Economics for

Business

MANAGERIAL DECISIONS
 MARKET STRUCTURE
• Factors that affect managerial decisions, including
the number of firms competing in a market, the
relative size of firms, technological and cost
considerations, demand conditions, and the ease
with which firms can enter or exit the industry

3
 MARKET STRUCTURE
• Concentration ratios measure how much of the total
output in an industry is produced by the largest firms
in that industry.
• The most common concentration ratio is the four-firm
concentration ratio (C4).
• The four-firm concentration ratio is the fraction of
total industry sales produced by the four largest firms
in the industry.

4
 MARKET STRUCTURE
• The Herfindahl-Hirschman index (HHI) is the sum of
the squared market shares of firms in a given
industry, multiplied by 10,000 to eliminate the need
for decimals.

• The value of the Herfindahl-Hirschman index lies between

0 and 10,000.
• A value of 10,000 arises when a single firm (with a market
share of w1 = 1) exists in the industry.
• A value of 0 results when there are numerous infinitesimally
small firms 5
MARKET STRUCTURE

6
MARKET STRUCTURE

7
The Four Types of Market Structure

8
 9
Perfect Competition Environment
• Many buyers and sellers.
• Homogeneous (identical) product.
• Perfect information on both sides of
market.
• No transaction costs.
• Free entry and exit.
 10
Key Implications
• Firms are “price takers”.
• In the short-run, firms may earn profits or
losses.
• Entry and exit forces long-run profits to
zero.
 8-11
Unrealistic? Why Learn?
• Many small businesses are “price-takers,”
and decision rules for such firms are similar
to those of perfectly competitive firms.
• It is a useful benchmark.
• Explains why governments oppose
monopolies.
• Illuminates the “danger”to managers of
competitive environments.
– Importance of product differentiation.
– Sustainable advantage.
 12

Managing a Perfectly Competitive Firm

(or Price-Taking Business)
 8-13
Setting Price

$ $
S

Pe Df

QM Qf
Market Firm
 Profit maximisation
• Firm in a competitive market
– Tries to maximize profit
• Profit
– Total revenue minus total cost
• Total revenue, TR = P ˣ Q
– Price times quantity
– Proportional to the amount of output

14
 Profit maximisation
• Average revenue, AR = TR / Q
– Total revenue divided by the quantity sold
• Marginal revenue, MR = ∆TR / ∆Q
– Change in total revenue from an additional
unit sold
• For competitive firms
– AR = P
– MR = P

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Table 1 Total, Average, and Marginal Revenue for
a Competitive Firm
(1) (2) (3) (4) (5)
Quantity Price Total Revenue Average Revenue Marginal
(Q) (P) (TR = P × Q) (AR = TR / Q) Revenue
(MR = ∆TR /
∆Q)
1 gallon $6 $6 $6

2 6 12 6 $6

3 6 18 6 6

4 6 24 6 6

5 6 30 6 6

6 6 36 6 6

7 6 42 6 6

8 6 48 6 6

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 Profit Maximization
• Maximize profit
– Produce quantity where total revenue
minus total cost is greatest
– Compare marginal revenue with marginal
cost
• If MR > MC: increase production
• If MR < MC: decrease production
• Maximize profit where MR = MC

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
17
management system for classroom use.
Table 2 Profit Maximization: A Numerical Example
(1) (2) (3) (4) (5) (6) (7)
Quantity (Q) Total Total Cost Profit Marginal Marginal Change in
Revenue (TC) (TR - TC) Revenue Cost Profit
(TR) (MR = ∆TR / (MC = ∆TC / (MR - MC)
∆Q) ∆Q)

0 gallons $0 $3 -$3

1 6 5 1 $6 $2 $4

2 12 8 4 6 3 3

3 18 12 6 6 4 2

4 24 17 7 6 5 1

5 30 23 7 6 6 0

6 36 30 6 6 7 -1

7 42 38 4 6 8 -2

8 48 47 1 6 9 -3

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 Graphically: Representative
19

Firm’s Output Decision

Profit = (Pe - ATC)  Qf*
MC
$
ATC
AVC
Pe Pe = Df = MR

ATC

Qf* Qf
Should this Firm Sustain Short Run 20

Losses or Shut Down?

Profit = (Pe - ATC)  Qf* < 0
MC ATC
$

AVC

ATC Loss
Pe Pe = Df = MR

Qf* Qf
 21
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.
• Decision rule:
– A firm should shutdown when P < AVC.
– Continue operating as long as P ≥ AVC.
 Shutdown Decision Rule
• Sunk cost
– A cost that has already been committed
and cannot be recovered
– Should be ignored when making decisions
– “Don’t cry over spilt milk”
– “Let bygones be bygones”
– In the short run, fixed costs are sunk costs

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 Near-empty restaurants
• Restaurant – stay open for lunch?
• Fixed costs: not relevant; are sunk costs in
short run
• Variable costs, VC: relevant
• Shut down if revenue from lunch < VC
• Stay open if revenue from lunch > VC

Staying open can be profitable,

even with many tables empty.
23
 Firm’s Short-Run Supply Curve: 24

MC Above Min AVC

MC ATC
$

AVC

P min AVC

Qf* Qf
 25
Short-Run Market Supply Curve
• The market supply curve is the summation of each
individual firm’s supply at each price.

P Firm 1 Firm 2 Market

P P

S1 S2
SM
15

10 18 Q 20 25 Q 30 43Q
 26
Long Run Adjustments?
• If firms are price takers but there are
barriers to entry, profits will persist.
• If the industry is perfectly competitive,
firms are not only price takers but there is
free entry.
– Other “greedy capitalists” enter the
market.
 27
Effect of Entry on Price?

$ $
S

Entry S*

Pe Df

Pe* Df*

QM Qf
Market Firm
 28

Effect of Entry on the Firm’s

Output and Profits?
MC
$
ATC

Pe Df

Pe* Df*

QL Qf* Q
 29
Summary of Logic
• Short run profits leads to entry.
• Entry increases market supply, drives
down the market price, increases the
market quantity.
• Demand for individual firm’s product shifts
down.
• Firm reduces output to maximize profit.
• Long run profits are zero.
 30
Features of Long Run Competitive Equilibrium
• P = MC
– Socially efficient output.
• P = minimum AC
– Efficient plant size.
– Zero profits
• Firms are earning just enough to offset their
opportunity cost.
Monopoly

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 Introduction
• Monopoly
– A firm that is the sole seller of a product
without close substitutes
– Has market power
• The ability to influence the market price of the
product it sells
• A competitive firm has no market power
– Arise due to barriers to entry
• Other firms cannot enter the market to
compete with it
32
 33
Monopoly Environment
• Single firm serves the “relevant market.”
• Most monopolies are “local”monopolies.
• The demand for the firm’s product is the
market demand curve.
• Firm has control over price.
– But the price charged affects the quantity
demanded of the monopolist’s product.
 Three Barriers to Entry
1. Monopoly resources
– A single firm owns a key resource.
• E.g., DeBeers owns most of the world’s
diamond mines
2. Government regulation
– The government gives a single firm the
exclusive right to produce the good.
• E.g., patents, copyright laws

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 Three Barriers to Entry
3. The production process
– Natural monopoly: a single firm can
produce the entire market Q at lower cost
than could several firms
Cost Electricity
Example: 1000 homes ATC slopes
need electricity. downward due
ATC is lower if one firm to huge FC and
services all 1000 homes $80 small MC
than if two firms each $50 ATC
service 500 homes. Q
500 1000
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 Monopoly vs. Competition: Demand Curves
P A competitive firm’s P A monopolist’s
demand curve demand curve

D
Q Q
•In a competitive market, the market demand curve slopes
downward. But the demand curve for any individual firm’s
product is horizontal at the market price. The firm can increase Q
without lowering P, so MR = P for the competitive firm.
•A monopolist is the only seller, so it faces the market demand
curve. To sell a larger Q, the firm must reduce P. Thus, MR ≠ P.
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 8-37
Managing a Monopoly
• Market power permits you to price above
MC
• Is the sky the limit?
• No. How much you sell depends on the
price you set!
 Active Learning 1 A monopoly’s
revenue
Common Grounds is
the only seller of Q P TR AR MR
cappuccinos in town.
0 $4.50 n.a.
The table shows the
market demand for 1 4.00
cappuccinos. 2 3.50
Fill in the missing 3 3.00
spaces of the table.
4 2.50
What is the relation
between P and AR? 5 2.00
Between P and MR? 6 1.50
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 Active Learning 1 Answers

• P = AR, Q P TR AR MR
same as for a 0 $4.50 $0 n.a.
$4
competitive 1 4.00 4 $4.00
3
firm. 2 3.50 7 3.50
2
• MR < P, 3 3.00 9 3.00
1
whereas MR = 4 2.50 10 2.50
P for a 5 2.00 10 2.00
0

competitive –1
6 1.50 9 1.50
firm.
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Common Grounds’ D and MR Curves
P, MR
Q P MR
$5
0 $4.50
$4 4
Demand curve (P)
1 4.00 3
3
2 3.50 2
2 1
3 3.00
1 0
4 2.50
0 -1 MR
5 2.00 -2
–1
6 1.50 -3
0 1 2 3 4 5 6 7 Q

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 Understanding the Monopolist’s MR
• Increasing Q has two effects on revenue:
– Output effect: higher output raises revenue
– Price effect: lower price reduces revenue
• Marginal revenue, MR < P
– To sell a larger Q, the monopolist must
reduce the price on all the units it sells
– Is negative if price effect > output effect
• e.g., when Common Grounds increases Q
from 5 to 6

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 Profit-Maximization
• Like a competitive firm, a monopolist
maximizes profit by producing the quantity
where MR = MC
– Sets the highest price consumers are
willing to pay for that quantity
– It finds this price from the D curve

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Profit-Maximization
Costs and
Revenue MC

The profit- P
maximizing Q is
where MR = MC.
D
Find P from the
demand curve at MR
this Q.
Q Quantity

Profit-maximizing output

43
The Monopolist’s Profit
Costs and
Revenue MC
As with a
competitive firm, P
ATC
the monopolist’s ATC
profit equals
(P – ATC) x Q D
MR

Q Quantity

44
 8-45
Long Run Adjustments?
• None, unless the source of monopoly
power is eliminated.
 A Monopoly Does Not Have an S Curve
• A competitive firm takes P as given
– Has a supply curve that shows how its Q
depends on P
• A monopoly firm is a “price-maker”
– Q does not depend on P
– Q and P are jointly determined by MC,
MR, and the demand curve
– Hence, no supply curve for monopoly.

46
CASE STUDY: Monopoly vs. Generic Drugs
Patents on new The market for
Price a typical drug
drugs give a
temporary
monopoly to the PM
seller.
PC = MC
When the
patent expires, D
the market MR
becomes
QM Quantity
competitive,
QC
generics appear.

47
 The Welfare Cost of Monopoly
• Recall:
– Competitive market equilibrium: P = MC
and total surplus is maximized
• Monopoly equilibrium, P > MR = MC
– The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC)
– The monopoly Q is too low – could increase
total surplus with a larger Q.
– Monopoly results in a deadweight loss
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The Welfare Cost of Monopoly
Competitive equilibrium:
Price Deadweight
• quantity = QC MC
•P = MC loss
•total surplus is P
P = MC
maximized
MC
Monopoly equilibrium:
D
•quantity = QM
MR
•P > MC
•deadweight loss QM QC Quantity

49
 50
Arguments for Monopoly
• The beneficial effects of economies of
scale, economies of scope, and cost
complementarities on price and output
may outweigh the negative effects of
market power.
• Encourages innovation.
Monopolistic
competition

51
 Monopolistic Competition: 52

Environment and Implications

• Numerous buyers and sellers
• Differentiated products
– Implication: Since products are
differentiated, each firm faces a downward
sloping demand curve.
• Consumers view differentiated products as
close substitutes: there exists some
willingness to substitute.
• Free entry and exit
– Implication: Firms will earn zero profits in
the long run.
 53
Managing a Monopolistically Competitive Firm
• 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.
 Monopolistic Competition: 54

Profit Maximization
• Maximize profits like a monopolist
– Produce output where MR = MC.
– Charge the price on the demand curve
that corresponds to that quantity.
 Short-Run Monopolistic 55

Competition
MC
$
ATC
Profit

PM
ATC

QM Quantity of Brand X
MR
 56
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 your product until
profits are ultimately zero.
 57
+ Long-Run Monopolistic Competition

Long Run Equilibrium

(P = AC, so zero profits) MC
$
AC

P*

P1

Entry D

MR D1
Q1 Q* Quantity of Brand
MR1 X
 58
Monopolistic Competition
The Good (To Consumers)
• Product Variety
The Bad (To Society)
• P > MC Conclusion

• Excess capacity
• Unexploited economies of scale

The Ugly (To Managers)

• Zero Profits (in the long run)!
Implications of Product Differentiation
• Firms in monopolistically competitive industries
employ two strategies to persuade consumers that
their products are better than those offered by
competitors.
• First, monopolistically competitive firms spend
considerable amounts on advertising
• Second, firms in monopolistically competitive
industries frequently introduce new products into
the market to further differentiate their products from
other firm 59
 Advertising
• Incentive to advertise
– When firms sell differentiated products
and charge prices above marginal cost
– Advertise to attract more buyers
• Advertising spending
– Highly differentiated goods: 10-20% of
revenue
– Industrial products: Little advertising
– Homogenous products: No advertising
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 Market Structure
Empty cell Perfect Monopolistic Monopoly
Competition Competition
Features that all three market Empty cell Empty cell Empty cell
structures share
Goal of firms Maximize profits Maximize profits Maximize profits

Rule for maximizing profit MR= MC MR= MC MR= MC

Can earn economic profits in the Yes Yes Yes
short run?
Features that monopolistic Empty cell Empty cell Empty cell
competition shares with
monopoly
Price taker? Yes No No
Price P = MC P > MC P> MC
Produces welfare-maximizing Yes No No
level of output?
Features that monopolistic Empty cell Empty cell Empty cell
competition shares with perfect
competition

Number of firms Many Many One

Entry in the long run? Yes Yes No
Can earn economic profits in the No No Yes
long run?
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Oligopoly

62
 Industry Concentration ratio
Video game consoles 100%
Tennis balls 100%
Credit cards 99%
Batteries 94%
Soft drinks 94%
Web search engines 92%
Breakfast cereal 92%
Cigarettes 89%
Greeting cards 88%
Beer 85%
Cell phone service 82%
Autos 79%
 64
Oligopoly Environment
• Relatively few firms, usually less than
10.
– Duopoly - two firms
– Triopoly - three firms
• The products firms offer can be either
differentiated or homogeneous.
• Firms’ decisions impact one another.
• Many different strategic variables are
modeled:
– No single oligopoly model.
 9-65
Role of Strategic Interaction

• Your actions affect the

profits of your rivals.
• Your rivals’ actions
affect your profits.
• How will rivals
respond to your
actions?
 The Economics of Cooperation
• The prisoners’ dilemma
– Particular “game” between two captured
prisoners
– Illustrates why cooperation is difficult to
maintain even when it is mutually
beneficial
• Dominant strategy
– Strategy that is best for a player in a game
• Regardless of the strategies chosen by the
other players
66
 The Prisoners’ Dilemma

•In this game between two criminals suspected of committing a crime, the sentence that each
receives depends both on his or her decision whether to confess or remain silent and on the
decision made by the other.

67
 The Economics of Cooperation
• Nash equilibrium
– Economic actors interacting with one
another
– Each choose their best strategy
– Given the strategies that all the other
actors have chosen

68
 The Economics of Cooperation
• The prisoners’ dilemma
– Because each pursues his or her own
interests
• The two prisoners together reach an outcome
that is worse for each of them
– Cooperation between the two prisoners is
difficult to maintain
• Because cooperation is individually irrational

69
 The Economics of Cooperation
• Game oligopolists play
– In trying to reach the monopoly outcome
– Similar to the game that the two prisoners
play in the prisoners’ dilemma
• Firms are self-interested
– And do not cooperate
• Even though cooperation (cartel) would
increase profits
– Each firm has incentive to cheat
70
 Markets with Only a Few Sellers
• A small group of sellers, oligopolists
– Tension between cooperation and self-
interest
– Best off cooperating, acting like a
monopolist
• Produce a small quantity of output
• Charge P >MC
– Each firm cares only about its own profit
• Powerful incentives not to cooperate

71
 Markets with Only a Few Sellers
• Duopoly
– Oligopoly with only two members
– Decide what quantity to sell
– Price is determined on the market by the
demand

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Table 1 The Demand Schedule for Water
Quantity Price Total Revenue
(and total profit)
0 gallons $120 $0
10 110 1,100
20 100 2,000
30 90 2,700
40 80 3,200
50 70 3,500
60 60 3,600
70 50 3,500
80 40 3,200
90 30 2,700
100 20 2,000
110 10 1,100
120 0 0
73
 Markets with Only a Few Sellers
• For a perfectly competitive firm
– Price = marginal cost
– Quantity is efficient
• For a monopoly
– Price > marginal cost
– Quantity is lower than the efficient quantity

74
 Markets with Only a Few Sellers
• A duopoly can:
– Collude and form a cartel, act as a
monopoly and agree on:
• Total level of production
• Quantity produced by each member
– Don’t collude, act in self-interest
• Difficult to agree; Antitrust laws
• Higher quantity; lower price; lower profit
• Not competitive allocation
• Nash equilibrium
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except
for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved
75
learning management system for classroom use.
 Markets with Only a Few Sellers
• Collusion
– Agreement among firms in a market
• Quantities to produce or
• Prices to charge
• Cartel
– Group of firms acting in unison

76
Figure 2 Jack and Jill’s Oligopoly Game

•In this game between Jack and Jill, the profit that each earns from selling
water depends on both the quantity he or she chooses to sell and the
quantity the other chooses to sell.

77
 Markets with Only a Few Sellers
• Oligopolists
– Better off cooperating and reaching the
monopoly outcome
– They pursue their own self-interest
• Do not end up reaching the monopoly
outcome and maximizing their joint profit
• Each is tempted to raise production and
capture a larger share of the market
• Total production rises and price falls

78
 Markets with Only a Few Sellers
• When firms in an oligopoly individually
choose production to maximize profit
– Produce a quantity of output
• Greater than the level produced by monopoly
• Less than the level produced by competition
– The price is
• Less than the monopoly price
• Greater than the competitive price (MC)

79
 Markets with Only a Few Sellers
• If oligopolists form a cartel
– Maximize total profit
– Produce monopoly quantity
– Charge monopoly price
– Difficult to reach and enforce an
agreement as the size of the group
increases

80
 Markets with Only a Few Sellers
• If oligopolists do not form a cartel, each
firm has to take into account:
– The output effect
• Because P > MC, selling one more unit
increases profit
– The price effect
• Increasing production increases total amount
sold
• Decrease in price and lower the profit

81
 Markets with Only a Few Sellers
• The size of an oligopoly affects the
market outcome
– As the number of sellers in an oligopoly
grows larger
• Oligopolistic market looks more like a
competitive market
• Price approaches marginal cost
• Quantity produced approaches socially
efficient level

82
 Exercises
1. The CEO of a major automaker
overheard one of its division managers
make the following statement regarding the
firm’s production plans: “In order to
maximize profits, it is essential that we
operate at the minimum point of our
average total cost curve.” If you were the
CEO of the automaker, would you praise or
chastise the manager? Explain

83
 Exercises
2. As a newly hired manager at your firm, you decide
to start your tenure by assessing the sensibility of
your current advertising expenditure. To do this, you
ask your analytics team to collect useful data on the
quantity of your product sold, the price, and
advertising (in thousands) across a range of markets
where your product is sold. The data they collected
are in Q08-25.xls.

84
 Exercises
a. Using these data, determine the advertising
elasticity of demand and the own-price
elasticity of demand. (Hint: Recall what a
log-log regression provides in terms of
estimates).
b. What is the profit-maximizing advertising-
to-sales ratio for your product? Do you
have any concern about the precision of
this estimate?

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