chapter 12: managerial decisions for firms with market power mcgraw-hill/irwin copyright © 2011 by...

Chapter 12: Managerial Decisions for Firms with Market Power

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

12-2

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)

12-3

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

12-4

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

12-5

• Lerner index measures proportionate amount by which price exceeds marginal cost:

• 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


Lerner index P MC

P

12-6

• 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


12-7

• 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

Barriers to Entry

12-8

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].

12-9

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.

12-10

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

12-11

Strategic BarriersAlcoa’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 plug-compatible 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.

12-12

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.”

12-13

The applications barrier in the Microsoft case

Hear audio explanation (wav)

“[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.”

Judge Jackson stated in his Finding of Fact:

12-14

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

12-15

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)

12-16

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.

12-17

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.

12-18

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.

12-19

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

12-20

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

12-21

Demand & Marginal Revenue for a Monopolist (Figure 12.1)

12-22

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

12-23

Short-Run Profit Maximization for Monopoly (Figure 12.3)

12-24

Short-Run Loss Minimization for Monopoly (Figure 12.4)

Shut-down rule

12-25

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

12-26

Long-Run Profit Maximization for Monopoly (Figure 12.5)

12-27

Profit-Maximizing Input Usage• Profit-maximizing level of input usage

produces exactly that level of output that maximizes profit

12-28

• 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 = input price

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

Profit-Maximizing Input Usage

TRMRP MR MP

L

12-29

Monopoly Firm’s Demand for Labor (Figure 12.6)

12-30

Profit-Maximizing Input Usage• 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

12-31

Monopolistic Competition

Examples: Women’s shoes, snack foods, furniture, carpet, bathroom fixtures, men’s suits, cold cuts.

A market structure featuring a relatively

large number of sellers and a differentiated

product/service

12-32

The monopolistic competitor faces a

downward sloping, but very elastic, demand

curve.

12-33

Short run equilibrium in monopolistic competition

Dollars per Unit of Output

PAC

MC AC

DFMRF

Q Output(a) The Firm Earns Excess Profit

12-34

Long Run Equilibrium in Monopolistic Competition

Dollars per Unit of Output

PE

QE Output

DFMRF

MCAC

(b) Long-Run Equilibrium:the Firm Earns Zero Economic Profit

12-35

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

12-36

• 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

Monopolistic Competition

12-37

Short-Run Profit Maximization for Monopolistic Competition (Figure 12.7)

12-38

Long-Run Profit Maximization for Monopolistic Competition (Figure 12.8)

12-39

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

Where Rˆ ˆa' a cM dP

12-40

• Step 2: Find inverse demand equation• Solve for P


1a'P Q A BQ

b b

1Where and , R

a'ˆ ˆa' a cM dP , A Bb b

12-41

• Step 3: Solve for marginal revenue• When demand is expressed as P = A + BQ,

marginal revenue is


22

a'MR A BQ Q

b b

• Step 4: Estimate AVC & SMC• Use statistical techniques from Chapter 10

AVC = a + bQ + cQ2

SMC = a + 2bQ + 3cQ2

12-42

• 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


12-43

• Step 7: Check shutdown rule• Substitute Q* into estimated AVC function

• If P* AVC*, produce Q* units of output & sell each unit for P*

• If P* < AVC*, shut down in short run


AVC* = a + bQ* + cQ*2

12-44

• 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


12-45

Maximizing Profit at Aztec Electronics: An Example

• Aztec possesses market power via patents

• Sells advanced wireless stereo headphones

12-46


• Estimation of demand & marginal revenue

41,000 500 0.6 22.5 RQ P M P

41,000 500 0.6(45,000) 22.5(800) P

50,000 500 P

12-47

• Solve for inverse demand


50 000 500Q , P

50 000 500

500 500

Q , P

50 000

500 500

Q ,P

1

100500

P Q

100 0 002. Q

12-48

• Determine marginal revenue function

P = 100 – 0.002Q

MR = 100 – 0.004Q


12-49

Demand & Marginal Revenue for Aztec Electronics (Figure 12.9)

12-50

• 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


12-51

• 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


12-52

• Output decision• Solve for Q* using the quadratic formula


20 006 0 006 4 72 0 000003

2 0 000003

( ) ( ) ( )( )

( )* . . .

Q.

0 0366 000

0 000006

.,

.

12-53

• Pricing decision• Substitute Q* into inverse demand

P* = 100 – 0.002(6,000)

= $88


12-54

• 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


12-55

• Computation of total profitπ = 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


12-56

Profit Maximization at Aztec Electronics (Figure 12.10)

12-57

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

12-58

A Multiplant Firm (Figure 12.11)

chapter 12: managerial decisions for firms with market power mcgraw-hill/irwin copyright © 2011 by...

Documents