Ch 8 Unit6


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Ch 8 Unit6

  1. 1. Managerial Economics & Business Strategy Chapter 8 – goes with unit six Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets
  2. 2. Overview <ul><li>I. Perfect Competition </li></ul><ul><ul><li>Characteristics and profit outlook. </li></ul></ul><ul><ul><li>Effect of new entrants. </li></ul></ul><ul><li>II. Monopolies </li></ul><ul><ul><li>Sources of monopoly power. </li></ul></ul><ul><ul><li>Maximizing monopoly profits. </li></ul></ul><ul><ul><li>Pros and cons. </li></ul></ul><ul><li>III. Monopolistic Competition </li></ul><ul><ul><li>Profit maximization. </li></ul></ul><ul><ul><li>Long run equilibrium. </li></ul></ul>
  3. 3. Perfect Competition Environment <ul><li>Many buyers and sellers. </li></ul><ul><li>Homogeneous (identical) product. </li></ul><ul><li>Perfect information on both sides of market. </li></ul><ul><li>No transaction costs. </li></ul><ul><li>Free entry and exit. </li></ul>
  4. 4. Key Implications <ul><li>Firms are “price takers” (P = MR). </li></ul><ul><li>In the short-run, firms may earn profits or losses. </li></ul><ul><li>Long-run economic profits are zero. </li></ul><ul><li>Firms cannot sell more by lowering price below the market price and cannot sell any by raising price above market price </li></ul>
  5. 5. Unrealistic? Why Learn? <ul><li>Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms. Individual farmers are an example of firms in perfect competition </li></ul><ul><li>It is a useful benchmark. </li></ul><ul><li>Explains why governments oppose monopolies. </li></ul><ul><li>Illuminates the “danger” to managers of competitive environments to avoid being a price-taker </li></ul><ul><ul><li>Importance of product differentiation. </li></ul></ul><ul><ul><li>Sustainable advantage. </li></ul></ul>
  6. 6. Managing a Perfectly Competitive Firm (or Price-Taking Business) Emphasis in this business environment is on cost reductions and productivity enhancements.
  7. 7. Setting Price Firm Q f $ D f Market Q M $ D S P e
  8. 8. Profit-Maximizing Output Decision <ul><li>MR = MC. </li></ul><ul><li>Since, MR = P, </li></ul><ul><li>Set P = MC to maximize profits. </li></ul>
  9. 9. Graphically: Representative Firm’s Output Decision P e = D f = MR Q f* ATC P e Profit = ( P e - ATC )  Q f* $ Q f ATC AVC MC
  10. 10. Should this Firm Sustain Short Run Losses or Shut Down? ATC P e = D f = MR Q f* ATC P e Profit = ( P e - ATC )  Q f* < 0 $ Q f AVC MC Loss
  11. 11. Shutdown Decision Rule <ul><li>A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs . </li></ul><ul><ul><li>Operating results in a smaller loss than ceasing operations. </li></ul></ul><ul><li>Decision rule: </li></ul><ul><ul><li>A firm should shutdown when P < min AVC. </li></ul></ul><ul><ul><li>Continue operating as long as P ≥ min AVC. </li></ul></ul>
  12. 12. Firm’s Short-Run Supply Curve: MC Above Min AVC Q f* P min AVC $ Q f ATC AVC MC
  13. 13. Short-Run Market Supply Curve <ul><li>The market supply curve is the summation of each individual firm’s supply at each price. </li></ul>Firm 1 Firm 2 5 Market Q Q Q P P P 15 10 20 30 18 25 43 S 1 S 2 S M
  14. 14. Long Run Adjustments? <ul><li>If firms are price takers but there are barriers to entry , profits will persist. </li></ul><ul><li>If the industry is perfectly competitive, firms are not only price takers but there is free entry. </li></ul><ul><ul><li>Other “greedy capitalists” enter the market. </li></ul></ul>
  15. 15. Effect of Entry on Price? S* P e* D f* Entry Firm Q f $ D f Market Q M $ D S P e
  16. 16. Effect of Entry on the Firm’s Output and Profits? P e D f P e* D f* Q f * $ Q AC MC Q L
  17. 17. Summary of Logic <ul><li>Short run profits leads to entry. </li></ul><ul><li>Entry increases market supply, drives down the market price, increases the market quantity. </li></ul><ul><li>Demand for individual firm’s product shifts down. </li></ul><ul><li>Firm reduces output to maximize profit. </li></ul><ul><li>Long run profits are zero according to the text </li></ul>
  18. 18. Features of Long Run Competitive Equilibrium <ul><li>P = MC </li></ul><ul><ul><li>Socially efficient output. </li></ul></ul><ul><li>P = minimum AC </li></ul><ul><ul><li>Efficient plant size. </li></ul></ul><ul><ul><li>Zero profits </li></ul></ul><ul><ul><ul><li>Firms are earning just enough to offset their opportunity cost. </li></ul></ul></ul>
  19. 19. Monopoly Environment <ul><li>Single firm serves the “relevant market.” </li></ul><ul><li>Most monopolies are “local” monopolies. </li></ul><ul><li>The demand for the firm’s product is the market demand curve. </li></ul><ul><li>Firm has control over price. </li></ul><ul><ul><li>But the price charged affects the quantity demanded of the monopolist’s product. </li></ul></ul>
  20. 20. Managing a Monopoly <ul><li>Market power permits you to price above MC </li></ul><ul><li>Is the sky the limit? </li></ul><ul><li>No. How much you sell depends on the price you set! </li></ul>
  21. 21. A Monopolist’s Marginal Revenue Q Q P TR 100 0 0 10 20 30 40 50 10 20 30 40 50 800 60 1200 40 20 Inelastic Elastic Elastic Inelastic Unit elastic Unit elastic MR
  22. 22. Monopoly Profit Maximization D MR Q M P M Profit ATC Produce where MR = MC. Charge the price on the demand curve that corresponds to that quantity. $ Q ATC MC
  23. 23. Useful Formulae <ul><li>What’s the MR if a firm faces a linear demand curve for its product? </li></ul><ul><li>Alternatively, </li></ul>
  24. 24. Long Run Adjustments? <ul><li>None, unless the source of monopoly power is eliminated. </li></ul>
  25. 25. Why the Justice Department Dislikes Monopoly? <ul><li>P > MC </li></ul><ul><ul><li>Too little output, at too high a price. </li></ul></ul><ul><li>Deadweight loss of monopoly. </li></ul><ul><li>But there is a portion of the U.S. population that is negative toward business in general even though they provide jobs and produce quality products and services </li></ul><ul><li>Gov’t, in comparison, produces mostly substandard products and services </li></ul>
  26. 26. Deadweight Loss of Monopoly – pricing above MC D MR MC Deadweight Loss of Monopoly $ Q ATC MC Q M P M
  27. 27. Arguments for Monopoly <ul><li>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. </li></ul><ul><li>Encourages innovation. </li></ul>
  28. 28. Monopolistic Competition: Environment and Implications <ul><li>Numerous buyers and sellers </li></ul><ul><li>Differentiated products </li></ul><ul><ul><li>Implication: Since products are differentiated, each firm faces a downward sloping demand curve. </li></ul></ul><ul><ul><ul><li>Consumers view differentiated products as close substitutes: there exists some willingness to substitute. </li></ul></ul></ul><ul><li>Free entry and exit </li></ul><ul><ul><li>Implication: Firms will earn zero profits in the long run. </li></ul></ul><ul><ul><li>According to the text that is so. But in practice, firms in industry segments with these characteristics can earn positive profits over time. </li></ul></ul>
  29. 29. Managing a Monopolistically Competitive Firm <ul><li>Like a monopoly, monopolistically competitive firms </li></ul><ul><ul><li>have market power that permits pricing above marginal cost. </li></ul></ul><ul><ul><li>level of sales depends on the price it sets. </li></ul></ul><ul><li>But … </li></ul><ul><ul><li>The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. </li></ul></ul><ul><ul><li>Free entry and exit impacts profitability. </li></ul></ul><ul><li>Therefore, monopolistically competitive firms have limited market power but if differentiated have some market power. </li></ul>
  30. 30. Marginal Revenue Like a Monopolist Q Q P TR 100 0 0 10 20 30 40 50 10 20 30 40 50 800 60 1200 40 20 Inelastic Elastic Elastic Inelastic Unit elastic Unit elastic MR
  31. 31. Monopolistic Competition: Profit Maximization <ul><li>Maximize profits like a monopolist </li></ul><ul><ul><li>Produce output where MR = MC. </li></ul></ul><ul><ul><li>Charge the price on the demand curve that corresponds to that quantity. </li></ul></ul>
  32. 32. Short-Run Monopolistic Competition D MR Q M P M Profit ATC Quantity of Brand X $ ATC MC
  33. 33. Long Run Adjustments? <ul><li>If the industry is truly monopolistically competitive, there is free entry. </li></ul><ul><ul><li>In this case other “greedy capitalists” enter, and their new brands steal market share. </li></ul></ul><ul><ul><li>This reduces the demand for your product until profits are ultimately zero. </li></ul></ul>
  34. 34. Long-Run Monopolistic Competition D MR Q* P* Quantity of Brand X MR 1 D 1 Entry P 1 Q 1 Long Run Equilibrium (P = AC, so zero profits) $ AC MC
  35. 35. Conclusion <ul><li>Firms operating in a perfectly competitive market take the market price as given. </li></ul><ul><ul><li>Produce output where P = MC. </li></ul></ul><ul><ul><li>Firms may earn profits or losses in the short run. </li></ul></ul><ul><ul><li>… but, in the long run, entry or exit forces profits to zero. </li></ul></ul><ul><li>A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power is not eliminated. </li></ul><ul><li>A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits over time. </li></ul>