Robin Naylor, Department of Economics, Warwick

1

In this lecture, we consider what factors influence whether there will be a large or a small number of firms in a market.

We also consider the specific issues arising when there is a ‘natural monopoly’ in a market.

Topic 5 Market structure, efficiency and failureLecture 19

Robin Naylor, Department of Economics, Warwick

2

Topic 5 Market structure, efficiency and failureLecture 19

X

p

D

X1

Minimum Efficient Scale refers to the smallest quantity at which the LAC attains its minimum level.

LAC1

LAC1 LAC2

X2

Firm 1Firm 2

LAC3

Firm 3

X3

Robin Naylor, Department of Economics, Warwick

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Topic 5 Market structure, efficiency and failureLecture 19

X

p

D

X1

LAC1

Suppose Firm 1 is producing X1. If there are no other firms in the market, what price can Firm 1 charge? Will it make a super-normal profit?

LAC1

Note that output at X1 is called Minimum Efficient Scale (MES).

Robin Naylor, Department of Economics, Warwick

4

Topic 5 Market structure, efficiency and failureLecture 19

X

p

D

X1

LAC1

Suppose Firm 1 is producing X1. If there are no other firms in the market, what price can Firm 1 charge? Will it make a super-normal profit?

LAC1

Note that output at X1 is called Minimum Efficient Scale (MES).

p1

Robin Naylor, Department of Economics, Warwick

5

Topic 5 Lecture 19

X

p

DX1

LAC1,2

Firm 1 is producing X1.

Suppose now that Firm 2 enters the market and is identical to Firm 1 and produces the same amount, X1. What is total output?

What price can be charged?

Can each firm make a super-normal profit?

X1

2X1

LAC1,2

Robin Naylor, Department of Economics, Warwick

6

Topic 5 Lecture 19

X

p

DX1

LAC1,2

Firm 1 is producing X1.

Suppose now that Firm 2 enters the market and is identical to Firm 1 and produces the same amount, X1. What is total output?

What price can be charged?

Can each firm make a super-normal profit?

X1

2X1

LAC1,2

P1,2

Robin Naylor, Department of Economics, Warwick

7

Topic 5 Lecture 19

X

p

D

3X1

LAC1

What if 3 identical firms are each producing X1?

Can they each at least break even?

X1X1 X1

Robin Naylor, Department of Economics, Warwick

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Topic 5 Lecture 19

X

p

D

LAC1

X1

3X1

P1,2

P1,2,3

Robin Naylor, Department of Economics, Warwick

9

Topic 5 Lecture 19

X

p

D

LAC1

How many (identical) firms in this market can each produce X1 and each break even?

X1

Robin Naylor, Department of Economics, Warwick

10

Topic 5 Lecture 19

X

p

D

LAC1

How many (identical) firms in this market can each produce X1 and each break even?

X1X1 X1

3X14X1

5X1 9X1

Robin Naylor, Department of Economics, Warwick

11

Topic 5 Lecture 19

X

p

D

LAC1

Suppose now that there is a reduction in market demand.

How many firms (with identical costs as before), each producing X1, can at least break even?

X1D’

Robin Naylor, Department of Economics, Warwick

12

Topic 5 Lecture 19

X

p

D

LAC1

Suppose now that there is a reduction in market demand.

How many firms (with identical costs as before), each producing X1, can at least break even?

X1D’

6X1

Robin Naylor, Department of Economics, Warwick

13

Topic 5 Lecture 19

X

p

D

LAC1

What can you conclude about what determines the number of firms that we will find in a market?

From this analysis, we see three crucial determinants . . .

X1

Robin Naylor, Department of Economics, Warwick

14

Topic 5 Lecture 19

X

p

D

LAC1

We have seen the importance of:

(i) the extent of demand.

Now consider:

(ii) MES

(iii) Minimum LAC

X1

LAC1’

X1 ’

LAC1

If MES is at X1’ instead of X1, how many firms can survive?

Robin Naylor, Department of Economics, Warwick

15

Topic 5 Lecture 19

X

p

D

LAC1

We have seen the importance of:

(i) the extent of demand.

Now consider:

(ii) MES

(iii) Minimum LAC

X1

LAC1’

X1 ’

LAC1

If MES is at X1’ instead of X1, how many firms can survive?

2X1 ’

P1,2

Robin Naylor, Department of Economics, Warwick

16

Topic 5 Lecture 19

X

p

D

LAC1

We have seen the importance of:

(i)the extent of demand.

(ii)MES

Now consider:

(iii) Minimum LAC

X1

LAC1

LAC1 ’

LAC1 ’ That is, what if the LAC curve shift upward, with no change in MES?

How many firms can survive?

Robin Naylor, Department of Economics, Warwick

17

Topic 5 Lecture 19

X

p

D

LAC1

What if the LAC curve shift upward, with no change in MES?

Whereas 9 firms could survive previously (see Slide 10), now only 5 can survive.

X1

LAC1

LAC1 ’

LAC1 ’

5X1 6X1

9X1

Robin Naylor, Department of Economics, Warwick

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Topic 5 Lecture 19

X

p

D

LAC1

Consider the case in which only 1 firm can survive . . .

. . . this is called:

Natural Monopoly

MES=X1

What will be the profit-maximising price and output of this Natural firm?

Robin Naylor, Department of Economics, Warwick

19

Topic 5 Lecture 19

X

p

D

LAC1

What will be the profit-maximising price and output of this Natural Monopoly firm?

X1

LMC1

MR

X*mon

pmon

LACmon

X*: MR=MC

Super-normal profit is given by area A=X*[pmon - LACmon]

Robin Naylor, Department of Economics, Warwick

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Topic 5 Lecture 19

X

p

D=MB

LAC1

What will be the Welfare Loss associated with this Natural Monopoly firm?

X1

LMC1

MR

X*mon

pmon

LACmon

X*soc

Welfare Loss is given by the area between the LMC and Demand curves.

Robin Naylor, Department of Economics, Warwick

Topic 5 Lecture 19

21

Now read B&B 4th Ed., pp. 298-300, 469-474, 530-533.