Baye 9e Chapter 08

CHAPTER 8

Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objectives 1.

2. 3. 4.

5. 6. 7.

8.

Identify the conditions under which a firm operates as perfectly competitive, monopolistically competitive, or a monopoly. Identify sources of (and strategies for obtaining) monopoly power. Apply the marginal principle to determine the profit-maximizing price and output. Show the relationship between the elasticity of demand for a firm’s product and its marginal revenue. Explain how long-run adjustments impact perfectly competitive, monopoly, and monopolistically competitive firms; discuss the ramifications of each of these market structures on social welfare. Decide whether a firm making short-run losses should continue to operate or shut down its operations. Illustrate the relationship between marginal cost, a competitive firm’s short-run supply curve, and the competitive industry supply; explain why supply curves do not exist for firms that have market power. Calculate the optimal output of a firm that operates two plants and the optimal level of advertising for a firm that enjoys market power. © 2017 by McGraw-Hill Education. All Rights Reserved.

2

Perfect Competition

Perfect Competition

• Perfectly competitive markets are characterized by: – The interaction between many buyers and sellers that are “small” relative to the market. – Each firm in the market produces a homogeneous (identical) product. – Buyers and sellers have perfect information. – No transaction costs. – Free entry into and exit from the market.

• The implications of these conditions are: – a single market price is determined by the interaction of demand and supply – firms earn zero economic profits in the long run. © 2017 by McGraw-Hill Education. All Rights Reserved.

8-3

Perfect Competition

Demand at the Market and Firm Levels Under Perfect Competition Price Price Market

Firm

S

𝑃𝑒

𝐷 𝑓 = 𝑃𝑒

D

0

Market output

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Firm’s output

8-4

Perfect Competition

Short-Run Output Decisions

• The short run is a period of time over which some factors of production are fixed. • To maximize short-run profits, managers must take as given the fixed inputs (and fixed costs), and determine how much output to produce by changing the variable inputs.

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8-5

Perfect Competition

Revenue, Costs, and Profits for a Perfectly Competitive Firm Costs 𝐶 𝑄

$

Revenue 𝑅 =𝑃×𝑄 B Maximum profits Slope of 𝐶 𝑄 = 𝑀𝐶

Slope of 𝑅 = 𝑀𝑅 = 𝑃 A

0

E

𝑄∗

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Firm’s output

8-6

Perfect Competition

Competitive Firm’s Demand • The demand curve for a competitive firm’s product is a horizontal line at the market price. This price is the competitive firm’s marginal revenue. 𝐷 𝑓 = 𝑃 = 𝑀𝑅

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8-7

Perfect Competition

Profit Maximization under Perfect $ Competition 𝐴𝑇𝐶 𝑀𝐶

𝑃𝑒 𝐴𝑇𝐶

𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅

Profits

𝑄∗

0

𝑄∗

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Firm’s output

8-8

Perfect Competition

Competitive Output Rule

• To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing. 𝑃 = 𝑀𝐶 𝑄

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8-9

Perfect Competition

Competitive Output Rule In Action • The cost function for a firm is 𝐶 𝑄 = 5 + 𝑄2 . • If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, what price should the manager of this firm charge? What level of output should be produced to maximize profits? How much profit will be earned? • Answer: – Charge $20. – Since marginal cost is 2𝑄, equating price and marginal cost yields: $20 = 2𝑄 ⟹ 𝑄 = 10 units. – Maximum profits are: 𝜋 = 20 × 10 − 5 + 102 = $95. © 2017 by McGraw-Hill Education. All Rights Reserved.

8-10

Perfect Competition

Short-Run Loss Minimization $

𝐴𝑇𝐶 𝑀𝐶

𝐴𝑇𝐶 𝑄 ∗

Loss

𝑃𝑒

0

𝐴𝑉𝐶

𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅

𝑄∗

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Firm’s output

8-11

Perfect Competition

The Shut-Down Case 𝑀𝐶

$

𝐴𝑇𝐶 𝐴𝑉𝐶

Loss if shut down 𝐴𝑇𝐶 𝑄 ∗

Fixed Cost

𝐴𝑉𝐶 𝑄∗ 𝑃𝑒

𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅 Loss if produce

0

𝑄∗

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Firm’s output

8-12

Perfect Competition

Short-Run Output Decision Under Perfect Competition • To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where 𝑃 = 𝑀𝐶, provided that 𝑃 ≥ 𝐴𝑉𝐶. If 𝑃 < 𝐴𝑉𝐶, the firm should shut down its plant to minimize it losses.

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8-13

Perfect Competition

Short-Run Firm Supply Curve for a 𝑀𝐶 $ CompetitiveShort-run Firm supply curve for individual firm

𝐴𝑉𝐶 𝑃1

𝑃0

0

𝑄0

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𝑄1 Firm’s output

8-14

Perfect Competition

The Short-Run Firm and Industry Supply Curves • The short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the 𝐴𝑉𝐶 curve.

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8-15

Perfect Competition

The Market Supply Curve P

Individual firm’s supply curve 𝑀𝐶𝑖

Market supply curve S

$12

$10

0

1

500

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Market output

8-16

Perfect Competition

Long-Run Decisions: Entry and Exit The Market and Firm’s Demand Price Price 𝑆2

𝑆0 𝐸𝑥𝑖𝑡

𝐸𝑛𝑡𝑟𝑦

𝑆1

𝑃2

𝐷 𝑓 = 𝑃2 = 𝑀𝑅2

Exit

𝑃0

Entry

𝑃1

𝐷 𝑓 = 𝑃0 = 𝑀𝑅0 𝐷 𝑓 = 𝑃1 = 𝑀𝑅1

D 0

Market output

0

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Firm’s output

8-17

Perfect Competition

Long-Run Competitive Equilibrium

𝑀𝐶

$

Long-run competitive equilibrium

𝐴𝐶

𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅

𝑃𝑒

0

𝑄∗

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Firm’s output

8-18

Perfect Competition

Long-Run Competitive Equilibrium • In the long run, perfectly competitive firms produce a level of output such that 1. 𝑃 = 𝑀𝐶 2. 𝑃 = 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝐴𝐶

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8-19

Monopoly

Monopoly and Monopoly Power • Monopoly: A market structure in which a single firm serves an entire market for a good that has no close substitutes. • Sole seller of a good in a market gives that firm greater market power than if it competed against other firms. – Implication: • market demand curve is the monopolist’s demand curve.

– However, a monopolist does not have unlimited market power. © 2017 by McGraw-Hill Education. All Rights Reserved.

8-20

The Monopolist’s Demand

Monopoly

Monopolist’s power is constrained by the demand curve.

Price

A

𝑃0

B

𝑃1 𝐷 𝑓 = 𝐷𝑀 0

𝑄0

𝑄1

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Output

8-21

Monopoly

Sources of Monopoly Power • Economies of scale: exist whenever long-run average costs decline as output increases. – Diseconomies of scale: exist whenever long-run average costs increase as output increases.

• Economies of scope: exist when the total cost of producing two products within the same firm is lower than when the products are produced by separate firms. • Cost complementarity: exist when the marginal cost of producing one output is reduced when the output of another product is increased. • Patents and other legal barriers © 2017 by McGraw-Hill Education. All Rights Reserved.

8-22

Elasticity of Demand and Total Revenues Price

Monopoly

Revenue Maximum revenues 𝑃0 × 𝑄0

Elastic

Unitary

𝑅0

Unitary

𝑃0

Inelastic

0

𝑄0

Elastic

Q

0

MR

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Inelastic

𝑄0

Firm’s output

8-23

Monopoly

Marginal Revenue and Elasticity

• The monopolist’s marginal revenue function is 1+𝐸 𝑀𝑅 = 𝑃 𝐸 , where 𝐸 is the elasticity of demand for the monopolist’s product and 𝑃 is the price charged. – For 𝑃 > 0 • 𝑀𝑅 > 0 when 𝐸 < −1. • 𝑀𝑅 = 0 when 𝐸 = −1. • 𝑀𝑅 < 0 when −1 < 𝐸 < 0.

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8-24

Marginal Revenue and Linear Demand

Monopoly

• Given an linear inverse demand function 𝑃 𝑄 = 𝑎 + 𝑏𝑄 , where 𝑎 > 0 𝑎𝑛𝑑 𝑏 < 0, the associated marginal revenue is 𝑀𝑅 𝑄 = 𝑎 + 2𝑏𝑄

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8-25

Marginal Revenue In Action

Monopoly

• Suppose the inverse demand function for a monopolist’s product is given by 𝑃 = 10 − 2𝑄. What is the maximum price per unit a monopolist can charge to be able to sell 3 units? What is marginal revenue when 𝑄 = 3? • Answer: – The maximum price the monopolist can charge for 3 units is: 𝑃 = 10 − 2 3 = $4. – The marginal revenue at 3 units for this inverse linear demand is: 𝑀𝑅 = 10 − 2 2 3 = −$2. © 2017 by McGraw-Hill Education. All Rights Reserved.

8-26

Monopoly

Monopoly Output Rule • A profit-maximizing monopolist should produce the output, 𝑄 𝑀 , such that marginal revenue equals marginal cost: 𝑀𝑅 𝑄 𝑀 = 𝑀𝐶 𝑄𝑀

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8-27

Monopoly

Costs, Revenues, and Profits Under 𝑄 Monopoly Cost𝐶function $

𝑅 =𝑃 𝑄 ×𝑄 Revenue function Slope of 𝑅 = 𝑀𝑅

Maximum profit

0

𝑄𝑀 © 2017 by McGraw-Hill Education. All Rights Reserved.

Slope of 𝐶 𝑄 = 𝑀𝐶

Output

8-28

Monopoly

Profit Maximization Under Monopoly Price

𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = 𝑀 𝑃 − 𝐴𝑇𝐶 𝑄𝑀 × 𝑄𝑀

MC ATC

𝑃𝑀 Profits 𝐴𝑇𝐶(𝑄𝑀 )

Demand 𝑄𝑀

MR

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Quantity

8-29

Monopoly Pricing Rule

Monopoly

• Given the level of output, 𝑄 𝑀 , that maximizes profits, the monopoly price is the price on the demand curve corresponding to the 𝑄 𝑀 units produced: 𝑃𝑀 = 𝑃 𝑄𝑀

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8-30

Monopoly

Monopoly In Action • Suppose the inverse demand function for a monopolist’s product is given by 𝑃 = 100 − 2𝑄 and the cost function is 𝐶 𝑄 = 10 + 2𝑄. Determine the profit-maximizing price, quantity and maximum profits. • Answer: – Profit-maximizing output is found by solving: 100 − 4𝑄 = 2 ⟹ 𝑄𝑀 = 24.5. – The profit-maximizing price is: 𝑃𝑀 = 100 − 2 24.5 = $51. – Maximum profits are: 𝜋 = $51 × 24.5 − 10 + 2 × 24.5 = $1,190.50. © 2017 by McGraw-Hill Education. All Rights Reserved.

8-31

Monopoly

The Absence of a Supply Curve • Recall, firms operating in perfectly competitive markets determine how much output to produce based on price (𝑃 = 𝑀𝐶). – Thus, a supply curve exists in perfectly competitive markets.

• A monopolist’s market power implies 𝑃 > 𝑀𝑅 = 𝑀𝐶. – Thus, there is no supply curve for a monopolist, or in markets served by firms with market power.

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8-32

Monopoly

Multiplant Decisions • Often a monopolist produces output in different locations. – Implications: manager has to determine how much output to produce at each plant.

• Consider a monopolist producing output at two plants: – The cost of producing 𝑄1 units at plant 1 is 𝐶 𝑄1 , and the cost of producing 𝑄2 at plant 2 is 𝐶 𝑄2 . – When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is 𝑃 𝑄 , where 𝑄 = 𝑄1 + 𝑄2 . © 2017 by McGraw-Hill Education. All Rights Reserved.

8-33

Multiplant Output Rule

Monopoly

• Let 𝑀𝑅 𝑄 be the marginal revenue of producing a total of 𝑄 = 𝑄1 + 𝑄2 units of output. Suppose the marginal cost of producing 𝑄1 units of output in plant 1 is 𝑀𝐶1 𝑄1 and that of producing 𝑄2 units in plant 2 is 𝑀𝐶2 𝑄2 . The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that: 𝑀𝑅 𝑄 = 𝑀𝐶1 𝑄1 𝑀𝑅 𝑄 = 𝑀𝐶2 𝑄2 © 2017 by McGraw-Hill Education. All Rights Reserved.

8-34

Monopoly

Implications of Entry Barriers

• A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits. – Implication: monopoly profits will continue over time provided the monopoly maintains its market power.

• Monopoly power, however, does not guarantee positive profits.

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8-35

Monopoly

A Monopolist Earning Zero Profits Price

MC

ATC

𝑃𝑀 = 𝐴𝑇𝐶(𝑄 𝑀 )

Demand 𝑄𝑀

MR

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Quantity

8-36

Monopoly

Deadweight Loss of Monopoly

• The consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost.

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8-37

Monopoly

Deadweight Loss of Monopoly Price

MC

𝑃𝑀

Deadweight loss

𝑃𝐶

Demand

MR 𝑄𝑀

𝑄𝐶

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Quantity

8-38

Monopolistic Competition

Monopolistic Competition • An industry is monopolistically competitive if: – There are many buyers and sellers. – Each firm in the industry produces a differentiated product. – There is free entry into and exit from the industry.

• A key difference between monopolistically competitive and perfectly competitive markets is that each firm produces a slightly differentiated product. – Implication: products are close, but not perfect, substitutes; therefore, firm’s demand curve is downward sloping under monopolistic competition. © 2017 by McGraw-Hill Education. All Rights Reserved.

8-39

Monopolistic Competition

Profit-Maximization under Monopolistic Competition Price

𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = ∗ 𝑃 − 𝐴𝑇𝐶 𝑄 ∗ × 𝑄∗

MC ATC

𝑃∗ 𝐴𝑇𝐶(𝑄∗ )

Profits

Demand 𝑄∗

MR

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Quantity

8-40

Monopolistic Competition

Profit-Maximization Rule for Monopolistic Competition

• To maximize profits, a monopolistically competitive firm produces where its marginal revenue equals marginal cost. • The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the profit-maximizing level of output. • The profit-maximizing output, 𝑄 ∗ , is such that 𝑀𝑅 𝑄∗ = 𝑀𝐶 𝑄 ∗ and the profit-maximizing price is 𝑃∗ = 𝑃 𝑄 ∗ . © 2017 by McGraw-Hill Education. All Rights Reserved.

8-41

Monopolistic Competition

Long-Run Equilibrium

• If firms in monopolistically competitive markets earn short-run – profits, additional firms will enter in the long run to capture some of those profits. – losses, some firms will exit the industry in the long run.

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8-42

Monopolistic Competition

Effect of Entry on a Monopolistically Competitive Firm’s Demand Price MC ATC

Due to entry of new firms selling other brands

𝑃∗

Demand1 𝑄∗

MR1

MR0

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Demand0

Quantity of Brand X

8-43

Monopolistic Competition

Long-Run Equilibrium under Monopolistic Competition Price MC Long-run monopolistically competitive equilibrium

ATC

𝑃∗

Demand1 𝑄∗

MR1

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Quantity of Brand X

8-44

Monopolistic Competition

The Long-Run and Monopolistic Competition • In the long run, monopolistically competitive firms produce a level of output such that: 1. 𝑃 > 𝑀𝐶 2. 𝑃 = 𝐴𝑇𝐶 > 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠

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8-45

Monopolistic Competition

Implications of Product Differentiation

• The differentiated nature of products in monopolistically competitive markets implies that firms in these industries must continually convince consumers that their products are better than their competitors.

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8-46

Monopolistic Competition

Implications of Product Differentiation

• Two strategies monopolistically competitive firms use to persuade consumers: – Comparative advertising: form of advertising where a firm attempts to increase the demand for its brand by differentiating its product from competing brands • Brand equity

– Niche marketing: a marketing strategy where goods and services are tailored to meet the needs of a particular segment of the market. • Green marketing

• Successful differentiation and branding strategies can make managers brand myopic, resting on the brand’s past laurels and in doing so missing opportunities to enhance its brand © 2017 by McGraw-Hill Education. All Rights Reserved.

47

Optimal Advertising Decisions

Optimal Advertising Decisions • How much should a firm spend on advertising to maximize profits? – Depends, in part, on the nature of the industry. – The optimal amount of advertising balances the marginal benefits and marginal costs.

• Profit-maximizing advertising-to-sales ratio is: 𝐸𝑄,𝐴 𝐴 = 𝑅 −𝐸𝑄,𝑃

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8-48