Title: Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets
1Managing in Competitive, Monopolistic, and
Monopolistically Competitive Markets
2Learning Objectives
- Describe the key characteristics of the four
basic market types used in economic analysis. - Compare and contrast the degree of price
competition among the four market types. - Provide specific actual examples of the four
types of markets. - Explain why the PMC rule leads firms to the
optimal level of production.
3Learning Objectives
- Describe what happens in the long run in markets
where firms that are either incurring economic
losses or are making economic profits. Explain
why this happens with particular attention to the
key assumptions used in this analysis. - Explain how and why the MRMC rule helps a
monopoly to determine the optimal level of price
and output. - Explain the relationship between the MRMC rule
and the PMC rule.
4Learning Objectives
- Cite the main differences between monopolistic
competition and oligopoly - Describe the role that mutual interdependence
plays in setting prices in oligopolistic markets - Illustrate price rigidity in oligopoly markets
using the kinked demand curve - Elaborate on how non-price factors help firms in
monopolistic competition and oligopoly to
differentiate their products and services - Cite and briefly describe the five forces in
Porters model of competition
5Four Basic Market Types
- 1. Perfect Competition (no market power)
- Large number of relatively small buyers and
sellers - Standardized product
- Very easy market entry and exit
- Nonprice competition not possible
6- 2. Monopoly (absolute market power subject to
government regulation) - One firm, firm is the industry
- Unique product or no close substitutes
- Market entry and exit difficult or legally
impossible - Nonprice competition not necessary
7- 3. Monopolistic Competition (market power based
on product differentiation) - Large number of relatively small firms acting
independently - Differentiated product
- Market entry and exit relatively easy
- Nonprice competition very important
8- Oligopoly (market power based on product
differentiation and/or the firms dominance of
the market) - Small number of relatively large firms that are
mutually interdependent - Differentiated or standardized product
- Market entry and exit difficult
- Nonprice competition very important among firms
selling differentiated products
9(No Transcript)
10Pricing and Output Decisions in Perfect
Competition
- The Basic Business Decision entering a market on
the basis of the following questions - How much should we produce?
- If we produce such an amount, how much profit
will we earn? - If a loss rather than a profit is incurred, will
it be worthwhile to continue in this market in
the long run (in hopes that we will eventually
earn a profit) or should we exit?
11Unrealistic? 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.
12- Key assumptions of the perfectly competitive
market - The firm operates in a perfectly competitive
market and therefore is a price taker. - The firm makes the distinction between the short
run and the long run. - The firms objective is to maximize its profit in
the short run. If it cannot earn a profit, then
it seeks to minimize its loss. - The firm includes its opportunity cost of
operating in a particular market as part of its
total cost of production.
13Setting Price
14Profit-Maximizing Output Decision
- MR MC.
- Since, MR P,
- Set P MC to maximize profits.
15Graphically Representative Firms Output Decision
Profit (Pe - ATC) ? Qf
Pe Df MR
Pe
ATC
Qf
16A Numerical Example
- Given
- P10
- C(Q) 5 Q2
- Optimal Price?
- P10
- Optimal Output?
- MR P 10 and MC 2Q
- 10 2Q
- Q 5 units
- Maximum Profits?
- PQ - C(Q) (10)(5) - (5 25) 20
17- The firm incurs a loss. At the optimum output
level price is below average cost. - However, since price is greater than average
variable cost, the firm is better off producing
in the short run, because it will still incur
fixed costs greater than the loss.
18Should this Firm Sustain Short Run Losses or Shut
Down?
Profit (Pe - ATC) ? Qf lt 0
ATC
ATC
Pe Df MR
Pe
Qf
19Shutdown Decision Rule
- A profit-maximizing firm should continue to
operate (sustain short-run losses) if its
operating loss is less than its fixed costs. - Operating results in a smaller loss than ceasing
operations. - Decision rule
- A firm should shutdown when P lt min AVC.
- Continue operating as long as P min AVC.
20- Contribution Margin (CM) the amount by which
total revenue exceeds total variable cost. - CM TR TVC
- If the contribution margin is positive, the firm
should continue to produce in the short run in
order to defray some of the fixed cost.
21- Shutdown Point the lowest price at which the
firm would still produce. - At the shutdown point, the price is equal to the
minimum point on the AVC. This is where selling
at the price results in zero contribution margin. - If the price falls below the shutdown point,
revenues fail to cover the fixed costs and the
variable costs. The firm would be better off if
it shut down and just paid its fixed costs.
22Firms Short-Run Supply Curve MC Above Min AVC
P min AVC
Qf
23Short-Run Market Supply Curve
- The market supply curve is the summation of each
individual firms supply at each price.
Market
Firm 1
Firm 2
P
P
P
15
5
Q
Q
Q
24Long Run Adjustments?
- If firms are price takers but there are barriers
to entry, profits will persist. - If the industry is perfectly competitive, firms
are not only price takers but there is free
entry. - Other greedy capitalists enter the market.
25Effect of Entry on Price?
S
Entry
Pe
Df
26Effect of Entry on the Firms Output and Profits?
Pe
Df
Df
Pe
Qf
27Summary of Logic
- Short run profits leads to entry.
- Entry increases market supply, drives down the
market price, increases the market quantity. - Demand for individual firms product shifts down.
- Firm reduces output to maximize profit.
- Long run profits are zero.
28Features of Long Run Competitive Equilibrium
- P MC
- Socially efficient output.
- P minimum AC
- Efficient plant size.
- Zero profits
- Firms are earning just enough to offset their
opportunity cost.
29- In the long run, the price in the competitive
market will settle at the point where firms earn
a normal profit. - Economic profit invites entry of new firms which
shifts the supply curve to the right, puts
downward pressure on price and reduces profits. - Economic loss causes exit of firms which shifts
the supply curve to the left, puts upward
pressure on price and increases profits.
30- Observations in perfectly competitive markets
- The earlier the firm enters a market, the better
its chances of earning above-normal profit
(assuming a strong demand in the market). - As new firms enter the market, firms that want to
survive and perhaps thrive must find ways to
produce at the lowest possible cost, or at least
at cost levels below those of their competitors. - Firms that find themselves unable to compete on
the basis of cost might want to try competing on
the basis of product differentiation instead.
31Monopoly Environment
- Single firm serves the relevant market.
- Most monopolies are local monopolies.
- The demand for the firms product is the market
demand curve. - Firm has control over price.
- But the price charged affects the quantity
demanded of the monopolists product.
32Natural Sources of Monopoly Power
- Economies of scale
- Economies of scope
- Cost complementarities
33Created Sources of Monopoly Power
- Patents and other legal barriers (like licenses)
- Tying contracts
- Exclusive contracts
- Collusion
Contract...
I. II. III.
34Managing a Monopoly
- Market power permits you to price above MC
- Is the sky the limit?
- No. How much you sell depends on the price you
set!
35A Monopolists Marginal Revenue
P
TR
Unit elastic
100
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
30
40
50
30
40
50
Q
Q
0
0
10
20
10
20
MR
Elastic
Inelastic
36Monopoly Profit Maximization
Produce where MR MC. Charge the price on the
demand curve that corresponds to that quantity.
Profit
PM
ATC
D
QM
MR
37Useful Formulae
- Whats the MR if a firm faces a linear demand
curve for its product? - Alternatively,
38A Numerical Example
- Given estimates of
- P 10 - Q
- C(Q) 6 2Q
- Optimal output?
- MR 10 - 2Q
- MC 2
- 10 - 2Q 2
- Q 4 units
- Optimal price?
- P 10 - (4) 6
- Maximum profits?
- PQ - C(Q) (6)(4) - (6 8) 10
39Long Run Adjustments?
- None, unless the source of monopoly power is
eliminated.
40Why Government Dislikes Monopoly?
- P gt MC
- Too little output, at too high a price.
- Deadweight loss of monopoly.
41Deadweight Loss of Monopoly
Deadweight Loss of Monopoly
D
MC
MR
42Arguments for Monopoly
- The beneficial effects of economies of scale,
economies of scope, and cost complementarities on
price and output may outweigh the negative
effects of market power. - Encourages innovation.
43Monopoly Multi-Plant Decisions
- Consider a monopoly that produces identical
output at two production facilities (think of a
firm that generates and distributes electricity
from two facilities). - Let C1(Q2) be the production cost at facility 1.
- Let C2(Q2) be the production cost at facility 2.
- Decision Rule Produce output where
- MR(Q) MC1(Q1) and MR(Q) MC2(Q2)
- Set price equal to P(Q), where Q Q1 Q2.
44Monopolistic Competition Environment and
Implications
- Numerous buyers and sellers
- Differentiated products
- Implication Since products are differentiated,
each firm faces a downward sloping demand curve. - Consumers view differentiated products as close
substitutes there exists some willingness to
substitute. - Free entry and exit
- Implication Firms will earn zero profits in the
long run.
45Managing a Monopolistically Competitive Firm
- Like a monopoly, monopolistically competitive
firms - have market power that permits pricing above
marginal cost. - level of sales depends on the price it sets.
- But
- The presence of other brands in the market makes
the demand for your brand more elastic than if
you were a monopolist. - Free entry and exit impacts profitability.
- Therefore, monopolistically competitive firms
have limited market power.
46Competing in ImperfectlyCompetitive Markets
- Non-price variables any factor that managers can
control, influence, or explicitly consider in
making decisions affecting the demand for their
goods and services. - Advertising
- Promotion
- Location and distribution channels
- Market segmentation
- Loyalty programs
- Product extensions and new product development
- Special customer services
- Product lock-in or tie-in
- Pre-emptive new product announcements
47Marginal Revenue Like a Monopolist
P
TR
Unit elastic
100
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
30
40
50
30
40
50
Q
Q
0
0
10
20
10
20
MR
Elastic
Inelastic
48Monopolistic Competition Profit Maximization
- Maximize profits like a monopolist
- Produce output where MR MC.
- Charge the price on the demand curve that
corresponds to that quantity.
49Short-Run Monopolistic Competition
Profit
PM
ATC
D
Quantity of Brand X
QM
MR
50Long Run Adjustments?
- If the industry is truly monopolistically
competitive, there is free entry. - In this case other greedy capitalists enter,
and their new brands steal market share. - This reduces the demand for your product until
profits are ultimately zero.
51Long-Run Monopolistic Competition
Long Run Equilibrium (P AC, so zero profits)
P
P1
Entry
D
D1
MR
Quantity of Brand X
Q1
Q
MR1
52Monopolistic Competition
- The Good (To Consumers)
- Product Variety
- The Bad (To Society)
- P gt MC
- Excess capacity
- Unexploited economies of scale
- The Ugly (To Managers)
- P ATC gt minimum of average costs.
- Zero Profits (in the long run)!
53Optimal Advertising Decisions
- Advertising is one way for firms with market
power to differentiate their products. - But, how much should a firm spend on advertising?
- Advertise to the point where the additional
revenue generated from advertising equals the
additional cost of advertising.
54Optimal Advertising Decisions
- Equivalently, the profit-maximizing level of
advertising occurs where the advertising-to-sales
ratio equals the ratio of the advertising
elasticity of demand to the own-price elasticity
of demand.
55Maximizing Profits A Synthesizing Example
- C(Q) 125 4Q2
- Determine the profit-maximizing output and price,
and discuss its implications, if - You are a price taker and other firms charge 40
per unit - You are a monopolist and the inverse demand for
your product is P 100 - Q - You are a monopolistically competitive firm and
the inverse demand for your brand is P 100 Q.
56Marginal Cost
- C(Q) 125 4Q2,
- So MC 8Q.
- This is independent of market structure.
57Price Taker
- MR P 40.
- Set MR MC.
- 40 8Q.
- Q 5 units.
- Cost of producing 5 units.
- C(Q) 125 4Q2 125 100 225.
- Revenues
- PQ (40)(5) 200.
- Maximum profits of -25.
- Implications Expect exit in the long-run.
58Monopoly/Monopolistic Competition
- MR 100 - 2Q (since P 100 - Q).
- Set MR MC, or 100 - 2Q 8Q.
- Optimal output Q 10.
- Optimal price P 100 - (10) 90.
- Maximal profits
- PQ - C(Q) (90)(10) -(125 4(100)) 375.
- Implications
- Monopolist will not face entry (unless patent or
other entry barriers are eliminated). - Monopolistically competitive firm should expect
other firms to clone, so profits will decline
over time.
59Conclusion
- Firms operating in a perfectly competitive market
take the market price as given. - Produce output where P MC.
- Firms may earn profits or losses in the short
run. - but, in the long run, entry or exit forces
profits to zero. - A monopoly firm, in contrast, can earn persistent
profits provided that source of monopoly power is
not eliminated. - A monopolistically competitive firm can earn
profits in the short run, but entry by competing
brands will erode these profits over time.
60Oligopoly
- Oligopoly is a market dominated by a relatively
small number of large firms - Products are either standardized or
differentiated - Measures of Market Concentration
- Herfindahl-Hirschman index (HH) measure of
market concentration (max HH 10,000) - n number of firms in the industry
- Si firms market share
- Unconcentrated markets have HH lt 1,000
61Pricing in an Oligopolistic MarketRivalry and
Mutual Interdependence
- Mutual Interdependence relatively few sellers
create a situation where each is carefully
watching the others as it sets its price. - Kinked Demand Curve Model
- Basic Assumption competitor will follow a price
decrease but will not make a change in reaction
to a price increase.
62Pricing in an Oligopolistic MarketRivalry and
Mutual Interdependence
- If reduce price and competitors match the price
cut then move along more inelastic demand segment
Di. - If increase price and competitors do not follow
then move along the more elastic segment Df. - Marginal Revenue curve will be discontinuous
where the kink occurs (at point A).
Competitors do not match price increases
Competitors match price cuts
63- Price Leader one firm in the industry takes the
lead in changing prices. - The price leader assumes that firms will follow a
price increase. It assumes that firms may follow
a reduction in price, but will not go even lower
in order not to trigger a price war. - Non-Price Leader firm that leads the
differentiation of products on other, non-price
attributes.
64- Equalizing at the margin general economic
concept which managers can use to help make an
optimal decision. - Can be used to decide the optimal expenditure
level of a non-price factor that influences a
firms demand. - MR MC is an example of equalizing at the
margin. - Revenue and costs may be realized over a long
period of time. - Firm must adjust MR, MC for the time value of
money.