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What Is A Competitive Market?
A perfectly competitive market has
the following characteristics:
There are many buyers and sellers in
the market.
2) The goods offered by the various
sellers are the same (identical).
3) Firms can freely enter or exit the
market.
4) Information is perfect. Buyers and
sellers know all prices offered,...
1)
What Is A Competitive Market?
As a result of these characteristics,
the perfectly competitive market has
the following outcomes:
The actions of any single buyer or seller
in the market have no impact on the
market price.
Each buyer and seller takes the market
price as given.
Ex: Gasoline, fish, eggs, pencils, tomatoes,
etc.
What Is A Competitive Market?
Buyers and sellers must accept the
price determined by the market. No
single seller has market power (the
power to influence the market
price).
“Demand Faced By A Competitive
Firm” versus “Market Demand”
Price
Price
Pm
QTY
(millions)
QTY
(ones)
Demand faced by
one competitive firm
Market Demand
The Revenue of a Competitive
Firm
Total revenue for a firm is the market
price times the quantity sold.
TR = P  Q
Table 1 Total, Average, and Marginal Revenue for a
Competitive Firm
Copyright©2004 South-Western
The Revenue of a Competitive Firm
Marginal revenue is the change in
total revenue when an additional unit
is sold.
MR =TR / Q
The Revenue of a Competitive Firm
1. Only in a competitive market, marginal
revenue equals the price of the good. This
is because a firm in a competitive market
can sell as much as it wants at the
constant market price.
2. If a monopolist or oligopolist sells more,
this causes the price of the good to fall.
Ex1: Think of crude oil price and OPEC.
Ex2: Consider a downward sloping
demand curve.
Profit Maximization and The
Competitive Firm’s Supply Curve
The goal of a competitive firm is to
maximize profit.
This means that the firm wants to
produce the quantity that maximizes
the difference between total revenue
and total cost.
Table 2 Profit Maximization: A Numerical Example
Copyright©2004 South-Western
Profit Maximization and The
Competitive Firm’s Supply Curve
Profit maximization occurs at the
quantity where marginal revenue
equals marginal cost.
Profit Maximization And The
Competitive Firm’s Supply Curve
When MR > MC, profit is
increasing, so must produce more.
When MR < MC, profit is
decreasing, so must produce less.
When MR = MC, profit is constant,
so this is the point where profit is
maximized.
Figure 1 Profit Maximization for a Competitive Firm
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
MC
MC2
P = MR1 = MR2
P = AR = MR
MC1
0
Q1
QMAX
Q2
Quantity
Copyright © 2004 South-Western
Figure 2 Marginal Cost as the Competitive Firm’s
Supply Curve
Price
P2
This section of the
firm’s MC curve is
also the firm’s supply
curve.
MC
ATC
P1
AVC
0
Q1
Q2
Quantity
Copyright © 2004 South-Western
The Firm’s Short-Run Decision to
Shut Down
A shutdown refers to a short-run
decision to stop production
temporarily because the firm’s
revenue cannot even cover variable
costs.
Exit refers to a long-run permanent
decision to leave the market. A firm
exits the market if it makes negative
economic profit in the long-term.
The Firm’s Short-term Decision to
Shut Down
The firm ignores its fixed costs (=
sunk costs) when deciding to shut
down or not in the short-term, but
considers them when deciding
whether to exit or not in the long-term.
Fixed costs are costs that have already
been committed and cannot be
recovered in the short-term. example:
rent and lease contracts.
The Firm’s Short-Run Decision to
Shut Down
The firm shuts down if its revenue is
less than its variable costs:
Shut down if
TR < VC
–
Shut down if TR / Q < VC / Q
– Shut down if
P < AVC
Figure 3 The Competitive Firm’s Short Run
Supply Curve
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s short-run
supply curve
MC
ATC
If P > AVC, firm will
continue to produce
in the short run.
AVC
Firm
shuts
down if
P < AVC
0
Quantity
Copyright © 2004 South-Western
The Firm’s Long-Run Decision to
Exit or Enter a Market
In the long run, a firm exits the market
if the profit is negative .
Exit if TR < TC
if TR/Q < TC/Q
if P < ATC
A new firm Enters the market if profit
is positive, or if: P > ATC
Figure 4 The Competitive Firm’s Long-Run
Supply Curve
Costs
Firm’s long-run
supply curve
Firm
enters if
P > ATC
MC = long-run S
ATC
Firm
exits if
P < ATC
0
Quantity
Copyright © 2004 South-Western
THE SUPPLY CURVE IN A
COMPETITIVE MARKET
The competitive firm’s long-run supply
curve is the part of its marginal-cost
curve that lies above average total
cost.
Figure 5 Profit as the Area between Price
and Average Total Cost
(a) A Firm with Profits
Price
MC
ATC
Profit
P
ATC
P = AR = MR
0
Quantity
Q
(profit-maximizing quantity)
Copyright © 2004 South-Western
Figure 5 Profit as the Area between Price and
Average Total Cost
(b) A Firm with Losses
Price
MC
ATC
ATC
P
P = AR = MR
Loss
0
Q
(loss-minimizing quantity)
Quantity
Copyright © 2004 South-Western
FIRM VERSUS MARKET SUPPLY
Market supply equals the sum of the
quantities supplied by all firms in the
market.
The Short Run: Market Supply with
a Fixed Number of Firms
For any given price, each firm
supplies a quantity of output so that
its marginal cost equals price.
The market supply curve adds up the
individual firms’ marginal cost curves.
Figure 6: SR Market Supply with a Fixed
Number of Firms
(a) Individual Firm Supply
(b) Short Run Market Supply
Price
Price
SR
MC
Supply
$2.00
$2.00
1.00
1.00
0
100
200
Quantity (firm)
0
100,000
200,000 Quantity (market)
Copyright © 2004 South-Western
The Long Run: Market Supply with
Entry and Exit
Long run equilibrium is reached when
there are no more entries or exits in
the market.
Firms will enter or exit the market until
profit approaches to zero. Then longrun equilibrium happens when profit
equals zero.Then at the long run
equilibrium, price must be equal to the
minimum of average total cost.
The Long Run: Market Supply with
Entry and Exit
Then long-run market supply curve is
horizontal at price = min(ATC).
At the long-run equilibrium, firms
operate at their efficient scale (scale
that minimizes ATC).
Figure 7 Market Supply with Entry and Exit
(a) Firm’s Zero-Profit Condition
(b) Long Run Market Supply
Price
Price
SR
MC
Supply
ATC
LR
P = minimum
ATC
Supply
Demand, D1
0
Quantity (firm)
0
Quantity (market)
Copyright © 2004 South-Western
Why Do Competitive Firms Stay in
Business If They Make Zero Profit?
Remember that accounting (nominal)
profit is positive even if economic
profit is zero.
The firm making zero economic profit
means the firm is doing the best it can
and there is no other alternative that
will give better profit. If there was,
current economic profit would be
negative. See example in notes.
Exercise: A Shift in Demand and
Short Run and Long Run
Consequences
An increase in demand raises price
and quantity in the short run.
Firms earn profits because price now
exceeds average total cost.
Figure 8 An Increase in Demand in the Short Run
and Long Run
(a) Initial Condition
Market
Firm
Price
Price
MC
ATC
Short-run supply, S1
A
P1
Long-run
supply
P1
Demand, D1
0
Quantity (firm)
0
Q1
Quantity (market)
Figure 8 An Increase in Demand in the Short
Run and Long Run
(b) Short-Run Response
Market
Firm
Price
Price
Profit
MC
ATC
P2
B
P2
S1
A
P1
P1
D2
Long-run
supply
D1
0
Quantity (firm)
0
Q1
Q2
Quantity (market)
Copyright © 2004 South-Western
Figure 8 An Increase in Demand in the Short
Run and Long Run
(c) Long-Run Response
Market
Firm
Price
Price
MC
ATC
B
P2
S1
S2
C
A
P1
Long-run
supply
P1
D2
D1
0
Quantity (firm)
0
Q1
Q2
Q3 Quantity (market)
Copyright © 2004 South-Western
Imperfect Market
Imperfect competition is a market
situation where individual firms have a
measure of control over the price of
the commodity in an industry.
a firm that can affect the market price of
its output can be classified as an
imperfect competitor.
Normally, imperfect competition arises
when an industry's output is supplied
only by one, or a relatively small number
of firms.
Imperfect Market
An imperfect market is a situation where individual
firms have some measure of control or discretion
over the price of the commodity in an industry
This imperfect competition does not necessarily
mean that a firm can arbitrarily put any price on its
commodity
an imperfect competitor does not have absolute
power over price
Aside from discretion over price, imperfect
competitors may or may not have product
differentiation/variation
Demand curve faced by firm
The firm under an imperfect market faces
the market demand curve or part of it.
In either case, the firm faces a downward
sloping demand curve
This implies that if the firm wants to sell more, it
should lower the price; if it wishes a higher
price, he should restrict output.
In contrast, a perfectly competitive firm, since it
has no control over price, faces a horizontal
demand curve.
Sources of market imperfection
Imperfect competition often arises when an
industry’s output is supplied by one or a
small number of firms.
This may be traced to the existence of
barriers to entry and the existence of
significant differences or advantages in
cost conditions.
Barriers to Entry
Barriers to entry – natural or artificial
constraints that prevent other firms
from entering the industry
legal restrictions like patents and
exclusive franchises;
existence of advantages in cost conditions
– demand for commodity may be too
small, firm’s production function may
exhibit increasing returns to scale (LAC
curve shows economies of scale over all
profitable output levels).
P
Price
MC
k
AC
D
Q
0
Quantity
FIGURE 7.2. Marginal cost and average cost curves of a firm in a natural
monopoly relative to market demand. A natural monopoly arises when
increasing returns to scale (decreasing average cost) makes most efficient plant
size (at point k) large relative to market demand. In this case, the market can
only support one firm in the industry. In the region of increasing returns, the
marginal cost lies below the average cost.
Imperfect Markets
Monopoly – market situation where a single seller
exists and has complete control over an industry
e.g., Meralco is sole distributor of electric power in
Metro Manila
Oligopoly – market structure with few sellers;
e.g., cement and automobile industries,
firms operating in an oligopolistic market situation
may either collude or act independently
Monopolistic competition – occurs when there are
many sellers producing differentiated products
firms have slight control over the price of the
commodity and they advertise
The Truth Behind Monopolies
being a monopolist does not ensure the
firm instant profit;
it is not true that the firm can impose any
price it wants; maximum price is dictated
by market demand; and
a monopolist cannot maximize profit at
the inelastic portion of the market
demand curve.
Demand and MR Curves of the Monopolist
Price
P
D
0
Q
MR
Quantity
FIGURE 7.4. Demand and marginal revenue curves faced by the monopolist. In contrast to
perfectly competitive firms, the marginal revenue is lower than, not equal to, the price of the last
unit sold. For the firm to sell one more unit of output, it must not only lower the price of the last
unit but also reduce the price of all previous units. Thus, the additional revenue falls faster than
the price.
Table 7.1. Demand for output, P, TR and MR of a monopolist.
Q
P
TR
MR
0
200
0
-
1
198
198
198
2
196
392
194
3
194
582
190
4
192
768
186
5
190
950
182
6
188
128
178
7
186
1302
174
8
184
1472
170
9
182
1638
166
10
180
1800
162
11
178
1958
158
12
176
2112
154
Price and Marginal Revenue of a
Monopolist
Note that P  MR, unlike pure
competition.
P is also the AR curve, hence as price
drops, MR is less than price
On a linear demand curve, MR
decreases twice as fast as the demand
curve.
Short-run Profit Maximization
Firm will try to produce output that will
maximize profit.
Maximum profit is at the largest vertical
difference between total revenue TR and
total cost TC.
At maximum vertical difference, slopes of
TR and TC are equal, hence, MR=MC.
Firm will produce (at MR=MC) unless price
falls below AVC.
Table 7.2. Profit-maximizing output of a monopolist
Q
P
TR
MR
TC
MC

0
200
0
-
500
-
-500
1
198
198
198
589
89
-391
2
196
392
194
660
71
-268
9
182
1638
166
1168
114
470
10
180
1800
162
1330
162
470
11
178
1958
158
1550
220
408
12
176
2112
154
1850
300
262
13
174
2262
150
2262
412
0
TR, TC
4,500
TC
Total revenue, total cost
4,000
3,500
3,000
TR
2,500
2,000
1,500
1,000
500
Q
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
Quantity
Total revenue and total cost curves of the monopolist. At
output levels equal to 4 and 13, the monopolist breaks even; total cost
equals total revenue. At output levels greater than 4 but less than 13, the
monopolist makes a profit. At Q = 10, the firm maximizes its profits.
FIGURE 7.5.
The profit curve

600
500
400
300
Profits
200
100
0
-100
Q
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
Q*
-200
-300

-400
-500
-600
Quantity
FIGURE 7.6. Profit curve of the monopolist. The monopolist’s profit curve is bellshaped. At output levels less than and greater than the profit-maximizing level, Q*, total
profits of the monopolist show a decline.
Profit Maximization: Per Unit
Curves
Any firm who aims to maximize profit will evaluate
whether it pays to increase output or not.
This is achieved by comparing MR with MC
When added revenue is greater than added
cost(MR>MC), the firm will increase output
When added revenue is less than added
cost(MR<MC), the firm will decrease output to
increase profit.
When MR=MC, the firm has determined the output
that maximizes profit.
Profit is maximum at Q* where MR=MC. Price
will be set at P* as given by the demand curve.
P
MC
AC
P*
Profit
D=AR
0
Q
Q*
MR
Is MC curve the supply curve?
Note: the MC curve of the monopolist
does not reflect the short run supply
curve since the monopolist does not
produce output at the levels where
MC = P
It produces output at MR=MC to
maximize profit. But MR is always
less than P.
Does a monopolist always make a profit?
P
MC
AC
P*
Loss
No!
D=AR
0
Q
Q*
MR
Inefficiency of a monopolist
The price set by monopolist is greater compared
to that under pure competition. Hence some
consumers are unable to purchase the commodity
implying some welfare loss
The level of output under monopoly is lower
compared to that under pure competition.
Consumer surplus
Price
The demand curve shows the
maximum willingness to pay by
consumers.
The price line shows what
consumers have to pay.
Consumer
surplus
P0
D
Q0
Quantity
Producer surplus
Price
The supply curve shows
what firms have to recover
in costs to continue to
produce..
S
The price line shows what
firms receive.
P0
Producer
surplus
D
Q0
Quantity
Deadweight loss in monopoly
P
F
MC
A
Price
P*
E
AC
B
G
C
D
0
Q
Q*
MR
Quantity
FIGURE 7.8. Deadweight loss. The area ABC represents the decline
in total welfare (the reduction in both consumer surplus and producer
surplus) associated with a monopoly. ABC is the deadweight loss.
Regulation of a monopoly
Lump sum tax –is a fixed amount of tax levied on a
producer
The tax increases the firm’s fixed cost but not the variable cost
The firm’s marginal cost is not affected (does not change)
The change in fixed cost however affects total cost and average
cost
Specific tax – is a tax proportional to level of output
produced.
Affects the firm’s variable cost, average cost and marginal cost
Price regulation – a set price imposed by the
government to enhance the welfare of the consumers,
a regulatory body can impose a price equal to MC.
P
MC
ACLST
a
Price (in pesos)
P*
e
h

g
AC
b

f

c
D
0
Q*
Q
MR
Quantity
FIGURE 7.9. Lump sum tax regulation. The imposition of a lump sum tax affects
only the average cost of the firm. It is borne completely by the monopolist and has no
effect at all on the firm’s level of output and price.
P
MCST
Price
MC
PST
P*
a
ACST
b
i
e
c
AC

j
h
f
m
g
k
D
0
QST Q*
Q
MR
Quantity
FIGURE 7.10. Specific tax regulation. The imposition of a specific tax
affects both the average cost and the marginal cost of the firm. As a result,
the monopolist increases the price of the commodity while decreasing the
amount of the output it produces. Thus, the deadweight loss increases.
P
MC
a
Price (in pesos)
P*
PMC
b
c
e
AC
h
f
g
MR
0
Q*
D
Q
QMC
Quantity
FIGURE 7.11. Price regulation. Under price regulation, the optimal levels
of price and output are determined by the intersection of the demand curve
and the marginal cost curve. The deadweight loss is transformed into a net
welfare gain for society.
A Summary of Market Structures
63
Managerial Economics &
Business Strategy
Basic Oligopoly Models
9-65
Oligopoly Environment
Relatively few firms, usually less than 10.
Duopoly - two firms
Triopoly - three firms
The products firms offer can be either
differentiated or homogeneous.
Firms’ decisions impact one another.
Many different strategic variables are
modeled:
Market Structure
The number of firms, price, profits, and other properties of markets
vary, depending on whether the market is monopolistic, oligopolistic,
monopolistically competitive, or competitive
Game Theory
When there are relatively few firms in a market, firms take in to account
how their actions affect other firms and how other firms action affect
them. Economist use a set of tools called game theory to analyze
conflicts and cooperation between them.
Cooperative oligopoly models
If firms successfully coordinate their actions, they can collectively
behave like a oligopoly
The group of firms that explicitly agree to coordinate their activities is
called a Cartel. These firm may agree on how much each firm will
sell or on a common price, by cooperating and behaving like a
monopoly, The members of a Cartel collectively earn monopoly
profit- the maximum possible profit. OPEC is the best example of
Cartel Model
Non-cooperative Oligopoly
How explain Oligopoly if they behave
Independently
Sweezy (Kinked-Demand) Model
Nash equilibrium
Cournot Model
Bertrand Model
Stackelberg Model
Non-cooperative Oligopoly
Your actions affect the profits
of your rivals.
Your rivals’ actions affect
your profits.
How will rivals respond to
your actions?
An Example
You and another firm sell
differentiated products.
How does the quantity demanded for
your product change when you
change your price?
P
D2 (Rival matches your price change)
PH
P0
PL
D1 (Rival holds its
price constant)
QH1 QH2Q0QL2
QL1
Q
“Kinked” Demand Curve
P
Where do p* and q*
come from?
Elastic
p*
Inelastic
D or d
Q* or q*
Q or q
Cournot Model
Market in which firms sets its output simultaneously and let
the market determine the price
Cournet models explain how oligopoly firms behave if they
choose how much to produce at the same time .
Air line example two air lines other cannot obtain landing
rights, both airports . How many passengers does each airline
choose to carry? To answer this question we determine the
Nash equilibrium for this model, the Nash equilibrium in which
firm choose quantities is also called a Cournet equilibrium.
Stackelberg Model
In the Curnet model, both firms make their output decisions at the
same time.
In a Stakelberg model leader firm chooses its output level before its
identical rivals. Market out put is greater than if firms choose their
output simultaneously, and a leader makes higher profit than the
other firm.
Naturally if one firm enter the market before another He get the
more benefit.
Bertrand Model
Bertrand argued that oligopolies set prices, and then consumers
decide how many units to buy. The resulting Nash equilibrium is
called a Bertrand equilibrium.
Four Market Structures
The focus of this lecture is the four market structures. Students will learn the characteristics of pure
competition, pure monopoly, monopolistic competition, and oligopoly. Using the cost schedule from the
previous lecture, the idea of profit maximization is explored.
OBJECTIVES
1. Identify various market structures and their characteristics.
2. Be able to category firms into four market structures.
3. Describe the effects of imperfect competition upon the market and the firm.
4. Understand the pricing structure of the four structures.
TOPICS
Please read all the following topics.
PERFECT COMPETITION
PERFECT COMPETITION CONT.
PERFECT COMPETITION EXAMPLE
PURE MONOPOLY
MONOPOLY EXAMPLE
PRICE DISCRIMINATION
MONOPOLISTIC COMPETITION
OLIGOPOLY
TECHNOLOGICAL DEVELOPMENT
ECONOMIC EFFICIENCY
Perfect Competition
Pure or perfect competition is rare in the real world, but the model is important because it
helps analyze industries with characteristics similar to pure competition. This model provides a
context in which to apply revenue and cost concepts developed in the previous lecture.
Examples of this model are stock market and agricultural industries.
Characteristics
1. Many sellers: there are enough so that a single seller’s decision has no impact on market
price.
2. Homogenous or standardized products: each seller’s product is identical to its competitors’.
3. Firms are price takers: individual firms must accept the market price and can exert no
influence on price.
4. Free entry and exit: no significant barriers prevent firms from entering or leaving the
industry.
Demand
The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is
a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only
appears that way to the individual firms, since they must take the market price no matter what
quantity they produce. Therefore, the firm’s demand curve is a horizontal line at the market
price.
Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in
output. Since the price is constant in the perfect competition. The increase in total revenue
from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect competition.
Profit-Maximizing Output
Short Run Analysis
In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting output. Firms
should produce if the difference between total revenue and total cost is profitable (EP >0), or if the loss is less
than the fixed cost (EP>- FC). The firm should not produce, but should shut down in the short run if its loss
exceeds its fixed costs. By shutting down, its loss will just equal those fixed costs. Fixed cost in real life would be
rent of the office, business license fees, equipment lease, etc. These cost would have to be paid with or without
any output. Therefore, fixed cost would be the loss of shut down at any time. If by producing one unit of output,
this loss could be lowered, then this unit should be produced to minimize the loss. However, if by producing one
unit of output, this loss would be higher , then this unit should not be produced. The firm should shut down, just
pay for the fixed cost.
If EP< - FC firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < - FC, market
price, P, must be lower than the minimum AVC.
If EP> - FC, firm should produce. That is when market price is greater than minimum AVC.
Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output.
If MR > MC, then the firm should continue to produce.
If MR = MC, then the firm should stop producing the additional unit. As the additional unit’s MC would be higher
according to law of diminishing returns, MR would be less than MC; that is, the firm would loss profit by producing
additional units. Therefore, this is the profit maximizing output level.
If MR < MC, then the firm should lower its output.
In conclusion:
The shutdown point is the level of output and price at which the firm just covers its total variable cost. If the MR of
the product is less than the minimum average variable cost (min AVC), the firm will shut down because this action
minimizes the firm’s loss. In this case, the firm’s economic loss equals its total fixed costs. If MR < min AVC, then
each additional unit produced would increase the loss. For pure competition, MR is equal to price as the firm is
facing a perfectly elastic demand. Therefore, for short run, if Price < min AVC, then the firm should shut down. If
Price > min AVC, then the firm should produce. Price and MC are compared to find the profit maximizing or loss
minimizing output level. The supply curve of the pure competition firms would be the portion of the MC curve
above the min AVC.
1. If EP < - FC or Market P < Min AVC, firm should shut down. Output = 0 , and EP = -FC
Perfect Competition Cont.
Following the rules discussed in the previous section. Here is an example.
Firms fixed cost is $100, its min AVC is $55.
If market price is 50 which is less than min AVC, the firm would loss $5 more by producing each unit. If the firm produces
one unit, its total loss would be $5 plus $100 fixed cost. If the firm decides to shut down, its loss would be only $100 as the
firm does not need to pay for the variable cost. Shut down would be the loss minimization strategy.
If the market price is 60, the firm would lose $5 less by producing each unit. If the firm produces one unit, its total cost
would be fixed cost less $5, which is $95. The firm is better off by producing, not shutting down. When the market price is
higher than the minimum AVC, MR and MC should be compared to find out the optimal level of output.
Long Run Analysis
Obviously, the firm cannot be in loss for long. Three assumptions are made for the long run analysis:
1. Entry and exit are the only long run adjustments.
2. Firms in the industry have identical cost curves.
3. The industry is in constant return to scale.
In long run, if economic profits are earned, firms enter the industry, which increases the market supply, causing the product
price to go down. Until zero economic profits are earned, then the supply will be steady. If losses are incurred in the short
run, firms will leave the industry which decreases the market supply, causing the product price to rise until losses disappear.
This model is one of zero economic profits in long run. The long run equilibrium is achieved, the product price will be exactly
equal to, and production will occur at, each firm’s point of minimum average total cost.
Efficiency Analysis
1. Productive efficiency: occurs where P= min ATC. Perfect competitive firms
will achieve productive efficiency as firms must use the least-cost technology
or they won't survive.
2. Allocative efficiency: occurs where P = MC. Price represent the benefit that
society gets from additional units of a product, MC represents the cost to
society of other goods given up to produce this product. Dynamic
adjustments will occur in this market structure when changes in demand,
supply or technology occurs. Perfect competitive firms will achieve this
efficiency. Since no explicit orders are given to the industry, "the Invisible
Hand" works in this system.
Even though both efficiencies are achieved in this system, the consumers are
facing standard products, making shopping to be no fun at all. On the other
hand, the consumers will receive the highest consumer surplus in this structure
as the long run market price will be at the min ATC. Producers will receive the
lowest producer surplus as consumers can easily find substitutes.
An Example
The following data represents a cost function of a perfect
competitive firm:
TP or Q
AFC
AVC
ATC
MC
0
1
60
45
105
45
2
30
42.5
72.5
40
3
20
40
60
35
4
15
37.5
52.5
30
5
12
37
49
35
6
10
37.5
47.5
40
7
8.57
38.57
47.14
45
8
7.5
40.63
48.13
55
9
6.67
43.33
50
65
10
6
46.5
52.5
75
If the market price, P < 37; this firm's output Q = 0;
firm's economic profit, EP = -60
If the market price, P > 37, this firm's output Q > 0;
firms' economic profit , EP= TR - TC.
For example, when P = 65, Q = 9, EP = $65 x 9 - 50 X 9
= 135
An Example Cont.
By given the market demand at various price level, a market equilibrium price could be found.
TP or Q
AFC
AVC
ATC
MC
0
1
60
45
105
45
2
30
42.5
72.5
40
3
20
40
60
35
4
15
37.5
52.5
30
5
12
37
49
35
6
10
37.5
47.5
40
7
8.57
38.57
47.14
45
8
7.5
40.63
48.13
55
9
6.67
43.33
50
65
10
6
46.5
52.5
75
One firm's output level (column 2 in the above table) is
obtained by comparing P and MC. Since all firms are having
the same cost function, the market output level is the sum of
individual firms' output (column 4 in the above table).
By comparing the market supply and market demand, we can
find the market equilibrium at:
P= 46 and Q = 10500
At this level, each firm is losing 8 dollars, indicating a
contraction in this industry. Some firms may leave in the long
run, causing the market supply to decrease and equilibrium
price will increase to the break-even level.
PRICE Qs (1 firm's output) PROFIT Qs(1500 firms in the market) / market supply
Qd / market demand
26
0
-60
0
17000
32
0
-60
0
15000
38
5
-55
7500
13500
41
6
-39
9000
12000
46
7
-8
10500
10500
56
8
63
12000
9500
66
9
144
13500
8000
(assuming identical cost function for all firms)
Pure Monopoly
Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes.
Examples are public utilities and professional sports leagues.
Characteristics
1. A single seller: the firm and industry are synonymous.
2. Unique product: no close substitutes for the firm’s product.
3. The firm is the price maker: the firm has considerable control over the price because it can control the quantity
supplied.
4. Entry or exit is blocked.
Barriers to Entry
Economies of scale is the major barrier. This occurs where the lowest unit cost and, therefore, low unit prices for
consumers depend on the existence of a small number of large firms, or in the case of monopoly, only one firm.
Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in
industries with economies of scale. Public utilities are known as natural monopolies because they have economies
of scale in the extreme case. More than one firm would be inefficient because the maze of pipes or wires that
would result if there were competition among water companies or cable companies. Legal barriers also exist in the
form of patents and licenses, such as radio and TV stations. Ownership or control of essential resources is
another barrier to entry, such as the professional sports leagues that control player contracts and leases on major
city stadiums. It has to be noted that barrier is rarely complete. Think about the telephone companies a couple
decades ago; there was no substitute for the telephone. Nowadays, cellular phones are very popular. It creates a
substitute for your house phone, causing the traditional telephone companies to lose their monopoly position.
Demand Curve
Monopoly demand is the industry or market demand and is therefore downward sloping. Price will exceed
marginal revenue because the monopolist must lower price to boost sales and cannot price discriminate in most
cases. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on
all prior units of output. The marginal revenue curve is below the demand curve.
Profit –Maximizing Output &
Efficiency
Profit –Maximizing Output:
The MR = MC rule will still tell the monopolist the profit – maximizing output. The monopolist cannot charge the
highest price possible, it will maximize profit where TR minus TC is the greatest. This depends on quantity sold as
well as on price.
The monopolist can charge the price that consumers will pay for that output level. Therefore, the price is on the
demand curve. Losses can occur in monopoly, although the monopolist will not persistently operate at loss in the
long run.
Monopolies will sell at a smaller output and charge a higher price than would pure competitive producers selling in
the same market.
Income distribution is more unequal than it would be under a more competitive situation, unless the government
regulates the monopoly and prevents monopoly profits. If a monopoly creates substantial economic inefficiency
and appears to be long-lasting, antitrust laws could be used to break up the monopoly.
Efficiency:
1. Productive efficiency: occurs where P= min ATC. Monopoly firms will not achieve productive efficiency as
firms will produce at an output which is less than the output of min ATC. X-inefficiency may occur since there is no
competitive pressure to produce at the minimum possible costs.
2. Allocative efficiency: occurs where P = MC. This efficiency is not achieved because price( what product is
worth to consumers) is above MC (opportunity cost of product).
It is possible that monopoly is more efficient than many small firms. Economies of scale (natural monopoly) may
make monopoly the most efficient market model in some industries. However, X-inefficiency and rent-seeking cost
(lobbying, legal fees, etc.) can entail substantial costs, causing inefficiency.
Producer surplus is significant due to lack of competition, consumer surplus may be minimized. This market
structure will not contribute to a fair income distribution of our society.
An Example
In this example, the cost function is the same as the one used in the
perfect competition example. You can see from the following analysis
that the output level and market price are different in monopoly .
The output level is lower than output of the perfect competitive
firm; and price is higher than the price of perfect competitive firm.
TP or Q
AFC
It is possible for this firm to continue earning this profit in the long
run as there are no competition in the market.
ATC
MC
0
1
60
45
105
45
2
30
42.5
72.5
40
3
20
40
60
35
4
15
37.5
52.5
30
5
12
37
49
35
6
10
37.5
47.5
40
7
8.57
38.57
47.14
45
8
7.5
40.63
48.13
55
9
6.67
43.33
50
65
10
6
46.5
52.5
75
Pd
By comparing the MR and MC unit by unit, we can find this firm's
output at:
Q = 4, and P= 63. This is the profit maximization output level, with
EP = 42.
AVC
Qd
TR
MR
EP
115
0
0
0
100
1
100
100
-5
83
2
166
66
21
71
3
213
47
33
63
4
252
39
42
55
5
275
23
30
48
6
288
13
3
42
7
294
6
-35.98
37
8
296
2
-89.04
33
9
297
1
-153
29
10
290
-7
-235
Price Discrimination
Price discrimination is selling a good or service at a number of different prices,
and the price differences is not justified by the cost differences. In order to price
discriminate, a monopoly must be able to
1. be able to segregate the market
2. make sure that buyers cannot resell the original product or services.
Perfect price discrimination is a price discrimination that extracts the entire
consumer surplus by charging the highest price that consumer are willing to
pay for each unit.
As a result, the demand curve becomes the MR curve for a perfect price
discriminator. Firms capture the entire consumer surplus and maximize
economic profit.
Monopolistic Competition
Monopolistic competition refers to a market situation with a relatively large number of
sellers offering similar but not identical products. Examples are fast food restaurants
and clothing stores.
Characteristics
1. A lot of firms: each has a small percentage of the total market.
2. Differentiated products: variety of the product makes this model different from
pure competition model. Product differentiated in style, brand name, location,
advertisement, packaging, pricing strategies, etc.
3. Easy entry or exit.
Demand Curve
The firm’s demand curve is highly elastic, but not perfectly elastic. It is more elastic
than the monopoly’s demand curve because the seller has many rivals producing close
substitutes; it is less elastic than pure competition, because the seller’s product is
differentiated from its rivals.
Profit - Maximizing Output
The MR = MC rule will give the firms the profit – maximizing output. The price they charge would
be on the demand curve.
In the long run, the situation will tend to be breaking even for firms. Firms can enter the industry
easily and will if the existing firms are making an economic profit. As firms enter the industry, the
demand curve facing by an individual firm shift down, as buyers shift some demand to new firms
until the firm just breaks even. If the demand shifts below the break-even point, some firms will
leave the industry in the long run.
Therefore, most monopolistic competitive firms should experience break-even in the long run
theoretically. In reality, some firms experience profit as they able to distinguish themselves from
the others and build a loyal customer base; such as some name brand apparel companies.
Some firms experience lost in long run but may continue the business as they are still earning
normal profit. These firm owners usually like the flexible life style and willing to earn a normal
profit that is lower than their opportunity cost.
Price exceeds marginal cost in the long run, suggesting that society values additional units which
are not being produced. Average costs may also be higher than under pure competition, due to
advertising cost involved to attract customers from competitors. The various types, styles, brands
and quality of products offers consumers choices. However, economic inefficiency is the result.
The excess capacity (producing at the quantity that a firm produces is less than the quantity at
which ATC is a minimum) exists in this industry.
Oligopoly
Oligopoly exits where few large firms producing a homogeneous or differentiated
product dominate a market. Examples are automobile and gasoline industries.
Characteristics
1. Few large firms: each must consider its rivals’ reactions in response to its decisions
about prices, output, and advertising.
2. Standardized or differentiated products.
3. Entry is hard: economies of scale, huge capital investment may be the barriers to
enter.
Demand Curve
Facing competition or in tacit collusion, oligopolies believe that rivals will
match any price cuts and not follow their price rise. Firms view their demands
as inelastic for price cuts, and elastic for price rise. Firms face kinked demand
curves. This analysis explains the fact that prices tend to be inflexible in some
oligopolistic industries.
Efficiency & Advertisement
1. Productive efficiency: occurs where P= min ATC.
Monopolistic competitive firms will not achieve productive efficiency as firms will
produce at an output which is less than the output of min ATC. Product
differentiation is the major cause of excess capacity.
2. Allocative efficiency: occurs where P = MC.
This efficiency is not achieved because price( what product is worth to
consumers) is above MC (opportunity cost of product).
Advertisement is very crucial for each firm in this market structure as firms need
exposure to get consumer's attention. However, too much spending will result in
higher cost, and lower profit. Price, product attributes, and advertisement are
three main factors that producers have to consider. The perfect combination
cannot be forecasted easily.
Game Theory & Cartel
Game theory suggests that collusion is beneficial to the participating firms. Collusion reduces uncertainty, increases profits,
and may prohibit entry of new rivals.
Consider the following payoff matrix in which the numbers indicate the profit in millions of dollars for a duopoly (GM and
Ford) based on either a high-price or a low-price strategy. This example illustrated that GM or Ford will earn the highest
individual profit when each adopts low price strategy while other firm continues with the higher price strategy (in B or C).
But firms will earn the highest total profit when both adopt the high price strategy (A). When firms form a cartel, they are
acting as one entity (A). They will perform as they are a large monopoly, earning the highest total profit possible. However,
members do have an incentive to cheat as individuals can increase their own profits by cheating in short run (B or C). When
other members are aware of the cheating, they may carry out the same practice, sometimes it may result in a price war and
all members loss (D).
Duopoly
GM
Ford
High-price
Low-price
Profit Analysis
High-price
A: GM=$50M Ford=$50M
C: GM=$20M Ford=$60M
Low-price
B: GM=$60M Ford=$20M
D: GM=$30M Ford=$30M
GM Profit
Earns $50M
Ford Profit
Earns $50M
Total profit in the industry
$50 + $50 =$100M
B: GM lowers price and Ford continues with
high price strategy
Increased to $60 M
Dropped to $20M
$60 + $20 =$80M
C: Ford lowers price and GM continues with
high price strategy
Dropped to $20 M
Increased to $60M
$20 + $60 =$80M
D: Both firms adopt low price strategy
Earns $30M
Earns $30M
$30 + $30 =$60M
A: Both firms adopt high price strategy
The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries agreed on the output amount
and working together to control the world’s crude oil supply. In US, anti-trust law has set up guidelines for corporations to
follow to avoid collusion of large firms in the same industry and protect consumer rights.
Technological Development
Technological advance is a three-step process that shifts the economy‘s production possibilities
curve outward enabling more production of goods and services.
1. Invention: is the discovery of a product or process and the proof that it will work.
2. Innovation: is the first successful commercial introduction of a new product, the first use of a
new method, or the creation of a new form of business enterprise.
3. Diffusion: is the spread of innovation through imitation or copying.
Expenditures on research and development (R&D) include direct efforts by business toward
invention, innovation, and diffusion. Government also engages in R&D, particularly for national
defense. Finding the optimal amount of R&D is an application of basic economics: marginal
benefit and marginal cost analysis. Optimal R&D expenditures occur when the interest rate cost
of funds is equal to the expected rate of return.
Many projects may be affordable but not worthwhile because the marginal benefit is less than
marginal cost. Often the R&D spending decision is complex because the estimation of future
benefits is highly uncertain while costs are immediate and more clear-cut.
The Role of Market Structure
1. Pure competition: the small size of competitive firms and the fact hat they earn zero
economic profit in the long run leads to serious questions as to whether such producers can
finance substantial R&D programs. The firms in this market structure would spend no
significant amount. However, firms of the same industry may gather their resources and
develop R&D programs.
2. Monopolistic competition: there is a strong profit incentive to engage in product
development in this market structure as the firms depend on product differentiation to stand
out from a large number of rivals. However, most firms remain small which limits their ability
to secure inexpensive financing for R&D and any economic profits are usually temporary.
Therefore, spending on R&D is limited in this market structure.
3. Oligopoly: many of the characteristics of oligopoly are conducive to technical advances
including: their large size, ongoing economic profits, the existence of barriers to entry and a
large volume of sales. Firms in oligopoly spent the highest amount on R&D among the four
different market structures.
4. Pure monopoly: monopoly has little incentive to engage in R&D as the profit is protected by
absolute barriers to entry, the only reason for R&D would be defensive – to reduce the risk of a
new product or process which would destroy the monopoly.
Economic Efficiency
Economics is a science of efficiency in the use of scarce resources. Efficiency requires full employment of available
resources and full production. Full employment means all available resources should be employed. Full production
means that employed resources are providing maximum satisfaction for our material wants. Full production implies two
kinds of efficiency:
1. Allocative efficiency means that resources are used for producing the combination of goods and services most wanted
by society. For example, producing computers with word processors rather than producing manual typewriters.
2. Productive efficiency means that least costly production techniques are used to produce wanted goods and services.
Full efficiency means producing the "right" (Allocative efficiency) amount in the "right "way (productive efficiency).
Pure competition:
Productive efficiency occurs where price is equal to minimum average total cost (min ATC); at this point firms must use
the lease-cost technology or they won’t survive.
Under pure competition, this outcome will be achieved, as the long run equilibrium price of pure competitive firms
would be at the min ATC.
Allocative efficiency occurs where price is equal to marginal cost ( P=MC), because price is society’s measure of relative
worth of a product at the margin or its marginal benefit. And the marginal cost of producing product X measures the
relative worth of the other goods that the resources used in producing an extra unit of X could otherwise have produced.
In short, price measures the benefit that society gets from additional units of good X, and the marginal cost of this unit
of X measures the sacrifice or cost to society of other goods given up to produce more of X.
Under pure competition, this outcome will be achieved. Dynamic adjustments will occur automatically in pure
competition when changes in demand or in resources supply, or in technology occur. Disequilibrium will cause expansion
or contraction of the industry until the new equilibrium at P=MC occurs.
Efficiency Cont.
Non-perfect competition:
Price of non-perfect competitive firms will exceed marginal cost, because price exceeds marginal revenue and the firms
produce where marginal revenue (MR) and marginal cost are equal. Then the firms can charge the price that consumers will
pay for that output level. Allocative efficiency is not achieved because price (what product is worth to consumers) is above
marginal cost (opportunity cost of product). Ideally, output should expand to a level where P=MC, but this will occur only
under pure competitive conditions where P = MR. Productive efficiency is not achieved because the firms’ output is less
than the output at which average total cost is minimum.
Economies of scale (natural monopoly) may make monopoly the most efficient market model in some industries. Xinefficiency, the inefficiency that occurs in the absence of fear of entry and rivalry, may occur in monopoly since there is no
competitive pressure to produce at the minimum possible costs. Rent-seeking behavior often occurs as monopolies seek to
acquire or maintain government –granted monopoly privileges. Such rent-seeking may entail substantial cost (lobbying,
legal fees, public relations advertising etc.) which are inefficient.
There are several policy options available when monopoly creates substantial economic inefficiency:
1. Antitrust laws could be used to break up the monopoly if the monopoly’s inefficiency appears to be long-lasting.
2. Society may choose to regulate its prices and operations if it is a natural monopoly.
3. Society may simply ignore it if the monopoly appears to be short-lived because of changing conditions or technology.
Efficiency Vs technological advances:
Allocative efficiency is improved when technological advance involves a new product that increases the utility consumers
can obtain from their limited income. Process innovation can lower production cost and improve productive efficiency.
Innovation can create monopoly power through patents or the advantages of being first, reducing the benefit to society
from the innovation. Innovation can also reduce or even disintegrate existing monopoly power by providing competition
where there was none. In this case economic efficiency is enhanced because the competition drives prices down closer to
marginal cost and minimum average total cost.