Perfect Competition & Monopoly PDF

VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Pe r f e c t C o m p e t i t i o n & M o n o p o l y Perfect Competition Reading: Parkin Ch.12 Key Issues: Profit Maximisation under perfect competition (Perfect Competition: Characteristics; How it...

VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Pe r f e c t C o m p e t i t i o n & M o n o p o l y Perfect Competition Reading: Parkin Ch.12 Key Issues: Profit Maximisation under perfect competition (Perfect Competition: Characteristics; How it arises; Price takers; Demand & Revenue & the firm’s output decisions) Short & Long-run equilibrium under perfect competition (The profit-maximising rule: revenue cost analysis; Output, price & profit in the short run as well as long run; The firm’s shutdown point and supply curve; Effects of a change in demand as technology changes & Efficiency in perfect competition) What Is Perfect Competition? Perfect competition is a market in which: Many firms sell identical products to many buyers There are no restrictions on entry into or exit from the market Established firms have no advantage over new ones Sellers and buyers are well informed about prices How Perfect Competition Arises Perfect competition arises if the minimum efficient scale of a single producer is small relative to the market demand for the good/service Price Takers A price taker is a firm that cannot influence the market price because its production is an insignificant part of the total market Economic Profit and Revenue A firm’s total revenue equals the price of its output multiplied by the number of units of output sold Marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold Demand – Revenue in Perfect Competition Note: Market/Industry: Downward sloping Demand Curve Firm: Horizontal Demand Curve (Perfectly elastic) Total Revenue: P x Q Page 1 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 A Firm’s goal is to maximise Economic Profit. To achieve its goal, a firm must decide on the following key decisions: √ How to produce (at minimum cost)? √ What quantity to produce? √ Whether to enter or exit a market? Maximising Profit: Firm’s Output Decisions TR – TC analysis & MR-MC analysis From the firm’s cost curves and revenue curves, we can find the output that maximises the firm’s economic profit. Page 2 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Marginal Analysis and the Output Decision Marginal analysis compares marginal revenue (MR) with marginal cost (MC). If marginal revenue exceeds marginal cost (MR > MC), then the revenue from selling one more unit exceeds the cost of producing it and an increase in output increases economic profit. If marginal revenue is less than marginal cost (MR < MC), then the revenue from selling one more unit is less than the cost of producing that unit and a decrease in output increases economic profit. Profit Maximisation output: MR=MC. Page 3 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Shut-Down & Supply Curve: The Firm’s Shutdown The firm will temporarily shut down in the short run when price falls below the shutdown point The shutdown point occurs at the price and the quantity at which average variable cost (AVC) is a minimum The Firm’s Supply Curve A perfectly competitive firm’s supply curve shows how its profit-maximising output varies as the market price varies, other things remaining the same The firm maximises profit by producing the output at which marginal cost equals marginal revenue, so the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero. Page 4 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Output, Price & Profit : Three Possible Short-Run Equilibrium Outcomes Note:  In the short run, even though firms attempt to maximize profit, they may end up breaking even or incurring an economic loss.  If the price exceeds the ATC, the firm makes an economic profit (as illustrated in figure b).  If the price equals the ATC, the firm “breaks even” by making zero economic profit. In this case, the entrepreneur makes a normal profit (as illustrated in figure a).  If the price is less than the ATC, the firm incurs an economic loss (as illustrated in figure c). Page 5 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Ouput, Price & Profit : Long-Run Equilibrium Outcome Note: When economic profit and economic loss have been eliminated and entry (new firms coming into the market and the number of firms increases) and exit (existing firms leave and the number of firms decreases) have stopped, a competitive market is in long-run equilibrium. Long-run equilibrium in a competitive market occurs there is zero economic profit/ a firm break even. Change in Demand as Technology changes Change in Demand: Decrease in demand  If demand decreases, the price falls and economic losses are created. Firms exit the market, which raises the price and decreases the remaining firms’ economic losses. Eventually the price rises so that the surviving firms break even /make zero economic profit. Also the number of firms Is less than before the decrease in demand. Page 6 - 11 VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Competition and Efficiency Resources are used efficiently, at the competitive equilibrium, the marginal social benefit (MSB) equals the marginal social cost (MSC). This equality is the condition for allocative efficiency. So in equilibrium, a competitive market achieves allocative efficiency. Resource use is efficient at the equilibrium quantity of Q* and total surplus (sum of Consumer surplus & producer surplus) is maximized. Page 7 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 M o n o p o l y & Pe r f e c t C o m p e t i t i o n Monopoly Reading: Parkin Ch.13 & Ch.12 Key Issues: Singe-Price Monopoly (Monopoly: Characteristics; Barriers to entry; Natural Monopoly; Price & revenue; Price elasticity of demand in monopoly) Monopoly in equilibrium & monopoly comparison with perfect competition (Monopoly’s equilibrium price and output decision ; Single-price monopoly and competition efficiency compared) What Is a Monopoly? A monopoly is a market with a single firm that produces a good or service for which no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or service. Note: a key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output, whereas a competitive firm is a price taker a monopoly firm is a price maker. How Monopoly Arises Two key Features:  No Close Substitutes:There are no close substitutes for the good or service.  Barriers to Entry: A constraint that protects a firm from potential competition is called a barrier to entry. There are three types of entry barriers:  Natural barriers to entry create a natural monopoly, which is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost (one firm can supply the entire market at a lower cost than two or more firms can). Also in a natural monopoly the firm’s LRAC curve falls throughout the relevant range of production.  An ownership barrier to entry, occurs if one firm owns a significant portion of a key resource.  Legal barriers to entry, creates a legal monopoly, which is a market in which competition and entry are restricted by the granting of a public franchise, government license, patent or a copyright. Monopoly Price-Setting Strategies  A single-price monopoly is a firm that sells 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. Page 8 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 A Single-Price Monopoly’s Output and Price Decision Demand, Price and Marginal Revenue Because in a monopoly there is only one firm, the demand curve facing the firm is the market demand curve (downward sloping). Total revenue (TR) is the price (P) multiplied by the quantity sold (Q). Marginal revenue (MR) is the change in total revenue resulting from a one-unit increase in the quantity sold. The table shows the calculation of TR and MR. Quantity Total Marginal Note: A key feature of a single-price Price demanded revenue revenue monopoly is that MR < P at each R4 0 R0 quantity so the MR curve lies below the R3 demand curve. R3 20 R60 R1 R2 40 R80 -R1 R1 60 R60 Figure :Monopoly  To maximize its profit, a monopoly produces the level of output where MR = MC.  In the figure, the firm produces 3 units of output and sets a price of R140 per unit.  The firm makes an economic profit since P > ATC. Note: The monopoly can make an economic profit even in the long run because the barriers to entry protect the firm from competition. Page 9 - 11  VT Lecture Notes: Part 4 Economics 101 Semester 1 2022 Marginal Revenue and Elasticity A single-price monopoly’s marginal revenue is related to the elasticity of demand for its good. The demand for a good can be elastic (the elasticity is greater than 1), inelastic (the elasticity is less than 1), or unit elastic (the elasticity is equal to 1). Note: If demand is elastic, the MR is positive. If demand is unit elastic (as it is at the midpoint), the MR equals zero. If demand is inelastic, the MR is negative. Note: A profit-maximising monopolist would only produce in the elastic region and never produce an output in the inelastic range of the demand curve. Single-Price Monopoly and Competition Compared Comparing Price and Output The market demand curve is D. The market supply curve is S. In the figure, the competitive equilibrium quantity is Qc and the competitive equilibrium price is Pc. In the figure, the monopoly produces Qm output and sets its price at Pm. Compared to a perfectly competitive market, a single-price monopoly produces a smaller output and charges a higher price. Page 10 -  VT Lecture Notes: Part 4 Economics 101 Semester 1 2022 The Inefficiency – Monopoly Monopoly charges a price above marginal cost. The quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer). Efficiency Comparison (Perfect Competition & Monopoly) Perfect competition is efficient: produces the efficient quantity of output, where marginal social benefit (MSB) = marginal social cost (MSC); total surplus is maximised; firms produce at the lowest possible long-run average cost; and resource use is efficient. A monopoly is inefficient : produces a smaller output than perfect competition and faces no competition, so it does not produce at the lowest possible long-run average cost As a result, monopoly can damage consumer interest (producing less/increasing the cost of production/raising the price by more than the increased cost of production). Page 11 -  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Monopolistic Competition & Oligopoly Monopolistic Competition Reading: Parkin Ch.14 Key Issues: Monopolistic competition: Key characteristics; Product differentiation; Demand & Revenue) Equilibrium in monopolistic competition: (Equilibrium of the firm – Short Run & Long Run; Mark-up pricing & excess capacity & efficiency of monopolistic competition) What Is Monopolistic Competition? Monopolistic competition is a market structure in which:  A large number of firms compete  Each firm produces a differentiated product (each firm makes a product that is slightly different from the products of competing firms)  Firms compete on product quality, price, and marketing  Firms are free to enter and exit Demand – MR: Demand Curve:  The demand curve for a monopolistically competitive firm is downward sloping (similar to the demand curve for a monopoly), indicating that the firm has a degree of market power. The market power derives from product differentiation, since each firm provides different product or service. Marginal Revenue Curve:  The firm’s marginal revenue curve also is downward sloping and lies below the demand curve (similar to monopoly). Maximising Profit: Price and Output Decisions – S/R & L/R Profit Maximization & Price setting: The firm maximizes its economic profit producing the quantity where MR=MC & using the demand curve to set the price at which people will buy the quantity it produces. In the short run, a firm in monopolistic competition makes its output and price decisions like a monopoly firm. In the long run, unlike a monopoly, firms in monopolistic competition earn zero economic profit. Short run & Long run – Monopolistic Competition (Refer :Figure 14.1 – 14.3) Page 1 - 8  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Note: Profit Max Qty? Price? Economic Profit? The firm earns an economic profit (P > ATC). Page 2 - 8  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Note: Profit Max Qty? Price? Economic Profit? The firm earns zero economic profit / a normal profit (P = ATC). Page 3 - 8  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Monopolistic Competition and Perfect Competition Unlike firms in perfect competition, firms in monopolistic competition have excess capacity and a markup.  Excess Capacity: A firm has excess capacity if it produces below its efficient scale, which is the quantity at which average total cost is a minimum.  Markup: A firm’s markup is the amount by which its price exceeds its marginal cost. Monopolistic Competition: Advertising A firm with a differentiated product as in the case in monopolistic competition needs to ensure that buyers know how its product is different from the competition. Firms use advertising and packaging to achieve this goal. Firms in monopolistic competition in advertising incur large costs to ensure that buyers appreciate and value the differences between their own products and those of their competitors. Advertising expenditures can affect the profits of firms in two ways: Costs (increase) & Demand (change). Advertising costs per unit decrease: as the quantity produced increases / increasing the quantity bought/sold can lower ATC. Is Monopolistic Competition Efficient?  Firms in monopolistic competition have higher costs than firms in perfect competition, but firms in monopolistic competition produce variety, which is valued by consumers. So compared to the alternative of complete uniformity, monopolistic competition might be efficient! Page 4 - 8  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Oligopoly Oligopoly Reading: Parkin Ch.15 Key Issues: Oligopoly: (Characteristics; Cartel, duopoly & Collusion) Oligopoly: (Games theory & Kinked Demand model) What Is Oligopoly? The firms in oligopoly might produce an identical product and compete only on price, or they might produce a differentiated product and compete on price, product quality, and marketing. Key Characteristics: Oligopoly is a market structure in which: Natural or legal barriers prevent the entry of new firms A small number of firms compete (a duopoly if only two firms in the market) Barriers to Entry Natural barrier that can create a natural monopoly or legal barriers to entry can create oligopoly (similar to Monopoly). Small Number of Firms Because barriers to entry exist, oligopoly consists of a small number of firms, each of which has a large share of the market Such firms are interdependent, and they face a temptation to cooperate/collude to increase their joint economic profit Interdependence With a small number of firms in a market, each firm’s actions influence the profits of all the other firms Temptation to Cooperate When a small number of firms share a market, they can increase their profits by forming a cartel and acting like a monopoly A cartel is a group of firms acting together – colluding – to limit output, raise price, and increase economic profit Page 5 - 8  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Colluding to increase Profits To maximize industry profit, the firms (duopoly) agree to restrict output to the rate that makes the industry marginal cost and marginal revenue equal. In Fig (b): Output rate is units a week. Collusion: To split the market equally. In Fig (a) each producing units a week & selling at price R per unit.  Economic profit each firm: R. With the two firms colluding to produce the monopoly profit-maximizing output and divide that output equally between them. From the industry point of view, this solution is identical to a monopoly. A duopoly that operates in this way is indistinguishable from a monopoly. Page 6 - 8  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Oligopoly Games – Oligopolistic Behavior Game Theory  Game theory: tool for studying strategic behavior.  Games: rules, strategies, payoffs, and outcomes.  The Prisoner’s Dilemma captures many of the essential features of games and gives a good illustration of how game theory works and generates predictions. Prisoner’s Dilemma?  In the prisoner’s dilemma, the rules specify that each prisoner must choose whether to confess without conferring with his accomplice.  Strategies are all the possible actions of each player.  The game’s payoff matrix shows the payoffs for every possible action by each player. In it are the payoffs from each prisoner’s strategies, which are to confess or deny involvement.  The choices of both players determine the outcome of the game. A Duopoly Price-Fixing Game  Two firms, A and B. The firms could enter into a collusive A’s strategies Cheat Comply agreement to jointly boost their price and decrease their output. $0 $1 million Once the agreement is made, Cheat each firm must select its strategy: cheat /comply with the agreement. B’s $0 $5 million strategies  Dominant Strategy / Nash $5 million $3 million equilibrium? Comply $1 million $3 million Page 7 - 8  VT Lecture Notes: Part 4 Economics 101 Semester 1 2023 Kinked Demand Curve Model One example of a kinked demand curve is the model for an oligopoly. This model of oligopoly suggests that prices are rigid and that firms will face different effects for increasing price or decreasing price. Figure Key Points: The kinked demand curve has different elasticity for higher and lower prices: The upper segment of the demand curve is elastic The lower segment of the demand curve is relatively inelastic Note: Two key Assumptions & Behaviour: (1) If a firm lowers the price below the prevailing level, then the competitors will follow. (2) If a firm increases the price above the prevailing level, then the competitors will not follow. Page 8 - 8