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Class 2 and 3
Figure 2.1 Short-run relationship between total, marginal and average product
of labour
Figure 2.2 Short-run total cost, marginal cost, average variable and fixed cost, and
short-run average cost
Figure 2.3 Increasing, constant and decreasing returns to scale
Figure 2.4 Long-run average cost and long-run marginal cost
Figure 2.5 Short-run and long-run average cost functions
Figure 2.6 Isoquant and isocost functions
Figure 2.7 Surface area and volume of small and large storage tanks
Figure 2.8 Long-run average cost functions with constant returns to scale
Figure 2.9 Total, average and marginal revenue
Theory of Perfect Competition and
Monopoly
Theory of the firm
Edwin Chamberlein and Joan Robinson
(1939)
Alfred Marshall (1890)
Augustin Cournot (1830)
Adam Smith (1770)
Developments in theory was built on the
preceding analysis.
Profit Maximization
The coherent body of theory that explains
the determination of price and output for
both the industry and the firm based on
the assumption of profit maximization:
Neoclassical theory of the firm.
Two most extreme cases:
– Perfect competition
– Monopoly
The Neoclassical Theory of the
Firm
Perfect Competition
– Many firms, free entry, identical products
Imperfect Competition
Monopolistic Competition
– Many firms, free entry, some differentiation
Oligopoly
– Few firms, barriers to entry, some differentiation
Monopoly
– One firm, no entry, complete differentiation
Perfect Competition
Large numbers of buyers and sellers:
Atomistic
Firms are free to enter and exit
Identical goods
Perfect information
No transport costs
Firms act independently
Price taking behavior, i.e. horizontal firmlevel demand function, located at the
current market price. Perfectly elastic
demand.
Firm’s demand function is its average
revenue function. AR=P.
Given that the firm’s demand or AR function
is horizontal, AR=MR=P
Figure 2.10 Short-run pre-entry and post-entry equilibrium in perfect competition
Figure 2.11 Long-run post-entry equilibrium in perfect competition
Monopoly
Large number of atomistic buyers, there is only
one seller.
The selling firm’s demand function is the market
demand function and firm’s output decision
determine the market price.
There are barriers to entry
Good or service produced and sold is unique
Buyers and sellers have imperfect information
Geographical location
Seek to max prifit.
Figure 2.12 Long-run equilibrium in monopoly
Mathematical Representation
For profit maximizing equilibrium for the
case where LRAC and LRMC are
horizontal (and equal): constant returns to
scale.
See appendix 1 for formal mathematical
derivation (from the text book)
Efficiency and Welfare Properties
Comparison between long run industry
equilibrium under perfect competition and long
run profit maximization under monopoly:
– Under monopoly, market price is higher and output is
lower.
– The monopolist fails to produce at the minimum
efficient scale and therefore fails tp produce at the
minimum attinable LRAC. The perfectly competitive
firm produces atthe minimum efficient scale.
– The monopoly earns an abnormal profit in the long
run.
Lerner Index for Market Power
The degree to which price exceeds marginal
cost provides a useful indicator of market power.
Lerner Index
L=(P-MC)/P
In perfect competition P=MC and L=0
In monopoly, P>MC and if MC>0, 0>L>1
For a profit maximizing firm MR=MC, Lerner
index can be written as the recipricon of the
firm’s price elasticity of demand.
Welfare Properties of the Two
Models
Allocative efficiency
Productive efficiency
– Technical efficiency
– Economic efficiency
Allocative efficiency: AE is achieved when there
is no possible reallocation of resources that
could make one agent better off without making
one other worse off
Necessary condition for allocative efficiency:
MB=MC
If market price is considered as a measure
of the value society as a whole places in
the marginal unit of output produced,
P=MC
If P>MC; value (WTP) exceeds cost
(produce more)
If P>MC; value (WTP) is less than cost
(produce less)
Productive Efficiency
Technical efficiency: Producing maximum
quantity of output that is technologically
feasible, given the quantities of the factor
inputs it is currently employing (operate on
its production function).. X-efficiency.
Economic efficiency: Producing by
selecting the combination of factor inputs
that enable it to produce its current output
level at the lowest cost.
Figure 2.13 Allocative inefficiency in monopoly
Figure 2.14 Allocative inefficiency and productive inefficiency in monopoly
Figure 2.15 Natural monopoly
Monopolistic Competition
Robinson (1933); Chamberlein (1933)
Theory of imperfect competitiın
Monopolistic competition
– Large number of atomistic buyers and sellers
– Firms are free to enter and exit. No additional cost
– Goods and services provided are similar but not
identical
– Perfect or imperfect information
– Geography
– Each selling firm seek to maximize profit.
Figure 2.16 Short-run pre-entry and post-entry equilibrium in monopolistic
competition