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Chapter 7

Chapter 7 EC260.docx

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Karen Huff

EC260 Chapter 7 – Monopoly and Monopolistic Competition Week 7 -The question faced by most managers is how to set prices and output when they have market power -When managers have market power, they have the ability to overrule the invisible hand -The equilibrium price is set by the intersection of the supply and demand curves -Managers with monopoly power do not have to consider the actions of market rivals because there are none -Monopolies have no intramarket competition, and firm demand is equal to market demand -The demand faced by managers of monopolies is downward-sloping; as price increases, quantity demanded decreases -Managers must decide both price and quantity -They are no longer passive price takers -Even if managers create demand for their products, they still must efficiently manage costs and resources -Cross elasticities can tell us what goods, locations, an times are substitutes for a “monopoly” product -Even when there is no intramarket competition, managers must work hard if substitute products, locations, and times exist Pricing and Output Decisions in Monopoly -An unregulated monopolist maximizes profit by choosing the price and output were the difference between total revenue and total cost is the largest -The manager maximizes profit at the output where total revenue exceeds total cost by the greatest amount -Managers maximize profit if they set output at the point where marginal cost equals marginal revenue -With a linear demand curve, the marginal revenue curve has the same dollar intercept as the demand curve but it falls at twice the speed; that is the marginal revenue curve has twice the slope of the demand curve -The firm’s marginal revenue is no longer constant; nor is it equal to price -Marginal revenue is price minus something positive – so price must exceed marginal revenue -No rational manager produces where marginal revenue is negative -If managers are to produce where marginal revenue equals marginal cost, a negative marginal revenue implies a negative marginal cost -A monopolist will not produce in the inelastic range of her demand curve if she is maximizing profit -To maximize profit, managers need to produce the output where the marginal cost curve intersects that of marginal revenue -Because the monopolist is the only member of the market, the firm’s demand curve is the industry demand curve -Monopolists choose a higher price and a lower output – this lets them charge a price higher than marginal cost and generate economic profit -Managers in perfectly competitive markets can only set price equal to marginal cost -The extra profit earned by monopoly managers is generated by their ability to choose a price greater than marginal cost, whereas the perfect competitor merely charges the marginal cost Cost-Plus Pricing -Cost-plus pricing – simplistic strategy that guarantees that price is higher than the estimated average cost -Many managers act as if cost is the primary driver of price -Price is set as a function of cost – managers first allocate unit costs conditional on a given output level EC260 Chapter 7 – Monopoly and Monopolistic Competition Week 7 and then add a profit margin -This profit margin is generally a percentage of costs and is added to the estimated average costs -Profit margin – the price of a product minus its cost -Target return – what managers hope to earn and what determines the markup -One issue facing managers who produce more than one product is the charge for indirect cost, or overhead Cost-Plus Pricing at Therma-Stent -Managers set price by estimating the average production costs -Price is set without considering prices of rival products – this pricing scheme works better when products are differentiated Cost-Plus Pricing at Internet Companies and Government-Regulated Industries -Managers at many online companies seem to have adopted a cost-plus pricing scheme -Managers have structures a pricing policy called “At Cost” where they sell products based at the wholesale price plus a fixed transaction fee (the markup) The Multiple-Product Firm: Demand Interrelationships -Managers need to recognize that a change in the price or quantity sold of one product may influence the demand for other products -An increase in the quantity sold of one product reduce
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