Managerial Economics

ELEMENTS OF SUPPLY AND OUTPUTS

Outline
1.1 Profit Maximization
1.2 Break Even Analysis

1.3 Taxonomy of Markets

1.4 Perfect Competition
1.5 Monopoly
6-Aug-16

Profit Maximization
Two Steps to Maximize Profit: (q) = R (q) C (q)
Profit varies with the level of output because both revenue and cost vary with
output.
So, a firm decides how much q to sell to maximize profits.
And, to maximize profits, any firm must answer 2 questions.
First Step: Output Decision
What is the output level, q, that maximizes profit or minimizes loss?
Second Step: Shutdown Decision
Is it more profitable to produce q or to shut down and produce no output?

6-Aug-16

Profit Maximization Contd

Output Rules
Output Rule 1: Set output where profit is
maximized
If the firm knows its entire profit curve , it sets
output at q* to get *.

Output Rule 2: Set output where M = 0

Marginal profit , p/q, where q = 1, is the
slope of the profit curve. The maximum profit
occurs where the slope is zero.
Output Rule 3: Set output where MR(q)=MC(q)
Marginal Profit = MR - MC. The extra income
raises profit but the extra cost reduces profit.
Maximum profit occurs at MR(q) = MC(q).
Using calculus: d (q)/dq = dR (q)/dq dC (q)/dq
= 0; MR(q)=MC(q)
6-Aug-16

Profit Maximization Contd

Shutdown Rules
Should the firm shut down if its profit is negative? It depends
Shutdown Rule 1: Shut down only if loss can be reduced
This rule applies to the short run and long run alike.
Shutdown Rule 2: Shut down only if revenue < avoidable cost
In the short run, variable costs are avoidable but fixed costs are unavoidable (sunk costs).
As long as revenue covers variable costs and some fixed costs, no shut down occurs.
In the long run all costs are avoidable; shutting down eliminates all costs.

6-Aug-16

Break-even Analysis
Many of the planning activities that take place within a firm are based on anticipated levels of
output.
The interrelationships among a firms sales, costs, and operating profit at various anticipated
output levels is known as break-even analysis.

6-Aug-16

Break-even Analysis: Some Algebra

Total revenue is equal to the selling price per unit times the output quantity:
TR = P Q
Total (operating) cost is equal to fixed plus variable costs, where the variable
cost is the product of the variable cost per unit times the output quantity:
TC = F + (V Q)

Break-even:

TR = TC

PQb = F + VQb Qb = F/(P-V) = (Fixed Cost)/Contribution Margin

The difference between the selling price per unit and the variable cost per unit,
(P V), is referred to as the contribution margin.
It measures how much each unit of output contributes to meeting fixed costs
and operating profits.
6-Aug-16

Break-Even Analysis: An Example

Assume that A manufactures one product, which it sells for 250 per unit (P).
Variable costs (V) are 150 per unit. The firms fixed costs (F) are 1 million.
Qb = 10,000 units
This analysis can be used to approve or reject a batch sale promotion.
Suppose that the 1 million is a trade rebate to elicit better shelf location for As
product. If the estimated effect of this promotion is additional sales of 9,000
units, which is less than the break-even output, the change in total contributions
will fall below the 1 million promotion cost (i.e., [250 150] 9,000 <
1,000,000). Therefore, the promotion plan should be rejected.

6-Aug-16

Another Example
Youre the new CEO of a company that
operates two manufacturing plants.
The old plant has higher MC at every
level of production than the new plant.

Old Plant

New Plant

50 Years old

4 Years Old

Old Machinery

New Technology

6-Aug-16

Economic Profits
As the CEO, should you
close the old plant and
shift production to the
new plant?
The new plant:
Earns more profit
Has lower costs
Has newer
technology

Total revenue for old plant:

$10 x 20,000 = $200,000
Total costs for old plant:
20,000 x $10 (ATC) = $200,000
Economic profit = $0
6-Aug-16

Total revenue for new plant:

$10 x 50,000 = $500,000
Total costs for new plant:
50,000 x $7.50 (ATC) = $375,000
Economic profit = $125,000
10

One year later..

Old Plant:
Output = 0
Profit = $0

New Plant:
Output = 70,000
Profit = -$875,000

What?
Profit = Q(P ATC)
= 70,000($10 $22.50)
= $875,000

6-Aug-16

11

Competition and Market Types in Economic Analysis

Perfect competition (no market power)
large number of relatively small buyers and sellers
standardized product
very easy market entry and exit
non-price competition not possible

Examples: perfect competition

agricultural products
financial instruments
commodities

Competition and Market Types in Economic Analysis

Monopoly (absolute market power, subject to government
regulation)
one firm, firm is the industry
unique product or no close substitutes
market entry and exit difficult or legally impossible
non-price competition not necessary

Examples: monopoly
pharmaceuticals with patents
regulated utilities (although this is changing)
last chance gas station on the edge of the desert

Competition and Market Types in Economic Analysis

Monopolistic competition (market power based on product
differentiation)
large number of small firms acting independently
differentiated product
market entry and exit relatively easy
non-price competition very important

Examples: monopolistic competition

boutiques
restaurants
repair shops

Competition and Market Types in Economic Analysis

Oligopoly (product differentiation and/or the firms dominance
of the market)
small number of large mutually interdependent firms
differentiated or standardized product
market entry and exit difficult
non-price competition important

Examples: oligopoly
oil refining
processed foods
airlines
internet access and cell phone service

Competition and Market Types in Economic Analysis

Market
Characteristics

Perfect
competition

Monopoly

Number & Size of Very large number of

One
Firms
relatively small firms

Monopolistic
competition

Oligopoly

Large number of
Small number of
relatively small firms relatively large firms
Standardised or
Differentiated
differentiated

Type of Product

Standardised

Unique

Market Entry &

Exit

Very Easy

Very Difficult or
Impossible

Easy

Difficult

Non-Price
Competition

Impossible

Not Necessary

Possible

Possible or Difficult

Key Indicator of Competition

Market Power

None

Long-run Economic
None
Profit

6-Aug-16

Low to High

Low to High

High

None

Low to High,
subject to mutual
interdepndence

High, subject to
regulation

16

Pricing and Output Decisions in Perfect Competition

Basic business decision: entering a market using the following
questions
How much should we produce?
If we produce such an amount, how much profit will we earn?
If a loss rather than a profit is incurred, will it be worthwhile to continue in this
market in the long run (in hopes that we will eventually earn a profit), or
should we exit?

Pricing and Output Decisions in Perfect Competition

Key assumptions of the perfectly competitive market:
The firm is a price taker (it must accept the market price)
The firm makes the distinction between the short run and the long run

Additional key assumptions of the perfectly competitive market:

The firms objective is to maximize its profit (or minimize loss) in the short run
The firm includes its opportunity cost of operations in its total cost of production

Pricing and Output Decisions in Perfect Competition

Perfectly elastic demand curve:
consumers are willing to buy as much
as the firm is willing to sell at the going
market price
The firm receives the same marginal revenue
from the sale of each additional unit of
product; equal to the price of the product
There is no limit to the total revenue that the
firm can gain in a perfectly competitive
market

Pricing and Output Decisions in Perfect Competition

Case A: economic profit
The point where
P=MR=MC
is the optimal output
(Q*)
profit = TR TC
Q* =(P - AC)

Pricing and Output Decisions in Perfect Competition

Case B: economic loss
The firm incurs a loss.
At optimum output, price is below AC
however, since P > AVC, the firm is
better off producing in the short run,
because it will still incur fixed costs
greater than the loss

Pricing and Output Decisions in Perfect Competition

Contribution margin: the amount by
which total revenue exceeds total
variable cost
CM = TR TVC
if CM > 0,
the firm should continue to produce in the
short run in order to defray some of the
fixed cost.

Existence of Monopoly
How does a firm obtain monopoly power?
Government Creation of Monopoly
Governments grant a license, monopoly rights, or patents

Barriers to Entry
Governments create monopolies either by making it difficult for new firms to obtain a license to operate
or by explicitly granting a monopoly right to one firm, thereby excluding other firms.
By auctioning a monopoly to a private firm, a government can capture the future value of monopoly
earnings. However, for political or other reasons, governments frequently do not capture all future
profits.

Patents
A patent is an exclusive right granted to the inventor of a new and useful product, process, substance,
or design for a specified length of time.
The length of a patent varies across countries, although it is now 20 years in the US.

Existence of Monopoly (contd)

Advertising and Net Profit
A successful advertising campaign shifts the monopolist
market demand curve outward and makes it less elastic.
This allows the monopolist to sell more units at a higher
price.
After successful advertising D2 is to the right and it is
less elastic than D1.

Deciding Whether to Advertise

Do it only if firm expects net profit (gross profit minus the
cost of advertising) to increase.
Gross profit is B. Only if its cost of advertising is less
than B, its net profit rises and advertising should be
done.

How Much to Advertise

Do it until its marginal benefit (gross profit from one more
unit of advertising or marginal revenue from one more unit
of output) equals its marginal cost.

Existence of Monopoly (contd)

Network Externalities
A good has a network externality if one persons demand depends on the consumption of a good by others.
If a good has a positive network externality, its value to a consumer grows as the number of units sold increases (smart phones).
Firms can benefit from direct size effects if a customer can get a direct benefit from a larger network
Firms can also benefit from indirect effects when users benefit from complementary goods that are offered when a product has a
critical mass of users (enough adopters that others wanted to join).

Network Externalities and Behavioral Economics

The direct effect of network externalities depends on the size of the network because customers want to interact with each other.
Why?
Bandwagon effect: A person places greater value on a good as more and more other people possess it
Snob effect: A person places greater value on a good as fewer and fewer other people possess it

Network Externalities as an Explanation for Monopolies

Because of the need for a critical mass of customers in a market with a positive network externality, we sometimes
see only one large firm surviving.
The Windows operating system largely dominates the marketnot because it is technically superior to Apples
operating system or Linuxbut because it has a critical mass of users.
But having obtained a monopoly, a firm does not necessarily keep it.

6-Aug-16

25

Existence of Monopoly (contd)

Economies of scale:
Low unit costs and prices drive out rivals.
The largest firm can produce at the lowest average
total cost.

Natural monopoly
A natural monopoly arises from the peculiar production
characteristics in an industry.
It usually arises when there are large economies of
scale.
One firm can produce at a lower average cost than can
be achieved by multiple firms.

The Demand Curve a Monopolist Faces

The monopolist faces the industry demand curve because the monopolist is
the entire industry.

Setting the Price

Apple introduced the iPod on October 23, 2001. Although the iPod was not the
first hard-drive CHALLENGE music player, it was the most elegant one at the
time. Equipped with a tiny hard drive, it was about a quarter the size of its
competitors, fit in ones pocket, and weighed only 6.5 ounces. Moreover, it was
the only player to use a high-speed FireWire interface to transfer files, and it
held a thousand songs. Perhaps most importantly, the iPod offered an intuitive
interface, an attractive white case, and unusual ear buds.
People loved the iPod. Even at its extremely high price of $399, virtually
everyone who wanted a hard-drive, digital music player bought the iPod during
its first five years. In 2004, the iPod had 95.6% of the hard-drive player market,
and Apple reported that it still had more than 90% in 2005.
How did Apple set the price for the iPod when it was essentially the only
game in town?
6-Aug-16

28

Question
Initially, Apples constant marginal cost of producing its top-of-the-line iPod was
$200, its fixed cost was $736 million, and its demand function was
p=600-25Q,
where Q is millions of iPods per year.
What was Apples average cost function?

Assuming that Apple was maximizing short-run monopoly profit, what was its
marginal revenue function?
What were its profit-maximizing price and quantity and what was its profit?
Show Apples profit-maximizing solution in a figure.

6-Aug-16

29

Answer

6-Aug-16

30

How Monopolies Make Production and Pricing Decisions

Monopoly versus Competition

Price

A Competitive Firms Demand Curve

Monopoly

Is the sole producer

Faces a downward-sloping demand curve
Is a price maker
Reduces price to increase sales

Competitive Firm

Is one of many producers

Faces a horizontal demand curve
Is a price taker
Sells as much or as little at same price

Demand

0
Price

Quantity of Output
(A Monopolists Demand Curve

Demand

Quantity of Output

A Monopolys Revenue
A monopolists marginal revenue is
always less than the price of its
good.
The demand curve is downward sloping.
When a monopoly drops the price to sell
one more unit, the revenue received from
previously sold units also decreases.

When a monopoly increases the

amount it sells, it has two effects on
total revenue (P Q).
The output effectmore output is sold, so
Q is higher.
The price effectprice falls, so P is lower.

6-Aug-16

Price
11
10
9
8
7
6
5
4
3
2
1
0
1
2
3
4

marginal social
benefit

marginal
Private benefit

Demand
(average
revenue)

Marginal
revenue
1

Quantity of Water

32

Profit Maximization for a Monopoly

A monopoly maximizes profit by
producing the quantity at which
marginal revenue equals marginal
cost.

Costs and
Revenue

2. . . . and then the demand

curve shows the price
consistent with this quantity.

Monopoly
price

It then uses the demand curve to

find the price that will induce
consumers to buy that quantity.

1. The intersection of the

marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .

Average total cost

A

Demand

Marginal
cost

Marginal revenue
0
6-Aug-16

Quantity

QMAX Q
33

A Monopolys Profit
Comparing Monopoly and Competition
Costs and

For a competitive firm, price equals marginal

Revenue
cost.
P = MR = MC
For a monopoly firm, price exceeds marginal
Monopoly E
cost.
price
P > MR = MC
Since price exceeds marginal cost,
consumers are willing to pay more for extra
output than it costs to produce it.

Profit equals total revenue minus

costs.

Average
D
total total
cost

Marginal cost
B
Monopoly
profit

Average total cost

C
Demand

Profit = TR - TC
Profit = (TR/Q - TC/Q) Q
Profit = (P - ATC) Q

Marginal revenue
0

6-Aug-16

Quantity

QMAX
34

Welfare Cost of Monopoly (P>MC)

Because a monopoly sets its
price above marginal cost, it
places a wedge between the
consumers willingness to pay
and the producers cost.
This wedge causes the quantity sold
to fall short of the social optimum.

Price
Deadweight
loss

Marginal cost

Monopoly
price

The Inefficiency of Monopoly

The monopolist produces less than
the socially efficient quantity of
output.

Marginal
revenue

Monopoly Efficient
quantity quantity

Demand

Quantity

Types of monopolies
Pure Monopoly
One firm dominates the market and can maintain this because of high barriers to entry

Natural Monopoly
One firm is able to supply the entire market at a lower cost than two or more firms

Natural Monopoly
Has the same characteristics as a pure monopoly and a main
distinguishing feature
Its average cost curves are downwards sloping over the whole output due to
economies of scale.
Examples town infrastructure

Distribution of electricity
Railways
Pipelines
Fixed-line telephone networks

Economies of Scale and Natural Monopolies

Economies of scale occur because of two factors
High fixed costs
Costs involved in setting up the business

Low marginal costs

Cost of adding new consumers
to the network is low
As output increases, the AC curve falls as greater economies of scale are achieved.

Resource Allocation Effects: Market for Drugs

Price D

MR
Price During
Patent Life

P**

P*

MC ( =AC)

Price After
Patent Expires

6-Aug-16

Q**

Q*
39

Allocational Effects: Market for Drugs

Price D

MR
Price During
Patent Life

P**

P*

A
Price After
Patent Expires

0
Q**
6-Aug-16

MC ( =AC)

Value of
transferred
inputs

Q*
40

Distributional Effects: Market for Drugs

Price D

MR
Price During
Patent Life

P**
Transfer
from
consumers
to firm
P*

E
A

Price After
Patent Expires

0
Q**
6-Aug-16

MC ( =AC)

Value of
transferred
inputs

Q*
41

Deadweight Loss: Market for Drugs

Price D

MR
Price During
Patent Life

P**
Transfer
from
consumers
to firm
P*

Deadweight
loss
A

6-Aug-16

MC ( =AC)

Value of
transferred
inputs

Price After
Patent Expires

Q**

Q*
42