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30. Monopoly and Competition
1. Describe short run equilibrium for a firm in perfect competition? How does it differ from monopoly?
Why do economists consider this a problem?
Diagrams
2.
3.
Draw a diagram illustrating the equilibrium price and quantity of a firm in perfect competition.
Draw a diagram of a “monopoly.” Show the output and price that would exist under perfect
competition.
Perfect Competition
Perfect Competition exists in an industry when each firm believes that its production has no impact on
the market price. Each firm takes the market price as “given.” While this belief is necessarily unrealistic,
since any increase in production has at least a small impact on the market price, in some industries, this
effect is so small that firms typically ignore it. For example, famers growing corn don’t worry about how
their individual planting will impact the market price of corn during the harvest season.
A firm in this situation maximizes its profits by producing a level of output such that marginal cost is
equal to price. An alternative way of describing this is that firms in such an industry produce a level of
output where marginal revenue is equal to marginal cost, but the marginal revenue is equal to the price.
Firm in Perfect Competition
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The market supply of a good in an industry with perfect competition is found by adding up the profit
maximizing output for each firm at a particular price. The equilibrium price will be where quantity
supplied by the market is equal to quantity demanded. In the long run, firms enter or exist until there is no
more economic profit. That implies that the equilibrium price will each each firms average cost as well as
its marginal cost. Since marginal cost and average cost are only equal at the minimum of average cost,
that means that price is at the minimum of average cost for each firm.
Monopoly
Perfect Competition is literally impossible. It would require an infinite number of infinitely small
firms producing each product. Most industries are made up of firms that produce somewhat unique
products. Even when the products appear very similar to those of other firms, the firms are located in
places so that many buyers find one firm more convenient. In these situations, each firm sets a price and
quantity. If it wants to sell more, it must lower its price to sell the extra output. The result is that
marginal revenue is less than price. When a firm produces an output where marginal revenue and marginal
cost are equal, it produces at an output such that marginal cost is less than price.
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Why is this a problem? Because the marginal cost represents the value of the other goods that
must be sacrificed to produce this particular product. The demand curve shows what buyers are willing to
pay. If more of the product were produced, consumers would be getting a product they value more than
the other products that must be sacrificed to get the resources needed to produce it.
One way to see this is to put the competitive price and quantity on the diagram of the
“monopolist.”
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Pc
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In a nutshell, a monopolist produces too little and charges too much relative to perfect competition.
However, there is an important complication. In a world in which most firms are producing where
marginal revenue equals marginal cost, the demand for resources are lower, which lowers their prices,
moves the marginal cost curves to the right. This results in expanded output and lower prices for all the
products. A few industries with monopoly in a market made up mostly of perfectly competitive firms
results in the monopolies producing too little and the competitive industries producing just a little too
much. In a world of monopolies with only a few examples of perfect competition, the monopolies may be
producing just about right (a bit too little,) and the few competitive industries producing way too much.
Oligopoly
An industry with a small number of firms producing very similar products is described as oligopoly.
When any one firm lowers its price, the other firms generally must meet the new price. If any one firm
raises its price, the other firms can raise their prices and still sell the same amount of output. While such
industries include what most laymen count as competition—firms cutting prices in response to one another,
the mathematical and graphical tools of modern economists don’t apply very well when each firms price
and quantity depends on what the other firms do and each firm knows it. Most economists believe that
oligopoly fails to provide the seemingly attractive results of perfect competition.
Cartel
A cartel is a group of firms that jointly set their price. In the U.S., this has always been illegal under
common law—a rule that was reinforced by the anti-trust laws. When firms form an illegal cartel, the
result is called collusion. OPEC is a cartel that is made up of countries that export petroleum. They
member countries force the firms that actually produce the oil to obey the price floor (or so they promise
the other countries in the cartel.) The price floor doesn’t apply to domestic sales of oil or oil products in
these countries. It is only exported oil subject to the cartel.
A formal cartel or a group of firms involved in price collusion (colluding on their prices,) can
increase prices and profits for all firms. Unfortunately for the cartel (or colluding firms,) each firm can
increase its profits by shaving its price and expanding production. To control this problem, cartels usuall
give each member firm a quota, with the total of the firms’ quotas being equal to the estimated market
demand at the price floor set by the cartel. Most cartels suffer problems of each firms breaking their
quotas, producing more, and then undercutting the price floor. OPEC has this problem.
Firms that collude on price illegally, generally never get as far as setting quotas.
Firms that have
been caught usually point out that they no one failed to stick to the collusion agreement. That isn’t a
defense under the law, but it points out that collusion isn’t very effective.
Competitive Market Process Again
Careful consideration of the conditions under which most firm’s operate suggest that the market fails
to produce the proper amount of each good. The invisible hand doesn’t work very well except with perfect
competition, and industries that even approach perfect competition are rare. But this analysis is “static.”
The firms are assumed to have given cost functions. Usually, the firms are assumed to have identical cost
functions. The products are assumed to be given and unchanged.
When these assumptions are given up and the competitive market process is considered, the “carrot”
and “stick” of profit from innovating first and loss from failing to keep up with other firms’ innovation that
seems to work quite well in nearly all markets. Aside from government bureaucracies that provide goods
at taxpayer expense, firms appear to be constantly looking to cut their costs and introduce better products.
The long run consequence of that process is lower prices and better products for everyone.