Lecture 8: Market Structures

Market Structures
Chapter 8

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Profit Maximization
The goal of the firm is to maximize profits

= Pq C(q)

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Profit Maximization
Each unit of output increases revenues by the Marginal Revenue (Pq) MR = q It also increases costs by the Marginal Cost C MC = q
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Profit Maximization
If MR > MC, profits increase because revenues rise faster than costs, but if MR < MC, profits decrease. Therefore, the firm should only expand output as long as MR MC For the very last unit produced

MR = MC
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopoly
A monopolist is the only firm in the market. A monopolist does not have to be big, it only has to face no competitors. Barriers to entry will prevent other firms from entering Because there is only one firm, the firms demand curve is the same as the market demand curve
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Sources of Monopoly
Natural Monopoly (Economies of Scale)
Market Demand ceases in the portion where AC is still declining. Therefore, AC is lowest if there is only one firm

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Sources of Monopoly
Natural Monopoly Economies of Scope
If it is cheaper to produce two goods together, and producing the goods requires large amounts of capital, the large capital requirement will constitute a barrier to entry and new firms may not be able to enter

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Sources of Monopoly
Natural Monopoly Economies of Scope Government Regulation
The Government may grant a local or even a national monopoly
Ex. Local utilities

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Profit Maximization
MR = MC for Profit Maximization However, for a Monopolist, MR < P This is because, in order to sell one more unit of output, the monopolist must lower the price of all the other units
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopoly
MR = = (Pq) q P q q +

is the slope of the demand curve (which is negative)

P q

q P q <P
Prof. Colin Mang, 2011

P MR = P + q q
ECON 2106: Managerial Economics

Lecture 8: Market Structures

Marginal Revenue
For a Linear Demand Curve
If P = a bQ

MR = a 2bQ
For a Non-Linear Demand Curve

1+E MR = P E
ECON 2106: Managerial Economics

Where E is the Elasticity of Demand

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Notes on Monopoly
1. The Monopoly is inefficient because
a) P > MC implies that the value to society of the last unit of output is greater than the cost to society of obtaining it b) MC AC i.e. production costs per unit are not minimized

2. The monopoly can earn positive economic profits because other firms cannot enter the market
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopoly
Ex. Suppose a Monopolist faces market demand Q = 600 2P and has a cost function C = 100 + q2 where MC = 2q . Find the equilibrium price, quantity, and monopoly profit.

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopoly
Depending on the shape of the AC curve relative to market demand, it may be beneficial for the monopolist to produce output at more than one plant If a firm decides to produce in a multiplant setting, it must decide how much output to produce at each plant
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Multi-plant Output
Producing one more unit of output increases revenue by MR and cost by MC so

MR = MC1(Q1)
and

MR = MC2(Q2)
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Multi-plant Output
This implies that

MC1(Q1) = MC2(Q2)
so that marginal cost is the same at all plants (makes sense since if one plant was cheaper than another, you should produce more at the cheap one and less at the expensive one)
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Multi-plant Output
This DOES NOT imply that output is the same at both plants. To the extent that the plants have different cost functions (and thus different MC functions), output will vary

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Multi-plant Output
Ex. Suppose demand is given by Q = 140 2P . The Monopolist has two plants, one with MC1 = 3Q1 and the other with MC2 = Q2 . How much output should be produced at each plant?

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Social Cost of a Monopoly

The Monopoly will generate a Dead Weight Loss because P > MC

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopolistic Competition
There are no barriers to entry (like perfect competition) Each firm sells a differentiated product so each firm has some discretion over the price it charges

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopolistic Competition
Monopolistically Competitive firms face a downward sloping demand curve and so have a downward sloping MR curve They set MR = MC
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopolistic Competition
If P > AC , the firm will earn profits and new firms will enter the market until price has eroded to the point where P = AC
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Notes on Monopolistic Competition

Capital distribution is efficient. P = AC so no firm is earning economic profits. There is no advantage to entering or leaving this market Production is NOT efficient. P > MC so there is some deadweight loss to society. AC > MC so AC is NOT minimized
ECON 2106: Managerial Economics Prof. Colin Mang, 2011

Lecture 8: Market Structures

Monopolistic Competition
Ex. Suppose a Monopolistically Competitive firm faces a demand function Q = 160 P and has a Cost Function C = 3200 + q2 where MC = 2q. What quantity and price does the firm charge? Would you expect this firm to face increased competition in the Long Run?

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011

Lecture 8: Market Structures

ECON 2106: Managerial Economics

Prof. Colin Mang, 2011