MANAGERIAL ECONOMICS

Market Structure & Pricing

 Market
 A collection of buyers and sellers organized
for the purpose of exchanging goods and
services for money.

 Markets can be global, national, regional, or

local depending upon the item being bought
and sold.

 Markets can be Competitive or not!

 Pricing in Market
 Price of a commodity depends on the number
of buyers & sellers in the market
 With few exceptions, number of buyers is
larger than number of sellers
 Thus number of sellers determines the Nature
& Degree of Competition in the market
 Nature & Degree of Competition make
Structure of the market
 Pricing varies with the difference in Structure
of markets
Market Structure & Degree of Competition
The Higher the degree of Competition, the Lower the degree of
freedom in pricing decision & control over price of own product.

Market No. of Firms & Nature of Control over

Structure Degree of Product Industry Price
Differentiation
1. Perfect Large No. of Firms Financial Markets & None
Competition with Identical some Farm
products products
2. Imperfect Competition
a. Many Firms with real Manufacturing Some
Monopolistic or perceived product Firms
Competition differentiation
b. Little or no product Aluminum, cars, Some
Oligopoly differentiation steel

c. One single producer, Public Utilities Considerable

Monopoly without close but usually
substitute regulated
Perfectly Competitive Market
Perfectly Competitive Market
Perfect Competition in an industry means:
 Many firms sell identical products to many buyers
 No restrictions on entry into or exit from the industry
 Established firms have no advantage over new ones
 No transaction cost
 Sellers and buyers are well informed about prices
 No Government Intervention
 What really counts is each buyer and seller has insignificant
impact on price, Firms are basically “price takers” (P = MR)
 In the short-run, firms may earn economic profits/losses
 Long-run profits are zero
Firm’s Short-run Decisions
In the short-run, the firm must decide

Whether to produce or to shut down.

If the decision is to produce, what quantity to produce.

Using marginal analysis, a comparison is made between

a unit’s marginal revenue and marginal cost.
Marginal Revenue = Marginal Cost  Max. Econ. Profit

Marginal Revenue > Marginal Cost  Sell more

The extra revenue from selling one more unit exceeds the
extra cost, firm makes an economic profit.
Marginal Revenue < Marginal Cost  Decrease output
The extra revenue from selling one more unit is less than the
extra cost, firm incurs an economic loss.
 Firm’s Short-run Decisions
Profit-
maximization MC
30 Profit decreases
point
Revenue & Cost

25 MR=AR=D

20

Profit-maximizing
10 Can increase quantity
Profit

8 9 10
Quantity
Profits and Losses in the Short-Run
 If price equals 30
average total cost, Break-even
MC ATC
a firm breaks even. 25
point

Price
 If price exceeds
min. average total 20
P=AR = MR=D
cost, a firm makes
an economic profit. 15
Total cost =
Total revenue
 If price is less than
min. average total 8 10
cost, a firm incurs Quantity
an economic loss.
Profits and Losses in the Short-Run
Positive Profit Negative Profit
30 30
MC MC
ATC ATC
25 25
P > Min ATC
Price

20
20

17
P < Min ATC
15

7 10
9 10
Quantity Quantity
 A Numerical Example
Given estimates of
 P=Tk.10 is the going price
 C(Q) = 5 + Q2
 Optimal Price?
 P=Tk.10
 Optimal Output?
 MR = P = Tk.10 and MC = 2Q
 MR=MC
 10 = 2Q
 Q = 5 units
 Maximum Profits?
 PQ - C(Q) = (10)(5) - (5 + 25) = Tk.20
 What happens if you charge less? More?
 Firm’s Supply Curve
1. Price is Marginal Revenue
2. A firm chooses the quantity where,
Marginal Cost = Price
3. By definition a Supply Curve shows Quantity
Supplied at alternative Prices
4. Thus firm’s Marginal Cost curve is its Supply Curve
5. But Firms shut down if price falls below the
minimum of average variable cost
6. Thus firm’s supply curve is its marginal cost curve
ABOVE the point of minimum average variable
cost
 Firm’s Supply Curve
MC = S S

cost
Marginal revenue & marginal
cost
Marginal revenue & marginal

31 31

25 25
AVC

s
17 17
MR=AR
Revenue =
variable cost
7 9 10 7 9 10
Quantity Quantity
 Firm’s Long-run Decisions
 Whether to stay in the industry or leave it
(Entry/Exit Decision)
 Whether to increase or decrease plant size

Entry/Exit Decision
 The prospect of persistent profit or loss causes
firms to enter or exit an industry.
 If firms are making economic profits, other
firms get attracted to enter into the industry.
 If firms are making economic losses, some of
the existing firms exit the industry.
 Entry/Exit Decision
Entry: price falls and the
economic profit of each
existing firm decreases.
S1
Exit: price rises and the
economic loss of each
remaining firm decreases.
S2

23 Break-even
Break-even price 23 price

Price
20
20
17
17
D1 D1

6 7 8 9 10 6 7 8 9 10
Quantity Quantity
 Firm’s Long-run Decisions
Plant Size Adjustment & Long-Run Equilibrium
 All firms remaining in Tk. MC0
the industry move to SRAC0
output at the point of LRAC
MC1
Minimum Long-run SRAC1
Average Cost. PS

 Otherwise there would PL

be positive profit &
entry

 Long-run equilibrium 0
occurs when firms are QSR QLR Q
earning zero economic
profit (normal profit).
Summary: Managing a Competitive Firm

 Take prevailing price P as given

 Chose quantity to equate MC to P.
 Look for ways to lower cost

 Performance
 zero economic profit
Pure Monopoly Market
Pure Monopoly
 Monopoly is an industry that produces a good or service for
which no close substitute exists and in which there is one
supplier that is protected from competition by a barrier
preventing the entry of new firms.
 Single firm serves the “relevant market”
 Most monopolies are “local” monopolies
 The demand for the firm’s product is the market demand
 The key: demand is not very elastic, so Firm has some control
over price, of course, the price charged affects the quantity
demanded of the monopolist’s product
 How Monopoly arises
 No close substitute
 Barriers to entry
Natural Barriers
 Economies of scale
 Economies of scope
 Cost complementarities
Legal Barriers
 Public Franchise
 government license
 patent and copyright
 Tying contracts
 Exclusive contracts
Monopoly Price Setting Strategies
1. Single price means selling each unit of output for the same
price to all of its customers.
Produce where MR = MC., Charge Price on the Demand
curve that corresponds to that Quantity
Elasticity of Demand and Profit
Tk./Q The more elastic is Tk./Q
demand, the less the
markup.

MC
P* MC

P*
AR=D
P*-MC

MR

AR=D

MR

Q* Quantity Q* Quantity
A Numerical Example
Given estimates of
 P = 10 - Q
 C(Q) = 6 + 2Q
 Optimal output?
 MR = 10 - 2Q
 MC = 2
 MR=MC
 10 - 2Q = 2
 Q = 4 units
 Optimal price?
 P = 10 - (4) = Tk. 6
 Maximum profits?
 PQ - C(Q) = (6)(4) - (6 + 8) =Tk.10
Monopoly Price Setting Strategies
2. Price discrimination is charging different prices for a single
good because of differences in buyer’s willingness to pay and
not because of differences in production costs.

The difference between what a buyer Consumer Surplus

is willing to pay for the units of a good
which he buys, and the amount he P

actually pays, is called the buyer’s D

consumer surplus

To be able to price discriminate, a monopoly must:

Identify and separate different buyers type.
Sell a product that cannot be resold.
Different Types of Price Discrimination
 Charging a different price to every buyer.
Examples: Car sales

 Segmenting the Market. Examples: phone

companies with time-of-day pricing, retail
stores pricing by location.

 Price Discrimination Over Product-Life-

Cycle: introduce a product at a high price
and reduce the price over time.
 Monopoly Policy Issues
If it is so bad, why does it exists? Do we do
anything about it?
Yes, there are laws that actually limit monopoly
power and regulate the prices that monopolies
are permitted to charge, but monopoly also
brings some benefits:
Incentives to Innovation
 Innovations come faster with monopolies
Economies of Scale and Scope
 Where significant economies of scale or
scope exist, it is usually worth putting up with
the monopoly and regulating its prices.
Does a Monopoly always earn Economic Profit?

 Market power permits Monopolist to price above MC

 But, is the sky the limit?
 No, How much the Monopolist sell depends on the price he sets!
 At MR=MC,
 AR>AC, is Economic Profit
 AR=AC, is Normal Profit
 AR>AC, is loss (only theoretically possible)

Long Run Adjustments?

 None, unless the source of monopoly power is
eliminated.
Monopolistically Competitive
Market
Monopolistic Competition
 Implications of having a large number of firms:
Small market share
Ignore other firms
Collusion is impossible
 Product differentiation means Competing in:
 Quality
 Price: because of product differentiation, a firm in
monopolistic competition faces a downward-
sloping demand curve. (like monopoly!!)
 Marketing: convince that yours is better.
 Free entry and exit, implies that there are no
economic profits in the long run (incentives to go in
or out exist)
Short-run Profit Maximization
Maximize profits like a monopolist
Produce where MR = MC
Charge price on demand curve that corresponds to that quantity
The marginal revenue curve is derived in the same way
as in the single price monopolist case!
In the short run
 the firm behaves as a single price monopolist,
 it produces the quantity at which marginal revenue
equals marginal cost and then
 charges the highest price possible for this quantity.

Economic Profit and Economic Loss in the Short Run.

Short-run Profit Maximization
Long-run Profit Maximization
 Zero economic profits!!
 What is the adjustment process?
 In a true monopolistically competitive market, entry is free. Thus
other “greedy capitalists” enter, and their new brands steal
market share, this reduces the demand for your product until
profits are ultimately zero!
Managing a Monopolistically Competitive Firm
 Market power permits you to price above MC, just like a
monopolist.
 How much you sell depends on the price you set, just like a
monopolist. But …
 The presence of other brands in the market makes the
demand for your brand more elastic than if you were a
monopolist: You have limited market power.
 Strategies to Avoid (or Delay) Zero Profit Outcome
 Change; don’t let the long-run set in.
 Be the first to introduce new brands or to improve existing
products and services.
 Seek out sustainable niches (natural barriers)
 Create barriers to entry.
 Guard “trade secrets” and “strategic plans” to increase the
time it takes other firms to clone your brand.
Monopolistic Competition
 The Good (To Consumers)
 Product Variety

 The Bad (To Society)

 P > MC
 Excess capacity
 Unexploited economies of scale

 The Ugly (To Managers)

 Zero Profits
Maximizing Profits: A Synthesizing Example
 If 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 Tk. 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
 Example
 C(Q) = 125 + 4Q2, So MC = 8Q (This is independent of market
structure)
 Price Taker
 MR = P = Tk. 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 –Tk.25
 Implications: Expect exit in the long-run
 Example
 Monopoly/Monopolistic Competition
 MR = 100 - 2Q (since P = 100 – Q, so PQ= 100Q-Q 2)
 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
Oligopolistic Market:
A non-price competition
Oligopolistic Market
 Oligopolistic Market Structures
 Few number of firms
 Heterogeneous or Homogeneous Products
 Natural or legal barriers to entry
 Decisions depend on the decisions made by other firms
 Sources of Oligopoly
 Huge capital investment
 Economies of Scale
 Patent
 Control over certain raw materials
 Merger & Takeover
Example -- athletic shoe market
 Nike has 57% of market
 Reebok has 26%
 and Adidas has 17%
 Pricing Under Oligopoly
The current models
Kinked demand curve
model
d
If the firm raises its price,

Price
others will not follow. D

If it cuts its price, so will the D1

others. d1

Quantity
The kink in the Demand
curve causes a break in the
marginal revenue curve.
 Pricing Under Oligopoly
Dominant firm oligopoly
When one firm has a big cost advantage (the
dominant one) over the other firms and
produces a large part of the industry output.

 These models do not match what is happening out there,

so the new fashion in economics is the use of Game
theory to explain these type of markets.
 Game Theory
 It is used to analyze strategic behavior (behavior that takes in to
account the behavior of others and the mutual recognition of
interdependence).

 Game theory seeks to understand oligopoly as well as other forms of

economics, political, social and even biological rivalries.

 An Oligopoly Price-Fixing Game: “The Duopoly example”

 Collusive agreement: “Cartel”
 Prisoners’ dilemma
Strategies: Comply and Cheat
Actions: There are four of them
 If they collude
 If one firm cheats on a collusive agreement
 If both firms cheat
 If both firms cheat
 The Prisoner’s Dilemma
 Often the payoffs vary  Noncooperative Solution
depending on the  both confess: {C, C}
strategy choices  Cooperative Solution
 both do not confess {NC,NC}
 Prisoner’s Dilemma
 Two suspects are
caught & held suspect 2
separately
NC C
 Their strategies are either
to Confess (C) or Not 1 yr 0 yrs
Confess (NC) NC 1 yr 15 yrs
suspect 1
 a one period game 15 yrs 6 yrs
C
 Suspect 1 in lower 0 yrs 6 yrs
triangle (Bold Red)
 Paradox?
 The Prisoner’s Dilemma highlights the situation
where both parties would be best off it the
cooperated (both 1Year)

 But the logic of their situation ends up with a non-

cooperative solution(both 6Year)

 The solution to cooperation appears to be

transforming a one-period game into a multi-
period game.

 The actions you take now will then have

consequences in future periods.