Profit Maximisation under Perfect Competition and Monopoly

Alternative Market Structures

Classifying markets (by degree of competition)
number of firms freedom of entry to industry
free, restricted or blocked?

nature of product
homogeneous or differentiated?

nature of demand curve

degree of control the firm has over price

Alternative Market Structures

The four market structures
perfect competition

monopoly
monopolistic competition

oligopoly

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants Cement cars, electrical appliances Local water company, train operators (over particular routes)

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants Cement cars, electrical appliances Local water company, train operators (over particular routes)

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants Cement cars, electrical appliances Local water company, train operators (over particular routes)

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants Cement cars, electrical appliances Local water company, train operators (over particular routes)

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants Cement cars, electrical appliances Local water company, train operators (over particular routes)

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Features of the four market structures

Type of market Number of firms Freedom of entry Nature of product Examples Implications for demand curve faced by firm Horizontal: firm is a price taker Downward sloping, but relatively elastic Downward sloping. Relatively inelastic (shape depends on reactions of rivals) Downward sloping: more inelastic than oligopoly. Firm has considerable control over price

Perfect competition Monopolistic competition

Very many Many / several

Unrestricted

Homogeneous (undifferentiated)

Cabbages, carrots (approximately) Builders, restaurants Cement cars, electrical appliances Local water company, train operators (over particular routes)

Unrestricted

Differentiated

Undifferentiated Oligopoly Few Restricted or differentiated

Monopoly

One

Restricted or completely blocked

Unique

Alternative Market Structures

The four market structures
perfect competition

monopoly
monopolistic competition

oligopoly

Structure conduct performance

Perfect Competition
Assumptions
firms are price takers freedom of entry of firms to industry identical products perfect knowledge

Distinction between short and long run

normal profits

supernormal profits

Perfect Competition
Short-run equilibrium of the firm
Price
given by market demand and supply

Output
where P = MC

Profit
(AR AC) Q possible supernormal profits

Short-run equilibrium of industry and firm under perfect competition

P
S

MC

AC

Pe

AR AC

D = AR = MR

O
Q (millions)

Qe Q (thousands)

(a) Industry

(b) Firm

Loss minimising under perfect competition

P
S

MC

AC

AC P1 AR1

D1 = AR1 = MR1

O
Q (millions)

Qe Q (thousands)

(a) Industry

(b) Firm

Short-run shut-down point

P
S

MC

AC

AVC

P2 D2

AR2

D2 = AR2 = MR2

O
Q (millions)

O
Q (thousands)

(a) Industry

(b) Firm

Perfect Competition
Short-run equilibrium of the firm (cont.)
short-run supply curve of firm
the MC curve

Short-run supply curve of industry

sum of supply curves of firms

Perfect Competition
The long run
long-run equilibrium of the firm
all supernormal profits competed away

Long-run equilibrium under perfect competition

Profits return Supernormal profits New firms enter to normal
P
S1 Se LRAC P1 PL AR1 D1 DL

ARL

O
Q (millions)

QL Q (thousands)

(a) Industry

(b) Firm

Perfect Competition
The long run
long-run equilibrium of the firm
all supernormal profits competed away
LRAC = AC = MC = MR = AR

Long-run equilibrium of the firm under perfect competition

(SR)MC (SR)AC

LRAC

DL AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

Perfect Competition
The long run
long-run equilibrium of the firm
all supernormal profits competed away

LRAC = AC = MC = MR = AR

long-run industry supply curve

Perfect Competition
The long run
long-run equilibrium of the firm
all supernormal profits competed away

LRAC = AC = MC = MR = AR

long-run industry supply curve incompatibility of economies of scale with perfect competition

Perfect Competition
The long run
long-run equilibrium of the firm
all supernormal profits competed away

LRAC = AC = MC = MR = AR

long-run industry supply curve incompatibility of economies of scale with perfect competition

Does the firm benefit from operating under perfect competition?

Monopoly
Defining monopoly
importance of market power concentration ratios

Concentration ratios in the UK

Industry Chilled Indian ready meals Frozen Indian ready meals Record companies Batteries Skin care products Jeans retail Book publishing 5-firm ratio 89.3 75.0 73.9 70.9 64.4 39.0 37.6 Chocolate manufactures Breakfast cereals 3-firm ratio 76.0 69.0 Industry Bottled water (still) Bottled water (sparkling) Frozen foods 5-firm ratio 58.0 35.0 34.4

Monopoly
Barriers to entry
economies of scale product differentiation and brand loyalty lower costs for an established firm ownership/control of key factors or outlets legal protection

mergers and takeovers

aggressive tactics

Monopoly
The monopolist's demand curve
downward sloping MR below AR

AR and MR curves for a monopoly

8
Q P =AR (units) () 8 1 7 2 6 3 5 4 4 5 3 6 2 7

AR, MR ()

AR

0 1 -2 2 3 4 5 6 7

Quantity

-4

AR and MR curves for a monopoly

8
Q P =AR (units) () 8 1 7 2 6 3 5 4 4 5 3 6 2 7 TR MR () () 8 6 14 4 18 2 20 0 20 -2 18 -4 14

AR, MR ()

AR

0 1 -2 2 3 4 5 6 7

Quantity

-4

MR

Monopoly
Equilibrium price and output
MC = MR

Profit maximising under monopoly

MC

MR
O

Qm

Monopoly
Equilibrium price and output
MC = MR

measuring level of supernormal profit

Profit maximising under monopoly

MC

MR
O

Qm

Profit maximising under monopoly

MC

AC

AR

AC

AR MR
O

Qm

Profit maximising under monopoly

MC Total profit

AC

AR

AC

AR MR
O

Qm

Monopoly
Equilibrium price and output
MC = MR measuring level of supernormal profit

Monopoly versus perfect competition

Monopoly
Equilibrium price and output
MC = MR measuring level of supernormal profit

Monopoly versus perfect competition

lower output at a higher price

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

MC Monopoly

P1

AR = D

MR
O
Q1

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

MC ( = supply under
perfect competition)

P1 P2

Comparison with Perfect competition

AR = D

MR
O
Q1 Q2

Monopoly
Equilibrium price and output
MC = MR
measuring level of supernormal profit

Monopoly versus perfect competition

lower output at a higher price
short run and long run

Monopoly
Equilibrium price and output
MC = MR
measuring level of supernormal profit

Monopoly versus perfect competition

lower output at a higher price
short run and long run

costs under monopoly

Equilibrium of industry under perfect competition and monopoly: with different MC curves

MCmonopoly

P1

AR = D
MR
O Q1 Q

Equilibrium of industry under perfect competition and monopoly: with different MC curves

MC ( = supply)perfect competition

MCmonopoly
P2 P1 P3

AR = D
MR
O Q2 Q1 Q3 Q

Monopoly
Equilibrium price and output
MC = MR
measuring level of supernormal profit

Monopoly versus perfect competition

lower output at a higher price
short run and long run

costs under monopoly innovation and new products

Contestable Markets
Importance of potential competition
low entry costs low exit costs

Perfectly contestable markets Contestable markets & natural monopolies The importance of costless exit
absence of sunk costs hit-and-run competition

Assessment of the theory