Transcript Econ 420

Welcome to
EC 209: Managerial
Economics- Group A
By: Dr. Jacqueline Khorassani
Week Nine
1
Managerial EconomicsGroup A
Week Nine- Class 1
Monday, October 29
11:10-12:00
Fottrell (AM)
Bank Holiday- no class
2
Chapter 8 of Baye
Managing in Competitive,
Monopolistic, and Monopolistically
Competitive Markets
3
What are the characteristics
of a perfectly competition
market?
1.
2.
3.
4.
5.
Many buyers and sellers.
Homogeneous (identical) product.
Perfect information on both sides of
market.
No transaction costs.
Free entry and exit.
4
Key Implications?
1.
2.
3.
Firms are “price takers”.
In the short-run, firms may earn
profits or losses.
Long-run profits are zero.
5
Unrealistic? Yes.
So, why learn?
1.
2.
3.
4.
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.
6
Managing a Perfectly
Competitive Firm
(or Price-Taking Business)
7
Setting Price
$
Remember: MR =
marginal revenue = the
revenue of selling one
more unit of output.
$
S
Df = MR
10
D
QM
Market
Firm
Qf
8
Profit-Maximizing Output
Decision

General rule of profit maximization:
– Choose the quantity of output where MR =
MC. Why?
If produce more  MC>MR  total profits
decline
_______
.
 If produce less  MC<MR  can increase
more
total profits by selling _______.



Since, MR = P,
Produce where P = MC
9
Graph of a Firm’s Output
Decision
Profit = €20
MC
€
ATC
AVC
Pe = Df = MR
10
ATC = 6
5
Qf
10
A Numerical Example

Given
– P=€10
– C(Q) = 5 + Q2

Optimal Output?
– MR = P = €10
– and MC = 2Q
– 10 = 2Q
– Q = 5 units

How much are the profits?
– PQ - C(Q) = (10)*(5) - (5 + 25) = $20
11
Should this Firm Sustain Short
Run Losses or Shut Down?
If operate Profit = € -1
ATC
MC
$
AVC
ATC= € 4.5
€4
Loss
Pe = Df = MR
AVC= €2
2
Qf
If shut down loss = €5 = fixed cost
12
Shutdown Decision Rule


firm should continue to operate if its
operating loss is less than its fixed
costs.
Decision rule:
– A firm should shutdown when P < min
AVC.
– Continue operating as long as P ≥ min
AVC.
13
Firm’s Short-Run Supply
Curve: MC Above Min AVC
ATC
MC
$
AVC
P= min AVC
Break even
point
Qf*
Qf
Shut down
point
14
Short-Run Market Supply Curve
•
P
The market supply curve is the summation of
each individual firm’s supply at each price.
Firm 1
Market
Firm 2
P
P
S1
S2
SM
15
5
10
18
Q
20
25
Q
43Q
30
15
Long Run Adjustments?

If firms are price takers but there are
barriers to entry, profits will persist.
16
But if the industry is perfectly competitive, firms
are not only price takers but there is free entry.
$
$
S
Entry
Other “greedy
capitalists”
enter the
market.
S*
Pe
Pe*
Df
Df*
D
QM
Market
As new firms enter the
market price falls
Firm
Qf
17
As price falls
MC
$
AC
Pe
Df
Pe*
Df*
QL Qf*
Q
Profits diminish and output of each firm goes down
18
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.
19
Managerial EconomicsGroup A

Week Nine- Class 2
– Thursday, November 1
– Cairnes
– 15:10-16:00
20
Monopoly Environment




Single firm serves the “relevant market.”
Most monopolies are “local”
monopolies. E.g. petrol station in small town
The demand for the firm’s product is
the market demand curve.
Firm has control over price.
– But the price charges affects the quantity
demanded of the monopolist’s product.
21
“Natural” Sources of
Monopoly Power



Economies of scale
Economies of scope
Cost complementarities
22
“Created” Sources of
Monopoly Power



Patents and other legal barriers (like
licenses)
Exclusive contracts
Collusion
23
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!
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A Monopolist’s Marginal
Revenue
P
100
TR
Unit elastic
Elastic
80
Unit elastic
1200
60
Inelastic
40
800
0
10
20
30
50
Q
0
10
20
30
50
MR
Elastic
Inelastic
25
Q
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Q
26
Useful Formulae

What’s the MR if a firm faces a linear demand
curve for its product?
P  a  bQ
MR  a  2bQ, where b  0.

Alternatively,
1  E 
MR  P 

E


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A Numerical Example

Given estimates of
P = 10 - Q
 C(Q) = 6 + 2Q


Optimal output?
MR = 10 - 2Q
 MC = 2
 10 - 2Q = 2
 Q = 4 units


Optimal price?


P = 10 - (4) = $6
Maximum profits?

PQ - C(Q) = (6)(4) - (6 + 8) = $10
28
Long Run Adjustments?

None, unless the
source of
monopoly power
is eliminated.
29
Why Government Dislikes
Monopoly?

P > MC
– Too little output, at too
high a price.

Deadweight loss of
monopoly-welfare loss (in
terms of consumer and
producer surplus)
30
Deadweight Loss of
Monopoly
$
MC
Deadweight Loss
of Monopoly
ATC
PM
D
MC
QM
MR
Q
31
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.
32
Monopoly Multi-Plant
Decisions


Consider a monopoly that produces identical
output at two production facilities (think of a
firm that generates and distributes electricity
from two facilities).
– Let C1(Q1) be the production cost at facility
1.
– Let C2(Q2) be the production cost at facility
2.
Decision Rule: Produce output where
MR(Q) = MC1(Q1) and MR(Q) = MC2(Q2)
– Set price equal to P(Q), where Q = Q1 + Q2.
33
Monopolistic Competition:
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
34
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.
35
Marginal Revenue Like a
Monopolist
P
100
TR
Unit elastic
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
20
30
40
50
MR
Elastic
Inelastic
36
Q
Monopolistic Competition:
Profit Maximization

Maximize profits like a monopolist
– Produce output where MR = MC.
– Charge the price on the demand curve
that corresponds to that quantity.
37
Short-Run Monopolistic
Competition
MC
$
ATC
Profit
PM
ATC
D
QM
MR
Quantity of Brand X
38
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.
39
Long-Run Monopolistic
Competition
Long Run Equilibrium
(P = AC, so zero profits)
$
MC
AC
P*
P1
Entry
MR
Q1 Q*
MR1
D
D1
Quantity of Brand
X
40
Monopolistic Competition
The Good (To
Consumers)
– Product Variety
The Bad (To Society)
P > MC
– Excess capacity

Unexploited economies of
scale
The Ugly (To Managers)
P = ATC > minimum of
average costs.

Zero Profits (in LR)
41
Monopolistic Competition
and the Welfare of Society


There is the normal deadweight loss of
monopoly pricing in monopolistic
competition caused by the markup of
price over marginal cost.
However, the administrative burden of
regulating the pricing of all firms that
produce differentiated products would
be overwhelming.
42
Optimal Advertising
Decisions


Advertising is one way for firms with market power
to differentiate their products.
But, how much should a firm spend on
advertising?
– Advertise to the point where the additional revenue generated
from advertising equals the additional cost of advertising.
– Equivalently, the profit-maximizing level of advertising occurs
where the advertising-to-sales ratio equals the ratio of the
advertising elasticity of demand to the own-price elasticity of
demand.
A EQ , A

R  EQ , P
43
Advertising (Read pp. 380-384 in
Mankiw)


Firms that sell highly differentiated consumer
goods typically spend between 10 and 20
percent of revenue on advertising.
Overall, about 2 percent of total revenue, or
over $200 billion a year, is spent on
advertising. See Table 7-6 in Baye for
examples of A/TR ratios. High in
pharmaceutical, cosmetics and food
industries. Low in industrial products.
44
Critique of Advertising




Critics of advertising argue that firms advertise in
order to manipulate people’s tastes.
They also argue that it impedes competition by
implying that products are more different than they
truly are.
Defenders argue that advertising provides
information to consumers and that advertising
increases competition by offering a greater variety
of products and prices.
The willingness of a firm to spend advertising
dollars can be a signal to consumers about the
quality of the product being offered.
45
Advertising and
Competition




Study in the U.S. found that the price of spectacles
was about 20% lower in states where advertising
by optometrists was allowed.
Ireland – optometrists are one of the professions
being examined by the Competition Authority.
Study by Indecon found that, while 75% of
optometrists in Ireland said there was significant or
extensive price competition, only 38% of the public
agreed. 50% of the public said they would like
more information about prices.
Comparative advertising by optometrists is
prohibited in Ireland. Indecon recommended that
this restriction be removed.
46
Maximizing Profits: A
Synthesizing Example


C(Q) = 125 + 4Q2
Determine the profit-maximizing output
and price, and discuss its implications, if
– You are a price taker and other firms charge
$40 per unit;
– You are a monopolist and the inverse demand
for your product is P = 100 - Q;
– You are a monopolistically competitive firm
and the inverse demand for your brand is P =
100 – Q.
47
Marginal Cost



C(Q) = 125 + 4Q2,
So MC = 8Q.
This is independent of market
structure.
48
Price Taker


MR = P = $40.
Set MR = MC.
40 = 8Q.
 Q = 5 units.


Cost of producing 5 units.


Revenues:



C(Q) = 125 + 4Q2 = 125 + 100 = $225.
PQ = (40)(5) = $200.
Maximum profits of -$25.
Implications: Expect exit in the longrun.
49
Monopoly/Monopolistic
Competition


MR = 100 - 2Q (since P = 100 - Q).
Set MR = MC, or 100 - 2Q = 8Q.
– Optimal output: Q = 10.
– Optimal price: P = 100 - (10) = $90.
– Maximal profits:


PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375.
Implications
– Monopolist will not face entry (unless patent
or other entry barriers are eliminated).
– Monopolistically competitive firm should
expect other firms to clone, so profits will
50
Conclusion

Firms operating in a perfectly competitive market
take the market price as given.
– Produce output where P = MC.
– Firms may earn profits or losses in the short run.
– … but, in the long run, entry or exit forces profits to
zero.


A monopoly firm, in contrast, can earn persistent
profits provided that source of monopoly power
is not eliminated.
A monopolistically competitive firm can earn
profits in the short run, but entry by competing
brands will erode these profits over time.
51