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Lecture 8: Market Structure and
Competitive Strategy
Managerial Economics
September 11, 2014
Focus of This Lecture
• Examine optimal price and output decisions of
managers operating in environments with different
types of market structures.
• Identify conditions for different types of market
structures.
• Identify sources of (and strategies for obtaining) market
power.
• Examine how long-run adjustments impact perfectly
competitive, monopoly, and monopolistically
competitive firms.
• Discuss ramifications of market structure on social
welfare.
Market Structure
• Market structure: Factors that affect managerial
decisions, including the number of firms competing in
a market, relative size of firms, technological and cost
considerations, demand conditions, and the ease with
which firms can enter or exit the industry.
• Major structural variables:
–
–
–
–
–
Firm size
Industry concentration
Technology
Demand and market conditions
Potential for entry
Four Basic Models of Market Structure
• Perfect competition
– Market is characterized by many firms, each of which is small relative to the
entire market. Firms have access to same technology and produce similar
products. Firm do not have market power, i.e. no individual firm has a
perceivable impact on the market price.
• Monopoly
– A firm (monopolist) is the sole producer of a good.
• Monopolistic competition
– Market is characterized by many firms as in perfect competition. However,
unlike in perfect competition, each firm produces a good that is slightly
different from products produced by other firms. Firms have some control
over price.
• Oligopoly
– A few large firms tend to dominate the market. When one firm in an
oligopolistic markets changes its price or output, it affects its own and other
firms’ profits. This interdependence of profits gives rise to strategic
interaction among firms.
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.
Perfect Competition Environment
• Many buyers and sellers, each of which is
“small” relative to the market.
• Each firm in the market produces a
homogeneous (identical) product.
• Perfect information on both sides of
market.
• No transaction costs.
• Free entry and exit from the market.
Key Implications
• Firms are “price takers”, i.e. no single firm can
control the price of the product.
• All firms charge the same price for the good, and
this price is determined by the interaction of buyers
and sellers.
• Free entry and exit implies that additional firms can
enter the market if economic profits are being
earned, and firms are free to leave the market if
they are sustaining losses.
– In the short-run, firms may earn profits or losses.
– Entry and exit forces long-run profits to zero.
Unrealistic? Why Learn?
• Many small businesses are “price-takers,” and decision
rules for such firms are similar to those of perfectly
competitive firms.
• In real world, a number of approximations of perfectly
competitive markets exists. Examples: large auction with
all potential buyers and sellers present, stock exchange,
street food, fish or vegetable market.
• It is a useful benchmark.
• Explains why governments oppose monopolies.
• Illuminates the “danger” to managers of competitive
environments.
– Importance of product differentiation.
– Sustainable advantage.
Demand at the market and firm level
(under perfect competition)
$
$
S
Df
Pe
D
Market
•
•
•
QM
Firm
Qf
Market price is outside of control of a single perfectly competitive firm.
From firm’s point of view, firm can sell as much as it wishes at price Pe, i.e.
demand curve is perfectly elastic (if firm charges a slightly higher price, it would
not sell anything).
Pricing decision of perfectly competitive firm is trivial: charge the price that every
other firm in the market charges.
Profit-maximizing output decision (for a
perfectly competitive firm)
• MR = MC.
• Since, MR = P,
• Set P = MC to maximize profits.
Graphically: Representative Firm’s
Output Decision
$
MC
Profit = (Pe - ATC) × Qf*
ATC
AVC
Pe = Df = MR
Pe
ATC
Qf*
Qf
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
Minimizing Losses
• We have seen the optimal level of output to
maximize profits. In some instances, short-
run losses are inevitable.
• We now analyze procedures for minimizing
losses in the short run.
• If losses are sustained in the long run, a firm
should exit the industry.
Should this Firm Sustain Short Run
Losses or Shut Down?
Profit = (Pe - ATC) × Qf* < 0
ATC
MC
$
AVC
ATC
Pe
•
•
Loss
Pe = Df = MR
Q
f*
Qf
Consider a situation with fixed costs. Suppose market price Pe lies below ATC
but above AVC.
Because Pe > AVC, firm should continue to produce in the short run even
though it is incurring losses. Not shutting down allows the firm to partially
recover fixed costs.
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.
• Short-run decision rule under perfect competition
to maximize profits:
– A firm should shutdown when P < min AVC.
– Continue operating as long as P ≥ min AVC.
• Thus a firm should always produce (i.e. a choose
positive output) in the range of increasing
marginal cost.
Firm’s Short-Run Supply Curve: MC
Above Min AVC
ATC
MC
$
AVC
P min AVC
Qf*
Qf
Long-Run Decisions
• With free entry and exit, if firms earn short-run profits, in the
long-run additional firms will enter to reap some of those
profits.
• As more firms enter industry, industry supply curve shifts to the
right  lowers equilibrium price  shifts down the demand
curve for an individual firm  lowers profits.
Long-run competitive equilibrium
• In the long-run with free entry and exit, market price adjusts such that
all firms in the market earn zero profits.
• At Pe each firms receives just enough to cover AC (recall that in the
long run there is no distinction between fixed and variable costs).
• Long-run competitive equilibrium:
1. P = MC
2. P = minimum of AC
Long-run properties of perfectly
competitive markets
• Two important welfare implications:
1.
P=MC
-
2.
Market price reflects the value of society of an additional value of output (recall that in
consumer optimum, P = marginal utility).
This valuation is based on preferences of all consumers in the market.
Marginal costs represent resources that would have to be taken from some other
sector of the economy to produce more output in this industry.
If P>MC, social welfare could be improved by expanding output.
Since P=MC in a competitive industry, the industry produces the socially efficient level
of output.
P=minimum of AC
-
Firms are earning zero profits (just covering their opportunity costs).
All economies of scale have been exhausted, there is not way to produce the output at
a lower average cost of production.
• Why do firms produce in the long run even though they earn zero
profits? Distinction between economic and accounting profits.
Monopoly
• Monopoly: a market structure in which a single firm
serves an entire market for a good that has no close
substitutes.
• Monopoly need not be a very large firm; relevant
consideration is whether there are other firms selling
close substitutes for the good in a given market.
• Market demand curve is demand curve for
monopolist’s product.
• In absence of legal restrictions, the monopolist is free
to charge any price; but is restricted by consumers to
choose only those price-quantity combinations along
the market demand curve.
Sources of Monopoly Power
• Economies of scale
• Economies of scope
– Exist when total cost of producing two products within the same firm
is lower than when the products are produced by separate firms.
– May lead to “larger” firms  may, for example, provide greater
access to capital markets  lower costs of capital may serve as
barrier for new (smaller) firms to enter.
• Cost complementarity
– Exist when MC of producing one output is reduced when the output
of another product is increased.
– Multiproduct firms that enjoy cost complementarities tend to have
lower MC than firms producing a single product.
• Patents and other legal barries
– Government may grant a firm a monopoly right, e.g., prevent
competition against local utility company.
– Patens gives inventor of a new product the exclusive right to sell
product for a given period of time.
Economies of scale and minimum prices
• For quantity QM consumers are
willing to pay PM.
• Single firm would make a
positive profit as PM > ATC(QM).
• Suppose a second firm enters
market and two firms share
market each producing QM/2.
• Each of the two firms would
make losses as PM < ATC(QM/2).
 Economies of scale can lead to
a situation where a single firm
services the entire market for a
good.
Marginal (MR) and Total Revenue (TR) for
a Monopolist
P
100
TR
Unit elastic
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
20
30
40
MR
Elastic
Inelastic
50
Q
Marginal Revenue of Monopolist
• Marginal revenue of a monopolist is given by:
MR = P (1+E)/E
(1)
where E is the elasticity of demand for the
monopolist’s product and P is the price charged
for the product.
• Derivation of (1)?
• Why is MR schedule below monopolist’s demand
curve?
Optimal Output Choice of a
Monopolist
• A profit-maximizing monopolist should produce
output, QM, such that marginal revenue equals
marginal cost:
MR(QM) = MC(QM)
(2)
If MR>MC, it is optimal to increase output as this
would increase revenues by more than it would
increase costs.
• Derivation of (2)?
• Graphically: Slope of revenue function equals slope of
cost function.
Profit Maximization under
Monopoly
MC
$
ATC
Profits = [PM-ATC(QM)] QM
PM
ATC
D
QM
MR
Quantity
Absence of a Supply Curve
• Recall that supply curve determines how much
will be produced at a given price.
• Perfectly competitive firms produce based on
P=MC.
• Monopolist produce based on marginal revenue,
which is less than price: P > MR=MC.
• As a consequence, there is no supply curve in
markets served by firms with market power.
A Monopolist Earning Zero Profits
• Presence of monopoly power does not imply
positive profits: it depends solely on where the
demand curve lies in relation to the ATC curve.
Social Cost of a Monopoly
• Price reflects the value of society of another unit of
output.
• MC reflects cost to society of the resources used to
produce an additional unit of output.
• P > MC:
– Monopolist produces less output than is socially desirable.
– Society would be willing to pay more for one unit of output
than it would cost to produce the unit.
– Monopolists refuses to do so because it would reduce the
firm’s profits.
• Given same demand and cost conditions, a perfectly
competitive market would produce where P = MC, i.e.
more output at a lower price.
Deadweight Loss of Monopoly
• Consumer and producer surplus that is lost due to
the monopolist charging a price in excess of
marginal cost.
Monopolistic Competition
• Market structure of monopolistic competition
exhibits some characteristics present in both
perfect competition and monopoly.
• 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.
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.
• Important difference in interpretation:
– Monopoly: demand curve is the market demand curve
– Monopolistic competition: demand for an individual firm’s
product.
• Market demand curve for monopolistically competitive
markets is not well defined as each firm produces a
product that differs slightly from other firms’ products.
Short-Run Monopolistic Competition
MC
$
ATC
Profit
PM
ATC
Demand for firm’s product
QMC
MR
Firm’s output
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 products for a firm
until profits are ultimately zero.
Long-Run Monopolistic Competition
$
Long-run equilibrium
(P = AC, so zero profits)
MC
AC
P*
P1
Entry
MR
Q1 Q*
MR
1
D
D1
Output
In the long run, monopolistically competitive firms produce a level of output such that:
1. P > MC
2. P = AC > minimum of average costs.
Monopolistic Competition
• The good (to consumers):
– Product Variety
• The bad (to society):
– P > MC
– Excess capacity
• Unexploited economies of scale
• The ugly (to managers):
– P = ATC > minimum of average costs.
• Zero profits in the long run.
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.
Marginal Cost
2
• C(Q) = 125 + 4Q ,
• So MC = 8Q.
• This is independent of market structure.
Price Taker
• MR = P = $40.
• Set MR = MC.
• 40 = 8Q.
• Q = 5 units.
• Cost of producing 5 units.
2
• C(Q) = 125 + 4Q = 125 + 100 = $225.
• Revenues:
• PQ = (40)(5) = $200.
• Maximum profits of -$25.
• Implications: Expect exit in the long-run.
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.
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.