Chapter 12

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

McGraw-Hill/IrwinManagerial Economics, 9e

Managerial Economics ThomasMauriceninth edition

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

McGraw-Hill/IrwinManagerial Economics, 9e

Managerial Economics ThomasMauriceninth edition

Chapter 12

Managerial Decisions for Firms with Market Power

Managerial EconomicsManagerial Economics

12-2

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)


12-3

Monopoly

• Single firm• Produces & sells a good or service

for which there are no good substitutes

• New firms are prevented from entering market because of a barrier to entry


12-4

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


12-5


• Lerner index measures proportionate amount by which price exceeds marginal cost:

P MCP

Lerner index


12-6


• Lerner index• 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


12-7


• 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


12-8

Determinants 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


12-9

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


12-10


• 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


12-11


• 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 value 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 network of buyers


12-12

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


12-13

Demand & Marginal Revenue for a Monopolist (Figure 12.1)


12-14

Short-Run Profit Maximization for Monopoly• Monopolist will produce a positive

output if some price on the demand curve exceeds average variable cost

• Profit maximization or loss minimization occurs by producing quantity for which MR = MC


12-15

Short-Run Profit Maximization for Monopoly• If P > ATC, firm makes economic

profit

• If ATC > P > AVC, firm incurs loss, but continues to produce in short run

• If demand falls below AVC at every level of output, firm shuts down & loses only fixed costs


12-16

Short-Run Profit Maximization for Monopoly (Figure 12.3)


12-17

Short-Run Loss Minimization for Monopoly (Figure 12.4)


12-18

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


12-19

Long-Run Profit Maximization for Monopoly (Figure 12.5)


12-20

Profit-Maximizing Input Usage

• Profit-maximizing level of input usage produces exactly that level of output that maximizes profit


12-21


• 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

TRMRP MR MP

L


12-22

Monopoly Firm’s Demand for Labor (Figure 12.6)


12-23


• 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


12-24

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


12-25

Monopolistic Competition

• 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


12-26

Short-Run Profit Maximization for Monopolistic Competition (Figure 12.7)


12-27

Long-Run Profit Maximization for Monopolistic Competition (Figure 12.8)


12-28

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

Rˆ ˆa' a cM dP Where


12-29


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

a'P Q A BQ

b b

1

Rˆ ˆa' a cM dP , A a' b , B

b 1

Where and


12-30


• Step 3: Solve for marginal revenue• When demand is expressed as

P = A + BQ, marginal revenue is

a'MR A BQ Q

b b

22


12-31


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

Chapter 10

SMC a bQ cQ22 3

AVC a bQ cQ2


12-32

• 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



12-33


• 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

* * *AVC a bQ cQ 2


12-34


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

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

* *P Q AVC Q TFC *( P AVC )Q TFC


12-35

Maximizing Profit at Aztec Electronics: An Example• Aztec possesses market power via

patents• Sells advanced wireless stereo

headphones


12-36

Maximizing Profit at Aztec Electronics: An Example

• Estimation 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


12-37

Maximizing Profit at Aztec Electronics: An Example• Solve for inverse demand

50,000 500

500 500

Q P

50,000

500 500

QP

1

100500

P Q

50,000 500Q P

100 0.002Q


12-38


• Determine marginal revenue function

100 0.002P Q

100 0.004MR Q


12-39

Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)


12-40

Maximizing Profit at Aztec Electronics: An Example• Estimation of average variable cost

and marginal cost• Given the estimated AVC equation:

228 0.005 0.000001AVC Q Q

• So,

228 (2 0.005) (3 0.000001)SMC Q Q 228 0.01 0.000003Q Q


12-41


• Output decision• Set MR = MC and solve for Q*

2100 0.004 28 0.01 0.000003Q Q Q

20 (28 100) ( 0.01 0.004) 0.000003Q Q 272 0.006 0.000003 Q Q


12-42


• Output decision• Solve for Q* using the quadratic

formula

0.036

0.000006 6,000

2( 0.006) ( 0.006) 4( 72)(0.000003)*

2(0.000003)Q

*


12-43


• Pricing decision• Substitute Q* into inverse demand

$88

* 100 0.002(6,000)P *


12-44


• Shutdown decision• Compute AVC at 6,000 units:

$34

$88 $34P AVC Because , Aztec shouldproduce rather than shut down

2* 28 0.005(6,000) 0.000001(6,000)AVC *


12-45


• Computation of total profit

TR TVC TFC

($88 6,000) ($34 6,000) $270,000

$528,000 $204,000 $270,000

$54,000

( * *) ( * *)P Q AVC Q TFC * * * *


12-46

Profit Maximization at Aztec Electronics (Figure 12.10)


12-47

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


12-48

A Multiplant Firm (Figure 12.11)

Chapter 12

Documents

Transcript of Chapter 12