firms with market powers

8/3/2019 Firms With Market Powers

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Firms with Market Powers



Market Power

• Ability of a firm to raise price without losingall its sales

– Any firm that faces downward sloping demandhas market power

• Gives firm ability to raise price aboveaverage cost & earn economic profit (if

demand & cost conditions permit)



Monopoly

• Single firm

• Produces & sells a particular good orservice for which there are no goodsubstitutes

• New firms are prevented from enteringmarket



Measurement of Market

Power• Degree of market power inversely related toprice 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 ishorizontal), the firm has no market power




Power• Lerner index measures proportionateamount by which price exceeds marginalcost:

P MC

P

Lerner index




Power• Lerner index

– 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 ofmarket power




Power• If consumers view two goods assubstitutes, cross-price elasticity ofdemand (E XY ) is positive

– The higher the positive cross-price elasticity,the greater the substitutability between twogoods, & the smaller the degree of market

power for the two firms



Determinants of Market

Power• Entry of new firms into a market erodesmarket power of existing firms by increasingthe number of substitutes

• A firm can possess a high degree of marketpower only when strong barriers to entry exist

– Conditions that make it difficult for new firmsto enter a market in which economic profits

are being earned



Common Entry Barriers

• Economies of scale

– When long-run average cost declines over a widerange of output relative to demand for the

product, there may not be room for another largeproducer to enter market

• Barriers created by government

– Licenses, exclusive franchises




• Input barriers

– One firm controls a crucial input in the productionprocess

• Brand loyalties – Strong customer allegiance to existing firms may

keep new firms from finding enough buyers tomake entry worthwhile




• Consumer lock-in – Potential entrants can be deterred if they believe

high switching costs will keep them from inducingmany consumers to change brands

• Network externalities – Occur when value of a product increases as more

consumers buy & use it

– Make it difficult for new firms to enter marketswhere firms have established a large network ofbuyers



Demand & Marginal Revenue for

a Monopolist• Market demand curve is the firm’s demand curve

• Monopolist must lower price to sell additional unitsof 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




a Monopolist (Figure 12.1)



Short-Run Profit Maximizationfor Monopoly

• Monopolist will produce a positive output ifsome price on the demand curve exceedsaverage variable cost

• Profit maximization or loss minimizationoccurs by producing quantity for which MR =

MC



Short-Run Profit Maximization

for Monopoly

• If P > ATC , firm makes economic profit

• If ATC > P > AVC , firm incurs loss, but

continues to produce in short run

• If demand falls below AVC at every level ofoutput, firm shuts down & loses only fixedcosts



Short-Run Profit Maximization

for Monopoly (Figure 12.3)



Short-Run Loss Minimization for

Monopoly (Figure 12.4)



Long-Run Profit Maximization forMonopoly

• Monopolist maximizes profit by choosing toproduce output where MR = LMC , as long asP 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 atthe profit-maximizing output level



Long-Run Profit Maximization for

Monopoly (Figure 12.5)



Profit-Maximizing Input Usage

• Profit-maximizing level of input usageproduces exactly that level of output thatmaximizes profit




• Marginal revenue product (MRP)

– MRP is the additional revenue attributable to hiring one

more unit of the input

• When producing with a single variable input:

• Employ amount of input for which MRP = inputprice

• Relevant range of MRP curve is downward sloping,positive portion, for which ARP > MRP

TR MRP MR MP L



Monopoly Firm’s Demand for

Labor (Figure 12.6)




• For a firm with market power, profit-maximizing 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



Monopolistic Competition

• Large number of firms sell a differentiatedproduct – 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



Sh t R P fit M i i ti f



Short-Run Profit Maximization for

Monopolistic Competition (Figure

12.7)

L R P fit M i i ti f



Long-Run Profit Maximization for

Monopolistic Competition (Figure

12.8)

Implementing the Profit



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 toget

Q a' bP

Rˆ ˆ a' a cM dP Where






Decision• Step 2: Find inverse demand equation

– Solve for P

a' P Q A BQ

b b

1

Rˆ ˆ a' a cM dP , A a' b , B

b 1

Where and






Decision• Step 3: Solve for marginal revenue

– When demand is expressed as P = A +

BQ, marginal revenue is

a' MR A BQ Q

b b

22






Decision• Step 4: Estimate AVC & SMC

– Use statistical techniques from Chapter 10

SMC a bQ cQ2

2 3

AVC a bQ cQ2




• Step 5: Find output where MR = SMC

– Set equations equal & solve for Q*

– The larger of the two solutions is the profit-maximizing output level

• Step 6: Find profit-maximizing price

– Substitute Q* into inverse demand

P* = A + BQ*

Q* & P* are only optimal if P AVC



Decision




Aztec Electronics (Figure 12.9)



Maximizing Profit at AztecElectronics: An Example

• Estimation of average variable cost andmarginal cost

– Given the estimated AVC equation:

228 0.005 0.000001 AVC Q Q

• So,

228 (2 0.005) (3 0.000001)SMC Q Q

228 0.01 0.000003Q Q




• Output decision

– Set MR = MC and solve for Q*

2100 0.004 28 0.01 0.000003Q Q Q

20 (28 100) ( 0.01 0.004) 0.000003Q Q

272 0.006 0.000003Q Q




• Output decision

– Solve for Q* using the quadratic formula

2( 0.006) ( 0.006) 4( 72)(0.000003)*

2(0.000003)Q

0.036

0.000006 6,000




• Pricing decision

– Substitute Q* into inverse demand

* 100 0.002(6, 000)P

$88




• Shutdown decision

– Compute AVC at 6,000 units:

2* 28 0.005(6, 000) 0.000001(6, 000) AVC

$34

$88 $34P AVC Because , Aztec shouldproduce rather than shut down




• Computation of total profit

TR TVC TFC

( * *) ( * *)P Q AVC Q TFC

($88 6, 000) ($34 6, 000) $270, 000

$528, 000 $204, 000 $270, 000

$54,000



Profit Maximization at Aztec

Electronics (Figure 12.10)

firms with market powers

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