econ 101: introduction to economics - i lecture 8 – perfect competition and pure monopoly

ECON 101: Introduction to Economics - I

Lecture 8 – Perfect Competition and Pure Monopoly

Perfect competitionCharacteristics of a perfectly competitive

market:• many buyers and sellers

– so no individual believes that their own action can affect market price

• firms take price as given

– so face a horizontal demand curve

• the product is homogeneous

• perfect customer information

• free entry and exit of firms

©McGraw-Hill Education, 2014

© 2012 Pearson Education

How Perfect Competition Arises

Perfect competition arises when:

the firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the market.

each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm’s good they buy.

What Is Perfect Competition?


Price Takers

In perfect competition, each firm is a price taker.

A price taker is a firm that cannot influence the price of a good or service.

No single firm can influence the price—it must “take” the equilibrium market price.

Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.



Figure below illustrates a firm’s revenue concepts.

Part (a) shows that market demand and market supply determine the market price that the firm must take.

The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.



The demand for a firm’s product is perfectly elastic because one firm’s sweater is a perfect substitute for the sweater of another firm.

The market demand is not perfectly elastic because a sweater is a substitute for some other good.



A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces.

So the firm must decide:

1. How to produce at minimum cost

2. What quantity to produce

3. Whether to enter or exit a market

We start by looking at the firm’s output decision.



At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.

At intermediate output levels, the firm makes an economic profit.

At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns.

The firm maximizes its economic profit when it produces 9 sweaters a day.

The Firm’s Output Decision


If MR > MC, economic profit increases if output increases.

If MR < MC, economic profit decreases if output increases.

If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.



Temporary Shutdown Decision

If the firm makes an economic loss, it must decide to exit the market or to stay in the market.

If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily.

The decision will be the one that minimizes the firm’s loss.



Loss Comparisons

The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR).

Economic loss = TFC + TVC – TR

= TFC + (AVC – P) x Q

If the firm shuts down, Q is 0 and the firm still has to pay its TFC.

So the firm incurs an economic loss equal to TFC.

This economic loss is the largest that the firm must bear.



The Shutdown Point

A firm’s shutdown point is the price and quantity at which it is indifferent between producing and shutting down.

This point is where AVC is at its minimum.

It is also the point at which the MC curve crosses the AVC curve.

At the shutdown point, the firm is indifferent between producing and shutting down temporarily.

The firm incurs a loss equal to TFC from either action.




The shutdown point.

Minimum AVC is $17 a sweater.

If the price is $17, the profit-maximizing output is 7 sweaters a day.

The firm incurs a loss equal to the red rectangle.


Profits and Losses in the Short Run

Maximum profit is not always a positive economic profit.

To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost at the profit-maximizing output with the market price.

Figure 12.8 on the next slide shows the three possible profit outcomes.

Output, Price, and Profit in the Short Run


In part (c) price is less than average total cost and the firm incurs an economic loss—economic profit is negative.

Output, Price, and Profit in the Short Run

The supply curve under perfect competition (1)

• Above price P3 (point C), the firm makes profit above the opportunity cost of capital in the short run

• At price P3, (point C), the firm makes NORMAL PROFITS

P1

£

OutputQ1

P3

A

C

Q3



• Between P1 and P3, (A

and C), the firm makes short-run losses, but remains in the market

• Below P1 (the SHUT-

DOWN PRICE), the firm fails to cover SAVC, and exits the market

P1

£

OutputQ1

P3

A

C

Q3



– showing how much the firm would produce at each price level.

P1

£

Output

SMC

Q1

P3

A

C

Q3

• So the SMC curve above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE



The Firm’s Supply Curve

A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same.

Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve.

But at a price below the shutdown point, the firm produces nothing.



How the firm’s supply curve is constructed.

If price equals minimum AVC, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.

If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC.

If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC.

The blue curve in part (b) traces the firm’s short-run supply curve.

The Firm’s Decisions

The firm and the industry in the short run under perfect

competition (1)

Output

£

Q

P

D

Market price is set at industry level at the intersection of demand and supply. The industry supply curve is the sum of the individual firm’s supply curves.

P

£

Output

D=MR=AR


FIRM

INDUSTRY

P

Output

£

Q

The firm and the industry in the short run under perfect

competition (2)

INDUSTRY

FIRM

The firm accepts price as given at P and chooses output at q where SMC=MR to maximize profits.

P

£

Outputq


Long-run equilibrium

INDUSTRYFIRM

D=MR=AR

LAC

P*

£

Output

LMC

q*

The market settles in long-run equilibrium when the typical firm just makes normal profit by setting LMC=MR at the minimum point of LAC. Long-run industry supply is horizontal.

If the expansion of the industry pushes up input prices (e.g. wages) the long-run supply curve will not be horizontal, but upward-sloping.

SRSS

D

P*

Output

£

Q

LRSS


Adjustment to an increase in market demand: the short run

Suppose a perfectly competitive market startsin equilibrium at P0Q0.

If market demand shifts to D'D'…

…in the short run the newequilibrium is P1Q1 .

Adjustment is throughexpansion of individualfirms along their SMCs.

Q1

P1

Output

£

D

SRSS

Q0

P0

D D'

D'


Adjustment to an increase in market demand: the long run

In the long run, new firms are attracted by the supernormal profits now being made here – and firms are able to adjust their input of fixed factors.

Output

£

D

SRSS

Q0

P0

D

D'

D'

Q1

P1

If wages are bid up by thisexpansion, the long-runsupply schedule is upward-sloping

LRSS

– and the market finally settles at P2Q2.

Q2

P2


Entry to and exit from the industry

Given the long-run average cost curve depicted in the figure when the price is P1, a firm in the market makes supernormal profits.

New firms may then enter the market.

The main effect of this entry is that more firms will produce in the market and so the market supply will shift to the right.


Monopoly

• A monopolist

– is the sole supplier of an industry’s product and the only potential supplier

– is protected by some form of barrier to entry

– faces the market demand curve directly.

– Unlike under perfect competition, MR is always below AR.



How Monopoly Arises

A monopoly has two key features:

No close substitutes

Barriers to entry

No Close Substitute

If a good has a close substitute, even if it is produced by only one firm, that firm effectively faces competition from the producers of the substitute.

A monopoly sells a good that has no close substitutes.

Monopoly and How It Arises


Barriers to Entry

A constraint that protects a firm from potential competitors are called barriers to entry.

Three types of barriers to entry are

Natural

Ownership

Legal



Natural Barriers to Entry

Natural barriers to entry create natural monopoly.

A natural monopoly is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost.

Ownership Barriers to Entry

An ownership barrier to entry occurs if one firm owns a significant portion of a key resource.

During the last century, De Beers owns 90 percent of the world’s diamonds.



Legal Barriers to Entry

Legal barriers to entry create a legal monopoly.

A legal monopoly is a market in which competition and entry are restricted by the granting of a

Public franchise (like the U.S. Postal Service, a public franchise to deliver first-class mail)

Government license (like a license to practice law or medicine)

Patent or copyright



Monopoly Price-Setting Strategies

For a monopoly firm to determine the quantity it sells, it must choose the appropriate price.

There are two types of monopoly price-setting strategies:

A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.

Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.


Profit maximization by a monopolist

Profits are maximized where MC = MR at Q1P1.

In this position, AR isgreater than AC so the firm makesmonopoly profits shown by the shaded area.

Entry barriers preventnew firms joining theindustry.

Output

£

P1

Q1

MC

AC

D = ARMR


Profit-maximizing monopoly


Comparing monopoly with perfect competition (1)

Suppose a competitive industry is taken over by a monopolist:

Output

DMR

SRSS£

Q1

P1

A

Competitive equilibrium is at A, with output Q1

and price P1.

The monopolistmaximizes profits in theshort run at MR = SMCat P2Q2.Q2

P2



Suppose a competitive industry is taken over by a monopolist.

Output

In the long run thefirm can adjust other inputs ...

to set MR = LMC

And priceat P3Q3.

P3

Q3

SRSS£

Q1

P1

A

Q2

P2



• So we see that monopoly compared with perfect competition implies:– higher price– lower output

• Does the consumer always lose from monopoly?– Among other things, this depends on whether the

monopolist faces the same cost structure.– there may be the possibility of economies of scale.



Redistribution of Surpluses

Some of the lost consumer surplus goes to the monopoly as producer surplus.

Single-Price Monopoly and Competition Compared

A natural monopoly• This firm enjoys

substantial economies of scale relative to market demand

• LAC declines right up to market demand

• the largest firm always enjoys cost leadership

• and comes to dominate the industry

• It is a NATURAL MONOPOLY.

LMC

LAC

D

P1

£

Q1 Output



Price Discrimination

Price discrimination is the practice of selling different units of a good or service for different prices.

To be able to price discriminate, a monopoly must:

1. Identify and separate different buyer types.

2. Sell a product that cannot be resold.

Price differences that arise from cost differences are not price discrimination.

Discriminating monopoly• Suppose a monopolist supplies two separate

groups of customers

– with differing elasticities of demand

– e.g. business travellers may be less sensitive to air fare levels than tourists.

• The monopolist may increase profits by charging higher prices to the businessmen than to tourists.

• Discrimination is more likely to be possible for goods that cannot be resold

– e.g. dental treatment.©McGraw-Hill Education, 2014

Concluding comments (1)• In a competitive market each buyer and seller

is a price taker.

• For a firm operating in a perfectly competitive market its price is equal to marginal revenue.

• Adding at each price the quantities supplied by each firm, we obtain the industry supply curve.

• In long-run equilibrium, the marginal firm makes only normal profits.

• A profit-maximizing monopolist will select the level output at which marginal revenue and cost are equal. ©McGraw-Hill Education, 2014

Concluding comments (2)

• Compared to a perfectly competitive market, a monopoly creates a deadweight loss.

• A discriminating monopolist charges different prices to different customers.


econ 101: introduction to economics - i lecture 8 – perfect competition and pure monopoly

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