Principles of Economics

By Gregory Mankiw

Instructor: Dr. Bushra Naqvi

Lecture 10
1 Source: Copyright 2004: South Western 27-Oct-11

Markets and the Competitive Environment

The markets in which the firm operate vary a great deal. Economists identify four market types on the basis of Control over Prices.
1. 2. 3. 4.

Perfect Competition Monopolistic Competition Oligopoly Monopoly

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Firm in Monopoly

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What is Monopoly

A firm is considered a monopoly if . . .

it is the sole seller of its product. its product does not have close substitutes. There are barriers to entry

Consequently, a monopoly firm is a price maker.

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WHY MONOPOLIES ARISE?

Ownership of a key resource.

in practice monopolies rarely arise for this reason

The government gives a single firm the exclusive right to produce some good.

Patent and copyright laws are two important examples

Costs of production make a single producer more efficient than a large number of producers.

Its called natural monopoly and arises when there are economies of scale over the relevant range of output.

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Figure 1 Economies of Scale as a Cause of Monopoly

Cost

Average total cost 0

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Quantity of Output
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Monopoly versus Competition

Competitive Firm

Is one of many producers Faces a horizontal demand curve Is a price taker Sells as much or as little at same price Is the sole producer Faces a downward-sloping demand curve Is a price maker Reduces price to increase sales

Monopoly

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Figure 2 Demand Curves for Competitive and Monopoly Firms

(a) A Competitive Firms Demand Curve Price Price

(b) A Monopolists Demand Curve

Demand

Demand

Quantity of Output

Quantity of Output

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A Monopolys Revenue

Total Revenue P Q = TR

Average Revenue
TR/Q = AR = P Marginal Revenue DTR/DQ = MR

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Table 1: A Monopolys Total, Average, and Marginal Revenue

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Figure 3 Demand and Marginal-Revenue Curves for a Monopoly

Price $11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4
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Marginal revenue 1 2 3 4 5 6 7 8

Demand (average revenue) Quantity of Water

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Profit Maximizing Output and Price

A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. MR=MC It then uses the demand curve (which is also AR curve) to find the price that will induce consumers to buy that quantity.

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Figure 4 Profit Maximizing Output and Price

Costs and Revenue

2. . . . and then the demand curve shows the price consistent with this quantity. B

Monopoly price

1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . .

Average total cost A

Marginal cost

Demand

Marginal revenue
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QMAX

Quantity
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Profit Maximizing Output and Price

Comparing Monopoly and Competition

For a competitive firm, price equals marginal cost. P = MR = MC For a monopoly firm, price exceeds marginal cost. P > MR = MC

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Figure 5 The Monopolists Profit in Short Run

Costs and Revenue Marginal cost Monopoly E price Monopoly profit Average total D cost B

Average total cost

Demand

Marginal revenue
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QMAX

Quantity
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Figure 5 The Monopolists Profit in Long Run

Costs and Revenue Marginal cost Monopoly E price Monopoly profit Average total D cost B

Average total cost

Demand

Marginal revenue
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QMAX

Quantity
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A Monopolists Profit

The monopolist will receive economic profits as long as price is greater than average total cost.

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MONOPOLISTIC COMPRTITION

A type of Market

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The Four Types of Market Structure

Number of Firms? Many firms Type of Products?

One firm

Few firms

Differentiated products

Identical products

Monopoly (Chapter 15)

Tap water Cable TV

Oligopoly (Chapter 16)

Tennis balls Crude oil

Monopolistic Competition (Chapter 17) Novels Movies

Perfect Competition (Chapter 14) Wheat Milk

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What is Monopolistic Competition?

Markets that have some features of competition and some features of monopoly.

Many sellers

There are many firms competing for the same group of customers. Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc. Each firm produces a product that is at least slightly different from those of other firms. Rather than being a price taker, each firm faces a downwardsloping demand curve.

Product differentiation

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Free entry and exit

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Figure 1 Monopolistic Competition in the Short Run

(a) Firm Makes Profit Price MC

ATC

Price Average total cost Profit

Demand

MR
0
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Profitmaximizing quantity

Quantity

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Figure 1 Monopolistic Competitors in the Short Run

(b) Firm Makes Losses Price MC ATC

Losses

Average total cost

Price

MR 0
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Demand
Quantity

Lossminimizing quantity

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Monopolistic Competitor Long-Run Equilibrium

Firms will enter and exit until the firms are making exactly zero economic profits.

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Figure 2 A Monopolistic Competitor in the Long Run

Price MC ATC

P = ATC

Demand MR 0
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Profit-maximizing quantity

Quantity

Long-Run Equilibrium

Two Characteristics

As in a monopoly, price exceeds marginal cost.

Profit maximization requires marginal revenue to equal marginal cost. The downward-sloping demand curve makes marginal revenue less than price.

As in a competitive market, price equals average total cost.

Free entry and exit drive economic profit to zero.

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