W09 - Managerial Decisions For Firms With Market Power-FJO

Creating the great business leaders
Managerial Economics
By
Team Teaching FEB
Chapter 12 - Managerial Decisions for Firms with Market Power
Christopher Thomas, S. Charles Maurice
2020
Fakultas Ekonomi dan Bisnis
School of Economic and Business Learning Objectives
Telkom University
After reading this chapter, you will be able to:
12.1 Define market power and describe how own-price elasticity, cross-price elasticity,
and the Lerner index are used to measure market power.
12.2 Explain why barriers to entry are necessary for market power in the long run and
discuss the major types of entry barriers.
12.3 Find the profit-maximizing output and price for a monopolist.
12.4 Find the profit-maximizing input usage for a monopolist.
12.5 Find the profit-maximizing price and output under monopolistic competition.
12.6 Employ empirically estimated or forecasted demand, average variable cost, and
marginal cost to calculate profit-maximizing output and price for monopolistic or
monopolistically competitive firms.
12.7 Select production levels at multiple plants to minimize the total cost of producing a
given total output for a firm.

School of Economic and Business
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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)

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■ 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

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Measurement
■ Degree of of Marketpower
market Powerinversely 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

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Measurement of Market Power
■ Lerner index measures proportionate amount by which price

exceeds marginal cost:
P  MC
Lerner index 
P
● 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

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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

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Barriers to Entry
■ 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

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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

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■ Essential 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

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■ 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 benefit or utility 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 base or network of buyers

Demand & Marginal Revenue for a Monopolist

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■ 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

Demand & Marginal Revenue for a Monopolist (Figure 12.1)

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Short-Run Profit Maximization for Monopoly

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■ Monopolist will produce where MR = SMC as long as TR at least

covers the firm’s total avoidable cost (TR ≥ TVC)
● Price for this output is given by the demand curve
■ If TR < TVC (or, equivalently, P < AVC) the firm shuts down & loses
only fixed costs
■ If P > ATC, firm makes economic profit
■ If ATC > P > AVC, firm incurs a loss, but continues to produce in
short run

Short-Run Profit Maximization for Monopoly (Figure 12.3)

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Short-Run Loss Minimization for Monopoly (Figure 12.4)

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Long-Run Profit Maximization for Monopoly

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■ 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 profit-maximizing output level

Long-Run Profit Maximization for Monopoly (Figure 12.5)

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Profit-Maximizing Input Usage
■ Profit-maximizing level of input usage produces exactly that level of

output that maximizes profit

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■ 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

Monopoly Firm’s Demand for Labor (Figure 12.6)

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■ 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

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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

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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

Short-Run Profit Maximization for Monopolistic Competition

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(Figure 12.7)

Long-Run Profit Maximization for Monopolistic Competition

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(Figure 12.8)

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Implementing the Profit-Maximizing Output & Pricing Decision
■ Step 1: Estimate demand equation
● Use statistical techniques from Chapter 7
● Substitute forecasts of demand-shifting variables into estimated
demand equation to get
Q = a′ + bP
ˆ  dP
Where a'  a  cM ˆ
R

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■ Step 2: Find inverse demand equation
● Solve for P
 a' 1
P  Q  A  BQ
b b
ˆ ˆ  a' 1
Where a'  a  cM  dPR , A  , and B 
b b

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■ Step 3: Solve for marginal revenue
● When demand is expressed as P = A + BQ, marginal revenue is
 a' 2
MR  A  2 BQ   Q
b b
• Step 4: Estimate AVC & SMC

• Use statistical techniques from Chapter 10
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2
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■ Step 5: Find output where MR = SMC
●Set equations equal & solve for Q*
● The larger of the two solutions is the profit-maximizing output level
■ Step 6: Find profit-maximizing price
● Substitute Q* into inverse demand
P* = A + BQ*
Q* & P* are only optimal if P  AVC

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■ Step 7: Check shutdown rule
● Substitute Q* into estimated AVC function
AVC* = a + bQ* + cQ*2
• If P*  AVC*, produce Q* units of output & sell each unit for P*

• If P* < AVC*, shut down in short run

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■ Step 8: Compute profit or loss
● Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
● If P < AVC, firm shuts down & profit is -TFC

Maximizing Profit at Aztec Electronics: An Example

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■ Aztec possesses market power via patents

■ Sells advanced wireless stereo headphones


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■ 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


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■ 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

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■ Determine marginal revenue function
P = 100 – 0.002Q
MR = 100 – 0.004Q

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Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)


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■ Estimation of average variable cost and marginal cost

● Given the estimated AVC equation:
AVC = 28 – 0.005Q + 0.000001Q2
● Then,
SMC = 28 – (2 x 0.005)Q + (3 x 0.000001)Q2
= 28 – 0.01Q + 0.000003Q2


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■ Output decision
● Set MR = MC and solve for Q*
100 – 0.004Q = 28 – 0.01Q + 0.000003Q2

0 = (28 – 100) + (-0.01 + 0.004)Q + 0.000003Q2
= -72 – 0.006Q + 0.000003Q2


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■ Output decision
● Solve for Q* using the quadratic formula
(  0.006)  (  0.006)2  4(  72)(0.000003)

Q* 
2( 0.000003)
0.036
  6 , 000
0.000006


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■ Pricing decision
● Substitute Q* into inverse demand
P* = 100 – 0.002(6,000)
= $88


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■ Shutdown decision
● Compute AVC at 6,000 units:
AVC* = 28 - 0.005(6,000) + 0.000001(6,000)2

= $34
● Because P = $88 > $34 = ATC, Aztec should produce rather than shut down


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■ Computation of total profit

π = TR – TVC – TFC
= (P* x Q*) – (AVC* x Q*) – TFC
= ($88 x 6,000) – ($34 x 6,000) - $270,000
= $528,000 - $204,000 - $270,000
= $54,000

Profit Maximization at Aztec Electronics (Figure 12.10)

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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

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A Multiplant Firm (Figure 12.11)

School Economics and Business
TERIMA KASIH….
47 Creating the great business leaders

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Creating the great business leaders

Creating the great business leaders

■ Ability of a firm to raise price without losing all its sales

Creating the great business leaders

Creating the great business leaders

Creating the great business leaders

■ Lerner index measures proportionate amount by which price

Creating the great business leaders

■ If consumers view two goods as substitutes, cross-price elasticity of

Creating the great business leaders

■ Entry of new firms into a market erodes market power of existing

Creating the great business leaders

Creating the great business leaders

■ Essential input barriers

Creating the great business leaders

Creating the great business leaders

Demand & Marginal Revenue for a Monopolist

■ Market demand curve is the firm’s demand curve

Creating the great business leaders

Demand & Marginal Revenue for a Monopolist (Figure 12.1)

Creating the great business leaders

Short-Run Profit Maximization for Monopoly

■ Monopolist will produce where MR = SMC as long as TR at least

Creating the great business leaders

Short-Run Profit Maximization for Monopoly (Figure 12.3)

Creating the great business leaders

Short-Run Loss Minimization for Monopoly (Figure 12.4)

Creating the great business leaders

Long-Run Profit Maximization for Monopoly

■ Monopolist maximizes profit by choosing to produce output where

Creating the great business leaders

Long-Run Profit Maximization for Monopoly (Figure 12.5)

Creating the great business leaders

■ Profit-maximizing level of input usage produces exactly that level of

Creating the great business leaders

■ Marginal revenue product (MRP)

Creating the great business leaders

Monopoly Firm’s Demand for Labor (Figure 12.6)

Creating the great business leaders

■ For a firm with market power, profit-maximizing conditions MRP =

Creating the great business leaders

■ Large number of firms sell a differentiated product

Creating the great business leaders

■ Short-run equilibrium is identical to monopoly

Creating the great business leaders

Short-Run Profit Maximization for Monopolistic Competition

Creating the great business leaders

Long-Run Profit Maximization for Monopolistic Competition

Creating the great business leaders

Creating the great business leaders

Creating the great business leaders

• Step 4: Estimate AVC & SMC

Q* & P* are only optimal if P  AVC

Creating the great business leaders

AVC* = a + bQ* + cQ*2

• If P*  AVC*, produce Q* units of output & sell each unit for P*

Creating the great business leaders

● If P < AVC, firm shuts down & profit is -TFC

Creating the great business leaders

• If P*  AVC, produce Q units of output & sell each unit for P*