CHAPTER 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets © 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives 1. 2. 3. 4. 5. 6. 7. 8. Identify the conditions under which a firm operates as perfectly competitive, monopolistically competitive, or a monopoly. Identify sources of (and strategies for obtaining) monopoly power. Apply the marginal principle to determine the profit-maximizing price and output. Show the relationship between the elasticity of demand for a firm’s product and its marginal revenue. Explain how long-run adjustments impact perfectly competitive, monopoly, and monopolistically competitive firms; discuss the ramifications of each of these market structures on social welfare. Decide whether a firm making short-run losses should continue to operate or shut down its operations. Illustrate the relationship between marginal cost, a competitive firm’s short-run supply curve, and the competitive industry supply; explain why supply curves do not exist for firms that have market power. Calculate the optimal output of a firm that operates two plants and the optimal level of advertising for a firm that enjoys market power. © 2017 by McGraw-Hill Education. All Rights Reserved. 2 Perfect Competition Perfect Competition • Perfectly competitive markets are characterized by: – The interaction between many buyers and sellers that are “small” relative to the market. – Each firm in the market produces a homogeneous (identical) product. – Buyers and sellers have perfect information. – No transaction costs. – Free entry into and exit from the market. • The implications of these conditions are: – a single market price is determined by the interaction of demand and supply – firms earn zero economic profits in the long run. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-3 Perfect Competition Demand at the Market and Firm Levels Under Perfect Competition Price Price Market Firm S ππ π· π = ππ D 0 Market output © 2017 by McGraw-Hill Education. All Rights Reserved. Firm’s output 8-4 Perfect Competition Short-Run Output Decisions • The short run is a period of time over which some factors of production are fixed. • To maximize short-run profits, managers must take as given the fixed inputs (and fixed costs), and determine how much output to produce by changing the variable inputs. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-5 Perfect Competition Revenue, Costs, and Profits for a Perfectly Competitive Firm Costs πΆ π $ Revenue π =π×π B Maximum profits Slope of πΆ π = ππΆ Slope of π = ππ = π A 0 E π∗ © 2017 by McGraw-Hill Education. All Rights Reserved. Firm’s output 8-6 Perfect Competition Competitive Firm’s Demand • The demand curve for a competitive firm’s product is a horizontal line at the market price. This price is the competitive firm’s marginal revenue. π· π = π = ππ © 2017 by McGraw-Hill Education. All Rights Reserved. 8-7 Perfect Competition Profit Maximization under Perfect $ Competition π΄ππΆ ππΆ ππ π΄ππΆ π· π = ππ = ππ Profits π∗ 0 π∗ © 2017 by McGraw-Hill Education. All Rights Reserved. Firm’s output 8-8 Perfect Competition Competitive Output Rule • To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing. π = ππΆ π © 2017 by McGraw-Hill Education. All Rights Reserved. 8-9 Perfect Competition Competitive Output Rule In Action • The cost function for a firm is πΆ π = 5 + π2 . • If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, what price should the manager of this firm charge? What level of output should be produced to maximize profits? How much profit will be earned? • Answer: – Charge $20. – Since marginal cost is 2π, equating price and marginal cost yields: $20 = 2π βΉ π = 10 units. – Maximum profits are: π = 20 × 10 − 5 + 102 = $95. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-10 Perfect Competition Short-Run Loss Minimization $ π΄ππΆ ππΆ π΄ππΆ π ∗ Loss ππ 0 π΄ππΆ π· π = ππ = ππ π∗ © 2017 by McGraw-Hill Education. All Rights Reserved. Firm’s output 8-11 Perfect Competition The Shut-Down Case ππΆ $ π΄ππΆ π΄ππΆ Loss if shut down π΄ππΆ π ∗ Fixed Cost π΄ππΆ π∗ ππ π· π = ππ = ππ Loss if produce 0 π∗ © 2017 by McGraw-Hill Education. All Rights Reserved. Firm’s output 8-12 Perfect Competition Short-Run Output Decision Under Perfect Competition • To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where π = ππΆ, provided that π ≥ π΄ππΆ. If π < π΄ππΆ, the firm should shut down its plant to minimize it losses. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-13 Perfect Competition Short-Run Firm Supply Curve for a ππΆ $ CompetitiveShort-run Firm supply curve for individual firm π΄ππΆ π1 π0 0 π0 © 2017 by McGraw-Hill Education. All Rights Reserved. π1 Firm’s output 8-14 Perfect Competition The Short-Run Firm and Industry Supply Curves • The short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the π΄ππΆ curve. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-15 Perfect Competition The Market Supply Curve P Individual firm’s supply curve ππΆπ Market supply curve S $12 $10 0 1 500 © 2017 by McGraw-Hill Education. All Rights Reserved. Market output 8-16 Perfect Competition Long-Run Decisions: Entry and Exit The Market and Firm’s Demand Price Price π2 π0 πΈπ₯ππ‘ πΈππ‘ππ¦ π1 π2 π· π = π2 = ππ 2 Exit π0 Entry π1 π· π = π0 = ππ 0 π· π = π1 = ππ 1 D 0 Market output 0 © 2017 by McGraw-Hill Education. All Rights Reserved. Firm’s output 8-17 Perfect Competition Long-Run Competitive Equilibrium ππΆ $ Long-run competitive equilibrium π΄πΆ π· π = ππ = ππ ππ 0 π∗ © 2017 by McGraw-Hill Education. All Rights Reserved. Firm’s output 8-18 Perfect Competition Long-Run Competitive Equilibrium • In the long run, perfectly competitive firms produce a level of output such that 1. π = ππΆ 2. π = ππππππ’π ππ π΄πΆ © 2017 by McGraw-Hill Education. All Rights Reserved. 8-19 Monopoly Monopoly and Monopoly Power • Monopoly: A market structure in which a single firm serves an entire market for a good that has no close substitutes. • Sole seller of a good in a market gives that firm greater market power than if it competed against other firms. – Implication: • market demand curve is the monopolist’s demand curve. – However, a monopolist does not have unlimited market power. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-20 The Monopolist’s Demand Monopoly Monopolist’s power is constrained by the demand curve. Price A π0 B π1 π· π = π·π 0 π0 π1 © 2017 by McGraw-Hill Education. All Rights Reserved. Output 8-21 Monopoly Sources of Monopoly Power • Economies of scale: exist whenever long-run average costs decline as output increases. – Diseconomies of scale: exist whenever long-run average costs increase as output increases. • Economies of scope: exist when the total cost of producing two products within the same firm is lower than when the products are produced by separate firms. • Cost complementarity: exist when the marginal cost of producing one output is reduced when the output of another product is increased. • Patents and other legal barriers © 2017 by McGraw-Hill Education. All Rights Reserved. 8-22 Elasticity of Demand and Total Revenues Price Monopoly Revenue Maximum revenues π0 × π0 Elastic Unitary π 0 Unitary π0 Inelastic 0 π0 Elastic Q 0 MR © 2017 by McGraw-Hill Education. All Rights Reserved. Inelastic π0 Firm’s output 8-23 Monopoly Marginal Revenue and Elasticity • The monopolist’s marginal revenue function is 1+πΈ ππ = π πΈ , where πΈ is the elasticity of demand for the monopolist’s product and π is the price charged. – For π > 0 • ππ > 0 when πΈ < −1. • ππ = 0 when πΈ = −1. • ππ < 0 when −1 < πΈ < 0. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-24 Marginal Revenue and Linear Demand Monopoly • Given an linear inverse demand function π π = π + ππ , where π > 0 πππ π < 0, the associated marginal revenue is ππ π = π + 2ππ © 2017 by McGraw-Hill Education. All Rights Reserved. 8-25 Marginal Revenue In Action Monopoly • Suppose the inverse demand function for a monopolist’s product is given by π = 10 − 2π. What is the maximum price per unit a monopolist can charge to be able to sell 3 units? What is marginal revenue when π = 3? • Answer: – The maximum price the monopolist can charge for 3 units is: π = 10 − 2 3 = $4. – The marginal revenue at 3 units for this inverse linear demand is: ππ = 10 − 2 2 3 = −$2. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-26 Monopoly Monopoly Output Rule • A profit-maximizing monopolist should produce the output, π π , such that marginal revenue equals marginal cost: ππ π π = ππΆ ππ © 2017 by McGraw-Hill Education. All Rights Reserved. 8-27 Monopoly Costs, Revenues, and Profits Under π Monopoly CostπΆfunction $ π =π π ×π Revenue function Slope of π = ππ Maximum profit 0 ππ © 2017 by McGraw-Hill Education. All Rights Reserved. Slope of πΆ π = ππΆ Output 8-28 Monopoly Profit Maximization Under Monopoly Price ππππππ‘π = π π − π΄ππΆ ππ × ππ MC ATC ππ Profits π΄ππΆ(ππ ) Demand ππ MR © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 8-29 Monopoly Pricing Rule Monopoly • Given the level of output, π π , that maximizes profits, the monopoly price is the price on the demand curve corresponding to the π π units produced: ππ = π ππ © 2017 by McGraw-Hill Education. All Rights Reserved. 8-30 Monopoly Monopoly In Action • Suppose the inverse demand function for a monopolist’s product is given by π = 100 − 2π and the cost function is πΆ π = 10 + 2π. Determine the profit-maximizing price, quantity and maximum profits. • Answer: – Profit-maximizing output is found by solving: 100 − 4π = 2 βΉ ππ = 24.5. – The profit-maximizing price is: ππ = 100 − 2 24.5 = $51. – Maximum profits are: π = $51 × 24.5 − 10 + 2 × 24.5 = $1,190.50. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-31 Monopoly The Absence of a Supply Curve • Recall, firms operating in perfectly competitive markets determine how much output to produce based on price (π = ππΆ). – Thus, a supply curve exists in perfectly competitive markets. • A monopolist’s market power implies π > ππ = ππΆ. – Thus, there is no supply curve for a monopolist, or in markets served by firms with market power. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-32 Monopoly Multiplant Decisions • Often a monopolist produces output in different locations. – Implications: manager has to determine how much output to produce at each plant. • Consider a monopolist producing output at two plants: – The cost of producing π1 units at plant 1 is πΆ π1 , and the cost of producing π2 at plant 2 is πΆ π2 . – When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is π π , where π = π1 + π2 . © 2017 by McGraw-Hill Education. All Rights Reserved. 8-33 Multiplant Output Rule Monopoly • Let ππ π be the marginal revenue of producing a total of π = π1 + π2 units of output. Suppose the marginal cost of producing π1 units of output in plant 1 is ππΆ1 π1 and that of producing π2 units in plant 2 is ππΆ2 π2 . The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that: ππ π = ππΆ1 π1 ππ π = ππΆ2 π2 © 2017 by McGraw-Hill Education. All Rights Reserved. 8-34 Monopoly Implications of Entry Barriers • A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits. – Implication: monopoly profits will continue over time provided the monopoly maintains its market power. • Monopoly power, however, does not guarantee positive profits. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-35 Monopoly A Monopolist Earning Zero Profits Price MC ATC ππ = π΄ππΆ(π π ) Demand ππ MR © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 8-36 Monopoly Deadweight Loss of Monopoly • The consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-37 Monopoly Deadweight Loss of Monopoly Price MC ππ Deadweight loss ππΆ Demand MR ππ ππΆ © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 8-38 Monopolistic Competition Monopolistic Competition • An industry is monopolistically competitive if: – There are many buyers and sellers. – Each firm in the industry produces a differentiated product. – There is free entry into and exit from the industry. • A key difference between monopolistically competitive and perfectly competitive markets is that each firm produces a slightly differentiated product. – Implication: products are close, but not perfect, substitutes; therefore, firm’s demand curve is downward sloping under monopolistic competition. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-39 Monopolistic Competition Profit-Maximization under Monopolistic Competition Price ππππππ‘π = ∗ π − π΄ππΆ π ∗ × π∗ MC ATC π∗ π΄ππΆ(π∗ ) Profits Demand π∗ MR © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 8-40 Monopolistic Competition Profit-Maximization Rule for Monopolistic Competition • To maximize profits, a monopolistically competitive firm produces where its marginal revenue equals marginal cost. • The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the profit-maximizing level of output. • The profit-maximizing output, π ∗ , is such that ππ π∗ = ππΆ π ∗ and the profit-maximizing price is π∗ = π π ∗ . © 2017 by McGraw-Hill Education. All Rights Reserved. 8-41 Monopolistic Competition Long-Run Equilibrium • If firms in monopolistically competitive markets earn short-run – profits, additional firms will enter in the long run to capture some of those profits. – losses, some firms will exit the industry in the long run. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-42 Monopolistic Competition Effect of Entry on a Monopolistically Competitive Firm’s Demand Price MC ATC Due to entry of new firms selling other brands π∗ Demand1 π∗ MR1 MR0 © 2017 by McGraw-Hill Education. All Rights Reserved. Demand0 Quantity of Brand X 8-43 Monopolistic Competition Long-Run Equilibrium under Monopolistic Competition Price MC Long-run monopolistically competitive equilibrium ATC π∗ Demand1 π∗ MR1 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity of Brand X 8-44 Monopolistic Competition The Long-Run and Monopolistic Competition • In the long run, monopolistically competitive firms produce a level of output such that: 1. π > ππΆ 2. π = π΄ππΆ > ππππππ’π ππ ππ£πππππ πππ π‘π © 2017 by McGraw-Hill Education. All Rights Reserved. 8-45 Monopolistic Competition Implications of Product Differentiation • The differentiated nature of products in monopolistically competitive markets implies that firms in these industries must continually convince consumers that their products are better than their competitors. © 2017 by McGraw-Hill Education. All Rights Reserved. 8-46 Monopolistic Competition Implications of Product Differentiation • Two strategies monopolistically competitive firms use to persuade consumers: – Comparative advertising: form of advertising where a firm attempts to increase the demand for its brand by differentiating its product from competing brands • Brand equity – Niche marketing: a marketing strategy where goods and services are tailored to meet the needs of a particular segment of the market. • Green marketing • Successful differentiation and branding strategies can make managers brand myopic, resting on the brand’s past laurels and in doing so missing opportunities to enhance its brand © 2017 by McGraw-Hill Education. All Rights Reserved. 47 Optimal Advertising Decisions Optimal Advertising Decisions • How much should a firm spend on advertising to maximize profits? – Depends, in part, on the nature of the industry. – The optimal amount of advertising balances the marginal benefits and marginal costs. • Profit-maximizing advertising-to-sales ratio is: πΈπ,π΄ π΄ = π −πΈπ,π © 2017 by McGraw-Hill Education. All Rights Reserved. 8-48
