Outline 5 Market Structures Perfect and Imperfect Competition

Outline 5 Market Structures: Perfect and Imperfect Competition, Profit Maximization, and Pricing Strategy 5. 1

Market Structures: Perfect and Imperfect Competition, Profit Maximization, and Pricing Strategy 5. 1 Perfect & Imperfect Competition Summary 5. 2 Market Power & Imperfect Competition 5. 3 Compare Perfect Competition & Imperfect Competition 5. 4 Monopolistic Competition as a Form of Imperfect Competition © 2005 Prentice Hall, Inc. 7. 2

Market Structures: Perfect and Imperfect Competition, Profit Maximization, and Pricing Strategy 5. 1 Perfect & Imperfect Competition Summary See class notes. © 2005 Prentice Hall, Inc. 7. 3

Perfect Competition Characterized by • A large number of firms in the market • An undifferentiated product • Ease of entry into the market • Complete information available to all market participants © 2005 Prentice Hall, Inc. 7. 4

Perfect Competition § Distinguished between behavior of individual firms and outcomes for entire market § No single firm has any influence on the price of a product § Price-taker: a firm cannot influence the price of its product, thus it can sell any amount of output at that price © 2005 Prentice Hall, Inc. 7. 5

Perfectly Competitive Figure 5. 1 Industry/Market MC P S PE Individual Firm ATC B A D=P=MR D 0 QE © 2005 Prentice Hall, Inc. Q 0 Q 1 Q 2 Q 7. 6

Profit Maximization = TR - TC where = profit TR = total revenue TC = total cost Profit-maximization rule: to maximize profits, a firm should produce the level of output where marginal revenue equals marginal cost © 2005 Prentice Hall, Inc. 7. 7

Marginal Revenue § Price equals marginal revenue for a perfectly competitive firm because the firm does not have to lower the price to sell more units of output § The profit-maximizing level of output occurs where marginal revenue equals marginal cost because any other level of output will result in smaller profit © 2005 Prentice Hall, Inc. 7. 8

Determining the Amount of Profit Earned § If you know total revenue and total cost, you can calculate amount of profit § Using TR and TC function graphs, you can calculate level of profitmaximizing by finding the greatest distance between the two curves and calculate the profit at that point © 2005 Prentice Hall, Inc. 7. 9

The Shutdown Point § The shutdown point for perfectly competitive firm: the price, which just equals AVC, below which it is more profitable for the perfectly competitive firm to shut down than to continue to produce § The supply curve is that portion of its marginal cost curve above minimum AVC © 2005 Prentice Hall, Inc. 7. 10

Supply Curve for Perfectly Competitive Industry § The supply curve shows the output produced by all perfectly competitive firms in the industry at different prices. © 2005 Prentice Hall, Inc. 7. 11

Long-run Adjustment § Two factors: • Entry and exit by new and existing firms • Changes in the scale of operations by all firms § These factors can occur simultaneously © 2005 Prentice Hall, Inc. 7. 12

Long-run Adjustment § Equilibrium point for the perfectly competitive firm: the point where price equals ATC since the firm earns zero economic profit at this point § Economic profit incorporates all implicit costs of production including normal rate of return on investment © 2005 Prentice Hall, Inc. 7. 13

Long-run Adjustment: Entry and Exit Figure 5. 2 Industry/Market S 1 S 2 PE 2 Individual Firm P ATC D 2=P 2=MR 2 PE 1 A B D 1 D 2 0 MC QE 1 QE 2 QE 3 © 2005 Prentice Hall, Inc. 0 D 1=P 1=MR 1 Q 2 7. 14

Long-run Adjustment § Firm is a price-taker; therefore, it must accept new equilibrium price and determine appropriate level of output § All firms know the positive economic profits § Other firms are able to enter the market © 2005 Prentice Hall, Inc. 7. 15

Optimum Scale of Production SMC 1 $ SATC 1 SMC 2 SATC 2 Figure 5. 3 LRAC P 1=MR 1 P 2=MR 2 0 Q 1 © 2005 Prentice Hall, Inc. Q 2 Q 7. 16

Optimum Scale of Production § In Figure 5. 3, LRAC incorporates both economies of scale and diseconomies of scale § Large-scale production will give managers competitive edge by decreasing production costs § Cannot influence price of product © 2005 Prentice Hall, Inc. 7. 17

Managerial Rule of Thumb: Competition Means Little Control Over Price § Managers have little or no control over product price § They compete on basis of lowering costs of production § Perfectly competitive firms earn zero economic profit because entry of other firms compete away excess profit © 2005 Prentice Hall, Inc. 7. 18

Managerial Rule of Thumb: Strategies to Gain Market Power Managers in competitive industries can gain market power by • Merging with other companies • Differentiating products • Forming producer association to change consumer preferences and increase demand for output of the entire industry © 2005 Prentice Hall, Inc. 7. 19

5. 2 Market Power & Imperfect Competition § Market power: ability of a firm to influence the prices of its products and develop strategies to earn profits over longer periods of time § Monopoly: single firm producing product with no close substitutes § Price-searchers: firms in imperfect competition © 2005 Prentice Hall, Inc. 7. 20

Imperfect Competition Model with Positive Economic Profit $ Figure 5. 4 MC PM ATCM A ATC B MR 0 © 2005 Prentice Hall, Inc. QM D Q 7. 21

Imperfect Competition with Negative Economic Profit $ Figure 5. 5 MC B ATCM PM A MR 0 © 2005 Prentice Hall, Inc. QM D Q 7. 22

Imperfect Competition § Monopolist maximizes profits by producing where MR = MC and earns positive economic profit due to barriers to entry § The monopolist could suffer losses if ATC is greater than price at the profit-maximizing level of output (previous slide) © 2005 Prentice Hall, Inc. 7. 23

Comparing Imperfect and Perfect Competition Figure 5. 6 $ MC ATC D=P=MR 0 QPC © 2005 Prentice Hall, Inc. $ P 2 MC P 1 ATC 0 MR QM Q 1 Q 7. 24

5. 3 Comparing Imperfect and Perfect Competition § Monopolistic firm must seek out optimal price, which depends on demand cost conditions § Firms with market power might pursue other profit goals § Price is higher and output lower under monopoly than under perfect competition © 2005 Prentice Hall, Inc. 7. 25

Barriers to Entry § Economies of scale and mergers § Barriers created by government § Input barriers § Brand loyalties § Consumer lock-in and switching costs © 2005 Prentice Hall, Inc. 7. 26

Economies of Scale and Mergers § Exist when a firm’s LRAC slopes downward or when lower production costs are associated with larger scale of operation § Can act as a barrier to entry in different industries § Mergers are particularly important in technology, media, and telecommunications © 2005 Prentice Hall, Inc. 7. 27

Barriers Created by Government § Licenses § Patents and copyrights © 2005 Prentice Hall, Inc. 7. 28

Input Barriers § Control over raw materials § Barriers in financial capital markets • Larger firms can get lower interest rates • Smaller firms need more collateral for loans • Smaller firms are perceived as riskier © 2005 Prentice Hall, Inc. 7. 29

Consumer Lock-In and Switching Costs § When consumers become locked into certain types or brands and would incur substantial switching costs if they changed § Although lock-in types are dominant, they represent managerial strategies that can be used elsewhere to gain market power © 2005 Prentice Hall, Inc. 7. 30

Measures of Market Power § Managers can use measures to better understand the markets • Lerner Index: measure of market power that focuses on the difference between a firm’s product price and marginal cost of production L = (P – MC) P © 2005 Prentice Hall, Inc. 7. 31

Antitrust Issues § Federal legislation that limits market power of firms and regulates how firms use their market power to compete § Major components of antitrust law: • Sherman Act of 1890 • Clayton Act of 1914 • Federal Trade Commission Act of 1914 © 2005 Prentice Hall, Inc. 7. 32

Managerial Rule of Thumb: Understanding Antitrust Laws § Managers must work within antitrust constraints § Because of generalities and ambiguities, managers may not know whether their actions are illegal unless the government initiates litigation © 2005 Prentice Hall, Inc. 7. 33

5. 4 Monopolistic Competition as a form of Imperfect Competition § Product differentiation exists among firms § Large number of firms exist § No interdependence exists among these firms § Entry by new firms is relatively easy © 2005 Prentice Hall, Inc. 7. 34

Monopolistic Competition, Long Run and Short run Figure 5. 7 $ P 1 $ MC MC ATC 0 MR Q 1 © 2005 Prentice Hall, Inc. ATC P 2 D Q 0 MR D Q 2 Q 7. 35