Perfect Competition and Monopoly

1
Perfect Competition and Monopoly
2
Perfect Competition

• Conditions
• Large number of buyers and sellers
• Homogeneous product
• Perfect knowledge
• Free entry and exit
• No government intervention
• Key Implications
• Flat firms demand determined by market
  equilibrium price
• Market participants are price takers without any
  market power to influence prices (have to charge
  MR P MC)
• In the short run firms earn profits or losses or
  shut down
• In the long run profit normal 0 (firms
  operate efficiently)

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Unrealistic? Why Learn?

• Many small businesses are price-takers.Decision
  rules for such firms are similar to those of
  perfectly competitive firms
• It is a useful benchmark
• Explains why governments oppose monopolies
• Illuminates the danger to managers of
  competitive environments
• Importance of product differentiation
• Sustainable advantage

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Setting Price

TR
Qf(units)


Df Pf AR MR
PM
Qf(units)
QM(106)
Firm
Market
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Setting Output

• To maximize total profit T? TR - TCFONC dT?
  /dQ M ? MR - MC 0In general (including
  monopoly) MR MC.In perfect competition MR P
  MC.
• To maximize profit increase output (Q) until
  1) MR P MC (at Q), and2) for Q gt Q gt MC
  gt MR gt M? lt 0 gt TC lt TR
• or MC is increasing

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A Numerical Example

• Given estimates of
• P 10
• C(Q) 5 Q2
• Optimal Price?
• P 10
• Optimal Output?
• MR P 10 2Q MC
• Q 5 units
• Maximum Profits?
• PQ - C(Q) 10(5) - (5 25) 20

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Profit gt Normal
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Normal Profit

• Normal profit is necessary for the firm to
  produce over the long run and is considered a
  cost of production
• Normal profit is required because investors
  expect a return on their investment.
• Profit lt normal leads to exit in the long run.
• Profit gt normal leads to entry in the long run.
• Profit normal maintains the of firms in the
  industry.

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Shut-Down Point

• In the long run all cost must be recovered.
• In the short run fixed cost incurred before
  production begins and do not change regardless
  of the level of production (even for Q 0).
• Shut down only if TFC gt T?
  (total) P lt
  AVC (per unit).
• TFC AFCQ (SAC AVC)Q
• Operate with loss if 0 gt T? gt TFC
  (total) SAC gt
  P ? AVC (per unit).
• This is the third T? maximizing condition.

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Shutdown
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Short-Run Supply Under Perfect Competition
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Effect of Entry on Market Price Quantity

• Short run profits leads to entry
• Entry increases market supply, driving down the
  market price and increasing the market quantity

13
Effect of Entry on Firms Output Profit

• Demand for individual firms product and
  hence its price shifts down
• Long run profits are driven to zero

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Perfect Competition in the Long Run

• Socially efficient output and price MR P MC
  (no dead weight loss)
• Efficient plant size P MC min AC (all
  economies of scale exhausted)
• Optimal resource allocation T? Normal ? 0,
  for P MC min AC (opportunity cost TR,
  lowered by free entry)

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Monopoly

• Conditions
• Large number of buyers and one sellers
• Product without close substitutes
• Perfect knowledge
• Barriers to entry
• No government intervention
• Key Implications
• Downward sloping firms demand is market demand
• Firm has market power and determines market price
  (can charge P gt MR MC)
• In the short run monopoly earns profit or loss or
  shuts down
• In the long run profit gt normal is sustainable
  indefinitely but even with profit normal 0
  (monopoly does not operate efficiently)

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Sources of Monopoly Power

• Natural
• Economies of scale and excess capacity
• Economies of scope and cost complementarities
• Capital requirements, sales and distribution
  networks
• Differentiated products and brand loyalty
• Created
• Patents and other legal barriers (licenses)
• Tying and exclusive contracts
• Collusion (tacit or open)
• Entry limit pricing (predatory pricing illegal)

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Natural Monopoly
Economies of scale exist over the entire LAC
curve.One firm distributes 4 million kWh at 5
a kWh.This same total output costs 10 a kWh
with two and 15 a kWh with four firms.Natural
monopoly one firm meets the market demand at a
lower cost than two or more firms.Public
utility commission ensures that P LAC (not P
associated with MR MC), eliminating monopoly
rent.
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Price (cents per kilowatt-hour)
10
5
LAC
DP
0
1
2
3
4
Quantity (millions of kilowatt-hours)
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Perfect Competition
Price
S MC gt min AVC
PPC
D P MR
0
Quantity
QPC
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Inefficiency of Monopoly
Price
S MC gt min AVC
PM
PPC
D P
MR
0
QM
QPC
Quantity
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Monopoly in the Long Run with Greater than
Normal and Normal Profit

• Socially inefficient P gt MR MC (QMltQPC,
  PMgtPPC, dead weight loss)
• Scale inefficient P gt MC min AC (economies
  of scale still exist)
• Misallocated resources even when T? normal
  ? 0, P is still gt min AC (because of market
  power or barriers to entry opportunity cost lt
  TR)
• Encouraged RD, benefits from natural
  monopolies, economies of scope and cost
  complementarity might offset inefficiencies

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Synthesizing Example
C(Q) 125 4Q2 gt MC 8Q is unaffected by
market structure. What are profit maximizing
output price, and their implications if

• You are a price taker, other firms charge 40
  per unit?
• P MR 40 8Q MC gt Q 5 and
  P 40
• Max T? TR - C(Q) 40(5) -
  (1254(5)2)
• 200 - 225 -25
• Expect exit in the long-run

• You are a monopolist with inverse demand P 100
  Q?
• MR 100 - 2Q 8Q MC gt Q 10 and
• P 100 - Q 100 - 10 90
• Max T? TR - C(Q) 90(10) -
  (1254(100)) 900 - 525 375
• No entry until barriers eliminated