Economic

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Title: Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets

Contents Perfect Competition.....................................................................................................................3

Pricing in Perfect Competition .....................................................................................................3

Short-Run Output Decisions in Perfect Competition ....................................................................3

Minimizing Losses in Perfect Competition ...................................................................................4

Long-Run Output Decisions in Perfect Competition.....................................................................4

Check Your Understanding .........................................................................................................5

Question 1 ........................................................................................................................................... 5

Question 2 ........................................................................................................................................... 5

Monopoly ....................................................................................................................................5

Sources of Monopoly Power .......................................................................................................5

Economies of Scale ............................................................................................................................. 5

Economies of Scope ............................................................................................................................ 6

Cost Complementarity ......................................................................................................................... 6

Patent and Legal Protections ............................................................................................................... 6

Maximizing Profits in Monopoly ...................................................................................................6

Barriers to Entry in Monopoly ......................................................................................................6

Check Your Understanding .........................................................................................................6

Question 3 ........................................................................................................................................... 6

Question 4 ........................................................................................................................................... 7

Monopolistic Competition ............................................................................................................7

Implications of Cost Differentiation ..............................................................................................7

Marketing Strategies ...................................................................................................................8

Comparative Advertisements ............................................................................................................... 8

Niche Marketing ................................................................................................................................... 8

Green Marketing .................................................................................................................................. 8

Check Your Understanding .........................................................................................................8

Question 5 ........................................................................................................................................... 8

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Question 6 ........................................................................................................................................... 8

Concept Scenario .......................................................................................................................9

Scenario 1 ........................................................................................................................................... 9

Scenario 1 Solution .............................................................................................................................. 9

Scenario 2 ........................................................................................................................................... 9

Scenario 2 Solution ............................................................................................................................ 10

Scenario 3 ......................................................................................................................................... 10

Scenario 3 Solution ............................................................................................................................ 10

Summary ..................................................................................................................................10

Review Questions .....................................................................................................................11

Question 1 ......................................................................................................................................... 11

Question 2 ......................................................................................................................................... 11

Question 3 ......................................................................................................................................... 11

Question 4 ......................................................................................................................................... 12

Question 5 ......................................................................................................................................... 12

Question 6 ......................................................................................................................................... 12

Question 7 ......................................................................................................................................... 12

What’s Next ..............................................................................................................................12

Reference .................................................................................................................................12

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Perfect Competition In this module, we will characterize the optimal price, output, and advertising decisions of managers operating in environments of perfect competition, monopoly, and monopolistic competition.

Understanding the concepts presented in this module will prepare you to manage a firm that operates in virtually any environment.

Let’s begin the analysis by examining the output decisions of managers operating in perfectly competitive markets. The characteristics of perfect competition are:

1. Many buyers

2. Many sellers, who all produces a relatively homogeneous product

3. Buyers and sellers have perfect information

4. No transaction costs

5. Free entry and exit barriers in that market

Pricing in Perfect Competition In a perfect competition, there are many sellers in the market since there are low barriers to entry. As a result, each seller has little to no power to influence the market or price. The implication of this is that there is no one seller who can influence the price of the homogenous product in the market, that is each seller is a price taker.

Since each firm takes the price that is set by the market through the interaction of market supply and demand, the demand curve for an individual firm’s product is simply the market price. If the individual firm was to increase its price, then buyers—with perfect information of where they can purchase that product from the many other sellers—would simply not buy that product from the firm that raises its price. As a result, the demand curve for each individual firm is perfectly elastic.

Short-Run Output Decisions in Perfect Competition Firms maximize profits when marginal revenue (MR) is equal to marginal cost (MC), that is, (MR = MC). Recall that, marginal revenue is the change in total revenue due to sale of an additional unit of output. Firms in perfectly competitive markets sell their units at the market price. Therefore, when an extra unit of output is sold, total revenue goes up by the market price— since that one additional unit of output is sold at the market price.

Therefore, for firms in perfectly competitive markets, marginal revenue is equal to the market price (P), that is (P = MR). As such, these firms maximize their profits when the cost of producing that additional unit of output (marginal cost) is equal to the market price.

• When marginal cost exceeds price, the company would face losses at those output levels—because they wouldn’t be able to recover costs at the prevailing market prices.

• When marginal cost is less than price, increasing output would result in more revenue being captured—and the firm can continue capturing that revenue (that is, increasing output) until marginal cost equals price.

Recall at the point where the market demand curve intersects the market supply curve, social welfare is maximized. That is, at that point consumer surplus and producer surplus are

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maximized. So, the price point and output or quantity produced or sold that results from the interaction of the market demand and market supply curves represent the socially efficient output level where resource allocation decisions (by buyers and sellers) are made in a manner that leads to maximization of social welfare.

Therefore, when perfectly competitive firms produce at the output level at which P = MC, those output decisions are socially efficient. In other words, P = MC is the socially efficient or welfare maximizing output rule.

Minimizing Losses in Perfect Competition If, at a particular level of production or output (Q), price is below the firm’s average variable cost, then the firm usually cannot cover its variable costs (such as wages). If the firm cannot even cover its variable costs to stay in operation, then it should shut down. Thus, the shutdown point is where the market price equals average variable cost.

If, at a particular level of production or output (Q), the price is above average variable cost, but below average of total cost, then although the firm can cover its variable costs, it cannot cover all that’s remaining of its total costs, that is all of its fixed costs. Thus, the firm should continue operating.

If, at a particular level of production or output (Q), price is above average total costs, then the firm is making a profit.

Therefore, given the shutdown condition, a firm should be operating or producing above the minimum of the average variable cost curve. Since the marginal cost curve represents the minimum return or selling price a producer is willing to receive in order to produce at various levels of production, the portion of the marginal cost curve that is above the average variable cost curve is the firm’s supply curve.

Long-Run Output Decisions in Perfect Competition Since there are low barriers to entry into a market, it is easy for firms to enter into a particular market when they detect that economic profits can be earned in that market.

Economic profits are present when the market price is above the average costs, or average cost curve.

• When market price is above the average cost curve, there is an incentive for firms to enter the market. As more firms enter a market, the market price would decrease.

• If price decreases to a point where it matches average costs—or rather, intersects the average cost curve—there would be no economic profits left to extract and, therefore, no more firms will enter the market.

• In fact, if price falls below average cost curve, firms will exit the market if they have cost structures that bear firm cost curves that result in that market price falling below their average variable cost curve.

Therefore, the long-run equilibrium point in a perfectly competitive market is where the market price is equal to average costs.

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Check Your Understanding Question 1 Is the following statement true or false?

In perfectly competitive firms, the portion of the marginal cost curve that is above the average cost curve is a firm’s supply curve.

Answer

The statement is true. In perfectly competitive firms, the portion of the marginal cost curve that is above the average cost curve is a firm’s supply curve.

Question 2 Which of the following is not true of firms in a perfectly competitive market?

• Buyers have perfect information about sellers.

• Products are distinguishable.

• It is easy to enter into a market.

• There are many buyers and sellers.

Answer

Products are not distinguishable in a perfectly competitive market.

Monopoly A monopoly market structure is one in which a single firm produces a good—which generally doesn’t have a close substitute—for an entire market. As such, they set the price in the market rather than take the prices from the market.

As compared to perfect competition, where there are many sellers, in a monopoly, there is one sole seller. In a perfectly competitive market, the firm’s demand curve is the market price because each firm has no market power. If there is a single producer, they have enough market power that the firm’s demand curve is the market demand.

Note that the monopolist is still subject to the law of demand—they sell less product at higher prices, and more product at lower prices. Therefore, the market demand curve is still downward sloping and consumers will choose how much they buy given the price that is set by the monopolist firm.

Sources of Monopoly Power Let us now learn how a firm obtains monopoly power. There are four major sources of monopoly power; one or more of these sources create a barrier to entry that prevents other firms from entering the market to compete against the monopolist.

Economies of Scale Economies of scale are realized when the expansion of output causes a continual decrease in long-run average costs. Conversely, diseconomies of scale occur when expansions in output cause increases in long-run average costs.

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Economies of Scope Economies of scope arise when the total cost of producing two products jointly is cheaper than producing two products separately by different firms. It is thus more efficient to produce those products jointly.

Cost Complementarity Cost complementarity arises when the marginal cost of producing one product falls as the production of another good within or by the same firm is expanded.

Patent and Legal Protections A patent gives legal protection to the inventor of a good by allowing the inventor the exclusive right to the benefits that are accrued from selling a good for a given period of time.

Maximizing Profits in Monopoly The monopolist’s profit maximizing level of output occurs where marginal revenue is equal to marginal cost (MR=MC), that is, where the slope (or first derivative) of the revenue function or equation is equal to the slope (or first derivative) of the cost equation or cost function.

When marginal revenue is greater than marginal cost, the cost of producing that additional unit of output would be less than the benefits accrued from producing that additional unit of output. As such, the firm should produce that additional unit. When marginal revenue is less than marginal cost, the cost of producing that additional unit of output would be more than the benefits accrued from producing that additional unit of output. The firm should not produce that additional unit. So, profit is maximized where a monopolist’s marginal revenue curve intersects its marginal cost curve.

Note that since the monopolist sets the prices and that they are still subject to the law of demand, an increase in the number of units sold requires a reduction in price. As such, its marginal revenue will always be lower than price. Since a monopolist has market power to determine price and how much it will produce, a monopolist does not necessarily have a supply curve.

If a firm is producing products in more than one plant, it would seek to reach production levels at the point where marginal cost of producing output in each plant equals marginal revenue in terms of total production of both plants.

Barriers to Entry in Monopoly A monopolist firm will have extracted all economic profits at the point where price equals average total costs. This means that the monopolist does not produce where P = MC. In fact, they produce at a point where P greater than MC and at output levels that are not at the bottom of the average total cost curve.

As such, they do not produce at output levels that are welfare maximizing. In other words, they do not produce output levels that maximize consumer and producer surplus. The resulting loss in consumer and producer surplus is called deadweight loss.

Check Your Understanding Question 3 Which of the following is not a source of monopoly power?

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• Patents

• Economies of scope

• Cost complementarities

• Diseconomies of scale

Answer

Diseconomies of scale is not a source of monopoly power.

Question 4 Is the following statement true or false?

The monopolist’s profit maximizing level of output occurs where marginal revenue is equal to marginal cost (MR=MC).

Answer

The statement is true. The monopolist’s profit maximizing level of output occurs where marginal revenue is equal to marginal cost (MR=MC).

Monopolistic Competition The main characteristics of monopolistic competitive market structures are:

a. Many buyers

b. Many sellers producing differentiated products

c. Free or low barriers to entry and exit

Monopolistic competitive market structure lies somewhere between a perfectly competitive market structure and a monopoly. How a monopolistic competitive market structure compares to the other two market structures in terms of differences, as well as similarities, can be seen in the characteristics outlined above.

Additionally, similar to a monopoly, the profit maximizing output level of a monopolistic competitive firm is where marginal revenue is equal to marginal cost.

Similar to perfectly competitive market structures, as long as economics profits are positive and entry barriers are low, firms will enter a monopolistic competitive market structure. This will continue until there is no incentive for new firms to enter the market, that is, where economic profits are zero, which occurs when price is equal to average cost. At this point, there will be no reason for new firms to enter the market. Thus, the profit maximizing price remains above the marginal cost. As a result, production levels are not at socially efficient amounts because: they produce where P greater than MC, not where P = MC and not at the bottom of the average total cost curve; so neither consumer nor producer surplus is maximized.

Implications of Cost Differentiation Producers in monopolistic competitive market structures produce differentiated goods. These differentiated goods are imperfect substitutes to each other to some degree. Typically, then, it is incumbent on the firm to make the case of how imperfect of a substitute other goods are to its own in order to convince the consumer that the value they are getting from the consumption of its good is higher.

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As such, a firm has to advertise, market and or brand their product in such a manner that convinces the consumer of the superior value of its product. Note that a firm operating in a monopolistic competitive market can successfully create brand equity and brand loyalty, such that many consumers prefer that firm’s brands and products. As such, that firm can attain a significant share of market power—and perhaps force some firms to exit that market due to reduction or lack of sales. In the process, that market can tend toward more of a monopoly structure, with less competition.

Marketing Strategies The optimal amount of advertising for a particular firm depends on consumers’ elasticity of advertising, that is, the extent to which advertising influences consumer behavior toward product purchases. So for example, if advertising has a huge effect on consumer purchases then that would justify more expenditures on advertising.

Comparative Advertisements These advertisements are designed to differentiate one firm’s brand from another. The idea is to create the perception that one brand has a higher utility or value or benefit from another brand. Brand equity is generated when a firm successfully creates value for its brand and convinces consumers that the products under its brand are worth paying a higher price for.

Niche Marketing When advertising is targeted at specific subsets of consumers, that form of advertising is called niche marketing.

Green Marketing Green marketing is designed to create brand or product value by underscoring environmentally friendly production practices or product features.

Check Your Understanding Question 5 Is the following statement true or false?

A difference between perfectly competitive markets and monopolistic competitive market is that firms in perfectly competitive markets produce homogenous goods while firms in monopolistic competitive market produce differentiated goods.

Answer

The statement is true. A difference between perfectly competitive markets and monopolistic competitive market is that firms in perfectly competitive markets produce homogenous goods while firms in monopolistic competitive market produce differentiated goods.

Question 6 Is the following statement true or false?

A difference between monopolies and firms in monopolistic competitive markets is that it is only monopolies whose profit maximizing price exceed marginal costs.

Answer

The statement is false. A difference between monopolies and firms in monopolistic competitive markets is that it is only monopolies whose profit maximizing price is equal to marginal cost.

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Concept Scenario Scenario 1 In order for your monopolistic firm to increase quantity produced from 20 units to 21 units, it must lower the price of its good from $9 to $8. Would you suggest that your firm produces the 21st unit?

Tip 1

Peer 1: Since the number of units sold would be greater, the firm should go ahead and produce the 21st unit.

Peer 2: You should consider what the change in revenue is from producing the extra unit and compare it to the loss in revenue from having to sell your products at a lower price.

Tip 2

Watch Monopolist optimizing price: Total revenue, an instructional video by Khan Academy to find your solution.

Tip 3

Refer to the lecturette section on monopoly to find your solution.

Scenario 1 Solution The increase or change in total revenue by selling the 21st unit is $1.

However, this comes with having to decrease the price of 20 units by $1 which gives a loss of revenue of twenty times one dollar equals to twenty dollar. So with a gain of $1 and a loss of $20, the potential gains do not outweigh the losses, and so the firm should not produce 21 units.

Scenario 2 Suppose your firm, which produces good X, is operating in a perfectly competitive market. The average variable cost of producing each unit of good X is $15, the average price of good X is $16. Average fixed cost for your firm is currently at $3. Should your firm continue operating in this market?

If yes, what would it take to stop operating in the market?

If no, why not?

Tip 1

Peer 1: It looks like the total average costs of operating in this market are higher than what the price of good X, so perhaps it is better for the firm to stop operating.

Peer 2: The company should continue operating because if it sells more units it would make more money and offset the costs.

Tip 2

Watch Shutting down or exiting industry based on price, an instructional video by Khan Academy, to find your solution.

Tip 3

Refer to the lecturette sections on perfect competition to find your solution.

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Scenario 2 Solution Price is higher than average variable cost so the shutdown condition has not been met; therefore, the company should continue operating.

Scenario 3 A firm operating in a monopolistic competitive market structure notices that when they spend a certain amount on advertising, their sales triple. If the monopolist was to spend the same amount of money on research and development (R&D), they would complete work on a value- adding invention that woulddifferentiate their product from their closest competitors because of its higher utility. Since they do not have unlimited finances, they must spend their financial resources on either advertising or R&D. How would you suggest they spend their financial resources and why?

Tip 1

Peer 1: Since you are sure that advertising leads to sales, you should use your financial resources on advertising.

Peer 2: Well, maybe your invention can give you the ability to introduce a better product into the market and earn revenues from it.

Tip 2

Watch Monopolistic competition and economic profit, an instructional video by Khan Academy, to find your solution.

Tip 3

Refer to Lecturette section on the economic profits in monopolies and monopolistic competition to find your solution.

Scenario 3 Solution The firm should invest in R&D and complete the newly innovated product, patent it and introduce it into the market, and use it to gain market power. This would shield the firm from competition for some time and they would be able to enjoy profits and revenues from that product without having to spend as much on advertising.

Summary Key learning points in this module include:

• Firms in perfectly competitive markets are price takers.

• For firms in perfectly competitive markets, marginal revenue is equal to the market price.

• In the short run, firms in perfectly competitive markets maximize their profits when the cost of producing that additional unit of output (marginal cost) is equal to the market price.

• In perfectly competitive markets, when market price is above the average cost curve, there is an incentive for firms to enter the market.

• A monopolistic market structure is one in which a single firm produces a good—which generally doesn’t have a close substitute—for an entire market.

• Monopolists are price setters.

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• Perfectly competitive firms are price takers.

• The four major sources of monopoly market power are economies of scale, economies of scope, cost complementarity, and patent and other legal sources.

• Economies of scale are realized when the expansion of output causes a continual decrease in long-run average costs.

• Economies of scope arise when the total cost of producing two products jointly is less than producing them separately.

• Cost complementarities arise when the marginal cost of producing one product falls as the production of another good, within or by the same firm, is expanded.

• Monopolists’ profit maximizing decision rule is where MR=MC, at the point P greater than MC; the same profit maximizing decision rule applies for firms in a monopolistically competitive market structure.

• Deadweight loss is the loss in consumer and producer surplus due to the monopolist producing where P greater than MC.

• A monopolistic competitive market structure lies somewhere between a perfectly competitive market structure and a monopoly.

• As long as economic profits exist, firms will enter a market.

• Firms will exit a market when economic profits become negative.

• The long-run equilibrium production level for monopolies and monopolistic competitive firms is met where price is equal to average cost.

• The welfare maximizing price and output is where price is equal to marginal cost.

Review Questions Question 1 Name two forms of imperfect competitiveness.

Answer

Monopolistic and monopolistic competition are two forms of imperfect competitiveness.

Question 2 Since monopolists dominate market power, why is their demand downward sloping?

Answer

The demand curve is downward sloping because they are subject to the law of demand—at higher prices, consumers buy fewer units and at lower prices, consumers buy more units of a good.

Question 3 What similarities are shared between perfectly competitive market structures and monopolistic competitive market structures?

Answer

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They both have free or low barriers to entry, and many buyers and sellers.

Question 4 How do monopolies create deadweight loss?

Answer

Monopolies create deadweight loss by producing at output levels where price is above marginal cost. It is only when price is equal to marginal cost that social welfare is maximized.

Question 5 What are the conditions that would incentivize firms to exit a market?

Answer

Firms will exit markets when economic profits are negative.

Question 6 How can a firm in a perfectly competitive market increase its profits?

Answer

In a perfectly competitive market, a firm is a price taker, therefore it can increase revenue and profit by reducing its costs. This will allow it to earn more revenue per unit.

Question 7 Describe how an innovation can create a monopoly.

Answer

A newly invented product that has the potential to create a lot of value in the marketplace could be patented by its inventor. Other firms would be legally prevented from producing that product for a certain period of time, ensuring that the inventor is the sole recipient of the benefits from the value that product creates in the marketplace.

What’s Next In Module 8, we will cover Chapter 11, which presents pricing strategies used by firms with some market power. These strategies range from simple markup rules to more complex two- part pricing strategies that enable a firm to extract all consumer surplus. We will also briefly go over pricing strategies that enhance profits, including peak-load pricing, block pricing, transfer pricing, commodity bundling, and cross-subsidization. The chapter concludes with descriptions of strategies that can help managers in a Bertrand oligopoly avoid the tendency toward zero economic profits.

Reference Baye, M. R., & Prince, J. T. (2013). Managerial economics and business strategy (8th edition). New York, NY: McGraw-Hill Education.