Managerial Economics - Market Structures Pricing and Output Decisions

Oligopoly

A market structure in which a few large firms dominate a market. When one firm in an oligopolistic market changes its price or marketing strategy, not only its own profits but the profits of the other firms in the industry are affected. Thus the distinguishing feature of an oligopolistic market is mutual interdependence among firms in the industry.

Lerner Index

A measure of the difference between price and marginal cost as a fraction of the product's price.

Rothschild Index

A measure of the sensitivity to price of a product group as a whole relative to the sensitivity of the quantity demanded of a single firm to a change in its price.

Principle: Monopoly Output Rule

A profit-maximizing monopolist should produce the output Q^m such that MR = MC

Monopoly

A pure monopoly exists when a single firm is the only producer of a good or service for which there are no close substitutes in an industry where entry is not allowed. This definition makes the firm and the industry the same.

The market demand for woozles is given by: Qd = 2,400 - 20p There is only one available technology, and it is employed by all producers—actual and potential. It implies the following average cost function: AC = 625q^-1 + 0.25q Currently, 20 firms serve the market. Determine the short-run competitive price and output.

Equating the market demand to the market supply and solving for P: Qs = Qd, 40p = 2400 - 20p 60p=2400 Pe= $40 and Qe = 40*40 =1,600 units Each firm will therefore produce: q=1,600/20 = 80 units

You have been hired by a restaurant owner to advise whether or not to close the restaurant. You have determined that the restaurant's only fixed cost is monthly rent of $5,000. The owner signed a 10-year lease with the landlord four years ago when she opened the restaurant. In the last year her sales revenue has declined to $185,000. She trimmed her labour cost to $125,000, which includes the opportunity cost of her time managing the restaurant. Her cost of materials was reduced to $40,000. She does not foresee any change in revenues or costs over the next six years. Last year her loss was $40,000.00. Her friends advise her to close the restaurant to cut her losses. What would you advise the owner? Explain.

FC = $5,000/month TFC= $5000*12*10 = $600,000 Last year sales revenue TR= $185,000 Variable cost: $125,000+$40,000 = $165,000 Total cost of last year: $600,000 + $165,000 = $225,000 Her revenues are $185,000 per year and faces a loss of $40,000. The firm should stay open as TR > TVC.By staying open her losses are $40,000 per year compared to $600,000 if she were to shut down the business.

Market Structures

Factors that affect managerial decisions, including the number of firms competing in a market, the relative size of firms, technological and cost considerations, demand conditions, and the ease with which firms can enter or exit the industry.

Sources of Monopoly Power

Four primary sources: - Economies of scale - Economies of scope - Cost complementarity - Patents and other legal barriers

Principle: Monopoly Pricing Rule

Given the level of output, Q^m, that maximizes profits, the monopoly price is the price on the demand curve corresponding to the Q^m units produced: P^m = P (Q^m)

Principle: Long-Run Competitive Equilibrium

In the long run, perfectly competitive firms produce a level of output such that 1. P = MC 2. P = min of AC

The market demand for woozles is given by: Qd = 2,400 - 20p There is only one available technology, and it is employed by all producers—actual and potential. It implies the following average cost function: AC = 625q^-1 + 0.25q Currently, 20 firms serve the market. Determine the long-run competitive market price and quantity and how many firms will operate.

In the long run, the firms will enter and exit from the market. Since there is a positive economic profit, the firms will continue to enter into the market until the economic profit reduces to zero. At this point, the firms will break-even. That is, they will start to exit from the market. At the break even point, the marginal cost curve cuts the average cost curbe at its minimum. Equating the marginal cost curve to the average cost curve and solving for q: 0.5q = 625q^-1 + 0.25q 0.5q^2 = 625 + 0.25q^2 0.25q^2 = 625 Q^2 = 2,500 Q* = 50 units Therefore, the long run level of output produced by each firm is 50 units. The market price charged by each firm is: P = MC = 0.5q P = MC = 0.5(50) =$25 The market demand curve will be represented by: Qs = 2nP Equating the market demand to the market supply: 2nP = 2,400 - 20P 50n = 2400 - 20(25) 50n =1900 N = (1900/50) = 38 firms

Principle: The long run and monopolistic competition

In the long-run, monopolistically competitive firms produce a level of output such that 1. P > MC 2. P = ATC > min of AC

Assume for a perfectly competitive firm that MC = AVC at $12, MC= ATC at $20, and MC = MR at $16. On the basis of this information, the firm should not be in production. Do you agree? Explain fully.

In the short run, decision making must include the evaluation of FC and VC. First, let's consider the price of the good. In perfect competition, the price of a good is equal to its MR so in this case its $16. In the short run, the decisions vary depending on the level of losses and whether the firm can cover its variable costs. To determine this, then price needs to be compare to the AVC. For this firm, their price exceeds their AVC as $16>$12. Since P>AVC implies that TR>TVC because P= TR/Q and AVC = TVC/Q then the loss is less than the TFC and the firm should then continue to produce in the short-run. However, if we bring in fixed costs into our decision making then we see that the price is lower than ATC of $20. Since P<ATC then the firm will experience an economic loss. But this loss is less that TFC. Stay open. Shut-down in the long run when TFC = 0.

Principle: Multiplant Output Rule

Let MR (Q) be the MR of producing a total of Q = Q1 + Q2 units of output. Suppose the MC of producing Q1 units of output in plant 1 is MC1(Q1) and that of producing Q2 units in plant 2 is MC2(Q2). The profit maximization rule for the two-plant monopolist to allocate output among the two plants such that MR(Q) = MC1 (Q1) MR (Q) = MC2(Q2)

Monopolist MR

MR = P [ ( 1 + E )/ E ] where E is the elasticity of demand for the monopolist's product and P is the price charged for the product.

Monopolistic Competition

Monopolistic competition refers to that market situation in which a relatively large number of producers or suppliers are offering similar but not identical products. Each firm has a comparatively small percentage of the total market, so each has a very limited amount of control over the market price. The great majority of firms in Canada fall into this market structure.

The market demand for woozles is given by: Qd = 2,400 - 20p There is only one available technology, and it is employed by all producers—actual and potential. It implies the following average cost function: AC = 625q^-1 + 0.25q Currently, 20 firms serve the market. Find the industry supply curve.

Since there are 20 identical firms in the market, the market supply function will be: Qs = 20 * 2p = 1

Principle: Competitive Firm's Demand

The demand curve for a competitive firm's product is a horizontal line at the market price. This price is the competitive firm's MR.

Firm demand curve

The demand curve for an individual firm's product; in a perfectly competitive market, it is simply the market price.

Four-Firm Concentration Ratio

The fraction of total industry sales generated by the four largest firms in the industry

Having completed this course as part of your MBA program you have been hired by a medium-sized company. You attend a meeting where the CEO explains that the goal of the company is to maximize profits, not total revenue. As such the firm must estimate both costs and revenues to determine the output where the difference between marginal revenue and marginal cost is the greatest. Will this output level maximize the firm's profits? Explain why or why not.

The profit maximization condition of the firm states that a firm maximizes its profit at the point where MR = MC. This can be proved using the following diagram: Revenues are one determinant of profits whereas costs are the other. Typical revenue and costs functions are graphed like below. Output levels below point A and above point B imply losses since the cost curve lies above the revenue curve. For output levels between points A and B, the revenue lies above the cost function, and profits are positive for those output levels. As the graph below shows, profits are greatest at an output of Q*, where the vertical distance between the revenue and cost functions is the greatest. This corresponds to the maximum profit point in section B. So the CEO is wrong and the output where the difference between MR and MC is the greatest will not maximize profits. For profit maximizing the level of output of Q*, the slope of the revenue function in section A must equal the slope of the cost function. This is because Profit = TR -TC. TR - TC is maximized when the slope of TR = slope TC. The slope of TR is MR and the slope of TC is MC which is why the quantity of where MR = MC maximizes total profits such as the diagram above. As long as TR < TC then firms can continue to produce in order to mitigate their losses.

Principle: The Firm's short-run supply curve

The short-run supply curve for a perfectly competitive firm is its MC curve above the min point on the AVC curve

Herfindahl-Hirschman Index

The sum of the squared market shares of firms in a given industry multiplied by 10,000.

Principle: Profit Maximization Rule for Monopolistic Competition

To max profits, a monopolistically competitive firm produces where its MR = MC. The profit maximizing price is the ax price per unit that consumers are willing to pay for the profit maximizing level of output. In other words, the profit-maximizing output, Q*, is such that MR(Q*) = MC(Q*) and the profit-maximizing price is P* = P(Q*)

Principle: Short Run Output Decision under Perfect Competition

To max short-run profits, a perfectly competitive firm should produce in the range of increasing MC where P = MC, provided that P greater than or equal to AVC. If P < AVC, the firm should shut down its plant to minimize its losses.

Principle: Competitive Output Rule

To maximize profits, a perfectly competitive firm produces the output at which price equals MC in the range over which MC is increasing: P = MC(Q)

The market demand for woozles is given by: Qd = 2,400 - 20p There is only one available technology, and it is employed by all producers—actual and potential. It implies the following average cost function: AC = 625q^-1 + 0.25q Currently, 20 firms serve the market. How much profit is the typical firm making?

Total profit will be: TP = (P - AC)*q = [40 - (625/80)+(0.25*80)]*80 = $975

Perfect Competition

_______ markets display the following characteristics: - There are many buyers and sellers in the market. Since each one is small relative to the size of the market, no participant can exert any influence in this market. In particular, each seller is too small to change the market supply. - The product is homogeneous. There is no product differentiation whatsoever, and therefore no need for any firm to advertise. - All market participants have perfect information. - There are no transaction costs. There is freedom of entry and exit.