Managerial Decisions For Firms With Market Power: Essential Concepts

Chapter 12:
MANAGERIAL DECISIONS FOR FIRMS WITH MARKET POWER

Essential Concepts
1. Market power is the ability of a firm to raise price without losing all its sales. Any firm that faces a
downward sloping demand curve has market power. Market power gives the firm the ability to raise
price above average cost and earn economic profit, if demand and cost conditions so permit.
2. 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.
3. The degree to which a firm possesses market power is inversely related to the price elasticity of
demand. The less (more) elastic the firm’s demand, the greater (less) its degree of market power. The
fewer the number of close substitutes consumers can find for a firm’s product, the smaller the
elasticity of demand (in absolute value), and the greater the firm’s market power. When demand is
perfectly elastic (demand is horizontal), the firm possesses no market power.
4. The Lerner index measures the proportionate amount by which price exceeds marginal cost:
Under perfect competition, the index is equal to zero, and the index increases in magnitude as market
power increases.
5. When consumers view two goods to be substitutes, the cross-price elasticity of demand (EXY) is
positive. The higher the (positive) cross-price elasticity, the greater the substitutability between two
goods, and the smaller the degree of market power possessed by the two firms.
6. A firm can possess a high degree of market power only when strong barriers to the entry of new firms
exist. Six common types of entry barriers are:
a. Economies of scale. When long-run average cost declines over a wide range of output relative to
the demand for the product, there may not be room in the market for another large producer to
enter the market—at least not without driving price below unit costs making it unprofitable to
enter.
b. Barriers created by government. Government barriers to entry, such as licenses and exclusive
franchises, have been created in many industries. Patent laws also can, but need not, create strong
barriers to entry.
c. Essential input barriers. When one firm controls a crucial input in the production process, that
firm can obviously block entry.
d. Brand loyalties. Over time, firms may develop such strong customer allegiance that new firms
cannot find enough buyers at a price that covers cost to make entry worthwhile.
e. Consumer lock-in. For some products or services, consumers may find it costly to switch to
another brand, which makes previous consumption decisions costly to change. Potential rivals
can be deterred from entering if they believe high switching costs will make it difficult for them
to induce many consumers to change brands.
f. Network externalities. Network externalities arise when the benefit or utility a consumer derives
from consuming a good is greater the larger the total number of other consumers who buy and use
the good. Thus, network externalities make it very difficult for new firms to enter markets where
incumbent firms have established a large base or network of buyers.
Chapter 12: Managerial Decisions for Firms with Market Power
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7. In the short run, the manager of a monopoly firm will choose to produce the output where MR =
SMC, rather than shut down, as long as total revenue at least covers the firm’s total avoidable cost,
which is the firm’s total variable cost (TR  TVC). The price for that output is given by the demand
curve. If total revenue cannot cover total avoidable cost, that is, if total revenue is less than total
variable cost (or, equivalently, P < AVC), the manager will shut down and produce nothing, losing an
amount equal to total fixed cost.
8. In the long run, the manager of a monopoly firm maximizes profit by choosing to produce the level of
output where marginal revenue equals long-run marginal cost (MR = LMC), unless price is less than
long-run average cost (P < LAC), in which case the firm exits the industry. In the long run, the
manager will adjust plant size to the optimal level, that is, the optimal plant is the one with the short-
run average cost curve tangent to the long-run average cost at the profit-maximizing output level.
9. Marginal revenue product (MRP) is the additional revenue attributable to hiring one additional unit of
the input: MRP = ∆TR/∆L. MRP is also equal to marginal revenue times marginal product: MRP =
MR × MP.
10. When producing with a single variable input, a firm with market power will maximize profit by
employing that amount of the input for which marginal revenue product (MRP) equals the price of the
input when input price is given. The relevant range of the MRP curve is the downward sloping,
positive portion of MRP for which ARP > MRP.
11. For a firm with market power, the profit-maximizing condition that the marginal revenue product of
the variable input must equal the price of the input (MRP = w) is equivalent to the profit-maximizing
condition that marginal revenue must equal marginal cost (MR = MC). Thus, regardless of whether
the manager chooses Q or L to maximize profit, the resulting levels of input usage, output, price and
profit are the same in either case.
12. Under monopolistic competition, a large number of firms sell a differentiated product. The market is
monopolistic in that product differentiation creates a degree of market power. It is competitive
because of the large number of firms and easy entry.
13. Short-run equilibrium under monopolistic competition is exactly the same as it is for monopoly.
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. At the equilibrium output, price equals long-run average cost, and marginal revenue
equals long-run marginal cost.
14. Making profit-maximizing pricing and output decisions for firms with market power can be
summarized in the following steps:
Step 1: Estimate the demand equation. Estimate demand for a price-setting firm using the OLS
regression procedure, as set forth in Chapter 7.
Step 2: Find the inverse demand equation. The inverse demand function is derived by solving for P in
the estimated demand equation:
where a' = a + c +d , , and B = 1/b.

Step 3: Solve for marginal revenue. Marginal revenue is

Step 4: Estimate average variable cost (AVC) and short-run marginal cost (SMC). Estimate AVC and
SMC functions, as set forth in Chapter 10:
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2
Step 5: Find the output level where MR = SMC. To find the optimal level of output, the manager sets
marginal revenue equal to marginal cost and solves for Q. The larger of the two roots or solutions is
the profit-maximizing level of output—unless P (found in Step 6) is less than AVC, and then the
optimal level of output is zero.
Step 6: Find the profit-maximizing price. Once the optimal quantity, Q*, has been found, the profit-
maximizing price is found by substituting Q* into the inverse demand equation to obtain the optimal
price, P*:
Step 7: Check the shutdown rule. The manager can calculate the average variable cost at Q* units by
substituting Q* into the estimated AVC function
AVC* = a + bQ* + cQ*2
If P* AVC*, then the firm produces Q* units of output and sells each unit for P*. If P* < AVC*, the
monopolist shuts down in the short run.
Step 8: Compute profit or loss. To compute profit or loss, the manager makes the same calculation
regardless of whether the firm operates in a monopoly, oligopoly, or perfectly competitive market
Profit = TR – TC = (P × Q) – (AVC × Q) – TFC
If P < AVC, the firm shuts down, and profit is –TFC.
15. If a firm produces in two plants, A and B, it should allocate production between the two plants so that
. The optimal total output for the firm is that output for which . Hence, for
profit maximization, the firm should produce the level of total output and allocate this total output
between the two plants so that
Answers to Applied Problems
1. a. Yes, MTA is a the only supplier of bridge and tunnel crossings in metropolitan New York City,
and there are no good substitutes for bridges and tunnels. MTA probably possesses a high degree
of market power because of the lack of good substitutes.
b. When MC is zero for each vehicle, the MC curve will be horizontal line coinciding with the
horizontal (quantity) axis. Therefore, tolls should be set where MR = MC = 0. This also happens
to be the same toll that maximizes total revenue, i.e., the price where demand is unit elastic (MR
= 0). For MTA, maximizing profit is the same as maximizing toll revenue because all costs of
vehicle crossing are fixed.
c. Treat the MTA as a monopolist for analytical purposes. When demand decreases, the optimal
number of vehicle crossings and the optimal toll charge both decrease. The decrease in demand
causes MR to reach zero at a smaller output, which, when demand is lower, corresponds to a
lower optimal price.

2. a. A monopolist, although the only supplier in the market, still faces the constraint of market
demand. Suppose that a monopolist is suffering losses even though it is charging the price
associated with the level of output at which MR = SMC. If the firm raises price, even larger
losses will be incurred. A monopoly market structure is no guarantee that a firm can earn
economic profits.
b. Market power could be measured by estimating the elasticity of demand. The less elastic is
demand, the greater the market power. It would also be useful to estimate the cross-price
elasticity of demand of QuadPlex Cinema with the Cedar Bluff Twin. The larger the (positive)
cross price elasticity, the more substitutable the two theaters and the smaller the degree of market
power.
c. If there are economies of scale, QuadPlex could increase its scale of operation. QuadPlex might
lobby the local government for ordinances which prevent any new theaters from opening.
QuadPlex should also try advertising as a means of creating brand loyalty. If all fails it might go
out of business in the long run.
3. a. See spreadsheet columns (1) through (6) in the spreadsheet below.

b. P* = $0.70 and Q* = 5,000
c. TR is maximized at Q = 9,000, which, as expected, is not the same level of output that maximizes
profit because MR = MC does not occur at the same point that maximizes TR (i.e., MR = 0).
d. See columns (7) and (8). Profit margin or profit per unit is maximized at 3,000 units, but total
profit is maximized at 5,000 units (the last or highest level of output for which MR > MC).
e. When TFC increases from $2,000 to $5,000, profit falls by $3,000 at every Q. Q* and P* remain
the same in the short run. TR still covers TVC. In the long run, Star should exit the industry if it
cannot restructure its cost to become profitable.
4. Tots-R-US should begin advertising immediately in order to enhance brand loyalty, which will
decrease elasticity of demand. Also the less elastic is demand, the greater the fall in price that results
when new firms enter. To the extent that potential entrants consider post-entry price, they will be less
likely to enter the more inelastic is demand.
5. One piece of evidence to support your firm's contention that the merger did not increase market
power would be showing that your firm's elasticity of demand either was unchanged by the merger, or
even got larger. By measuring own-price elasticity (E) before and after the merger, you may be able
to convince the FTC that consumers still have ample substitutes for your product post merger. You
may also wish to show that (post merger) there are "enough" other products that are close substitutes
to ensure a competitive market. This would involve presenting the FTC with evidence of large,
positive cross-price elasticities.
6. Significant economies of scale could force your bank out of business if your bank is a small- scale
bank and a large-scale bank, facing lower long-run average costs, lowers price (i.e., lowers interest
rates changed on loans and/or increases interest rates paid on deposits) below your bank’s average
cost (but greater than or equal to the large bank's LAC). If the demand for banking services in your
geographic market were not sufficient to allow your bank to expand its scale of operation in order to
take advantage of the economies of scale, then your bank would exit in the long run.
7. Possibly as a barrier to the entry of other firms into Harley-Davidson’s segment of the motorcycle
market. Also the name and the engine roar increase the brand loyalty of the firm’s customers.
8. Businesses know that once a customer goes through all the trouble of setting up electronic bill
payment, he or she is less likely to switch loyalties – 80 percent less likely in the banking industry,
according to Bank of America. So, this is an example of consumer lock-in, which increases market
power and profit.
9. In the absence of entry barriers, collusion among monopolistically competitive firms will not prevent
new firms from entering causing demand to decrease and become more elastic. The price will be the
same or higher with collusion but in the long run P = LAC.
10. a. Q = 112,000 – 500P + 5M = 112,000 – 500P + 5(20,000) = 212,000 – 500P; P = 424 – 0.002Q;
MR = 424 – 0.004Q ; SMC = 200 – 0.024Q + 0.000006Q2;
Set SMC = MR: 200 – 0.024Q + 0.000006Q2 = 424 – 0.004Q;
Solve: 0.000006Q2 – 0.02Q – 224 = 0, for Q* to find that

b. P* = 424 – 0.002(8,000) = $408
c. TR = $408(8,000) = $3,264,000:
AVC = 200 –0.012(8,000) + 0.000002(8,000)2 = $232;
TVC = $232(8,000) = $1,856,000; π = TR – TVC – TFC = $3,264,000 – $1,856,000 – $100,000 =
$1,308,000
d. Q = 112,000 – 500P + 5(30,000) = 262,000 – 500P;
P = 524 – 0.002Q; MR = 524 – 0.004Q; MC = MR:
200 – 0.024Q + 0.000006Q2 = 524 – 0.004Q and solve 0.000006Q2 – 0.02Q – 324 = 0 for
P* = 524 – 0.002(9,202) = $506.

AVC = 200 – 0.012(9,202) + 0.000002(9,202)2 = $258.93.
TR = $506(9,202) = $4,656,212; TVC = $258.93(9,202) = $2,382,675; π = TR –TVC – TFC =
$4,656,212 – $2,382,674 – $100,000 = $2,173,538.
11. a. P = 2,400 – 5Q
b. MR = 2,400 – 10Q
c. Must set MR = SMC. SMC = 6Q2 – 30Q + 400
2,400 – 10Q = 6Q2 – 30Q + 400  6Q2 – 20Q – 2,000 = 0
Q* = 20
d. P* = 2,400 – 5(20) = $2,300
e. π = TR – TVC – TFC
= (2,300)(20) – (900)(20) – 8,000
= 46,000 – 18,000 – 8,000
= $20,000
12. a. The firm is not maximizing profit. At the current allocation between the two factories, the last
unit produced in Michigan added more to total cost ($5) than the last unit produced in Texas ($3).
By switching one unit of output from the Michigan factory to Texas, total revenue will be
unchanged, total cost will decrease $2, and thus profit will increase $2. The firm should continue
to switch output from Michigan to Texas until the factories' marginal costs are equal.
b. By switching one unit of output from the Texas factory to Michigan, total revenue will be
unchanged, total cost will increase $2, and thus profit will decrease $2.
13. First, the pursuit of market share ignores the MR = MC rule for pricing. Lowering prices of soft
drinks solely for the purpose of increasing sales and market share will result in prices set close to
average cost, rather than close to marginal cost. Buying market share will likely reduce profits in the
soft drink category. Second, Coke’s plan to cross-subsidize low prices for soft drinks with high
prices for fruit drinks and sport drinks will result in prices that are too high to maximize profit in
these other two categories, which adds to the “financial cost” of “winning” market share. The only
scenarios in which this pricing tactic might be optimal would arise if soft drink buyers experience
network externalities –i.e., each consumer gets more utility from drinking a Coke soft drink the larger
the number of other consumers who choose to drink Coke soft drinks – and/or if consumer lock-in
makes it costly to switch brans. Such “bandwagon effects” and lock-in seem farfetched in soft drinks.
14. First, the claim that hedging by Southwest alone will drive down airfares on all airlines is likely to be
false. Southwest will make output and pricing decisions using the spot price of jet fuel (as will all
other airlines), and thus the success or failure of their hedges will have no impact on the price
Southwest charges passengers or the number of flights. Second, the decision to charge baggage fees
equal to zero is going to have the same affect on profit no matter what happens to Southwest’s fuel
hedges. In other words, the marginal cost of transporting bags depends only on the spot price of jet
fuel, not the hedged price.
15. Amtrak’s plan to raise ticket prices will only lead to higher total revenue if demand is inelastic at the
present price levels. If demand is indeed elastic, then raising price will not only raise total revenue,
the higher prices will also decrease ridership and total costs will fall. However, the impact on total
costs for Amtrak are likely to be rather small since most of Amtrak’s costs are quasi-fixed costs that
will not be reduced by carrying few passengers. Thus, it will be critical for the higher prices to
impact revenues in a substantial way.
16. The graph below shows that when demand shifts leftward to D’, the new profit-maximizing price will
always be lower than the profit-maximizing price before demand decreased. While this result is not
at all surprising to students of managerial economics, real-world managers sometimes have
trouble with this idea.


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Chapter 12:

MANAGERIAL DECISIONS FOR FIRMS WITH MARKET POWER

where a' = a + c +d , , and B = 1/b.

Chapter 12: Managerial Decisions for Firms with Market Power

Answers to Applied Problems

Chapter 12: Managerial Decisions for Firms with Market Power

3. a. See spreadsheet columns (1) through (6) in the spreadsheet below.

Solve: 0.000006Q2 – 0.02Q – 224 = 0, for Q* to find that

P* = 524 – 0.002(9,202) = $506.

Chapter 12: Managerial Decisions for Firms with Market Power

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