Managerial Economics eighth edition Thomas Maurice Chapter 12

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Managerial Economics eighth edition Thomas Maurice Chapter 12 Managerial Decisions for Firms with Market

Managerial Economics eighth edition Thomas Maurice Chapter 12 Managerial Decisions for Firms with Market Power Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved

2 Managerial Economics Market Power • Ability of a firm to raise price without

2 Managerial Economics 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) 2 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

3 Managerial Economics Monopoly • Single firm • Produces & sells a particular good

3 Managerial Economics Monopoly • Single firm • Produces & sells a particular good or service for which there are no good substitutes • New firms are prevented from entering market 3 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

4 Managerial Economics Measurement of Market Power • Degree of market power inversely related

4 Managerial Economics 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 4 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

5 Managerial Economics Measurement of Market Power • Lerner index measures proportionate amount by

5 Managerial Economics Measurement of Market Power • Lerner index measures proportionate amount by which price exceeds marginal cost: 5 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

6 Managerial Economics Measurement of Market Power • Lerner index • Equals zero under

6 Managerial Economics Measurement of Market Power • Lerner index • 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 6 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

7 Managerial Economics Measurement of Market Power • If consumers view two goods as

7 Managerial Economics 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 7 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

8 Managerial Economics Determinants of Market Power • Entry of new firms into a

8 Managerial Economics Determinants of Market Power • 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 8 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

9 Managerial Economics Common Entry Barriers • Economies of scale • When long-run average

9 Managerial Economics 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 9 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

10 Managerial Economics Common Entry Barriers • Input barriers • One firm controls a

10 Managerial Economics Common Entry Barriers • 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 10 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

11 Managerial Economics Common Entry Barriers • Consumer lock-in • Potential entrants can be

11 Managerial Economics 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 value 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 network of buyers 11 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

12 Managerial Economics Demand & Marginal Revenue for a Monopolist • Market demand curve

12 Managerial Economics 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 12 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

13 13 Managerial Economics Demand & Marginal Revenue for a Monopolist (Figure 12. 1)

13 13 Managerial Economics Demand & Marginal Revenue for a Monopolist (Figure 12. 1) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

14 Managerial Economics Short-Run Profit Maximization for Monopoly • Monopolist will produce a positive

14 Managerial Economics Short-Run Profit Maximization for Monopoly • Monopolist will produce a positive output if some price on the demand curve exceeds average variable cost • Profit maximization or loss minimization occurs by producing quantity for which MR = MC 14 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

15 Managerial Economics Short-Run Profit Maximization for Monopoly • If P > ATC, firm

15 Managerial Economics Short-Run Profit Maximization for Monopoly • If P > ATC, firm makes economic profit • If ATC > P > AVC, firm incurs loss, but continues to produce in short run • If demand falls below AVC at every level of output, firm shuts down & loses only fixed costs 15 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

16 16 Managerial Economics Short-Run Profit Maximization for Monopoly (Figure 12. 3) Mc. Graw-Hill/Irwin

16 16 Managerial Economics Short-Run Profit Maximization for Monopoly (Figure 12. 3) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

17 17 Managerial Economics Short-Run Loss Minimization for Monopoly (Figure 12. 4) Mc. Graw-Hill/Irwin

17 17 Managerial Economics Short-Run Loss Minimization for Monopoly (Figure 12. 4) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

18 Managerial Economics Long-Run Profit Maximization for Monopoly • Monopolist maximizes profit by choosing

18 Managerial Economics 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 longrun average cost at the profit-maximizing output level 18 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

19 19 Managerial Economics Long-Run Profit Maximization for Monopoly (Figure 12. 5) Mc. Graw-Hill/Irwin

19 19 Managerial Economics Long-Run Profit Maximization for Monopoly (Figure 12. 5) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

20 Managerial Economics Profit-Maximizing Input Usage • Profit-maximizing level of input usage produces exactly

20 Managerial Economics Profit-Maximizing Input Usage • Profit-maximizing level of input usage produces exactly that level of output that maximizes profit 20 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

21 Managerial Economics Profit-Maximizing Input Usage • Marginal revenue product (MRP) • MRP is

21 Managerial Economics 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 21 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

22 22 Managerial Economics Monopoly Firm’s Demand for Labor (Figure 12. 6) Mc. Graw-Hill/Irwin

22 22 Managerial Economics Monopoly Firm’s Demand for Labor (Figure 12. 6) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

23 Managerial Economics Profit-Maximizing Input Usage • For a firm with market power, profit

23 Managerial Economics Profit-Maximizing Input Usage • 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 23 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

24 Managerial Economics Monopolistic Competition • Large number of firms sell a differentiated product

24 Managerial Economics 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 24 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

25 Managerial Economics Monopolistic Competition • Short-run equilibrium is identical to monopoly • Unrestricted

25 Managerial Economics 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 25 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

26 26 Managerial Economics Short-Run Profit Maximization for Monopolistic Competition (Figure 12. 7) Mc.

26 26 Managerial Economics Short-Run Profit Maximization for Monopolistic Competition (Figure 12. 7) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

27 27 Managerial Economics Long-Run Profit Maximization for Monopolistic Competition (Figure 12. 8) Mc.

27 27 Managerial Economics Long-Run Profit Maximization for Monopolistic Competition (Figure 12. 8) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

28 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 1: Estimate

28 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 1: Estimate demand equation • Use statistical techniques from Chapter 7 • Substitute forecasts of demandshifting variables into estimated demand equation to get 28 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

29 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 2: Find

29 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 2: Find inverse demand equation • Solve for P 29 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

30 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 3: Solve

30 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 3: Solve for marginal revenue • When demand is expressed as = A + BQ, marginal revenue is 30 Mc. Graw-Hill/Irwin P Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

31 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 4: Estimate

31 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 4: Estimate AVC & SMC • Use statistical techniques from Chapter 10 31 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

32 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 5: Find

32 Managerial Economics 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 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 32 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

33 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 7: Check

33 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 7: Check shutdown rule • Substitute Q* into estimated AVC function • If P* AVC*, produce Q* units of output & sell each unit for P* • If P* < AVC*, shut down in short run 33 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

34 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 8: Compute

34 Managerial Economics Implementing the Profit-Maximizing Output & Pricing Decision • Step 8: Compute profit or loss • Profit = TR - TC • If P < AVC, firm shuts down & profit is -TFC 34 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

35 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Aztec possesses market

35 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Aztec possesses market power via patents • Sells advanced wireless stereo headphones 35 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

36 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Estimation of demand

36 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Estimation of demand & marginal revenue 36 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

37 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Solve for inverse

37 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Solve for inverse demand 37 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

38 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Determine marginal revenue

38 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Determine marginal revenue function 38 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

39 39 Managerial Economics Demand & Marginal Revenue for Aztec Electronics (Figure 12. 9)

39 39 Managerial Economics Demand & Marginal Revenue for Aztec Electronics (Figure 12. 9) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

40 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Estimation of average

40 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Estimation of average variable cost and marginal cost • Given the estimated AVC equation: • So, 40 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

41 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Output decision •

41 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Output decision • Set MR = MC and solve for Q* 41 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

42 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Output decision •

42 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Output decision • Solve for Q* using the quadratic formula 42 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

43 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Pricing decision •

43 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Pricing decision • Substitute Q* into inverse demand 43 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

44 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Shutdown decision •

44 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Shutdown decision • Compute AVC at 6, 000 units: 44 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

45 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Computation of total

45 Managerial Economics Maximizing Profit at Aztec Electronics: An Example • Computation of total profit 45 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve

46 46 Managerial Economics Profit Maximization at Aztec Electronics (Figure 12. 10) Mc. Graw-Hill/Irwin

46 46 Managerial Economics Profit Maximization at Aztec Electronics (Figure 12. 10) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserve