MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield

Chapter 8

MONOPOLY AND
MONOPOLISTIC
COMPETITION
OBJECTIVES

• Explain how managers should set price and

output when they have market power
• With monopoly power, the firm’s demand curve
is the market demand curve. A monopolist is the
only seller of a product for which there are no
close substitutes and which is protected by
barriers to entry.
• Monopolistically competitive firms have market
power based on product differentiation, but
barriers to entry are modest or absent.
PRICING AND OUTPUT DECISIONS IN
MONOPOLY

• Example
• Demand: P = 10 – Q
• Total revenue: TR = PQ = 10Q – Q2
• Marginal revenue: MR = 10 – 2Q
• Total cost: TC = 1 + Q + 0.5Q2
• Marginal cost: MC = 1 + Q
• MR = 10 – 2Q = 1 + Q = MC => Q = 3
• P = 10 – 3 = 7
• Profit = Q(P – ATC)
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TOTAL REVENUE, TOTAL COST, AND TOTAL
PROFI T OF A MONOPOLIST

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PROFIT AND OUTPUT OF A MONOPOLIST

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PRICING AND OUTPUT DECISIONS IN
MONOPOLY

• Marginal revenue
• Unlike perfect competition, MR is less than
price and depends on Q.
• MR = P[1 + (1/)] = P[1 – (1/||)] = P – P/||
PRICING AND OUTPUT DECISIONS IN
MONOPOLY

• MR = P[1 + (1/)] = P[1 – (1/||)] = P – P/||

(Continued)
• A profit-maximizing monopolist will not produce
where demand is inelastic; that is, where || < 1,
because MR < 0.
• MC = MR = P[1 – (1/||)]; so the profit-maximizing
price is
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MARGINAL REVENUE AND MARGINAL
COST OF A MONOPOLIST

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OUTPUT AND PRICE DECISIONS OF A
MONOPOLIST

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FRANCHISER VERSUS FRANCHISEE?

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COST-PLUS PRICING

• Cost-plus pricing: Simplistic strategy that

guarantees that price is higher than the
estimated average cost
• Studies of pricing behavior suggest that many
managers who use cost-plus pricing do not price
optimally.
• Markup = (Price – Cost)/Cost
• Price = (Cost)(1 + Markup)
• Example: Price = 6, Cost = 4, Markup = 0.50
COST-PLUS PRICING

• Profit margin: Price of a product minus its

cost
• Profit margin = Price – Cost
COST-PLUS PRICING

• Target Return: What managers hope to

earn and what determines the markup
• P = L + M + K + (F/Q) + (A/Q)
• L = unit labor cost
• M = unit material cost
• K = unit marketing cost
• F = total fixed costs
• Q = units to produce
• A = gross operating assets
•  = desired profit rate (%)
COST-PLUS PRICING

• Allocation of indirect cost among products

• Often done on the basis of average variable costs
• Example
• Indirect costs = $3 million
• Variable costs = $2 million
• Indirect cost allocation = 3/2 = 150 percent of variable cost.
• If a product’s variable cost is $10, then the allocated indirect
cost is ($10)(1.5) = $15. If there is a 40% markup, then the
product price is ($10 + $15)(1.4) = $25.
COST-PLUS PRICING AT THERMA-STENT

• Factory cost = $2,300

• Markup = 40% = $920
• Price = $3,220
COST-PLUS PRICING AT THERMA-STENT

• Cost-plus pricing is widely used in medical

group purchasing organizations.
• Factory cost = $2,300
• 40% markup = $920
• Price = $3,220
• Using the heuristic eases the complexity of
setting price by ignoring market considerations.
COST-PLUS PRICING AT INTERNET COMPANIES AND
GOVERNMENT-REGULATED INDUSTRIES

• Cost-plus pricing is used often used by

Internet companies and government-
regulated industries.
• The danger of such a pricing scheme in a
government-controlled industry is that
when the profit is guaranteed, firm
managers may lose the incentive to be
cost efficient.
CAN COST-PLUS PRICING MAXIMIZE
PROFIT?

• Optimal markup = 1/(|| - 1)

• Optimal markup is higher is demand is
less elastic
• Table 8.3: Relationship between Optimal
Markup and Price Elasticity of Demand
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THE MULTIPLE-PRODUCT FIRM: DEMAND
INTERRELATIONSHIPS

• Multiple-product firm
(Good X and Good Y)
• Total revenue = TR = TRX + TRY
• MRX = TR/QX = TRX/QX + TRY/QX
• MRY = TR/QY = TRX/QY + TRY/QY
• If the two goods are substitutes, then
TRX/QY and TRY/QX are negative.
• If the two goods are complements, then
TRX/QY and TRY/QX are positive.
THE MULTIPLE-PRODUCT FIRM: DEMAND
INTERRELATIONSHIPS

• Pricing of Joint Products: Fixed

Proportions
• Total marginal revenue curve: Vertical
summation of the two marginal revenue
curves for individual products
• Figure 8.5: Optimal Pricing for Joint Products
Produced in Fixed Proportions (Case 1)
• Marginal revenue of both products is positive at the
optimal level of output.
OPTIMAL PRICING FOR JOINT PRODUCTS
PRODUCED IN FIXED PROPORTIONS (CASE 1)

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THE MULTIPLE-PRODUCT FIRM: DEMAND
INTERRELATIONSHIPS

• Figure 8.6: Optimal Pricing for Joint Products

Produced in Fixed Proportions (Case 2)
• The marginal revenue of one product is negative at
the optimal level of output.
• If a product’s marginal revenue is negative, then
the firm will dispose of a quantity sufficient to bring
marginal revenue to zero and thereby maximize
revenue on that product.
OPTIMAL PRICING FOR JOINT PRODUCTS
PRODUCED IN FIXED PROPORTIONS (CASE 2)

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THE MULTIPLE-PRODUCT FIRM: DEMAND
INTERRELATIONSHIPS

• Output of Joint Products: Variable

Proportions
• Isocost curve: Curve showing the amounts of
goods produced at the same total cost
• Isorevenue lines: Lines showing the
combinations of output of products that yield
the same total revenue
THE MULTIPLE-PRODUCT FIRM: DEMAND
INTERRELATIONSHIPS

• Output of Joint Products: Variable

Proportions (cont’d)
• Optimal combinations of goods are found where
isocost and isorevenue lines are tangent.
• Optimal total production is found where profit is
maximized, which occurs at a point of tangency where
the difference between cost and revenue is
maximized.
OPTIMAL OUTPUTS FOR JOINT PRODUCTS
PRODUCED IN VARIABLE PROPORTIONS

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MONOPSONY

• Monopsony: Markets that consist of a

single buyer
• Contrast with monopoly markets that consist
of a single seller
• Buyers in a competitive market face a
horizontal supply curve; they are price takers.
MONOPSONY

• Monopsony: Markets that consist of a

single buyer (cont’d)
• There is only one buyer in a monopsony market, and
this buyer faces the upward-sloping market supply
curve, which means that marginal cost is above the
supply price.
• Under monopsony, the buyer will purchase a quantity
where marginal cost is equal to marginal revenue
product and pay a price below marginal cost.
MONOPSONY

• Example: Monopsony labor market

• Labor supply: P = c + eQ
• Total cost: C = PQ = (c + eQ)Q
• Marginal cost: C/Q = c + 2eQ = MC
• Figure 8.8: Optimal Monopsony Pricing
• The wage (P) and quantity hired (Q) are both
less than at the competitive equilibrium
OPTIMAL MONOPSONY PRICING

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MONOPOLISTIC COMPETITION

• Characteristics of monopolistic competition

• Product differentiation—products are not perceived as
identical by consumers
• Managers have some pricing discretion, but because
products are similar, price differences a relatively
small.
• Competition takes place within a product group.
• Product group: Group of firms that produce
similar products
MONOPOLISTIC COMPETITION

• Conditions that must be met, in addition to

product differentiation, to define a product
group as monopolistically competitive
• There must be many firms in the product group.
• The number of firms in the product group must be
large enough that each firm expects its actions to go
unheeded by its rivals and unimpeded by possible
retaliatory moves on their part.
MONOPOLISTIC COMPETITION

• Conditions that must be met, in addition to

product differentiation, to define a product
group as monopolistically competitive
(cont’d)
• Entry into the product group must be relatively easy,
and there must be no collusion, such as price fixing or
market sharing, among managers in the product
group.
MONOPOLISTIC COMPETITION

• Price and Output Decisions under Monopolistic

Competition
• Figure 8.9: Short-Run Equilibrium in Monopolistic
Competition.
• Identical to short-run equilibrium under monopoly
• Figure 8.10: Long-Run Equilibrium in Monopolistic
Competition
• Entry and exit of firms from the product group shifts individual
firms’ demand curves.
• Long-run equilibrium occurs where profit is equal to zero.
SHORT-RUN EQUILIBRIUM IN
MONOPOLISTIC COMPETITION

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LONG-RUN EQUILIBRIUM IN
MONOPOLISTIC COMPETITION

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ADVERTISING EXPENDITURES: A SIMPLE
RULE

• How much should a profit-maximizing manager

spend on advertising?
• Assume diminishing returns to advertising
expenditures.
• Assume that quantity demanded depends only on
price and advertising expenditures.
• Table 8.4: Relationship Between Advertising
Expenditures and Quantity
• Illustrates diminishing marginal returns (see below) between
advertising expenditures (A) and quantity demanded (Q)
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ADVERTISING EXPENDITURES: A SIMPLE
RULE

• Derivation
• Net profit = P – MC (omitting advertising
expenditures)
• Advertising expenditures are optimal if the
increase in net profit from an additional dollar
spent on advertising is equal to one dollar.
ADVERTISING EXPENDITURES: A SIMPLE
RULE

• Derivation (cont’d)
• If Q is defined as the number of extra units sold as a
result of an additional dollar of advertising
expenditures, then advertising expenditures are
optimal when
Q(P – MC) = 1
• The above implies that the marginal revenue from an
extra dollar of advertising = || when advertising
expenditures are optimal. Managers should therefore
increase advertising expenditures until this condition
is reached.
USING GRAPHS TO HELP DETERMINE
ADVERTISING EXPENDITURE

• Figure 8.11: Optimal Advertising Expenditure

• Curve A: Relationship between advertising
expenditures and the absolute value of the price
elasticity of demand—higher expenditures cause
demand to become less elastic.
• Curve B: Relationship between marginal revenue
from an extra dollar of advertising expenditures and
total advertising expenditures
USING GRAPHS TO HELP DETERMINE
ADVERTISING EXPENDITURE

• Figure 8.11: Optimal Advertising Expenditure

(cont’d)
• The intersection between Curve A and Curve B
defines the optimal level of advertising expenditures.
• Curve B’ represents a shift in Curve B due to
increasing advertising effectiveness. It results in an
increase in advertising expenditures.
OPTIMAL ADVERTISING EXPENDITURE

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ADVERTISING, PRICE ELASTICITY, AND BRAND
EQUITY: EVIDENCE ON MANAGERIAL BEHAVIOR

• Promotions
• Appeal to price sensitivity
• Price-oriented message
• Attempt to erode brand loyalty
• Attempt to increase price elasticity and limit
the premiums consumers are willing to pay for
brand-name products
ADVERTISING, PRICE ELASTICITY, AND BRAND
EQUITY: EVIDENCE ON MANAGERIAL BEHAVIOR

• Advertising
• Attempts to build brand loyalty
• Loyalty is measured as the frequency of repeat
purchases
• Product-quality oriented message
ADVERTISING, PRICE ELASTICITY, AND BRAND
EQUITY: EVIDENCE ON MANAGERIAL BEHAVIOR

• Evidence
• Promotions do increase the price elasticities of
consumers.
• Promotions have less effect on brand loyalists.
• The effects of promotions decay over time.
• Price elasticity of non-loyalists was found to be four
times that of loyalists in one study.
• The effects of advertising on brand loyalty erode over
time and price becomes more important to
consumers.
This concludes the Lecture
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Chapter 8: MONOPOLY AND
MONOPOLISTIC COMPETITION

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