MANAGERIAL ECONOMICS - Short-run and long-run does not have number of

1ST SEMESTER days

FINALS FIXED INPUT VARIABLE

CHAPTER 5: THE PRODUCTION ● Land and Capital - does not change

PROCESS AND COSTS with the level of production when
producing products
PRODUCTION FUNCTION ● Labor and Entrepreneurship - Could be
adjusted in the short-run (not fixed)
● Process of converting inputs into finished
products; producers/business firms — FORMULA:
soul producer of goods and services Q = f (L) = F(K*, L)
● A function that defines the maximum ● Where;
amount of output that can be produced - K* - Capital is fixed
with a given set of inputs. - L - Labor input
● Mathematically, the production function - Q - the quantity of output produced.
is denoted as
Q = F(K, L) THE PRODUCTION FUNCTION (TABLE)
● Where; ● K* - fixed input (capital)
- K - the quantity of capital, ● L - Variable input (Labor)
- L - the quantity of labor, ● ∆𝐿 - Change in labor (𝐿 − 𝐿 )
2 1
- Q - the level of output produced in the ● Q - Output
production process. ∆𝑄
●
∆𝐿
= 𝑀𝑃𝐿 - Marginal Product of Labor
1. FIXED INPUT - does not change with 𝑄2−𝑄1
the level of quantity (Q). A resource that ( 𝐿2−𝐿1
)
cannot be easily changed or adjusted in
𝑄
the short run. ●
𝐿
= 𝐴𝑃𝐿- Average Product of Labor
2. VARIABLE INPUT - Changes with the
level of input (no production; no input) or
MEASURE OF PRODUCTIVITY
variable inputs change directly with the
level of output; as production rises, more TOTAL PRODUCT
variable inputs are typically required. A
resource that can be adjusted quickly in ● total product (TP) The maximum level of
response to changes in production output that can be produced with a
demand. given amount of inputs.

SHORT-RUN VS LONG-RUN DECISIONS AVERAGE PRODUCT

Short-run period Long-run period ● Average product (AP) is a measure of the

output produced per unit of input. In
- At least one input - All inputs are particular, the average product of labor
is fixed considered (APL) is
- Losses of a variable, meaning 𝑄
company/business firms can adjust all 𝐴𝑃𝐿 = 𝐿
and has limited inputs, including ● and the average product of capital
budget capital, labor, and (APK) is
- Could not exit the production 𝑄
𝐴𝑃𝐾 =
market right away; capacity. 𝐾
difficulty exiting the - Profit increases Thus, the average product is a measure of
market because the (positive) the output produced per unit of input.
money used is not - Could exit the
yet recovered market because MARGINAL PRODUCT
- First year of a the profit is
● marginal product (MP) The change in
company (newbie/ recovered
total output attributable to the last unit
beginner)
of an input. The marginal product of

E .L .H . | 1
 capital (MPK) therefore is the change in an input
total output divided by the change in ● For example, if each unit of output can
capital: be sold at a price of P, the value
𝑀𝑃𝐾 =
∆𝑄 marginal product of labor is
∆𝐾 𝑉𝑀𝑃𝐿 = 𝑃 × 𝑀𝑃𝐿
● The marginal product of labor (MPL) is
- This is the additional output (widgets)
the change in total output divided by the
produced by hiring one more worker.
change in labor:
∆𝑄 ● and the value marginal product of
𝑀𝑃𝐿 = ∆𝐿 capital is
𝑉𝑀𝑃𝐾 = 𝑃 × 𝑀𝑃𝐾
DIMINISHING MARGINAL RETURN / - This is the additional output (widgets)
LAW OF DIMINISHING PRODUCT produced by adding one more unit of
capital (e.g., a machine).
● Increasing marginal returns - Range of
input usage over which marginal product PROFIT MAXIMIZATION INPUT USAGE
increases.
● Decreasing (diminishing) marginal ● To maximize profits, a manager should
returns - Range of input usage over use inputs at levels at which the
which marginal product declines. marginal benefit equals the marginal
● Negative marginal returns - Range of cost. More specifically, when the cost of
input usage over which marginal product each additional unit of labor is w, the
is negative. manager should continue to employ
labor up to the point where 𝑉𝑀𝑃𝐿 = 𝑤 in
RELATIONSHIP BETWEEN TOTAL
the range of diminishing marginal
PRODUCT (TP) AND MARGINAL
products.
PRODUCT (MP)
𝑉𝑀𝑃𝐿 = 𝑤
1. As TP increase, MP is positive - w - wages
2. When TP is at maximum, MP is 0 ● A firm will continue to hire workers as
3. As TP declines, MP is negative long as the VMPL is greater than or
equal to the wage rate W.
RELATIONSHIP BETWEEN AVERAGE ● If the price is fixed, the company is
PRODUCT (AP) AND MARGINAL competing in the perfectly competitive
PRODUCT (MP) market so that they have the same
product to sell and the same prices.
1. As AP rises, MP > AP
2. When AP is at maximum, AP = MP ALGEBRAIC FORMS OF PRODUCTION
3. As AP declines, MP < AP FUNCTIONS

THE ROLE OF THE MANAGER IN THE LINEAR PRODUCTION FUNCTION

PRODUCTION PROCESS
● A production function that assumes a
The manager’s role in guiding the perfect linear relationship between all
production process described earlier is inputs and total output
twofold: 𝑄 = 𝐹(𝐾, 𝐿) = 𝑎𝐾 + 𝑏𝐿
1. to ensure that the firm operates on the - a and b are constants
production function (the manager - K - Capital
know where the production is at - L - Labor
maximum)
2. to ensure that the firm uses the correct LEONTIEF PRODUCTION FUNCTION
level of inputs. (How many inputs
(laborers) are we going to hire) ● Also called the fixed- proportions
production function because it implies
USE RIGHT LEVEL OF INPUTS that inputs are used in fixed proportions.
● A production function that assumes that
● Value marginal product - The value of inputs are used in fixed proportions.
the output produced by the last unit of

E .L .H . | 2
 𝑄 = 𝐹(𝐾, 𝐿) = 𝑚𝑖𝑛 (𝑎𝐾, 𝑏𝐿) on the same isoquant, each will produce
- a and b are constants the same level of output, namely, Q0
- K - Capital units. Input mix A implies a more
- L - Labor capital-intensive plant than does input
mix B. As more of both inputs are used,
- Notice that the isoquants are convex.
● Example:
The reason isoquants are typically drawn
- The engineers at Morris Industries
with a convex shape is that inputs such
obtained the following estimate of
as capital and labor typically are not
the firm’s production function:
perfectly substitutable.
Q = F ( K, L ) = min { 3K, 4L }
- If we start at point A and begin
- How much output is produced when
substituting labor for capital, it takes
2 units of labor and 5 units of capital
increasing amounts of labor to replace
are employed? :
each unit of capital that is taken away.
- We simply calculate F(5, 2). But F(5,
The rate at which labor and capital can
2) = min{3(5), 4(2)} = min{15, 8}. Since
substitute for each other is called the
the minimum of the numbers “15”
marginal rate of technical substitution
and “8” is 8, we know that 5 units of
(MRTS). The MRTS of capital and labor is
capital and 2 units of labor produce 8
the absolute value of the slope of the
units of output.
isoquant and is simply the ratio of the
marginal products
COBB-DOUGLAS PRODUCTION 𝑀𝑃𝐿
FUNCTION 𝑀𝑅𝑇𝑆𝐾𝐿 = 𝑀𝑃𝐾
● Marginal rate of technical substitution
● A production function that assumes
(MRTS) - The rate at which a producer
some degree of substitutability among
can substitute between two inputs and
inputs.
𝑎 𝑏
maintain the same level of output.
𝑄 = 𝐹(𝐾, 𝐿) = 𝐾 𝐿
- a and b exponents are constants ISOCOST
- K - Capital
- L - Labor ● A line that represents the combinations
of inputs that will cost the producer the
ISOQUANTS same amount of money.

● An isoquant defines the combinations of

inputs (K and L) that yield the producer
the same level of output; that is, any
combination of capital and labor along
an isoquant produces the same level of
output.

● The relation for an isocost line is graphed

To understand this concept, suppose the
firm spends exactly $C on inputs. Then
the cost of labor plus the cost of capital
exactly equals $C:
𝑤𝐿 + 𝑟𝐾 = 𝐶
- This depicts a typical set of isoquants. ● where w is the wage rate (the price of
Because input bundles A and B both lie labor) and r is the rental rate (the price

E .L .H . | 3
 of capital). This equation represents the VARIABLE COSTS
formula for an isocost line.
● Costs that change with changes in
output; include the costs of inputs that
vary with output.
PRODUCTION FUNCTION SUMMARY OF
FORMULA: SHORT-RUN COST FUNCTION

GIVEN: ● A function that defines the minimum

● Fixed input (capital) - K* possible cost of producing each output
● Variable input (Labor) - L level when variable factors are employed
● Output - Q in the cost minimizing fashion.
● Price of output - P
● Unit Cost of Labor - W THE COST FUNCTIONS TABLE

● Change in Labor
𝐿2 − 𝐿1
● Change in Capital
𝐾2 − 𝐾1

● Marginal Product of Labor

∆𝑄 𝑄2−𝑄1
𝑀𝑃𝐿 = ∆𝐿
𝑜𝑟 𝐿2−𝐿1
● Marginal Product of Capital
∆𝑄 𝑄2−𝑄1
𝑀𝑃𝐾 = ∆𝐾
𝑜𝑟 𝐾2−𝐾1

● Average Product of Labor

𝑄
𝐴𝑃𝐿 = 𝐿
● Average Product of Capital
𝑄
𝐴𝑃𝐾 = 𝐾

● Value Marginal Product of Labor

𝑉𝑀𝑃𝐿 = 𝑃 × 𝑀𝑃𝐿
● Value Marginal Product of Capital
𝑉𝑀𝑃𝐾 = 𝑃 × 𝑀𝑃𝐾

THE COST FUNCTION

TOTAL COST

● Sum of fixed and variable costs.

FIXED COSTS

● Costs that do not change with changes

in output; include the costs of fixed
inputs used in production.

E .L .H . | 4
 GRAPH RELATIONS AMONG COSTS

AVERAGE AND MARGINAL COSTS ● The first thing to notice is that the
marginal cost curve intersects the ATC
AVERAGE FIXED COST (AFC)
and AVC curves at their minimum
Fixed costs divided by the number of units points. This implies that when marginal
of output cost is below an average cost curve,
𝐹𝐶 average cost is declining, and when
𝐴𝐹𝐶 = 𝑄 marginal cost is above average cost,
average cost is rising.
AVERAGE VARIABLE COST (AVC) ● The second thing to notice is that the
ATC and AVC curves get closer
Variable costs divided by the number of together as output increases. This is
units of output. because the only difference in ATC and
𝑉𝐶(𝑄) AVC is AFC.
𝐴𝑉𝐶 = 𝑄 ● The difference between average total
costs and average variable costs is
AVERAGE TOTAL COST ATC − AVC = AFC. Since average fixed
costs decline as output is expanded,
Total cost divided by the number of units this difference between average total
of output and average variable costs diminishes
𝐶(𝑄) as fixed costs are spread over
𝐴𝑇𝐶 = 𝑄
increasing levels of output.
MARGINAL (INCREMENTAL) COST (MC) RELATIONSHIP BETWEEN MC &
ATC/AVC
The change in total costs arising from a
change in the managerial control variable 1. When ATC/AVC declines,
Q. MC < ATC/AVC
∆𝐶 𝐶2−𝐶1 2. When ATC/AVC is at its minimum point,
𝑀𝐶 = ∆𝑄
or 𝑀𝐶 = 𝑄 −𝑄 MC = ATC/AVC
2 1
3. When ATC/AVC rises/increases,
MC > ATC/AVC

COST FUNCTION SUMMARY OF

FORMULA:

GIVEN:
● Cost of labor (L) - w
● Cost of capital (K) - r
● Fixed Input - Labor (L)
● Variable Input - Capital (K)

E .L .H . | 5
 SUNK COST
● Fixed Cost (FC) = 𝐿 × 𝑤
● Variable Cost (VC) = 𝐾 × 𝑟 ● A cost that is forever lost after it has
● Total Cost (TC) = 𝐹𝐶 + 𝑉𝐶 been paid.
● A decision maker should ignore sunk
costs to maximize profits or minimize
● Profit Formula (P) losses.
π = 𝑇𝑅 − 𝑇𝐶
● Total Revenue LONG-RUN COSTS
𝑝𝑟𝑜𝑓𝑖𝑡 (𝑃) × 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑢𝑡𝑝𝑢𝑡 (𝑄)
● In the long run, all costs are variable
● Average Fixed Cost because the manager is free to adjust
𝐹𝐶 the levels of all inputs.
𝐴𝐹𝐶 = 𝑄
LONG-RUN AVERAGE COST CURVE
● Average Variable Cost
𝑉𝐶 ● A curve that defines the minimum
𝐴𝑉𝐶 = 𝑄
average cost of producing alternative
● Average Total Cost levels of output, allowing for optimal
𝑇𝐶
𝐴𝑇𝐶 = or selection of both fixed and variable
𝑄
factors of production (denoted LRAC)
𝐴𝑇𝐶 = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
ECONOMIES OF SCALE
● Marginal Cost
𝑇𝐶2−𝑇𝐶1 ● Exist whenever long-run average costs
∆𝑇𝐶
𝑀𝐶 = ∆𝑄
or 𝑀𝐶 = 𝑄2−𝑄1 decline as output increases.

COST FUNCTION TABLE WITH THE DISECONOMIES OF SCALE

GIVEN EQUATION
● Exist whenever long-run average costs
2 3 increase as output increases
GIVEN: 100 + 2𝑄 + 10𝑄 + 5𝑄 ; Q=5
CONSTANT RETURNS TO SCALE
Q FC VC TC
● Exist when long-run average costs
5 100 885 985 remain constant as output is increased.

AFC AVC ATC MC

20 177 197 477

1. Fixed cost = 100 (a term w/o variable;

fixed)
2 3
2. Variable cost = 2𝑄 + 5𝑄 + 10𝑄 (terms
with variables then solve where Q=5)
2 3
- 2(5) + 10(5) + 5(5) = 885
3. Total cost = FC + VC = 100 + 885 = 985
4. AFC = FC/Q = 100/5 = 20
CHAPTER 7: THE NATURE OF INDUSTRY
5. AVC = VC/Q = 885/5 = 177
6. MC = (get the derivative of the given MARKET STRUCTURE
equation, then solve where Q = 5)
2 3
- Equation: 100 + 2𝑄 + 10𝑄 + 5𝑄 ● Factors that affect managerial decisions,
- Derivative: 2 + 20𝑄 + 15𝑄 ;(Q = 5)
2 including the number of firms competing
2 in a market, the relative size of firms,
- = 2 + 20(5) + 15(5) = 477
technological and cost considerations,
demand conditions, and the ease with

E .L .H . | 6
 which firms can enter or exit the while outdated technology may hinder
industry. performance and growth.
● It give rise to differences in production
1. FIRM SIZE (it determines what kind of product you
are producing)
● This refers to the relative scale of firms
operating in the market. Larger firms 4. DEMAND AND MARKET CONDITIONS
may benefit from economies of scale,
while smaller firms may focus on niche A. DEMAND CONDITION
markets or specialize in custom services. - Economic condition cannot be
Firm size impacts pricing, competition, controlled and can affect sales
and market share. - Include the preferences, purchasing
power, and buying behavior of
2. INDUSTRY CONCENTRATION consumers.
- High demand, high sale; low demand,
● This measures how much of the market is low sale
dominated by a few large firms. High - External factors; company doesn't have
industry concentration often indicates an control over it
oligopoly or monopoly and has the - Internal factors; company has control
biggest market share, while low B. MARKET CONDITION
concentration reflects a competitive - What affects the market (e.g.
market with many small firms. environment, calamities, economic
Concentration influences competition, trends and seasonal fluctuations, that
pricing, and innovation. influence sales and competition.)
● Measures of Industry Concentration 5. POTENTIAL FOR ENTRY
- Concentration ratios measure how
much of the total output in an industry ● This refers to how easy or hard it is for
is produced by the largest firms in that new businesses to enter the market. If
industry. starting a business in the industry
- The four-firm concentration ratio is requires a lot of money, special licenses,
the fraction of total industry sales or facing strong competitors, it becomes
produced by the four largest firms in harder for new companies to enter. On
the industry. the other hand, if it's simple and
𝑆1+𝑆2+𝑆3+𝑆4 affordable to start, more businesses can
𝐶4 = 𝑆𝑇 join, which increases competition.
Where; ● BARRIERS TO ENTRY
𝑆1 + 𝑆2 + 𝑆3 + 𝑆4 = 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑡ℎ𝑒 4 𝑙𝑎𝑟𝑔𝑒𝑠𝑡 𝑓𝑖𝑟𝑚𝑠 1. Capital requirements - Starting a
business in some industries requires a
𝑖𝑛 𝑎𝑛 𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦
significant investment in facilities,
● Herfindahl-Hirschman index (HHI)
equipment, or research, making it
- It measures how highly concentrated
challenging for new competitors.
products are.
2. Patent - grant exclusive rights to
- Sum of the squared market shares of
products or technologies, preventing
firms in a given industry,
competitors from entering the market
- High concentration - complement
until the patent expires.
products. They are closely monitored
3. Economies of scale - Established
- Low concentration - substitutes
companies produce goods more
products
efficiently and cheaply due to
3. TECHNOLOGY large-scale operations, making it hard
for new entrants to compete.
● The level and type of technology used in 4. Legal barriers - Government
an industry determine production regulations, licensing, and trade
efficiency, product quality, and cost restrictions can create obstacles for
structures. Advanced technology can new businesses trying to enter specific
provide firms with a competitive edge, industries.

E .L .H . | 7
5. Environmental Restrictions - markets)
Compliance with strict environmental
rules, such as emission limits, adds MONOPOLY
costs that may discourage potential
competitors. Number of firms One firm
6. Ownership of resources - Existing dominates the
firms controlling essential resources entire market
like land, raw materials, or technology
can block new competitors from Type of product Unique, no close
entering the market. substitutes, no
transaction cost
6. INTEGRATION AND MERGER
ACTIVITY Market power Complete control
over price (price
VERTICAL INTEGRATION maker).
- refers to a situation where various
stages in the production of a single Ease of entry/exit Very difficult, high
product are carried out in a single firm barriers (e.g.,
- involves merging two or more phases patents, legal
of production into a single firm. barriers, ownership
of resources)
HORIZONTAL INTEGRATION
- refers to the merging of the production Examples Utilities (e.g.,
of similar products into a single firm. electricity, water
- involves merging two or more final supply)
products into a single firm,

CHAPTER 8: MANAGING IN
COMPETITIVE, MONOPOLISTIC, AND
MONOPOLISTICALLY COMPETITIVE MONOPOLISTIC COMPETITION
MARKETS
Number of firms Many firms, each
PERFECT COMPETITION offering slightly
different products
Number of firms Many small firms
Type of product - Differentiated
Type of product Homogeneous products
(identical - No perfect
products), no information
transaction cost - Transaction cost
(could go from
Market power - Follow prices in another seller,
the market unless loyal)
(market - Demand is more
equilibrium) elastic
- it cannot
influence price Market power Limited control;
and quantity influenced by
- also known as product
price differentiation
takers/setter/ (price maker)
searcher
Ease of entry/exit Relatively easy, but
Ease of entry/exit Easy (no barriers) differentiation
creates mild
Examples Agriculture (e.g. barriers
wheat, corn

E .L .H . | 8
 Examples Clothing brands,
restaurants

OLIGOPOLY

Number of firms Few large firms

dominate the
market (“oli”
means few)

Type of product Homogeneous

(identical) or 2. Short-Run Output Decisions
differentiated
products Maximizing Profits

Market power Significant control, ● Marginal revenue The change in

influenced by revenue attributable to the last unit of
competitors (price output; for a competitive firm, MR is the
maker) market price.
∆𝑇𝑅
𝑀𝑅 = 𝑀𝐶 𝑀𝑅 = ∆𝑄
Ease of entry/exit Difficult; high
barriers (e.g., costs,
legal)

Examples Automobile
industry, airlines

I. PERFECT COMPETITION

The key conditions for perfect competition

are as follows:
1. There are many buyers and sellers in
the market, each of which is “small”
relative to the market.
2. Each firm in the market produces a
homogeneous (identical) product. ● 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (𝑇𝑅) = 10 × 100 = 1000
3. Buyers and sellers have perfect ● 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 (𝑇𝐶) = 8 × 100 = 800
information. ● 𝑝𝑟𝑜𝑓𝑖𝑡 (π) = 𝑇𝑅 − 𝑇𝐶 = 1000 − 800 = 200
4. There are no transaction costs.
5. There is free entry into and exit from 𝑃 > 𝐴𝑇𝐶
the market. 𝑃 < 𝐴𝑇𝐶 (𝑙𝑜𝑠𝑠𝑒𝑠)

What to do when encountering losses:

1. Minimize cost
1. Demand at the Market and Firm 2. Shut down
Levels
Competitive Output Rule
● Firm demand curve - The demand To maximize profits, a perfectly
curve for an individual firm’s product; in competitive firm produces the output at
a perfectly competitive market, it is which price equals marginal cost in the
simply the market price. range over which marginal cost is
increasing: P = MC ( Q )

E .L .H . | 9
 Minimizing Losses 1. The Output Decision

Profit Maximization

● 𝑇𝑅 = 10 × 100 = 1000
● 𝑇𝐶 = 11 × 100 = 1100
● 𝑝𝑟𝑜𝑓𝑖𝑡 (π) = 𝑇𝑅 − 𝑇𝐶 = 1000 − 1100
= − 100 (𝑙𝑜𝑠𝑠)
● 𝑉𝐶 = 7 × 100 = 700
● 𝐹𝐶 = 4 × 100 = 400
𝑛𝑜𝑡𝑒: 𝐹𝐶 = 𝑑𝑖𝑠𝑡𝑎𝑛𝑐𝑒 𝑏𝑒𝑡𝐴 𝑚𝑎𝑟𝑘𝑒𝑡 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒 𝑖𝑛

π: 𝑃 ≥ 𝐴𝑉𝐶
𝑙𝑜𝑠𝑠: 𝑃 < 𝐴𝑉𝐶

Short-Run Output Decision under

Perfect Competition
To maximize short-run profits, a
perfectly competitive firm should
produce in the range of increasing
marginal cost where P = MC, provided
that P ≥ AVC. If P < AVC, the firm
should shut down its plant to
minimize its losses.

● Suppose the market price, Pe, is below

the ATC curve but above the AVC
curve. In this instance, if the firm
produces the output Q*, where Pe = MC,
a loss of the shaded area will result.
However, since the price exceeds the
AVC, each unit sold generates more
revenue than the cost per unit of the
● If marginal revenue was greater than
variable inputs. Thus, the firm should
marginal cost (MR>MC), an increase in
continue to produce in the short run,
output would increase revenues more
even though it is incurring losses.
than it would increase costs. Thus, a
II. MONOPOLY profit-maximizing manager of a
monopoly should continue to expand
A market structure in which a single firm output when MR>MC. On the other hand,
serves an entire market for a good that if marginal cost exceeds marginal
has no close substitutes revenue, a reduction in output would
reduce costs by more than it would
reduce revenue. A profit-maximizing
manager thus is motivated to produce
where marginal revenue equals
marginal cost.
● An alternative characterization of the
profit-maximizing output decision of a

E .L .H . | 10
 monopoly is presented above. The PROFIT MAXIMIZATION IN FOUR
marginal revenue curve intersects the OLIGOPOLY SETTINGS
marginal cost curve when QM units are
produced, so the profit-maximizing 1. SWEEZY OLIGOPOLY
level of output is QM. The maximum
price per unit that consumers are willing ● The Sweezy model is based on a very
to pay for QM units is PM, so the specific assumption regarding how other
profit-maximizing price is PM. firms will respond to price increases and
Monopoly profits are given by the price cuts.
shaded rectangle in the figure, which is ● It is more focused on differentiated
𝑀 𝑀 𝑀 products.
the base 𝑝𝑟𝑜𝑓𝑖𝑡 = [𝑃 − 𝐴𝑇𝐶(𝑄 )] × 𝑄
● Price leaders - sets the price for a
product or service, which other
III. MONOPOLISTIC COMPETITION
companies in the same industry then
Implications of Product Differentiation follow (increase price - no one will follow
because no one will buy; decrease price -
● COMPARATIVE ADVERTISING - A form they’ll follow because many consumers
of advertising where a firm attempts to will buy)
increase the demand for its brand by ● An industry is characterized as a Sweezy
differentiating its product from oligopoly if
competing brands. 1. There are few firms in the market
● BRAND EQUITY - The additional value serving many consumers.
added to a product because of its brand. 2. The firms produce differentiated
● NICHE MARKETING - A marketing products.
strategy where goods and services are 3. Each firm believes rivals will cut their
tailored to meet the needs of a particular prices in response to a price reduction
segment of the market. but will not raise their prices in
● GREEN MARKETING - A form of niche response to a price increase.
marketing where firms target products 4. Barriers to entry exist.
toward consumers who are concerned
about environmental issues. 2. COURNOT OLIGOPOLY
● BRAND MYOPIC - A manager or
● If each firm must determine its output
company that rests on a brand’s past
level at the same time other firms
laurels instead of focusing on emerging
determine their output levels, or, more
industry trends or changes in consumer
generally, if each firm expects its own
preferences
output decision to have no impact on
CHAPTER 9: BASIC OLIGOPOLY rivals’ output decisions, then this
MODELS scenario describes a Cournot oligopoly
1. There are few firms in the market
OLIGOPOLY serving many consumers.
2. The firms produce either
● Oligopoly refers to a situation where differentiated or homogeneous
there are relatively few large firms in an products
industry. No explicit number of firms is 3. Each firm believes rivals will hold their
required for oligopoly, but the number output constant if it changes its
usually is somewhere between 2 and 10. output.
The products the firms offer may be - Firms will not follow if the leader
either identical (as in a perfectly changes the output, they will follow
competitive market) or differentiated their own output (a change in output
(as in a monopolistically competitive = change in price)
market). An oligopoly composed of only 4. Barriers to entry exist.
two firms is called a duopoly.
3. STACKELBERG OLIGOPOLY

● In a Stackelberg oligopoly, firms differ

with respect to when they make

E .L .H . | 11
 decisions. Specifically, one firm (the CHAPTER 11: PRICING STRATEGIES
leader) is assumed to make an output FOR FIRMS WITH MARKET POWER
decision before the other firms. Given
knowledge of the leader’s output, all STRATEGIES THAT YIELD EVEN
other firms (the followers) take as GREATER PROFITS
given the leader’s output and choose
outputs that maximize profits. Thus, in I. Extracting Surplus from Consumers
a Stackelberg oligopoly, each follower
1. PRICE DISCRIMINATION
behaves just like a Cournot oligopolist. In
fact, the leader does not take the ● The practice of charging different prices
followers’ outputs as given but instead to consumers for the same goods or
chooses an output that maximizes service.
profits given that each follower will ● Implemented by imperfect competitors
react to this output decision according except perfect competition
to a Cournot reaction function.
● An industry is characterized as a The three basic types of price
Stackelberg oligopoly if discrimination
1. There are few firms serving many
consumers. A. First-degree price discrimination
2. The firms produce either - charge each consumer the maximum
differentiated or homogeneous price he or she would be willing to pay
products. for each unit of the good purchased. By
3. A single firm (the leader) chooses an adopting this strategy, a firm extracts all
output before all other firms choose surplus from consumers and thus earns
their outputs. the highest possible profits.
4. All other firms (the followers) take as Unfortunately for managers, first-degree
given the output of the leader and price discrimination (also called perfect
choose outputs that maximize profits price discrimination) is extremely
given the leader’s output. difficult to implement because it requires
5. Barriers to entry exist. the firm to know precisely the maximum
price each consumer is willing and able
4. BERTRAND OLIGOPOLY to pay for alternative quantities of the
firm’s product.
● The treatment here assumes the firms B. Second-degree price discrimination
sell identical products and that - In situations where the firm does not
consumers are willing to pay the (finite) know the maximum price that each
monopoly price for the good. consumer will pay for a good, or when it
● Consumers have perfect information and is not practical to post a continuous
no transaction costs schedule of prices for each incremental
● An industry is characterized as a unit purchased, a firm might be able to
Bertrand oligopoly if employ second-degree price
1. There are few firms in the market discrimination to extract part of the
serving many consumers. surplus from consumers. Second-degree
2. The firms produce identical products price discrimination is the practice of
at a constant marginal cost. posting a discrete schedule of declining
3. Firms engage in price competition prices for different ranges of quantities.
and react optimally to prices charged C. Third-degree price discrimination
by competitors. - Recognize that the demand for their
- Firms compete in prices (other firms product differs systematically across
only follow prices that gives them consumers in different demographic
max profit) groups. In these instances, firms can
4. Consumers have perfect information profit by charging different groups of
and there are no transaction costs. consumers differ ent prices for the same
5. Barriers to entry exist product, a strategy referred to as
third-degree price discrimination. For
example, it is common for stores to offer

E .L .H . | 12
 “student discounts” and for hotels and III. Pricing Strategies in Markets with
restaurants to offer “senior citizen Intense Price Competition
discounts.” These practices effectively
mean that students and senior citizens 1. PRICE MATCHING
pay less for some goods than do other
consumers. One might think that these A strategy in which a firm advertises a
pricing strategies are instituted to price and a promise to match any lower
benefit students and senior citizens, but price offered by a competitor.
there is a more compelling reason: to
2. INDUCING BRAND LOYALTY
increase the firm’s profits
Another strategy a firm can use to reduce
2. TWO PART PRICING
the tension of Bertrand competition is to
Pricing strategy in which consumers are adopt strategies that induce brand loyalty.
charged a fixed fee for the right to Brand-loyal customers will continue to buy
purchase a product, plus a per-unit charge a firm’s product even if another firm offers
for each unit purchased. a (slightly) better price. By inducing brand
loyalty, a firm reduces the number of
3. BLOCK PRICING consumers who will “switch” to another
firm if it undercuts its price.
Pricing strategy in which identical
products are packaged together in order 3. RANDOMIZED PRICING
to enhance profits by forcing customers to
make an all-or-none decision to purchase. Pricing strategy in which a firm
intentionally varies its price in an attempt
4. COMMODITY BUNDLING to “hide” price information from
consumers and rivals.
The practice of bundling several different
products together and selling them at a
single “bundle price.”
CHAPTER 8: PERFECT COMPETITION
II. Pricing Strategies for Special Cost EXAMPLE PROBLEMS
and Demand Structures
1. The following graph summarizes the
1. PEAK-LOAD PRICING demand and costs for a firm that operates
in a perfectly competitive market.
Pricing strategy in which higher prices are Given: 𝑇𝑅 = 28 × 7 = 196
charged during peak hours than during a. What level of output should this firm
off-peak hours (or seasons)
produce in the short run?
2. CROSS-SUBSIDIES 𝑄=7
b. What price should this firm charge in the
Pricing strategy in which profits gained short run?
from the sale of one product are used to
𝑃 = 28
subsidize sales of a related product.
c. What is the firm’s total cost at this level
3. TRANSFER PRICING of output?
𝑇𝐶 = 32 × 7 = 224
Pricing strategy in which a firm optimally d. What is the firm’s total variable cost at
sets the internal price at which an
this level of output?
upstream division sells an input to a
downstream division. 𝑉𝐶 = 14 × 7 = 98
e. What is the firm’s fixed cost at this level
of output?
𝐹𝐶 = 𝑇𝐶 − 𝑉𝐶 = 223 − 98 = 126
f. What is the firm’s profit if it produces this
level of output?
𝑃𝑟𝑜𝑓𝑖𝑡 (π) = 𝑇𝑅 − 𝑇𝐶 = 196 − 224 = − 28
E .L .H . | 13
 (𝑎 𝑙𝑜𝑠𝑠 𝑜𝑓 $28)
g. What is the firm’s profit if it shuts down?
𝑝𝑟𝑜𝑓𝑖𝑡 (𝑠ℎ𝑢𝑡𝑑𝑜𝑤𝑛) = − 𝐹𝐶 = − 126
h. In the long run, should this firm continue
to operate or shut down?
𝐼𝑛 𝑡ℎ𝑒 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛, 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 𝑠ℎ𝑜𝑢𝑙𝑑 𝑠ℎ𝑢𝑡 𝑑𝑜𝑤𝑛
𝑠𝑖𝑛𝑐𝑒 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 ($28) 𝑖𝑠 𝑏𝑒𝑙𝑜𝑤 𝐴𝑇𝐶 (32), 𝑎𝑡
𝑝𝑟𝑜𝑓𝑖𝑡 − 𝑚𝑎𝑥𝑖𝑚𝑖𝑧𝑖𝑛𝑔 𝑜𝑢𝑡𝑝𝑢𝑡, 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚
𝑐𝑎𝑛𝑛𝑜𝑡 𝑠𝑢𝑠𝑡𝑎𝑖𝑛 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛

2. The following graph summarizes the

demand and costs for a firm that operates
in a monopolistically competitive market.
a. What is the firm’s optimal output?
𝑄=7
b. What is the firm’s optimal price?
𝑃 = 60
c. What are the firm’s maximum profits?
𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 − 𝑇𝐶
𝑇𝑅 = 130 × 7 = 910
𝑇𝐶 = 110 × 7 = 770
𝑝𝑟𝑜𝑓𝑖𝑡 = 910 − 770 = 140
d. What adjustments should the manager
be anticipating?
𝑃𝑟𝑒𝑝𝑎𝑟𝑒 𝑓𝑜𝑟 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑑 𝑐𝑜𝑚𝑝𝑒𝑡𝑖𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎.
𝑟𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑙𝑜𝑛𝑔 𝑟𝑢𝑛.

E .L .H . | 14