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Lesson 6

Firms in competitive markets:

Perfect Competition and

Monopoly

Henan University of Technology

Sino-British College

Transfer Abroad Undergraduate Programme

1

In this lesson, look for the answers to these

questions:

What is a perfectly competitive market?

What is marginal revenue? How is it related to

total and average revenue?

How does a competitive firm determine the

quantity that maximizes profits?

When might a competitive firm shut down in the

short run? Exit the market in the long run?

2

Why do monopolies arise?

Why is MR < P for a monopolist?

How do monopolies choose their P and Q?

How do monopolies affect society’s well-being?

What can the government do about monopolies?

What is price discrimination?

What market structures lie between perfect

competition and monopoly, and what are their

characteristics?

3

Introduction: A Scenario

Three years after graduating, you run your own

business.

You must decide how much to produce, what price

to charge, how many workers to hire, etc.

What factors should affect these decisions?

• Your costs

• How much competition you face

We begin by studying the behavior of firms in

perfectly competitive markets.

4

Characteristics of Perfect Competition

1. Many buyers and many sellers

2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

Because of 1 & 2, each buyer and seller is a

“price taker” – takes the price as given.

5

The Revenue of a Competitive Firm

Total revenue (TR)

Average revenue (AR)

Marginal Revenue (MR):

The change in TR from

selling one more unit.

∆TR

∆QMR =

TR = P x Q

TR

QAR = = P

A C T I V E L E A R N I N G 1:

ExerciseFill in the empty spaces of the table.

6

$50$105

$40$104

$103

$102

$10$101

n.a.$100

TRPQ MRAR

$10

A C T I V E L E A R N I N G 1:

AnswersFill in the empty spaces of the table.

7

$50$105

$40$104

$103

$10

$10

$10

$10$102

$10$101

n.a.

$30

$20

$10

$0$100

TR = P x QPQ∆TR

∆QMR =

TR

QAR =

$10

$10

$10

$10

$10

Notice that

MR = P

8

MR = P for a Competitive Firm

A competitive firm can keep increasing its output

without affecting the market price.

So, each one-unit increase in Q causes revenue

to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.

9

Profit Maximization

What Q maximizes the firm’s profit?

To find the answer,

“Think at the margin.”

If increase Q by one unit,

revenue rises by MR,

cost rises by MC.

If MR > MC, then increase Q to raise profit.

If MR < MC, then reduce Q to raise profit.

10

Profit Maximization

505

404

303

202

101

45

33

23

15

9

$5$00

Profit =

MR – MCMCMRProfitTCTRQAt any Q with

MR > MC,

increasing Q

raises profit.

5

7

7

5

1

–$5

10

10

10

10

–2

0

2

4

$6

12

10

8

6

$4$10

(continued from earlier exercise)

At any Q with

MR < MC,

reducing Q

raises profit.

11

P1 MR

MC and the Firm’s Supply Decision

At Qa, MC < MR.

So, increase Q

to raise profit.

At Qb, MC > MR.

So, reduce Q

to raise profit.

At Q1, MC = MR.

Changing Q

would lower profit. Q

Costs

MC

Q1Qa Qb

Rule: MR = MC at the profit-maximizing Q.

12

P1 MR

P2 MR2

MC and the Firm’s Supply Decision

If price rises to P2,

then the profit-

maximizing quantity

rises to Q2.

The MC curve

determines the

firm’s Q at any price.

Hence,

Q

Costs

MC

Q1 Q2

the MC curve is the

firm’s supply curve.

13

Shutdown vs. Exit

Shutdown:

A short-run decision not to produce anything

because of market conditions.

Exit:

A long-run decision to leave the market.

A key difference:

• If shut down in SR, must still pay FC.

• If exit in LR, zero costs.

14

A Firm’s Short-run Decision to Shut Down

• Cost of shutting down:

revenue loss = TR

• Benefit of shutting down:

cost savings = VC

(firm must still pay FC)

So, shut down if TR < VC.

Divide both sides by Q: TR/Q < VC/Q

So, firm’s decision rule is:

Shut down if P < AVC

15

The firm’s SR

supply curve is

the portion of

its MC curve

above AVC.

Q

Costs

A Competitive Firm’s SR Supply Curve

MC

ATC

AVC

If P > AVC, then

firm produces Q

where P = MC.

If P < AVC, then

firm shuts down

(produces Q = 0).

16

The Irrelevance of Sunk Costs

Sunk cost: a cost that has already been

committed and cannot be recovered

Sunk costs should be irrelevant to decisions;

you must pay them regardless of your choice.

FC is a sunk cost: The firm must pay its fixed

costs whether it produces or shuts down.

So, FC should not matter in the decision to shut

down.

17

A Firm’s Long-Run Decision to Exit

• Cost of exiting the market:

revenue loss = TR

• Benefit of exiting the market:

cost savings = TC

(zero FC in the long run)

So, firm exits if TR < TC.

Divide both sides by Q to write the firm’s

decision rule as:

Exit if P < ATC

18

A New Firm’s Decision to Enter Market

In the long run, a new firm will enter the market if

it is profitable to do so: if TR > TC.

Divide both sides by Q to express the firm’s

entry decision as:

Enter if P > ATC

19

The firm’s

LR supply curve

is the portion of

its MC curve

above LRATC.

Q

Costs

The Competitive Firm’s Supply Curve

MC

LRATC

A C T I V E L E A R N I N G 2A:

Identifying a firm’s profit

Determine

this firm’s

total profit.

Identify the

area on the

graph that

represents

the firm’s

profit.

20

Q

Costs, P

MC

ATC

P = $10 MR

50

$6

A competitive firm

profit

A C T I V E L E A R N I N G 2A:

Answers

21

Q

Costs, P

MC

ATC

P = $10 MR

50

$6

A competitive firm

profit per unit

= P – ATC

= $10 – 6

= $4

Total profit

= (P – ATC) x Q

= $4 x 50

= $200

A C T I V E L E A R N I N G 2B:

Identifying a firm’s loss

Determine

this firm’s

total loss,

assuming

AVC < $3.

Identify the

area on the

graph that

represents

the firm’s

loss.

22

Q

Costs, P

MC

ATC

A competitive firm

$5

P = $3 MR

30

lossMRP = $3

A C T I V E L E A R N I N G 2B:

Answers

23

Q

Costs, P

MC

ATC

A competitive firm

loss per unit = $2

Total loss

= (ATC – P) x Q

= $2 x 30

= $60$5

30

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CONCLUSION: The Efficiency of a Competitive Market

Profit-maximization: MC = MR

Perfect competition: P = MR

So, in the competitive eq’m: P = MC

Recall, MC is cost of producing the marginal unit.

P is value to buyers of the marginal unit.

So, the competitive eq’m is efficient, maximizes

total surplus.

In the next chapter, monopoly: pricing &

production decisions, deadweight loss, regulation.

25

Monopoly Introduction

A monopoly is a firm that is the sole seller of a

product without close substitutes.

In this part, we study monopoly and contrast it

with perfect competition.

The key difference:

A monopoly firm has market power, the ability

to influence the market price of the product it

sells. A competitive firm has no market power.

26

Why Monopolies Arise

The main cause of monopolies is barriers

to entry – other firms cannot enter the market.

Three sources of barriers to entry:

1. A single firm owns a key resource.

E.g., DeBeers owns most of the world’s

diamond mines

2. The govt gives a single firm the exclusive right

to produce the good.

E.g., patents, copyright laws

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Why Monopolies Arise

3. Natural monopoly: a single firm can produce

the entire market Q at lower ATC than could

several firms.

Q

Cost

ATC

1000

$50

Example: 1000 homes

need electricity. Electricity

ATC slopes

downward due

to huge FC and

small MC

ATC is lower if

one firm services

all 1000 homes

than if two firms

each service

500 homes. 500

$80

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Monopoly vs. Competition: Demand Curves

In a competitive market,

the market demand curve

slopes downward.

but the demand curve

for any individual firm’s

product is horizontal

at the market price.

The firm can increase Q

without lowering P,

so MR = P for the

competitive firm.

D

P

Q

A competitive firm’s

demand curve

29

Monopoly vs. Competition: Demand Curves

A monopolist is the only

seller, so it faces the

market demand curve.

To sell a larger Q,

the firm must reduce P.

Thus, MR ≠ P.

D

P

Q

A monopolist’s

demand curve

A C T I V E L E A R N I N G 1:

A monopoly’s revenue

Moonbucks is

the only seller of

cappuccinos in town.

The table shows the

market demand for

cappuccinos.

Fill in the missing

spaces of the table.

What is the relation

between P and AR?

Between P and MR?

30

Q P TR AR MR

0 $4.50

1 4.00

2 3.50

3 3.00

4 2.50

5 2.00

6 1.50

n.a.

A C T I V E L E A R N I N G 1:

Answers

Here, P = AR,

same as for a

competitive firm.

Here, MR < P,

whereas MR = P

for a competitive

firm.

31

1.506

2.005

2.504

3.003

3.502

1.50

2.00

2.50

3.00

3.50

$4.004.001

n.a.

9

10

10

9

7

4

$ 0$4.500

MRARTRPQ

–1

0

1

2

3

$4

32

Moonbuck’s D and MR Curves

-3

-2

-1

0

1

2

3

4

5

0 1 2 3 4 5 6 7 Q

P, MR

MR

$

Demand curve (P)

1.506

2.005

2.504

3.003

3.502

4.001

$4.500

MRPQ

–1

0

1

2

3

$4

33

Understanding the Monopolist’s MR

Increasing Q has two effects on revenue:

• The output effect:

Higher output raises revenue

• The price effect:

Lower price reduces revenue

To sell a larger Q, the monopolist must reduce the

price on all the units it sells.

Hence, MR < P

MR could even be negative if the price effect

exceeds the output effect

(e.g., when Moonbucks increases Q from 5 to 6).

34

Profit-Maximization

Like a competitive firm, a monopolist maximizes

profit by producing the quantity where MR = MC.

Once the monopolist identifies this quantity,

it sets the highest price consumers are willing to

pay for that quantity.

It finds this price from the D curve.

35

Profit-Maximization

1. The profit-

maximizing Q

is where

MR = MC.

2. Find P from

the demand

curve at this Q.

Quantity

Costs and

Revenue

MR

D

MC

Profit-maximizing output

P

Q

36

The Monopolist’s Profit

As with a

competitive firm,

the monopolist’s

profit equals

(P – ATC) x Q

Quantity

Costs and

Revenue

ATC

D

MR

MC

Q

P

ATC

37

A Monopoly Does Not Have an S Curve

A competitive firm

takes P as given

has a supply curve that shows how its Q depends

on P

A monopoly firm

is a “price-maker,” not a “price-taker”

Q does not depend on P;

rather, Q and P are jointly determined by

MC, MR, and the demand curve.

So there is no supply curve for monopoly.

38

The Welfare Cost of Monopoly

Recall: In a competitive market equilibrium,

P = MC and total surplus is maximized.

In the monopoly eq’m, P > MR = MC

• The value to buyers of an additional unit (P)

exceeds the cost of the resources needed to

produce that unit (MC).

• The monopoly Q is too low –

could increase total surplus with a larger Q.

• Thus, monopoly results in a deadweight loss.

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P = MC

Deadweight

loss

P

MC

The Welfare Cost of Monopoly

Competitive eq’m:

quantity = QC

P = MC

total surplus is

maximized

Monopoly eq’m:

quantity = QM

P > MC

deadweight loss Quantity

Price

D

MR

MC

QM QC

40

Public Policy Toward Monopolies

Increasing competition with antitrust laws

• ban some anticompetitive practices,

allow govt to break up monopolies

Regulation

• Govt agencies set the monopolist’s price

• For natural monopolies, MC < ATC at all Q,

so marginal cost pricing would result in losses.

• If so, regulators might subsidize the monopolist

or set P = ATC for zero economic profit.

41

Public Policy Toward Monopolies

Public ownership

• Example: U.S. Postal Service

• Problem: Public ownership is usually less

efficient since no profit motive to minimize costs

Doing nothing

• The foregoing policies all have drawbacks,

so the best policy may be no policy.

42

Price Discrimination

Discrimination: treating people differently based

on some characteristic, e.g. race or gender.

Price discrimination: selling the same good

at different prices to different buyers.

The characteristic used in price discrimination

is willingness to pay (WTP):

• A firm can increase profit by charging a higher

price to buyers with higher WTP.

43

Price Discrimination in the Real World

In the real world, perfect price discrimination is

not possible:

• no firm knows every buyer’s WTP

• buyers do not announce it to sellers

So, firms divide customers into groups

based on some observable trait

that is likely related to WTP, such as age.

44

Examples of Price Discrimination

Movie tickets

Discounts for seniors, students, and people

who can attend during weekday afternoons.

They are all more likely to have lower WTP

than people who pay full price on Friday night.

Airline prices

Discounts for Saturday-night stayovers help

distinguish business travelers, who usually have

higher WTP, from more price-sensitive leisure

travelers.

45

Examples of Price Discrimination

Quantity discounts

A buyer’s WTP often declines with additional

units, so firms charge less per unit for large

quantities than small ones.

Example: A movie theater charges $4 for

a small popcorn and $5 for a large one that’s

twice as big.

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CONCLUSION: The Prevalence of Monopoly

In the real world, pure monopoly is rare.

Yet, many firms have market power, due to

• selling a unique variety of a product

• having a large market share and few significant

competitors

47

Between Monopoly and Competition

Two extremes

• Competitive markets: many firms, identical

products

• Monopoly: one firm

In between these extremes

• Oligopoly: only a few sellers offer similar or

identical products.

• Monopolistic competition: many firms sell

similar but not identical products.

48

LESSON SUMMARY

For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.

If P > AVC, a firm maximizes profit by producing

the quantity where MR = MC. If P < AVC, a firm

will shut down in the short run.

If P < ATC, a firm will exit in the long run. .

49

LESSON SUMMARY

A monopoly firm is the sole seller in its market.

Monopolies arise due to barriers to entry,

including: government-granted monopolies, the

control of a key resource, or economies of scale

over the entire range of output.

A monopoly firm faces a downward-sloping

demand curve for its product. As a result, it must

reduce price to sell a larger quantity, which causes

marginal revenue to fall below price.

50

LESSON SUMMARY

Monopoly firms maximize profits by producing the

quantity where marginal revenue equals marginal

cost. But since marginal revenue is less than

price, the monopoly price will be greater than

marginal cost, leading to a deadweight loss.

Policymakers may respond by regulating

monopolies, using antitrust laws to promote

competition, or by taking over the monopoly and

running it. Due to problems with each of these

options, the best option may be to take no action.

51

LESSON SUMMARY

Monopoly firms (and others with market power) try

to raise their profits by charging higher prices to

consumers with higher willingness to pay. This

practice is called price discrimination.