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Perfect competition– so no individual believes that their own action can affect market price – so face a horizontal demand curve  free entry and exit of firms Characteristics of a perfe

Chapter 9

Perfect competition and monopoly:

The limiting cases of market structure

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

Perfect competition

– so no individual believes that their own action can affect market price

– so face a horizontal demand curve

 free entry and exit of firms

Characteristics of a perfectly competition market

The supply curve under perfect competition (1)

 Above price P3

(point C ), the firm makes profit above the opportunity cost

of capital in the short run

 At price P3, (point

C ), the firm makes NORMAL PROFITS

P 1

£

Output

SAVC SMC

Q

SATC

P 3

A C

Q

The supply curve under perfect competition (2)

 Between P 1 and P 3 , ( A

and C ), the firm makes short-run losses, but remains in the market

 Below P1 (the SHUT-DOWN PRICE), the firm fails to cover SAVC, and exits

P 1

£

Output

SAVC SMC

Q 1

SATC

P 3

A C

Q 3

The supply curve under perfect competition (3)

above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE

– showing how much the firm would

produce at each price level.

P 1

£

Output

SAVC SMC

Q

SATC

P 3

A C

Q

The firm and the industry in the short

run under perfect competition (1)

INDUSTRY

Output

£

Q

P

SRSS

D

Firm

SAC

P

£

Output

SMC

D=MR=AR

q

Market price is set at industry level at the intersection of

demand and supply

– the industry supply curve is the sum of the individual firm’s

supply curves.

The firm and the industry in the short

run under perfect competition (2)

INDUSTRY

Output

£

Q

P

SRSS

D

SAC

Firm

P

£

Output

SMC

D=MR=AR

q

The firm accepts price as given at P

– and chooses output at q where SMC=MR to maximize profits

The firm and the industry in the short

run under perfect competition (3)

INDUSTRY

Output

£

Q

P

SRSS

D

SAC

Firm

P

£

Output

SMC

D=MR=AR

q

At this price, profits are shown by the shaded area.

These profits attract new entrants into the industry.

As more firms join the market, the industry supply curve shifts

to the right, and market price falls.

SRSS 1

P 1

Long-run equilibrium

INDUSTRY

Output

£

Q

P*

SRSS

D

Firm

SAC

P*

£

Output

SMC

D=MR=AR

q*

LRSS

The market settles in long-run equilibrium when the typical

firm just makes normal profit by setting LMC=MR at the minimum point of LAC Long-run industry supply is horizontal.

If the expansion of the industry pushes up input prices (e.g wages)

Adjustment to an increase in market demand:

the short run

Suppose a perfectly competitive market starts

in equilibrium at P 0 Q 0

If market demand shifts to D'D'

Output

£

D

SRSS

Q 0

P 0

D

D'

D'

in the short run the new equilibrium is P 1 Q 1

– adjustment is through expansion of individual firms along their SMCs.

Q 1

P 1

Adjustment to an increase in market demand:

the long run

In the long run, new firms are attracted by the profits now being made here

Output

£

D

SRSS

Q

P 0

D

D' D'

Q 1

P 1 – and firms are able to adjust their input of fixed

factors

If wages are bid up by this expansion, the long-run supply schedule is upward-sloping

LRSS

And the market finally settles at P Q

Q 2

P 2

 A monopolist:

– is the sole supplier of an industry’s

product

 and the only potential supplier

– is protected by some form of barrier to

entry

– faces the market demand curve directly

– Unlike under perfect competition, MR is

always below AR.

AC 1

shown by the shaded area

Profit maximization by a monopolist

Profits are maximized where MC = MR at Q 1 P 1

In this position, AR is greater than AC

so the firm makes profits above the opportunity cost of capital

Entry barriers prevent new firms joining the

Output

£

P 1

Q 1

MC

AC

D = AR MR

MC=MR

Comparing monopoly with perfect

competition (1)

Suppose a competitive industry is taken over by a monopolist:

Output

D

MR

SRSS

LRSS

£

Q 1

Competitive equilibrium

is at A , with output Q 1 and price P 1

To the monopolist, LRSS

is the LMC curve, and SRSS is the SMC curve

= LMC

=SMC

The monopolist maximizes profits in the short run at MR = SMC

at P 2 Q 2

Q 2

P 2

Comparing monopoly with perfect

competition (2)

Suppose a competitive industry is taken over by a monopolist:

Output

D

MR

SRSS

LRSS

£

Q 1

= LMC

=SMC

Q 2

P 2

In the long run, the firm can adjust

other inputs

to set MR = LMC

At P 3 Q 3

P 3

Q 3

Comparing monopoly with perfect

competition (3)

 So we see that monopoly compared with perfect competition implies:

– higher price

– lower output

 Does the consumer always lose from

monopoly?

– Among other things, this depends on whether the monopolist faces the same cost structure

– there may be the possibility of economies of scale.

A natural monopoly

 This firm enjoys substantial economies of scale relative

to market demand

 LAC declines right up to market demand

 the largest firm always enjoys cost leadership

 and comes to dominate the industry

 It is a NATURAL MONOPOLY

LMC

LAC

D MR

P 1

£

Discriminating monopoly

 Suppose a monopolist supplies two separate groups of customers

– with differing elasticities of demand

 e.g business travellers may be less sensitive to air fare levels than tourists

 The monopolist may increase profits by

charging higher prices to the businessmen

than to tourists.

 Discrimination is more likely to be possible for goods that cannot be resold

 e.g dental treatment