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Learning Objectives
 Define market power and describe measurement of
market power
 Explain why entry barriers are necessary for long run
market power and discuss major types of entry barriers
 Find the profit‐maximizing output, price, and input
usage for a monopolist and monopolistic competitor
 Employ empirically estimated or forecasted demand,
average variable cost, and marginal cost to calculate
profit‐maximizing output and price for monopolistic or
monopolistically competitive firms
 Select production levels at multiple plants to minimize
the total cost of producing a given total output for a firm
12-1
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)
12-2
Monopoly
 Single firm
 Produces & sells a good or service for
which there are no good substitutes
 New firms are prevented from entering
market because of a barrier to entry
12-3
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
12-4
Measurement of Market Power
 Lerner index measures proportionate amount
by which price exceeds marginal cost:
P  MC
Lerner index 
P
~ 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
12-5
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
12-6
Barriers to Entry
 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
12-7
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
 Essential input barriers
~ One firm controls a crucial input in the
production process
12-8
Common Entry Barriers
 Brand loyalties
~ Strong customer allegiance to existing firms
may keep new firms from finding enough
buyers to make entry worthwhile
 Consumer lock-in
~ Potential entrants can be deterred if they
believe high switching costs will keep them
from inducing many consumers to change
brands
12-9
Common Entry Barriers
 Network externalities
~ Occur when benefit or utility 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 base or
network of buyers
 Sunk costs
~ Entry costs (which are sunk costs) can serve
as a barrier if they are so high that the
manager cannot expect to earn enough future
profit to make entry worthwhile
12-10
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,
and is twice as steep
12-11
Demand & Marginal Revenue
for a Monopolist (Figure 12.1)
12-12
Short-Run Profit Maximization
for Monopoly
 Monopolist will produce where MR = SMC as
long as TR at least covers the firm’s total
avoidable cost (TR ≥ TVC)
~ Price for this output is given by the demand curve
 If TR < TVC (or, equivalently, P < AVC) the firm
shuts down & loses only fixed costs
 If P > ATC, firm makes economic profit
 If ATC > P > AVC, firm incurs a loss, but
continues to produce in short run
12-13
Short-Run Profit Maximization
for Monopoly (Figure 12.3)
12-14
Short-Run Loss Minimization
for Monopoly (Figure 12.4)
12-15
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 profit-maximizing output level
12-16
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
12-17
Monopoly Firm’s Demand for Labor
(Figure 12.6)
12-18
Profit-Maximizing Input Usage
 For a firm with market power, profitmaximizing 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
12-19
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
12-20
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
12-21
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)
12-22
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)
12-23
The Short-Run and Long-Run Equilibria for
Vegetable Oil
If the demand curve is D1,
in the short run…
…in the long run…
If the demand curve is D2,
in the short run
…in the long run…
12-24
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 1: Estimate demand equation
~ Use statistical techniques from Chapter 7
~ Substitute forecasts of demand-shifting
variables into estimated demand equation
to get
Q = a′ + bP
ˆ  dPˆ
Where a'  a  cM
R
12-25
How a Competitive Firm
Maximizes Profit
p, $ per ton
(a)
MC
10
AC
e
8
p = MR
= $426,000
Profit is maximized when
MR, which is the market
price, equals its MC
6.50
6
0
140
284
q, Thousand metric tons of lime per year
Cost, revenue, Thousand $
(b)
426
(q)
0
140
284
q, Thousand metric
tons of lime per year
–100
12-26
If a specific tax of t per ton of lime
produced is collected from only one
competitive firm, how should this firm
change its output level to maximize its
profit, and how does its maximum profit
change?
12-27
Answer
12-28
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 2: Find inverse demand equation
~ Solve for P
a' 1
P
 Q  A  BQ
b
b
a'
1
ˆ
ˆ
Where a'  a  cM  dPR , A 
, and B 
b
b
12-29
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  2BQ 
 Q
b
b
 Step 4: Estimate AVC & SMC
~ Use statistical techniques from Chapter 10
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2
12-30
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 profitmaximizing output level
 Step 6: Find profit-maximizing price
~ Substitute Q* into inverse demand
P* = A + BQ*
Q* & P* are only optimal if P  AVC
12-31
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
12-32
Implementing the Profit-Maximizing
Output & Pricing Decision
 Step 8: Compute profit or loss
~ Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
~ If P < AVC, firm shuts down & profit
is -TFC
12-33
Maximizing Profit at Aztec
Electronics: An Example
 Aztec possesses market power via
patents
 Sells advanced wireless stereo
headphones
12-34
Maximizing Profit at Aztec
Electronics: An Example
 Estimation of demand & marginal
revenue
Q  41,000  500 P  0.6M  22.5PR
 41, 000  500 P  0.6(45, 000)  22.5(800)
 50, 000  500 P
12-35
Maximizing Profit at Aztec
Electronics: An Example
 Solve for inverse demand  50, 000  500 P
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
12-36
Maximizing Profit at Aztec
Electronics: An Example
 Determine marginal revenue function
 100  0.002Q
P = 100 – 0.002Q
Hard Math – double the slope!
MR = 100 – 0.004Q
12-37
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)
12-38
Maximizing Profit at Aztec
Electronics: An Example
 Estimation of average variable cost and
marginal cost
~ Given the estimated AVC equation:
AVC = 28 – 0.005Q + 0.000001Q2
~ Then,
SMC = 28 – (2 x 0.005)Q + (3 x 0.000001)Q2
= 28 – 0.01Q + 0.000003Q2
AVC = a + bQ + cQ2
12-39
2
Maximizing Profit at Aztec
Electronics: An Example
 Output decision
~ Set MR = MC and solve for Q*
100 – 0.004Q = 28 – 0.01Q + 0.000003Q2
0 = (28 – 100) + (-0.01 + 0.004)Q + 0.000003Q2
= -72 – 0.006Q + 0.000003Q2
12-40
Maximizing Profit at Aztec
Electronics: An Example
 Output decision
~ Solve for Q* using the quadratic formula
(  0.006)  (  0.006)  4(  72)(0.000003)
Q 
2(0.000003)
2
*
0.036

 6 , 000
0.000006
12-41
Maximizing Profit at Aztec
Electronics: An Example
 Pricing decision
~ Substitute Q* into inverse demand
P* = 100 – 0.002(6,000)
= $88
12-42
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 = ATC, Aztec should
produce rather than shut down
12-43
Maximizing Profit at Aztec
Electronics: An Example
 Computation of total profit
π = TR – TVC – TFC
= (P* x Q*) – (AVC* x Q*) – TFC
= ($88 x 6,000) – ($34 x 6,000) - $270,000
= $528,000 - $204,000 - $270,000
= $54,000
12-44
Profit Maximization at
Aztec Electronics (Figure 12.10)
12-45
Multiple Plants
 If a firm produces in 2 plants, A & B
~ Allocate production so MCA = MCB
~ Optimal total output is that for which MR =
MCT
 For profit-maximization, allocate total
output so that
MR = MCT = MCA = MCB
12-46
A Multiplant Firm
(Figure 12.11)
12-47
Summary
 Price-setting firms possess market power
~ A monopoly exists when a single firm produces and sells a
particular good or service for which there are no good substitutes
and new firms are prevented from entering the market
~ Monopolistic competition arises when the market consists of a
large number of relatively small firms that produce similar, but
slightly differentiated, products and have some market power
 A firm can possess a high degree of market power only
when strong barriers to the entry of new firms exist
 In the short run, the manager of a monopoly firm will
choose to produce where MR = SMC, rather than shut
down, as long as total revenue at least covers the
firm’s total variable cost (TR ≥ TVC)
12-48
Summary
 In the long run, the monopolist maximizes profit by
choosing to produce where MR = LMC, unless price is
less than long-run average cost (P < LAC), in which
case the firm exits the industry
 For firms with market power, marginal revenue product
(MRP) is equal to marginal revenue times marginal
product: MRP = MR × MP
 Whether the manager chooses Q or L to maximize
profit, the resulting levels of input usage, output, price,
and profit are the same
 Short-run equilibrium under monopolistic competition is
exactly the same as for monopoly
12-49
Summary
 Long-run equilibrium in a monopolistically competitive
market is attained when the demand curve for each
producer is tangent to the long-run average cost curve
~ Unrestricted entry and exit lead to this equilibrium
 8 steps can be employed for profit-maximization for a
monopoly or monopolistically competitive firm:
(1) estimate demand equation, (2) find inverse demand
equation, (3) solve for marginal revenue, (4) estimate
average variable cost and marginal cost, (5) find output
level where MR = SMC, (6) find profit-maximizing price,
(7) check the shutdown rule, and (8) compute profit/loss
 A firm producing in two plants, A and B, should allocate
production between the two plants so that MCA = MCB 12-50