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CHAPTER EIGHT bay75969_ch08_264-312.qxd 3/10/09 2:24 PM Confirming Pages Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets Learning Objectives After completing this chapter, you will be able to: LO1 Identify the conditions under which a firm operates as perfectly competitive, monopolistically competitive, or a monopoly. LO2 Identify sources of (and strategies for obtaining) monopoly power. LO3 Apply the marginal principle to determine the profit-maximizing price and output. LO4 Show the relationship between the elasticity of demand for a firm’s product and its marginal revenue. LO5 Explain how long-run adjustments impact perfectly competitive, monopoly, and monopolistically competitive firms; discuss the ramifications of each of these market structures on social welfare. LO6 Decide whether a firm making short-run losses should continue to operate or shut down its operations. LO7 Illustrate the relationship between marginal cost, a competitive firm’s short-run supply curve, and the competitive industry supply; explain why supply curves do not exist for firms that have market power. LO8 Calculate the optimal output of a firm that operates two plants and the optimal level of advertising for a firm that enjoys market power. 264 Page 264 HEADLINE McDonald’s New Buzz: Specialty Coffee Recently, McDonald’s unveiled plans to roll out McCafé—a premium line of coffee that includes cappuccino, latte, and iced mocha. About 3,000 of its 14,000 restaurants have already added the new McCafé line of drinks, but a recent downturn in the economy has made it difficult for the remaining franchisees to secure funding for remodeling and other expenses associated with the launch of specialty coffees. The recession left some analysts questioning whether it was the right time for McDonald’s to roll out its line of new specialty drinks. Regardless, why do you think McDonald’s embarked on the program? If the economy rebounds and the remaining McDonald’s restaurants launch the new line of McCafé drinks, do you think it will have a sustainable impact on the company’s bottom line? Explain. Sources: J. Adamy, “McDonald’s Coffee Strategy Is Tough Sell,” The Wall Street Journal, October 27, 2008; http://www.mymccafe.com. bay75969_ch08_264-312.qxd 3/10/09 2:24 PM Page 265 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets Confirming Pages 265 INTRODUCTION In the previous chapter, we examined the nature of industries and saw that industries differ with respect to their underlying structures, conduct, and performances. In this chapter, we characterize the optimal price, output, and advertising decisions of managers operating in environments of (1) perfect competition, (2) monopoly, and (3) monopolistic competition. We will analyze oligopoly decisions in Chapters 9 and 10 and examine more sophisticated pricing strategies in Chapter 11. With an understanding of the concepts presented in these chapters, you will be prepared to manage a firm that operates in virtually any environment. Because this is the beginning of our analysis of output decisions of managers operating in an industry, it is logical to start with the most simple case: a situation where managerial decisions have no perceptible impact on the market price. Thus, in the first section of this chapter we will analyze output decisions of managers operating in perfectly competitive markets. In subsequent sections, we will examine output decisions by firms that have market power: monopoly and monopolistic competition. The analysis in this chapter will serve as a building block for the analyses in the remainder of the book. PERFECT COMPETITION perfectly competitive market A market in which (1) there are many buyers and sellers; (2) each firm produces a homogeneous product; (3) buyers and sellers have perfect information; (4) there are no transaction costs; and (5) there is free entry and exit. We begin our analysis by examining the output decisions of managers operating in perfectly competitive markets. The key conditions for perfect competition are as follows: 1. There are many buyers and sellers in the market, each of which is “small” relative to the market. 2. Each firm in the market produces a homogeneous (identical) product. 3. Buyers and sellers have perfect information. 4. There are no transaction costs. 5. There is free entry into and exit from the market. Taken together, the first four assumptions imply that no single firm can influence the price of the product. The fact that there are many small firms, each selling an identical product, means that consumers view the products of all firms in the market as perfect substitutes. Because there is perfect information, consumers know the quality and price of each firm’s product. There are no transaction costs (such as the cost of traveling to a store); if one firm charged a slightly higher price than the other firms, consumers would not shop at that firm but instead would purchase from a firm charging a lower price. Thus, in a perfectly competitive market all firms charge the same price for the good, and this price is determined by the interaction of all buyers and sellers in the market. The assumption of free entry and exit simply implies that additional firms can enter the market if economic profits are being earned, and firms are free to leave the bay75969_ch08_264-312.qxd 266 3/10/09 2:24 PM Page 266 Confirming Pages Managerial Economics and Business Strategy market if they are sustaining losses. As we will show later in this chapter, this assumption implies that in the long run, firms operating in a perfectly competitive market earn zero economic profits. One classic example of a perfectly competitive market is agriculture. There are many farmers and ranchers, and each is so small relative to the market that he or she has no perceptible impact on the prices of corn, wheat, pork, or beef. Agricultural products tend to be homogeneous; there is little difference between corn produced by farmer Jones and corn produced by farmer Smith. The retail mailorder market for computer software and computer memory chips also is close to perfect competition. A quick look at the back of a computer magazine reveals that there are hundreds of mail-order computer product retailers, each selling identical brands of software packages and memory chips and charging the same price for a given product. The reason there is so little price variation is that if one mail-order firm charged a higher price than a competitor, consumers would purchase from another retailer. Demand at the Market and Firm Levels firm demand curve The demand curve for an individual firm’s product; in a perfectly competitive market, it is simply the market price. No single firm operating in a perfectly competitive market exerts any influence on price; price is determined by the interaction of all buyers and sellers in the market. The firm manager must charge this “market price” or consumers will purchase from a firm charging a lower price. Before we characterize the profit-maximizing output decisions of managers operating in perfectly competitive markets, it is important to explain more precisely the relation between the market demand for a product and the demand for a product produced by an individual perfectly competitive firm. In a competitive market, price is determined by the intersection of the market supply and demand curves. Because the market supply and demand curves depend on all buyers and sellers, the market price is outside the control of a single perfectly competitive firm. In other words, because the individual firm is “small” relative to the market, it has no perceptible influence on the market price. Figure 8–1 illustrates the distinction between the market demand curve and the demand curve facing a perfectly competitive firm. The left-hand panel depicts the market, where the equilibrium price, Pe, is determined by the intersection of the market supply and demand curves. From the individual firm’s point of view, the firm can sell as much as it wishes at a price of Pe; thus, the demand curve facing an individual perfectly competitive firm is given by the horizontal line in the right-hand panel, labeled D f. The fact that the individual firm’s demand curve is perfectly elastic reflects the fact that if the firm charged a price even slightly above the market price, it would sell nothing. Thus, in a perfectly competitive market, the demand curve for an individual firm’s product is simply the market price. Since the demand curve for an individual perfectly competitive firm’s product is perfectly elastic, the pricing decision of the individual firm is trivial: Charge the price that every other firm in the industry charges. All that remains is to determine how much output should be produced to maximize profits. bay75969_ch08_264-312.qxd 3/10/09 2:24 PM Page 267 Confirming Pages 267 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets FIGURE 8–1 Demand at the Market and Firm Levels under Perfect Competition P P Market Firm S Pe Df=P e D Market output 0 Firm’s output Short-Run Output Decisions Recall that the short run is the period of time in which there are some fixed factors of production. For example, suppose a building is leased at a cost of $10,000 for a one-year period. In the short run (for one year) these costs are fixed, and they are paid regardless of whether the firm produces zero or one million units of output. In the long run (after the lease is up), this cost is variable; the firm can decide whether or not to renew the lease. To maximize profits in the short run, the manager must take as given the fixed inputs (and thus the fixed costs) and determine how much output to produce given the variable inputs that are within his or her control. The next subsection characterizes the profit-maximizing output decision of the manager of a perfectly competitive firm. Maximizing Profits marginal revenue The change in revenue attributable to the last unit of output; for a competitive firm, MR is the market price. Under perfect competition, the demand for an individual firm’s product is the market price of output, which we denote P. If we let Q represent the output of the firm, the total revenue to the firm of producing Q units is R
PQ. Since each unit of output can be sold at the market price of P, each unit adds exactly P dollars to revenues. As Figure 8–2 illustrates, there is a linear relation between revenues and the output of a competitive firm. Marginal revenue is the change in revenue attributable to the last unit of output. Geometrically, it is the slope of the revenue curve. Expressed in economic terms, the marginal revenue for a competitive firm is the market price. A Calculus Alternative Marginal revenue is the derivative of the revenue function. If revenues are a function of output, R
R(Q) then MR
dR dQ bay75969_ch08_264-312.qxd 268 3/10/09 2:24 PM Page 268 Confirming Pages Managerial Economics and Business Strategy FIGURE 8–2 Revenue, Costs, and Profits for a Perfectly Competitive Firm $ Costs C (Q) Revenue R=PQ Maximum profits B Slope of C(Q) = MC Slope of R = MR = P E A Profit-maximizing output 0 Principle A Calculus Alternative Q* Firm’s output 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 marginal revenue. D f
P
MR Marginal revenue is the derivative of the revenue function. For a perfectly competitive firm, revenue is R
PQ where P is the market equilibrium price. Thus, dR MR

P dQ The profits of a perfectly competitive firm are simply the difference between revenues and costs: 
PQ  C(Q) Geometrically, profits are given by the vertical distance between the cost function, labeled C(Q) in Figure 8–2, and the revenue line. Note that for output levels to the left of point A, the cost curve lies above the revenue line, which implies that the firm would incur losses if it produced any output to the left of point A. The same is true of output levels to the right of point B. For output levels between points A and B, the revenue line lies above the cost curve. This implies that these outputs generate positive levels of profit. The bay75969_ch08_264-312.qxd 3/10/09 2:24 PM Page 269 Confirming Pages 269 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets profit-maximizing level of output is the level at which the vertical distance between the revenue line and the cost curve is greatest. This is given by the output level Q* in Figure 8–2. There is a very important geometric property at the profit-maximizing level of output. As we see in Figure 8–2, the slope of the cost curve at the profit-maximizing level of output (point E) exactly equals the slope of the revenue line. Recall that the slope of the cost curve is marginal cost and the slope of the revenue line is marginal revenue. Therefore, the profit-maximizing output is the output at which marginal revenue equals marginal cost. Since marginal revenue is equal to the market price for a perfectly competitive firm, the manager must equate the market price with marginal cost to maximize profits. An alternative way to express the competitive output rule is depicted in Figure 8–3, where standard average and marginal cost curves have been drawn. If the market price is given by Pe, this price intersects the marginal cost curve at an output of Q*. Thus, Q* represents the profit-maximizing level of output. For outputs below Q*, price exceeds marginal cost. This implies that by expanding output, the firm can sell additional units at a price that exceeds the cost of producing the additional units. Thus, a profit-maximizing firm will not choose to produce output levels below Q*. Similarly, output levels above Q* correspond to the situation in which marginal cost exceeds price. In this instance, a reduction in output would reduce costs by more than it would reduce revenue. Thus, Q* is the profit-maximizing level of output. The shaded rectangle in Figure 8–3 represents the maximum profits of the firm. To see this, note that the area of the shaded rectangle is given by its base (Q*) times FIGURE 8–3 Profit Maximization under Perfect Competition $ MC ATC Pe D f=P e=MR Profits ATC (Q*) 0 Q* Firm's output bay75969_ch08_264-312.qxd 270 3/10/09 2:24 PM Page 270 Confirming Pages Managerial Economics and Business Strategy the height [Pe  ATC(Q*)]. Recall that ATC(Q*)
C(Q*)/Q*; that is, average total cost is total cost divided by output. The area of the shaded rectangle is
Q* Pe   C(Q* )
PeQ*  C(Q* ) Q* which is the definition of profits. Intuitively, [Pe  ATC(Q*)] represents the profits per unit produced. When this is multiplied by the profit-maximizing level of output (Q*), the result is the amount of total profits earned by the firm. Principle Competitive Output Rule To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing: P
MC(Q) A Calculus Alternative The profits of a perfectly competitive firm are 
PQ  C(Q) The first-order condition for maximizing profits requires that the marginal profits be zero: d dC(Q)
P
0 dQ dQ Thus, we obtain the profit-maximizing rule for a firm in perfect competition: dC P
dQ or P
MC Demonstration Problem 8–1 The cost function for a firm is given by C(Q)
5  Q2 If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, what price should the manager of this firm put on the product? What level of output should be produced to maximize profits? How much profit will be earned? (Hint: Recall that for a cubic cost function C(Q)
f  aQ  bQ2  cQ3 the marginal cost function is MC(Q)
a  2bQ  3cQ2 Since a
0, b
1, and c
0 for the cost function in this problem, we see that the marginal cost function for the firm is MC(Q)
2Q.) bay75969_ch08_264-312.qxd 3/10/09 2:24 PM Page 271 Confirming Pages 271 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets Answer: Since the firm competes in a perfectly competitive market, it must charge the same price other firms charge; thus, the manager should price the product at $20. To find the profitmaximizing output, we must equate price with marginal cost. This firm’s marginal costs are MC
2Q. Equating this with price yields 20
2Q so the profit-maximizing level of output is 10 units. The maximum profits are thus 
(20)(10)  (5  102 )
200  5  100
$95 Minimizing Losses In the previous section, we demonstrated the optimal level of output to maximize profits. In some instances, short-run losses are inevitable. Here we analyze procedures for minimizing losses in the short run. If losses are sustained in the long run, the best thing for the firm to do is exit the industry. Short-Run Operating Losses. Consider first a situation where there are some fixed costs of production. Suppose the market price, Pe, lies below the average total cost curve but above the average variable cost curve, as in Figure 8–4. In this instance, if the firm produces the output Q*, where Pe
MC, a loss of the shaded area will result. However, since the price exceeds the average variable cost, each unit sold generates more revenue than the cost per unit of the variable inputs. Thus, the firm should continue to produce in the short run, even though it is incurring losses. Expressed differently, notice that the firm in Figure 8–4 has fixed costs that would have to be paid even if the firm decided to shut down its operation. Therefore, FIGURE 8–4 Loss Minimization $ MC ATC AVC ATC (Q*) Pe Loss 0 D f= P e = MR Q* Firm’s output bay75969_ch08_264-312.qxd 272 3/10/09 2:24 PM Page 272 Confirming Pages Managerial Economics and Business Strategy the firm would not earn zero economic profits if it shut down but would instead realize a loss equal to these fixed costs. Since the price in Figure 8–4 exceeds the average variable cost of producing Q* units of output, the firm earns revenues on each unit sold that are more than enough to cover the variable cost of producing each unit. By producing Q* units of output, the firm is able to put an amount of money into its cash drawer that exceeds the variable costs of producing these units and thus contributes toward the firm’s payment of fixed costs. In short, while the firm in Figure 8–4 suffers a short-run loss by operating, this loss is less than the loss that would result if the firm completely shut down its operation. The Decision to Shut Down. Now suppose the market price is so low that it lies below the average variable cost, as in Figure 8–5. If the firm produced Q*, where Pe
MC in the range of increasing marginal cost, it would incur a loss equal to the sum of the two shaded rectangles in Figure 8–5. In other words, for each unit sold, the firm would lose ATC(Q*)  Pe When this per-unit loss is multiplied by Q*, negative profits result that correspond to the sum of the two shaded rectangles in Figure 8–5. Now suppose that instead of producing Q* units of output this firm decided to shut down its operation. In this instance, its losses would equal its fixed costs; that is, those costs that must be paid even if no output is produced. Geometrically, fixed costs are represented by the top rectangle in Figure 8–5, since the area of this rectangle is [ATC(Q*)  AVC(Q*)]Q* FIGURE 8–5 The Shut-Down Case $ MC Loss if shut down ATC AVC ATC (Q*) Fixed cost AVC (Q*) Pe D f = P e = MR Loss if produce 0 Q* Firm’s output bay75969_ch08_264-312.qxd 3/10/09 2:24 PM Page 273 Confirming Pages Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets 273 INSIDE BUSINESS 8–1 Peugeot-Citroën of France: A Price-Taker in China’s Auto Market Competition in international markets is often more keen than in domestic markets. This is especially true in developing economies, where price rather than product differentiation is the main driver of consumer purchase decisions. Consider, for instance, the French automaker PSA Peugeot-Citroën. Its Citroën division has a minuscule share of China’s auto market—especially compared to the market share it enjoys in France and Europe. In a recent interview regarding the Chinese market, one of its managers remarked, “If prices fall, we will also follow suit, but not by more than the decrease in the market.” Another manager added, “This is a very competitive market . . . we have to think about the capacity at the factory . . .” These remarks suggest that, in China, Citroën has very little control over price; in essence, it operates as a “price taker” in the Chinese market for automobiles. As a price taker, it has no incentive to price below the market price. Furthermore, Citroën would lose customers to other automakers if it attempted to charge a price premium in the developing Chinese market. As a price taker, Citroën’s main decision is how many cars to produce at the market price. Managers in China must ensure that the capacity at factories is sufficient for producing the optimal volume of cars. In light of the large capacities of GM and other automakers with operations in China, Peugeot-Citroën is likely to continue to have limited power over its price for many years to come. Sources: “Citroën Forecasts Slowdown in Sales Growth in China this Year,” Channel News Asia, June 9, 2004; “General Motors’ China Success,” BusinessWeek, January 8, 2006. which equals fixed costs. Thus, when price is less than the average variable cost of production, the firm loses less by shutting down its operation (and producing zero units) than it does by producing Q* units. To summarize, we have demonstrated the following principle: Principle Short-Run Output Decision under Perfect Competition To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where P
MC, provided that P  AVC. If P  AVC, the firm should shut down its plant to minimize its losses. Demonstration Problem 8–2 Suppose the cost function for a firm is given by C(Q)
100 + Q2. If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $10, what level of output should the firm produce to maximize profits or minimize losses? What will be the level of profits or losses if the firm makes the optimal decision? Answer: First, note that there are fixed costs of 100 and variable costs of Q2, so the question deals with a short-run scenario. If the firm produces a positive level of output, it will produce where price equals marginal cost. The firm’s marginal costs are MC
2Q. Equating this with price yields 10
2Q, or Q
5 units. The average variable cost of producing 5 units of