© pearson education, 2005 perfect competition and monopoly market structures lubs1940: topic 5

© Pearson Education, 2005

Perfect Competition and Monopoly Market Structures

LUBS1940: Topic 5


Objectives

After studying this topic, you will able to:Define perfect competition

Explain how price and output are determined in a competitive industry and why firms sometimes shut down temporarily and lay off workers

Explain why firms enter and leave the industry

Predict the effects of a change in demand and of a technological advance

Explain why perfect competition is efficient

Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly

Explain how a single-price monopoly determines its output and price

Compare the performance and efficiency of single-price monopoly and competition.

Explain how price discrimination increases profit

Explain how monopoly regulation influences output, price, economic profit and efficiency


What is Perfect Competition?

Perfect competition is an industry in which:

1.Many firms sell identical products to many buyers.

2.There are no restrictions to entry into the industry.

3.Established firms have no advantages over new ones.

4.Sellers and buyers are well informed about prices.


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.

Economic Profit and Revenue

The goal of each firm is to maximize economic profit, which equals total revenue minus total cost.

Total cost is the opportunity cost of production, which includes normal profit.

A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P Q.



A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.



A perfectly competitive firm faces two constraints:

1. Market constraint summarized by the market price and the firm’s revenue curves

2. A technology constraint summarized by firm’s product curves and cost curves.

The perfectly competitive firm makes four key decisions.

Short-run decisions:

1. Whether to produce or temporarily shut down2. If the decision is to produce, what quantity to produce

Long-run decisions:

1. Whether to increase or decrease its plant size2. Whether to stay in the industry or leave it

The Firm’s Decisions in Perfect Competition


The perfectly competitive firm makes four key decisions.

Short-run decisions:

1.Whether to produce or temporarily shut down

2. If the decision is to produce, what quantity to produce

Long-run decisions:

1.Whether to increase or decrease its plant size

2.Whether to stay in the industry or leave it



Profit-Maximizing Output

A perfectly competitive firm chooses the output that maximizes its economic profit.

One way to find the profit-maximizing output is to look at the firm’s total revenue and total cost curves.



Part (a) shows the total revenue curve (TR). Part (a) also shows the total cost curve (TC), which is like the one in Chapter 10. Total revenue minus total cost is economics profit (or loss), shown in part (b).



Marginal Analysis

The firm can use marginal analysis to determine the profit-maximizing output.

Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue (MR) equals marginal cost (MC).

Figure 11.3 shows the marginal analysis that determines the profit-maximizing output.



Marginal Analysis

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.



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 (ATC) at the profit-maximizing output with the market price.



Profits and Losses in the Short Run



The Firm’s Short-run Supply CurveA perfectly competitive firm’s short-run 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 there is a price below which the firm produces nothing and shuts down temporarily.



Firm’s short-run supply curve

If price equals minimum average variable cost, £17 a jumper in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.

If the price is £25 a jumper, the firm produces 9 jumpers a day, the quantity at which P = MC.

If the price is £31 a jumper, the firm produces 10 jumpers a day, the quantity at which P = MC.

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



The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price.



Short-run Industry Supply Curve

The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.

The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price.



Output, Price and Profit in Perfect Competition

A Change in Demand

An increase in demand bring a rightward shift of the industry demand curve: the price rises and the quantity increases.

A decrease in demand bring a leftward shift of the industry demand curve: the price falls and the quantity decreases.


Long-run AdjustmentsIn short-run equilibrium, a firm might make an economic profit, incur an economic loss or break even (make normal profit).

Only one of these situations is a long run equilibrium.

In the long run, an industry adjusts in two ways:

Entry or exit: New firms enter an industry in which existing firms make an economic profit. Firms exit an industry in which they incur an economic loss.

Changes in plant size: Firms change their plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits.




The Effects of Entry

As new firms enter an industry, industry supply increases.

The price falls, the quantity increases and the economic profit of each firm decreases.

The industry supply curve shifts rightward.



Long-run equilibrium occurs when the firm is producing at the minimum long-run average cost and making zero economic profit.


Long-run Equilibrium

Long-run equilibrium occurs in a competitive industry when:

1. Economic profit is zero, so firms neither enter nor exit the industry.

2. Long-run average cost is at its minimum, so firms don’t change their plant size.



Changing Tastes and Advancing Technology

A Permanent Change in Demand

A decrease in demand shifts the demand curve leftward.



External Economics and Diseconomies

The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies.

External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases.

External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases.



Figure 11.11 illustrates the three possible cases and shows the long-run industry supply curve.

The long-run industry supply curve shows how the quantity supplied by an industry varies as the market price varies after all the possible adjustments have been made, including changes in plant size and the number of firms in the industry.


Figure shows that when external diseconomies are present, the price rises when demand increases.


The long-run industry supply curve is upward sloping.



Technological Change

New technologies are constantly discovered that lower costs.

A new technology enables firms to producer at a lower average cost and lower marginal cost firms’ cost curves shift downward.

Firms that adopt the new technology earn an economic profit.


Competition and Efficiency

Efficient Use of Resources

Resources are used efficiently when no one can be made better off without making someone else worse off.

This situation arises when marginal benefit equals marginal cost.



Choices, Equilibrium and Efficiency

Choices: D is MB curve and S is MC curve.

Equilibrium: D=S.

Efficiency: No external benefits or costs.


Figure 11.12 illustrates an efficient allocation of resources in a perfectly competitive industry.

In part (a), each firm is producing at the lowest possible long-run average cost at the price P* and the quantity q*.



The quantity Q* and price P* are the competitive equilibrium values.

Competitive equilibrium is efficient.

The consumer gains the consumer surplus,

and the producer gains the producer surplus.



Market Power

Market power and competition are the two forces that operate in most markets.

Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale.

A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.


Market Power

How Monopoly Arises

A monopoly has two key features:

No close substitutes Barriers to entry: Legal or natural constraints that protect a firm from potential competitors are called barriers to entry.


In a natural monopoly, economies of scale are so powerful that they are still being achieved even when the entire market demand is met.

The LRAC curve is still sloping downward when it meets the demand curve.

Market Power


Market Power

Monopoly Price-setting StrategiesAll monopolies face a trade-off between price and the quantity sold.

To sell a larger quantity, the monopoly must lower the price.

But two broad monopoly situations that create different trade-offs:

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

Single price: is a firm that must sell each unit of its output for the same price to all its customers.


A Single-Price Monopoly’s Output and Price Decision

Price and Marginal RevenueA monopoly is a price setter, not a price taker like a firm in perfect competition. The reason is that the demand curve for the monopoly’s output is the market demand curve. To sell a larger output, a monopoly must set a lower price.

Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.

Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold.

For a single-price monopoly, marginal revenue is less than price at each level of output. That is,

MR < P



Now suppose the firm cuts the price to £14 to sell 3 haircuts an hour.

It loses £4 of total revenue on the 2 haircuts it was selling at £16 each.

And it gains £14 of total revenue on the 3rd haircut.

So total revenue increases by £10, which is marginal revenue.



The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 haircuts and at £10 a haircut.

You can see that MR < P at each quantity.


A Single-Price Monopoly’sOutput and Price Decision

If demand is unit elastic, a fall in price leaves total revenue unchanged.

The rise in revenue from the increase in quantity sold equals the fall in revenue from the lower price per unit, and MR = 0.


A Single-Price Monopoly’sOutput and Price Decision

When marginal revenue is zero, total revenue is maximized.



Price and Output Decision

The monopoly faces the same types of technology constraints as the competitive firm, but the monopoly faces a different market constraint.

The monopoly selects the profit-maximizing level of output in the same manner as a competitive firm, where MR = MC.

The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity.



Figure 12.4 illustrates the profit-maximizing choices of a single-price monopolist.

In part (a), the monopoly sets the quantity produced at the level that maximizes total revenue minus total cost.



In part (b), the firm produces the output at which MR = MC and sets the price to sell that quantity.

The ATC curve tells us the average cost.

Economic profit is the profit per unit multiplied by the quantity produced the blue rectangle.


Single-Price Monopoly and Competition Compared

Because marginal revenue is less than price at each output level, QM < QC and PM > PC.

Compared to perfect competition, monopoly produces less output and charges a higher price.


Single-Price Monopoly and Competition Compared

Redistribution of Surpluses

Monopoly redistributes a portion of consumer surplus by changing it to producer surplus.


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.


With perfect price discrimination:Output increases to the quantity at which price equals marginal cost.

Economic profit increases above that earned by a single-price monopoly.


Deadweight loss is eliminated.



Efficiency and Rent Seeking with Price Discrimination

The more perfectly a monopoly can price discriminate, the closer is its output gets to the competitive output (P = MC) and the more efficient is the outcome.

But there are two differences between perfect competition and perfect price discrimination:

•The monopoly captures the entire consumer surplus.•The increase in economic profit attracts even more rent-seeking activity that leads to an inefficient use of resources.


Monopoly Policy Issues

Gains from MonopolyA single-price monopoly creates inefficiency and a price-discriminating monopoly captures consumer surplus and converts it into producer surplus and economic profit.

And monopoly encourages rent-seeking, which wastes resources.

But monopoly brings benefits.

Incentives to InnovatePatents and copyrights provide protection from competition and let the monopoly enjoy the profits stemming from innovation for a longer period of time.

Economies of scale and economies of scopeWhere economies of scale or scope exist, a monopoly can produce at a lower average total cost than what a large number of competitive firms could achieve.


Monopoly Policy Issues

Regulating Natural Monopoly

Profit Maximization

Efficient Regulation

Average Cost Pricing

© pearson education, 2005 perfect competition and monopoly market structures lubs1940: topic 5

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