Managerial Economics &
Business Strategy
Chapter 8
Managing in Competitive, Monopolistic,
and Monopolistically Competitive
Markets
Overview
I. Perfectly Competition
II. Monopolies
III. Monopolistic Competition
Perfect Competition
•
•
•
•
•
Many buyers and sellers
Homogeneous product
Perfect information
No transaction costs (mobility)
Free entry and exit
PRICE-TAKERS
Key Implications
• Firms are “price takers” (price determined
by interaction of buyers and sellers)
n
P = MR
• In the short-run, firms may earn profits or
losses
• Long-run economic profits are zero
(accounting profits  0)
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
n
n
Importance of product differentiation
Sustainable advantage
Setting Price
$
$
S
Pe
MR=Df
D
QM
Market
Firm
Qf
$
Setting Output:
C(Q)
C(Q), R
R=PQ
Slope of
revenue curve
is MR (linear,
so constant)
Slope of tangent line
to C(Q) is MC
(nonlinear so MC
constantly changing).
AT Q0 , MC=MR.
Q1
Q0
Q2
Output (Q)
Setting Output:
• MR = MC
where
• MR = P, therefore
• To max , choose Q
when
P = MC
dR
MR 
dQ
dC
MC 
dQ
Graphically (recall cost curves from Chapter 5)
Profit = (Pe - ATC)  Qf*
MC
$
ATC
AVC
Pe = Df = MR
Pe
ATC
Qf*
Qf
• Given
n
A Numerical Example
P=$80 and C(Q) = 40 + 8Q + 2Q2
• (Q) = PQ – C(Q)
n
(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.
n
n
n
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.
n
n
d2 /dQ2 = - 4, therefore concave down.
PQ - C(Q) = (80)(18) – [40 + 8(18) + 2(182)] = $608
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
n
Other “greedy capitalists” enter the market
Effect of Entry on Price?
$
$
S
Entry
S*
Pe
Pe*
Df
Df*
D
QM
Market
Firm
Qf
Effect of Entry on the Firm’s Output and Profits?
MC
$
AC
Pe
Df
Pe*
Df*
QL Qf*
Q
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
Negative Profits in the SR (AVC<P<ATC):
Negative
economic
profits, but less
than paying FC
$
ATC
Pe
AVC
MC
ATC
AVC
Df = MR
FC
Revenues
VC
Qf
Quantity
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
n
SHUTDOWN RULE
• Supply curve is MC above minimum of
AVC.
Negative Profits in the SR (P = minimum of AVC)
MC
$
ATC
Supply
AVC
Df = MR
Pe=AVC
Qf
Quantity
Features of Long Run
Competitive Equilibrium
• P = MC
n
Socially efficient output
• P = minimum ATC
n
Zero profits
• Firms are earning just enough to offset their opportunity
cost
Monopoly
• Single firm serves the “relevant market”
n
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
n
But the price charged affects the quantity demanded of
the monopolist’s product (don’t have unlimited Psetting power)
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)
A Monopolist’s Marginal
Revenue
P
Elastic
Unitary
Inelastic
Demand
Q
Total
Revenue
($)
MR
Q
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Q
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
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)
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?
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 = 10 - 2Q
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
Long Run Adjustments?
• None, unless the
source of monopoly
power is
eliminated.
Why Government Dislikes
Monopoly?
• P > MC
n
Too little output, at too high a price
• Deadweight loss of monopoly
Deadweight Loss of Monopoly
$
MC
Deadweight Loss
of Monopoly
ATC
Recall:
D represents
WTP, thus it
is a MB
D
curve.
PM
MR=MC
QM
MR
Q
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
Monopolistic Competition
• Numerous buyers and sellers
• Differentiated products
n
Implication: Since products are differentiated, each firm
faces a downward sloping demand curve.
• Firms have limited market power.
• Free entry and exit
n
Implication: Firms will earn zero profits in the long run.
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.
Marginal Revenue Like a
Monopolist
P
Elastic
Unitary
Inelastic
Total
Revenue
($)
Demand
Q
MR
Q
Monopolistic Competition:
Profit Maximization
• Maximize profits like a monopolist
n
Produce where MR = MC
• Charge the price on the demand curve that
corresponds to that quantity
Graphically
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Quantity of Brand
X
Long Run Adjustments?
• In the absence of free entry, no adjustments
occur.
• If the industry is truly monopolistically
competitive, there is free entry.
n
n
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.
Graphically
Long Run Equilibrium
(P = AC, so zero profits)
$
MC
AC
P*
P1
Entry
MR
Q1 Q*
MR1
D
D1
Quantity of Brand
X
Monopolistic Competition
The Good (To Consumers)
n
Product Variety
The Bad (To Society)
n
n
P > MC (MB>MC)
Excess capacity
• Unexploited economies of
scale because P>min AC.
The Ugly (To Managers)
n
Zero Profits
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.
Maximizing Profits: A
Synthesizing Example
• C(Q) = 125 + 4Q2
• Determine the profit-maximizing output and
price, and discuss its implications, if
n
n
n
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 = 100 - Q;
You are a monopolistically competitive firm and the inverse
demand for your brand is P = 100 – Q.
Marginal Cost
• C(Q) = 125 + 4Q2,
• So MC = 8Q
• This is independent of market structure
Price Taker
• MR = P = $40
• Set MR = MC
• 40 = 8Q
• Q = 5 units
• Cost of producing 5 units
• C(Q) = 125 + 4Q2 = 125 + 100 = 225
• Revenues:
• PQ = (40)(5) = 200
• Maximum profits of -$25
• Implications: Expect exit in the long-run
Monopoly/Monopolistic Competition
• MR = 100 - 2Q (since P = 100 - Q)
• Set MR = MC, or 100 - 2Q = 8Q
n
n
n
Optimal output: Q = 10
Optimal price: P = 100 - (10) = 90
Maximum profits:
• PQ - C(Q) = (90)(10) -(125 + 4(100)) = 375
• Implications
n
n
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