BEC 30325 Managerial Economics Managerial Decisions for Firms

BEC 30325 Managerial Economics Managerial Decisions for Firms with Market Power

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)

Monopoly • Single firm • Produces & sells a good or service for which there are no close substitutes • New firms are prevented from entering market because of a barrier to entry

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

Measurement of Market Power • Lerner index measures proportionate amount by which price exceeds marginal cost: – 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

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

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

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

Common Entry Barriers • 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

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 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 • 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

Short-Run Profit Maximization for Monopoly • 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

Short-Run Loss Minimization for Monopoly

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 profit-maximizing output level

Long-Run Profit Maximization for Monopoly

Profit-Maximizing Input Usage • Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

Profit-Maximizing Input Usage • Marginal revenue product (MRP) – MRP is the additional revenue attributable to hiring one more unit of the input • 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

Profit-Maximizing Input Usage • For a firm with market power, profitmaximizing conditions MRP = w and = MC are equivalent MR – Whether Q or L is chosen to maximize profit, resulting levels of input usage, output, price, & profit are the same

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

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

Long-Run Profit Maximization for Monopolistic Competition

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′ + b. P

Implementing the Profit-Maximizing Output & Pricing Decision • Step 2: Find inverse demand equation – Solve for P

Implementing the Profit-Maximizing Output & Pricing Decision • Step 3: Solve for marginal revenue – When demand is expressed as P = A + BQ, marginal revenue is • Step 4: Estimate AVC & SMC • Use statistical techniques from Chapter 10 AVC = a + b. Q + c. Q 2 SMC = a + 2 b. Q + 3 c. Q 2

Implementing the Profit-Maximizing Output & Pricing Decision • Step 5: Find output where MR = SMC – Set equations equal & solve for Q* – The larger of the two solutions is the profitmaximizing output level • Step 6: Find profit-maximizing price – Substitute Q* into inverse demand P* = A + BQ* Q* & P* are only optimal if P AVC

Implementing the Profit-Maximizing Output & Pricing Decision • Step 7: Check shutdown rule – Substitute Q* into estimated AVC function AVC* = a + b. Q* + c. Q*2 • If P* AVC*, produce Q* units of output & sell each unit for P* • If P* < AVC*, shut down in short run

Implementing the Profit-Maximizing Output & Pricing Decision • 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

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

A Multiplant Firm