BEC 30325

Managerial Economics

Managerial Decisions for Firms

with Market Power
 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)
 Monopoly
• Single firm
• Produces & sells a good or service for which
there are no close substitutes
• New firms are prevented from entering
market because of a barrier to entry
 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
 Measurement of Market Power
• Lerner index measures proportionate amount by
which price exceeds marginal cost:
– 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

P  MC
Lerner index 
P
 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
 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
 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
 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
 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
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
Demand & Marginal Revenue for a Monopolist
 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
Short-Run Profit Maximization for Monopoly
Short-Run Loss Minimization for Monopoly
 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
Long-Run Profit Maximization for Monopoly
 Profit-Maximizing Input Usage
• Profit-maximizing level of input usage
produces exactly that level of output that
maximizes profit
 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
Monopoly Firm’s Demand for Labor
Profit-Maximizing Input Usage
• For a firm with market power, profit-
maximizing 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
 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
 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
Short-Run Profit Maximization for Monopolistic Competition
Long-Run Profit Maximization for Monopolistic Competition
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
Implementing the Profit-Maximizing Output & Pricing Decision

• Step 2: Find inverse demand equation

– Solve for P

 a' 1
P  Q  A  BQ
b b
ˆ ˆ  a' 1
Where a'  a  cM  dPR , A  , and B 
b b
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  2 BQ   Q
b b

• Step 4: Estimate AVC & SMC

• Use statistical techniques from Chapter 10
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2
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 profit-
maximizing output level
• Step 6: Find profit-maximizing price
– Substitute Q* into inverse demand
P* = A + BQ*

Q* & P* are only optimal if P  AVC

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
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

 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
A Multiplant Firm