Managerial Decisions with

Market Power
Dilini Hemachandra (PhD)

1
 Market Power
• Ability of a firm changing output level to influence the market price
• Any firm that faces downward sloping demand has market power (MC to
Monopoly)
• Gives firm ability to charge price above marginal cost
• P > MC

2
 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

3
 Measurement of Market Power
• Lerner index measures proportionate amount by
which price exceeds marginal cost:
P − MC
Lerner index =
P
:
Lerner index is one of the measures (the most common measure) for market power. It only
requires the information of market price and a firm’s marginal cost. Given the definition, we
can see that 0 ≤ Lerner index ≤ 1. If Firm A has a greater Lerner index than Firm B’s, then
Firm A has a stronger market power. However, Lerner index doesn’t work well for some
industries in which most firms’ marginal costs are pretty low. For example, the software
industry, each firm’s marginal costs (additional cost per copy) are similar and close to zero.
Lerner index cannot tell the difference significantly between two firms. In the case, some
measures of market shares (e.g. Herfindahl index) will work better.

HI =ƩS2i
4
 Measurement of Market Power
• Lerner index
• Equals zero under perfect competition
• Increases as market power increases
• Also equals –1/ED, 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

5
 Monopoly
• Single firm
• Produces & sells a good or service for which there are no
good substitutes
• New firms are prevented from entering market because of a
barrier to entry

6
 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

Economies of scale is also known as a “natural” barrier. In the past, utility industry (e.g.
telephone service, electricity…etc) and transportation industry (e.g. railroad, airline…etc),
were defined as natural monopoly because their cost structures exhibited economies of
scale. A single seller might benefit consumers more by providing lower price with lower
average total costs. In order to control the price, the government set regulations (constraints)
on the revenues for those natural monopolies. So, they were also called “regulated
monopolies”.

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 Common Entry Barriers
• Barriers created by government
• Licenses, exclusive franchises
• 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

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 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 value 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 network of buyers

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 Demand & Marginal Revenue for a
Monopolist
• Market demand curve is the firm’s demand curve
• 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

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 Managerial Economics
Demand & Marginal Revenue for a
Monopolist

12-11
 Short-Run Profit Maximization for Monopoly

• Monopolist will produce a positive output if some price on

the demand curve exceeds average variable cost
• Profit maximization or loss minimization occurs by producing
quantity for which MR = MC

12
 Managerial Economics
Short-Run Profit Maximization for
Monopoly

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 Short-Run Profit Maximization for Monopoly

• If P > ATC, firm makes economic profit

• If ATC > P > AVC, firm incurs loss, but continues to produce
in short run
• If demand falls below AVC at every level of output, firm shuts
down & loses only fixed costs

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 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

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Long-Run Profit Maximization for Monopoly

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 Profit-Maximizing Input Usage
• Marginal revenue product (MRP)
• MRP is the additional revenue attributable to hiring one
more unit of the input (labor or capital)
• MRPL = MR * MPL =TR / L
• MRPK = MR * MPK =TR / K

• Duality
• For a firm with market power, the profit-maximizing
conditions MRP = input price in input and MR = MC in
output are equivalent

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Monopolistic Competition
• Large number of firms; each firm has its local
territory
• Differentiated product
• Pure monopoly in the short run
• Competitive in the long run

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Monopolistic Competition
• Short-run equilibrium is identical to
monopoly
• Unrestricted entry/exit leads to long-run
equilibrium (see the next slide)
• A firm’s demand will shrink (left shift) when new firms
enter its territory
• Attained when demand curve for each producer is
tangent to LAC
• At LR equilibrium output, P = LAC; that is, a M.C. firm
only earns a normal profit

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 Managerial Economics
Long-Run Profit Maximization for
Monopoly)

12-20
 Implementing the Profit-Maximizing Output &
Pricing Decision
• Step 1: Estimate demand equation
• Use statistical techniques
• Substitute forecasts of demand-shifting variables into
estimated demand equation to get

Q = a' + bP

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 Implementing the Profit-Maximizing Output &
Pricing Decision
• Step 2: Find inverse demand equation
• Solve for P

−a' 1
P= + Q = A + BQ
b b

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 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 + 2BQ = + Q
b b

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 Implementing the Profit-Maximizing Output &
Pricing Decision
• Step 4: Estimate AVC & SMC
• Use statistical techniques

AVC = a + bQ + cQ 2

SMC = a + 2bQ + 3cQ 2

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 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

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 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
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 Implementing the Profit-Maximizing Output &
Pricing Decision
• Step 8: Compute profit or loss
• Profit = TR - TC

= P  Q* − AVC  Q* − TFC
= ( P − AVC )Q − TFC
*

• If P < AVC, firm shuts down & profit

is -TFC

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 Example: Maximizing Profit at Aztec Electronics
• If demand is Q= 50000 -500P
• Solve for inverse demand
• Determine marginal revenue function

• Estimation of average variable cost and marginal cost

• Given the estimated AVC equation:
AVC = a + bQ + cQ 2
AVC = 28 − 0.005Q + 0.000001Q 2
SMC = a + 2bQ + 3cQ 2
• Derive equation for SMC

• Output decision − b  b 2 − 4ac

x=
• Set MR = MC and solve for Q* 2a

• Pricing decision
• Substitute Q* into inverse demand

• Shutdown decision
• Compute AVC at 6,000 units and compare price an AVC
• Computation of total profit (TFC =270,000)
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