Download Parkin-Bade Chapter 11

PERFECT
COMPETITION
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11
CHAPTER
11-1
Competition
Perfect competition is an industry in which:
 Many firms sell identical products to many buyers.
 There are no restrictions to entry into the industry.
 Established firms have no advantages over new ones.
 Sellers and buyers are well informed about prices.
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Competition
Price Takers
In perfect competition, each firm is a price taker.
A price taker is a firm that cannot influence the price of a
good or service.
No single firm can influence the price—it must “take” the
equilibrium market price.
Each firm’s output is a perfect substitute for the output of
the other firms, so the demand for each firm’s output is
perfectly elastic.
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Demand Facing a Single Firm in a
Perfectly Competitive Market
If a representative firm in a perfectly competitive industry raises
the price of its output above $2.45, the quantity demanded of that
firms output will drop to zero. Each firm faces a perfectly elastic
demand curve, d.
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Comparing Costs and Revenues to
Maximize Profit
The profit maximizing perfectly competitive firm will produce up to
the point where the price of its output is just equal to the short
run marginal cost; the level of output where:
P* = MC or MR = MC.
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The Profit-Maximizing Level of Output for a Perfectly
Competitive Firm
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Short-Run Supply Curve of a Perfectly Competitive Firm
The short-run
supply curve of a
competitive firm
is that portion of
its marginal cost
curve that lies
above its average
variable cost
curve.
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Short-Run Industry Supply Curve
The short run industry supply curve is the horizontal sum of the
marginal cost curves (above AVC) of all the firms in an
industry.
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Firms Expand Along in the Long Run When Increasing Returns to
Scale Are Available
Firms will be pushed by competition to produce at their optimal scales and the
price will be driven to the minimum point on the LRAC curve. Profits will be
driven to zero.
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Long-run Competitive Equilibrium
• Long-run equilibrium occurs in a competitive industry when:
 Economic profit is zero, so firms neither enter nor exit the
industry.
 Long-run average cost is at its minimum, so firms don’t change
their plant size.
• Long-run competitive equilibrium exists when:
P = SRMC = SRAC = LRAC
and economic profit is equal to zero.
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MONOPOLY
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Market Power
How Monopoly Arises
A monopoly has two key features:
 No close substitutes
 Barriers to entry
Legal or natural constraints that protect a firm from
potential competitors are called barriers to entry.
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Demand in Monopoly Markets
• With only one firm in the monopoly market, there is no
distinction between the firm and the industry.
 In a monopoly, the firm is the industry and therefore
faces the industry demand curve.
 The total quantity supplied is what the firm decides to
produce.
• For a monopolist, an increase in output involves not
just producing more and selling it, but also reducing the
price of its output in order to sell it.
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Marginal Revenue Facing a Monopolist
At every level except one unit, the monopolist’s marginal revenue is
below price. This is because to sell more output and raise total
revenue the firm lowers the price for all units sold.
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Price and Output Choice for a ProfitMaximizing Monopolist
The profit-maximizing
level of output for a
monopolist is the one
where MR = MC.
Beyond that point, where
marginal cost exceeds
marginal revenue, the
firm would reduce its
profits.
Relative to a competitively
organized industry, a
monopolist restricts
output, charges higher
prices, and earns
economic profits.
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Competition and Efficiency
Figure 11.12 illustrates an
efficient outcome in a
perfectly competitive
industry.
Along the demand curve D =
MB the consumer is efficient.
Along the supply curve S =
MC the producer is efficient.
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Competition and Efficiency
The quantity Q* and price
P* are the competitive
equilibrium values.
So competitive equilibrium
is efficient.
The consumer gains the
consumer surplus, and the
producer gains the
producer surplus.
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Single-Price Monopoly and Competition
Compared
Monopoly is inefficient
because price exceeds
marginal cost so
marginal benefit
exceeds marginal cost.
On all output levels for
which marginal benefit
exceeds marginal cost, a
deadweight loss is
incurred.
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Single-Price Monopoly and Competition
Compared
Rent Seeking
The social cost of monopoly may exceed the deadweight
loss through an activity called rent seeking, which is any
attempt to capture consumer surplus, producer surplus, or
economic profit.
Rent seeking is not confined to a monopoly. There are two
forms of rent seeking activity to pursue monopoly:
Buy a monopoly—transfers rent to creator of monopoly.
Create a monopoly—uses resources in political activity.
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Single-Price Monopoly and Competition
Compared
The resources used in rent
seeking can exhaust the
monopoly’s economic profit and
leave the monopoly owner with
only normal profit.
Average total cost increases and
the profits disappear to become
part of the enlarged deadweight
loss from rent seeking.
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Price Discrimination
Price discrimination is the practice of selling different units
of a good or service for different prices.
To be able to price discriminate, a monopoly must:
 Identify and separate different buyer types
 Sell a product that cannot be resold
Price differences that arise from cost differences are not
price discrimination.
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Price Discrimination
By price discriminating, the
firm can increase its profit.
In doing so, it converts
consumer surplus into
economic profit.
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Price Discrimination
With perfect price
discrimination:
Output increases to the
quantity at which price
equals marginal cost.
Economic profit increases
above that earned by a
single-price monopoly.
Deadweight loss is
eliminated.
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Price Discrimination
Efficiency and Rent Seeking with Price Discrimination
The more perfectly a monopoly can price discriminate, the
closer its output gets to the competitive output (P = MC)
and the more efficient is the outcome.
But this outcome differs from the outcome of perfect
competition in two ways:
 The monopoly captures the entire consumer surplus.
 The increase in economic profit attracts even more rentseeking activity that leads to an inefficient use of
resources.
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Market Power
Natural barriers to entry
create a natural
monopoly, which is an
industry in which one firm
can supply the entire
market at a lower price
than two or more firms
can.
Figure 12.1 illustrates a
natural monopoly.
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The Problem of Regulating a Monopoly
• An unregulated
monopolist produces
where MC = MR, at
400,000 units.
• If prices were set at
MC the firm would
always suffer a loss.
• A compromise would
be to set prices at
$0.75 which covers
costs and allows a
normal profit rate.
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MONOPOLISTIC
COMPETITION
AND OLIGOPOLY
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Monopolistic Competition
Monopolistic competition is a common form of industry
structure in Canada, characterized by:

a large number of firms, none of which can influence
market price by virtue of size alone

some degree of market power achieved through the
production of differentiated products

no barriers to entry or exit
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Monopolistic Competition
Product Differentiation
Firms in monopolistic competition practice product
differentiation, which means that each firm makes a
product that is slightly different from the products of
competing firms.
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Output and Price in Monopolistic
Competition
The firm produces the
quantity at which
marginal revenue
equals marginal cost
and sells that quantity
for the highest possible
price.
It earns an economic
profit (as in this
example) when P >
ATC.
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Output and Price in Monopolistic
Competition
Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
As firms enter the industry, each existing firm loses some of its
market share. The demand for its product decreases and the
demand curve for its product shifts leftward.
The decrease in demand decreases the quantity at which MR =
MC and lowers the maximum price that the firm can charge to sell
this quantity.
Price and quantity fall with firm entry until P = ATC and firms earn
zero economic profit.
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Monopolistically Competitive Firm at
Long-Run Equilibrium
As new firms enter the
monopolistically
competitive industry
the demand curves of
profit-making firms
begin to shift left.
The process continues
until profits are
eliminated and the
demand curve is just
tangent to the
average total cost
curve.
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Economic Efficiency and Resource
Allocation for Monopolistic Competition
• Firms in monopolistic competition are inefficient and
operate with excess capacity.
• Price is greater than marginal cost, greater than the
perfectly competitive solution.
• The long-run equilibrium quantity of output is to the left
of the minimum of ATC.
• Output is less than capacity output.
 A firm’s capacity output is the output at which
average total cost is at its minimum.
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Product Development and Marketing
Innovation and Product Development
To keep earning an economic profit, a firm in monopolistic
competition must be in a state of continuous product
development.
Marketing
A firm’s marketing program uses advertising and
packaging as the two principal methods to market its
differentiated products to consumers.
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Product Development and Marketing
With advertising, the
firm produces 130 units
of output at an average
total cost of $160.
The advertising
expenditure shifts the
average total cost curve
upward, but the firm
operates at a higher
output and lower ATC
than it would without
advertising.
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Product Development and Marketing
But advertising can increase a firm’s demand and profits
in the short run only.
Economic profit leads to entry, which decreases the
demand for each firm’s product in the long run.
To the extent that advertising and selling costs provide
consumers with information and services that they value
more highly than their cost, these activities are efficient.
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Oligopoly
Oligopoly is a form of industry structure characterized
by:
 a few firms, each large enough to influence market
price
 differentiated or homogeneous products
 firms behaving in a way that depends to a great
extent on the behaviour of other firms
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Oligopoly Models
• The Collusion Model
• The Cournot Model
• The Kinked Demand Model
• The Price Leadership Model
• Game Theoretic Models
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Collusion Model
A collusive agreement is an agreement between two (or
more) firms to restrict output, raise price, and increase
profits.
Such agreements are illegal in Canada and are
undertaken in secret.
Firms in a collusive agreement operate a cartel.
•Cartel refers to a group of firms that gets together and
makes joint price and output decisions in order to maximize
joint profits.
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Assumptions of the Cournot Model
• There are two firms in the industry - a duopoly.
• Each firm takes the output of the other firm as given.
• Both firms maximize profits.
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The Kinked Demand Curve Oligopoly
Model
If the firm increases its price
the demand will fall off
quite quickly.
If the firm drops its price the
other firms follow and
quantity demanded does
not change as much.
Demand is elastic above P*
and inelastic below P*.
If MC increases enough, all
firms raise their prices
and the kink vanishes.
A firm that bases its actions
on wrong beliefs doesn’t
maximize profit.
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Oligopoly
Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that
has a significant cost advantage over many other, smaller
competing firms.
The large firm operates as a monopoly, setting its price
and output to maximize its profit.
The small firms act as perfect competitors, taking as given
the market price set by the dominant firm.
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Oligopoly
The profit maximizing quantity for the large firm is 10 units.
The price charged is $1.00.
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Game Theory
• Game theory analyzes oligopolistic behaviour as a complex
series of strategic moves and reactive countermoves among
rival firms.
• In game theory, firms are assumed to anticipate rival reactions.
What Is a Game?
All games share four features:




Rules
Strategies
Payoffs
Outcome
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Dominant Strategy and Nash Equilibrium
A dominant strategy in game theory is a strategy that is
best no matter what the opposition does.
Nash equilibrium is the result in game theory, when all
players play their best strategy given what their
competitors are doing.
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Payoff Matrix for an Advertising Game
The dominant strategy for A and B is to advertise.
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The Prisoner’s Dilemma
The dominant strategy is for both Rocky and
Ginger to confess.
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Contestable Markets
• A market in which entry and exit are costless.
• Because entry is cheap, firms are continually faced
with competition or the threat of competition.
• In contestable markets, firms behave like perfectly
competitive firms.
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MONOPOLISTIC
COMPETITION
AND OLIGOPOLY
13
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THE
END
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