1. Managerial Economics & Business Strategy
Chapter 8
Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

2. Overview I. Perfectly Competition II. Monopolies
III. Monopolistic Competition

3. Perfect Competition Many buyers and sellers Homogeneous product
Perfect information
No transaction costs (mobility)
Free entry and exit
PRICE-TAKERS

4. Key Implications
Firms are “price takers” (price determined by interaction of buyers and sellers)
P = MR
In the short-run, firms may earn profits or losses
Long-run economic profits are zero (accounting profits  0)

5. 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

6. Setting Price
Market QM $ D S Pe
Firm Qf $
MR=Df

7. Setting Output: C(Q) R=PQ Output (Q) $ C(Q), R
Slope of revenue curve is MR (linear, so constant)
Slope of tangent line to C(Q) is MC (nonlinear so MC constantly changing). Q0
AT Q0 , MC=MR. Q1 Q2

8. Setting Output: MR = MC MR = P, therefore To max , choose Q when
where
MR = MC
MR = P, therefore
To max , choose Q when
P = MC

9. Graphically (recall cost curves from Chapter 5)
Profit = (Pe - ATC)  Qf* MC $ Qf
ATC
AVC Pe
Pe = Df = MR
ATC
Qf*

10. A Numerical Example Given (Q) = PQ – C(Q)
P=$80 and C(Q) = Q + 2Q2
(Q) = PQ – C(Q)
(Q) = 80Q – [40 + 8Q + 2Q2]
Optimal Q: set MR = MC and solve for Q; or find d /dQ, set equal to zero and solve for Q.
MR = P = $80 and MC = 8 + 4Q
d  /dQ = 80 – 8 – 4Q = 0.
Solving for Q in either case, Q = 18 units.
Max Profits? To ensure maximum, find 2nd derivative of  function. If 2nd derivative is negative (concave down), then indeed a maximum.
d2 /dQ2 = - 4, therefore concave down.
PQ - C(Q) = (80)(18) – [40 + 8(18) + 2(182)] = $608

11. Long Run Adjustments?
If firms are price takers but there are barriers to entry, profits will persist
If the industry is perfectly competitive, firms are not only price takers but there is free entry
Other “greedy capitalists” enter the market

12. Effect of Entry on Price?
Market QM $ D S Pe
Firm Qf $ Df S*
Entry
Pe*
Df*

13. Effect of Entry on the Firm’s Output and Profits?$ Q AC MC QL Pe Df
Pe*
Df*
Qf*

14. 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 profit
Long run profits are zero

15. Negative Profits in the SR (AVC<P<ATC):
Negative economic profits, but less than paying FC MC $
Quantity
ATC
AVC Qf
ATC VC FC Pe
Df = MR
Revenues
AVC

16. Summary: Negative Economic Profits
In SR, if AVC<P<ATC, OPERATE to cover portion of FC (look at 8-5)
In LR, EXIT. As firms exit, supply falls and price rises.
In SR, if P=AVC, DON’T OPERATE and pay FC. This is referred to as the
SHUTDOWN RULE
Supply curve is MC above minimum of AVC.

17. Negative Profits in the SR (P = minimum of AVC)MC $
Quantity
ATC
Supply
AVC
Df = MR
Pe=AVC Qf

18. Features of Long Run Competitive Equilibrium
P = MC
Socially efficient output
P = minimum ATC
Zero profits
Firms are earning just enough to offset their opportunity cost

19. Monopoly Single firm serves the “relevant market”
Most monopolies are “local” monopolies (can exist even if size of firm small)
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 product (don’t have unlimited P-setting power)

20. Sources of Monopoly Power
Economies of scale
Patents and other legal barriers (licenses)
Exclusive Contracts
Collusion
Ownership or control of a scarce resource
Government restrictions (e.g., Utah State Liquor Stores)
Product Proliferation (Microsoft)

21. A Monopolist’s Marginal RevenueQ
Demand
Elastic
Inelastic
Unitary MR
Total
Revenue
($)

22. Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity. $ Q
ATC MC
Profit PM
ATC D QM MR

23. Useful Formulas
What’s the MR if a firm faces a linear demand curve for its product?
P(Q) = a + bQ (inverse D function & b<0)
MR = a + 2bQ
Math Note:
R(Q) = P(Q)Q = (a + bQ)Q = aQ + bQ2
MR = R(Q) = a + 2bQ!
With a little algebra, we could show that
MR = P[(1+E)/E], E is elasticity of D

24. Because MR=MC at profit-maximizing output then
Useful Formulas
Math Note:
MR = P[(1+E)/E]
Because MR=MC at profit-maximizing output then
MC = P[(1+E)/E]
Rearranging terms:
(P-MC)/P = -1/E
(i.e., the Lerner Index)

25. Example Using, MR = P[(1+E)/E] {Note: Don’t take |E| when solving.}
Price = $1.25, MC = $0.25, and E = -2.5.
Based on this information, what should the firm do to boost profits?

26. A Numerical Example Given estimates of
P = 10 - Q
C(Q) = 6 + 2Q
Optimal output? Set MR = MC or find derivative of profit function and set equal to zero.
MR = Q
MC = 2
10 - 2Q = 2
Q = 4 units
Optimal price? Plug Q into inverse demand function
P = 10 - (4) = $6
Maximum profits?
PQ - C(Q) = (6)(4) - (6 + 8) = $10

27. Long Run Adjustments?
None, unless the source of monopoly power is eliminated.

28. Why Government Dislikes Monopoly?
P > MC
Too little output, at too high a price
Deadweight loss of monopoly

29. Deadweight Loss of Monopoly$ Q
ATC MC
Deadweight Loss of Monopoly
Recall:
D represents WTP, thus it is a MB curve. PM D
MR=MC QM MR

30. Arguments for Monopoly
The beneficial effects of economies of scale or economies of scope on price and output may outweigh the negative effects of market power
Encourages innovation

31. Monopolistic Competition
Numerous buyers and sellers
Differentiated products
Implication: Since products are differentiated, each firm faces a downward sloping demand curve.
Firms have limited market power.
Free entry and exit
Implication: Firms will earn zero profits in the long run.

32. Managing a Monopolistically Competitive Firm
Market power permits you to price above marginal cost, just like a monopolist.
How much you sell depends on the price you set, just like a monopolist. But …
The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist.
You have limited market power.

33. Marginal Revenue Like a MonopolistQ
Demand
Elastic
Inelastic
Unitary MR
Total
Revenue
($)

34. Monopolistic Competition: Profit Maximization
Maximize profits like a monopolist
Produce where MR = MC
Charge the price on the demand curve that corresponds to that quantity

35. Graphically $
ATC MC
Profit PM
ATC D
Quantity of Brand X QM MR

36. Long Run Adjustments?
In the absence of free entry, no adjustments occur.
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 zero.

37. Graphically Long Run Equilibrium (P = AC, so zero profits) MC $ AC P*
Entry D MR D1 Q*
Quantity of Brand X Q1
MR1

38. Monopolistic Competition
The Good (To Consumers)
Product Variety
The Bad (To Society)
P > MC (MB>MC)
Excess capacity
Unexploited economies of scale because P>min AC.
The Ugly (To Managers)
Zero Profits

39. Strategies to Avoid (or Delay) the Zero Profit Outcome
Comparative Advertisements
Be the first to introduce new brands or to improve existing products and services, “New Improved…”
Seek out sustainable niches.
Create barriers to entry.
Guard “trade secrets” and “strategic plans” to increase the time it takes other firms to clone your brand.

40. Maximizing Profits: A Synthesizing Example
C(Q) = Q2
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 = Q;
You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q.

41. Marginal Cost C(Q) = 125 + 4Q2, So MC = 8Q
This is independent of market structure

42. Price Taker MR = P = $40 Set MR = MC Cost of producing 5 units
40 = 8Q
Q = 5 units
Cost of producing 5 units
C(Q) = Q2 = = 225
Revenues:
PQ = (40)(5) = 200
Maximum profits of -$25
Implications: Expect exit in the long-run

43. Monopoly/Monopolistic Competition
MR = Q (since P = Q)
Set MR = MC, or Q = 8Q
Optimal output: Q = 10
Optimal price: P = (10) = 90
Maximum profits:
PQ - C(Q) = (90)(10) -( (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 time