Transcript Managerial Decisions for firms with Market Power

Chapter 12: Managerial Decisions
for Firms with Market Power
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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)
12-2
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
12-3
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
12-4
Measurement of Market Power
• Lerner index measures proportionate amount
by which price exceeds marginal cost:
P  MC
Lerner index 
P
• 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
12-5
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
12-6
Barriers to Entry
• 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
12-7
Barriers to entry: 2 definitions
1. “[A]nything which creates a disadvantage for potential
entrants vis à vis established firms. The height of the
barriers is measured by the extent to which, in the long
run, established firms can elevate their selling prices above
minimal average cost . . . without inducing potential
entrants to enter” [Joe Bain, Industrial Organization, 2nd
ed., p. 252].
2. Barriers to entry into a market . . . can be defined to be
socially undesirable limitations to entry of resources which
are due to protection of resource owners already in the
market” [Christian von Weizsäcker, Barriers to Entry, p.
13].
12-8
Examples of barriers to entry
Absolute cost advantages
Examples: Alcoa had access to low cost hydroelectric power
in Pacific NW; Weyerhauser procured extraction rights to
tracts of Douglas fir in 1901; International petroleum majors
(Texaco, SOCAL, BP, et al) formed a pipeline consortium in
California.
Economies of scale: Dominant firm may enjoy cost
advantages due to realization of scale economies in
production, distribution, capital raising, or sales promotion.
12-9
Barriers due to control of wholesale, retail distribution
systems
Examples: Control of wholesale diamond distribution by
DeBeers; Control of advantageous retail shelf space by
Proctor and Gamble, Kellogs.
Barriers due to patents, copyrights, trademarks, and
other legal barriers
Examples: Xerox’s patent on xerography; Polaroid’s patent
on instamatic photography
Barriers due to product differentiation/brand power
Examples: Cigarettes, pain relievers, designer jeans, athletic
wear, batteries, soft drinks
12-10
Strategic Barriers
Alcoa’s restrictive covenants with hydroelectric suppliers.
Standard Oil’s “secret rebate” policy with the railroad
companies.
“Lease-only” policy of IBM, United Shoe Machinery,
International Salt
IBM’s continual design modification was designed to
forestall entry of firms such as Calcomp that marketed plugcompatible peripherals—e.g.,tapes and line printers.
Microsoft charges PC makers a royalty for every computer
shipped—regardless of whether the machine has a Windows
operating system installed.
Microsoft requires that Explorer icon appear on desktop in
initial boot up sequence.
12-11
The Microsoft case
Microsoft Corporation v. U.S. 530 U.S. 1301 (2000)
The Antitrust Division of the
DOJ won Sherman section 1
and section 2 convictions
against the software giant. The
key element in the case was
the so-called “applications
barrier to entry.”
12-12
The applications barrier in
the Microsoft case
Hear audio explanation (wav)
Judge Jackson stated in his Finding of Fact:
“[T]he applications barrier would prevent an
aspiring entrant into the relevant market from
drawing a significant number of customers away
from a dominant incumbent even if the
incumbent priced its products substantially
above competitive levels for a significant period
of time.”
12-13
Proprietary control of “application program
interfaces” keeps software developers in the
Microsoft tent.
“These are synapses at which the developer of an
application can connect to invoke pre-fabricated
blocks of code in the operating system. These blocks
of code in turn perform crucial tasks, such as
displaying text on the computer screen. Because it
supports applications while interacting more closely
with the PC system's hardware, the operating system
is said to serve as a ‘platform.’” Judge Jackson’s
Finding of Fact
12-14
The middleware threat
Mr. Gates viewed middleware (the
Java programming language and
Netscape browser software) as rival
platforms for ISV’s. Gates feared
middleware would bring down the
applications barrier.
Hear Brown’s comments (wav)
12-15
Evidence of ‘willful acquisition and
maintenance . . . “
The government alleged that Microsoft
designed its licensing agreements with
OEM’s and IAP’s so as to preserve the
applications barrier. This was also its
objective in giving away Internet
Explorer for free.
12-16
The OEM Channel
•Licensing agreements with Original Equipment Makers
(OEM’s) stipulated pre-installation of Internet explorer.
• Internet Explorer icon must appear on the desktop after the
initial boot-up sequence.
•OEM’s prohibited from pre-installing Netscape browser
software.
12-17
The IAP Channel
•
Microsoft offered IAP’s valuable “real estate” on the Windows
desktop in exchange for their agreement to distribute Internet
Explorer exclusively. Hear audio explanation (wav)
•
If an IAP was already under contract to pay Netscape a certain
amount for browser licenses, Microsoft offered to compensate
the IAP the amount it owed Netscape.
•
Microsoft also reduced the referral fees that IAPs paid when
users signed up for their services using the Internet Referral
Server in Windows in exchange for the IAPs' efforts to convert
their installed bases of subscribers from Navigator to Internet
Explorer.
12-18
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
12-19
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
12-20
Demand & Marginal Revenue
for a Monopolist (Figure 12.1)
12-21
Short-Run Profit Maximization
for Monopoly
• Monopolist will produce where MR = SMC as
long as TR at least covers the firm’s total
avoidable cost (TR ≥ TVC)
• Price for this output is given by the demand curve
• If TR < TVC (or, equivalently, P < AVC) the firm
shuts down & loses only fixed costs
• If P > ATC, firm makes economic profit
• If ATC > P > AVC, firm incurs a loss, but
continues to produce in short run
12-22
Short-Run Profit Maximization
for Monopoly (Figure 12.3)
12-23
Short-Run Loss Minimization
for Monopoly (Figure 12.4)
Shut-down rule
12-24
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
12-25
Long-Run Profit Maximization
for Monopoly (Figure 12.5)
12-26
Profit-Maximizing Input Usage
• Profit-maximizing level of input usage
produces exactly that level of output that
maximizes profit
12-27
Profit-Maximizing Input Usage
• Marginal revenue product (MRP)
• MRP is the additional revenue attributable to hiring
one more unit of the input
TR
MRP 
 MR  MP
L
• 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
12-28
Monopoly Firm’s Demand for Labor
(Figure 12.6)
12-29
Profit-Maximizing Input Usage
• For a firm with market power, profitmaximizing 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
12-30
Monopolistic Competition
A market structure
featuring a relatively
large number of sellers
and a differentiated
product/service
Examples: Women’s shoes, snack foods,
furniture, carpet, bathroom fixtures, men’s
suits, cold cuts.
12-31
The monopolistic
competitor faces a
downward sloping, but
very elastic, demand
curve.
12-32
Short run equilibrium in monopolistic competition
Dollars per Unit of Output
MC AC
P
AC
MRF
DF
Q
Output
(a) The Firm Earns Excess Profit
12-33
Long Run Equilibrium in Monopolistic Competition
Dollars per Unit of Output
MC
AC
PE
MRF
DF
QE
Output
(b) Long-Run Equilibrium:
the Firm Earns Zero Economic Profit
12-34
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
12-35
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
12-36
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)
12-37
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)
12-38
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
Q = a′ + bP
ˆ  dPˆ
Where a'  a  cM
R
12-39
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 2: Find inverse demand equation
• Solve for P
a' 1
P
 Q  A  BQ
b
b
a'
1
ˆ
ˆ
Where a'  a  cM  dPR , A 
, and B 
b
b
12-40
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
• Step 4: Estimate AVC & SMC
• Use statistical techniques from Chapter 10
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2
12-41
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 profitmaximizing output level
• Step 6: Find profit-maximizing price
• Substitute Q* into inverse demand
P* = A + BQ*
Q* & P* are only optimal if P  AVC
12-42
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
12-43
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 8: Compute profit or loss
• Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
• If P < AVC, firm shuts down & profit
is -TFC
12-44
Maximizing Profit at Aztec
Electronics: An Example
• Aztec possesses market power via
patents
• Sells advanced wireless stereo
headphones
12-45
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of demand & marginal
revenue
Q  41,000  500 P  0.6M  22.5PR
 41, 000  500 P  0.6(45, 000)  22.5(800)
 50, 000  500 P
12-46
Maximizing Profit at Aztec
Electronics: An Example
• Solve for inverse demand
Q  50 , 000  500 P
Q  50 , 000 500 P

500
500
Q
50 , 000

P
500
500
1
P  100 
Q
500
 100  0.002Q
12-47
Maximizing Profit at Aztec
Electronics: An Example
• Determine marginal revenue function
P = 100 – 0.002Q
MR = 100 – 0.004Q
12-48
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)
12-49
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of average variable cost and
marginal cost
• Given the estimated AVC equation:
AVC = 28 – 0.005Q + 0.000001Q2
• Then,
SMC = 28 – (2 x 0.005)Q + (3 x 0.000001)Q2
= 28 – 0.01Q + 0.000003Q2
12-50
Maximizing Profit at Aztec
Electronics: An Example
• Output decision
• Set MR = MC and solve for Q*
100 – 0.004Q = 28 – 0.01Q + 0.000003Q2
0 = (28 – 100) + (-0.01 + 0.004)Q + 0.000003Q2
= -72 – 0.006Q + 0.000003Q2
12-51
Maximizing Profit at Aztec
Electronics: An Example
• Output decision
• Solve for Q* using the quadratic formula
(  0.006)  (  0.006)  4(  72)(0.000003)
Q 
2(0.000003)
2
*
0.036

 6 , 000
0.000006
12-52
Maximizing Profit at Aztec
Electronics: An Example
• Pricing decision
• Substitute Q* into inverse demand
P* = 100 – 0.002(6,000)
= $88
12-53
Maximizing Profit at Aztec
Electronics: An Example
• Shutdown decision
• Compute AVC at 6,000 units:
AVC* = 28 - 0.005(6,000) + 0.000001(6,000)2
= $34
• Because P = $88 > $34 = ATC, Aztec should
produce rather than shut down
12-54
Maximizing Profit at Aztec
Electronics: An Example
• Computation of total profit
π = TR – TVC – TFC
= (P* x Q*) – (AVC* x Q*) – TFC
= ($88 x 6,000) – ($34 x 6,000) - $270,000
= $528,000 - $204,000 - $270,000
= $54,000
12-55
Profit Maximization at
Aztec Electronics (Figure 12.10)
12-56
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
12-57
A Multiplant Firm
(Figure 12.11)
12-58