Because learning changes everything.

Chapter 12
Managerial
Decisions for Firms
with Market Power

© 2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Learning Objectives
v Define market power and describe measurement of
market power.
v Explain why entry barriers are necessary for long run
market power and discuss major types of entry barriers.
v Find the profit-maximizing output, price, and input usage
for a monopolist and monopolistic competitor.
v Employ empirically estimated or forecasted demand,
average variable cost, and marginal cost to calculate
profit-maximizing output and price for monopolistic or
monopolistically competitive firms.
v Select production levels at multiple plants to minimize the
total cost of producing a given total output for a firm.

© McGraw-Hill Education 2
 Monopoly and Monopolistic
Competition
A monopoly is a single firm that produces a good for
which there are no close substitutes in a market
that other firms are prevented from entering
because of a barrier to entry.
Monopolistic competition is a market consisting of a
large number of firms selling a differentiated
product with low barriers to entry.
Market power is the ability possessed by all price-
setting firms to raise price without losing all sales,
which causes the price-setting firm’s demand to be
downward-sloping.
© McGraw-Hill Education
 รถในการร นราค า โดยไ ่เส ีย ูก นไ
=> ความสามาร
Measurement of Market Power (1 of 3)
-

Degree of market power inversely related to price

elasticity of demand.
• The less elastic the firm’s demand, the greater its
คาเ ม น น 1% ญเเ ย ก าไ ป
degree of market power. +> => เ น
าราค
นซ
อ

• The fewer close substitutes for a firm’s product, the

smaller the elasticity of demand (in absolute value)
and the greater the firm’s market power.
• When demand is perfectly elastic (demand is
horizontal), the firm has no market power.

© McGraw-Hill Education
ลู
ลู
สู
อิ
สี
ขึ
ึ้
ม่
ขึ้
คื
ค้
น้
พิ่
ถ้
ช่
 Measurement of Market Power (2 of 3)
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 (and
market power) varies inversely with elasticity.
• The lower the elasticity of demand (absolute value),
the greater the index and the degree of market power.
,-
"#$%#$ &%'#( = * −
*

© McGraw-Hill Education
 Measurement of Market Power (3 of 3)
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, and
the smaller the degree of market power for the two
firms.

Market definition is the identification of the

producers and products that compete for
consumers in a particular geographic area.

© McGraw-Hill Education
 สิ่งทมาขว

Barriers to Entry
-

-ท ใใ หาย
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.

© McGraw-Hill Education
ที่
ห้
ำ
 Common Entry Barriers (1 of 2)
Barriers created by government
• Patents, licenses, exclusive franchises.
↳ ท ตร ร , ใบอน

Economies of scale -> ผ ตเ ม น

• When long-run average cost declines over a wide range of output

relative to demand for the product, there may not be room for a new
firm to enter the industry on a large-enough scale to compete.

Essential input barriers

• One firm controls a crucial input in the production process.

Brand loyalties
• Strong customer allegiance to existing firms may keep new firms
from finding enough buyers to make entry worthwhile.

© McGraw-Hill Education
ต้
สิ
ขึ้
พิ่
ธิ
ลิ
บั
 Common Entry Barriers (2 of 2)
Consumer lock-in
• Potential entrants can be deterred if they believe high switching
costs make previous consumption decisions very costly to change.
• Switching costs are incurred by consumers when they switch to new
or different products or services.
Network externalities
• Occur when benefit or utility a consumer derives from consuming a
good depends positively on the number of other consumers who use
the good.
Sunk costs
• Entry costs (which are sunk costs) can serve as a barrier if they are
so high that the manager cannot expect to earn enough future profit
to make entry worthwhile.

© McGraw-Hill Education
 Demand and 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, and is twice as
steep.

© McGraw-Hill Education
 Figure 12.1 Demand and Marginal
Revenue Facing a Monopolist

Figure 12.1

© McGraw-Hill Education 11
 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 and 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.

© McGraw-Hill Education
 Table 12.1 Profit Maximization for Southwest
Leather Designs

Table 12.1

© McGraw-Hill Education 13
 Figure 12.2 Profit Maximization for Southwest
Leather Designs: Choosing Output

Figure 12.2

© McGraw-Hill Education 14
 Figure 12.3 Short-Run Profit-Maximizing
Equilibrium under Monopoly

Figure 12.3

© McGraw-Hill Education 15
 Figure 12.4 Short-Run Loss Minimization
under Monopoly

Figure 12.4

© McGraw-Hill Education 16
 Long-Run Profit Maximization for
Monopoly
Monopolist maximizes profit by choosing to
produce output where MR = LMC, as long as
P ³ 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.

© McGraw-Hill Education
 Figure 12.5 Long-Run Profit Maximization
under Monopoly

Figure 12.5

© McGraw-Hill Education 18
 Profit-Maximizing Input Usage (1 of 2)

Marginal revenue product (MRP) is the additional

revenue earned when the firm hires one more
unit of the input.
∆&"
!"# = = !"×!#
∆'
If choose to produce:
• If the MRP of an additional unit of input is greater than
the price of input, that unit should be hired.
• Employ amount of input where MRP = input price = w.
• Profit-maximizing level of input usage produces exactly
that level of output that maximizes profit.
© McGraw-Hill Education
 Profit-Maximizing Input Usage (2 of 2)
Average revenue product (ARP) is the average
revenue per worker:
%"
!"# = = #×!#
&

Relevant range of MRP curve is downward sloping,

positive portion, for which ARP > MRP.
Shut down in short run if ARP < MRP.
• When ARP < MRP, TR < TVC

© McGraw-Hill Education
 Figure 12.6 A Monopoly Firms’ Demand
for Labor

Figure 12.6

© McGraw-Hill Education 21
 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.

© McGraw-Hill Education
 Profit Maximization for Monopolistic
Competition
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.

© McGraw-Hill Education
 Figure 12.7 Short-Run Profit Maximization under
Monopolistic Competition

Figure 12.7

© McGraw-Hill Education 24
 Figure 12.8 Long-Run Equilibrium under
Monopolistic Competition

Figure 12.8

© McGraw-Hill Education 25
 Implementing the Profit-Maximizing
Output and Pricing Decision (Step 1)
General rules for implementation
• Should the firm produce or shut down?
• If production occurs, how much should the firm
produce?

Step 1: Estimate demand equation

• Use statistical techniques from Chapter 7.
• Substitute forecasts of demand-shifting variables into
estimated demand equation to get:
) = *! + ,#
3 + 5 76"
-ℎ/0/ 1! = 1 + 2 4
© McGraw-Hill Education
 Implementing the Profit-Maximizing
Output and Pricing Decision (Step 2)
Step 2: Find inverse demand equation.
• Solve for P

−*! 9
#= + ) = : + ;)
, ,

−2 ! 1
! 5 5
.ℎ010 2 = 2 + 4, + 6*" , 8 = , 2:6 ; =
9 9

© McGraw-Hill Education
 Implementing the Profit-Maximizing
Output and Pricing Decision (Steps 3 & 4)
Step 3: Solve for marginal revenue
• When demand is expressed as P = A + BQ, marginal
revenue is
−*! &
!" = $ + &'( = + (
+ +

Step 4: Estimate AVC and SMC

• Use statistical techniques from Chapter 10.

AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2

© McGraw-Hill Education
 Implementing the Profit-Maximizing
Output and Pricing Decision (Steps 5 & 6)
Step 5: Find output where MR = SMC ·
• Set equations equal and solve for Q*.
• The larger of the two solutions is the profit-maximizing
output level. -> เอา ค่ ส

Step 6: Find profit-maximizing price

• Substitute Q* into inverse demand:

P* = A + BQ*
Q* and P* are only optimal if P ³ AVC

© McGraw-Hill Education
ที่
 Implementing the Profit-Maximizing
Output and Pricing Decision (Step 7)
Step 7: Check shutdown rule
• Substitute Q* into estimated AVC function:

AVC* = a + bQ* + cQ*2

• If P* ³ AVC*, produce Q* units of output and sell each

unit for P*.
• If P* < AVC*, shut down in the short run.

© McGraw-Hill Education
 Implementing the Profit-Maximizing
Output and Pricing Decision (Step 8)
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 and profit is –TFC

© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (1 of 9)
Aztec possesses market power via patents and sells
advanced wireless stereo headphones.

Estimation of demand and marginal revenue:

< = 41,000 − 5007 + 0.64 − 22.57"

= 41,000 − 5007 + 0.6 45,000 − 22.5 800

= 50,000 − 5007

© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (2 of 9)
Solve for inverse demand:

= − 50,000 = −500@

= − 50,000 500@
=−
−500 −500

= −50,000
+ =@
−500 −500

1
@ = 100 − = = 100 − 0.002=
500
© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (3 of 9)
Determine the marginal revenue function from the
inverse demand function (same P-intercept, twice as
steep):

P = 100 – 0.002Q

MR = 100 – 0.004Q

© McGraw-Hill Education
 Figure 12.9 Demand and Marginal
Revenue for Aztec Electronics

Figure 12.9

© McGraw-Hill Education 35
 Maximizing Profit at Aztec
Electronics: An Example (4 of 9)
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

© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (5 of 9)
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

© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (6 of 9)
Output decision:
• Solve for Q* using the quadratic formula

− −0.006 + (−0.006)" − 4(−72)(0.000003) 0.036

#∗ = = = 6,000
2(0.000003) 0.000006

© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (7 of 9)
Pricing decision:
• Substitute Q* into inverse demand

P* = 100 – 0.002(6,000)
= $88

© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (8 of 9)
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.

© McGraw-Hill Education
 Maximizing Profit at Aztec
Electronics: An Example (9 of 9)
Computation of total profit:

π = 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

© McGraw-Hill Education
 Figure 12.10 Profit Maximization at Aztec
Electronics

Figure 12.10

© McGraw-Hill Education 42
 Multi-plant Firms
If a firm produces in two plants, A and B:
• The total cost of producing any given level of total output
QT (= QA + QB) in minimized when production is allocated
production so that MCA = MCB

The total marginal cost curve (MCT) is the horizontal

summation of all plants’ marginal cost curves, which
gives the addition to total cost attributable to increasing
total output (QT) by one unit.
• Profit maximizing total output is that for which MR = MCT

© McGraw-Hill Education
 Figure 12.11 A Multi-plant Firm

Figure 12.11

© McGraw-Hill Education 44
 Figure 12.12 Multi-plant Production at
Mercantile Express

Figure 12.12

© McGraw-Hill Education 45
 Summary (1 of 3)
• Price-setting firms possess market power.
• A monopoly exists when a single firm produces and sells a
particular good or service for which there are no good substitutes
and new firms are prevented from entering the market.
• Monopolistic competition arises when the market consists of a
large number of relatively small firms that produce similar, but
slightly differentiated, products and have some market power.
• A firm can possess a high degree of market power only when
strong barriers to the entry of new firms exist.
• In the short run, the manager of a monopoly firm will choose
to produce where MR = SMC, rather than shut down, as long
as total revenue at least covers the firm’s total variable cost
(TR ≥ TVC).

© McGraw-Hill Education
 Summary (2 of 3)
• In the long run, the monopolist maximizes profit by choosing
to produce where MR = LMC, unless price is less than long-
run average cost (P < LAC), in which case the firm exits the
industry.
• For firms with market power, marginal revenue product
(MRP) is equal to marginal revenue times marginal product:
MRP = MR × MP.
• Whether the manager chooses Q or L to maximize profit, the
resulting levels of input usage, output, price, and profit are
the same.
• Short-run equilibrium under monopolistic competition is
exactly the same as for monopoly.

© McGraw-Hill Education
 Summary (3 of 3)
• Long-run equilibrium in a monopolistically competitive market
is attained when the demand curve for each producer is
tangent to the long-run average cost curve

• 8 steps can be employed for profit-maximization for a

monopoly or monopolistically competitive firm: (1) estimate
demand equation, (2) find inverse demand equation, (3)
solve for marginal revenue, (4) estimate average variable
cost and marginal cost, (5) find output level where MR =
SMC, (6) find profit-maximizing price, (7) check the shutdown
rule, and (8) compute profit/loss

• A firm producing in two plants, A and B, should allocate

production between the two plants so that MCA = MCB

© McGraw-Hill Education
Because learning changes everything. ®

www.mheducation.com

© 2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.