfect competition– Increases as market power increases– Also equals –1/E, which shows that the index (& market power), vary

inversely with elasticity– The lower the elasticity of demand (absolute value), the greater the

index & the degree of market power

Measurement of Market Power

Lerner index P MC

P

• If consumers view two goods as substitutes, cross-price elasticity of demand (EXY) is positive– The higher the positive cross-price elasticity, the

greater the substitutability between two goods, & the smaller the degree of market power for the two firms

Measurement of Market Power

• Entry of new firms into a market erodes market power of existing firms by increasing the number of substitutes

• A firm can possess a high degree of market power only when strong barriers to entry exist– Conditions that make it difficult for new firms to

enter a market in which economic profits are being earned

Barriers to Entry

Common Entry Barriers

• Economies of scale– When long-run average cost declines over a wide

range of output relative to demand for the product, there may not be room for another large producer to enter market

• Barriers created by government– Licenses, exclusive franchises

• Essential input barriers– One firm controls a crucial input in the production

process• Brand loyalties

– Strong customer allegiance to existing firms may keep new firms from finding enough buyers to make entry worthwhile

Common Entry Barriers

• Consumer lock-in– Potential entrants can be deterred if they believe

high switching costs will keep them from inducing many consumers to change brands

• Network externalities– Occur when benefit or utility of a product

increases as more consumers buy & use it– Make it difficult for new firms to enter markets

where firms have established a large base or network of buyers

Common Entry Barriers

Demand & Marginal Revenue for a Monopolist

• Market demand curve is the firm’s demand curve• Monopolist must lower price to sell additional

units of output– Marginal revenue is less than price for all but the first

unit sold• When MR is positive (negative), demand is elastic

(inelastic)• For linear demand, MR is also linear, has the same

vertical intercept as demand, & is twice as steep

Demand & Marginal Revenue for a Monopolist

Short-Run Profit Maximization for Monopoly

• Monopolist will produce where MR = SMC as long as TR at least covers the firm’s total avoidable cost (TR ≥ TVC)– Price for this output is given by the demand curve

• If TR < TVC (or, equivalently, P < AVC) the firm shuts down & loses only fixed costs

• If P > ATC, firm makes economic profit• If ATC > P > AVC, firm incurs a loss, but continues to

produce in short run

Short-Run Profit Maximization for Monopoly

Short-Run Loss Minimization for Monopoly

Long-Run Profit Maximization for Monopoly

• Monopolist maximizes profit by choosing to produce output where MR = LMC, as long as P LAC

• Will exit industry if P < LAC• Monopolist will adjust plant size to the

optimal level– Optimal plant is where the short-run average cost

curve is tangent to the long-run average cost at the profit-maximizing output level

Long-Run Profit Maximization for Monopoly

Profit-Maximizing Input Usage• Profit-maximizing level of input usage

produces exactly that level of output that maximizes profit

• Marginal revenue product (MRP)– MRP is the additional revenue attributable to hiring

one more unit of the input

• When producing with a single variable input:• Employ amount of input for which MRP = input price

• Relevant range of MRP curve is downward sloping, positive portion,

for which ARP > MRP

Profit-Maximizing Input Usage

TRMRP MR MP

L

Monopoly Firm’s Demand for Labor

Profit-Maximizing Input Usage• For a firm with market power, profit-

maximizing conditions MRP = w and MR = MC are equivalent– Whether Q or L is chosen to maximize profit,

resulting levels of input usage, output, price, & profit are the same

Monopolistic Competition• Large number of firms sell a differentiated

product– Products are close (not perfect) substitutes

• Market is monopolistic– Product differentiation creates a degree of

market power• Market is competitive

– Large number of firms, easy entry

• Short-run equilibrium is identical to monopoly

• Unrestricted entry/exit leads to long-run equilibrium– Attained when demand curve for each producer

is tangent to LAC– At equilibrium output, P = LAC and

MR = LMC

Monopolistic Competition

Short-Run Profit Maximization for Monopolistic Competition

Long-Run Profit Maximization for Monopolistic Competition

Implementing the Profit-Maximizing Output & Pricing Decision

• Step 1: Estimate demand equation– Use statistical techniques from Chapter 7– Substitute forecasts of demand-shifting

variables into estimated demand equation to get

Q = a′ + bP

Where Rˆ ˆa' a cM dP

• Step 2: Find inverse demand equation– Solve for P

Implementing the Profit-Maximizing Output & Pricing Decision

1a'P Q A BQ

b b

1Where and , R

a'ˆ ˆa' a cM dP , A Bb b

• Step 3: Solve for marginal revenue– When demand is expressed as P = A + BQ, marginal

revenue is

Implementing the Profit-Maximizing Output & Pricing Decision

22

a'MR A BQ Q

b b

• Step 4: Estimate AVC & SMC• Use statistical techniques from Chapter 10

AVC = a + bQ + cQ2

SMC = a + 2bQ + 3cQ2

• Step 5: Find output where MR = SMC– Set equations equal & solve for Q*

– The larger of the two solutions is the profit-maximizing output level

• Step 6: Find profit-maximizing price– Substitute Q* into inverse demand

P* = A + BQ*

Q* & P* are only optimal if P AVC

Implementing the Profit-Maximizing Output & Pricing Decision

• Step 7: Check shutdown rule– Substitute Q* into estimated AVC function

• If P* AVC*, produce Q* units of output & sell each unit for P*

• If P* < AVC*, shut down in short run

Implementing the Profit-Maximizing Output & Pricing Decision

AVC* = a + bQ* + cQ*2

• Step 8: Compute profit or loss– Profit = TR – TC

= P x Q* - AVC x Q* - TFC

= (P – AVC)Q* - TFC

– If P < AVC, firm shuts down & profit is -TFC

Implementing the Profit-Maximizing Output & Pricing Decision

Multiple Plants

• If a firm produces in 2 plants, A & B– Allocate production so MCA = MCB

– Optimal total output is that for which MR = MCT

• For profit-maximization, allocate total output so that MR = MCT = MCA = MCB

A Multiplant Firm