Managerial Economics

PGDM-HR: 2019 – 2021

Term 1 (July – September)
(Lectures on Market Structure and Pricing Strategy: Perfect Competition
and Monopoly)
A market consists of all potential buyers and sellers of
a particular product.

Market structure refers to the competitive

environment in which the buyers and sellers of the
product operate.
These types of market structure are defined in terms of :

• Number and size of buyers

• Sellers of product
• Type of product bought and sold
• Entry and Exit
• Degree of knowledge amongst economic agents
More Competitive Market Structure

Perfect Competition
Oligopoly
Monopoly

Less Competitive
A note on Marginal Revenue, Marginal Cost, And Profit
Maximization
Profit: Difference between total revenue and total cost.
π(q) = R(q) − C(q)
= P(q) *q - C(q)
Marginal revenue Change in revenue resulting from a one-unit increase in
output.

Profit Maximization in the Short Run

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is maximized.
At that output, marginal revenue (the
slope of the revenue curve) is equal
to marginal cost (the slope of the
cost curve).

Δπ/Δq = ΔR/Δq − ΔC/Δq = 0

MR(q) = MC(q)
P(q) + [dP(q)/dq] * q = MC(q)
A Rose is a Rose is a Rose
Nevado Roses is a producer of fresh cut roses located in Ecuador. Ecuador’s warm days,
cool nights, dry air, rich volcanic soil and most of all abundant and intense sunlight, make
it a near perfect location for growing tall, bountiful roses.

Perhaps not surprisingly, as the fresh cut rose market has globalized over the past two
decades, the country of Ecuador has emerged as one of the world’s leading supplier of
fresh cut roses. Of the nearly 1.5 bn roses bought annually by U.S. households in the late
2000s, nearly 400 mn came from Ecuador, a quantity exceeded only by Colombia. Though
Nevado roses is one of the largest rose producers in Ecuador, its size is actually quite small
in comparison to the overall size of the market. It is just 1 of 400 or so rose growers
operating in Ecuador. Since Ecuadorian rose growers compete with their counterparts in
Colombia, the U.S. and other parts of the world, Nevado Roses is actually a part of a
much larger pool of all firms producing fresh-cut roses.

In the eyes of a typical consumer in U.S. who purchases fresh cut roses from his/her local
flower shop, the specific grower is almost certainly unknown and probably immaterial.
Given this reality it is virtually certain that no single firm such a Nevado Roses can
determine the price of fresh cut roses on the world market. As a result, the key decision
Nevado roses has to make is not what price to charge but rather how many roses shall it
produce given the anticipated price of fresh cut roses.
 Perfectly Competitive Market
The model of perfect competition rests on the following
basic assumptions:
1. Infinitely large number of buyers and sellers: each firm
has no influence on price i.e., price taking behavior,
2. product homogeneity,
3. free entry and exit, and
4. Perfect Information
 Perfectly Competitive Market : Assumptions

Price Taking: Because each individual firm sells a sufficiently small proportion
of total market output, its decisions have no impact on market price.

Product Homogeneity: When the products of all of the firms in a market are
perfectly substitutable with one another—that is, when they are homogeneous—no
firm can raise the price of its product above the price of other firms without losing
most or all of its business.

Free Entry and Exit: Condition under which there are no special costs that make it
difficult for a firm to enter (or exit) an industry. ( Buyer and seller)

Perfect Information: All sellers and buyers have perfect knowledge about
the market
Marginal Revenue, Marginal Cost, And Profit Maximization
for a Competitive firm
Demand and Marginal Revenue for a Competitive Firm

Demand Curve Faced by a Competitive Firm

A competitive firm supplies only a small portion of the total output of all the firms in an
industry. Therefore, the firm takes the market price of the product as given, choosing its
output on the assumption that the price will be unaffected by the output choice.
In (a) the demand curve facing the firm is perfectly elastic, even though the market
demand curve in (b) is downward sloping.
Marginal Revenue, Marginal Cost, And Profit Maximization

Demand and Marginal Revenue for a Competitive Firm

The demand d curve facing an individual firm in a competitive market is both its
average revenue curve and its marginal revenue curve. Along this demand curve,
marginal revenue, average revenue, and price are all equal.

Profit Maximization by a Competitive Firm (Recall the principle

that a rational firm thinks at the margin)

MC(q) = MR = P = AR
Short-Run Profit Maximization by a Competitive Firm

Marginal revenue equals marginal cost at a point at which the marginal cost
curve is rising.

Output Rule: If a firm is producing any output, it should produce at the level
at which marginal revenue equals marginal cost.
Short-Run Profit Maximization by a Competitive Firm:
Graphical Approach
The Short-Run Profit of a Competitive Firm
A Competitive Firm
Making a Positive Profit

In the short run, the

competitive firm maximizes
its profit by choosing an
output q* at which its
marginal cost MC is equal
to the price P (or marginal
revenue MR) of its product.

The profit of the firm is

measured by the rectangle
ABCD.

Any change in output,

whether lower at q1 or
higher at q2, will lead to
lower profit.
Short-Run Profit Maximization by a Competitive Firm:
Graphical Approach

The Short-Run Profit of a Competitive Firm

A Competitive Firm Incurring

Losses

A competitive firm should

shut down if price is below
AVC.

The firm may produce in

the short run if price is
greater than average
variable cost.
• A market consists of 300 identical firms and the market
demand is given by Q (P) = 60- P. Each firm has a short run
cost curve STC = 0.1 + 150Q2.

• Profit Maximizing Quantity ?

• Short run eqlbm price?

MR = MC = P ( Profit maximization for Perfect comp)

MC = 300Q
300 Q = P or Q = P/300

At eqlbm, Qty demanded = Qty Supplied

Total Qty supplied = 300 X P/ 300 = P
Total Qty demanded = 60 – P
Therefore P = 30
A competitive firm sells its product at a price of $0.10 per unit. Its total and
marginal cost functions are:
TC = 5 - 0.5Q + 0.001Q2
MC = -0.5 + 0.002Q,

Calculate the profit maximizing quantity.

MR = MC = P

- 0.5 + 0.002Q = 0.10

Q = 300
Long-run Competitive Equilibrium

A long-run competitive equilibrium occurs when three

conditions hold:

 All firms in the industry are maximizing profit.

 No firm has an incentive either to enter or exit the

industry because all firms are earning zero economic
profit.

 The price of the product is such that the quantity

supplied by the industry is equal to the quantity
demanded by consumers.
 Long-run Profit Maximization - Choosing Output in The
Long Run: Explanation
Entry and Exit: In a market with entry and exit, a firm enters when it can earn a
positive long-run profit and exits when it faces the prospect of a long-run loss.

Long-Run Competitive Equilibrium

Initially the long-run equilibrium
price of a product is $40 per unit,
shown in (b) as the intersection of
demand curve D and supply curve S1.
In (a) we see that firms earn positive
profits because long-run average cost
reaches a minimum of $30 (at q2).
Positive profit encourages entry of
new firms and causes a shift to the
right in the supply curve to S2, as
shown in (b).
The long-run equilibrium occurs at a
price of $30, as shown in (a), where
each firm earns zero profit and there
is no incentive to enter or exit the
industry.
 Monopoly
Monopoly: Single seller that produces a product with no close substitutes

Market Power: Ability of a seller or buyer to affect the price of a good.

Sources of Monopoly Power : Structural, Legal, Strategic

•Control of an essential input to a product
•Patents or copyrights
•Economies of scale: Natural monopoly
•Government franchise: Post office
 Monopoly
Average Revenue: Revenue per unit of output sold

Marginal revenue: Change in revenue resulting from a one-unit

To
increase
see theinrelationship
output. among total, average, and marginal revenue,
consider a firm facing the following demand curve:
P=6–Q

Total, Marginal, and Average Revenue

Total Marginal Average
Price (P) Quantity (Q) Revenue (R) Revenue (MR) Revenue (AR)
$6 0 $0 --- ---
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
Average Revenue and Marginal Revenue: Graphical Exposition

Average and Marginal

Revenue

Average and marginal

revenue are shown for
the demand curve
P = 6 − Q.
 The Monopolist’s Output Decision: Graphical Approach

Profit Is Maximized When

Marginal Revenue Equals
Marginal Cost

Q* is the output level at which MR

= MC.
If the firm produces a smaller
output—say, Q1—it sacrifices some
profit because the extra revenue
that could be earned from
producing and selling the units
between Q1 and Q* exceeds the
cost of producing them.
Similarly, expanding output from
Q* to Q2 would reduce profit
because the additional cost would
exceed the additional revenue.
The Monopolist’s Output Decision: Algebraic Approach

We can also see algebraically that Q* maximizes profit. Profit π is the

difference between revenue and cost, both of which depend on Q:

As Q is increased from zero, profit will increase until it reaches a

maximum and then begin to decrease. Thus the profit-maximizing Q is
such that the incremental profit resulting from a small increase in Q is just
zero (i.e., Δπ /ΔQ = 0). Then

But ΔR/ΔQ is marginal revenue and ΔC/ΔQ is marginal cost. Thus the
profit-maximizing condition is that

, or
 A Rule of Thumb for Pricing for a Monopolist

We want to translate the condition that marginal revenue should equal marginal cost into a rule of
thumb that can be more easily applied in practice.
To do this, we first write the expression for marginal revenue:

Note that the extra revenue from an incremental unit of quantity, Δ(PQ)/ΔQ, has two components:
1. Producing one extra unit and selling it at price P brings in revenue (1)(P) = P.
2. But because the firm faces a downward-sloping demand curve, producing and selling this
extra unit also results in a small drop in price ΔP/ΔQ, which reduces the revenue from all
units sold (i.e., a change in revenue Q[ΔP/ΔQ]).

Thus,
 A Rule of Thumb for Pricing

(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand, 1/Ed, measured at

the profit-maximizing output, and

Now, because the firm’s objective is to maximize profit, we can

set marginal revenue equal to marginal cost:

which can be rearranged to give us

Equivalently, we can rearrange this equation to express price

directly as a markup over marginal cost:
 MARKET POWER/ MONOPOLY
POWER
Part (a) shows the market
demand for toothbrushes.
The Demand for Toothbrushes
Part (b) shows the demand for
toothbrushes as seen by Firm A.
At a market price of $1.50,
elasticity of market demand is
−1.5.
Firm A, however, sees a much
more elastic demand curve DA
because of competition from
other firms.
At a price of $1.50, Firm A’s
demand elasticity is −6.
Still, Firm A has some
monopoly power: Its profit-
maximizing price is $1.50,
which exceeds marginal cost.
Monopoly power depends
upon : how differentiated are
products and how firms
compete.
COST FUNCTION : 10Q + Q2

DEMAND CURVE : Q = 20 – P

Find P & Q to maximize profit

MC = 10 + 2Q

TR = P.Q = (20-Q) . Q = 20 Q – Q2

MR = 20 – 2Q

MR = MC 10 + 2Q = 20 – 2Q

Q = 2.5
 Measuring Market Power
Remember the important distinction between a perfectly competitive
firm and a firm with monopoly power: For the competitive firm, price
equals marginal cost; for the firm with monopoly power, price exceeds
marginal cost.
Lerner Index of Monopoly Power: Measure of monopoly power
calculated as excess of price over marginal cost as a fraction of price.

Mathematically:

This index of monopoly power can also be expressed in terms of the

elasticity of demand facing the firm.
 Measuring Market Power: Importance of Elasticity

Elasticity of Demand and Price Markup

The markup (P − MC)/P is equal to minus the inverse of the elasticity of demand facing the firm.
If the firm’s demand is elastic, as in (a), the markup is small and the firm has little monopoly power.
The opposite is true if demand is relatively inelastic, as in (b).
A Note on Market Power

As evident from Lerner Index, Elasticity of demand determines market power.

Three factors determine a firm’s elasticity of demand.

1. The elasticity of market demand. Because the firm’s own demand will be
at least as elastic as market demand, the elasticity of market demand
limits the potential for monopoly power.

2. The number of firms in the market. If there are many firms, it is unlikely
that any one firm will be able to affect price significantly.

3. The interaction among firms. Even if only two or three firms are in the
market, each firm will be unable to profitably raise price very much if the
rivalry among them is aggressive, with each firm trying to capture as
much of the market as it can.
A Note on Market Power (contd.)

The Number of Firms

When only a few firms account for most of the sales in a market, we say that
the market is highly concentrated.
Barrier to Entry: Condition that impedes entry by new competitors.

The Interaction Among Firms

Firms might compete aggressively, undercutting one another’s prices to
capture more market share.
This could drive prices down to nearly competitive levels.
Firms might even collude (in violation of the antitrust laws), agreeing to limit
output and raise prices.
Because raising prices in concert rather than individually is more likely to be
profitable, collusion can generate substantial monopoly power.
A Note on Market Power (contd.)
The Elasticity of Market Demand
If there is only one firm—a pure monopolist—its demand curve is the market
demand curve.
Because the demand for oil is fairly inelastic (at least in the short run), OPEC
could raise oil prices far above marginal production cost during the 1970s
and early 1980s.
Because the demands for such commodities as coffee, cocoa, tin, and copper
are much more elastic, attempts by producers to cartelize these markets and
raise prices have largely failed.
In each case, the elasticity of market demand limits the potential market
power of individual producers.
Markup Pricing : Supermarkets to Designer Jeans
Although the elasticity of market demand for food is
small (about −1), no single supermarket can raise its
prices very much without losing customers to other
stores.
The elasticity of demand for any one supermarket is
often as large as −10.
We find P = MC/(1 − 0.1) = MC/(0.9) = (1.11)MC.

The manager of a typical supermarket should set prices about 11 percent above
marginal cost.
Small 24*7 convenience stores typically charge higher prices because its customers
are generally less price sensitive.
Because the elasticity of demand for a convenience store is about −5, the markup
equation implies that its prices should be about 25 percent above marginal cost.
With designer jeans, demand elasticities in the range of −2 to −3 are typical.
This means that price should be 50 to 100 percent higher than marginal cost.
 Example: Astra-Merck Prices Prilosec

In 1995, Prilosec, represented a new generation of antiulcer

medication. Prilosec was based on a very different
biochemical mechanism and was much more effective than
earlier drugs.

By 1996, it had become the best-selling drug in the world and faced no major
competitor.
Astra-Merck was pricing Prilosec at about $3.50 per daily dose.
The marginal cost of producing and packaging Prilosec is only about 30 to 40
cents per daily dose.
The price elasticity of demand, ED, should be in the range of roughly −1.0 to −1.2.
Setting the price at a markup exceeding 400 percent over marginal cost is
consistent with our rule of thumb for pricing.