Managerial Economics
ninth edition
Thomas
Maurice
Chapter 12
Managerial Decisions for
Firms with Market Power
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial
Economics, 9e
Managerial Economics, 9e
Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
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)
12-2
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
12-3
Managerial Economics
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
12-4
Managerial Economics
Measurement of Market Power
• Lerner index measures
proportionate amount by which
price exceeds marginal cost:
P  MC
Lerner index 
P
12-5
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
12-6
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
12-7
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
12-8
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
12-9
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
12-10
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
12-11
Managerial Economics
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
12-12
Managerial Economics
Demand & Marginal Revenue for a
Monopolist (Figure 12.1)
12-13
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
12-14
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
12-15
Managerial Economics
Short-Run Profit Maximization for
Monopoly (Figure 12.3)
12-16
Managerial Economics
Short-Run Loss Minimization for
Monopoly (Figure 12.4)
12-17
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
12-18
Managerial Economics
Long-Run Profit Maximization for
Monopoly (Figure 12.5)
12-19
Managerial Economics
Profit-Maximizing Input Usage
• Profit-maximizing level of input
usage produces exactly that level
of output that maximizes profit
12-20
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
12-21
Managerial Economics
Monopoly Firm’s Demand for
Labor (Figure 12.6)
12-22
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
12-23
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
12-24
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
12-25
Managerial Economics
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)
12-26
Managerial Economics
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)
12-27
Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Aztec possesses market power via
patents
• Sells advanced wireless stereo
headphones
12-28
Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of demand & marginal
revenue
Q  41,000  500 P  0.6M  22.5PR
 41, 000  500 P  0.6(45, 000)  22.5(800)
 50, 000  500 P
12-29
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
12-30
Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Determine marginal revenue
function
P  100  0.002Q
MR  100  0.004Q
12-31
Managerial Economics
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)
12-32
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
2
• So,
SMC  28  (2  0.005)Q  (3  0.000001)Q
 28  0.01Q  0.000003Q
12-33
2
2
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
2
0  (28  100)  (0.01  0.004)Q  0.000003Q
 72  0.006Q  0.000003Q
12-34
2
2
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

0.000006
12-35
 6, 000
Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Pricing decision
• Substitute Q* into inverse demand
P**  100  0.002(6, 000)
 $88
12-36
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)
 $34
Because P  $88  $34  AVC, Aztec should
produce rather than shut down
12-37
2
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
12-38
Managerial Economics
Profit Maximization at Aztec
Electronics (Figure 12.10)
12-39
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
12-40
Managerial Economics
A Multiplant Firm
12-41
(Figure 12.11)