Chapter 8

Perfect competition and pure monopoly

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward

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Perfect competition
Characteristics of a perfectly competitive 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
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The supply curve under perfect competition (1)

SMC

P3 P1

C A

SATC SAVC

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

Q1 Q3

Output

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The supply curve under perfect competition (2)

SMC

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

P3 P1

C A

SATC SAVC

Q1 Q3

Output

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The supply curve under perfect competition (3)

SMC

P3 P1

C A

SATC SAVC

So the SMC curve above SAVC represents the firm s SHORT-RUN SUPPLY CURVE showing how much the firm would produce at each price level.

Q1 Q3

Output

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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

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The firm and the industry in the short run under perfect competition (1) Firm
SMC SAC P P D=MR=AR D q Output Q Output

INDUSTRY
SRSS

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
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The firm and the industry in the short run under perfect competition (2) Firm
SMC SAC P P D=MR=AR D q Output Q Output

INDUSTRY
SRSS

The firm accepts price as given at P and chooses output at q where SMC=MR to maximise profits
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The firm and the industry in the short run under perfect competition (3) Firm
SMC SAC P P D=MR=AR P 1 D q Output Q Q1 Output

INDUSTRY
SRSS SRSS1

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.
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Long-run equilibrium
Firm
LAC LMC

INDUSTRY
SRSS

P* D=MR=AR

P*

LRSS

D
Q Output 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) the long-run supply curve will not be horizontal, but upward-sloping. q*
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Adjustment to an increase in market demand: the short run

D'

SRSS

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

P1 P0

D
Q0 Q1

D'
Output
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Adjustment to an increase in market demand: the long run

D' SRSS In the long run, new firms are attracted by the profits now being made here and firms are able to adjust their input of fixed factors If wages are bid up by this expansion, the long-run supply schedule is upwardsloping and the market finally settles at P2Q2.

D
P1 P2 P0

LRSS

D
Q0 Q1 Q2

D'

Output
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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 maximisation by a monopolist

Profits are maximised where MC = MR at Q1P1. In this position, AR is greater than AC so the firm makes profits above the opportunity cost of capital shown by the shaded area. Entry barriers prevent new firms joining the industry.

MC

AC P1

MC=MR

MR
Q1

D = AR Output
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Comparing monopoly with perfect competition (1)

Suppose a competitive industry is taken over by a monopolist:

SRSS =SMC

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

P2 P1

LRSS

= LMC
MR Q2 Q1

D
Output
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Comparing monopoly with perfect competition (2)

Suppose a competitive industry is taken over by a monopolist: SRSS
=SMC P3 P2 P1

In the long run the firm can adjust other inputs ... to set MR = LMC at P3Q3.

LRSS = LMC

MR Q3 Q2 Q1

D
Output
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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
P1 LMC LAC

the largest firm always enjoys cost leadership and comes to dominate the industry It is a NATURAL MONOPOLY.
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MR
Q1

D
Output
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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.
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