1. Chapter 12: Managerial Decisions for Firms with Market Power
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2. 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)

3. 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

4. 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

5. Measurement of Market Power
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

6. 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

7. Barriers to Entry
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

8. Barriers to entry: 2 definitions
“[A]nything which creates a disadvantage for potential entrants vis à vis established firms. The height of the barriers is measured by the extent to which, in the long run, established firms can elevate their selling prices above minimal average cost without inducing potential entrants to enter” [Joe Bain, Industrial Organization, 2nd ed., p. 252].
Barriers to entry into a market can be defined to be socially undesirable limitations to entry of resources which are due to protection of resource owners already in the market” [Christian von Weizsäcker, Barriers to Entry, p. 13].

9. Examples of barriers to entry
Absolute cost advantages Examples: Alcoa had access to low cost hydroelectric power in Pacific NW; Weyerhauser procured extraction rights to tracts of Douglas fir in 1901; International petroleum majors (Texaco, SOCAL, BP, et al) formed a pipeline consortium in California.
Economies of scale: Dominant firm may enjoy cost advantages due to realization of scale economies in production, distribution, capital raising, or sales promotion.

10. Barriers due to control of wholesale, retail distribution systems Examples: Control of wholesale diamond distribution by DeBeers; Control of advantageous retail shelf space by Proctor and Gamble, Kellogs.
Barriers due to patents, copyrights, trademarks, and other legal barriers Examples: Xerox’s patent on xerography; Polaroid’s patent on instamatic photography
Barriers due to product differentiation/brand power Examples: Cigarettes, pain relievers, designer jeans, athletic wear, batteries, soft drinks

11. Strategic Barriers
Alcoa’s restrictive covenants with hydroelectric suppliers.
Standard Oil’s “secret rebate” policy with the railroad companies.
“Lease-only” policy of IBM, United Shoe Machinery, International Salt
IBM’s continual design modification was designed to forestall entry of firms such as Calcomp that marketed plug-compatible peripherals—e.g.,tapes and line printers.
Microsoft charges PC makers a royalty for every computer shipped—regardless of whether the machine has a Windows operating system installed.
Microsoft requires that Explorer icon appear on desktop in initial boot up sequence.

12. The Microsoft case Microsoft Corporation v. U.S. 530 U.S. 1301 (2000)
The Antitrust Division of the DOJ won Sherman section 1 and section 2 convictions against the software giant. The key element in the case was the so-called “applications barrier to entry.”
                                               

13. The applications barrier in the Microsoft case
Hear audio explanation (wav)
Judge Jackson stated in his Finding of Fact:
“[T]he applications barrier would prevent an aspiring entrant into the relevant market from drawing a significant number of customers away from a dominant incumbent even if the incumbent priced its products substantially above competitive levels for a significant period of time.”

14. Proprietary control of “application program interfaces” keeps software developers in the Microsoft tent.
“These are synapses at which the developer of an application can connect to invoke pre-fabricated blocks of code in the operating system. These blocks of code in turn perform crucial tasks, such as displaying text on the computer screen. Because it supports applications while interacting more closely with the PC system's hardware, the operating system is said to serve as a ‘platform.’” Judge Jackson’s Finding of Fact

15. The middleware threat
Mr. Gates viewed middleware (the Java programming language and Netscape browser software) as rival platforms for ISV’s. Gates feared middleware would bring down the applications barrier.
Hear Brown’s comments (wav)

16. Evidence of ‘willful acquisition and maintenance . . . “
The government alleged that Microsoft designed its licensing agreements with OEM’s and IAP’s so as to preserve the applications barrier. This was also its objective in giving away Internet Explorer for free.

17. The OEM Channel
Licensing agreements with Original Equipment Makers (OEM’s) stipulated pre-installation of Internet explorer.
Internet Explorer icon must appear on the desktop after the initial boot-up sequence.
OEM’s prohibited from pre-installing Netscape browser software.

18. The IAP Channel
Microsoft offered IAP’s valuable “real estate” on the Windows desktop in exchange for their agreement to distribute Internet Explorer exclusively. Hear audio explanation (wav)
If an IAP was already under contract to pay Netscape a certain amount for browser licenses, Microsoft offered to compensate the IAP the amount it owed Netscape.
Microsoft also reduced the referral fees that IAPs paid when users signed up for their services using the Internet Referral Server in Windows in exchange for the IAPs' efforts to convert their installed bases of subscribers from Navigator to Internet Explorer.

19. 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

20. 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, & is twice as steep

21. Demand & Marginal Revenue for a Monopolist (Figure 12.1)

22. 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

23. Short-Run Profit Maximization for Monopoly (Figure 12.3)

24. Short-Run Loss Minimization for Monopoly (Figure 12.4)
Shut-down rule

25. 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

26. Long-Run Profit Maximization for Monopoly (Figure 12.5)

27. Profit-Maximizing Input Usage
Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

28. Profit-Maximizing Input Usage
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

29. Monopoly Firm’s Demand for Labor (Figure 12.6)

30. 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

31. Monopolistic Competition
A market structure featuring a relatively large number of sellers and a differentiated product/service
Examples: Women’s shoes, snack foods, furniture, carpet, bathroom fixtures, men’s suits, cold cuts.

32. The monopolistic competitor faces a downward sloping, but very elastic, demand curve.

33. Short run equilibrium in monopolistic competition5 5 5

34. Long Run Equilibrium in Monopolistic CompetitionD o l l a r s p e r U n i t o f O u t p u t A C M C P E M R D F F Q E O u t p u t ( b ) L o n g - R u n E q u i l i b r i u m: t h e F i r m E a r n s Z e r o E c o n o m i c P r o f i t 6 6 6

35. 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

36. 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

37. Short-Run Profit Maximization for Monopolistic Competition (Figure 12

38. Long-Run Profit Maximization for Monopolistic Competition (Figure 12

39. 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

40. Implementing the Profit-Maximizing Output & Pricing Decision
Step 2: Find inverse demand equation
Solve for P

41. Implementing the Profit-Maximizing Output & Pricing Decision
Step 3: Solve for marginal revenue
When demand is expressed as P = A + BQ, marginal revenue is
Step 4: Estimate AVC & SMC
Use statistical techniques from Chapter 10
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2

42. 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

43. 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

44. Implementing the Profit-Maximizing Output & Pricing Decision
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

45. Maximizing Profit at Aztec Electronics: An Example
Aztec possesses market power via patents
Sells advanced wireless stereo headphones

46. Maximizing Profit at Aztec Electronics: An Example
Estimation of demand & marginal revenue

47. Maximizing Profit at Aztec Electronics: An Example
Solve for inverse demand

48. Maximizing Profit at Aztec Electronics: An Example
Determine marginal revenue function
P = 100 – 0.002Q
MR = 100 – 0.004Q

49. Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)

50. Maximizing Profit at Aztec Electronics: An Example
Estimation of average variable cost and marginal cost
Given the estimated AVC equation:
AVC = 28 – 0.005Q Q2
Then,
SMC = 28 – (2 x 0.005)Q + (3 x )Q2
= 28 – 0.01Q Q2

51. Maximizing Profit at Aztec Electronics: An Example
Output decision
Set MR = MC and solve for Q*
100 – 0.004Q = 28 – 0.01Q Q2
0 = (28 – 100) + ( )Q Q2
= -72 – 0.006Q Q2

52. Maximizing Profit at Aztec Electronics: An Example
Output decision
Solve for Q* using the quadratic formula

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

54. Maximizing Profit at Aztec Electronics: An Example
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

55. Maximizing Profit at Aztec Electronics: An Example
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

56. Profit Maximization at Aztec Electronics (Figure 12.10)

57. 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

58. A Multiplant Firm (Figure 12.11)