Economics for Managersby Paul Farnhamy

Ch t 8Chapter 8Market Structure: MonopolyMarket Structure: Monopoly

and Monopolistic Competition

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Market PowerMarket Power

Market power: ability of a firm to influence the prices of its

d t d d l t t iproducts and develop strategies to earn profits over longer periods of timeof timeMonopoly: single firm producing product with no close substitutesproduct with no close substitutesPrice-searchers: firms in imperfect competition

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imperfect competition

Monopoly Model with Positive Economic ProfitPositive Economic Profit

Figure 8 1aFigure 8.1a

PMC

APM

ATCBATCM

DMR

D

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Q0 QM

Monopoly Model with LossesLosses

Figure 8.1bg

B MC

A

ATCM

PM

ATC

AM

MR D

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Q0 QM

Monopoly ModelMonopoly Model

Monopolist maximizes profits by producing where MR = MC and

iti i fitearns positive economic profit due to barriers to entryTh li t ld ffThe monopolist could suffer losses if ATC is greater than price at the profit-maximizing level ofat the profit maximizing level of output (see next slide)The model has no supply curve

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The model has no supply curve

Comparing Monopoly d P f t C titiand Perfect Competition

Figure 8 2

MC

Figure 8.2

ATCMCP2

D=P=MRATC

P1

0Q Q Q

ATC

0

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QPC QQM Q1MR

Comparing Monopoly d P f t C titi and Perfect Competition

Monopolistic firm must seek out optimal price, which depends on p p , pdemand and cost conditionsFirms with market power mightFirms with market power might pursue other profit goalsPrice is higher and output lowerPrice is higher and output lower under monopoly than under perfect competition

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perfect competition

Barriers to EntryBarriers to Entry

Economies of scale and mergersBarriers created by governmentBarriers created by governmentInput barriersBrand loyaltiesConsumer lock-in and switchingConsumer lock-in and switching costsN t k t liti

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Network externalities

Economies of Scale d Mand Mergers

Exist when a firm’s LRAC slopes downward or when lower

d ti t i t dproduction costs are associated with larger scale of operationC t b i t t iCan act as a barrier to entry in different industriesM ti l l i t tMergers are particularly important in technology, media, and telecommunications

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telecommunications

Barriers Createdb G tby Government

LicensesPatents and copyrightsPatents and copyrights• Public good• Cost of exclusionRegulationRegulation

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Input BarriersInput Barriers

Control over raw materialsBarriers in financial capitalBarriers in financial capital markets• Larger firms can get lower interestLarger firms can get lower interest

rates• Smaller firms need more collateral

for loans• Smaller firms are perceived as

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priskier

Consumer Lock-In and S it hi C tSwitching Costs

When consumers become locked into certain types or brands and ypwould incur substantial switching costs if they changedAlthough lock-in types are dominant, they represent , y pmanagerial strategies that can be used elsewhere to gain market

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power

Consumer Lock-In CostsConsumer Lock In Costs

Contractual commitmentsDurable purchasesDurable purchasesSpecialized suppliersS h tSearch costsLoyalty programs

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Consumer S it hi C t Switching Costs

Replacement of equipmentLearning a new systemLearning a new systemConverting data to a new formatF di f liFunding of new supplierCombined buyer and seller search costscostsLost benefits from current supplier

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Managerial Rule of Thumb: U i L k i St tUsing Lock-in as Strategy

Managers can • Use lock-in as a competitive p

strategy• Be prepared to offer customers

i d tt ti tconcessions and attractive terms• Sell to influential buyers and

attract b ers ith high s itchingattract buyers with high switching costs

• Increase customer commitment8.15© 2005 Prentice Hall, Inc.

• Increase customer commitment and entrenchment

Network ExternalitiesNetwork Externalities

Act as a barrier to entry because the value of a product depends on p pnumber of customers using the productCan be considered demand-side economies of scale, in contrast to ,supply-side economies

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Measures of M k t PMarket Power

Managers can use measures to better understand the markets• Lerner Index: measure of market

power that focuses on thepower that focuses on the difference between a firm’s product price and marginal cost of

d tiproduction

L = (P – MC)

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L (P MC)P

Cross Elasticityf D dof Demand

Percentage change in the quantity demanded of good X relative to gthe percentage change in the price of good YThe higher the cross elasticity, the greater the potential g psubstitution between goods

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Concentration RatiosConcentration Ratios

Measure market power by focusing on share of the market held by the largest fifirmsAssume that the larger the share of the

k t h ld b f fi thmarket held by few firms, the more market power those firms have

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Herfindahl-Hirschman I dIndex

Uses information about market shares of firms in the industryIs the sum of the squares of the market share of each firm in the industryThe U.S. Justice Dept. uses it to evaluate competitive efforts of mergers

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Antitrust IssuesAntitrust Issues

Federal (country) or supranational (EU) legislation that limits market power of firms and regulates howpower of firms and regulates how firms use their market power to competep

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Focus of the Horizontal M G id liMerger Guidelines

D fi iti f th l t k tDefinition of the relevant marketLevel of seller competition in that marketmarketPossibility that a merging firm might affect price and outputNature and extent of entry into the marketExtent to which any cost savings andExtent to which any cost savings and efficiencies could offset increase in market power

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Managerial Rule of Thumb: U d t di A tit t LUnderstanding Antitrust Laws

Managers must work within antitrust constraintsBecause of generalities and ambiguities, managers may notambiguities, managers may not know whether their actions are illegal unless the government g ginitiates litigation

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Assumptions of M li ti C titiMonopolistic Competition

Product differentiation exists among firmsgLarge number of firms existN i t d d i tNo interdependence exists among these firmsEntry by new firms is relatively easy

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Monopolistic Competition, L R d Sh t Long Run and Short run

Figure 8 4Figure 8.4

MCMCP1

ATCMC

P2

P1ATC

P2

0 Q Q0 Q QMR D MR D

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Q2 QQ1 Q

Managerial Rule of Thumb: Market Power inMarket Power in

Monopolistic Competition

Managers must develop a variety of strategies to maintain market gpower when faced with intense competitionThey can exploit geographic advantages, offer improved g , pcustomer service, become part of a cooperative to lower cost, and d l i li d i h

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develop specialized niches

Summary of Key TermsSummary of Key Terms

Antitrust lawsBarriers to entryBarriers to entryConcentration ratiosH fi d hl Hi h I dHerfindahl-Hirschman IndexLerner IndexLock-in and switching costs

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Summary of Key TermsSummary of Key Terms

Market powerMonopolistic competitionMonopolistic competitionMonopolyN t k t litiNetwork externalitiesPrice-searcher

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Do you haveDo you haveany questions?any questions?

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