Chapter 8Perfect competition and pure monopoly

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

7th Edition, McGraw-Hill, 2003

Power Point presentation by Alex Tackie

2

Perfect competition

• many buyers and sellers– so no individual believes that their own action can

affect market price

• firms take price as given– so face a horizontal demand curve

• the product is homogeneous• perfect customer information• free entry and exit of firms

Characteristics of a perfectly competitive market

3

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

P1

£

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

4

The supply curve under perfect competition (2)

• Between P1 and P3, (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

P1

£

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

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The supply curve under perfect competition (3)

– showing how much the firm would produce at each price level.

P1

£

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

• So the SMC curve above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE

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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

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The firm and the industry in the short run under perfect competition (1)

INDUSTRY

Output

£

Q

P

SRSS

D

Firm

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

SAC

P

£

Output

SMC

D=MR=AR

q

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The firm and the industry in the short run under perfect competition (2)

INDUSTRYFirm

The firm accepts price as given at P

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

SAC

P

£

Output

SMC

D=MR=AR

q Output

£

Q

P

SRSS

D

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The firm and the industry in the short run under perfect competition (3)

INDUSTRY

Output

£

Q

P

SRSS

D

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 shiftsto the right, and market price falls.

SRSS1

P1

SAC

Firm

P

£

Output

SMC

D=MR=AR

q Q1

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Long-run equilibrium

INDUSTRYFirm

LAC

P*

£

Output

LMC

D=MR=AR

q*

The market settles in long-run equilibrium when the typicalfirm 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)then the long-run supply curve will not be horizontal, but upward-sloping.

SRSS

D

Output

£

Q

P* LRSS

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Adjustment to an increase in market demand:the short run

Suppose a perfectly competitive market startsin equilibrium at P0Q0.

If market demand shifts to D'D' ...

in the short run the newequilibrium is P1Q1 ...

– adjustment is throughexpansion of individualfirms along their SMCs.Q1

P1

Output

£

D

SRSS

Q0

P0

D

D'

D'

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Adjustment to an increase in market demand:the long run

In the long run, new firmsare attracted by the profitsnow being made here

Output

£

D

SRSS

Q0

P0

D

D'

D'

Q1

P1

– and firms are able toadjust their input of fixedfactorsIf wages are bid up by thisexpansion, the long-runsupply schedule is upward-sloping

LRSS

– and the market finally settles at P2Q2.

Q2

P2

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Monopoly

• 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.

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Profit maximization by a monopolist

Profits are maximized where MC = MR at Q1P1.

In this position, AR isgreater than ACso the firm makesprofits above theopportunity cost ofcapital

Entry barriers preventnew firms joining theindustry.

AC1 shown by the shaded area

Output

MC=MR

£

P1

Q1

MC

AC

D = ARMR

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Comparing monopoly with perfect competition (1)

Suppose a competitive industry is taken over by a monopolist:

Output

DMR

SRSS

LRSS

£

Q1

P1

A

Competitive equilibrium is at A, with output Q1

and price P1.

To the monopolist, LRSSis the LMC curve, andSRSS is the SMC curve

= LMC

=SMC

The monopolistmaximizes profits in theshort run at MR = SMCat P2Q2.Q2

P2

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Comparing monopoly with perfect competition (2)

Suppose a competitive industry is taken over by a monopolist:

Output

In the long run, thefirm can adjust other inputs ...

to set MR = LMC

At P3Q3.

P3

Q3

DMR

SRSS

LRSS

£

Q1

P1

A

= LMC

=SMC

Q2

P2

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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.

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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

DMR

P1

£

Q1 Output

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Discriminating monopoly

• Suppose a monopolist supplies two separate groups of customers– with differing elasticities of demande.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 resolde.g. dental treatment