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McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12 Managerial Decisions for Firms with Market Power.

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Presentation on theme: "McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12 Managerial Decisions for Firms with Market Power."— Presentation transcript:

1 McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 12 Managerial Decisions for Firms with Market Power

2 12-2 Learning Objectives  Define market power and describe measurement of market power  Explain why entry barriers are necessary for long run market power and discuss major types of entry barriers  Find the profit ‐ maximizing output, price, and input usage for a monopolist and monopolistic competitor  Employ empirically estimated or forecasted demand, average variable cost, and marginal cost to calculate profit ‐ maximizing output and price for monopolistic or monopolistically competitive firms  Select production levels at multiple plants to minimize the total cost of producing a given total output for a firm

3 12-3 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)

4 12-4 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

5 12-5 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

6 12-6  Lerner index measures proportionate amount by which price exceeds marginal cost: ~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 Measurement of Market Power

7 12-7  If consumers view two goods as substitutes, cross-price elasticity of demand (E XY ) 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 Measurement of Market Power

8 12-8  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 Barriers to Entry

9 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  Essential input barriers ~One firm controls a crucial input in the production process

10 12-10  Brand loyalties ~Strong customer allegiance to existing firms may keep new firms from finding enough buyers to make entry worthwhile  Consumer lock-in ~Potential entrants can be deterred if they believe high switching costs will keep them from inducing many consumers to change brands Common Entry Barriers

11 12-11  Network externalities ~Occur when benefit or utility 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 base or network of buyers  Sunk costs ~Entry costs (which are sunk costs) can serve as a barrier if they are so high that the manager cannot expect to earn enough future profit to make entry worthwhile Common Entry Barriers

12 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, and is twice as steep

13 12-13 Demand & Marginal Revenue for a Monopolist (Figure 12.1)

14 12-14 Short-Run Profit Maximization for Monopoly  Monopolist will produce where MR = SMC as long as TR at least covers the firm’s total avoidable cost ( TR ≥ TVC ) ~Price for this output is given by the demand curve  If TR < TVC (or, equivalently, P < AVC ) the firm shuts down & loses only fixed costs  If P > ATC, firm makes economic profit  If ATC > P > AVC, firm incurs a loss, but continues to produce in short run

15 12-15 Short-Run Profit Maximization for Monopoly (Figure 12.3)

16 12-16 Short-Run Loss Minimization for Monopoly (Figure 12.4)

17 12-17 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

18 12-18 Long-Run Profit Maximization for Monopoly (Figure 12.5)

19 12-19 Profit-Maximizing Input Usage  Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

20 12-20  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 Profit-Maximizing Input Usage

21 12-21 Monopoly Firm’s Demand for Labor (Figure 12.6)

22 12-22 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

23 12-23 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

24 12-24  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 Monopolistic Competition

25 12-25 Short-Run Profit Maximization for Monopolistic Competition (Figure 12.7)

26 12-26 Long-Run Profit Maximization for Monopolistic Competition (Figure 12.8)

27 12-27 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

28 12-28  Step 2: Find inverse demand equation ~Solve for P Implementing the Profit-Maximizing Output & Pricing Decision

29 12-29  Step 3: Solve for marginal revenue ~When demand is expressed as P = A + BQ, marginal revenue is Implementing the Profit-Maximizing Output & Pricing Decision  Step 4: Estimate AVC & SMC ~Use statistical techniques from Chapter 10 AVC = a + bQ + cQ 2 SMC = a + 2bQ + 3cQ 2

30 12-30  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 Implementing the Profit-Maximizing Output & Pricing Decision

31 12-31  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 Implementing the Profit-Maximizing Output & Pricing Decision AVC * = a + bQ * + cQ *2

32 12-32  Step 8: Compute profit or loss ~Profit = TR – TC = P x Q * - AVC x Q * - TFC = (P – AVC)Q * - TFC ~If P < AVC, firm shuts down & profit is -TFC Implementing the Profit-Maximizing Output & Pricing Decision

33 12-33 Maximizing Profit at Aztec Electronics: An Example  Aztec possesses market power via patents  Sells advanced wireless stereo headphones

34 12-34 Maximizing Profit at Aztec Electronics: An Example  Estimation of demand & marginal revenue

35 12-35  Solve for inverse demand Maximizing Profit at Aztec Electronics: An Example

36 12-36  Determine marginal revenue function P = 100 – 0.002Q MR = 100 – 0.004Q Maximizing Profit at Aztec Electronics: An Example

37 12-37 Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)

38 12-38  Estimation of average variable cost and marginal cost ~Given the estimated AVC equation: AVC = 28 – 0.005Q Q 2 ~Then, SMC = 28 – (2 x 0.005)Q + (3 x )Q 2 = 28 – 0.01Q Q 2 Maximizing Profit at Aztec Electronics: An Example

39 12-39  Output decision ~Set MR = MC and solve for Q * 100 – 0.004Q = 28 – 0.01Q Q 2 0 = (28 – 100) + ( )Q Q 2 = -72 – 0.006Q Q 2 Maximizing Profit at Aztec Electronics: An Example

40 12-40  Output decision ~Solve for Q * using the quadratic formula Maximizing Profit at Aztec Electronics: An Example

41 12-41  Pricing decision ~Substitute Q * into inverse demand P * = 100 – 0.002(6,000) = $88 Maximizing Profit at Aztec Electronics: An Example

42 12-42  Shutdown decision ~Compute AVC at 6,000 units: AVC * = (6,000) (6,000) 2 = $34 ~Because P = $88 > $34 = ATC, Aztec should produce rather than shut down Maximizing Profit at Aztec Electronics: An Example

43 12-43  Computation of total profit π = TR – TVC – TFC = (P * x Q * ) – (AVC * x Q * ) – TFC = ($88 x 6,000) – ($34 x 6,000) - $270,000 = $528,000 - $204,000 - $270,000 = $54,000 Maximizing Profit at Aztec Electronics: An Example

44 12-44 Profit Maximization at Aztec Electronics (Figure 12.10)

45 12-45 Multiple Plants  If a firm produces in 2 plants, A & B ~Allocate production so MC A = MC B ~Optimal total output is that for which MR = MC T  For profit-maximization, allocate total output so that MR = MC T = MC A = MC B

46 12-46 A Multiplant Firm (Figure 12.11)

47 12-47 Summary  Price-setting firms possess market power ~A monopoly exists when a single firm produces and sells a particular good or service for which there are no good substitutes and new firms are prevented from entering the market ~Monopolistic competition arises when the market consists of a large number of relatively small firms that produce similar, but slightly differentiated, products and have some market power  A firm can possess a high degree of market power only when strong barriers to the entry of new firms exist  In the short run, the manager of a monopoly firm will choose to produce where MR = SMC, rather than shut down, as long as total revenue at least covers the firm’s total variable cost ( TR ≥ TVC )

48 12-48 Summary  In the long run, the monopolist maximizes profit by choosing to produce where MR = LMC, unless price is less than long-run average cost ( P < LAC ), in which case the firm exits the industry  For firms with market power, marginal revenue product ( MRP ) is equal to marginal revenue times marginal product: MRP = MR × MP  Whether the manager chooses Q or L to maximize profit, the resulting levels of input usage, output, price, and profit are the same  Short-run equilibrium under monopolistic competition is exactly the same as for monopoly

49 12-49 Summary  Long-run equilibrium in a monopolistically competitive market is attained when the demand curve for each producer is tangent to the long-run average cost curve ~Unrestricted entry and exit lead to this equilibrium  8 steps can be employed for profit-maximization for a monopoly or monopolistically competitive firm: (1) estimate demand equation, (2) find inverse demand equation, (3) solve for marginal revenue, (4) estimate average variable cost and marginal cost, (5) find output level where MR = SMC, (6) find profit-maximizing price, (7) check the shutdown rule, and (8) compute profit/loss  A firm producing in two plants, A and B, should allocate production between the two plants so that MC A = MC B


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