Managerial Economics & Business
Strategy
Chapter 8
Managing in
Competitive,
Monopolistic, and
Monopolistically
Competitive Markets
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Overview
I. Perfect Competition
– Characteristics and profit outlook.
– Effect of new entrants.
II. Monopolies
– Sources of monopoly power.
– Maximizing monopoly profits.
– Pros and cons.
III. Monopolistic Competition
– Profit maximization.
– Long run equilibrium.
8-2
Perfect Competition Environment
 Many buyers and sellers.
 Homogeneous (identical) product.
 Perfect information on both sides of
market.
 No transaction costs.
 Free entry and exit.
8-3
Key Implications
 Firms are “price takers” (P = MR).
 In the short-run, firms may earn profits
or losses.
 Entry and exit forces long-run profits to
zero.
8-4
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.
8-5
Managing a Perfectly
Competitive Firm
(or Price-Taking Business)
8-6
Market and Individual Demand
 Difference between Market demand and
individual demand functions.
 Perfectly elastic demand facing the firm
implies no market power.
 Charge the market price and determine
what level of output to produce.
8-7
Setting Price
$
$
S
Pe
Df
D
QM
Market
Firm
Qf
8-8
Profit-Maximizing Output
Decision
 MR = MC.
 Since, MR = P,
 Set P = MC to maximize profits.
8-9
Graphically: Representative
Firm’s Output Decision
Profit = (Pe - ATC)  Qf*
MC
$
ATC
AVC
Pe = Df = MR
Pe
ATC
Qf*
Qf
8-10
A Numerical Example
 Given
– P=$10
– C(Q) = 5 + Q2
 Optimal Price?
– P=$10
 Optimal Output?
– MR = P = $10 and MC = 2Q
– 10 = 2Q
– Q = 5 units
 Maximum Profits?
– PQ - C(Q) = (10)(5) - (5 + 25) = $20
8-11
Should this Firm Sustain Short
Run Losses or Shut Down?
Profit = (Pe - ATC)  Qf* < 0
ATC
MC
$
AVC
ATC
Pe
Loss
Pe = Df = MR
Qf*
Qf
8-12
Shutdown Decision Rule
 A profit-maximizing firm should continue to
operate (sustain short-run losses) if its
operating loss is less than its fixed costs.
– Operating results in a smaller loss than
ceasing operations.
 Decision rule:
– A firm should shutdown when P < min
AVC.
– Continue operating as long as P ≥ min
AVC.
8-13
Firm’s Short-Run Supply Curve:
MC Above Min AVC
ATC
MC
$
AVC
P min AVC
Qf*
Qf
8-14
Supply in the Long Run
 Free entry and exit in the LR causes LRS
curve to be horizontal at the market price.
 All firms in the industry earn zero economic
profits in equilibrium.
 If costs increase due to input market
pressures then LRS can be upward
sloping.
 P=MC where the industry is producing the
socially efficient level of output.
8-15
Monopoly
 A monopoly is a firm that is the sole seller
of a product without close substitutes.
 A monopoly firm has market power, the
ability to influence the market price of the
product it sells. A competitive firm has no
market power.
8-16
Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws
8-17
3. Natural monopoly: a single firm can produce
the entire market Q at lower ATC than could
several firms.
Example: 1000 homes
need electricity.
ATC is lower if
one firm services
all 1000 homes
than if two firms
each service
500 homes.
Cost
Electricity
Economies of
scale due to
huge FC
$80
$50
ATC
500
1000
Q
8-18
Why Monopolies Arise
 4. Economies of scale – the natural
monopoly case.
 5. Economies of scope – joint production
of two outputs is cheaper in one production
system than in two. Tends to encourage
the growth of larger firms.
8-19
Monopoly vs. Competition: Demand Curves
In a competitive market,
the market demand curve
slopes downward.
but the demand curve
for any individual firm’s
product is horizontal
at the market price.
The firm can increase Q
without lowering P,
P
A competitive firm’s
demand curve
D
so MR = P for the
competitive firm.
Q
8-20
Monopoly vs. Competition: Demand Curves
A monopolist is the only
seller, so it faces the
market demand curve.
P
A monopolist’s
demand curve
To sell a larger Q,
the firm must reduce P.
Thus, MR ≠ P.
D
Q
8-21
A Monopoly’s Revenue
Moonbucks is
the only seller of
cappuccinos in town.
Q
P
0
$4.50
The table shows the
market demand for
cappuccinos.
1
4.00
2
3.50
Fill in the missing
spaces of the table.
3
3.00
4
2.50
5
2.00
6
1.50
What is the relation
between P and AR?
Between P and MR?
TR
AR
MR
n.a.
8-22
22
A Monopoly’s Revenue
Here, P = AR,
same as for a
competitive firm.
Here, MR < P,
whereas MR = P
for a competitive
firm.
Q
0
P
TR
$4.50
$0
AR
MR
n.a.
$4
1
4.00
4
$4.00
3
2
3.50
7
3.50
2
3
3.00
9
3.00
1
4
2.50
10
2.50
0
5
2.00
10
2.00
6
1.50
9
1.50
–1
8-23
23
Moonbuck’s D and MR Curves
P, MR
$5
4
3
2
1
0
-1
-2
-3
Demand curve (P)
MR
0
1
2
3
4
5
6
7
Q
8-24
Understanding the Monopolist’s MR
 Increasing Q has two effects on revenue:
– The output effect:
More output is sold, which raises revenue
– The price effect:
The price falls, which lowers revenue
 To sell a larger Q, the monopolist must reduce the price
on all the units it sells.
 Hence, MR < P
 MR could even be negative if the price effect exceeds
the output effect
(e.g., when Moonbucks increases Q from 5 to 6).
8-25
Profit-Maximization
 Like a competitive firm, a monopolist
maximizes profit by producing the quantity
where MR = MC.
 Once the monopolist identifies this
quantity, it sets the highest price
consumers are willing to pay for that
quantity.
 It finds this price from the D curve.
8-26
Profit-Maximization
1. The profitmaximizing Q
is where
MR = MC.
Costs and
Revenue
MC
P
2. Find P from
the demand
curve at this Q.
D
MR
Q
Quantity
Profit-maximizing output
8-27
A Monopoly Does Not Have an S Curve
A competitive firm
 takes P as given
 has a supply curve that shows how its Q depends on P
A monopoly firm
 is a “price-maker,” not a “price-taker”
 Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.
So there is no supply curve for monopoly.
8-28
Multi-Plant Monopoly
 Profit max occurs when the monopoly produces
in each plant such that the MC of producing in
each plant equals the MR of total output.
 If MR>MC in one plant then it pays to expand
output in that plant and decrease output in the
other plant.
 As output expands MR declines until MR=MC.
 Demonstration problem 8-6 page 290.
8-29
Case Study: Monopoly vs. Generic Drugs
Patents on new drugs
give a temporary
monopoly to the seller.
Price
The market for
a typical drug
PM
When the
patent expires,
PC = MC
the market
becomes competitive,
generics appear.
D
MR
QM
Quantity
QC
8-30
The Welfare Cost of Monopoly
Competitive eq’m:
quantity = QE
P = MC
total surplus is
maximized
Monopoly eq’m:
quantity = QM
P > MC
deadweight loss
Price
Deadweight
MC
loss
P
P = MC
MC
D
MR
QM QE
Quantity
8-31
Public Policy Toward Monopolies
 Increasing competition with antitrust laws
– Examples: Sherman Antitrust Act (1890), Clayton Act
(1914)
– Antitrust laws ban certain anticompetitive practices,
allow govt to break up monopolies.
 Regulation
– Govt agencies set the monopolist’s price
– For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
– If so, regulators might subsidize the monopolist or set
P = ATC for zero economic profit.
8-32
Public Policy Toward Monopolies
 Public ownership
– Example: U.S. Postal Service
– Problem: Public ownership is usually less
efficient since no profit motive to minimize
costs
 Doing nothing
– The foregoing policies all have drawbacks,
so the best policy may be no policy.
8-33
Managing a Monopolistically
Competitive Firm
 Like a monopoly, monopolistically competitive
firms
– have market power that permits pricing above marginal cost.
– level of sales depends on the price it sets.
 But …
– The presence of other brands in the market makes the
demand for your brand more elastic than if you were a
monopolist.
– Free entry and exit impacts profitability.
 Therefore, monopolistically competitive firms
have limited market power.
8-34
Marginal Revenue Like a
Monopolist
P
100
TR
Unit elastic
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
20
30
40
50
Q
MR
Elastic
Inelastic
8-35
Monopolistic Competition:
Profit Maximization
 Maximize profits like a monopolist
– Produce output where MR = MC.
– Charge the price on the demand curve that
corresponds to that quantity.
8-36
Short-Run Monopolistic
Competition
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Quantity of Brand X
8-37
Long Run Adjustments?
 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.
8-38
Long-Run Monopolistic Competition
Long Run Equilibrium
(P = AC, so zero profits)
$
MC
AC
P*
P1
Entry
MR
Q1 Q*
MR1
D
D1
Quantity of Brand
X
8-39
Monopolistic Competition
The Good (To Consumers)
– Product Variety
The Bad (To Society)
– P > MC
– Excess capacity
• Unexploited economies of scale
The Ugly (To Managers)
– P = ATC > minimum of average costs.
• Zero Profits (in the long run)!
8-40
Advertising
 Comparative advertising – differentiating
a brand
 Brand equity - additional value added to
a product because of a well known brand.
 Niche marketing – targeting a specific
group in the market
8-41
Optimal Advertising Decisions
 Advertising is one way for firms with market power
to differentiate their products.
 But, how much should a firm spend on
advertising?
– Advertise to the point where the additional revenue generated
from advertising equals the additional cost of advertising.
– Equivalently, the profit-maximizing level of advertising occurs
where the advertising-to-sales ratio equals the ratio of the
advertising elasticity of demand to the own-price elasticity of
demand.
EQ , A
A

R  EQ , P
– Demonstration problem 8-8 page 301
8-42
Maximizing Profits: A
Synthesizing Example
 C(Q) = 125 + 4Q2
 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 = 100 - Q;
– You are a monopolistically competitive firm and
the inverse demand for your brand is P = 100 – Q.
8-43
Marginal Cost
 C(Q) = 125 + 4Q2,
 So MC = 8Q.
 This is independent of market structure.
8-44
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.
8-45
Monopoly/
Monopolistic Competition
 MR = 100 - 2Q (since P = 100 - Q).
 Set MR = MC, or 100 - 2Q = 8Q.
– Optimal output: Q = 10.
– Optimal price: P = 100 - (10) = $90.
– Maximal profits:
• PQ - C(Q) = (90)(10) -(125 + 4(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.
8-46
Conclusion
 Firms operating in a perfectly competitive market
take the market price as given.
– Produce output where P = MC.
– Firms may earn profits or losses in the short run.
– … but, in the long run, entry or exit forces profits to zero.
 A monopoly firm, in contrast, can earn persistent
profits provided that source of monopoly power is
not eliminated.
 A monopolistically competitive firm can earn
profits in the short run, but entry by competing
brands will erode these profits over time.
8-47