Managing in Perfectly Competitive and Monopolistic Markets Perfect

Managing in Perfectly Competitive and Monopolistic Markets

Perfect Competition Conditions: • Large number of buyers and sellers • Homogeneous product • Perfect knowledge • Free entry and exit • No government intervention Key Implications: • Flat firms’ demand determined by market equilibrium price • Market participants are price takers without any market power to influence prices (have to charge MR = P = MC) • In the short run firms earn profits or losses or shut down • In the long run profit = normal = 0 (firms operate efficiently)

Monopoly Conditions: • Large number of buyers and one sellers • Product without close substitutes • Perfect knowledge • Barriers to entry • No government intervention Key Implications: • Downward sloping firm’s demand is market demand • Firm has market power and determines market price (can charge P > MR = MC) • In the short run monopoly earns profit or loss or shuts down • In the long run profit > normal is sustainable indefinitely but even with profit = normal = 0 (monopoly does not operate efficiently)

Sources of Monopoly Power Natural: • Economies of scale and excess capacity • Economies of scope and cost complementarities • Capital requirements, sales and distribution networks • Differentiated products and brand loyalty Created: • Patents and other legal barriers (licenses) • Tying and exclusive contracts • Collusion (tacit or open) • Entry limit pricing (predatory pricing illegal)

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

Profit Maximization for Total Measures Industry D (TR) = Firm D (TR) T is maximized: • Where the slope of T is 0 (TR and TC are parallel or their slopes are equal). d. T / d. Q = M = 0 2 such points (Q 1, Q 3) need additional condition: 2. d 2 T / d. Q 2 is negative or max TR - TC => Q* = Q 3.

Profit Maximization for per Unit Measures T is maximized: • At Q where MR = MC. 2 points, need additional condition • MR < MC for any Q > Q* = Q 3 (Q* is one of FONC candidates) or when MC is increasing. T = [(TR – TC)/Q]Q = (AR – AC)Q = (P – AC)Q Max T = area of the rectangle = (AR|Q* - AC|Q*)Q* = (P|Q* - AC|Q*)Q*

A Numerical Example • Given estimates of • P = 10 - Q • C(Q) = 6 + 2 Q • Optimal output? • MR = 10 - 2 Q = 2 = MC • Q = 4 units • Optimal price? • P = 10 - (4) = $6 • Maximum profits? • PQ - C(Q) = 6(4) - (6 + 8) = $10

=0

Shut-Down Point • In the long run all cost must be recovered. • In the short run fixed cost incurred before production begins and do not change regardless of the level of production (even for Q = 0). • Shut down only if: –TFC > T (total) AVC > P (per unit). • TFC = AFC*Q = (SAC – AVC)*Q • Operate with loss if: 0 > T –TFC (total) SAC > P AVC (per unit). • This is the third T maximizing condition.

Setting Price $ TR Firm small part of industry: Industry D (TR) > Firm D (TR) Firm’s D small segment of upward slopping Industry D $ Qf(units) $ SM Df = Pf = AR = MR PM DM QM(106) Market Firm Qf(units)

Choosing Output • To maximize total profit: T = TR - TC FONC: d. T /d. Q = MR - MC = 0 In general (including monopoly) MR = MC. In perfect competition MR = P = MC. • To maximize profit increase output (Q) until 1) MR = P = MC (at Q*), and 2) for Q > Q* => MC > P (or MC is increasing) => M < 0 => TC < TR • As long as: max T ≥ -TFC or P ≥ AVC

A Numerical Example • Given estimates of • • P = $10 C(Q) = 5 + Q 2 • Optimal Price? • P = $10 • Optimal Output? • • MR = P = $10 = 2 Q = MC Q = 5 units • Maximum Profits? • PQ - C(Q) = 10(5) - (5 + 25) = $20

Profit > Normal

Normal Profit • Normal profit is necessary for the firm to produce over the long run and is considered a cost of production • Normal profit is required because investors expect a return on their investment. • Profit < normal leads to exit in the long run. • Profit > normal leads to entry in the long run. • Profit = normal maintains the # of firms in the industry.

Shutdown

Short-Run Supply Under Perfect Competition

Effect of Entry on Market Price & Quantity $ $ S Entry S* Pe Df Pe* Df* D QM Market Firm Qf • Short run profits leads to entry • Entry increases market supply, driving down the market price and increasing the market quantity

Effect of Entry on Firms Output & Profit LMC $ LAC Pe Df Pe* Df* Q L Q f* • Demand for individual firm’s product and hence its price shifts down • Long run profits are driven to zero Q

Perfect Competition in the Long Run • Socially efficient output and price: MR = P = MC (no dead weight loss) • Efficient plant size: P = MC = min AC (all economies of scale exhausted) • Optimal resource allocation: T = Normal = 0 because P = min AC (because of no market power or free entry opportunity cost equals TR )

Price Perfect Competition Consumer surplus S = MC > min AVC PPC Producer surplus 0 Efficient quantity QPC D = P = MR Quantity

Price Inefficiency of Monopoly PA Consumer surplus S = MC > min AVC PM Deadweight loss PPC Monopoly’s gain MR 0 QM Producer surplus QPC D=P Quantity

Monopoly in the Long Run with Greater than Normal and Normal Profit • Socially inefficient: P > MR = MC (QM<QPC, PM>PPC, dead weight loss) • Scale inefficient: P > MC = min AC (economies of scale still exist) • Misallocated resources: even when T = normal = 0, P is still > min AC (because of market power or barriers to entry opportunity cost < TR) • Encouraged R&D, benefits from natural monopolies, economies of scope and cost complementarity might offset inefficiencies

Synthesizing Example C(Q) = 125 + 4 Q 2 => MC = 8 Q is unaffected by market structure. What are profit maximizing output & price, and their implications if • You are a price taker, other firms charge $40 per unit? • You are a monopolist with inverse demand P = 100 – Q? • P = MR = 40 = 8 Q = MC • MR = 100 - 2 Q = 8 Q = MC => Q* = 5 and P* = 40 => Q* = 10 and P* = 100 - Q = 100 - 10 = 90 • Max T = TR - C(Q*) = 40(5) - (125+4(5)2) = 200 - 225 = -$25 • Max T = TR - C(Q*) = 90(10) - (125+4(100)) = 900 - 525 = $375 • Expect exit in the long-run • No entry until barriers eliminated

Price (cents per kilowatt-hour) Natural Monopoly Economies of scale exist over the entire LAC curve. 15 One firm distributes 4 million k. Wh at ¢ 5 a k. Wh. This same total output costs ¢ 10 a k. Wh with two and ¢ 15 a k. Wh with four firms. 10 5 LAC D=P 0 1 Natural monopoly: one firm meets the market demand at a lower cost than two or more firms. Public utility commission ensures that P = LAC (not P 2 3 4 associated with MR = MC), Quantity (millions of kilowatt-hours) eliminating monopoly rent.

Break-Even Analysis Approximation in absence of detailed data on revenue & costs. Assume both TR & TC are linear. At the Break-even output: TR = TC = TVC + TFC P*QBE = AVC*QBE + TFC (P – AVC)*QBE = TFC / (P – AVC) P = $6, AVC = $3. 6, TFC = $60 K QBE = 60, 000 / (6 – 3. 6) QBE = $25, 000 (P – AVC) unit contribution margin. 1 – P/AVC contribution margin ratio (fraction of P to recover TFC)