managing in perfectly competitive and monopolistic markets
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Managing in Perfectly Competitive and Monopolistic Markets. Perfect Competition. Conditions: Large number of buyers and sellers Homogeneous product Perfect knowledge Free entry and exit No government intervention Key Implications: - PowerPoint PPT PresentationTRANSCRIPT
Managing in Perfectly Competitive
and Monopolistic Markets
Perfect CompetitionConditions:
• Large number of buyers and sellers
• Homogeneous product
• Perfect knowledge
• Free entry and exit
• No government intervention
Key Implications:
• Flat firms’ demand determined by market equilibrium price
• Market participants are price takers without any market power to influence prices (have to charge MR = P = MC)
• In the short run firms earn profits or losses or shut down
• In the long run profit = normal = 0 (firms operate efficiently)
MonopolyConditions:
• Large number of buyers and one sellers
• Product without close substitutes
• Perfect knowledge
• Barriers to entry
• No government intervention
Key Implications:
• Downward sloping firm’s demand is market demand
• Firm has market power and determines market price (can charge P > MR = MC)
• In the short run monopoly earns profit or loss or shuts down
• In the long run profit > normal is sustainable indefinitely but even with profit = normal = 0 (monopoly does not operate efficiently)
Sources of Monopoly PowerNatural:• Economies of scale and excess capacity• Economies of scope and cost complementarities• Capital requirements, sales and distribution networks• Differentiated products and brand loyalty
Created:• Patents and other legal barriers (licenses)• Tying and exclusive contracts• Collusion (tacit or open)• Entry limit pricing (predatory pricing illegal)
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
Profit Maximization for Total Measures
Industry D (TR) = Firm D (TR)
T is maximized:• Where the slope of T is 0
(TR and TC are parallel or their slopes are equal).
dT / dQ = M = 0
2 such points (Q1, Q3) need additional condition:
2. d2T / dQ2 is negative ormax TR - TC => Q* = Q3.
Profit Maximization for per Unit Measures
T is maximized:• At Q where MR = MC.
2 points, need additional condition
• MR < MC for any Q > Q* = Q3
(Q* is one of FONC candidates)or when MC is increasing.
T = [(TR – TC)/Q]Q = (AR – AC)Q = (P – AC)Q Max T = area of the rectangle = (AR|Q* - AC|Q*)Q* = (P|Q* - AC|Q*)Q*
0MCMRdQ
dTC
dQ
dTR
dQ
dTM
A Numerical Example• Given estimates of
• P = 10 - Q
• C(Q) = 6 + 2Q
• Optimal output?• MR = 10 - 2Q = 2 = MC
• Q = 4 units
• Optimal price?• P = 10 - (4) = $6
• Maximum profits?• PQ - C(Q) = 6(4) - (6 + 8) = $10
= 0
Shut-Down Point
• In the long run all cost must be recovered.• In the short run fixed cost incurred before
production begins and do not change regardless of the level of production (even for Q = 0).
• Shut down only if: –TFC > T (total) AVC > P (per unit).
• TFC = AFC*Q = (SAC – AVC)*Q• Operate with loss if: 0 > T –TFC (total)
SAC > P AVC (per unit).• This is the third T maximizing condition.
Setting Price
FirmQf(units)
$
Df = Pf = AR = MR
MarketQM(106)
$
DM
SM
PM
Qf(units)
$ TR
Firm small part of industry:Industry D (TR) > Firm D (TR)
Firm’s D small segment of upward slopping Industry D
Choosing Output• To maximize total profit: T = TR - TC
FONC: dT /dQ = M = MR - MC = 0
In general (including monopoly) MR = MC.In perfect competition MR = P = MC.
• To maximize profit increase output (Q) until 1) MR = P = MC (at Q*), and2) for Q > Q* => MC > P (or MC is increasing)
=> M < 0=> TC < TR
• As long as: max T ≥ -TFC or P ≥ AVC
A Numerical Example
• Given estimates of• P = $10• C(Q) = 5 + Q2
• Optimal Price?• P = $10
• Optimal Output?• MR = P = $10 = 2Q = MC• Q = 5 units
• Maximum Profits?• PQ - C(Q) = 10(5) - (5 + 25) = $20
Profit > Normal
Normal Profit
• Normal profit is necessary for the firm to produce over the long run and is considered a cost of production
• Normal profit is required because investors expect a return on their investment.
• Profit < normal leads to exit in the long run.
• Profit > normal leads to entry in the long run.
• Profit = normal maintains the # of firms in the industry.
Shutdown
Short-Run Supply Under Perfect Competition
Effect of Entry on Market Price & Quantity
FirmQf
$
Df
MarketQM
$
D
S
Pe
S*
Pe* Df*
Entry
• Short run profits leads to entry• Entry increases market supply, driving down the market price and increasing the market quantity
Effect of Entry on Firms Output & Profit
$
Q
LACLMC
QL
Pe Df
Pe* Df*
Qf*
• Demand for individual firm’s product and hence its price shifts down• Long run profits are driven to zero
Perfect Competition in the Long Run
• Socially efficient output and price: MR = P = MC (no dead weight loss)• Efficient plant size: P = MC = min AC (all economies of scale exhausted)• Optimal resource allocation: T = Normal = 0 because P = min AC (because
of no market power or free entry opportunity cost equals TR )
Perfect Competition
Pri
ce
Quantity0
D = P = MR
QPC
PPC
S = MC > min AVC
Consumersurplus
Producersurplus
Efficientquantity
Inefficiency of Monopoly
Pri
ce
Quantity
PA
PM
0
D = PMR
QM QPC
PPC
Consumersurplus
Deadweightloss
Producersurplus
S = MC > min AVC
Monopoly’sgain
Monopoly in the Long Run with Greater than Normal and Normal Profit
• Socially inefficient: P > MR = MC (QM<QPC, PM>PPC, dead weight loss)
• Scale inefficient: P > MC = min AC (economies of scale still exist)
• Misallocated resources: even when T = normal = 0, P is still > min AC (because of market power or barriers to entry opportunity cost < TR)
• Encouraged R&D, benefits from natural monopolies, economies of scope and cost complementarity might offset inefficiencies
• You are a price taker, other firms charge $40 per unit?
• P = MR = 40 = 8Q = MC
=> Q* = 5 and P* = 40
• Max T = TR - C(Q*) = 40(5) - (125+4(5)2)
= 200 - 225 = -$25
• Expect exit in the long-run
• You are a monopolist with inverse demand P = 100 – Q?
• MR = 100 - 2Q = 8Q = MC
=> Q* = 10 and P* = 100 - Q = 100 - 10 = 90
• Max T = TR - C(Q*) = 90(10) - (125+4(100)) = 900 - 525 = $375
• No entry until barriers eliminated
Synthesizing ExampleC(Q) = 125 + 4Q2 => MC = 8Q is unaffected by market structure. What are profit maximizing output & price, and their implications if
Natural Monopoly
LAC
Quantity (millions of kilowatt-hours)
5
10
15
0 1 2 3 4
D=P
Pri
ce (
cent
s pe
r ki
low
att-
hour
)
Economies of scale exist over the entire LAC curve.
One firm distributes 4 million kWh at ¢5 a kWh.
This same total output costs ¢10 a kWh with two and ¢15 a kWh with four firms.
Natural monopoly: one firm meets the market demand at a lower cost than two or more firms.
Public utility commission ensures that P = LAC (not P associated with MR = MC), eliminating monopoly rent.
Break-Even AnalysisApproximation in absence of detailed data on revenue & costs.
Assume both TR & TC are linear.
At the Break-even output: TR = TC = TVC + TFC
P*QBE = AVC*QBE + TFC
(P – AVC)*QBE = TFC
QBE = TFC / (P – AVC)
P = $6, AVC = $3.6, TFC = $60KQBE = 60,000 / (6 – 3.6)QBE = $25,000
(P – AVC) unit contribution margin.
1 – P/AVC contribution margin ratio (fraction of P to recover TFC)