08 - Managing in Competitive, Monopolistic and Monopolistic Competitive Environments

Question 1

Perfect Competition (PC)

Basic Characteristics -

Answer 1

1. Many buyers and Sellers so each firm is small relative to market size.
2. All firms produce homogeneous (identical) products.
3. Buyers and sellers have perfect information.
4. Zero transaction costs
5. Free market entry/exit

Question 2

PC Market implications

Answer 2

Customers view homogeneous goods as perfect substitutes. Perfect information eliminates ability to differentiate. Customers will not invest more effort for one product over another. Thus, all firms charge same price and no single firm can influence the market.

Free entry if economic profits are being earned will drive long run economic profits to zero

Question 3

PC Market vs Firm Level Demand

Answer 3

Price is determined by the intersection of the market supply and market demand curves.

The demand curve for a firm in a perfectly competitive market is horizontal (perfectly elastic) and simply the market price where market supply and demand curves intersect.

Question 4

PC pricing strategy

Answer 4

Easy!

Since demand is perfectly elastic - you MUST charge the same price as all other firms in industry.

The demand curve for a competitive firm is the horizontal line at market price.

Question 5

PC - output decisions

Short Run - when fixed costs exist

Maximizing Profits

Answer 5

Maximum Profit per unit qty will generate maximum revenue.

Since each unit of output can be sold at market price, each unit sold adds exactly P dollars of revenue.

Marginal revenue is the slope of the revenue curve. Profits are the difference between revenues and costs. The manager must equate the market price with marginal cost to maximize profits.

Question 6

PC - Marginal Revenue

Answer 6

In a PC environment

MR = price (P)
MR = slope of revenue (R)

Question 7

PC - Marginal Cost

Answer 7

In a PC environment

MC = price (P)
MC = slope of cost C(Q)

Question 8

PC - Profit maximizing calculations

Answer 8

In a PC environment

Will typically be given the market equilibrium price and cost function of the firm.

Use cubic function equation to convert firm’s cost function into marginal cost equation.

The market equilibrium price = MR(Q)

So set MR = MC and solve for optimal Q at market price.

Question 9

Competitive Output Rule

Answer 9

To maximize profits, a competitive firm produces the output at which price (market price) equals marginal cost on the range over which marginal cost is increasing.

May be expressed as where price = change in cost over change in quantity.

Change in profit over change in quantity = price minus change in cost over change in quantity = 0. Or, marginal profits = 0

Question 10

PC - output decisions

Minimizing Losses

Answer 10

As long as price (market price) exceeds AVC, some revenue is contributing to pay down of fixed costs. Since the fixed costs would be incurred even if the firm shut down, operating at a short run loss with revenues between AVC and ATC is acceptable.

Question 11

PC - shut down decision

Answer 11

Whenever market price falls below firm’s AVC.

Question 12

PC - Short Run Supply

Range of output

Answer 12

The short-run supply curve for a perfectly competitive firm is its Marginal Cost curve above the minimum point on the Average Variable Cost curve.

Question 13

PC - Firm and Market Supply Curves

Answer 13

Since the qty an individual firm will produce at a given price is determined by its marginal cost curve, the horizontal sum of all firms marginal costs equals the total output produced by the industry at each price.

Also, since each firm’s supply curve is its marginal cost curve above the minimum AVC, the market supply curve is the horizontal sum of all firms marginal cost curves above their individual AVC curves.

Question 14

PC - Long Run Decisions

Answer 14

If economic profits are earned in short run, more firms will enter industry.

As more firms enter, supply shifts right which lowers equilibrium price and increases qty demanded. The inverse happens as well.

The above balancing takes place until in the long run, all firms earn zero economic profits. Each firm just covers Average Costs. In long run no distinction between VC and FC.

Question 15

PC - Long - Run Competitive Equilibrium

Answer 15

In the long-run, perfectly competitive firms produce a level of output such that:
P = MC
P = minimum of AC
This is the socially efficient level of output.

Since implicit costs are covered, firms earn no more and no less than they could earn using resources in another way. Firms stay in because opportunity costs are covered.

Question 16

PC - Market Equilibrium

Answer 16

Because firms are relatively small in the market, entry and exit of firms will temporarily impact supply but the activity will have no long run effects in demand, supply or price.

Price equilibrium will return to pre- exit/entry levels.

Question 17

Monopoly (MON)

Basic Characteristics

Answer 17

Must define what is the extent of “market” to discern if firm is a monopoly.

A single firm that serves an entire market. The market demand curve is the firm’s demand curve. The firm’s demand curve is elastic at low qtys and inelastic at high qtys.

Customers choose qty demanded based on firm’s choice of price. Thus, the firm can choose price or qty but not fix both.

Question 18

MON

Economies of Scale

Answer 18

If monopolist produces qty where ATC is below Market Price, fixed costs are covered.

If multiple firms share demanded qty., each has fixed costs. The sum of firm cost may exceed what market will support. That is qty at combined ATC may cost mor than what market is willing to pay.

Question 19

MON - sources of monopoly power

Answer 19

1. Economies of Scale
2. Economies of Scope
3. Cost Complementarity
4. Patents and other protections

Question 20

MON

Economies of Scope

Answer 20

When the total costs of producing more than one product in same firm is less than same products produced in separate firms.

Biggest advantage is multi-process firms tend to be more attractive to the capital markets. In extreme cases, the inability to secure capital can become a barrier to entry.

Question 21

MON

Cost Complementarity

Answer 21

When the marginal cost of producing one product decreases when another product output increases.

Question 22

MON

Utility Patent

Design Patent

Plant Patent

Trademark

Copyright

Answer 22

Utility protects how it works

Design protects how it looks

Plant protects asexually reproduced plant discoveries

Trademarks protect words, names and symbols

Copyright protects firms of expression

Question 23

MON

Profit Maximization

Answer 23

Quantities above unity produce lower revenues. Total revenue is maximized at unity.

Profit maximizing Q* is where
MC(Q) = MC(Q)

Profit maximizing price is then
P* = P(Q*)

Question 24

MON

Marginal Revenue reduction with increase in qty produced.

Answer 24

Since monopolist must reduce price of each additional unit produced, total revenue declines as spread across all units produced.

One unit priced at $4
To sell 2 units, must price at $3 ea.
Total revenue for 2 is $6
$6 is less than if each unit sold at $4 and $3

Question 25

MON

The price a monopolist can charge depends on the qty they offer.

Inverse Demand Function

Answer 25

P(Q) = a + bQ

a is number greater than zero
b is number less than zero

Question 26

MON - Profit Maximizing calculations

Answer 26

In monopoly environment:
Convert given inverse linear demand function P(Q) = a + bQ to MR for linear demand function MR = a + 2bQ

Convert given cost function C(Q) to to MC cost function.

Set MR(Q) = MC(Q) solve for Q
Use found Q to find P

Total profit = (P • Q) - C(Q)

Question 27

MON - Supply Curves

Answer 27

Since a change in Qty by the monopolist changes the whole market supply there is no way to express a how a monopolist’s qty choice would change in reaction to market price.

No supply curve exists in markets served by firms with market power. This includes Monopolistic Competition as well.

Question 28

MON - Multi Plant Output

Answer 28

Marginal cost in each plant should be set equal to the marginal revenue of the TOTAL output.

MR(Q) = MC1(Q1)
MR(Q) = MC2(Q2)

Profit = R(Q1+Q2) - C1(Q1) - C2(Q2)

MC1(Q1) = MC2(Q2)

Question 29

MON - Deadweight Loss

Answer 29

The monopolist is encouraged to produce less and charge higher prices because in a monopoly the MR curve lies below the demand curve.

The welfare loss to society is similar to the deadweight loss when an artificial price floor exists. The area calculation for total impact is the same.

Question 30

Monopolistic Competition (MC)

Basic Characteristics

Answer 30

Many buyers and sellers.

Each firm produces a differentiated product. Market dominated by existence of close (but not perfect) substitutes.

Free entry and exit

Downward sloping demand curve so to sell more must lower price like a monopoly.

Question 31

MC - market dynamics

Answer 31

Compared to perfect competition, substitutes are not exact, differentiation means customers will switch at varied cost levels. The downward slope of demand is more similar to a monopoly.

Compared to monopoly, switching exists and profits will attract more competition with minimal barriers to entry.

Question 32

MC - Profit Naximization

Answer 32

Determined same as if monopoly.

Optimal Q is where MC = MR
Optimal P is where Q hits Demand curve
Total profit:
[P* - ATC(Q)] • Q

Question 33

Demand and MR curve differences among market types.

Answer 33

In PC - the demand curve is for the whole market of homogeneous goods.
In MON - the monopolist’s demand curve of the firm IS the market demand because they ARE the market.
In MC - the notion of a market demand curve is not clear as the demand for various degree of substitutes would be added together. The demand and MR curves used to determine profit maximizing output are the firm’s demand and MR curves rather than the market’s.

Question 34

MC - Profit Maximizing calculations

Answer 34

Same as monopoly:
Convert given inverse linear demand function P(Q) = a + bQ to MR for linear demand function MR = a + 2bQ

Convert given cost function C(Q) to to MC cost function.

Set MR(Q) = MC(Q) solve for Q
Use found Q to find P

Total profit = (P • Q) - C(Q)

Question 35

MC - Profit maximizing qty and price

Answer 35

Quantities above unity produce lower revenues. Total revenue is maximized at unity.

Profit maximizing Q* is where
MC(Q) = MC(Q)

Profit maximizing price is then
P* = P(Q*)

Question 36

MC - Entry

Answer 36

As more firms enter, the demand shifts down to left. The new MR = MC point aligns with a qty on the demand curve. As such, in the long run, all profits fall to zero.

In the long run, MC firms produce a level of output such that:

P > MC
P = AC (at minimum AC)

Question 37

MC - market implications

Answer 37

As in monopoly, MC firms will reduce less and charge higher prices but only until new entrants force prices down.

Eventually profits turn to zero.

The settled price exceeds the min AC in the long run. This is because there are too many firms to take advantage of economies of scale. This may the cost of product variety compared to a monopoly.

Question 38

Differentiation Methods

*** Avoid brand Myope!

Answer 38

Comparative Advertising to increase Brand Equity to command higher price.

Niche Marketing to cater to a tight market segment.

Invest in product development.

Question 39

Evolution of Markets

Answer 39

Markets are fluid and change over time. A market can come about in any manner. Frequently a monopoly begins around a novel idea protected by a patent or other barriers. As barriers break down, some competitors move in to create an oligopoly or monopolistic competitive market. Eventually most markets turn into perfect competition until a major disruption takes place and a new market is born.
CJ

Question 40

Optimal Advertising Decisions

Answer 40

Advertising generally not helpful in Perfect Competition environments.

Otherwise, should advertise up to the point where incremental revenues from advertising equals the incremental costs.

Question 41

Market comparisons

Answer 41

Firms in perfect competition are price takers, produce output where P = MC, may earn profits/losses in short run but in long run entry/exit forces drive economic profits to zero.

A monopoly does not get guaranteed profits but can maintain consistent profits if market power is sustained.

Monopolistic competitive firms earn short run profits but entry drive market to zero profits.