introductory microeconomics (es10001) topic 5: perfect competition & monopoly

Introductory Microeconomics (ES10001)

Topic 5: Perfect Competition & Monopoly

1. Introduction

MR = MC rule requires knowledge of market structure

One of the major influences on MR, and thus on its supply decision, is the degree of competitiveness the firm faces in the market.

That is, the number of actual and potential competitors

1. Introduction

This makes sense! If firm is the only player in the market, then we would expect it to behave differently than if it were one of (very) many

In what follows we will examine the causes and effects of market structure

2. Taxonomy of Competition

Microeconomics has tended to categorise the degree of competition a particular firm faces into three very precise and distinct categories:

A lot;

A bit;

None!

Perfect Competition

Collusive (i.e. Cartel)

Oligopoly

Monopoly

Monopolistic Competition

Imperfect Competition

Non-Collusive

Figure 1: Taxonomy of Competition

More Competition Less Competition

3. Perfect Competition

Market structure where competitive forces are at their greatest

Definition: A Perfectly Competitive (PC) market is one in which both buyers and sellers believe that their own buying or selling decisions have no effect on the market price

Sometimes referred to as an ‘atomistic’ market


Formal Characteristics

1. (Very) Large number of buyers and sellers;

2. Homogenous product;

3. Free entry and exit (in long-run);

4. Perfect knowledge.

Implication: All firms face same, perfectly elastic, demand curve

p

0

Q0 Q q

p0

S0

D0

d0

Figure 2: Perfectly Elastic Demand

Industry Representative Firm

E0


Why would firm not raise or lower price above or below p0?

If p > p0, then it would sell nothing because consumers have perfect knowledge and good is homogenous

Conversely, no point in setting p < p0 since it can sell as much as it wishes at p0


Firm’s demand curve is also its AR and MR curve

Recall:

AR = TR / q

MR = ΔTR / Δq

Since demand is perfectly elastic, AR = MR = p

p

0 q

d

1 2

5

Figure 3: Demand = AR = MR

E0 E1

p

0 q

d

1 2

5


E0 E1

TR1=5

AR1=5/1=5

p

0 q

d

1 2

5


E0 E1

TR2 =2*5=10

AR2=5/1=5

MR2 = TR2–TR1= 5

p

0 q

d = AR = MR

1 2

5


E0 E1


Consider short-run profit maximising rule

First, we know that to maximise profit we need to set SMR = SMC

But, SMC must also be rising …

… otherwise, profit (loss) is minimised (maximised)

p

0 q

SMC

q0 q1

p0 d = AR = MR

Figure 4: Optimal Output

E0 E1

π min π max


Thus, short-run profit maximising rule

(1) MR = SMC

(2) SMC is rising

But, it could always be in firm’s interest to produce nothing!

Is there a ‘shut-down’ price?

p

0 q

SMC

SAVC

SAC

q0

p0

SAC0

PROFIT


π > 0

Eo AR =MR

p

0 q

SMC

SAVC

SAC

q1

p1 AR = MR


π = 0

E1

p

0 q

SMC

SAVC

SAC

q2

p2

SAC2LOSS < - TFC


- TFC < π < 0

MR

E2

p

0 q

SMC


π = - TFC < 0

SAC

q3

p3

SAC3

LOSS = TFC

SAVC

AR = MR

E3

p

0 q

SMC

SAVC

SAC

q4

p4

SAC4

LOSS > TFC


π < - TFC < 0

AR = MR

E4


Thus, short-run profit maximising rule

MR = SMC

SMC is rising

p > SAVC

Supply curve of the firm is that part of its SMC curve above minimum SAVC

p

0 q

SMC


π = - TFC < 0

SAC

q3

p3

SAC3

LOSS = TFC

SAVC

AR = MR

E3

p

0 q

SMC

Figure 8:

p3

AR = MR

SAVC

p

0 q

SR Supply

Figure 8:

Min AVC


Note, short-run ‘shutdown’ price = p3 = SAVC(q3)

π(p3) = p3*q3 – SAC(q3)*q3

= [SAVC(q3) – SAC(q3)]*q3

= -AFC(q3)*q3

= -TFC


Thus, short-run supply curve of firm is that part of its SMC above minimum AVC

Similarly, long-run supply curve is that part of LMC above minimum LAC

i.e. long-run ‘shutdown’ option is to leave the industry

p

0 q

LMC

LAC

q0

p0 AR = MR

Figure 10: Long-Run Shut-Down


Compare SR and LR supply curves

SR supply curve of firm is that part of its SMC above minimum AVC; similarly, long-run supply curve is that part of LMC above minimum LAC

i.e. LR ‘shutdown’ option is to leave the industry

Note that SR supply curve lays below LR supply curve (recall ‘Envelope’) and is steeper

p

0 q

SSR

SLR

p1

p0

Min LAC

Min AVC

Figure 11: Long-Run & Short-Run Supply


SSR lays below SLR because LAC is envelope of SAC’s and SAVC’s lay below SAC since SAC includes AFC

SSR is steeper than SLR because it will always be less costly for firm to increase output when it can alter all inputs (i.e. K an L) appropriately (i.e. when it is in LR)

Now, consider MR = MC condition


TR0 = p0q0

TR1 = p1q1

Thus:

ΔTR =TR1 - TR0 = p1q1 - p0q0

= p1q1 - p0q0 + (p1q0 - p1q0)

= p1q1 - p1q0 + p1q0 - p0q0

= p1(q1 - q0) + (p1 - p0)q0


ΔTR = p1(q1 - q0) + (p1 - p0)q0

= p1Δq + Δpq0

Thus:

Consider ‘small’ changes in (p, q) such that p1 ≈ p0, q1 ≈ q0 , and so (p0, p1) ≈ p and (q0, q1) ≈ q


Thus:

Now, recall:


Thus:

Under perfect competition, E => ∞ such that MR => p

Also, since MR = MC in equilibrium, then:


Thus:


Lerner (1934) ‘Index of Monopoly Power’

Note that under perfect competition, E => ∞ such that p => MC

Firms can only ‘mark-up’ p over MC iff E < ∞

p

0 q

da

Figure 12: Elasticity of Demand and Slope of (Inverse) Demand Curve

db

dc

E0


Industry Supply

SR industry supply curve (when factor prices are given) is the horizontal summation of each firm’s SMC curve above minimum AVC

Similarly, LR industry supply curve (when factor prices are given) is horizontal summation of each firm’s LMC curve above minimum LAC

p p p

0

p0

p1

p2

0 0

Firm A Firm B Industry

q0 q1 q2 q0 q1 q2 Q0 Q1 Q2 qa qb Q

Figure 13: SR Industry Supply


Consider effect of an exogenous increase in industry demand for the good

Increase in demand will increase each existing firm’s profit

Existing firms increase SR supply by moving up their SMC curves

p p

0

Q0 Q q0 q

p0

D0

d0

SMC

Figure 14a: SR Industry Supply

SAC

E0e0


p p

0

Q0 Q1 Q q0 q1 q

p0

D0

d0

SMC

d1

D1

Figure 14b: SR Industry Supply

SAC

E0

E1

e0

e1



But, the existence of super-normal profits will attract other firms into the industry

This will shift out industry (SR) supply curve and lead to a fall in the (perfectly elastic) demand facing individuals firms

Industry supply is higher because of entry of new firms; each firm produces same amount in new equilibrium (E2) as original firms produced in original equilibrium (E0)

p p

0

Q0 Q1 Q2 Q q0 q1 q

p0

D0

d0

SMC

d1

D1

Figure 14c: SR Industry Supply

SAC

E0 E2

E1

e2 = e0

e1



LR supply curve of industry is horizontal / perfectly elastic

LR supply price of industry is equal to minimum LAC of constituent firms

Thus, demand only determines quantity; price is supply (i.e. cost) determined)

p P

0 q* q 0 Q* Q

p* SLR

LMC

LAC

e*

D

E*

Figure 15: LR Industry Supply

Representative Firm Industry


LR supply curve of industry is upward sloping in two situations:

1. Factor prices increase with usage

2. Heterogeneous firms

Consider each in turn


Consider first the SR response of a representative firm and the industry to an increase in demand

If factor prices increase with usage, then increase in demand induces each firm to increase output along its SMC curve

But, increase in industry supply of output increases demand for / price of the variable input


Increase in price of variable input shifts up vertically each firm’s SMC curve

The expansion of output by each firm can thus be interpreted as a combination of a ‘movement along’ and a ‘shift of’ its SMC curve

Similarly, the expansion of output by the industry - combination of a ‘movement along’ / ‘shift of’ the aggregation of constituent firms’ SMC curves

p p

0

q0 q1 q Q0 Q1 Q

p0

D1

∑SMC0

D0

SMC1

Figure 16: SR Industry Supply

Factor prices increase with usage

e0

e1E1

E0

Representative Firm Industry

SMC0

SSR

p1

∑SMC1

∑SSR


In LR, free entry / exit implies each firm produces at minimum LAC

If firms are equally efficient, then firms have same minimum LAC and industry supply is perfectly elastic

Intuitively, whatever happens to demand, SR supply, and thus price, competitive forces ensure a normal-profit LR equilibrium such that LR supply is perfectly elastic at minimum LAC


But this presumes factor prices are fixed

What if factor prices increase with their usage?

In this case, then LR expansion of output by the industry will increase the price of all factors such that each constituent firm’s LAC and LMC will shift-up


Thus, LR industry response to increase in demand when factor prices increase with their usage is a combination of:

(i) a ‘movement along’ a perfectly elastic LR supply curve (i.e. one determined by minimum LAC of equally efficient constituent firms, but where factor prices are held constant);

(ii) a ‘shift-up’ of such a curve (i.e. where factor prices are allowed to increase)

p

0 Q

D1

Figure 17: LR Industry Supply

Factor prices increase with usage

D0

E1

E0


Consider also ‘heterogeneous firms’

i.e. inter-firm differences in efficiency

The earlier firms enter into an industry, the lower their cost curves; subsequent firms are increasingly less efficient


At any particular LR equilibrium price, p*, the least efficient (i.e. ‘marginal’) firm is that firm which can make just normal profit at p*

The more efficient (i.e. ‘intra-marginal’) firms make positive profits at p* and, thus, produce in the region of DRS

p p p

0

0 0

(Intra-Marginal) Firm 1 (Marginal) Firm 2 Industry

SLRLMC1

LMC2

LAC2

D

LAC1

p*

q1 q q2 q Q* Q

LAC1

Figure 18: LR Industry SupplyHeterogeneous Firms

e2E*

e1

4. Monopoly

Consider now the other extreme market environment

Monopoly; single seller

The monopolist is the industry; no distinction between firm and industry; less need to distinguish SR and LR since entry / exit is less of an issue

Consider monopolist's AR and MR curves

4. Monopoly

As with PC firm, demand curve is also the AR curve

But since AR curve is downward sloping, MR curve lays below AR curve

Intuitively, to sell more Q, monopolist has to cut p on all units of Q

p

0 Q

D = AR

TR1 = p1

TR2 = 2p2

MR2 = 2p2 - p1

= p2 - (p1-p2) < p2

1 2

p1

p2

MR2

MR

Figure 19a: AR and MR

A

B

C

p

0 Q

D = AR

TR1 = p1

TR2 = 2p2

MR2 = 2p2 - p1

= p2 - (p1-p2) < p2

1 2

p1

p2

MR2

MR

Figure 19b: AR and MR

A

B

C

p2

p

0 Q

D = AR

TR1 = p1

TR2 = 2p2

MR2 = 2p2 - p1

= p2 - (p1-p2) < p2

1 2

p1

p2

MR2

MR

Figure 19c: AR and MR

A

B

C

p2

(p1-p2)

4. Monopoly

We will assume that the monopolist, like PC firms and industries, faces increasing and then decreasing returns to both factors and scale; i.e. ‘U-Shaped’ SAC / LAC

N.B. Monopoly that faces IRS always is termed a ‘Natural Monopoly’

Monopolist's profit can be supernormal (most likely), normal or negative

p

0 Q

LMC

LAC

Q0

p0

LAC0D = AR

MR

Profit

Figure 20a: Monopolist LR Equilibrium

π > 0

p

0 Q

LMCLAC

Q0

p0

LAC0

D = ARMR

Loss

Figure 20b: Monopolist LR Equilibrium

π < 0

p

0 Q

LMC

LAC

Q0

p0 = LAC0

D = ARMR

Figure 20c: Monopolist LR Equilibrium

π = 0

4. Monopoly

Consider efficiency

Allocative Efficiency (AE)

p = MC

Productive Efficiency (PE)

IRS are exhausted such that LAC is minimised

4. Monopoly

(Non-Discriminating) monopolist is never AE and (extremely) unlikely to be PE

PE would require MR curve to cross MC at minimum AC

It can happen, but infinitely small chance!

p

0 Q

LMC

LAC

Qmes

pmes

LACmes

D = AR

MR

Figure 21: Monopolist LR Equilibrium

Productive efficiency is possible, but very unlikely!

4. Monopoly

Allocative Efficiency requires marginal (social) benefit (MSB) to equal marginal (social) cost (MSC)

Define: MSC = MPC + MEC

MSB = MPB + MEB

i.e. marginal social benefit (cost) equals marginal private benefit (cost) plus marginal external benefit (costs)

4. Monopoly

Private benefits (costs) are those enjoyed (incurred) by agent producing or consuming) the good

External benefits (costs) are the non-price effects on the production or consumption of other members of society

Assume (for now!) that MEC = MEB = 0 such that allocative efficiency requires MPC = MPB

4. Monopoly

Now:

MPC = LMC of monopolist

MPB = price consumers willing to pay for good

Thus, the MPB can be derived from the monopolist's Demand = AR curve

Recall, the (inverse) demand curve sets out consumer's reservation price vis. the maximum price the consumer is willing to pay

p

0 Q

D = MPB

Q1 Q2 Q3

p1

p2

Figure 22: D = MPB

A

B

Cp3

4. Monopoly

It is apparent that the monopolist produces less output than the socially optimal (allocatively efficient) level

Monopolist maximises profit by setting MR = MC

Allocative efficiency is achieved when p = MC

Since p > MR, it must be the case that monopolist output is less than socially optimal

p

0 Q

LMC = MPC

LAC

Q0 Q1

p0

LAC0D = AR = MPB

MR

Figure 23: Monopolist LR Equilibrium

DWL = ABC

A

C

B

Privately Optimal

Socially Optimal

4. Monopoly

Consider the (‘overnight’) monopolisation of a PC industry

The constituent firms of the industry become manufacturing plants for the monopolist

Assume that the SLR = ∑LMC of the PC industry becomes the monopolist’s LMC curve (N.B. heterogeneous firms thus SLR is upward sloping)

4. Monopoly

Define social welfare (SW) as sum of consumer surplus (CS) and producer surplus (PS)

SW = PS + CS

NB: No concern with equity! 1+ 99 = 100 = 99 + 1

Define CS as excess of what consumers are willing to pay over what they actually pay; PS as excess of what producers actually receive over what they are willing to receive

p

0 Q

D = AR

Qc

pc

CS

SLR

PS

A

B C

D

Figure 22a: Monopoly and PC

Perfect CompetitionCS = ABCPS = BCDSW = ABD

p

0 Q

D = AR

Qm Qc

pc

MR

LMC

A

B C

D

pm E

F

G

Figure 22a: Monopoly and DWL

MonopolyCS = AEGPS = GEFDSW = AEFDDWL = EBF

p

0 Q

D = AR

Qm Qc

pc

MR

LMC

A

B C

D

pm E

F

G


MonopolyΔCS = -GEHC - EBHΔPS = +GEHC - BHFΔSW = -EBH - BHF

H

4. Monopoly

But this is a static analysis - i.e. the instantaneous effects of monopolisation; what happens to cost over time, i.e. dynamic effects?

Two scenarios: (i) Liebenstein ‘X-Inefficency’ (pessimistic)

(ii) Schumpeter ‘R&D’ (optimistic)

Balance of argument - empirical issue

p

0 Q

D = AR

Qm Qc

pc

MR

LMC

A

B C

D

pm E

F

B

Schumpeter

Liebenstein


4. Monopoly

To summarise; monopolies would appear to be harmful to society in sense that they lead to DWL (i.e. consumers lose more than producers gain)

Perhaps some benefits over time (R&D), but that is an empirical issue

There is an argument, however, that if we are to have monopolies, then we should make them as powerful as possible!

4. Monopoly

Price Discrimination (PD)

Selling different units of the same good at different

prices

Two basic approaches to PD:

Charging different prices to different consumers for same units of the good;

Charging same consumers different prices for different units of the good

4. Monopoly

Three main types of PD:

1. First-Degree (Perfect);

2. Second-Degree;

3. Third-Degree

Consider each in turn

4. Monopoly

First-Degree (Perfect) Price Discrimination

Monopolist charges each consumer maximum price willing to pay for each unit of the good; thus demand curve is also MR curve, since only reduce p on additional units of Q

Monopolist produces socially optimal Q (i.e. p = MC) and is thus allocatively efficient (DWL = 0) but completely inequitable (CS = 0)

p

0 Q

D = MR

1 2 Q*

LMC

PS

A

B

C

Figure 23: First Degree (Perfect) Price Discrimination

Perfect PDCS = 0PS = ABCSW = ABC

DWL = 0

p1

p2

p*

A'

A''

4. Monopoly

First-Degree (Perfect) Price Discrimination

Monopolist charges each consumer maximum price willing to pay for each unit of the good; thus demand curve is also MR curve, since only reduce p on additional units of Q

Monopolist produces socially optimal Q (i.e. p = MC) and is thus allocatively efficient (DWL = 0) but completely inequitable (CS = 0)

p

0 Q

D = MR

1 2 3 Q*

LMC

PS

A

F B

E


Perfect Price Discrimination

Price = ABCD; Quantity = Q*

CS = 0PS = ABESW = ABE

DWL = 0

p1

p2

p*

A1

A2

A3p3

D C

p

0 Q

D = MR

1 2 3 Q*

LMC

PS

A

B

E


Perfect Price Discrimination

Price = ABCD; Quantity = Q*

CS = 0PS = ABESW = ABE

DWL = 0

4. Monopoly

Second-Degree Price Discrimination

Monopolist knows there are different ‘types’ of consumers with different WTP (i.e. utility from consuming good) but cannot identify them individually

CSi(x) = ui(x) – p(x) i = H, L

uH(x) > uL(x) – i.e. H values good x more than L

p

0 x A C

xL xH

Figure 23: Second-Degree Price Discrimination

DH

DL

Consider two ‘packages’ vis:

(pH, xH)

(pL, xL)

Assume production is costless

D

B

p

0 x A C

xL xH


DH

DL

Ideally, monopolist would like to extract all CS. e.g.

pH = A + B + C

pL = A

D

B

p

0 x A C

xL xH


DH

DL

Such pricing will ensure zero CS vis:

pH = A + B + C

pL = A

=>

CSH(xH) = 0 = CSL(xL)

D

B

p

0 x A C

xL xH


DH

DL

D

But H prefers (pL, xL) to (pH, xH):

pH = A + B + C

pL = A

=>

CSL(xH) = - (B + C + D) < 0

CSH(xL) = B > 0B

p

0 x A C

xL xH


DH

DL

D

B

Thus, monopolist must remove B from (pH, xH):

pH = A + C pL = A

=>

CSH(xH) = B = CSH(xL)

CSL(xL) = 0

CSL(xH) = - (C + D) < 0

p

0 x A1 A2 C

xLL xL xH


B1 B2

DH

DL

Optimal packages? Consider cut in xL to xLL

=>

pH(xH) = A1 + A2 + B2 + C pL(xLL) = A1

D

p

0 x A1 A2 C

xLL xL xH


B1 B2

DH

DL

(xLL, xH) is still incentive compatible

=>

CSH(xH) = B1 = CSH(xL)

CSL(xLL) = 0

CSL(xH) = - (B2+ C + D) < 0

D

p

0 x A1 A2 C

xLL xL xH


B1 B2

DH

DL

Effect on profit?

=>

π(xH, xL) = (A1 + A2) + (A1 + A2 + C)

π(xH, xLL) = A1 + (A1 + A2 + B2 + C)

=>

Δπ = π(xH, xLL) - π(xH, xL) = - A2 + B2

D

p

0 x A1 A2 C

xL* xH*


B1

DH

DL

Optimal package is found by reducing xL until MC (i.e. in A2) equals MR (i.e. in B2)

pH(xH*) = A1 + A2 + B2 + C

pL(xL*) = A1

where

a-b = b-c

a

b

c

B2

D

4. Monopoly

Third-Degree Price Discrimination

Monopolist sells good at different prices to different groups of consumers

Monopolist must be able to identify distinct markets

Geographical, age, gender, race …

4. Monopoly

Assume monopolist sells identical good to two markets (A and B)

Assume costs of producing and supplying good to either market are identical

E.g. Cinema selling seats in Bath to students and lecturers who have distinct reservations prices and elasticities of demand from each other

p p p

0

0 0

Market A Market B Market A + B Lecturers Students

LMC

MRA

MRBARA

ARB

MR

AR

Figure 24a: Third-Degree Price Discrimination

4. Monopoly

Assume first that price-discrimination is illegal

The cinema will maximise profit by setting (aggregate) MR = LMC

Thus, sells seats in total at a common price of

to lecturers and to students

p p p

0

0 0

LMC

MRA

MRBARA

ARB

MR

AR

Figure 24b: Third-Degree Price Discrimination


4. Monopoly

Assume now that price discrimination is legal

Setting a common price implies that MRA ≠ MRB

Thus, the monopolist can increase its revenue (and since production costs are independent of the market supplied, its profit) by transferring Q from the low MR market to the high MR market

p p p

0

0 0

LMC

MRA

MRBARA

ARB

MR

AR

Figure 24c: Third-Degree Price Discrimination


4. Monopoly

As Q is withdrawn from the low MR market, p and MR in that market rise;

And vice versa, as Q is transferred to the high MR market, p and MR in that market fall; profit is maximised when MRA = MRB

p p p

0

0 0

LMC

MRA

MRBARB

ARB

MR

AR

Market A Market B Market A + B

4. Monopoly

Intuitively, lecturers have relatively inelastic demand, thus it is optimal to raise the price they face, since relatively little demand is lost

Conversely, students have relatively elastic demand, thus it is optimal to lower the price they face since demand increases substantially

4. Monopoly

Recall:

Thus:

4. Monopoly

Recall:

Thus:

If MRA = MRB, but EA < EB, then pA > pB

4. Monopoly

For all this to work:

1. Group making up sub-markets must have distinct elasticities of demand;

2. Third-degree price discrimination must be legal;

3. There must be no arbitrage between the groups (i.e. usually used in service industries)

p p

0 qb

pb

pa

ARb = Db ARa = Da

A K

B E G J M

D F H N

I L

C

Area No Price Discrimination (1)

Price Discrimination (2)

Change (2) – (1)

CSb +A +A+B+E+G +B+E+G

Rb +B+E+C+D+F +C+D+F+H -B-E+H

CSa +K+I+L +K -I-L

Ra +G+H+J+M+N +L+M+N -G-H-J+L

SW +A+B+C+D+E+F+G+H+I+J+K+L+M+

N

+A+B+C+D+E+F+G+H+K+L+M+N

-I-J

p

0 Q

D

Qm

Figure 23: Natural Monopoly

pm

LMC

LAC

MR

LAC

p

0 Q

D

QLAC Q*


LMC

LAC

MR

p = LMC

p

0 Q

D

QMES

Figure 23: Monopoly and Perfect Competition

LAC

If demand is small relative to MES, A competitive market is likely to result

4. Monopoly

When is monopoly likely to happen?

Depends on minimum efficient scale and demand

p

0 Q

D

QMES

Figure 23: Monopoly and Competition

LAC

If demand is large relative to MES, A monopolistic market structure is possible

p

0 Q

D

Q*


p* = LMC

LMC

LAC

MR

LAC

4. Monopoly

Finally …

Note that the monopolist does not have a supply curve

No one-to-one mapping between price and quantity supplied

p

0 Q

LMC

Q0 Q1

p0

AR1

MR0

MR1AR0

E0 E1

Figure 23: Monopolist does not have a supply curve

introductory microeconomics (es10001) topic 5: perfect competition & monopoly

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