Brickley, Smith, and Zimmerman, Managerial Economics and

Organizational Architecture, 4th ed.

Students should be able to

Differentiate among the four archetypal market structures

Distinguish between price takers and price searchers

Last week we analyzed production and costs decisions and how costs influence a manager’s decision on what inputs to use and how much to produce.

This week we look at how market structures influence a manager’s decision on how much to produce, what price to charge and how to maximize profitability under different market structures

Please read The Market for Cable Television case study, pages 160-161

The example of cable TV illustrates how policy choices-such as pricing, product design, and advertising-are influenced critically by the market environment.

Policies that work within a protected market environment often have to be amended radically when facing a more competitive environment.

It is important that managers understand the firm’s market environment and how this set of market circumstances affects decision making.

Our purpose in this chapter is to enhance that understanding by exploring the implications of alternative market structures.

Our primary focus is on output and pricing decisions within different market structures.

We begin by discussing markets and market structures in greater detail.

Then pricing and output decisions within different market structures

A market consists of all firms and individuals who are willing and able to buy or sell a particular product.

These parties include those currently engaged in buying and selling the product, as well as potential entrants.

A market is a process that facilitates trade rather than a place and where prices and quantity bought and sold are discovered through interaction of buyers and sellers

Market structure refers to the basic characteristics of the market environment, including (1) the number and size of buyers, sellers, and potential entrants; (2) the degree of product differentiation; (3) the amount and cost of information about product price and quality; and (4) the conditions for entry and exit.

Pure Competition Pure Monopoly Monopolistic Competition Oligopoly

Market Structure Continuum

PureCompetition

MonopolisticCompetition Oligopoly

PureMonopoly

Imperfect Competition

Many buyers and sellers

Product homogeneity (standardized products)

Low cost and accurate information

Free entry and exit

The firm is a price taker Best regarded as a benchmark to compare other market

structures and their efficiencies

To examine demand from a seller’s viewpoint (including pricing and output decisions)

To see how a competitive producer responds to market price in the short-run

To explore the nature of long-run adjustments

To evaluate the efficiency of competitive industries

In competitive markets, individual buyers and sellers take the market price of the product as given:

They have no control over price.

Firms thus view their demand curves as horizontal at that given market price

Every company should

Continue to produce more as long as MR>MC

Stop at a production level where MR = MC

Cut back production when MR<MC

Economic Profit - When the price is above ATC (produce)

Normal Profit – When the price is equal to ATC (produce)

Reduce Losses – When the price is below ATC but above AVC (continue production)

Shut Down Point – When the price is below AVC. Your losses will be equal to fixed costs (stop production)

Cost

an

d R

even

ue

$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Economic Profit

Marginal Revenue-Marginal Cost Approach ( MR = MC Rule)

MR = P

MCMR = MC

AVC

ATC

P=$131

A=$97.78

Lower the Price to $81 andObserve the Results!

Cost

an

d R

even

ue

$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Loss

Marginal Revenue-Marginal Cost ApproachMR = MC Rule

MR = P

MC

AVCATC

Loss Minimizing Case

P=$81

A=$91.67

V = $75

Lower the Price Further to $71 and Observe the Results!

Cost

an

d R

even

ue

$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Marginal Revenue-Marginal Cost ApproachMR = MC Rule

MR = P

MC

AVC

ATC

Short-Run Shut Down Case

P=$71Short-Run

Shut Down PointP < Minimum AVC

$71 < $74

V = $74

Why the marginal-cost curve and supply curve of competitive firms are identical

The firm's short run supply curve is that portion of its short-run marginal cost curve above short-run average variable cost.

The long-run supply curve is that portion of its long-run marginal cost curve above long-run average cost.

Generalizing the MR=MC Relationship and its Use

P1

0

Cost

an

d R

even

ues (

Dollars

)

Quantity Supplied

MR1

P2 MR2

P3 MR3

P4 MR4

P5 MR5

MC

AVC

ATC

Q2 Q3 Q4 Q5

This Price is Below AVCAnd Will Not Be Produced

ab

c

d

e

Generalizing the MR=MC Relationship and its Use

P1

0

Cost

an

d R

even

ues (

Dollars

)

Quantity Supplied

MR1

P2 MR2

P3 MR3

P4 MR4

P5 MR5

MC

AVC

ATC

Q2 Q3 Q4 Q5

This Price is Below AVCAnd Will Not Be Produced

ab

c

d

e

MC Above AVC Becomesthe Short-Run Supply CurveS

Examine the MC for the Competitive Firm

Break-even(Normal Profit) Point

Shut-Down Point (If P is Below)

How industry entry and exit produce economic efficiency P = ATC in the long run and production takes place where MR = MC

What is long run competitive equilibrium and why companies only make normal profit

How short-run economic profits will disappear with entry of other firms

How short-run economic losses will disappear with exit of some firms

Productive Efficiency – requires that goods be produced in the least costly way. In the long run, pure competition forces firms to produce at the minimum ATC.

P = Minimum ATC Allocative Efficiency – requires that resources

be apportioned among firms and industries to yield mix of products and services most wanted by society

P = MC Maximum Consumer and Producer

Surplus Dynamic Adjustments and “Invisible

Hand” Revisited

Single Firm Industryp P

p P0 0

EconomicProfit

d

ATC

AVC

s = MC

$111 $111

D

S = ∑ MC’s

8 8000

Competitive Firm Must Take the Price that isEstablished By Industry Supply and Demand

Single Firm Industryp P

p P0 0100 90,00080,000 100,000

ATC

MR

MC

$60

50

40

D1

S1

An Increase in Demand Temporarily Raises PriceHigher Prices Draw in New CompetitorsIncreased Supply Returns Price to Equilibrium

D2

$60

50

40

S2

Single Firm Industryp P

p P0 0100 90,00080,000 100,000

ATC

MR

MC

$60

50

40

D3

S3

A Decrease in Demand Temporarily Lowers PriceLower Prices Drive Away Some CompetitorsDecreased Supply Returns Price to Equilibrium

D1

$60

50

40

S1

Single Firm MarketP

rice

Pri

ce

Quantity Quantity

0 0

Competitive Firm and Market

P MR

D

S

QeQf

ATC

Productive Efficiency: Price = Minimum ATCAllocative Efficiency: Price = MCPure Competition Has Both in

Its Long-Run Equilibrium

MCP=MC=MinimumATC (Normal Profit)

P

In a competitive equilibrium, firms make no economic profits. Production is efficient in that firms produce at their minimum long run average cost.

Firms in competitive industries must move rapidly to take advantage of transitory opportunities. They also must strive for efficient production in order to survive.

Some firms in the industry can employ resources that give them a competitive advantage (for example, an extremely talented manager).

Yet in such cases, any excess returns often go to the factor of production responsible for the particular advantage, rather than to the firm's owners.

Although the competitive model provides a useful description of the interaction between buyers and sellers for many industries,

there are others where firms have substantial market power—prices are affected materially by the output decisions of individual firms.

extreme case of a firm with market power is monopoly, where the industry consists of only one firm.

Here, industry and firm demand curves are one and the same.

A necessary condition for market power to exist is that there are effective barriers to entry into the industry

In contrast to competitive markets, consumers pay more than marginal cost and the firm earns economic profits.

Output is restricted from competitive levels.

With a monopoly, not all the potential gains from trade are exhausted

Firms consider entering a new market when they observe economic profits (higher than normal) being reported by firms.

Entry decisions depends on three important factors:

First: Whether entry will affect the prices are the firms likely to cut prices?

Second: Incumbent advantages do existing firms have advantage that are hard to duplicate, ones that make it highly unlikely that the new firms will enjoy similar profits.

Third: Cost of Exit how expensive would it be to exit if the firm fails

Market power can exist when there are substantial barriers to entry into the industry. Expectations about incumbent reactions, incumbent advantages, and exit costs all can serve as entry barriers.

Incumbent reactions

Specific assets

Economies of scale

Excess capacity

Reputation effects

Incumbent advantages

Precommitment contracts

Licenses and patents

Learning-curve effects

Pioneering brand advantages

What conditions enable it to arise and survive?

How does a pure monopolist determine its profit-maximizing price and output quantity?

Does a pure monopolist achieve the efficiency associated with pure competition?

If not, what should the government do about it?

Single Seller No Close Substitutes “Price Maker” Blocked Entry Non-price Competition Examples - natural gas & electric companies,

water, cable, local telephone•Regulated Monopolies•Unregulated monopolies

Dual Objectives of Study - not only to understand monopolies but more common imperfect competition such as monopolistic competition and oligopolies

Economies of Scale – public utilities

Legal Barriers to Entry•Patents - Pharmaceuticals

•Licenses – Radio & TV stations, Cabs

Ownership or Control of Essential Resources – DeBeers, Alcoa

Pricing and Other Strategic Barriers to Entry – Advertising and pricing,

Windows

0 1 2 3 4 5 6

$142

132

122

112

102

92

82

Marginal Revenue is Less Than Price

D

•A Monopolist isSelling 3 Units at$142

•To Sell More (4), Price Must BeLowered to $132

•All Customers Must Pay the SamePrice

•TR Increases $132 Minus $30 (3x$10)

Gain = $132

Loss = $30

0 1 2 3 4 5 6

$142

132

122

112

102

92

82

Marginal Revenue is Less Than Price

D

•A Monopolist isSelling 3 Units at$142

•To Sell More (4), Price Must BeLowered to $132

•All Customers Must Pay the SamePrice

•TR Increases $132 Minus $30 (3x$10)

•$102 Becomes a Point on the MR Curve

•Try Other Prices toDetermine Other MR Points

Gain = $132

Loss = $30

The Constructed Marginal Revenue CurveMust Always Be Less Than the Price

MR

$200

150

100

50

0

$750

500

250

0

2 4 6 8 10 12 14 16 18

2 4 6 8 10 12 14 16 18

Pri

ce

Tota

l R

even

ue

Demand, Marginal Revenue, and Total Revenue for a Pure Monopolist

Elastic InelasticDemand and Marginal Revenue Curves

Total-Revenue Curve

DMR

TR

0

$200

175

150

125

25

100

75

50

Pri

ce,

Costs

, an

d R

even

ue

1 2 3 4 5 6 7 8 9 10

Quantity

By A Pure Monopolist

D

MR

ATC

MC

MR=MC

Pm=$122

A=$94

EconomicProfit

Cannot Charge the Highest Price it can get

Total, Not Unit, Profit is the goal of the monopolist

Possibility of Losses However, pure monopolist can

continue to receive economic profits in the long run

Concerning Monopoly Pricing

0

Pri

ce,

Costs

, an

d R

even

ue

Quantity

By A Pure Monopolist

D

MR

ATC

MC

MR=MC

Loss

AVCPm

Qm

V

A

Price, Output, and Efficiency

PurelyCompetitive

Market

PureMonopoly

D D

S=MC MC

P=MC=Minimum

ATC

MR

Pc

Qc

Pc

Pm

QcQm

Pure Competition is EfficientMonopoly Price is Greater Than MC

And Is Therefore Inefficient

a

b

c

Monopolist is a Price Maker

Sets Price in the Elastic Region

Output and Price Determination•Cost Data•MR = MC Rule

No Supply Curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on location of the demand curve.

Price - Monopolist will charge a higher price than perfect competition

Output – Monopoly will produce a smaller output

Productive Inefficiency - output is less than the output where ATC is minimum

Allocative Inefficiency – efficiency is not achieved because of lower output is produced than society is willing and ready to pay for

Deadweight loss - because price exceeds MC there is deadweight loss (reduced consumer and producer surplus)

Income Transfer – from consumer to producer

Cost Complications• Simultaneous Consumption• Network Effects

Economies of Scale in one or two companies

Multiple firms produce similar products

Firms face down sloping demand curves

Profit maximization occurs where MC=MR

In the long run, firms compete away economic profits

Most firms have distinguishable rather than standardized products and have some discretion over the price they charge.

Competition often occurs on the basis of price, quality, location, service and advertising.

Entry to most real-world industries ranges from easy to very difficult but is rarely completely blocked

Monopolistic Competition mixes a small amount of monopoly power, a small amount of competition.

Characteristics•Small Market Shares•No Collusion•Independent Action

Differentiated Products•Product Attributes•Service•Location•Brand Names and Packaging•Advertising•Some Control Over Price

Easy Entry and Exit Advertising

• Non-price Competition Monopolistically Competitive Industries

include grocery stores, gas station, dry cleaners, restaurants

Firm’s demand curve is highly, but not perfectly elastic because:

It has fewer rivals and products are differentiated

The Firm’s Demand Curve Downward sloping

The Short Run:•Profit or Loss

The Long Run:•Only a Normal Profit (P = ATC but not equal to

minimum ATC)•Economic Profits: Firms Enter•Economic Losses: Firm’s Leave

Complications•Product Variety

In Monopolistic Competition

In Monopolistic Competition

Short-Run Profits

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D1

ATC

EconomicProfit

Q1

A1

P1

0

In Monopolistic Competition

Short-Run Losses

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D2

ATC

Loss

Q2

A2

P2

0

In Monopolistic CompetitionLong-Run Equilibrium

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D3

ATC

Q3

P3=A3

0

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D3

ATC

Q3

P3=A3

0

Recall: P=MC=Minimum ATC

P4

Q4

Price is Higher

Excess Capacity atMinimum ATC

Monopolistic Competition is Not Efficient

Productive Efficiency is not achieved because production occurs where ATC is greater than minimum ATC.

Allocative Efficiency is not realized because the product price exceeds marginal cost

A few firms produce most market output

Products may or may not be differentiated

Effective entry barriers protect firm Profitability However, these profits can be eliminated through competition among existing firms in the industry.

Firm interdependence requires strategic thinking

To analyze output and pricing decisions in oligopolistic industries, we use the concept of a Nash equilibrium:

A Nash equilibrium exists when each firm is doing the best it can given the actions of its rivals.

Characteristics•A Few Large Producers•Homogeneous or Differentiated ProductsHomogeneous, Steel, copper, cement Differentiated, Auto, detergents

•Control Over Price, But Mutual InterdependenceStrategic Behavior

•Entry Barriers, economies of scale, large capital investments, patents, control of raw material, advertising,

brand loyalty and pricing •Oligopoly Through Mergers

An oligopolist does the best it can, given expectations of rival behavior

Behaviors are noncooperative

Duopolists considering a low price or a high price must consider rival’s response

Nash equilibrium occurs when each firm does the best it can given rival’s actions

The Nash equilibrium is not the outcome that maximizes the joint profits of the two companies

Combined profits could be higher if the two companies decide to cooperate

Game Theory Model to Analyze Behavior

RareAir’s Price Strategy

Up

tow

n’s

Pri

ce

Str

ate

gy A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low•2 Competitors•2 Price Strategies

•Each Strategy Has a Payoff Matrix

•Greatest CombinedProfit

• Independent ActionsStimulate a Response

Game Theory Model to Analyze Behavior

RareAir’s Price Strategy

Up

tow

n’s

Pri

ce

Str

ate

gy A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low• Independently Lowered Prices in Expectation of Greater Profit Leads to the Worst Combined Outcome

•Eventually Low Outcomes Make Firms Return to Higher Prices

O 11.2

In the Cournot model, each firm treats the output level of its competitor as fixed and then decides how much to produce.

In equilibrium, firms make economic profits.

However, these profits are not as large as would be made if the firms effectively colluded and posted the monopoly price.

Other models of oligopoly yield different equilibriums. For instance, one model based on price competition yields the competitive solution: Price equals marginal cost with no economic profits.

Economic theory makes no clear-cut prediction about the behavior of firms in oligopolistic industries.

Available evidence suggests that in some oligopolistic industries, firms restrict output from competitive levels and hence capture some economic profits.

It is in the economic interests of firms in oligopolistic industries to find ways to cooperate, thereby capturing higher profits.

Even when firms are free to cooperate, effective cooperation is not always easy to achieve. Individual firms have incentives to deviate from agreed-on outputs and prices and increase their revenues and profits

This incentive is illustrated by the prisoners' dilemma.

This model highlights incentives that can cause cartels to be unstable. However, firms sometimes can cooperate successfully when they can impose penalties on non-cooperative firms. Cooperation also can be sustained through the incentives provided by long-run, repeated relationships.

Online Quiz

Current Events

Concept Questions

Test