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Chapter 8
Perfect competition and pure
monopoly
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
9th Edition, McGraw-Hill, 2008
PowerPoint presentation by Alex Tackie and Damian Ward
©The McGraw-Hill Companies, 2008
Perfect competition
Characteristics of a perfectly competitive market
• many buyers and sellers
– so no individual believes that their own
action can affect market price
• firms take price as given
– so face a horizontal demand curve
• the product is homogeneous
• perfect customer information
• free entry and exit of firms
©The McGraw-Hill Companies, 2008
The supply curve under perfect
competition (1)
£
SMC
C
P3
P1
SATC
SAVC
A
Q1 Q3
• Above price P3 (point C),
the firm makes profit
above the opportunity
cost of capital in the
short run
• At price P3, (point C), the
firm makes NORMAL
PROFITS
Output
©The McGraw-Hill Companies, 2008
The supply curve under perfect
competition (2)
£
SMC
C
P3
P1
SATC
SAVC
A
Q1 Q3
• Between P1 and P3, (A
and C), the firm makes
short-run losses, but
remains in the market
• Below P1 (the SHUTDOWN PRICE), the
firm fails to cover
SAVC, and exits
Output
©The McGraw-Hill Companies, 2008
The supply curve under perfect
competition (3)
£
SMC
C
P3
P1
SATC
SAVC
A
Q1 Q3
• So the SMC curve above
SAVC represents the
firm’s SHORT-RUN
SUPPLY CURVE
– showing how much
the firm would
produce at each price
level.
Output
©The McGraw-Hill Companies, 2008
The firm and the industry in the short run under
perfect competition (1)
Firm
INDUSTRY
SMC
£
£
SRSS
SAC
P
D=MR=AR
P
D
Output
Q
Output
Market price is set at industry level at the intersection of
demand and supply
– the industry supply curve is the sum of the individual firm’s
supply curves
©The McGraw-Hill Companies, 2008
The firm and the industry in the short run under
perfect competition (2)
Firm
INDUSTRY
SMC
£
£
SRSS
SAC
P
D=MR=AR
P
D
q
Output
Q
Output
The firm accepts price as given at P
– and chooses output at q where SMC=MR to maximise profits
©The McGraw-Hill Companies, 2008
The firm and the industry in the short run under
perfect competition (3)
Firm
INDUSTRY
£
£
SMC
SRSS
SRSS1
SAC
P
P
D=MR=AR P
1
D
q
Output
Q Q1
Output
At this price, profits are shown by the shaded area.
These profits attract new entrants into the industry.
As more firms join the market, the industry supply curve shifts
to the right, and market price falls.
©The McGraw-Hill Companies, 2008
Long-run equilibrium
Firm
£
P*
INDUSTRY
LMC
LAC £
D=MR=AR
SRSS
LRSS
P*
D
Q
q*
Output
Output
The market settles in long-run equilibrium when the typical
firm just makes normal profit by setting LMC=MR at the minimum
point of LAC. Long-run industry supply is horizontal.
If the expansion of the industry pushes up input prices (e.g. wages)
the long-run supply curve will not be horizontal, but upward-sloping.
©The McGraw-Hill Companies, 2008
Adjustment to an increase in market demand:
the short run
£
D
D'
Suppose a perfectly
competitive market starts
in equilibrium at P0Q0.
SRSS
If market demand shifts to
D'D' ...
P1
in the short run the new
equilibrium is P1Q1 ...
P0
D
Q0 Q1
D'
– adjustment is through
expansion of individual
firms along their SMCs.
Output
©The McGraw-Hill Companies, 2008
Adjustment to an increase in market demand:
the long run
£
D
D'
SRSS
P1
P2
P0
LRSS
D
Q0 Q1 Q 2
D'
In the long run, new firms
are attracted by the profits
now being made here
– and firms are able to
adjust their input of fixed
factors
If wages are bid up by this
expansion, the long-run
supply schedule is upwardsloping
– and the market finally
settles at P2Q2.
Output
©The McGraw-Hill Companies, 2008
Monopoly
• A monopolist:
– is the sole supplier of an industry’s
product
• and the only potential supplier
– is protected by some form of barrier to
entry
– faces the market demand curve directly
– Unlike under perfect competition, MR is
always below AR.
©The McGraw-Hill Companies, 2008
WHY MONOPOLIES ARISE
• Barriers to entry have three sources:
– Ownership of a key resource.
– The government gives a single firm the
exclusive right to produce some good.
– Costs of production make a single
producer more efficient than a large
number of producers.
©The McGraw-Hill Companies, 2008
Profit maximisation by a
monopolist
£
MC
AC
P1
MR
MC=MR
Q1
D = AR
Profits are maximised
where MC = MR at Q1P1.
In this position, AR is
greater than AC
so the firm makes
profits above the
opportunity cost of
capital shown by the
shaded area.
Entry barriers prevent
new firms joining the
industry.
Output
©The McGraw-Hill Companies, 2008
Comparing monopoly with perfect competition
(1)
Suppose a competitive industry is taken over by a monopolist:
SRSS = SMC Competitive equilibrium
is at A, with output Q1
and price P1.
£
P2
To the monopolist, LRSS
is the LMC curve, and
SRSS is the SMC curve.
A
P1
MR
Q2
Q1
D
Output
The monopolist
maximises profits in the
short run at MR = SMC
at P2Q2.
©The McGraw-Hill Companies, 2008
Comparing monopoly with perfect
competition (2)
• So we see that monopoly compared
with perfect competition implies:
– higher price
– lower output
• Does the consumer always lose from
monopoly?
– Among other things, this depends on
whether the monopolist faces the same cost
structure
– there may be the possibility of economies of
scale.
©The McGraw-Hill Companies, 2008
A natural monopoly
• This firm enjoys
substantial economies of
scale relative to market
demand
£
• LAC declines right up to
market demand
P1
LMC
LAC
MR
Q1
D
Output
• the largest firm always
enjoys cost leadership
• and comes to dominate
the industry
• It is a NATURAL
MONOPOLY.
©The McGraw-Hill Companies, 2008
Discriminating monopoly
• Suppose a monopolist supplies two
separate groups of customers
– with differing elasticities of demand
– e.g. business travellers may be less
sensitive to air fare levels than tourists.
• The monopolist may increase profits by
charging higher prices to the
businessmen than to tourists.
• Discrimination is more likely to be
possible for goods that cannot be resold
– e.g. dental treatment.
©The McGraw-Hill Companies, 2008
Monopoly and Perfect
Competition (Summary)
• Monopoly versus Competition
– Monopoly
• Is the sole producer
• Faces a downward-sloping demand curve
• Is a price maker
• Make supernormal profits. P>MC
– Competitive Firm
• Is one of many producers
• Faces a horizontal demand curve
• Is a price taker
• Make zero (normal) profits. P=MC
©The McGraw-Hill Companies, 2008