Managerial Economics

ninth edition

Thoma
Mauric

Chapter 12
Managerial Decisions for
Firms with Market Power
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial
Economics,
Managerial Economics,

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

Managerial 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)
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Managerial Economics

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
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Managerial Economics

Measurement of Market Power

Degree of market power inversely
related to price elasticity of demand
The less elastic the firms demand, the
greater its degree of market power
The fewer close substitutes for a firms
product, the smaller the elasticity of
demand (in absolute value) & the greater the
firms market power
When demand is perfectly elastic (demand is
horizontal), the firm has no market power
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Managerial Economics

Measurement of Market Power

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

P MC
Lerner index
P

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Managerial Economics

Measurement of Market Power

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
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Managerial Economics

Measurement of Market Power

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
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Managerial Economics

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
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Managerial Economics

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

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Managerial Economics

Common Entry Barriers

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

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Managerial Economics

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 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
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Managerial Economics

Demand & Marginal Revenue for a

Monopolist
Market demand curve is the firms 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
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Managerial Economics

Demand & Marginal Revenue for a

Monopolist (Figure 12.1)

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Managerial Economics

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

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Managerial Economics

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

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Managerial Economics

Short-Run Profit Maximization for

Monopoly (Figure 12.3)

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Managerial Economics

Short-Run Loss Minimization for

Monopoly (Figure 12.4)

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Managerial Economics

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 profitmaximizing output level
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Managerial Economics

Long-Run Profit Maximization for

Monopoly (Figure 12.5)

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Managerial Economics

Profit-Maximizing Input Usage

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

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Managerial Economics

Profit-Maximizing Input Usage

Marginal revenue product (MRP)
MRP is the additional revenue attributable to
hiring one more unit of the input

TR
MRP
MR MP
L
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
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Managerial Economics

Monopoly Firms Demand for

Labor (Figure 12.6)

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Managerial Economics

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

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Managerial Economics

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
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Managerial Economics

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
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Managerial Economics

Short-Run Profit Maximization for

Monopolistic Competition (Figure 12.7)

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Managerial Economics

Long-Run Profit Maximization for

Monopolistic Competition (Figure 12.8)

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Managerial Economics

Implementing the Profit-Maximizing

Output & Pricing Decision

Step 1: Estimate demand equation

Use statistical techniques from
Chapter 7
Substitute forecasts of demandshifting variables into estimated
demand equation to get

Q a' bP
dP
Where a' a cM
R
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Managerial Economics

Implementing the Profit-Maximizing

Output & Pricing Decision

Step 2: Find inverse demand

equation
Solve for P

a' 1
P
Q A BQ
b
b
1

Where a' a cM dPR , A a' b , and B

b
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Managerial Economics

Implementing the Profit-Maximizing

Output & Pricing Decision

Step 3: Solve for marginal revenue

When demand is expressed as
P = A + BQ, marginal revenue is

a' 2
MR A 2 BQ
Q
b
b

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Managerial Economics

Implementing the Profit-Maximizing

Output & Pricing Decision

Step 4: Estimate AVC & SMC

Use statistical techniques from

Chapter 10

AVC a bQ cQ

SMC a 2bQ 3cQ

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Managerial Economics

Implementing the Profit-Maximizing

Output & Pricing Decision

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
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Managerial Economics

Implementing the Profit-Maximizing

Output & Pricing Decision

Step 7: Check shutdown rule

Substitute Q* into estimated AVC

function

AVC a bQ cQ
*

*2

If P* AVC*, produce Q* units of

output & sell each unit for P*
If P* < AVC*, shut down in short run
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Managerial Economics

Implementing the Profit-Maximizing

Output & Pricing Decision

Step 8: Compute profit or loss

Profit = TR - TC
P Q* AVC Q* TFC
( P AVC )Q* TFC

If P < AVC, firm shuts down & profit

is -TFC
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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example

Aztec possesses market power via

patents
Sells advanced wireless stereo
headphones

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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
Estimation of demand & marginal
revenue
Q 41, 000 500 P 0.6 M 22.5 PR
41, 000 500 P 0.6(45, 000) 22.5(800)
50, 000 500 P

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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example

Solve for inverse demand

Q 50, 000 500 P
Q 50, 000 500 P

500
500

Q
50, 000

P
500
500
1
P 100
Q
500
100 0.002Q
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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
Determine marginal revenue
function

P 100 0.002Q
MR 100 0.004Q

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Managerial Economics

Demand & Marginal Revenue for

Aztec Electronics (Figure 12.9)

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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example

Estimation of average variable cost

and marginal cost
Given the estimated AVC equation:

AVC 28 0.005Q 0.000001Q

So,

SMC 28 (2 0.005)Q (3 0.000001)Q

28 0.01Q 0.000003Q
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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example

Output decision

Set MR = MC and solve for Q*

100 0.004Q 28 0.01Q 0.000003Q

0 (28 100) (0.01 0.004)Q 0.000003Q

72 0.006Q 0.000003Q
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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
Output decision
Solve for Q* using the quadratic
formula
(0.006) (0.006) 2 4(72)(0.000003)
Q**
2(0.000003)
0.036
6, 000

0.000006
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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
Pricing decision
Substitute Q* into inverse demand

P** 100 0.002(6, 000)

$88

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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
Shutdown decision
Compute AVC at 6,000 units:

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

$34
Because P $88 $34 AVC, Aztec should
produce rather than shut down
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Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
Computation of total profit
TR TVC TFC
( P** Q*)
* TFC
* ( AVC ** Q*)
($88 6, 000) ($34 6, 000) $270, 000
$528, 000 $204, 000 $270, 000
$54, 000
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Managerial Economics

Profit Maximization at Aztec

Electronics (Figure 12.10)

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Managerial Economics

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

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Managerial Economics

A Multiplant Firm

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(Figure 12.11)