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Managerial Economics
eighth edition
Thomas
Maurice
Chapter 12
Managerial Decisions for
Firms with Market Power
McGraw-Hill/Irwin
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Managerial Economics
Market Power
• Ability of a firm to raise price
without losing all its sales
• Any firm that faces downward sloping
demand has market power
• Gives firm ability to raise price
above average cost & earn
economic profit (if demand & cost
conditions permit)
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Managerial Economics
Monopoly
• Single firm
• Produces & sells a particular good
or service for which there are no
good substitutes
• New firms are prevented from
entering market
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Managerial Economics
Measurement of Market Power
• Degree of market power inversely
related to price elasticity of demand
• The less elastic the firm’s demand, the
greater its degree of market power
• The fewer close substitutes for a firm’s
product, the smaller the elasticity of
demand (in absolute value) & the greater the
firm’s market power
• When demand is perfectly elastic (demand is
horizontal), the firm has no market power
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Managerial Economics
Measurement of Market Power
• Lerner index measures
proportionate amount by which
price exceeds marginal cost:
P  MC
Lerner index 
P
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Managerial Economics
Measurement of Market Power
• Lerner index
• Equals zero under perfect competition
• Increases as market power increases
• Also equals –1/E, which shows that the
index (& market power), vary inversely
with elasticity
• The lower the elasticity of demand
(absolute value), the greater the index
& the degree of market power
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Managerial Economics
Measurement of Market Power
• If consumers view two goods as
substitutes, cross-price elasticity
of demand (EXY) is positive
• The higher the positive cross-price
elasticity, the greater the
substitutability between two goods, &
the smaller the degree of market
power for the two firms
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Managerial Economics
Determinants of Market Power
• Entry of new firms into a market
erodes market power of existing
firms by increasing the number of
substitutes
• A firm can possess a high degree of
market power only when strong
barriers to entry exist
• Conditions that make it difficult for
new firms to enter a market in which
economic profits are being earned
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Managerial Economics
Common Entry Barriers
• Economies of scale
• When long-run average cost declines over
a wide range of output relative to
demand for the product, there may not
be room for another large producer to
enter market
• Barriers created by government
• Licenses, exclusive franchises
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Managerial Economics
Common Entry Barriers
• Input barriers
• One firm controls a crucial input in the
production process
• Brand loyalties
• Strong customer allegiance to existing
firms may keep new firms from finding
enough buyers to make entry worthwhile
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Managerial Economics
Common Entry Barriers
• Consumer lock-in
• Potential entrants can be deterred if
they believe high switching costs will
keep them from inducing many consumers
to change brands
• Network externalities
• Occur when value of a product increases
as more consumers buy & use it
• Make it difficult for new firms to enter
markets where firms have established a
large network of buyers
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Managerial Economics
Demand & Marginal Revenue for a
Monopolist
• Market demand curve is the firm’s demand
curve
• Monopolist must lower price to sell
additional units of output
• Marginal revenue is less than price for all but
the first unit sold
• When MR is positive (negative), demand is
elastic (inelastic)
• For linear demand, MR is also linear, has
the same vertical intercept as demand, & is
twice as steep
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Managerial Economics
Demand & Marginal Revenue for a
Monopolist (Figure 12.1)
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Managerial Economics
Short-Run Profit Maximization for
Monopoly
• Monopolist will produce a positive
output if some price on the demand
curve exceeds average variable cost
• Profit maximization or loss
minimization occurs by producing
quantity for which MR = MC
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Managerial Economics
Short-Run Profit Maximization for
Monopoly
• If P > ATC, firm makes economic
profit
• If ATC > P > AVC, firm incurs loss, but
continues to produce in short run
• If demand falls below AVC at every
level of output, firm shuts down &
loses only fixed costs
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Managerial Economics
Short-Run Profit Maximization for
Monopoly (Figure 12.3)
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Managerial Economics
Short-Run Loss Minimization for
Monopoly (Figure 12.4)
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Managerial Economics
Long-Run Profit Maximization for
Monopoly
• Monopolist maximizes profit by
choosing to produce output where
MR = LMC, as long as P  LAC
• Will exit industry if P < LAC
• Monopolist will adjust plant size to
the optimal level
• Optimal plant is where the short-run
average cost curve is tangent to the
long-run average cost at the profitmaximizing output level
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Managerial Economics
Long-Run Profit Maximization for
Monopoly (Figure 12.5)
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Managerial Economics
Profit-Maximizing Input Usage
• Profit-maximizing level of input
usage produces exactly that level
of output that maximizes profit
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Managerial Economics
Profit-Maximizing Input Usage
• Marginal revenue product (MRP)
• MRP is the additional revenue attributable to
hiring one more unit of the input
TR
MRP 
 MR  MP
L
• When producing with a single variable input:
• Employ amount of input for which MRP = input
price
• Relevant range of MRP curve is downward sloping,
positive portion, for which ARP > MRP
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Managerial Economics
Monopoly Firm’s Demand for
Labor (Figure 12.6)
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Managerial Economics
Profit-Maximizing Input Usage
• For a firm with market power,
profit-maximizing conditions MRP
= w and MR = MC are equivalent
• Whether Q or L is chosen to maximize
profit, resulting levels of input usage,
output, price, & profit are the same
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Managerial Economics
Monopolistic Competition
• Large number of firms sell a
differentiated product
• Products are close (not perfect)
substitutes
• Market is monopolistic
• Product differentiation creates a
degree of market power
• Market is competitive
• Large number of firms, easy entry
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Managerial Economics
Monopolistic Competition
• Short-run equilibrium is identical to
monopoly
• Unrestricted entry/exit leads to
long-run equilibrium
• Attained when demand curve for each
producer is tangent to LAC
• At equilibrium output, P = LAC and
MR = LMC
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Managerial Economics
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)
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Managerial Economics
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)
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Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 1: Estimate demand equation
• Use statistical techniques from
Chapter 7
• Substitute forecasts of demandshifting variables into estimated
demand equation to get
Q  a'  bP
ˆ  dPˆ
Where a'  a  cM
R
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Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 2: Find inverse demand
equation
• Solve for P
a' 1
P
 Q  A  BQ
b
b
1
ˆ
ˆ
Where a'  a  cM  dPR , A   a' b , and B 
b
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Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 3: Solve for marginal revenue
• When demand is expressed as
P = A + BQ, marginal revenue is
a' 2
MR  A  2 BQ 
 Q
b
b
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Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 4: Estimate AVC & SMC
• Use statistical techniques from
Chapter 10
AVC  a  bQ  cQ
2
SMC  a  2bQ  3cQ
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Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 5: Find output where MR = SMC
• Set equations equal & solve for Q*
• The larger of the two solutions is the
profit-maximizing output level
• Step 6: Find profit-maximizing price
• Substitute Q* into inverse demand
P* = A + BQ*
Q* & P* are only optimal if P  AVC
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Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 7: Check shutdown rule
• Substitute Q* into estimated AVC
function
AVC  a  bQ  cQ
*
*
*2
• If P*  AVC*, produce Q* units of
output & sell each unit for P*
• If P* < AVC*, shut down in short run
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Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 8: Compute profit or loss
• Profit = TR - TC
 P  Q*  AVC  Q*  TFC
 ( P  AVC )Q*  TFC
• If P < AVC, firm shuts down & profit
is -TFC
34
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Aztec possesses market power via
patents
• Sells advanced wireless stereo
headphones
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of demand & marginal
revenue
Q  41,000  500P  0.6M  22.5PR
 41, 000  500 P  0.6(45, 000)  22.5(800)
 50, 000  500P
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Solve for inverse demand
Q  50, 000  500 P
Q  50, 000 500 P

500
500
Q
50, 000

P
500
500
1
P  100 
Q
500
 100  0.002Q
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Determine marginal revenue
function
P  100  0.002Q
MR  100  0.004Q
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Managerial Economics
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of average variable cost
and marginal cost
• Given the estimated AVC equation:
AVC  28  0.005Q  0.000001Q
2
• So,
SMC  28  (2  0.005)Q  (3  0.000001)Q
 28  0.01Q  0.000003Q
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Output decision
• Set MR = MC and solve for Q*
100  0.004Q  28  0.01Q  0.000003Q
2
0  (28  100)  (0.01  0.004)Q  0.000003Q
 72  0.006Q  0.000003Q
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Output decision
• Solve for Q* using the quadratic
formula
(0.006)  (0.006)2  4(72)(0.000003)
Q* 
2(0.000003)
0.036
 6, 000

0.000006
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Pricing decision
• Substitute Q* into inverse demand
P*  100  0.002(6, 000)
 $88
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Shutdown decision
• Compute AVC at 6,000 units:
AVC*  28  0.005(6,000)  0.000001(6,000)2
 $34
Because P  $88  $34  AVC, Aztec should
produce rather than shut down
44
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Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Computation of total profit
  TR  TVC  TFC
 ( P * Q*)  ( AVC * Q*)  TFC
 ($88  6, 000)  ($34  6, 000)  $270, 000
 $528, 000  $204, 000  $270, 000
 $54, 000
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Managerial Economics
Profit Maximization at Aztec
Electronics (Figure 12.10)
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