Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

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Managing in Competitive, Monopolistic, and
Monopolistically Competitive Markets
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Learning 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.

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Learning 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.

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Learning 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

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Four 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

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• 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

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• 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

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• 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

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Pricing 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?

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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.

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• 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.

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Setting Price
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Profit-Maximizing Output Decision

• MR MC.
• Since, MR P,
• Set P MC to maximize profits.

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Graphically Representative Firms Output Decision
Profit (Pe - ATC) ? Qf
Pe Df MR
Pe
ATC
Qf
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A 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

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• 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.

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Should this Firm Sustain Short Run Losses or Shut
Down?
Profit (Pe - ATC) ? Qf lt 0
ATC
ATC
Pe Df MR
Pe
Qf
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Shutdown 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.

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• 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.

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• 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.

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Firms Short-Run Supply Curve MC Above Min AVC
P min AVC
Qf
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Short-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
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Long 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.

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Effect of Entry on Price?
S
Entry
Pe
Df
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Effect of Entry on the Firms Output and Profits?
Pe
Df
Df
Pe
Qf
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Summary 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.

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Features 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.

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• 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.

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• 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.

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Monopoly 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.

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Natural Sources of Monopoly Power

• Economies of scale
• Economies of scope
• Cost complementarities

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Created Sources of Monopoly Power

• Patents and other legal barriers (like licenses)
• Tying contracts
• Exclusive contracts
• Collusion

Contract...
I. II. III.
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Managing 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!

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A 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
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Monopoly Profit Maximization
Produce where MR MC. Charge the price on the
demand curve that corresponds to that quantity.
Profit
PM
ATC
D
QM
MR
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Useful Formulae

• Whats the MR if a firm faces a linear demand
  curve for its product?
• Alternatively,

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A 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

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Long Run Adjustments?

• None, unless the source of monopoly power is
  eliminated.

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Why Government Dislikes Monopoly?

• P gt MC
• Too little output, at too high a price.
• Deadweight loss of monopoly.

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Deadweight Loss of Monopoly
Deadweight Loss of Monopoly
D
MC
MR
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Arguments 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.

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Monopoly 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.

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Monopolistic 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.

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Managing 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.

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Competing 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

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Marginal 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
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Monopolistic 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.

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Short-Run Monopolistic Competition
Profit
PM
ATC
D
Quantity of Brand X
QM
MR
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Long 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.

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Long-Run Monopolistic Competition
Long Run Equilibrium (P AC, so zero profits)
P
P1
Entry
D
D1
MR
Quantity of Brand X
Q1
Q
MR1
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Monopolistic 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)!

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Optimal 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.

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Optimal 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.

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Maximizing 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.

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Marginal Cost

• C(Q) 125 4Q2,
• So MC 8Q.
• This is independent of market structure.

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Price 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.

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Monopoly/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.

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Conclusion

• 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.

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Oligopoly

• 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

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Pricing 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.

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Pricing 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
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• 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.

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• 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.