There will not be a Livescribe for Unit 6 because the material is so similar to Unit 5. I want to
give you a couple of hints that distinguish perfect competition from monopoly.
1. Note that a monopolist will produce where MR=MC. Unlike a competitive firm, the
monopolist does not have to set P=MR.
2. The shut-down rule will be the same for the monopolist as it was for a competitive firm.
Don't forget that your spreadsheet must include embedded formulas in each cell, or you must
submit a document showing your calculations done by hand.
After reading this chapter, you will be able to:
for Firms with Market
12.1 Define market power and describe how own-price elasticity, cross-price
elasticity, and the Lerner index
T are used to measure market power.
12.2 Explain why barriers to entryE
are necessary for market power in the long run
and discuss the major types of entry barriers.
12.4 Find the profit-maximizing input usage for a monopolist.
E and output under monopolistic competition.
12.5 Find the profit-maximizing price
12.6 Employ empirically estimatedNor forecasted demand, average variable cost, and
marginal cost to calculate profit-maximizing
output and price for monopolistic
or monopolistically competitive firms.
12.3 Find the profit-maximizing output and price for a monopolist.
12.7 Select production levels at multiple plants to minimize the total cost of
producing a given total output for a firm.
or many years, the “premium”
brands of coffee at grocery stores sold
for prices very close to the prices of generic “value-brands,” and a
“coffeehouse” was a roadside
establishment serving mostly weary
truck drivers. As everyone on the
T planet knows, Starbucks Corp. changed the
commodity-like nature of coffee by successfully creating “grande” cachet with its
cappuccinos, lattes, and mochas served in Starbucks cafés designed to look like
the coffeehouses in Italy. Although far from being a pure monopolist, Starbucks
nonetheless dominated the specialty coffee market for many years. Starbucks
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C H A P T E R 12 Managerial Decisions for Firms with Market Power 447
The ability possessed
by all price-setting firms
to raise price without
losing all sales, which
causes the price-setting
firm’s demand to be
enjoyed substantial market power, giving it the ability to price its coffee beans and
specialty drinks well above costs and to earn impressive profits for many years.
Times have now changed for Starbucks, however, as it finds itself surrounded
by rivals offering competing coffee products. Companies such as Second Cup,
Dunkin’ Donuts, and even McDonald’s, attracted by the economic profits in specialty coffees and facing no barriers to entry, have diminished Starbucks’ market
power and profitability. Even though some market analysts blame management
for opening too many Starbucks coffeehouses worldwide, the greater problem
C new firms from entering its profitable niche. As you
was the inability to prevent
will learn in this chapter,A
lasting market power cannot happen without some type
of entry barrier.
L competitive firms don’t have—makes long-run
economic profit possible.
V All price-setting firms possess market power, which
is the ability to raise their prices without losing all their sales.1 In contrast to
E firms discussed in Chapter 11, price-setting firms
the competitive price-taking
do not sell standardized
Rcommodities in markets with many other sellers of
nearly identical products, and so price-setting firms do not face perfectly elastic
(horizontal) demand curves. Because the product is somehow differentiated from
rivals’ products or perhaps
, because the geographic market area has only one
(or just a few) sellers of the product, firms with market power face downwardsloping demand curves for the products they sell. All firms except price-taking
T monopolistic competitors, and oligopolies—have
some market power.
When firms with market power raise price, even though sales do not fall to
zero, sales do, of course,R
decrease because of the law of demand. The effect of the
change in price on the firm’s
R sales depends to a large extent on the amount of its
market power, which can differ greatly among firms. Firms with market power
E monopolies with a great deal of latitude over the prices
range in scope from virtual
they charge, such as Amgen’s
N Enbrel drug for psoriatic arthritis treatment, to firms
with a great deal of competition and only a small amount of market power, such
as shoe stores or clothingCstores in a large mall.
The primary focus ofEthis chapter is to show how managers of price-setting
firms can choose price, output, and input usage in a way that maximizes the firm’s
profit. For the types of firms discussed in this chapter—firms possessing market
power that can set prices1without worrying too much about retaliatory responses
by any rival firms—the profit-maximizing decision is a straightforward application
of the MR = MC rule. However, in the next chapter on oligopoly firms, we will
5 arise for oligopoly managers because their demand
discuss complications that
and marginal revenue conditions
depend critically on the decisions of rival firms.
In other courses or in other textbooks, you may see the terms market power and monopoly power
used interchangeably, as if both terms have exactly the same meaning. Strictly speaking, they do not.
Throughout this textbook we will always use the term market power, rather than monopoly power, when
we refer to the price-setting power allowing firms to raise price without losing all sales. In Chapter 16
we will explain that monopoly power is a legal concept that differs in rather important ways from the
economic concept of market power.
8/11/15 5:07 PM
448 C H A P T E R 12 Managerial Decisions for Firms with Market Power
A firm that produces a
good for which there
are no close substitutes
in a market that other
firms are prevented from
entering because of a
barrier to entry.
A market consisting of
a large number of firms
selling a differentiated
product with low barriers
Understanding the complexities of decision making when rivals can undermine
planned price changes will require the tools of strategic decision making presented
in the next chapter. Thus, for now, you should understand that decision-making
rules presented in this chapter will be much simpler than those in Chapter 13 for
oligopoly. The reason for this is that the monopolist has no rival firms to worry
about and the monopolistically competitive firm faces only relatively small rivals
who can be safely ignored for decision-making purposes.
The first part of this chapter describes some ways of measuring market power
C than terms such as “great deal” or “limited
that are more precise and concrete
amount.” We then discuss some of
Athe determinants of the market power possessed
by a firm and reasons why some firms have much more market power than others.
L is devoted to the theory of monopoly. A
The major portion of the chapter
monopoly exists when a firm produces
and sells a good or service for which there
are no close substitutes and other firms are prevented by some type of entry barE
rier from entering the market. A monopoly,
consequently, has more market power
than any other type of firm. Although
are few true monopolies in real-world
markets—and most of these are subject to some form of government regulation—
many large and small firms possess a considerable amount of market power in
the sense of having few close substitutes
for the products they sell. The theory of
monopoly provides the basic analytical framework for the analysis of how managers of all price-setting firms with market power can make decisions to maximize
T oligopolistic firms that face a high degree of
their profit (except, as mentioned,
We end this chapter with a fairly brief analysis of firms selling in markets unR
der conditions of monopolistic competition.
Under monopolistic competition, the
market consists of a large number
small firms that produce similar
but slightly differentiated products and therefore have some, but not much, marE is characterized by easy entry into and exit
ket power. Monopolistic competition
from the market. Most retail andN
wholesale firms and many small manufacturers
are examples of monopolistic competition.
Certainly, monopoly and monopolistic
competition are very different market
structures, but firms in both of these
structures possess some degree of
market power. In both cases, managers employ precisely the same analysis to
choose the profit-maximizing point on a downward-sloping demand curve. As we
will show you in this chapter, there
1 is virtually no difference between monopoly
and monopolistic competition in the short run. And even though the outcomes are
somewhat different in the long run for the two structures, it is convenient to exam5 kinds of market structures in a single chapter.
ine decision making in both of these
Even though we have not set forth
S a precise way to measure a firm’s market
12.1 MEASUREMENT OF MARKET POWER
power, you have probably figured out that the amount of market power is related
to the availability of substitutes. The better the substitutes for the product sold
by a firm, the less market power the firm possesses. However, there is no single
8/11/15 5:07 PM
C H A P T E R 12 Managerial Decisions for Firms with Market Power 449
measurement of market power that is totally acceptable to economists, policymakers, and the courts. Economists have come to rely on several measures of market
power. These methods are widely used, frequently in antitrust cases that require
objective measurement of market power.
Any of the methods of measuring the market power of a firm will fail to provide an accurate measure of market power if the scope of the market in which the
firm competes has not been carefully defined. This section begins by discussing
how to determine the proper market definition: identifying the products that comC the geographic area in which the competition occurs.
pete with one another and
Then we discuss some measures
of market power.
A market definition identifies the producers and products or service types that
compete in a particular E
geographic area, which is just large enough to include
all competing sellers. As
Ryou can see by this definition of a market, properly
defining a market requires considering the level of competition in both the
product dimension and the geographic dimension of a market. Although the
methodology of appropriately
defining a market is primarily of interest to firms
The identification of the
producers and products
that compete for
consumers in a particular
engaged in federal or state antitrust litigation—specifically cases involving
illegal monopolization of a market or the impact of a proposed merger on the
merged firm’s market power—managers
should know how to properly define
the firm’s market to measure
firm’s market power. We will now
discuss some guidelines for determining the proper product and geographic
dimensions of a market.R
A properly defined market
R should include all the products or services that consumers perceive to be substitutes. A manager who fails to identify all the products
that consumers see as substitutes
for the firm’s product will likely overestimate
the firm’s market power.
of Coca-Cola would be foolish to view the
company as a monopolist in the production of cola soft drinks and expect it to
enjoy substantial marketC
power. No doubt Coca-Cola’s syrup formula is a closely
guarded secret, but most
E soft-drink consumers consider rival brands of soft
drinks, as well as a variety of noncarbonated drinks such as iced tea and Gatorade,
as reasonable substitutes for Coca-Cola.
The geographic boundaries
1 of a market should be just large enough to include
all firms whose presence limits the ability of other firms to raise price without
a substantial loss of sales. Two statistics provide guidelines for delineating the
5 a market: (1) the percentage of sales to buyers outside
geographic dimensions of
the market and (2) the percentage
of sales from sellers outside the market. Both
percentages will be small if the geographic boundary includes all active buyers
and sellers. These two guidelines
for determining the geographic dimensions of
a market are sometimes S
referred to as LIFO and LOFI: little in from outside and
little out from inside.
As mentioned earlier, economists have developed several measures of market
power. We will discuss briefly only a few of the more important measures.
8/11/15 5:07 PM
450 C H A P T E R 12 Managerial Decisions for Firms with Market Power
Elasticity of Demand
One approach to measuring how much market power a firm possesses is to measure
the elasticity of the firm’s demand curve. Recall that a firm’s ability to raise price
without suffering a substantial reduction in unit sales is inversely related to the price
elasticity of demand. The less elastic is demand, the smaller the percentage reduction
in quantity demanded associated with any particular price increase. The more elastic is demand, the larger the percentage decrease in unit sales associated with a
given increase in price. Also recallCthat the elasticity of demand is greater (i.e., more
elastic) the larger the number of substitutes available for a firm’s product. As demand
A the product as having fewer good substitutes.
becomes less elastic, consumers view
Although a firm’s market power
L is greater the less elastic its demand, this does
not mean a firm with market power chooses to produce on the inelastic portion
V power does not imply that a manager proof its demand. In other words, market
duces where |E| < 1; rather, theEless elastic is demand, the greater the degree of
market power. We will demonstrate later in this chapter that a monopolist always
chooses to produce and sell on the elastic portion of its demand.
Relation The degree to which a firm possesses market power is inversely related to the elasticity of
demand. The less (more) elastic the firm’s demand, the greater (less) its degree of market power. The fewer
the number of close substitutes consumers can find for a firm’s product, the less elastic is demand and the
greater the firm’s market power. When demand is perfectly elastic (demand is horizontal), the firm possesses
no market power.
A ratio that measures the
by which price exceeds
marginal cost: ________
P 2 MC
The Lerner Index
A closely related method of measuring
R the degree of market power is to measure
the extent to which price deviates from the price that would exist under competiE
tion. The Lerner index, named for Abba Lerner, who popularized this measure, is a
N amount by which price exceeds marginal cost
ratio that measures the proportionate
C index = ________
P − MC
Price equals marginal cost when firms are price-takers, so the Lerner index equals
zero under competition. The higher the value of the Lerner index, the greater the
degree of market power.
The Lerner index can be related to the price elasticity of demand. In profit8
maximizing equilibrium, marginal cost equals marginal revenue. Also recall from
Chapter 6 that MR = P(1 + 1/E).5Thus the Lerner index can be expressed as
P − P(1 + 1/E)
Lerner index = ________
P − MR
= 1 − (1 + 1/E) = − __
In this form, it is easy to seeSthat the less elastic is demand, the higher the
Lerner index and the higher the degree of market power. The Lerner index is
consistent with this discussion, showing that market power is inversely related to
the elasticity of demand.
8/11/15 5:07 PM
C H A P T E R 12 Managerial Decisions for Firms with Market Power 451
MC , measures the proportionate amount by which price exceeds mar
The Lerner index, _________
ginal cost. Under perfect competition, the index is equal to zero, and the index increases in magnitude as
market power increases. The Lerner index can be expressed as −1/E, which shows that the index, and market
power, vary inversely with the elasticity of demand. The lower (higher) the elasticity of demand, the greater
(smaller) the Lerner index and the degree of market power.
Cross-Price Elasticity of Demand
An indicator, though not strictly a measure, of market power is the cross-price
elasticity of demand. Cross-price
elasticity measures the sensitivity of the quantity purchased of one good
in the price of another good. It indicates
whether two goods are viewed by consumers as substitutes. A large, positive
V that consumers consider the goods to be readily subcross-price elasticity means
stitutable. Market power
Ein this case is likely to be weak. If a firm produces a
product for which there are no other products with a high (positive) cross-price
R to possess a high degree of market power.
elasticity, the firm is likely
The cross-price elasticity
T of demand is often used in antitrust cases to help determine whether consumers of a particular firm’s product perceive other products to be
, Using cross-price elasticities, antitrust officials try to desubstitutes for that product.
termine which products compete with one another. For example, antitrust officials
might wish to determine the degree of market power enjoyed by Nike brand athletic
shoes. Nike Corporation has spent a great deal of money advertising to establish a
prominent position in theE
market for athletic shoes. To determine which other products compete with Nike, the cross-price elasticity of the quantity demanded of Nike
shoes with respect to a change in the price of a rival’s product can be calculated. UsR antitrust officials can determine whether consumers
ing such cross-price elasticities,
view Nike as having any E
real competitors in the market for athletic shoes.
Relation If consumers viewN
two goods to be substitutes, the cross-price elasticity of demand (EXY ) is
positive. The higher the cross-price elasticity, the greater the perceived substitutability and the smaller the
C by the firms producing the two goods.
degree of market power possessed
Now try Technical
These are only a few of the measures of market power. The courts in antitrust
cases and the Justice Department in merger and acquisition hearings sometimes
use a combination of measures,
including concentration ratios and share of the
market. It is also not always clear just how high a cross elasticity or how low an
elasticity constitutes “too8much” market power. If you are ever involved in such
a hearing, you should be
5 aware of the problems in measuring market power.
Illustration 12.1 shows the difficulty of determining what constitutes a market and
9 of market power.
what determines the amount
12.2 BARRIERS TO ENTRY
Entry or potential entry of new firms into a market can erode the market power
of existing firms by increasing the number of substitutes. Therefore, as a general
case, a firm can possess a high degree of market power only when strong barriers
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452 C H A P T E R 12 Managerial Decisions for Firms wit ...
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