Managerial Economics Thomas

ninth edition Maurice

Chapter 12
Managerial Decisions for
Firms with Market Power
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial Economics, 9e
Managerial Economics, 9e Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 Managerial Economics

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)

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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

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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

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 Managerial Economics

Measurement of Market Power

• Lerner index measures
proportionate amount by which
price exceeds marginal cost:

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 Managerial Economics

Measurement of Market Power

• Lerner index
• 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
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 Managerial Economics

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

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Determinants of Market Power

• 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
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 Managerial Economics

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

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Common Entry Barriers

• 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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 Managerial Economics

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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 Managerial Economics
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

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 Managerial Economics
Demand & Marginal Revenue for a
Monopolist (Figure 12.1)

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 Managerial Economics
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

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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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 Managerial Economics
Short-Run Profit Maximization for
Monopoly (Figure 12.3)

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 Managerial Economics
Short-Run Loss Minimization for
Monopoly (Figure 12.4)

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 Managerial Economics
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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 Managerial Economics
Long-Run Profit Maximization for
Monopoly (Figure 12.5)

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 Managerial Economics

Profit-Maximizing Input Usage

• Profit-maximizing level of input
usage produces exactly that level
of output that maximizes profit

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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

• 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
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 Managerial Economics
Monopoly Firm’s Demand for
Labor (Figure 12.6)

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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

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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

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 Managerial Economics

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

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 Managerial Economics
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)

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 Managerial Economics
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)

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 Managerial Economics
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

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

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 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 3: Solve for marginal revenue
• When demand is expressed as
P = A + BQ, marginal revenue is

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 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 4: Estimate AVC & SMC
• Use statistical techniques from
Chapter 10

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 Managerial Economics
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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 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 7: Check shutdown rule
• Substitute Q* into estimated AVC
function

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

• If P < AVC, firm shuts down & profit

is -TFC

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 Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
• Aztec possesses market power via
patents
• Sells advanced wireless stereo
headphones

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of demand & marginal
revenue

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Solve for inverse demand

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Determine marginal revenue
function

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 Managerial Economics
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)

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 Managerial Economics

Maximizing Profit at Aztec

Electronics: An Example
• Estimation of average variable cost
and marginal cost
• Given the estimated AVC equation:

• So,

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Output decision
• Set MR = MC and solve for Q*

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Output decision
• Solve for Q* using the quadratic
formula

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Pricing decision
• Substitute Q* into inverse demand

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Shutdown decision
• Compute AVC at 6,000 units:

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 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Computation of total profit

* * * *

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 Managerial Economics
Profit Maximization at Aztec
Electronics (Figure 12.10)

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 Managerial Economics

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

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A Multiplant Firm (Figure 12.11)

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