Managerial Economics & Business

Strategy
Chapter 8
Managing in Competitive, Monopolistic,
and Monopolistically Competitive Markets
 8-2

Overview
I. Perfect Competition
– Characteristics and profit outlook.
– Effect of new entrants.
II. Monopolies
– Sources of monopoly power.
– Maximizing monopoly profits.
– Pros and cons.
III. Monopolistic Competition
– Profit maximization.
– Long run equilibrium.
 8-3

Perfect Competition Environment

• Many buyers and sellers.

• Homogeneous (identical) product.
• Perfect information on both sides of
market.
• No transaction costs.
• Free entry and exit.
 8-4

Key Implications
• Firms are “price takers” (P = MR).
• In the short-run, firms may earn profits or
losses.
• Entry and exit forces long-run profits to
zero.
 8-5

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.
 8-6

Managing a Perfectly Competitive

Firm
(or Price-Taking Business)
 8-7

Setting Price

$ $
S

Pe Df

QM Qf
Market Firm
 8-8

Profit-Maximizing Output Decision

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

• Profit for the perfectly competitive market:

 8-9
Graphically: Representative
Firm’s Output Decision
Profit = (Pe - ATC)  Qf*
MC
$
ATC
AVC
Pe Pe = Df = MR

ATC

Qf* Qf
 8-10
A Numerical Example
• Given
– P=$10
– C(Q) = 5 + Q2
• Optimal Price?
– P=$10
• Optimal Output?
– MR = P = $10 and MC = 2Q
– 10 = 2Q
– Q = 5 units
• Maximum Profits?
– PQ - C(Q) = (10)(5) - (5 + 25) = $20
 8-11
Should this Firm Sustain Short Run Losses or
Shut Down?
Profit = (Pe - ATC)  Qf* < 0
MC ATC
$

AVC

ATC
Loss
Pe Pe = Df = MR

Qf* Qf
 8-12

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 < min AVC.
– Continue operating as long as P ≥ min AVC.
 8-13
Firm’s Short-Run Supply Curve: MC
Above Min AVC
MC ATC
$

AVC

P min AVC

Qf* Qf
 8-14

Short-Run Market Supply Curve

• The market supply curve is the summation of
each individual firm’s supply at each price.

P Firm 1 Firm 2 Market

P P

S1 S2
SM
15

10 18 Q 20 25 Q 30 43Q
 8-15

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.
 8-16

Effect of Entry on Price?

$ $
S
Entry S*
Pe Df
Pe* Df*

QM Qf
Market Firm
 8-17

Effect of Entry on the Firm’s

Output and Profits?
MC
$
AC

Pe Df

Pe* Df*

QL Qf* Q
 8-18

• Short run profits leads to entry.

• Entry increases market supply, drives down
the market price, increases the market
quantity.
• Demand for individual firm’s product shifts
down.
• Firm reduces output to maximize profit.
• Long run profits are zero.
 8-19

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.
 8-22

Monopoly Environment
• Single firm serves the “relevant market.”
• Most monopolies are “local” monopolies.
• The demand for the firm’s product is the
market demand curve.
• Firm has control over price.
– But the price charged affects the quantity
demanded of the monopolist’s product.
 8-23

“Natural” Sources of
Monopoly Power
• Economies of scale
• Economies of scope: economies of scope exist
when the total cost of producing two products
within the same firm is lower than when the
products are produced by separate firms.
• Cost complementarities: Exist when the
marginal cost of producing one output is
reduced when the output of another product is
increased.
 8-24

“Created” Sources of
Monopoly Power
• Patents and other legal barriers (like
licenses)
• Tying contracts
• Exclusive contracts
 8-25

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!
 8-26

A Monopolist’s Marginal Revenue

P
TR Unit elastic
100
Elastic
Unit elastic
60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
MR
Elastic Inelastic
 8-27
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
MC
$
Profit ATC

PM
ATC

QM Q
MR
 Why MR Curve is half of Demand Curve and Negatively Sloped?

An alternative explanation for why marginal revenue is less than price

for a monopolist is as follows. Suppose a monopolist sells one unit of
output at a price of $4 per unit, for a total revenue of $4. What happens
to revenue if the monopolist produces one more unit of output?
Revenue increases by less than $4. To see why, note that the
monopolist can sell one more unit of output only by lowering price,
say, from $4 to $3 per unit. But the price reduction necessary to sell
one more unit lowers the price received on the first unit from $4 to $3.
The total revenue associated with two units of output thus is $6. The
change in revenue due to producing one more unit is therefore $2,
which is less than the price charged for the product.
 8-29

Alternative Profit Computation

 = Total Revenue - Total Cost
 = P  Q − Total Cost
 P  Q − Total Cost
=
Q Q
 Total Cost
= P−
Q Q

= P − ATC
Q
 = (P − ATC )Q
 8-30
A Numerical Example
• Given estimates of
• P = 10 - 2Q
• C(Q) = 6 + 2Q
• Optimal output?
• MR = 10 - 2Q
• MC = 2
• 10 - 2Q = 2 (MR=MC)
• Q = 4 units
• Optimal price?
• P = 10 - (4) = $6
• Maximum profits?
• PQ - C(Q) = (6)(4) - (6 + 8) = $10
 8-31

Long Run Adjustments?

• None, unless the
source of
monopoly power is
eliminated.
 8-33

Why Government Dislikes

Monopoly?
• P > MC
– Too little output, at too high price.
• Deadweight loss of
monopoly.
 8-34

Deadweight Loss of Monopoly

Deadweight Loss MC
$
of Monopoly ATC

PM

D
MC

QM MR Q
 8-35

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.
 8-37

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.
 8-38
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.
 8-39

Marginal Revenue Like a Monopolist

P
TR Unit elastic
100
Elastic
Unit elastic
60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
MR
Elastic Inelastic
 8-40

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.
 Short-Run Monopolistic 8-41

Competition
MC
$
ATC
Profit

PM
ATC

QM Quantity of Brand X
MR
 8-42

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.
 8-43

Long-Run Monopolistic Competition

Long Run Equilibrium
(P = AC, so zero profits) MC
$
AC

P*

P1

Entry D

MR D1
Q1 Q* Quantity of Brand
MR1 X
 8-45

Monopolistic Competition
The Good (To Consumers)
– Product Variety
The Bad (To Society)
– P > MC
– Excess capacity
• Unexploited economies of
scale
The Unpleasant (To Managers)
– P = ATC > minimum of average
costs.
• Zero Profits (in the long
run)!
 8-46

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.
– 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.
– To maximize these profits, managers should advertise up to the
point where the incremental revenue from advertising equals the
incremental cost.
A EQ, A
=
R − EQ, P
 8-47

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.
 8-48

Marginal Cost
• C(Q) = 125 + 4Q2,
• So MC = 8Q.
• This is independent of market structure.
 8-49
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.
 8-50
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.
 8-52

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.