Chapter 5Perfect Competition,

Monopoly, and Economic versus

Normal Profit

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Chapter Outline

• From Perfect Competition to Monopoly

• Supply Under Perfect Competition

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You Are Here

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From Perfect Competition to Monopoly

• Perfect Competition• Monopolistic Competition• Oligopoly• Monopoly

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Picking the Quantity to Maximize Profit The

Perfectly Competitive CaseMC ATC

AVC

MR

Q*

P*

P

QMany Competitors

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AVC

MRD

MC

ATC

Q*

P*

P

QNo Competitors

Picking the Quantity to Maximize Profit The Monopoly

Case

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Characteristics of Perfect Competition

• a large number of competitors, such that no one firm can influence the price

• the good a firm sells is indistinguishable from the ones its competitors sell

• firms have good sales and cost forecasts • there is no legal or economic barrier to its

entry into or exit from the market

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Monopoly

• The sole seller of a good or service.• Some monopolies are generated

because of legal rights (patents and copyrights).

• Some monopolies are utilities (gas, water, electricity etc.) that result from high fixed costs.

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Monopolistic Competition•Monopolistic Competition: a

situation in a market where there are many firms producing similar but not identical goods.

• Example : the fast-food industry. McDonald’s has a monopoly on the “Happy Meal” but has much competition in the market to feed kids burgers and fries.

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Oligopoly

•Oligopoly: a situation in a market where there are very few discernible competitors

• Examples – Satellite TV service (Direct TV,

Dish Network)– Airlines (American, Delta etc.)

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Which Model Fits Reality?

• Perfect competition is rare outside agriculture though it fits some labor markets.

• Monopolies are common in utilities• Major branded companies are

typically either in oligopolistic or monopolistically competitive industries.

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Examples of Different Market Forms

Perfect Competition

Monopolistic Competition

Oligopoly Monopoly

1) Agriculture2) Lumber

1) Fast Food

2) Long Distance Service

1) Cars and Trucks

2) Soft Drinks

1) Windows Operating system

2) Local Residential electric power

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Distinguishing Characteristics Between

Market FormsPerfect competition

Monopolistic Competition

Oligopoly

Monopoly

Number of Firms

Many-often thousands or even millions

Several* Few* One

Barriers to Entry

None Few Substantial

Insurmountable, at least in the short run

Product Similarity

Identical Similar but not identical

Similar or Identical

N/A

* The line between “several” and “few” is not definite

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Concentration Ratios

• there is no magic line that separates oligopoly from monopolistic competition.

• a “concentration ratio” measures the percentage of total market sales for the top firms (from 4 firms to 100 firms).

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Concentration Ratios For Various Manufacturing Industries

Industry Group Concentration Ratios4 Largest Firms 8 Largest Firms 50 Largest Firms

Breakfast Cereals

78.4% 91.1% 100.0%

Ice Cream 48.0 64.4 93.1Beer 90.8 93.8 98.1Clothing 17.3 21.3 38.7Computers and

Peripherals40.5 65.2 88.3

Furniture 11.0 18.0 30.6Long Distance 59.7 80.9 92.5

Cellular Service 61.7 81.7 90.0

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Supply Under Perfect Competition

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Normal vs. Economic Profit

•Normal Profit : the level of profit that business owners could get in their next best alternative investment

•Economic Profit: any profit above normal profit

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Return on Equity For Various Industries

Industry Rate of ReturnNet Income/(Assets-Liabilities)

Agriculture 3.1%Manufacturing 21.8%Transportation and Public Utilities

8.2%

Retail Trade 16.1%

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When and Why Economic Profits Go to Zero

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Time Horizons•Short Run: the period of time

where we cannot change things like plant and equipment

•Long Run : the period of time where we can change things like plant and equipment

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Market Forms and Economic Profits

• Under perfect competition or monopolistic competition, economic profits go to zero because of the entry of new firms increases market supply and lowers prices.

• Economic profits are under no pressure to shrink under oligopoly or monopoly because entry doesn’t occur so prices do not fall.

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Figure 2 The Pressures on Price in Perfect Competition $

Q

MC

ATCAVCMR3

MR1

MR2

MR4

Long Run Pressure

Short Run Pressure

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Figure 3 Points of Production in Perfect Competition

$

Q

MC

ATCAVC

MR4

MR3MR2

MR1

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Figure 4 Supply in Perfect Competition

$

Q

MC

ATCAVC

Supply