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Profit Maximisation under
Perfect Competition
and Monopoly
Alternative Market Structures
• Classifying markets (by degree of
competition)
– number of firms
– freedom of entry to industry
• free, restricted or blocked?
– nature of product
• homogeneous or differentiated?
– nature of demand curve
• degree of control the firm has over price
Alternative Market Structures
• The four market structures
– perfect competition
– monopoly
– monopolistic competition
– oligopoly
Features of the four market structures
Type of
market
Number
of firms
Freedom of
entry
Nature of
product
Examples
Implications for
demand curve
faced by firm
Perfect
competition
Very
many
Unrestricted
Homogeneous
(undifferentiated)
Cabbages, carrots
(approximately)
Horizontal:
firm is a price taker
Monopolistic
competition
Many /
several
Unrestricted
Differentiated
Builders,
restaurants
Downward sloping,
but relatively elastic
Undifferentiated
Cement
or differentiated
cars, electrical
appliances
Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)
Oligopoly
Monopoly
Few
One
Restricted
Restricted or
completely
blocked
Unique
Local water
company, train
operators (over
particular routes)
Downward sloping:
more inelastic than
oligopoly. Firm has
considerable
control over price
Features of the four market structures
Type of
market
Number
of firms
Freedom of
entry
Nature of
product
Examples
Implications for
demand curve
faced by firm
Perfect
competition
Very
many
Unrestricted
Homogeneous
(undifferentiated)
Cabbages, carrots
(approximately)
Horizontal:
firm is a price taker
Monopolistic
competition
Many /
several
Unrestricted
Differentiated
Builders,
restaurants
Downward sloping,
but relatively elastic
Undifferentiated
Cement
or differentiated
cars, electrical
appliances
Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)
Oligopoly
Monopoly
Few
One
Restricted
Restricted or
completely
blocked
Unique
Local water
company, train
operators (over
particular routes)
Downward sloping:
more inelastic than
oligopoly. Firm has
considerable
control over price
Features of the four market structures
Type of
market
Number
of firms
Freedom of
entry
Nature of
product
Examples
Implications for
demand curve
faced by firm
Perfect
competition
Very
many
Unrestricted
Homogeneous
(undifferentiated)
Cabbages, carrots
(approximately)
Horizontal:
firm is a price taker
Monopolistic
competition
Many /
several
Unrestricted
Differentiated
Builders,
restaurants
Downward sloping,
but relatively elastic
Undifferentiated
Cement
or differentiated
cars, electrical
appliances
Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)
Oligopoly
Monopoly
Few
One
Restricted
Restricted or
completely
blocked
Unique
Local water
company, train
operators (over
particular routes)
Downward sloping:
more inelastic than
oligopoly. Firm has
considerable
control over price
Features of the four market structures
Type of
market
Number
of firms
Freedom of
entry
Nature of
product
Examples
Implications for
demand curve
faced by firm
Perfect
competition
Very
many
Unrestricted
Homogeneous
(undifferentiated)
Cabbages, carrots
(approximately)
Horizontal:
firm is a price taker
Monopolistic
competition
Many /
several
Unrestricted
Differentiated
Builders,
restaurants
Downward sloping,
but relatively elastic
Undifferentiated
Cement
or differentiated
cars, electrical
appliances
Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)
Oligopoly
Monopoly
Few
One
Restricted
Restricted or
completely
blocked
Unique
Local water
company, train
operators (over
particular routes)
Downward sloping:
more inelastic than
oligopoly. Firm has
considerable
control over price
Features of the four market structures
Type of
market
Number
of firms
Freedom of
entry
Nature of
product
Examples
Implications for
demand curve
faced by firm
Perfect
competition
Very
many
Unrestricted
Homogeneous
(undifferentiated)
Cabbages, carrots
(approximately)
Horizontal:
firm is a price taker
Monopolistic
competition
Many /
several
Unrestricted
Differentiated
Builders,
restaurants
Downward sloping,
but relatively elastic
Undifferentiated
Cement
or differentiated
cars, electrical
appliances
Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)
Oligopoly
Monopoly
Few
One
Restricted
Restricted or
completely
blocked
Unique
Local water
company, train
operators (over
particular routes)
Downward sloping:
more inelastic than
oligopoly. Firm has
considerable
control over price
Features of the four market structures
Type of
market
Number
of firms
Freedom of
entry
Nature of
product
Examples
Implications for
demand curve
faced by firm
Perfect
competition
Very
many
Unrestricted
Homogeneous
(undifferentiated)
Cabbages, carrots
(approximately)
Horizontal:
firm is a price taker
Monopolistic
competition
Many /
several
Unrestricted
Differentiated
Builders,
restaurants
Downward sloping,
but relatively elastic
Undifferentiated
Cement
or differentiated
cars, electrical
appliances
Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)
Oligopoly
Monopoly
Few
One
Restricted
Restricted or
completely
blocked
Unique
Local water
company, train
operators (over
particular routes)
Downward sloping:
more inelastic than
oligopoly. Firm has
considerable
control over price
Alternative Market Structures
• The four market structures
– perfect competition
– monopoly
– monopolistic competition
– oligopoly
• Structure  conduct  performance
Perfect Competition
• Assumptions
– firms are price takers
– freedom of entry of firms to industry
– identical products
– perfect knowledge
• Distinction between short and long run
– normal profits
– supernormal profits
Perfect Competition
• Short-run equilibrium of the firm
– Price
• given by market demand and supply
– Output
• where P = MC
– Profit
• (AR – AC) × Q
• possible supernormal profits
Short-run equilibrium of industry and firm under perfect
competition
P
£
MC
S
Pe
D = AR
= MR
AR
AC
D
O
O
Q (millions)
(a) Industry
AC
Qe
Q (thousands)
(b) Firm
Loss minimising under perfect competition
P
£
AC
P1
AC
MC
S
D1 = AR1
AR1
= MR1
D
O
O
Q (millions)
(a) Industry
Qe
Q (thousands)
(b) Firm
Short-run shut-down point
P
£
S
AC
MC
AVC
P2
D2 = AR2
AR2
= MR2
D2
O
O
Q (millions)
(a) Industry
Q (thousands)
(b) Firm
Perfect Competition
• Short-run equilibrium of the firm (cont.)
– short-run supply curve of firm
• the MC curve
• Short-run supply curve of industry
– sum of supply curves of firms
Perfect Competition
• The long run
– long-run equilibrium of the firm
• all supernormal profits competed away
Long-run equilibrium under perfect competition
Profits return
Supernormal
New firms enter
to normalprofits
P
£
S1
Se
LRAC
P1
AR1
D1
PL
ARL
DL
D
O
O
Q (millions)
(a) Industry
QL
Q (thousands)
(b) Firm
Perfect Competition
• The long run
– long-run equilibrium of the firm
• all supernormal profits competed away
• LRAC = AC = MC = MR = AR
Long-run equilibrium of the firm under perfect competition
£
(SR)MC
(SR)AC
LRAC
DL
AR = MR
LRAC = (SR)AC = (SR)MC = MR = AR
O
Q
Perfect Competition
• The long run
– long-run equilibrium of the firm
• all supernormal profits competed away
• LRAC = AC = MC = MR = AR
– long-run industry supply curve
Perfect Competition
• The long run
– long-run equilibrium of the firm
• all supernormal profits competed away
• LRAC = AC = MC = MR = AR
– long-run industry supply curve
– incompatibility of economies of scale with
perfect competition
Perfect Competition
• The long run
– long-run equilibrium of the firm
• all supernormal profits competed away
• LRAC = AC = MC = MR = AR
– long-run industry supply curve
– incompatibility of economies of scale with
perfect competition
• Does the firm benefit from operating
under perfect competition?
Monopoly
• Defining monopoly
– importance of market power
– concentration ratios
Concentration ratios in the UK
Industry
5-firm ratio
Industry
5-firm ratio
Chilled Indian ready meals
89.3
Bottled water (still)
58.0
Frozen Indian ready meals
75.0
Bottled water (sparkling)
35.0
Record companies
73.9
Frozen foods
34.4
Batteries
70.9
Skin care products
64.4
Jeans retail
39.0
Chocolate manufactures
76.0
Book publishing
37.6
Breakfast cereals
69.0
3-firm ratio
Monopoly
• Barriers to entry
– economies of scale
– product differentiation and brand loyalty
– lower costs for an established firm
– ownership/control of key factors or outlets
– legal protection
– mergers and takeovers
– aggressive tactics
Monopoly
• The monopolist's demand curve
– downward sloping
– MR below AR
AR and MR curves for a monopoly
Q P =AR
(units) (£)
8
1
7
2
6
3
5
4
4
5
3
6
2
7
8
AR, MR (£)
6
4
2
AR
0
1
-2
-4
2
3
4
5
6
7
Quantity
AR and MR curves for a monopoly
Q P =AR
(units) (£)
8
1
7
2
6
3
5
4
4
5
3
6
2
7
8
AR, MR (£)
6
4
2
TR MR
(£) (£)
8
6
14
4
18
2
20
0
20
-2
18
-4
14
AR
0
1
2
3
4
5
6
7
-2
-4
MR
Quantity
Monopoly
• Equilibrium price and output
– MC = MR
Profit maximising under monopoly
£
MC
MR
O
Qm
Q
Monopoly
• Equilibrium price and output
– MC = MR
– measuring level of supernormal profit
Profit maximising under monopoly
£
MC
MR
O
Qm
Q
Profit maximising under monopoly
£
MC
AC
AR
AC
AR
MR
O
Qm
Q
Profit maximising under monopoly
£
MC
Total profit
AC
AR
AC
AR
MR
O
Qm
Q
Monopoly
• Equilibrium price and output
– MC = MR
– measuring level of supernormal profit
• Monopoly versus perfect competition
Monopoly
• Equilibrium price and output
– MC = MR
– measuring level of supernormal profit
• Monopoly versus perfect competition
– lower output at a higher price
Equilibrium of industry under perfect competition and
monopoly: with the same MC curve
£
MC
Monopoly
P1
AR = D
MR
O
Q1
Q
Equilibrium of industry under perfect competition and
monopoly: with the same MC curve
£
MC ( = supply under
perfect competition)
Comparison with
Perfect competition
P1
P2
AR = D
MR
O
Q1
Q2
Q
Monopoly
• Equilibrium price and output
– MC = MR
– measuring level of supernormal profit
• Monopoly versus perfect competition
– lower output at a higher price
• short run and long run
Monopoly
• Equilibrium price and output
– MC = MR
– measuring level of supernormal profit
• Monopoly versus perfect competition
– lower output at a higher price
• short run and long run
– costs under monopoly
Equilibrium of industry under perfect competition and
monopoly: with different MC curves
£
MCmonopoly
P1
AR = D
MR
O
Q1
Q
Equilibrium of industry under perfect competition and
monopoly: with different MC curves
£
MC ( = supply)perfect competition
MCmonopoly
P2
P1
x
P3
AR = D
MR
O
Q2
Q1
Q3
Q
Monopoly
• Equilibrium price and output
– MC = MR
– measuring level of supernormal profit
• Monopoly versus perfect competition
– lower output at a higher price
• short run and long run
– costs under monopoly
– innovation and new products
Contestable Markets
• Importance of potential competition
– low entry costs
– low exit costs
• Perfectly contestable markets
• Contestable markets & natural
monopolies
• The importance of costless exit
– absence of sunk costs
– hit-and-run competition
• Assessment of the theory