MODULE 6 MANAGING IN COMPETITIVE,

MONOPOLISTIC, AND MONOPOLISTICALLY SHORT-RUN OUTPUT DECISIONS

COMPETITIVE MARKETS • The short run is a period of time over which some
factors of production are fixed
PERFECT COMPETITION • To maximize short-run profits, managers must take
as given the fixed inputs (and fixed costs) and
• The interaction between many buyers and sellers determine how much output to produce by
that are “small” relative to the market. changing the variable inputs.
• Each firm in the market produces a homogeneous • Firm must determine how much output to produce
(identical) product. given the variable inputs that are within his or her
• Buyers and sellers have perfect information. control.
• No transaction costs.
• Free entry into and exit from the market. REVENUE, COSTS, AND PROFITS FOR A
PERFECTLY COMPETITIVE FIRM
Implications

• A single market price is determined by the Maximizing Profits

interaction of demand and supply Demand of an Individual Firm (Df) =
• Firms earn zero economic profits in the long run. Market Price (P)
o They exit the market if they earned lower R = PQ
and enter another market that is more
• Each unit of output can be sold at the market price
profitable
of P, each unit add exactly P dollars to revenues
EXAMPLE OF PRODUCTS IN PERFECTLY • There is a linear relation between revenue
COMPETITION attributable to the last unit of output.
• Agricultural Crops
• Technological parts or products Marginal Revenue
• Change in the revenue attributable to the last unit
DEMAND AT THE MARKET AND FIRM of output.
LEVELS UNDER PERFECT COMPETITION • Slope of the revenue curve.
Slope of R = MR = P = Df
• Perfectly competitive market’s price is determined
by the intersection of supply curve and demand
curve
• Perfect Competitive Firm can only sell his goods at
the equilibrium price
• Demand Curve (Df) = Price Equilibrium (Pe)
• Firm Demand Curve – the demand curve for an
individual firm’s product in a perfectly competitive
market, it is simply the market price.
• The pricing decision of an individual firm is trivial:
charge the price that every other firm in the industry
charges.
• The firm should know how many output should be
produced to maximize profits.
COMPETITIVE FIRM’S DEMAND
• The demand curve for a competitive firm’s product is
a horizontal line at the market price. This price is the
competitive firm’s marginal revenue.

Slope of R = MR = P = Df

PROFIT MAXIMIZATION UNDER PERFECT

COMPETITION
MR > ATC
MC = P
MR = MC
 Loss Formula for Short Run Loss:
Profit Formula:
ATC (Q*) - P
𝝅 = PQ – C(Q)/ 𝝅= MR - MC THE SHUT-DOWN CASE
• The firm must decide to shut down its operation given
COMPETITIVE OUTPUT RULE that:
• To maximize profits, a perfectly competitive firm
produces the output at which price equals marginal ATC > AVC > P
cost in the range over which marginal cost is • The firm earnings are not enough for both AVC and
increasing. AFC.
• Loss will be equal to its fixed costs
𝑃 = 𝑀𝐶 (Q) • When price is less than the average variable cost
𝝅 = PQ – C(Q)/ 𝝅= MR - MC of production, AVC > P, the firm loses less by
shutting down its operating (and producing zero
• The cost function for a firm is 𝐶(𝑄) = 5 + 𝑄2 units)
If the firm sells output in a perfectly competitive
market and other firms in the industry sell output at a
price of $20, what price should the manager of this
firm charge? What level of output should be produced
to maximize profits? How much profit will be earned?
• Answer:
o Charge $20.
o Since marginal cost is 2𝑄, equating price and
marginal
o cost yields: $20 = 2𝑄 ⟹ 𝑄 = 10 units.
o Maximum profits are: 𝜋 = 20 × 10 − 5 + 102 =
o $95.

SHORT-RUN LOSS MINIMIZATION

• The firm should continue to produce in short run if:
Loss Formula for Shut Down Case:
ATC > P > AVC [ATC (Q*) – AVC(Q*)] Q*
• The revenue incurred is greater than the variable
cost per variable inputs P > AVC
SHORT-RUN OUTPUT DECISION UNDER PERFECT
• The firm will not earn zero economic profits if it COMPETITION
shuts down its operation but would realize a loss of
fixed cost • To maximize short-run profits, a perfectly competitive
• Firm earns revenues each unit sold that are more firm should produce in the range of increasing
than enough to cover the variable cost of marginal cost where 𝑃 = 𝑀𝐶, provided that 𝑃 ≥ 𝐴𝑉𝐶.
producing Q units. If 𝑃 < 𝐴𝑉𝐶, the firm should shut down its plant to
• Even if the firm suffers a short run loss by operating, minimize it losses
this loss is less than the loss that would result if
the firm completely shut down its operation.
SHORT-RUN FIRM SUPPLY CURVE FOR A • The market supply curve for a perfectly competitive
COMPETITIVE FIRM industry is the horizontal sum of the individual
marginal costs about their respective AVC curves
• Supply curve is flatter than the supply curve of an
individual firm
• The more firms in the industry, the farther to the
right is the market supply curve

LONG-RUN DECISIONS: ENTRY AND EXIT THE

MARKET AND FIRM’S DEMAND
Theory of the Perfect Competition
• Free Entry and Exit in Perfect Competitive Market
• In short run, firms earn economic profits. However, in
long run, additional firms will enter the industry to reap
some of those profits.

• When price is zero given by P0, the firm produces Q0

units of outputs. This point where P = MC in the range
of the marginal cost
• When the price is P1 given that the firm produces Q 1
units of output. Output Is determined by the
intersection of price and marginal cost
• P < AVC, firm produces zero units because it
cannot cover the variable cost of the production
No of Units Produced
• Firm should produce an output where P = MC
Positive Level of Unit Outputs
• Firm will produce an output where P > AVC

THE SHORT-RUN FIRM AND INDUSTRY SUPPLY Firms Entering the Industry
CURVES • Supply curve shifts to the right. S0 to S1
• The short-run supply curve for a perfectly • Decrease in market price P0 will be lowered to P1
• Lowers each individual firms’ profits
competitive firm is its marginal cost curve above the
Firms Exiting the Industry
minimum point on the 𝐴𝑉𝐶 curve
• If firms in a competitive industry sustain short run
P > AVC losses, in the long run they will exit the industry
because they are not covering their opportunity cost
THE MARKET SUPPLY CURVE • Supply curve decreases from S0 to S2
• Increase in market price from P0 to P2
• Demand curve shifts up
LONG-RUN COMPETITIVE EQUILIBRIUM

• The horizontal sum of the marginal cost of all

individual firms determines how much total output
will be produced at each price.
• The entering and exit of firms in the industry will
continue until ultimately the market price is such
 that all firms in the market earn zero economic
profits
• At the price of Pe, each firm receives just enough
to cover the average costs of production
o Average Cost (AC) is used because in the
long all costs are variable
• The firm economic profits are zero
• If economic profits were positive, entry would
occur, and the market price would fall until the
demand curve for an individual firm’s product is
tangent to the AC curve
• If economic profits are negative, exit would occur,
increasing the market price until the firm demand
curve is tangent to the AC curve
• As the monopolist increase its price, the lesser the
LONG-RUN COMPETITIVE EQUILIBRIUM demand will be
• In the long run, perfectly competitive firms produce a • Monopolist is restricted by consumer to only choose
level of output such that price-quantity combinations along the market
𝑃 = 𝑀𝐶 demand curve
• Monopolist can choose between price or quantity but
• The industry produces a socially efficient level of
not both.
output where cost of resource obtain by to produce
the output is same as how the society value the • The monopolist can sell higher quantities only by
output produced. lowering the price. If the price is too high consumers
may choose to buy nothing at all.
𝑃 = 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝐴𝐶
SOURCES OF MONOPOLY POWER
• Firms are earning zero economic profits and all
• The sources of Monopolistic power is technological in
economies of scale have been exhausted.
nature.
• There is no way to produce the output at a lower Economies of Scale
average cost of production. Economies of scale
• Exist whenever long-run average costs decline as
MONOPOLY output increases.
Diseconomies of scale
• A market structure which a single firm serves an • Exist whenever long-run average costs increase as
entire market for a good for which there are no close output increases.
substitutes
• Sole seller of a good in a market gives that firm a
greater market power than if it completed against
other firms for consumers
Implications
• Market demand curve is the monopolists demand
curve
o There is only one sole producer in the market
• However, a monopolist does not have unlimited
market power.

MONOPOLIST DEMAND CURVE

• Monopolist’s power is constrained by the demand
curve.
• Since all consumers in the market demand the good
from the monopolist, market demand Dm is equal to • There is an economies of scale for the output level
the demand for the firm’s product below Q* (since ATC is declining in this range).
Dm = Df • Diseconomies of scale exists above output levels
• In the absence of legal restrictions, the monopolist is of Q* (since ATC is increasing in this range).
free to charge any price for the product.
• The price set by the monopolist let the consumer
decide how much it will purchase
Single Monopolistic Firm Patents and Other Legal Barriers
• Produce QM units, consumers would be willing to pay • A government may grant an individual firm by a
PM per unit for the QM monopoly right
• PM > ATC (QM) • Patent System - gives the inventor of a new product
• The firm sells goods at a price that is higher than the the exclusive rights to sell the product for a long
average cost of production and earns positive period of time
profits • In the absence of a patent system, there would be a
Two Monopolistic Firm reduced incentive on the part of the firms to develop
• Each firm produces QM/2 and the total quantity new technologies and products
produce will the same to the outputs produced by a • Patent system doesn’t lead to absolute monopoly and
single firm managers enjoying patent protection are by no means
• Since same outputs are produced, price will remain at immune from the competitive pressures.
PM
• PM < ATC (QM) ELASTICITY OF DEMAND AND TOTAL REVENUES
• The firm sells goods at a price that is lower than the
average cost of production and incurs losses.
• Economies of scale leads to a situation where a single
firm services the entire market for a good.

Economies of Scope
• Exist when the total cost of producing two
products within the same firm is lower than when
the products are produced by separate firms.
• In the presence of economies of scope, efficient
production requires that a firm produce several
products jointly
• Multiproduct firm does not necessarily have more
market power than the firms producing a single
product, economies of scope tend to encourage
Maximizing Profits
“larger” firms • Characterize the price and output decisions that
• Provides greater access to capital markets, where maximize the monopolists’ profits. This can be made
working capital and funds for investment are by manager exploiting the source of power that the
obtained. monopoly currently has.
• Smaller firms have more difficulty obtaining funds
than do larger firms, the higher the cost of capital MARGINAL REVENUE AND ELASTICITY
may serve as a barrier to entry. • The monopolist’s marginal revenue function is
• In extreme cases of economies of scope, this will
lead to an monopoly power.

Cost complementarity
• Exist when the marginal cost of producing one output where 𝐸 is the elasticity of demand for the
is reduced when the output of another product is monopolist’s product and 𝑃 is the price charged
increased. 𝑀𝑅 > 0 when 𝐸 < −1.
• Multiproduct firms enjoy cost complementarities tend 𝑀𝑅 = 0 when 𝐸 = −1.
to have lower marginal costs than firms producing 𝑀𝑅 < 0 when −1 < 𝐸 < 0.
single products • As output is increased above zero, demand is elastic
• This give multiproduct firms cost advantage ti single and the increase in output (which implies a lower
product firms price) leads in total revenue
• Firms must produce several products to be able to • As output is increased, it follows the total revenue test
compete against the firm with lower marginal costs • As output is increased beyond Q0 into the inelastic
• To the extent that capital requirements exist for region of demand, further increases of output leads to
multiproduct firms than for a single product firms, a decrease in total output, until it becomes zero again
this requirement can limit the ability of small firms • Total revenue is maximized at output of Q 0 where
to enter the market. In extreme cases monopoly demand is unitary elastic
power can result. • Monopolist marginal revenue is s less than the
price charged for the good.
• Monopolist must lower a price in able to sell another • Output below A and above B implies losses since
unit of output the cost curve lies above the revenue curve
• Profits are positive between A and B
MARGINAL REVENUE AND LINEAR DEMAND
• Monopolist can charge the product depends on how PROFIT MAXIMIZATION UNDER MONOPOLY
much is produced
• Given a linear inverse demand function
𝑃 𝑄 = 𝑎 + 𝑏𝑄
Let P (Q) represent the price per unit paid by the
consumers and for Q units of output where 𝑎 > 0 𝑎𝑛𝑑
𝑏 < 0, the associated marginal revenue is
𝑀𝑅 𝑄 = 𝑎 + 2𝑏Q
• Suppose the inverse demand function for a
monopolist’s product is given by 𝑃 = 10 − 2𝑄
• What is the maximum price per unit a monopolist can
charge to be able to sell 3 units?
• What is marginal revenue when 𝑄 = 3?
• Answer:
o The maximum price the monopolist can charge • A MR curve intersects MC curve when QM units are
for 3 units is: 𝑃 = 10 − 2 3 = $4. produced, so the profit maximizing level of output
o The marginal revenue at 3 units for this inverse is QM
linear demand is: 𝑀𝑅 = 10 − 2 2 3 = −$2. • The maximum price per unit that the consumer is
willing to pay for QM units is PM, so the profit-
MONOPOLY OUTPUT RULE maximizing price is PM
A profit-maximizing monopolist should produce the Profit of Monopolistic Firm:
output, 𝑄𝑀, such that marginal revenue equals marginal [PM – ATC (QM)]
cost:
𝑀𝑅(𝑄M) = 𝑀𝐶 (𝑄M) MONOPOLY PRICING RULE
• If MR > MC, an increase in output would increase • Given the level of output, 𝑄 𝑀, that maximizes
revenues more than it would increase cost. profits, the monopoly price is the price on the
• A profit maximizing monopolist should expand output demand curve corresponding to the 𝑄 𝑀 units
when MR > MC produced:
• If MR < MC, a reduction in output would decrease cost
by more than it would reduce revenue
𝑃 𝑀 = 𝑃 𝑄M
COSTS, REVENUES, AND PROFITS UNDER
MONOPOLY • Suppose the inverse demand function for a
monopolist’s product is given by 𝑃 = 100 − 2𝑄 and the
cost function is 𝐶 𝑄 = 10 + 2𝑄.
• Determine the profit-maximizing price, quantity and
maximum profits.
• Answer:
• Profit-maximizing output is found by solving:
100 − 4𝑄 = 2 ⟹ 𝑄𝑀 = 24.5.
• The profit-maximizing price is:
𝑃𝑀 = 100 −2 24.5 = $51.
• Maximum profits are:
𝜋 = $51 × 24.5 – [10 + 2 (24.5)] = $1,190.50.

Profit of monopolist cost function is computed as:

𝝅 = R(Q) – C(Q)
• The vertical distance between the revenue and cost
functions reflects the profits of the monopolist of
alternative levels of output.
THE ABSENCE OF A SUPPLY CURVE
• Recall, firms operating in perfectly competitive
markets determine how much output to produce
based on price
(𝑃 = 𝑀𝐶)
• Thus, a supply curve exists in perfectly competitive
markets.
• A monopolist’s market power implies
𝑃 >𝑀𝑅 = 𝑀𝐶
• Thus, there is no supply curve for a monopolist, or
in markets served by firms with market power.

MULTIPLANT DECISIONS
• Often a monopolist produces output in different DEADWEIGHT LOSS OF MONOPOLY
locations. • The consumer and producer surplus that is lost due
Implications to the monopolist charging a price in excess of
• Manager has to determine how much output to marginal cost.
produce at each plant.
Monopolist Producing Output at Two Plants:
• The cost of producing 𝑄1 units at plant 1 is 𝐶(𝑄1),
and the cost of producing 𝑄2 at plant 2 is 𝐶(𝑄2) .
• When the monopolist produces a homogeneous
product, the per-unit price consumers are willing
to pay for the total output produced at the two
plants is
𝑃(𝑄), where 𝑄 = 𝑄1 + 𝑄2.

• Let 𝑀𝑅(𝑄) be the marginal revenue of producing a

total of 𝑄 = 𝑄1 + 𝑄2 units of output. Suppose the
marginal cost of producing 𝑄1 units of output in plant
1 is 𝑀𝐶1(𝑄1) and that of producing 𝑄2 units in plant 2
MONOPOLISTIC COMPETITION
is 𝑀𝐶2 (𝑄2). The profit-maximizing rule for the two-
• There are many buyers and sellers.
plant monopolist is to allocate output among the two
• Each firm in the industry produces a differentiated
plants such that:
product.
𝑀𝑅(𝑄) = 𝑀𝐶1 (𝑄1)
• There is free entry into and exit from the industry.
𝑀𝑅(𝑄) = 𝑀𝐶2 (𝑄2) o This is different from monopoly where
barriers to entry exist
IMPLICATIONS OF ENTRY BARRIERS • A key difference between monopolistically
• A monopolist may earn positive economic profits, competitive and perfectly competitive markets is
which in the presence of barriers to entry (source that each firm produces a slightly differentiated
of power) prevents other firms from entering the product.
market to reap a portion of those profits. Implication:
Implication • Products are close, but not perfect, substitutes:
o Monopoly profits will continue over time therefore, firm’s demand curve is downward
provided the monopoly maintains its market sloping under monopolistic competition
power. o This is in contrast to monopoly where
• Monopoly power, however, does not guarantee demand curve is not downward sloping as
positive profits. well as to perfect competitive which demand
curve is horizontal.
A MONOPOLIST EARNING ZERO PROFITS
• The optimal price exactly equals the average total
PROFIT-MAXIMIZATION UNDER MONOPOLISTIC
cost of production
COMPETITION
• In the short run, a monopolist may even
• The determination of the profit maximizing price
experience losses
and output under monopolistic competition is the
PM = ATC (QM)
 same for the firm operating under monopoly. P = Losses
MR • Some firms will exit the industry in the long run.
• MR curve lies below to demand curve, which is EFFECT OF ENTRY ON A MONOPOLISTICALLY
the same to monopoly COMPETITIVE FIRM’S DEMAND

• Demand curve D0 lies above the ATC curve and the

Profit firm is gaining positive economic profits
[𝑃 ∗ − 𝐴𝑇𝐶 (𝑄*)] × Q* • More firms will be attracted to enter the market
Difference of Monopolistically Competitive to • As additional firms entered, the demands for the
Monopoly firm’s product will decrease because some
• Demand and Marginal Revenue curves used to consumers will substitute towards new products
determine the monopolistically competitive firm’s • This entry will continue, and demand curve will shift
profit maximizing outputs Q* to left given at D1 it will tangent to AC curve. In this
• Price P* is based on the individual firm’s demand case, firms are earning economic profits and will not
curve (Monopoly’s price is based on the market attract any firms to enter the market anymore
demand curve) • When firms incur losses, they will exit the industry.
• Market demand curve of monopolistically The demand for the remaining firms will increase.
competitive is not well defined because of the This process leads to an increased in profit. Firms
differentiated products offered stop leaving when the remaining firms earn zero
• Market demand curve can be calculated by adding all economic profits.
the products purchased in the market at a given price,
which is impossible to monopolistically competitive as LONG-RUN EQUILIBRIUM UNDER MONOPOLISTIC
products are different. COMPETITION

PROFIT-MAXIMIZATION RULE FOR MONOPOLISTIC

COMPETITION
• To maximize profits, a monopolistically competitive
firm produces where its marginal revenue equals
marginal cost.
• The profit-maximizing price is the maximum price per
unit that consumers are willing to pay for the profit-
maximizing level of output.
The profit-maximizing output, 𝑄*, is such that
𝑀𝑅 (𝑄*) = 𝑀𝐶 (Q*)
The profit-maximizing price is
𝑃 *= 𝑃(Q*)
• Each firms earns zero economic profits but charges
LONG-RUN EQUILIBRIUM
price that exceeds the marginal cost of producing
If firms in monopolistically competitive markets earn
the good.
short run:
• Monopolistically competitive firms produced less
Profits
outputs than is socially desirable
• Additional firms will enter in the long run to
• Consumers are willing to pay more for another unit
capture some of those profits.
than it would cost the firm to produce another
 unit; yet the firm will not produce more outputs
because of its concern with profits.
• As P = AC, firms earn zero economic profits like in
perfect competitive markets do
• Firms have control over price, but the competition
prevents them from earning economic profits
• P > min. AC, implies that firms do not take full
advantage of economies of scale of the
production (there are many firms that it would be
hard for a firm to take advantage of economies of
scale of production).
o More firms, less exploitation of economies of
scale, more product variety in the market
o Fewer firms, more exploitation of economies of
scale, more product variety in the market.

THE LONG-RUN AND MONOPOLISTIC COMPETITION

• In the long run, monopolistically competitive firms
produce a level of output such that:
𝑃 > 𝑀𝐶
𝑃 = 𝐴𝑇𝐶 > 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠

IMPLICATIONS OF PRODUCT DIFFERENTIATION

• The differentiated nature of products in
monopolistically competitive markets implies that
firms in these industries must continually
convince consumers that their products are
better than their competitors.
• Two strategies monopolistically competitive
firms use to persuade consumers:
o Comparative advertising: form of
advertising where a firm attempts to increase
the demand for its brand by differentiating
its product from competing brands
→ Brand equity
o Niche marketing: a marketing strategy
where goods and services are tailored to
meet the needs of a particular segment of
the market.
→ Green marketing
• Successful differentiation and branding
strategies can make managers brand myopic,
resting on the brand’s past laurels and in doing so
missing opportunities to enhance its brand.

OPTIMAL ADVERTISING DECISIONS

• How much should a firm spend on advertising to
maximize profits?
• Depends, in part, on the nature of the industry.
• The optimal amount of advertising balances the
marginal benefits and marginal costs.
• Profit-maximizing advertising-to-sales ratio is: