Imperfect Competition

Characteristics & Behavior of Firms With Market Power

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Objectives of Discussion

Consider what it means for a firm to have “market power”

Examine some measures of market power Consider some of the factors that will create market

power for a firm Examine the optimizing behavior of a monopoly firm Examine the monopoly firm’s short-run & long-run

equilibrium Examine the monopoly firm’s optimal resource

utilization behavior Examine Output decisions for multi-plant firms

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Market Power

A firm has “Market Power” (MP) if it can raise its price without losing all of its sales Consider case of firm in perfect competition--what happens when it

tries to raise price Implications of market power

Firm’s demand curve is downward sloping No perfect substitutes for its products Gives firm ability to raise price above average cost & earn

economic profit (if demand & cost conditions permit) Almost all firms have some degree of market power

Degree of market power varies greatly from industry to industry Local gas/convenience stores have market power based on

location Major department stores have market power based on location and

advertising induced name recognition

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Measures of Market Power

Most direct measure of firm’s MP is the price elasticity of demand for its product: The more inelastic the firm’s demand, the greater its MP Note the emphasize on the firm as opposed to the industry

elasticity A secondary set of measures of MP is the cross-

elasticity of firm’s product with respect to “possible substitutes” Relatively high positive cross-elasticity coefficients indicates

that there are close substitutes and firm’s MP is limited Cross-elasticity is frequently used in anti-trust cases to

determine if products are viewed as competitors Lerner Index—based on how much a firm can raise

its price above its MC

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Lerner Index

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

Equals zero under perfect competition because Q is chosen where P = MC

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

dEP

MCP 1Index Lerner

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Determinants of Market Power

Ease of entry Entry of new firms erodes market power of

existing firms Excessive economic profits by existing firms

provides incentive for new firms to enter More firms means more substitutes

Strong barriers to entry must exist to sustain a high degree of market power

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Barriers to Entry & Market Power

“Barriers to Entry” (BtoE) are technical, governmental or economic factors that impede entry of firms into a market Limits potential substitutes

Large Minimum Efficient Economies of Scale Capacity of firm required to achieve lowest point on LAC

curve is large relative to total market demand Large capital investment required to achieve competitive

cost level Significant cost disadvantages for smaller firms Number of firms required to satisfy total market demand is

small

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Other Barriers to Entry

Government created BtoE’s: Licensing & franchises--e.g. local telephone companies, trash

collection, toll roads, etc Federally granted patents on products & processes

Control of, or limited access to, resource markets Classic case was ALCOA’s control of bauxite before WWII Walmart is frequently accused of controlling suppliers’

interactions with competitors Advertising & Brand Loyalties

Soft drinks & chewing gum are classic examples Beauty products and cosmetics are other examples Cost of entry for a new firm is an overwhelming advertising

budget

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Other 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

Cell phone contracts, internet contracts, etc.

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 Cell phones, internet access, computer software,

etc.

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Profit Maximization in Monopoly

Single firmProduces & 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

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Monopoly Firm’s Demand & MR

Firm’s demand curve is the downward sloping market demand curve

Firm must accept a reduction in price if it desires to sell more

Firm’s MR curve deviates from its demand & AR curve

For linear demand, MR declines twice as fast as demand

MR becomes zero at quantity at which demand elasticity is unitary

MR is only positive when

|E| > 1

Point of unitary E

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Profit Maximization for Monopoly Firm

Short-run cost curves for monopoly firm are same u-shaped curves as PC

Like firm in PC, monopolist chooses Q where its MR = MC

Firm then sets price that market will bear for that quantity

Firm’s profits are (P - ATC) x Q Profits represented by rectangle

ABCD & equal $1,400

πMaxπMax Q is where MR = MC

Set P based on demand curve WTP

Profit = $1,400

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Losses in Short-run

Monopolist not always guaranteed profit

Like firm in PC, monopolist will operate with loss in SR as long as can cover all of AVC

Firm chooses Q where MR = MC & sets price along demand

In this case, firm suffers loss represented by ABCD

Loss = (P - ATC) x Q Loss = (75 - 80) x 50 = - $250

Loss = ABCD = (P – ATC)Q = (75 – 80) x 50 = -$ 250

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Long-run Equilibrium for Monopoly Firm

At LR equilibrium, firm will choose Q where MR=LMC=SMC

Firm may make profits, or break even, but will not suffer a loss

Monopolist does not have to maximize profits to survive

In LR, monopoly firm will not operate with loss

Firm’s LR cost curves are similar to those of PC firm

Once LR plant size is chosen, firm will operate along its SR cost curves

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Optimal Hiring Decision for Monopolist

Monopolist’s optimal hiring rule is similar to that of PC firm

Expand use of factor as long as its MRP ≥ MC

Main difference between Monopolist & PC is way MRP is determined

For monopolist MRP = MR x MP whereas for PC firm

MRP = P x MP Monopolist must reduce P to

sell the additional MPL

MRP for monopolist declines faster than MRP for PC

As was true in PC Shut down if w > ARPMax

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Profit-Maximizing Input Usage

For a firm with market power, profit-maximizing conditions MRP = w and MR = MC are equivalentWhether Q or L is chosen to

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

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Monopolistic Competition

Large number of firms sell a differentiated productProducts are close (not perfect)

substitutesMarket is monopolistic

Product differentiation creates a degree of market power

Market is competitiveLarge number of firms, easy entry

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Monopolistic Competition

Short-run equilibrium is identical to monopoly Choose Q where MR = MC Set price on basis of willingness to pay as

reflected by the demand curve Long-run equilibrium

Excessive economic profits provide incentive for entry

Unrestricted entry/exit reduces each existing firm’s demand and increases cost

Long-run equilibrium attained when demand curve for each producer is tangent to its LAC

At equilibrium output, P = LAC and MR = LMC However, does operate at minimum LAC and P >

LMC

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Short-Run Profit Maximization for Monopolistic Competition

πMax Q: MR = MC

Π = PABC

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Long-Run Profit Maximization for Monopolistic Competition

Firm’s Initial Demand CurveFirm’s Demand Shifts

left as firms enter

LR equilibrium occurs when D shifts to left so that P = LAC

At LR equilibrium P = LAC & MR = LMC &

Π = Zero

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Maximizing Profit at Aztec Electronics: An Example

Aztec possesses market power via patents

Sells advanced wireless stereo headphones

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Estimate Aztec Electronics Demand Function

Assume the following demand function was estimated where P is price, M is income and PR is the price of a related good:

Substituting for M & PR:

The direct demand function is:

41,000 500 0.6 22.5 RQ P M P

41,000 500 0.6(45,000) 22.5(800) P

Q = 50,000 – 500P

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Inverse Demand for Aztec Electronics:

Start with direct demand function:

Divide all terms by -500:

Solve for P:

Inverse demand function is:

50,000 500

500 500

Q P

1100

500P Q

50,000 500Q P

P = 100 - .002Q

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Determine MR Function:

Multiple Inverse Demand by Q to find TR:

MR is 1st Derivative of TR

2002.100 QQQPTR

QdQTRdMR 004.100)(

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Demand & Marginal Revenue for Aztec Electronics

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Given the estimated AVC equation:

Find TVC:

Find SMC:

Estimating AVC & MC

228 0.005 0.000001AVC Q Q

2)000001.03()005.2(28)( QQQTVCSMC

32 000001.0005.028 QQQQAVCTVC

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Find πMax Output for Aztec

Set MR = MC and put equation in general quadratic equation form

2100 0.004 28 0.01 0.000003Q Q Q

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

0 = -72 - 0.006Q + 0.000003Q2

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Find πMax Output for Aztec

Plug coefficients into quadratic formula

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

2(0.000003)Q

*

000,6000006.0

036.0Q

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Finding P*

Pricing decisionSubstitute Q* into inverse demand

* 100 0.002(6,000)P *

P * = $88

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Aztec’s Shut-Down Point

Shutdown decisionCompute 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 *

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Total Profit at Aztec Electronics

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 * * * *

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Profit Maximization at Aztec Electronics

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A Multiplant Firm

Firm produces in 2 plants A & B

Find total Q* by setting MCT = MR

Determine total MC: MCT = MCA + MCB

Set each plant’s Q where MR = MCT = MCA = MCB