Download Chapter 3: Supply and Demand - Vancouver Island University

Managing in
Competitive,
Monopolistic, and
Monopolistically
Competitive Markets
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 P=MC rule leads firms to
the optimal level of production.
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 MR=MC rule helps
a monopoly to determine the optimal level
of price and output.
• Explain the relationship between the
MR=MC rule and the P=MC rule.
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
Porter’s model of competition
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
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
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
4. Oligopoly (market power based on
product differentiation and/or the firm’s
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
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?
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.
• 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 firm’s 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.
Setting Price
$
$
S
Pe
Df
D
QM
Market
Firm
Qf
Profit-Maximizing Output
Decision
• MR = MC.
• Since, MR = P,
• Set P = MC to maximize profits.
Graphically: Representative
Firm’s Output Decision
Profit = (Pe - ATC)  Qf*
MC
$
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
• 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.
Should this Firm Sustain Short Run
Losses or Shut Down?
Profit = (Pe - ATC)  Qf* < 0
ATC
MC
$
AVC
ATC
Pe
Loss
Pe = Df = MR
Qf*
Qf
Shutdown Decision Rule
• A profit-maximizing firm should
continue to operate (sustain shortrun 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.
• 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.
• 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.
Firm’s Short-Run Supply Curve:
MC Above Min AVC
ATC
MC
$
AVC
P min AVC
Qf*
Qf
Short-Run Market Supply Curve
• The market supply curve is the summation
of each individual firm’s supply at each
price.
P
Firm 1
Market
Firm 2
P
P
S1
S2
SM
15
5
10
18
Q
20
25
Q
30
43Q
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.
Effect of Entry on Price?
$
$
S
Entry
S*
Pe
Pe*
Df
Df*
D
QM
Market
Firm
Qf
Effect of Entry on the Firm’s
Output and Profits?
MC
$
AC
Pe
Df
Pe*
Df*
QL Qf*
Q
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 firm’s product
shifts down.
• Firm reduces output to maximize
profit.
• Long run profits are zero.
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.
• 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.
• 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.
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.
“Natural” Sources of
Monopoly Power
• Economies of scale
• Economies of scope
• Cost complementarities
“Created” Sources of
Monopoly Power
• Patents and other legal barriers (like
licenses)
• Tying contracts
• Exclusive contracts
Contract...
• Collusion
I.
II.
III.
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!
A Monopolist’s Marginal Revenue
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
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Q
Useful Formulae
• What’s the MR if a firm faces a linear
demand curve for its product?
P  a  bQ
MR  a  2bQ, where b  0.
• Alternatively,
1  E 
MR  P 
 E 
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
Long Run Adjustments?
• None, unless the
source of
monopoly power
is eliminated.
Why Government Dislikes
Monopoly?
• P > MC
– Too little output, at too
high a price.
• Deadweight loss of
monopoly.
Deadweight Loss of
Monopoly
$
MC
Deadweight Loss
of Monopoly
ATC
PM
D
MC
QM
MR
Q
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.
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.
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.
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.
Competing in Imperfectly
Competitive 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
Marginal Revenue Like 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
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
Competition
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Quantity of Brand X
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.
Long-Run Monopolistic
Competition
Long Run Equilibrium
(P = AC, so zero profits)
$
MC
AC
P*
P1
Entry
MR
Q1 Q*
MR1
D
D1
Quantity of Brand
X
Monopolistic Competition
The
–
The
–
–
Good (To Consumers)
Product Variety
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)!
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.
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.
EQ , A
A

R  EQ , P
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
• C(Q) = 125 + 4Q2,
• 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.
• C(Q) = 125 + 4Q2 = 125 + 100 = $225.
• Revenues:
• PQ = (40)(5) = $200.
• Maximum profits of -$25.
• Implications: Expect exit in the longrun.
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.
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
HH   S i2
i 1
• n: number of firms in the industry
• Si: firm’s market share
• Unconcentrated markets have HH < 1,000
Pricing in an Oligopolistic Market:
Rivalry 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.
Pricing in an Oligopolistic Market:
Rivalry 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
• 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.
• 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
firm’s 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.