Managing in Competitive, Monopolistic, and Monopolistically

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Managing in Competitive, Monopolistic, and Monopolistically Powered By Docstoc
					   Managing in
 Monopolistic, and
Competitive Markets
    Learning Objectives
• Describe the key characteristics of the
  four basic market types used in economic
• Compare and contrast the degree of price
  competition among the four market types.
• Provide specific actual examples of the
  four types of markets.
• Explain why the P=MC rule leads firms to
  the optimal level of production.
    Learning Objectives
• Describe what happens in the long run in
  markets where firms that are either
  incurring economic losses or are making
  economic profits. Explain why this
  happens with particular attention to the
  key assumptions used in this analysis.
• Explain how and why the MR=MC rule helps
  a monopoly to determine the optimal level
  of price and output.
• Explain the relationship between the
  MR=MC rule and the P=MC rule.
     Learning Objectives
• Cite the main differences between monopolistic
  competition and oligopoly
• Describe the role that mutual interdependence
  plays in setting prices in oligopolistic markets
• Illustrate price rigidity in oligopoly markets using
  the “kinked demand curve”
• Elaborate on how non-price factors help firms in
  monopolistic competition and oligopoly to
  differentiate their products and services
• Cite and briefly describe the five forces in
  Porter’s model of competition
Four Basic Market Types

1.      Perfect Competition (no market power)
     – Large number of relatively small buyers and
     – Standardized product
     – Very easy market entry and exit
     – Nonprice competition not possible
2.      Monopoly (absolute market power
     subject to government regulation)
     – One firm, firm is the industry
     – Unique product or no close substitutes
     – Market entry and exit difficult or legally
     – Nonprice competition not necessary
3.       Monopolistic Competition (market
     power based on product differentiation)
      – Large number of relatively small firms
        acting independently
      – Differentiated product
      – Market entry and exit relatively easy
      – Nonprice competition very important
4. Oligopoly (market power based on
   product differentiation and/or the firm’s
   dominance of the market)

  –   Small number of relatively large firms
      that are mutually interdependent
  –   Differentiated or standardized
  –   Market entry and exit difficult
  –   Nonprice competition very important
      among firms selling differentiated
   Pricing and Output Decisions
       in Perfect Competition
• The Basic Business Decision: entering a
  market on the basis of the following
  – How much should we produce?
  – If we produce such an amount, how much profit
    will we earn?
  – If a loss rather than a profit is incurred, will it
    be worthwhile to continue in this market in the
    long run (in hopes that we will eventually earn a
    profit) or should we exit?
      Unrealistic? Why Learn?
• Many small businesses are “price-takers,” and
  decision rules for such firms are similar to those
  of perfectly competitive firms.
• It is a useful benchmark.
• Explains why governments oppose monopolies.
• Illuminates the “danger” to managers of
  competitive environments.
   – Importance of product differentiation.
   – Sustainable advantage.
• Key assumptions of the perfectly
  competitive market
  – The firm operates in a perfectly competitive
    market and therefore is a price taker.
  – The firm makes the distinction between the
    short run and the long run.
  – The firm’s objective is to maximize its profit in
    the short run. If it cannot earn a profit, then
    it seeks to minimize its loss.
  – The firm includes its opportunity cost of
    operating in a particular market as part of its
    total cost of production.
        Setting Price
$                      $

Pe                                Df


                  QM              Qf
     Market                Firm
 Profit-Maximizing Output
• MR = MC.
• Since, MR = P,
• Set P = MC to maximize profits.
      Graphically: Representative
       Firm’s Output Decision
          Profit = (Pe - ATC)  Qf*
 Pe                                              Pe = Df = MR


                                      Qf*             Qf
          A Numerical Example
• Given
  – P=$10
  – C(Q) = 5 + Q2
• Optimal Price?
  – P=$10
• Optimal Output?
  – MR = P = $10 and MC = 2Q
  – 10 = 2Q
  – Q = 5 units
• Maximum Profits?
  – PQ - C(Q) = (10)(5) - (5 + 25) = $20
• The firm incurs a loss.
  At the optimum output
  level price is below
  average cost.
• However, since price
  is greater than
  average variable cost,
  the firm is better off
  producing in the short
  run, because it will
  still incur fixed costs
  greater than the loss.
 Should this Firm Sustain Short Run
       Losses or Shut Down?

       Profit = (Pe - ATC)  Qf* < 0
                                       MC            ATC


  Pe                                        Pe = Df = MR

                            Qf*                 Qf
        Shutdown Decision Rule
• A profit-maximizing firm should
  continue to operate (sustain short-
  run losses) if its operating loss is less
  than its fixed costs.
  – Operating results in a smaller loss than
    ceasing operations.
• Decision rule:
  – A firm should shutdown when P < min
  – Continue operating as long as P ≥ min
• Contribution Margin
  (CM): the amount by
  which total revenue
  exceeds total variable
• CM = TR – TVC
• If the contribution
  margin is positive, the
  firm should continue
  to produce in the
  short run in order to
  defray some of the
  fixed cost.
• Shutdown Point: the lowest price at which
  the firm would still produce.
• At the shutdown point, the price is equal
  to the minimum point on the AVC. This is
  where selling at the price results in zero
  contribution margin.
• If the price falls below the shutdown
  point, revenues fail to cover the fixed
  costs and the variable costs. The firm
  would be better off if it shut down and
  just paid its fixed costs.
Firm’s Short-Run Supply Curve:
      MC Above Min AVC
                     MC        ATC


P min AVC

             Qf*          Qf
      Short-Run Market Supply Curve
     • The market supply curve is the summation
       of each individual firm’s supply at each
P      Firm 1                     Firm 2            Market
                         P                      P

                S1                         S2


      10   18        Q       20     25      Q       30       43Q
    Long Run Adjustments?

• If firms are price takers but there
  are barriers to entry, profits will
• If the industry is perfectly
  competitive, firms are not only price
  takers but there is free entry.
  – Other “greedy capitalists” enter the
      Effect of Entry on Price?

 $                            $
                 Entry   S*
Pe                                       Df
Pe*                                      Df*


                         QM               Qf
        Market                    Firm
Effect of Entry on the Firm’s
    Output and Profits?

    Pe                      Df

    Pe*                     Df*

              QL Qf*              Q
      Summary of Logic
• Short run profits leads to entry.
• Entry increases market supply, drives
  down the market price, increases the
  market quantity.
• Demand for individual firm’s product
  shifts down.
• Firm reduces output to maximize
• Long run profits are zero.
Features of Long Run Competitive

• P = MC
  – Socially efficient output.
• P = minimum AC
  – Efficient plant size.
  – Zero profits
    • Firms are earning just enough to offset
      their opportunity cost.
• In the long run, the price in the
  competitive market will settle at the point
  where firms earn a normal profit.
  – Economic profit invites entry of new firms
    which shifts the supply curve to the right, puts
    downward pressure on price and reduces
  – Economic loss causes exit of firms which shifts
    the supply curve to the left, puts upward
    pressure on price and increases profits.
• Observations in perfectly competitive
  – The earlier the firm enters a market, the
    better its chances of earning above-normal
    profit (assuming a strong demand in the
  – As new firms enter the market, firms that want
    to survive and perhaps thrive must find ways to
    produce at the lowest possible cost, or at least
    at cost levels below those of their competitors.
  – Firms that find themselves unable to compete
    on the basis of cost might want to try competing
    on the basis of product differentiation instead.
      Monopoly Environment

• Single firm serves the “relevant
• Most monopolies are “local”
• The demand for the firm’s product is
  the market demand curve.
• Firm has control over price.
  – But the price charged affects the
    quantity demanded of the monopolist’s
     “Natural” Sources of
       Monopoly Power
• Economies of scale
• Economies of scope
• Cost complementarities
     “Created” Sources of
        Monopoly Power
• Patents and other legal barriers (like
• Tying contracts
• Exclusive contracts
• Collusion                    I.

   Managing a Monopoly
• Market power
  permits you to price
  above MC
• Is the sky the limit?
• No. How much you
  sell depends on the
  price you set!
           A Monopolist’s Marginal Revenue

                                                      TR                            Unit elastic
                              Unit elastic
 60                                                  1200

 20                                                   800

      0   10   20        30     40      50       Q          0   10        20   30      40       50   Q
                                                                Elastic             Inelastic
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
                                Profit                         ATC



                             QM                                Q
       Useful Formulae
• What’s the MR if a firm faces a linear
  demand curve for its product?
                P  a  bQ
                   MR  a  2bQ, where b  0.

• Alternatively,
                          1  E 
                   MR  P 
                           E   
              A Numerical Example

• Given estimates of
    • P = 10 - Q
    • C(Q) = 6 + 2Q
• Optimal output?
    •   MR = 10 - 2Q
    •   MC = 2
    •   10 - 2Q = 2
    •   Q = 4 units
• Optimal price?
    • P = 10 - (4) = $6
• Maximum profits?
    • PQ - C(Q) = (6)(4) - (6 + 8) = $10
 Long Run Adjustments?
• None, unless the
  source of
  monopoly power
  is eliminated.
  Why Government Dislikes
• P > MC
  – Too little output, at too
    high a price.
• Deadweight loss of
     Deadweight Loss of
        Deadweight Loss        MC
        of Monopoly                     ATC



              QM          MR            Q
Arguments for Monopoly
• The beneficial effects of economies
  of scale, economies of scope, and
  cost complementarities on price and
  output may outweigh the negative
  effects of market power.
• Encourages innovation.
Monopoly Multi-Plant Decisions
• Consider a monopoly that produces
  identical output at two production facilities
  (think of a firm that generates and
  distributes electricity from two facilities).
   – Let C1(Q2) be the production cost at
     facility 1.
   – Let C2(Q2) be the production cost at
     facility 2.
• Decision Rule: Produce output where
      MR(Q) = MC1(Q1) and MR(Q) = MC2(Q2)
  – Set price equal to P(Q), where Q = Q1 + Q2.
     Monopolistic Competition:
    Environment and Implications

• Numerous buyers and sellers
• Differentiated products
  – Implication: Since products are
    differentiated, each firm faces a
    downward sloping demand curve.
    • Consumers view differentiated products as
      close substitutes: there exists some
      willingness to substitute.
• Free entry and exit
  – Implication: Firms will earn zero profits
    in the long run.
Managing a Monopolistically Competitive Firm

• Like a monopoly, monopolistically
  competitive firms
  – have market power that permits pricing above
    marginal cost.
  – level of sales depends on the price it sets.
• But …
  – The presence of other brands in the market
    makes the demand for your brand more elastic
    than if you were a monopolist.
  – Free entry and exit impacts profitability.
• Therefore, monopolistically competitive
  firms have limited market power.
Competing in Imperfectly
  Competitive Markets
• Non-price variables: any factor that managers can control,
  influence, or explicitly consider in making decisions
  affecting the demand for their goods and services.
   –   Advertising
   –   Promotion
   –   Location and distribution channels
   –   Market segmentation
   –   Loyalty programs
   –   Product extensions and new product development
   –   Special customer services
   –   Product “lock-in” or “tie-in”
   –   Pre-emptive new product announcements
           Marginal Revenue Like a

                                                      TR                            Unit elastic
                              Unit elastic
 60                                                  1200

 20                                                   800

      0   10   20        30     40      50       Q          0   10        20   30      40       50   Q
                                                                Elastic             Inelastic
  Monopolistic Competition:
    Profit Maximization
• Maximize profits like a monopolist
  – Produce output where MR = MC.
  – Charge the price on the demand curve
    that corresponds to that quantity.
         Short-Run Monopolistic



                QM             Quantity of Brand X
 Long Run Adjustments?
• If the industry is truly
  monopolistically competitive, there is
  free entry.
  – In this case other “greedy capitalists”
    enter, and their new brands steal
    market share.
  – This reduces the demand for your
    product until profits are ultimately
         Long-Run Monopolistic
          Long Run Equilibrium
          (P = AC, so zero profits)            MC



                                      Entry         D

                               MR         D1
                    Q1 Q*                     Quantity of Brand
                               MR1                    X
Monopolistic Competition
The   Good (To Consumers)
  –   Product Variety
The   Bad (To Society)
  –   P > MC
  –   Excess capacity
       • Unexploited economies of
The Ugly (To Managers)
  – P = ATC > minimum of
    average costs.
       • Zero Profits (in the long
      Optimal Advertising
• Advertising is one way for firms with market
  power to differentiate their products.
• But, how much should a firm spend on
  – Advertise to the point where the additional
    revenue generated from advertising equals the
    additional cost of advertising.
   Optimal Advertising

– Equivalently, the profit-maximizing level of
  advertising occurs where the advertising-to-sales
  ratio equals the ratio of the advertising
  elasticity of demand to the own-price elasticity
  of demand.

                 A   EQ, A
                 R  EQ, P
   Maximizing Profits: A Synthesizing

• C(Q) = 125 + 4Q2
• Determine the profit-maximizing output
  and price, and discuss its implications, if
  – You are a price taker and other firms
    charge $40 per unit;
  – You are a monopolist and the inverse
    demand for your product is P = 100 - Q;
  – You are a monopolistically competitive firm
    and the inverse demand for your brand is P
    = 100 – Q.
        Marginal Cost
• C(Q) = 125 + 4Q2,
• So MC = 8Q.
• This is independent of market
              Price Taker
• MR = P = $40.
• Set MR = MC.
    • 40 = 8Q.
    • Q = 5 units.
• Cost of producing 5 units.
    • C(Q) = 125 + 4Q2 = 125 + 100 = $225.
• Revenues:
    • PQ = (40)(5) = $200.
• Maximum profits of -$25.
• Implications: Expect exit in the long-
    Monopoly/Monopolistic Competition
• MR = 100 - 2Q (since P = 100 - Q).
• Set MR = MC, or 100 - 2Q = 8Q.
   – Optimal output: Q = 10.
   – Optimal price: P = 100 - (10) = $90.
   – Maximal profits:
      • PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.
• Implications
   – Monopolist will not face entry (unless patent or
     other entry barriers are eliminated).
   – Monopolistically competitive firm should expect
     other firms to clone, so profits will decline over
• Firms operating in a perfectly competitive
  market take the market price as given.
  – Produce output where P = MC.
  – Firms may earn profits or losses in the short run.
  – … but, in the long run, entry or exit forces profits
    to zero.
• A monopoly firm, in contrast, can earn
  persistent profits provided that source of
  monopoly power is not eliminated.
• A monopolistically competitive firm can earn
  profits in the short run, but entry by
  competing brands will erode these profits over
• Oligopoly is a market dominated by a
  relatively small number of large firms
• Products are either standardized or
• Measures of Market Concentration
  – Herfindahl-Hirschman index (HH): measure of
    market concentration (max HH = 10,000)
            HH   S i2
                  i 1

     • n: number of firms in the industry
     • Si: firm’s market share
     • Unconcentrated markets have HH < 1,000
  Pricing in an Oligopolistic Market:
 Rivalry and Mutual Interdependence

• Mutual Interdependence: relatively
  few sellers create a situation where
  each is carefully watching the others
  as it sets its price.
• Kinked Demand Curve Model
  – Basic Assumption: competitor will follow
    a price decrease but will not make a
    change in reaction to a price increase.
   Pricing in an Oligopolistic Market:
  Rivalry and Mutual Interdependence

• If reduce price and           Competitors do not
  competitors match the         match price increases
  price cut then move
  along more inelastic
  demand segment Di.                       Competitors
• If increase price and                     price cuts
  competitors do not
  follow then move along
  the more elastic
  segment Df.
• Marginal Revenue
  curve will be
  discontinuous where
  the kink occurs (at
  point A).
• Price Leader: one firm in the industry
  takes the lead in changing prices.
  – The price leader assumes that firms will
    follow a price increase. It assumes that
    firms may follow a reduction in price,
    but will not go even lower in order not to
    trigger a price war.
• Non-Price Leader: firm that leads
  the differentiation of products on
  other, non-price attributes.
• Equalizing at the margin: general economic
  concept which managers can use to help
  make an optimal decision.
  – Can be used to decide the optimal expenditure
    level of a non-price factor that influences a
    firm’s demand.
  – MR = MC is an example of equalizing at the
• Revenue and costs may be realized over a
  long period of time.
  – Firm must adjust MR, MC for the time value of

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