Module 7 Organization of Industry

Most markets dont have a perfect completion ( no identical product, profit

maximizes, face no entry restrictions, have perfect information on resource cost).

7.2 Perfect competition

Very large number of firms so individual action is negligible

o Price and quantity not affected
Identical good ( no real or imagined differences)
No restriction to enter market as long as firm as resources
Aim is to maximize profit both short and long runs by using appropriate factor
level inputs
Firms have info on opportunity cost of their resources

Perfectly elastic demand curve ie can sell all otput at fixed price ( market price,
price )
Since firm is small in comparison to market it can sell all product at P.

Since price taker the price for each additional unit is same so marginal revenue MR
is fixed at P.
MR = P
Also average revenue AR = MR = P
AR =

Total revenue
quantity

MR =

TR
Q

Quantity x price
Quantity
Qx P
Q

=P

=P

P = AR = MR

X is output that gives max profit

At max profit quantity MR ( ie price) = MC
At this output firms earn above normal profit ( distance E-C) since P > average cost.
This acts as incentive for firms/resources to enter industry ( or expand to produce
more)
As resources move in at cet par
price will fall
Once balance is reach there is no incentives for resources to move into industry and
this means each firm is in long run and therefore price = long run marginal cost
MC.
Max
profit
From previous chart;
P is P . This is above normal profit.
Resources enter industry and supply moves to S1
This causes P to to P1
Since firms are price takers as P the AR/MR also ( MR = P = AR)
Even at P1
P>ATC so more resources will get into industry
Above normal profit

As long as resources keep entering industry S and P will .

At P2 resources stop entering industry mark.
At P2 profit is maximized by producing at marginal cost that equals marginal
revenue = P2
P = LRMC = LRAC
Therefor only normal profit is earned.
And again
Since consumers want utility maximization and producers profit maximization in
perfect competition economic efficiency is reached.

Since utility maximization needs

MU
P

for all goods to be equal and profit

maximization required price = MC for all goods -> economic efficiency is achieved

MU
MC

since

MUa
Pa

MUb
Pb

MUb
MCb

P = MC

MUa
MCa

is equal for all goods.

Monopoly is the opposite.

7.3 Monopoly
=> one producer supplies all marker
=> consumer HAS to purchase from him
Disincentives barrier of entry
-

Legal eg patents
Economic eg market share leaders

Since sole produce -> short run MC curve = Market supply curve.
Also market demand curve is the demand curve forced by firm ( all demand at diff
prices).
Since demand curve is downward sloping
Therefore AR and MR diverge
((revenue received is less than that received for the previous unit (marginal revenue
received for unit 2 is less than that for unit 1). Therefor the marginal revenue will be
less than the average
revenue. Unit 1 sold for $5 Marginal revenue=$5 Average Revenue=$5 Unit 2 sold
for $4 Marginal revenue=$4 Average Revenue=$4.50 ($5+$4/2)))
Max profit is still when quantity at which MC = MR ( same as competition).
At this quantity the price it will sell for is found on demand curve that = AR curve
Also at this quantity ATC is found so above average profit : T is found. This above
from normal profit remains since no competition.
In the long run the monopolist can expand or contract
Expand if ling run MC > MR
Contracts if long run MC < MR
Until long run MC = MR
In monopoly MR < AR therefore P > MC ( price exceeds marginal cost).

IE produce at output where price is greater than marginal cost.

This means that economic efficiency is not achieved.

P MC

P>MC so

MU
MC

ratio is higher than a product in competitive

industry.
It is however possible to increase UTILITY by reallocation resources and produce
more of this product since it has a higher utility ratio than competitive product.
Ie when

MUa
MCa

MUb
MCb

is not max utility.

7.3.1 Economies of scale

Monopolists may be in societys best interest if economies of scale exist when
average costs declines as output increases.
ATC at increasing output quantities;
Minimum ATC as output
This is mostly due to ;
-Specialization of labour
per unit cost of larger capital equipment
per unit cost of bulk raw material
Eg 4 firms work ATC1 will still produce Q4 but per unit cost will be higher C1
1 Firm working at ATC4 will result in a per unit cost of C4 lower.

In a forced completive environment ( eg law states production is max fixed at q1)

At this quantity firm produce at minimum cost
Total output is Q1 ; Aggregate demand = aggregate supply. Each firm is in short run
equilibrium since
MC = MR = Pc
On the other hand a monopolist can produce at Qm where MR = MC and change
profit maximizing price of Pm.
Since Pm > MC marginal equivalency is not present( ie above average profit)
( inefficient allocation f resources).
Therefore In Monopoly with economies of scale quantity + price + rescores
overall.
Therefore economies of scale favor monopolies.

7.4 Imperfect competition

Still in line with economic theory since there is increased perceived value or
increased price time saved.
Still large number of firms and downward demand slope but less than perfect
competition + demand curve is not completely elastic.
Firms have degree of control over price because of several factors;
-

Real or imagined product difference ( eg adverts, loyalty)

Local monopoly elements ( eg convinced).
Firms can join and leave
The greater the differences on local monopoly the more inelastic the
demand curve is. ( large increase in rice for small loss in quantity
demand).

Eg firm has a downward sloping demand curve so AR and MR diverge but less than
a monopolist.
The decision for maximizing profit for competition, monopolist and also imperfect
competition firm applies as well;
output until MC = MR
Max profit when MC = MR . At this quantity the demand curve denotes an above
normal profit at equivalent price. This above normal profit will be incentive for
resources.
Demand curve shifts left until in lung run equilibrium
ATC = AR = P = normal profit.
At long run price P > MC therefore economic inefficiency.
Firm could produce higher output at MC = ATC ( min ATC) and this would be
economically efficient but since the output would be at a lower cost and price it is
not profit maximizing and would be less.
This is called space capacity and offsets product differentiation.
deman

7.5 Oligopoly
-Limited number of producers for bulk of output
- competition and interdependence
Homogenous good eg air travel
Main issue is pricing and market share

At going price P airline sells q . at this MR MC so still profit maximising

Due to increase in costs MC shifts to MC2. Same quantity is still profit maximizing
due to kink.
At kink price is inelastic. If price is increased they operated in elastic portion of
demand curve and loose business.
Kink because price/demand is strongly related to competition.
Pricing optimally ;

 The issue is that you cannot be sure how price inelastic the demand curve
and if competitors will match the increase or decrease in price.
Kink demand curve means you cannot move MR even if MC ( costs)
change. MR is not elastic since depends on competitions as well.
Only option is cartel all charge profit maximizing monopoly price and
split the market between them
o This is illegal however firms can allow one firm to lead and follow
any change
NASH Equilibrium
When output equilibrium is at above monopoly ( or illegal cartel) output
BECAUSE of anticipation of competitive strategy, top try and minimize
loss.
Principal Agent Problem
If monopoly becomes regulated this can happen. Monopoly has the
advantage of economies of scale. If gov ( principal) imposes economic
efficiency and forces MC= MR
Then conflict arises that the manufacturing firm ( agent) has no incentive
to minimize costs since its guaranteed normal profit irrespectively.
Agent can increase its cost therefore efficiency gals is thwarted
Principal agent problem always cases economy when compared to free
competition since there is no incentive to cost and profit

7.6 Regulation and economic efficiency

Unregulat
ed profit
mazimizin
g
monopoly

No
economic
efficeicncy

since no
mariganl
equivanlcy
condition

Therefore body to equate P with MC is needed.

In relegated public monopolies price change requires approval and this is given/not
after considering marginal conditions. Economic efficacy can sometimes be
achieved by replacing with competitive firms.
VIP
Monopoly with 3
Perfect comp
plants ( no
with 3 firms
economies of
scale).

In this monopoly MR diverges from AR ( demand) curves which results in prince

and output.
Each firm produces at this output point and above normal profit is made.
However output Qm and Pm is only short run.
Long run MC is a horizontal line equating long run average cost - > LRMC = LRAC
This leads to output of Qmlr and Pmlr which is a further price and output in
comparison to monopoly short run.
If gov was to split monopoly in 3 under perfect competition price = long run MC and
economic efficiency will be achieved. Unless monopoly Has economies of scale. In
comparison more small firms are needed and long run equilibrium is not achieved.
If monopoly has economies of scale
Suppose this is in long run equilibrium
Ie MR = LRMC = MCSR
ATCSR = LRAC
No economic efficiency since P > MC
If replaced with smaller firms and equilibrium is reached at P1 where MC = ATC = P
However no firm will be in long run equilibrium since P > LRMC
Therefore in monopoly WITH economies of scale Quantities and Price than short
run competitive conditions.
When production is characterized by economies of scale regulation to equate P to
MC is needed for greater economic efficacy.

Suppose initially long run at Pm when MR = LRMC

Price (D) > LRMC at this P
Gov pushes price down to P2 where P = LRMC
At this price P and Q than monopoly
Since P = LRMC we have economic efficiency and marginal equivalency conditions.
Once P is fixed at P2 firm becomes price tier and profit maximize behavior to
produce Q2 with min resources.
In competitive market long run P =MCSR = LRMC = Min ATC = Min LRAC
However in monopoly even if P = MCSR there is no guarantee that MC = min ATC and
min LRAC so above normal profit ( X-Y) is still earned and this could be taxed or
panelized.
However there is still no interested from other firms to enter sine economies of
scale.
If under regulation P < ATC than loss is made
> Subsidy is needed to prevent resources leaving industry or allow P to equal
AC recognizing that economic efficacy loss will occur.
For economic efficacy gov puts price

P = MC

If production at this price causes P to be less than AC ( average costs are higher
than the price) there is loss. This loss ( cause of the opp cost ) leads to resources

leaving industry unless is refunded. Or else allow P to be higher and production

lower so that MC = AC. ( below normal loss K L).
In monopoly economic eff will not prevail since
P > MC
Therefore

MU
MC

ratio is higher

By regulation price so that P = MC there will be more allocation of resources to

monopoly product and less competitive products are produced. Total utility increase
an economic efficiency will be achieved because marginal equivalence condition is
satisfied.
Regulation costs money so society to determine f this costs results in net gain.