EC 500

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EC 500

• Chapter 8
• Managing in Competitive, Monopolistic, and
  Monopolistically Competitive Markets

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Headline

• McDonalds Adds New Tastes and Products to Menu
  Boards
• Recently, McDonalds announced the launch of its
  New Tastes Menu at all of its U.S. restaurants.
  McDonalds is one of the worlds largest
  food-service retailers, serving over 43 million
  customers each day. More than 85 percent of
  McDonalds restaurants around the world are owned
  and operated by independent franchisees.

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• McDonalds New Tastes Menu is an innovative plan
  to bring choice and variety to customers by
  permitting local restaurants to showcase seasonal
  and regional menu items that cater to the
  cravings of local customers.
• Based on local preferences, a restaurant might
  offer the McRib Jr., Mighty Wings, or the Sausage
  Breakfast Burrito on its local menu board.
• Do you think McDonalds new launch will have a
  sustainable impact on its bottom line? Explain.

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Overview

• I. Perfect Competition
• Characteristics and profit outlook.
• Effect of new entrants.
• II. Monopolies
• Sources of monopoly power.
• Maximizing monopoly profits.
• Pros and cons.
• III. Monopolistic Competition
• Profit maximization.
• Long run equilibrium.

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Perfect Competition Environment

• Many buyers and sellers.
• Homogeneous (identical) product.
• Perfect information on both sides of market.
• No transaction costs.
• Free entry and exit.

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Key Implications

• Firms are price takers (P MR).
• In the short-run, firms may earn profits or
  losses.
• Long-run profits are zero.

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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.

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1. Perfectly Competition (or Price-Taking
Business)
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Setting Price
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Profit-Maximizing Output Decision

• MR MC.
• This rule holds in all cases.
• Since, MR P in a perfect competition
  environment,
• Set P MC to maximize profits.

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Profit Maximization Rule

• MR MC in all cases!
• When MR MC, the difference between Revenue and
  Cost is maximized.
• Point We decide on Q to make MR MC.

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Some Definitions (Ch 5)
Average Total Cost ATC AVC AFC ATC
C(Q)/Q Average Variable Cost AVC
VC(Q)/Q Average Fixed Cost AFC FC/Q Marginal
Cost MC DC/DQ
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• Points
• MC passes the lowest point of AC (ATC or AVC).
• At the minimum of AC, satisfying d(AC) 0, we
  have MC AC.
• FC does not change when Q changes.
• AFC decreases monotonically as Q increases.

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Fixed Cost (Ch 5)
Q0?(ATC-AVC) Q0? AFC Q0?(FC/ Q0) FC
ATC
Fixed Cost
AFC
AVC
Q0
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Variable Cost (Ch 5)
Q0?AVC Q0?VC(Q0)/ Q0 VC(Q0)
AVC
Variable Cost
Q0
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Total Cost (end of Ch 5)
Q0?ATC Q0?C(Q0)/ Q0 C(Q0)
ATC
Total Cost
Q0
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Graphically Representative Firms Output Decision
Profit (Pe - ATC) ? Qf
Pe Df MR
Pe
ATC
Qf
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• Here, P (MR) is given higher than ATC.
• Then, the firm produces Qf to satisfy MR MC.
• Profit (P - ATC) ? Qf

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Can you draw it again?
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A Numerical Example

• Given
• P10
• C(Q) 5 Q2
• Optimal Price?
• P10
• Optimal Output?
• MR P 10 and MC 2Q
• 10 2Q (MR MC)
• Q 5 units
• Maximum Profits?
• PQ - C(Q) (10)(5) - (5 25) 20

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What will happen if P is lower than ATC or AVC at
the point where P (MR) MC?
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Should this Firm Sustain Short Run Losses or Shut
Down?
Profit (Pe - ATC) ? Qf lt 0
ATC
ATC
Pe Df MR
Pe
Qf
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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 lt min AVC.
• Continue operating as long as P min AVC.

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Firms Short-Run Supply Curve MC Above Min AVC
P min AVC
Qf
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Short-Run Market Supply Curve

• The market supply curve is the summation of each
  individual firms supply at each price.

Market
Firm 1
Firm 2
P
P
P
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5
Q
Q
Q
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Note MC is the SR supply curve of an individual
firm
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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.

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Effect of Entry on Price?
S
Entry
Pe
Df
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Effect of Entry on the Firms Output and Profits
Pe
Df
Df
Pe
Qf
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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 firms product shifts down.
• Firm reduces output to maximize profit.
• Long run profits are zero.

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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.

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2. Monopoly Environment

• Single firm serves the relevant market.
• Most monopolies are local monopolies.
• The demand for the firms product is the market
  demand curve.
• Firm has control over price.
• But the price charged affects the quantity
  demanded of the monopolists product.

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Natural Sources of Monopoly Power

• Economies of scale
• Economies of scope
• Cost complementarities

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Economies of Scale?
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Created Sources of Monopoly Power

• Patents and other legal barriers (like licenses)
• Tying contracts
• Exclusive contracts
• Collusion

Contract...
I. II. III.
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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 Monopolists Marginal Revenue Recall Ch. 3
P
TR
Unit elastic
100
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
30
40
50
30
40
50
Q
Q
0
0
10
20
10
20
MR
Elastic
Inelastic
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• Recall
• Profit is maximized when
• Elasticity is -1.0
• At this point, MR 0

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Monopoly Profit Maximization
Produce where MR MC. Charge the price on the
demand curve that corresponds to that quantity.
Profit
PM
ATC
D
QM
MR
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• Points
• Choose Q (say, QM), where MR MC
• At QM, we know PM is given from the demand curve.
• Profit is calculated when the difference between
  P and ATC is multiplied by QM.

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Can you draw it again?
D
QM
MR
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Useful Formulae

• Whats the MR if a firm faces a linear demand
  curve for its product?
• Alternatively,

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A Numerical Example

• Given estimates of
• P 10 - Q
• C(Q) 6 2Q
• Optimal output?
• R PQ (10 Q)Q 10Q Q2
• MR 10 - 2Q
• MC 2
• MR MC gives 10 - 2Q 2
• Q 4 units
• Optimal price?
• P 10 - (4) 6
• Maximum profits?
• PQ - C(Q) (6)(4) - (6 8) 10

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Long Run Adjustments?

• None, unless the source of monopoly power is
  eliminated.

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Why Government Dislikes Monopoly?

• P gt MC !!
• Too little output, at too high a price.
• Deadweight loss of monopoly.

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Deadweight Loss of Monopoly
Deadweight Loss of Monopoly
D
MC
MR
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Alternatively,
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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.

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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(Q2) 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.

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3. Monopolistic Competition

• Environment and Implications
• Numerous buyers and sellers
• Differentiated products
• 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.

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• 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.

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Marginal Revenue Like a Monopolist
P
TR
Unit elastic
100
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
30
40
50
30
40
50
Q
Q
0
0
10
20
10
20
MR
Elastic
Inelastic
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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.

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Short-Run Monopolistic Competition
Profit
PM
ATC
D
Quantity of Brand X
QM
MR
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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.

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Long-Run Monopolistic Competition
Long Run Equilibrium (P AC, so zero profits)
P
P1
Entry
D
D1
MR
Quantity of Brand X
Q1
Q
MR1
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Alternatively,
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Monopolistic Competition

• The Good (To Consumers)
• Product Variety
• The Bad (To Society)
• P gt MC
• Excess capacity
• Unexploited economies of scale
• The Ugly (To Managers)
• P ATC gt minimum of average costs.
• Zero Profits (in the long run)!

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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.

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• 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.

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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.

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Marginal Cost

• C(Q) 125 4Q2,
• So MC 8Q.
• This is independent of market structure.

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Price Taker

• MR P 40.
• Set MR MC.
• 40 8Q.
• Q 5 units.
• Cost of producing 5 units.
• C(Q) 125 4Q2 125 100 225.
• Revenues
• PQ (40)(5) 200.
• Maximum profits of -25.
• Implications Expect exit in the long-run.

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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 decline
  over time.

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Answering the Headline

• McDonalds New Tastes Menu is unlikely to have
  a sustainable impact on its bottom line. As noted
  earlier in this chapter, the fast-food restaurant
  business has many features of monopolistic
  competition.
• Indeed, the owner of a typical McDonalds
  franchise competes not only against Burger King
  and Wendys but against a host of other
  establishments such as KFC, Arbys, Taco Bell,
  and Popeyes.
• While each of these establishments offers quick
  meals at reasonable prices, the products offered
  are clearly differentiated. This gives these
  businesses some market power.

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• While a monopolistically competitive business
  like McDonalds might earn positive economic
  profits in the short run by introducing new
  products more quickly than its rivals, in the
  long run its competitors will attempt to mimic
  the strategies that are profitable.
• Thus, while McDonalds New Taste Menus might
  lead to short-run profits, in the long run other
  firms are likely to copy this strategy if it
  proves successful. This type of entry by rival
  firms would reduce the demand for meals at
  McDonalds and ultimately result in long-run
  economic profits of zero.

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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.

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Homework

• Chapter 8
• Q. 4, 5, 8, 12, 13