Marginal Analysis

Basic production (pricing) theory

Course outline

demand Basic Model Cost/Market structure Managerial perspective Organization of firm

Managerial Microeconomics markets

Marginal analysis
Strategic analysis

Additional topics

Applying economics Methodology Matching thoery

Question-1

Eurostar operates the only high speed train service between the centers of London and Paris via Eurotunnel. One of Eurostars major costs is the interest on bank loans. If Eurostar renegotiates these loans, so reducing the average cost of service, should the company cut its fares by the same amount?
As a monopoly, you should also lower your price when the marginal cost curve is lowered However, in this case interest cost is a fixed cost, so price should remain unchanged.

Question-2

The manager of a convenience store buys cola from a supplier at a price of $1.25 per liter. According publicly available data and her own estimation, she believes that the elasticity for cola sold by her store is -4. What price should the manager charge for a liter of cola to maximize profits?

Lecture Outline
1.

Managing without market power

Optimal production rate Profitability

2.

Managing with market power

Optimal production rate (or pricing) (three views) Multiplant output decision Optimal advertising rule

3.

Measuring market power

1. Managing without market power

No market power:

your firms participation has no impact on the market. price taker: at the market price, your firm faces a horizontal demand curve within your production capacity.

Given a price, what is your optimal strategy?

1. Managing without market power

Profitability

The future is not very bright: make ____ economic zero profit! (why?) zero But its not extremely dark either: _____ economic profit ______ accounting profit zero

The firm is still able to pay the wage, and all other costs.

2. Managing with market power

Market power

Your firm Faces a downward-sloping demand curve You may choose either the price or the quantity (but not both!)

Optimal production (pricing) strategy (view 1)

Set price (quantity) such that

marginal cost marginal revenue ______________=____________

2.1.1 Marginal Revenue

Marginal Revenue: the change in total revenue arising from selling an additional unit.

To sell an additional unit, a monopolist must reduce its price. Inframarginal Units: are those other than the marginal unit. Marginal Revenue = Price - Loss of revenue on the inframarginal units

2.1.1 Monopoly Production Rate

250

150 130

demand (marginal benefit)

70
50 marginal cost 0.4 -50 0.8

e marginal revenue d

1.2

1.4

1.6

Quantity (Millions units a year)

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2.1.1 Linear Demand

How to derive marginal revenue curve: Demand: Q=100-2P

Rewrite: P=50- Q Total Revenue = P * Q = (50- Q) *Q Marginal Revenue = 50 Q Q MR= 50-Q

Product Rule; For evrey unit increase in output, price decrease by 1/2.

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2.1.1 Marginal Revenue

$ a

P= a - bQ (Demand) MR=a 2b Q

a / 2b

a / bQ

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2.1.2 Optimal pricing(production rate)view 2 (optimal IM%)

MR=MC When demand curve is unknown, hence cannot work out MR curve. If instead, we know the price elasticity of demand. We can choose a profit maximizing price by setting the incremental margin percentage equal to the inverse of price elasticity of demand, that is, -1/e = (price - MC) / price.
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Rewrite MR=MC

Total revenue = P(Q) * Q MR = Q ( dP/dQ) + P =MC (optimal Q) eP = (P/Q)(dQ/dP) by definition (P-MC)/P= - (1/eP)

Always operate at the elastic portion of demand curve

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2.1.2 Optimal IM%

lower incremental margin percentage (IM%) for more elastic product

e = -2 => IM% = 1/2 e = -1.5 =>IM% = 2/3

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2.1.3 Optimal pricing (production rate)view 3 (Optimal mark-up rule)

MR=P[(1/e)+1]=MC P=[e/(1+e)]MC Profit-maximizing markup factor: e/(1+e) The optimal price is a simple markup over relevant costs! More elastic the demand, lower markup. Less elastic the demand, higher markup.

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2.1.4 Economic Inefficient

Deadweight Loss
P

Pm Pc b

a c MC

MR

Qm

Qc

Q
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2.1.5 Demand Change

Find new quantity where marginal revenue = marginal cost demand shift should change price

new quantity and price depend on both new demand and costs

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2.1.5 Demand Increase

Price ($ per unit)

250 200 150 100 50 0 marginal cost 0.4 0.8 1.2 1.6 a new marginal revenue 2 new demand original demand

Quantity (Million units a year)

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2.1.6 Cost Change

Find new quantity where marginal revenue = marginal cost change in fixed cost should not change price change in marginal cost should change price (but not equal to change in MC)

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2.1.6 Reduction in Marginal Cost

200
demand 150 100 50 original marginal cost new marginal cost 0.4 -50 0.8 1.2 1.6 2 k

marginal revenue

Quantity (Millions units a year)

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2.2 Multiplant Decisions

Suppose the inverse demand for a monopolists product is given by P(Q)=70-0.5Q The monopolist can produce output in two plants. The marginal cost of producing in plant 1 is MC1=3Q1, and the marginal cost of producing in plant 2 is MC2=Q2. How much output should be produced in each plant, and what price should be charged to maximize profit?

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2.2 Multiplant Decisions

Multiplant Output Rule MR(Q)=MC1(Q1)=MC2(Q2).

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2.3 Optimal advertising-to-sales ratio

(P,A)=Q(P,A)P-C(Q(P,A))-A F.O.C.

/P =(Q/P)P+Q- (C/Q)(Q/P)=0 and /A= (Q/A)P- (C/Q)(Q/A)-1=0 [(P-MC)/P]=-1/eP (A/R)=[(P-MC)/P]eA

A/R =-eA/eP !

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2.3 Optimal advertising-to-sales ratio

Corpus Industries produces a product at constant marginal cost that it sells in a monopolistically competitive market. In an attempt to bolster profits, the manager hired an economist to estimate the demand for its product. She found that the demand for the firms product is log-linear, with an own price elasticity of demand of -10 and an advertising elasticity of demand of 0.2. To maximize profits, what fraction of revenues should the firm spend on advertising?

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2.3 Advertising-to-sales ratio

industry Ad as % of sales Ad as % of (sales-cost of goods)

Amusement parks
Auto dealer, gas station beverages Educational services Games, toys, chld veh Hotels and motels Household audio video Eq Jewelry stores Wine, brandy

8.5
0.8 6.7 12.8 8.5 1.4 6.5 5.4 6.2

17.9
5.7 10.9 24.8 18.5 6.2 51.9 14.3 13.8

http://adage.com/datacenter/article?article_id=106575
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3. Potential Competition

Competition will push down the market price toward the long-run average cost. Sometimes, potential competition is sufficient to keep the market price close to the long-run average cost.

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3. Measure monopoly (market) power

Lerner Index:

Defined as the incremental margin divided by the price. (P-MC)/P The _____ inelastic is market demand, the higher a monopoly can raise its price above its marginal cost.

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3. Lerner Index

Total revenue = P(Q) * Q MR = Q ( dP/dQ) + P =MC (optimal Q) eP = (P/Q)(dQ/dP) by definition (P-MC)/P= - (1/eP)

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3. Lerner Index

Lerner Index is a ______, hence we can compare different markets . It captures the impact of ________ competition.

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3. Lerner Index Domowitz, Hubbard, and Petersen (1986) estimates

Period Total # C4 industries [0,20] (284) (64) 0.244 0.213 C4 [21,40] (92) 0.232 C4 [41,60] (72) 0.242 C4 [61,80] (41) 0.284 C4 [81,100] (15) 0.348

19581965 19661973

0.267

0.242

0.254

0.263

0.305

0.358

19741981

0.273

0.256

0.269

0.269

0.294

0.332

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Common Misconception

Monopolys supply curve? Duopolys supply curve?

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Topic Intended Learning Outcomes

Students should be able to:

6.1 Explain and calculate the profit maximizing/ revenue maximizing production rate under perfect competition, monopolistic competition, and monopoly. 6.2 Explain and apply multi-plant decision rule. 6.3 Explain and apply optimal advertising rules. 6.4 Calculate Lerner index and explain why it is a good measure of market power. 6.5 Calculate Deadweight loss of monopoly.

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