Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed.

Students

should be able to

Differentiate

among the four archetypal market structures between price takers and price

Distinguish

searchers

 Last

week we analyzed production and costs decisions and how costs influence a managers decision on what inputs to use and how much to produce. week we look at how market structures influence a managers decision on how much to produce, what price to charge and how to maximize profitability under different market structures

This

 Please

read The Market for Cable Television case study, pages 160-161

The

example of cable TV illustrates how policy choices-such as pricing, product design, and advertising-are influenced critically by the market environment.

Policies

that work within a protected market environment often have to be amended radically when facing a more competitive environment.

 It

is important that managers understand the firms market environment and how this set of market circumstances affects decision making. purpose in this chapter is to enhance that understanding by exploring the implications of alternative market structures.

Our

 Our

primary focus is on output and pricing decisions within different market structures. begin by discussing markets and market structures in greater detail. pricing and output decisions within different market structures

We

Then

market consists of all firms and individuals who are willing and able to buy or sell a particular product. parties include those currently engaged in buying and selling the product, as well as potential entrants.
A market is a process that facilitates trade rather than a place and where prices and quantity bought and sold are discovered through interaction of buyers and sellers

These

 Market

structure refers to the basic characteristics of the market environment, including (1) the number and size of buyers, sellers, and potential entrants; (2) the degree of product differentiation; (3) the amount and cost of information about product price and quality; and (4) the conditions for entry and exit.

Pure

Competition Pure Monopoly Monopolistic Competition Oligopoly

Imperfect Competition
Pure Competition Monopolistic Competition Oligopoly Pure Monopoly

Market Structure Continuum

 Many

buyers and sellers homogeneity (standardized products)

Product

Low
Free The

cost and accurate information

entry and exit

firm is a price taker

Best regarded as a benchmark to compare other market structures and their efficiencies

 To

examine demand from a sellers viewpoint (including pricing and output decisions) see how a competitive producer responds to market price in the short-run explore the nature of long-run adjustments evaluate the efficiency of competitive industries

To

To

To

 In

competitive markets, individual buyers and sellers take the market price of the product as given: have no control over price.

They

Firms

thus view their demand curves as horizontal at that given market price

 Every

company should to produce more as long as

Continue

MR>MC
Stop

at a production level where MR =

MC
Cut

back production when MR<MC

 Economic

Profit - When the price is above ATC (produce) Normal Profit When the price is equal to ATC (produce) Reduce Losses When the price is below ATC but above AVC (continue production) Shut Down Point When the price is below AVC. Your losses will be equal to fixed costs (stop production)

Marginal Revenue-Marginal Cost Approach ( MR = MC Rule)

$200

Cost and Revenue

150

P=$131

MR = MC

MC MR = P ATC AVC

Economic Profit
100 A=$97.78 50

10

Output

Marginal Revenue-Marginal Cost Approach MR = MC Rule

$200

Loss Minimizing Case

Cost and Revenue

150

Lower the Price to $81 and Observe the Results!

Loss
A=$91.67

MC

100 P=$81 50 V = $75

ATC AVC MR = P

10

Output

Marginal Revenue-Marginal Cost Approach MR = MC Rule

$200

Short-Run Shut Down Case

Cost and Revenue

150

Lower the Price Further to $71 and Observe the Results! MC

ATC
V = $74

100

AVC MR = P

50

P=$71

Short-Run Shut Down Point P < Minimum AVC $71 < $74
2 3 4 5 6 7 8 9 10

Output

 Why

the marginal-cost curve and supply curve of competitive firms are identical

The

firm's short run supply curve is that portion of its short-run marginal cost curve above short-run average variable cost. The long-run supply curve is that portion of its long-run marginal cost curve above long-run average cost.

Generalizing the MR=MC Relationship and its Use

Cost and Revenues (Dollars)

e P5 d P4 P3 P2 P1 b a c

MC MR5 ATC AVC MR4 MR3 MR2 MR1

This Price is Below AVC And Will Not Be Produced

0 Q2 Q3 Q4 Q5

Quantity Supplied

Generalizing the MR=MC Relationship and its Use

Examine the MC for the Competitive Firm
Cost and Revenues (Dollars)

MC Above AVC Becomes the Short-Run Supply Curve

Break-even (Normal Profit) Point P5 P4 P3 P2 P1 b a Shut-Down Point (If P is Below) Q2 Q3 Q4 Q5 c d e

S
MC MR5 ATC AVC MR4 MR3 MR2 MR1

This Price is Below AVC And Will Not Be Produced

0

Quantity Supplied

 How

industry entry and exit produce economic efficiency P = ATC in the long run and production takes place where
MR = MC

What

is long run competitive equilibrium and why companies only make normal profit short-run economic profits will disappear with entry of other firms short-run economic losses will disappear with exit of some firms

How

How

 Productive

requires that goods be produced in the least costly way. In the long run, pure competition forces firms to produce at the minimum ATC.

Efficiency

P = Minimum ATC Allocative Efficiency requires that resources be

apportioned among firms and industries to yield mix of products and services most wanted by society

P = MC Maximum Consumer and Producer Surplus Dynamic Adjustments and Invisible Hand Revisited

Single Firm
p P s = MC

Industry
S = MCs

Economic Profit
$111

ATC d AVC D
$111

8000

Competitive Firm Must Take the Price that is Established By Industry Supply and Demand

Single Firm
p P MC ATC
$60 50 $60 50

Industry
S1

S2

MR
40 40

D2 D1

100

80,000

90,000

100,000

An Increase in Demand Temporarily Raises Price Higher Prices Draw in New Competitors Increased Supply Returns Price to Equilibrium

Single Firm
p P MC ATC
$60 50 $60 50

Industry
S3

S1

MR
40 40

D1 D3

100

80,000

90,000

100,000

A Decrease in Demand Temporarily Lowers Price Lower Prices Drive Away Some Competitors Decreased Supply Returns Price to Equilibrium

Competitive Firm and Market

Single Firm
P=MC=Minimum ATC (Normal Profit)

Market
S

MC

ATC
Price Price
P MR P D 0 Qf 0 Qe

Quantity

Quantity

Productive Efficiency: Price = Minimum ATC Allocative Efficiency: Price = MC

Pure Competition Has Both in Its Long-Run Equilibrium

 In

a competitive equilibrium, firms make no economic profits. Production is efficient in that firms produce at their minimum long run average cost. in competitive industries must move rapidly to take advantage of transitory opportunities. They also must strive for efficient production in order to survive.

Firms

 Some

firms in the industry can employ resources that give them a competitive advantage (for example, an extremely talented manager). in such cases, any excess returns often go to the factor of production responsible for the particular advantage, rather than to the firm's owners.

Yet

 Although

the competitive model provides a useful description of the interaction between buyers and sellers for many industries, are others where firms have substantial market powerprices are affected materially by the output decisions of individual firms.

there

 extreme

case of a firm with market power is monopoly, where the industry consists of only one firm. industry and firm demand curves are one and the same. necessary condition for market power to exist is that there are effective barriers to entry into the industry

Here,

 In

contrast to competitive markets, consumers pay more than marginal cost and the firm earns economic profits. is restricted from competitive

Output

levels.
With

a monopoly, not all the potential gains from trade are exhausted

 Firms

consider entering a new market when they observe economic profits (higher than normal) being reported by firms. decisions depends on three important factors: Whether entry will affect the prices are

Entry

First:

the firms likely to cut prices?

 Second:

Incumbent advantages do existing firms

have advantage that are hard to duplicate, ones that make it highly unlikely that the new firms will enjoy similar profits.

Third:
firm fails

Cost of Exit how expensive would it be to exit if the

Market

power can exist when there are substantial barriers to entry into the industry. Expectations about incumbent reactions, incumbent advantages, and exit costs all can serve as entry barriers.

Incumbent reactions
Specific

Incumbent advantages
Precommitment

assets of scale

contracts
Licenses

Economies

and patents

Excess

capacity
effects

Learning-curve

effects

Reputation

Pioneering brand advantages

 What

conditions enable it to arise and survive? How does a pure monopolist determine its profit-maximizing price and output quantity? Does a pure monopolist achieve the efficiency associated with pure competition? If not, what should the government do about it?

Single Seller No Close Substitutes Price Maker Blocked Entry Non-price Competition Examples - natural gas & electric companies, water,
cable, local telephone

Regulated Monopolies Unregulated monopolies

Dual

understand monopolies but more common imperfect competition such as monopolistic competition and oligopolies

Objectives of Study - not only to

Economies

of Scale public utilities Legal Barriers to Entry

Patents Pharmaceuticals

Licenses Radio & TV stations, Cabs

Ownership

or Control of Essential

Resources DeBeers, Alcoa Pricing and Other Strategic Barriers to Entry Advertising and pricing, Windows

Marginal Revenue is Less Than Price

A Monopolist is Selling 3 Units at $142 To Sell More (4), Price Must Be Lowered to $132 All Customers Must Pay the Same Price TR Increases $132 Minus $30 (3x$10)

$142 132 122 112 102 92 82

Loss = $30 Gain = $132

Marginal Revenue is Less Than Price

A Monopolist is Selling 3 Units at $142 To Sell More (4), Price Must Be Lowered to $132 All Customers Must Pay the Same Price TR Increases $132 Minus $30 (3x$10) $102 Becomes a Point on the MR Curve Try Other Prices to Determine Other MR Points

$142 132 122 112 102 92 82

Loss = $30 Gain = $132

MR
1 2 3 4 5 6

The Constructed Marginal Revenue Curve Must Always Be Less Than the Price

Demand, Marginal Revenue, and Total Revenue for a Pure Monopolist

$200 150

Demand and Marginal Revenue Curves Elastic Inelastic

Price

100 50

D MR
0 $750 2 4

Total-Revenue Curve

10

12

14

16

18

Total Revenue

500

250

TR
2 4 6 8 10 12 14 16 18

By A Pure Monopolist
$200 175

MC Price, Costs, and Revenue

150 Pm=$122 125 Economic Profit

100 75
50 25

ATC

A=$94

D MR=MC

MR
1 2 3 4 5 6 7 8 9 10

Quantity

Concerning Monopoly Pricing

Cannot

Charge the Highest Price it can

get Total, Not Unit, Profit is the goal of the monopolist Possibility of Losses However, pure monopolist can continue to receive economic profits in the long run

By A Pure Monopolist
MC Price, Costs, and Revenue ATC
Loss

A Pm

AVC
V

D MR=MC MR
0 Qm

Quantity

Price, Output, and Efficiency

Purely Competitive Market
S=MC
Pm Pc P=MC= Minimum ATC Pc a b c

Pure Monopoly

MC

D MR
Qc Qm Qc

Pure Competition is Efficient Monopoly Price is Greater Than MC And Is Therefore Inefficient

Monopolist Sets

is a Price Maker

Price in the Elastic Region

Output

and Price Determination

Cost Data MR = MC Rule

No

Supply Curve because there is no unique

relationship between price and quantity supplied. The price and quantity supplied will always depend on location of the demand curve.

Price - Monopolist will charge a higher price than perfect

competition

Output Monopoly will produce a smaller output

Productive Inefficiency
output where ATC is minimum

- output is less than the

Allocative Inefficiency efficiency is not achieved

because of lower output is produced than society is willing and ready to pay for

Deadweight

loss - because price exceeds MC there

is deadweight loss (reduced consumer and producer surplus)

Income Cost

Transfer from consumer to producer

Complications of Scale in one or two companies

Simultaneous Consumption Network Effects

Economies

 Multiple Firms Profit In

firms produce similar products

face down sloping demand curves maximization occurs where MC=MR

the long run, firms compete away economic profits

 Most

firms have distinguishable rather than standardized products and have some discretion over the price they charge. Competition often occurs on the basis of price, quality, location, service and advertising. Entry to most real-world industries ranges from easy to very difficult but is rarely completely blocked

 Monopolistic

Competition mixes a small amount of monopoly power, a small amount of competition.

Characteristics

Small Market Shares No Collusion Independent Action

Product Attributes Service Location Brand Names and Packaging Advertising Some Control Over Price

Differentiated

Products

 Easy

Entry and Exit Advertising

Non-price Competition
Monopolistically

Competitive Industries

include
Firms

grocery stores, gas station, dry cleaners, restaurants

demand curve is highly, but not perfectly elastic because: has fewer rivals and products are differentiated

It

In Monopolistic Competition
The The The

Profit or Loss
ATC)

Firms Demand Curve Downward sloping Short Run: Long Run:

(P = ATC but not equal to minimum

Only a Normal Profit

Economic Profits: Firms Enter Economic Losses: Firms Leave

Product Variety

Complications

In Monopolistic Competition
Short-Run Profits
MC ATC

Price and Costs

P1 A1

Economic Profit
MR = MC

D1

MR 0 Q1

Quantity

In Monopolistic Competition
Short-Run Losses
MC A2 P2 ATC

Price and Costs

Loss
D2 MR = MC

MR 0 Q2

Quantity

In Monopolistic Competition
Long-Run Equilibrium
MC ATC

Price and Costs

P3= A3

D3 MR = MC

MR 0 Q3

Quantity

Recall: P=MC=Minimum ATC

MC ATC P3= A3 P4

Price and Costs

Price is Higher
D3 MR = MC

Excess Capacity at Minimum ATC

0 Q3 Q4

MR

Quantity

Monopolistic Competition is Not Efficient

 Productive

Efficiency is not achieved because production occurs where ATC is greater than minimum ATC. Efficiency is not realized because the product price exceeds marginal cost

Allocative

few firms produce most market output may or may not be differentiated

Products Effective

entry barriers protect firm Profitability However, these profits can be eliminated through
competition among existing firms in the industry.

Firm

interdependence requires strategic thinking

 To

analyze output and pricing decisions in oligopolistic industries, we use the concept of a Nash equilibrium: Nash equilibrium exists when each firm is doing the best it can given the actions of its rivals.

Characteristics

A Few Large Producers Homogeneous or Differentiated Products Homogeneous, Steel, copper, cement Differentiated, Auto, detergents Control Over Price, But Mutual

Interdependence Strategic Behavior

Entry Barriers,
loyalty and pricing

economies of scale, large capital investments, patents, control of raw material, advertising, brand

Oligopoly Through Mergers

 An

oligopolist does the best it can, given expectations of rival behavior are noncooperative

Behaviors Duopolists

considering a low price or a high price must consider rivals response equilibrium occurs when each firm does the best it can given rivals actions

Nash

 The

Nash equilibrium is not the outcome that maximizes the joint profits of the two companies profits could be higher if the two companies decide to cooperate

Combined

Game Theory Model to Analyze Behavior

RareAirs Price Strategy 2 Competitors 2 Price Strategies Each Strategy Has a Payoff Matrix Greatest Combined Profit Independent Actions Stimulate a Response
High Low

Uptowns Price Strategy

A High
$12

$12

$15 $6

C Low $15

$6

$8

$8

Game Theory Model to Analyze Behavior

RareAirs Price Strategy Independently Lowered Prices in Expectation of Greater Profit Leads to the Worst Combined Outcome Eventually Low Outcomes Make Firms Return to Higher Prices
High Low

Uptowns Price Strategy

A High
$12

$12

$15 $6

C Low $15

$6

$8

$8

O 11.2

 In

the Cournot model, each firm treats the output level of its competitor as fixed and then decides how much to produce. equilibrium, firms make economic profits. these profits are not as large as would be made if the firms effectively colluded and posted the monopoly price.

In

However,

 Other

models of oligopoly yield different equilibriums. For instance, one model based on price competition yields the competitive solution: Price equals marginal cost with no economic profits.
Economic theory makes no clear-cut prediction about the behavior of firms in oligopolistic industries. Available evidence suggests that in some oligopolistic industries, firms restrict output from competitive levels and hence capture some economic profits.

 It

is in the economic interests of firms in oligopolistic industries to find ways to cooperate, thereby capturing higher profits. when firms are free to cooperate, effective cooperation is not always easy to achieve. Individual firms have incentives to deviate from
agreed-on outputs and prices and increase their revenues and profits

Even

 This

incentive is illustrated by the prisoners' dilemma. model highlights incentives that can cause cartels to be unstable. However, firms
sometimes can cooperate successfully when they can impose penalties on non-cooperative firms. Cooperation also can be sustained through the incentives provided by long-run, repeated relationships.

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