1 ec 500 chapter 8 managing in competitive, monopolistic, and monopolistically competitive markets

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EC 500

Chapter 8Managing in Competitive,

Monopolistic, and Monopolistically Competitive Markets

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Headline

• McDonald’s Adds New Tastes and Products to Menu Boards

Recently, McDonald’s announced the launch of its “New Tastes Menu” at all of its U.S. restaurants. McDonald’s is one of the world’s largest food-service retailers, serving over 43 million customers each day. More than 85 percent of McDonald’s restaurants around the world are owned and operated by independent franchisees.

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• McDonald’s 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 McDonald’s 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

FirmQf

$

Df

MarketQM

$

D

S

Pe

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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 CostATC = AVC + AFCATC = C(Q)/Q

Average Variable CostAVC = VC(Q)/Q

Average Fixed CostAFC = FC/Q

Marginal CostMC = C/Q

$

Q

ATCAVC

AFC

MC

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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)

$

Q

ATC

AVC

MC

ATC

AVC

Q0

AFC Fixed Cost

Q0(ATC-AVC)

= Q0 AFC

= Q0(FC/ Q0)

= FC

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Variable Cost (Ch 5)

$

Q

ATC

AVC

MC

AVCVariable Cost

Q0

Q0AVC

= Q0[VC(Q0)/ Q0]

= VC(Q0)

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$

Q

ATC

AVC

MC

ATC

Total Cost

Q0

Q0ATC

= Q0[C(Q0)/ Q0]

= C(Q0)

Total Cost (end of Ch 5)

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Graphically: Representative Firm’s Output Decision

$

Qf

ATC

AVC

MC

Pe = Df = MR

Qf*

ATC

Pe

Profit = (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?

$

Qf

ATC

AVC

MC

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A Numerical Example• Given

– P=$10– C(Q) = 5 + Q2

• Optimal Price?– P=$10

• 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?

$

Qf

ATC

AVC

MC

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$

Qf

ATC

AVC

MC

Pe = Df = MR

Qf*

ATC

Pe

Profit = (Pe - ATC) Qf* < 0

Should this Firm Sustain Short Run Losses or Shut Down?

Loss

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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 < min AVC.– Continue operating as long as P ≥ min AVC.

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$

Qf

ATC

AVC

MC

Qf*

P min AVC

Firm’s Short-Run Supply Curve: MC Above Min AVC

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Short-Run Market Supply Curve

• The market supply curve is the summation of each individual firm’s supply at each price.

Firm 1 Firm 2

5

10 20 30

Market

Q Q Q

PP P

15

18 25 43

S1 S2

SM

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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?

FirmQf

$

Df

MarketQM

$

D

S

Pe

S*

Pe* Df*

Entry

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Effect of Entry on the Firm’s Output and Profits

$

Q

ACMC

Pe Df

Pe* Df*

Qf*QL

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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 firm’s 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 firm’s product is the market demand curve.

• Firm has control over price.– But the price charged affects the quantity

demanded of the monopolist’s 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 Monopolist’s Marginal Revenue: Recall Ch. 3

QQ

PTR

100

0 010 20 30 40 50 10 20 30 40 50

800

60 1200

40

20

Inelastic

Elastic

Elastic Inelastic

Unit elastic

Unit elastic

MR

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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

$

Q

ATCMC

D

MRQM

PM

Profit

ATC

Produce where MR = MC.Charge the price on the demand curve that corresponds to that quantity.

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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?

$

Q

ATCMC

D

MRQM

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Useful Formulae

• What’s the MR if a firm faces a linear demand curve for its product?

• Alternatively,

bQaP

.0,2 bwherebQaMR

E

EPMR

1

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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 > MC !!– Too little output, at too high a

price.

• Deadweight loss of monopoly.

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$

Q

ATCMC

D

MRQM

PM

MC

Deadweight Loss of Monopoly

Deadweight Loss of Monopoly

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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 whereMR(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

QQ

PTR

100

0 010 20 30 40 50 10 20 30 40 50

800

60 1200

40

20

Inelastic

Elastic

Elastic Inelastic

Unit elastic

Unit elastic

MR

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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

$ATC

MC

D

MRQM

PM

Profit

ATC

Quantity of Brand X

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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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$AC

MC

D

MR

Q*

P*

Quantity of Brand XMR1

D1

Entry

P1

Q1

Long Run Equilibrium(P = AC, so zero profits)

Long-Run Monopolistic Competition

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Alternatively,

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Monopolistic Competition

The Good (To Consumers)– Product Variety

The Bad (To Society)– P > MC– Excess capacity

• Unexploited economies of scale

The Ugly (To Managers)– P = ATC > 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.

PQ

AQ

E

E

R

A

,

,

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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.

PQ

AQ

E

E

R

A

,

,

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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

• McDonald’s “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 McDonald’s franchise competes not only against Burger King and Wendy’s but against a host of other establishments such as KFC, Arby’s, 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 McDonald’s 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 McDonald’s “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