Lecture 8: Market Structure and Competitive Strategy. Managerial Economics September 11, 2014

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1 Lecture 8: Market Structure and Competitive Strategy Managerial Economics September 11, 2014

2 Focus of This Lecture Examine optimal price and output decisions of managers operating in environments with different types of market structures. Identify conditions for different types of market structures. Identify sources of (and strategies for obtaining) market power. Examine how long-run adjustments impact perfectly competitive, monopoly, and monopolistically competitive firms. Discuss ramifications of market structure on social welfare.

3 Market Structure Market structure: Factors that affect managerial decisions, including the number of firms competing in a market, relative size of firms, technological and cost considerations, demand conditions, and the ease with which firms can enter or exit the industry. Major structural variables: Firm size Industry concentration Technology Demand and market conditions Potential for entry

4 Four Basic Models of Market Structure Perfect competition Market is characterized by many firms, each of which is small relative to the entire market. Firms have access to same technology and produce similar products. Firm do not have market power, i.e. no individual firm has a perceivable impact on the market price. Monopoly A firm (monopolist) is the sole producer of a good. Monopolistic competition Market is characterized by many firms as in perfect competition. However, unlike in perfect competition, each firm produces a good that is slightly different from products produced by other firms. Firms have some control over price. Oligopoly A few large firms tend to dominate the market. When one firm in an oligopolistic markets changes its price or output, it affects its own and other firms profits. This interdependence of profits gives rise to strategic interaction among firms.

5 Overview I. Perfect Competition Characteristics and profit outlook. Effect of new entrants. II. Monopolies Sources of monopoly power. Maximizing monopoly profits. Pros and cons. III. Monopolistic Competition Profit maximization. Long run equilibrium.

6 Perfect Competition Environment Many buyers and sellers, each of which is small relative to the market. Each firm in the market produces a homogeneous (identical) product. Perfect information on both sides of market. No transaction costs. Free entry and exit from the market.

7 Key Implications Firms are price takers, i.e. no single firm can control the price of the product. All firms charge the same price for the good, and this price is determined by the interaction of buyers and sellers. Free entry and exit implies that additional firms can enter the market if economic profits are being earned, and firms are free to leave the market if they are sustaining losses. In the short-run, firms may earn profits or losses. Entry and exit forces long-run profits to zero.

8 Unrealistic? Why Learn? Many small businesses are price-takers, and decision rules for such firms are similar to those of perfectly competitive firms. In real world, a number of approximations of perfectly competitive markets exists. Examples: large auction with all potential buyers and sellers present, stock exchange, street food, fish or vegetable market. It is a useful benchmark. Explains why governments oppose monopolies. Illuminates the danger to managers of competitive environments. Importance of product differentiation. Sustainable advantage.

9 Demand at the market and firm level $ (under perfect competition) $ S P e D f D Market Q M Firm Q f Market price is outside of control of a single perfectly competitive firm. From firm s point of view, firm can sell as much as it wishes at price P e, i.e. demand curve is perfectly elastic (if firm charges a slightly higher price, it would not sell anything). Pricing decision of perfectly competitive firm is trivial: charge the price that every other firm in the market charges.

10 Profit-maximizing output decision (for a perfectly competitive firm) MR = MC. Since, MR = P, Set P = MC to maximize profits.

11 Graphically: Representative Firm s Output Decision $ Profit = (P e - ATC) Q f* MC ATC P e AVC P e = D f = MR ATC Q f* Q f

12 Given A Numerical Example P=10 C(Q) = 5 + Q 2 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

13 Minimizing Losses We have seen the optimal level of output to maximize profits. In some instances, shortrun losses are inevitable. We now analyze procedures for minimizing losses in the short run. If losses are sustained in the long run, a firm should exit the industry.

14 Should this Firm Sustain Short Run $ Losses or Shut Down? Profit = (P e - ATC) Q f* < 0 MC AVC ATC ATC P e Loss P e = D f = MR Consider a situation with fixed costs. Suppose market price P e lies below ATC but above AVC. Q f* Because P e > AVC, firm should continue to produce in the short run even though it is incurring losses. Not shutting down allows the firm to partially recover fixed costs. Q f

15 Shutdown Decision Rule A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs. Operating results in a smaller loss than ceasing operations. Short-run decision rule under perfect competition to maximize profits: A firm should shutdown when P < min AVC. Continue operating as long as P min AVC. Thus a firm should always produce (i.e. a choose positive output) in the range of increasing marginal cost.

16 Firm s Short-Run Supply Curve: MC Above Min AVC $ MC AVC ATC P min AVC Q f* Q f

17 Long-Run Decisions With free entry and exit, if firms earn short-run profits, in the long-run additional firms will enter to reap some of those profits. As more firms enter industry, industry supply curve shifts to the right lowers equilibrium price shifts down the demand curve for an individual firm lowers profits.

18 Long-run competitive equilibrium In the long-run with free entry and exit, market price adjusts such that all firms in the market earn zero profits. At P e each firms receives just enough to cover AC (recall that in the long run there is no distinction between fixed and variable costs). Long-run competitive equilibrium: 1. P = MC 2. P = minimum of AC

19 Long-run properties of perfectly competitive markets Two important welfare implications: 1. P=MC - Market price reflects the value of society of an additional value of output (recall that in consumer optimum, P = marginal utility). - This valuation is based on preferences of all consumers in the market. - Marginal costs represent resources that would have to be taken from some other sector of the economy to produce more output in this industry. - If P>MC, social welfare could be improved by expanding output. - Since P=MC in a competitive industry, the industry produces the socially efficient level of output. 2. P=minimum of AC - Firms are earning zero profits (just covering their opportunity costs). - All economies of scale have been exhausted, there is not way to produce the output at a lower average cost of production. Why do firms produce in the long run even though they earn zero profits? Distinction between economic and accounting profits.

20 Monopoly Monopoly: a market structure in which a single firm serves an entire market for a good that has no close substitutes. Monopoly need not be a very large firm; relevant consideration is whether there are other firms selling close substitutes for the good in a given market. Market demand curve is demand curve for monopolist s product. In absence of legal restrictions, the monopolist is free to charge any price; but is restricted by consumers to choose only those price-quantity combinations along the market demand curve.

21 Sources of Monopoly Power Economies of scale Economies of scope Exist when total cost of producing two products within the same firm is lower than when the products are produced by separate firms. May lead to larger firms may, for example, provide greater access to capital markets lower costs of capital may serve as barrier for new (smaller) firms to enter. Cost complementarity Exist when MC of producing one output is reduced when the output of another product is increased. Multiproduct firms that enjoy cost complementarities tend to have lower MC than firms producing a single product. Patents and other legal barries Government may grant a firm a monopoly right, e.g., prevent competition against local utility company. Patens gives inventor of a new product the exclusive right to sell product for a given period of time.

22 Economies of scale and minimum prices For quantity Q M consumers are willing to pay P M. Single firm would make a positive profit as P M > ATC(Q M ). Suppose a second firm enters market and two firms share market each producing Q M /2. Each of the two firms would make losses as P M < ATC(Q M /2). Economies of scale can lead to a situation where a single firm services the entire market for a good.

23 Marginal (MR) and Total Revenue (TR) for a Monopolist P 100 Elastic TR Unit elastic Unit elastic Inelastic Q Q MR Elastic Inelastic

24 Marginal Revenue of Monopolist Marginal revenue of a monopolist is given by: MR = P (1+E)/E (1) where E is the elasticity of demand for the monopolist s product and P is the price charged for the product. Derivation of (1)? Why is MR schedule below monopolist s demand curve?

25 Optimal Output Choice of a Monopolist A profit-maximizing monopolist should produce output, Q M, such that marginal revenue equals marginal cost: MR(Q M ) = MC(Q M ) (2) If MR>MC, it is optimal to increase output as this would increase revenues by more than it would increase costs. Derivation of (2)? Graphically: Slope of revenue function equals slope of cost function.

26 Profit Maximization under Monopoly $ Profits = [P M -ATC(Q M )] Q M MC ATC P M ATC D Q M MR Quantity

27 Absence of a Supply Curve Recall that supply curve determines how much will be produced at a given price. Perfectly competitive firms produce based on P=MC. Monopolist produce based on marginal revenue, which is less than price: P > MR=MC. As a consequence, there is no supply curve in markets served by firms with market power.

28 A Monopolist Earning Zero Profits Presence of monopoly power does not imply positive profits: it depends solely on where the demand curve lies in relation to the ATC curve.

29 Social Cost of a Monopoly Price reflects the value of society of another unit of output. MC reflects cost to society of the resources used to produce an additional unit of output. P > MC: Monopolist produces less output than is socially desirable. Society would be willing to pay more for one unit of output than it would cost to produce the unit. Monopolists refuses to do so because it would reduce the firm s profits. Given same demand and cost conditions, a perfectly competitive market would produce where P = MC, i.e. more output at a lower price.

30 Deadweight Loss of Monopoly Consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost.

31 Monopolistic Competition Market structure of monopolistic competition exhibits some characteristics present in both perfect competition and monopoly. 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.

32 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. Important difference in interpretation: Monopoly: demand curve is the market demand curve Monopolistic competition: demand for an individual firm s product. Market demand curve for monopolistically competitive markets is not well defined as each firm produces a product that differs slightly from other firms products.

33 Short-Run Monopolistic Competition $ Profit MC ATC P M ATC Demand for firm s product Q MC MR Firm s output

34 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 products for a firm until profits are ultimately zero.

35 Long-Run Monopolistic Competition $ Long-run equilibrium (P = AC, so zero profits) MC AC P* P 1 Entry D MR D 1 Q 1 Q* MR 1 Output In the long run, monopolistically competitive firms produce a level of output such that: 1. P > MC 2. P = AC > minimum of average costs.

36 Monopolistic Competition The good (to consumers): Product Variety The 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.

37 Maximizing Profits: A Synthesizing C(Q) = Q 2 Example 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 = Q; You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 Q.

38 Marginal Cost C(Q) = Q 2, So MC = 8Q. This is independent of market structure.

39 Price Taker MR = P = $40. Set MR = MC. 40 = 8Q. Q = 5 units. Cost of producing 5 units. C(Q) = Q 2 = = $225. Revenues: PQ = (40)(5) = $200. Maximum profits of -$25. Implications: Expect exit in the long-run.

40 Monopoly/Monopolistic Competition MR = 100-2Q (since P = Q). Set MR = MC, or 100-2Q = 8Q. Optimal output: Q = 10. Optimal price: P = (10) = $90. Maximal profits: PQ - C(Q) = (90)(10) -( (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.

41 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.

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