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Chapter 12: Managerial Decisions
for Firms with Market Power
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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
12-8
Common Entry Barriers
• Essential 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
12-9
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 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
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, & 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
Long-Run Profit Maximization
for Monopoly (Figure 12.5)
12-17
Profit-Maximizing Input Usage
• Profit-maximizing level of input usage
produces exactly that level of output that
maximizes profit
12-18
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
12-19
Monopoly Firm’s Demand for Labor
(Figure 12.6)
12-20
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
12-21
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
12-22
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
12-23
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)
12-24
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)
12-25
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
12-26
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
12-27
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
12-28
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
12-29
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
12-30
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
12-31
Maximizing Profit at Aztec
Electronics: An Example
• Aztec possesses market power via
patents
• Sells advanced wireless stereo
headphones
12-32
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
12-33
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
12-34
Maximizing Profit at Aztec
Electronics: An Example
• Determine marginal revenue function
P = 100 – 0.002Q
MR = 100 – 0.004Q
12-35
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)
12-36
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
12-37
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
12-38
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
12-39
Maximizing Profit at Aztec
Electronics: An Example
• Pricing decision
• Substitute Q* into inverse demand
P* = 100 – 0.002(6,000)
= $88
12-40
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
12-41
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
12-42
Profit Maximization at
Aztec Electronics (Figure 12.10)
12-43
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
12-44
A Multiplant Firm
(Figure 12.11)
12-45