Chapter 9

Perfect competition and monopoly:

The limiting cases of market structure

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
Perfect competition
Characteristics of a perfectly competition market
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
9.2
The supply curve under perfect competition (1)

Above price P3
(point C), the firm
makes profit above
SMC
the opportunity cost
of capital in the
SATC
C short run
P3
SAVC
At price P3, (point
P1
A C), the firm makes
NORMAL PROFITS
Q1 Q3 Output

9.3
The supply curve under perfect competition (2)

Between P1 and P3, (A

and C), the firm makes
short-run losses, but
SMC
remains in the market
SATC Below P1 (the SHUT-
C DOWN PRICE), the
P3
P1 SAVC firm fails to cover
A
SAVC, and exits

Q1 Q3 Output

9.4
The supply curve under perfect competition (3)

So the SMC curve

above SAVC
SMC represents the
firms SHORT-RUN
SATC SUPPLY CURVE
C
P3 showing how much
P1 SAVC the firm would
A
produce at each
price level.
Q1 Q3 Output

9.5
The firm and the industry in the short
run under perfect competition (1)
Firm SMC INDUSTRY
SRSS

SAC

P P
D=MR=AR

D
q Output Q Output
Market price is set at industry level at the intersection of
demand and supply
the industry supply curve is the sum of the individual firms
supply curves.
9.6
The firm and the industry in the short
run under perfect competition (2)
Firm SMC INDUSTRY
SRSS

SAC

P P
D=MR=AR

D
q Output Q Output
The firm accepts price as given at P
and chooses output at q where SMC=MR to maximize profits

9.7
The firm and the industry in the short
run under perfect competition (3)
Firm SMC INDUSTRY
SRSS

SAC SRSS1

P P
D=MR=AR P
1

D
q Output Q Output
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 shifts
to the right, and market price falls.
9.8
 Long-run equilibrium

Firm SMC INDUSTRY

SRSS
SAC

LRSS
P* P*
D=MR=AR

D
q* Output Q Output
The market settles in long-run equilibrium when the typical
firm 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.

9.9
 Adjustment to an increase in market demand:
the short run

Suppose a perfectly
competitive market starts
D D' SRSS
in equilibrium at P0Q0.
If market demand shifts to
P1
D'D' ...
P0 in the short run the new
equilibrium is P1Q1 ...
D' adjustment is through
D
expansion of individual
Q0 Q1 firms along their SMCs.
Output

9.10
 Adjustment to an increase in market demand:
the long run

In the long run, new firms

are attracted by the profits
D D' SRSS
now being made here
and firms are able to
P1 adjust their input of fixed
P2 LRSS factors
P0 If wages are bid up by this
expansion, the long-run
D' supply schedule is upward-
D sloping
And the market finally
Q0 Q1 Q2 Output
settles at P2Q2.
9.11
Monopoly
A monopolist:
is the sole supplier of an industrys 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.

9.12
 Profit maximization by a monopolist

Profits are maximized

where MC = MR at Q1P1.
MC In this position, AR is
greater than AC
AC so the firm makes
P1 profits above the
opportunity cost of
AC1
capital
shown by the shaded area
MR D = AR
MC=MR
Entry barriers prevent
Q1 new firms joining the
Output
industry.
9.13
 Comparing monopoly with perfect
competition (1)
Suppose a competitive industry is taken over by a monopolist:

SRSS
Competitive equilibrium
=SMC is at A, with output Q1
and price P1.
To the monopolist, LRSS
P2 is the LMC curve, and
A LRSS
P1 SRSS is the SMC curve
= LMC The monopolist
D maximizes profits in the
MR
short run at MR = SMC
Q2 Q1 Output at P2Q2.

9.14
 Comparing monopoly with perfect
competition (2)
Suppose a competitive industry is taken over by a monopolist:

SRSS
In the long run, the
=SMC firm can adjust
other inputs ...
P3
P2 to set MR = LMC
A LRSS
P1
= LMC At P3Q3.

MR D
Q3 Q2 Q1 Output

9.15
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.

9.16
 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
P1 LMC and comes to dominate the
industry
LAC It is a NATURAL
D MONOPOLY
MR
Q1 Output

9.17
Discriminating monopoly
Suppose a monopolist supplies two separate
groups of customers
with differing elasticities of demand
e.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 resold
e.g. dental treatment

9.18