Price and Output under Perfect

Competition and Monopoly

Perfect Competition
• Perfect competition arises when:
• There are many firms, each selling an identical
product.
• There are many buyers.
• There are no restrictions on entry into the
industry.
• Firms in the industry have no advantage over
potential new entrants.
• Firms and buyers are completely informed
about other firms’ prices.
Perfect Competition
Market Structure and Firm Behaviour
• Competitive behaviour refers to the extent to which individual firms
compete with each other to sell their products.
• Competitive market structure refers to the power that individual
firms have over the market - perfect competition occurring where
firms have no market power and hence no need to react to each
other.
Perfectly Competitive Markets
• The theory of perfect competition is based on the following
assumptions: firms sell a homogenous product; customers are well
informed; each firm is a price-taker; the industry can support many
firms, which are free to enter or leave the industry.
 Elasticity of Industry and Firm Demand
• Since each firm produces a small fraction of total industry output
and the products are identical, no firm has any control over price.

• Firms are price takers in perfectly competitive markets. A price

taker is a firm that cannot influence the price of a good or service.

• A price taker firm faces a demand curve that is perfectly elastic

(horizontal) because the product from firm A is a perfect
substitute for the product from firm B.

• However, the market demand curve will still slope downward;

elasticity will be positive, but not infinite.
 The Demand Curve for a Competitive Industry
and for One Firm

• Total revenue (TR): TR = P  Q

• Marginal revenue (MR) d ( P.Q )
– MR = = P = MR
dQ
• Average revenue (AR)
– Total revenue divided by the quantity sold — revenue per unit sold.
– AR = TR/Q = (PxQ)/Q = P

• In perfect competition, Price = MR = AR

Revenue Curve for a Firm
The Short-run Equilibrium of a Firm
• At each output the vertical distance
between the TR and TC curves
shows by how much total revenue
exceeds or falls short of total cost.
• The gap is largest at output qE
which is the profit-maximizing
output.

• Price is total revenue per unit, or

average revenue (P=AR=TR/Q)
• Average total cost is total cost per
unit (ATC=TC/Q).
• Profit = TR - TC
• Profit per unit=(TR-TC)/Q=(TR/Q) -
(TC/Q) = (P - ATC)
• That means total profit
= (P - ATC)*Q
 Alternative Short-run Equilibrium Positions for
a Firm in Perfect Competition
Price per unit

Loss

Price per unit

Break Even
[i] [ii]
SRATC MC MC
SRATC

E E
p1 p2
SARVC

0 q1 Output 0 q2 Output
Profit
[iii] If price equals average total
Price per unit

If price is less than MC cost (P=ATC), a firm breaks

average total cost SRATC
even.
(P<ATC), a firm incurs E
an economic loss. p3

0 q3
Output
If price exceeds average total cost (P>ATC), a firm
makes an economic profit.
The Firm’s Decisions in Perfect Competition

[Loss] • Whether to produce or

to shut down.
Price per unit

SRATC
MC • If the decision is to
produce, what quantity
to produce.
E
p1
• Price is not a decision
SARVC
because firm is a price
taker.
0 q1 Output
A Firm’s Shut-down Point
Marginal revenue & marginal cost
MC
3.5

ATC
3.0
AVC
2.5

2.0

7 9 10
Quantity
A Firm’s Shut-down Point
Marginal revenue & marginal cost
MC = Supply
3.5

ATC
a
3.0 MR1=P1=3.0
AVC
2.5 b MR2=P2=2.5
c
2.0 MR3=P3=2.0

Shutdown 7 8 9
point
Quantity
A Firm’s Shut-down Point
Marginal revenue & marginal cost
MC
3.5

3.0
Shutdown AVC
point
c
2.0 MR0=P0=2.0

7 9 10
Quantity
Temporary Plant Shutdown
• A firm cannot avoid incurring its fixed costs but it
can avoid variable costs.
• A firm that shuts down and produces no output
incurs a loss equal to its total fixed cost.
• A firm’s shutdown point is the level of output and
price where the firm is just covering its total
variable cost.
• In other words, if its losses are bigger than its
fixed costs, the firm will shut down.
 The Supply Curve for a Price-taking Firm
MC S
E3 p3
5 5

E2 p2
Price per nut

4 4
AVC
E1 p1
3 3

E0
p0
2 2

1 1

q0 q1 q2 q3
Output Quantity

[i] Marginal cost and average variable cost curves [ii] The supply curve
The Firm’s Short-Run Supply Curve

• A perfectly competitive firm’s short-run supply curve

shows how its profit-maximizing output varies as
market price changes.
• Since price must equal marginal cost, the marginal
cost curve is also the supply curve.
• However, only the portion of the marginal cost curve
above the minimum average variable cost curve is
relevant.
The Firm’s Short-Run Supply Curve
• Fixed costs must be paid in the short-run.
• Variable-costs can be avoided by laying off
workers and shutting down.
• Firms shut down if price falls below the
minimum of average variable cost.
Production Decisions

• When price is below the minimum point of the AVC

curve, the firm will shut down and supply zero
output.
• When price is above the lowest point of the AVC
curve, the firm will produce the level of output where
price equals marginal cost.
• The short-run supply curve is therefore the MC curve
above the AVC curve.
Price and Output under Monopoly
Monopoly
Features:
• High barriers to entry
• Firm controls price OR output/supply
• Abnormal profits in long run
• Possibility of price discrimination
• Consumer choice limited
• Prices in excess of MC
Why Monopoly Exists:
• Legal: from the ownership of a patent or a copyright,
• Technological, from a secret method of production,
- due to large size, age, or good reputation,
• Natural: Iron Ore, Gas
• Government Regulatory : Gas, Electricity, Rail
Monopoly
A Single-Price Monopolist
• A monopoly is an industry containing a single firm.
• The monopoly firm maximises its profits by equating marginal
cost to marginal revenue, which is less than price.
• Production under monopoly is less than it would be under
perfect competition, where marginal cost is equated to price.
A Multi-Price Monopolist: Price Discrimination
• If a monopolist can discriminate among either different units or
different customers, it will always sell more and earn greater
profits than if it must charge a single price.
• For price discrimination to be possible, the seller must be able
to distinguish individual units bought by a single buyer or to
separate buyers into classes among whom resale is impossible.
Monopoly
Long-run Monopoly Equilibrium
• A monopoly can earn positive profits in the long run if there
are barriers to entry.
• These may be man-made, such as patents or exclusive
franchises, or natural, such as economies of large-scale
production.

The Allocative Inefficiency of Monopoly

• Monopoly is allocatively inefficient.
• By producing less than the perfectly competitive output it
transfers some consumers’ surplus to its own profits and also
causes deadweight loss of surplus that would have resulted
from the output that is not produced.
Total, Average and Marginal Revenue
Price Quantity Total Marginal
Revenue Revenue
p=AR q TR=p*q MR = TR/q
p0
(Rs) (Rs) (Rs) (Rs)
p1
9.10 9 81.90
8.10 Reduction Addition to
9.00 10 90.00 in revenue revenues
7.90
8.90 11 97.90

q0 q1 Quantity

• The revenue from the extra unit sold is shown as the medium blue area.
• The loss in revenue is shown as the dark blue area.
• Marginal revenue of the extra unit is equal to the difference between the
two areas.
Revenue curves and Demand elasticity
Elasticity
greater P = a − bQ
10 than one >1
Unity elasticity TR = P.Q = aQ − bQ 2
=1
dTR
Elasticity = MR = a − 2bQ
between dQ
zero and one
AR 0 <  <1
5
50 100

-10 MR

Quantity
250 • Rising TR, positive MR, and
TR elastic demand all go
Rs together.
• Falling TR negative MR and
inelastic demand all go
50 Quantity
0 100 together.
The Equilibrium of a Monopoly
• Average total cost is total cost per
unit (ATC=TC/Q).
• Profit = TR - TC
• Profit per unit=(TR-TC)/Q=(TR/Q) -
(TC/Q)
= (P - ATC)
• That means total profit = (P - ATC)*Q
• To determine the profit-maximizing
price (where MC = MR), one first finds
that output and then extends a
vertical line up to the demand curve.
No Supply Curve under Monopoly
• The demand curves D’ and D’’ both
have marginal revenue curves that
D” intersect the marginal cost curve at
output q0.

p1

p0
MC

MR” MR’ D’
Quantity
0 q0
The same output at different prices

• But because the demand curves are different, q0 is sold at:

• p0 when the demand curve is D’ and at p1 when the demand curve is D’’.
• Thus under monopoly there is no unique relation between price and the
quantity sold.
Monopoly is allocatively inefficient
MC
Price
Monopolist
36 price(MR=MC)
30 Competitive price
24 (MR=MC=P)
18
12
6
D
0
1 2 3 4 5 6 7 8 9 10
6
MR
12

• By producing less than the perfectly competitive output it transfers

some consumers’ surplus to its own profits and also causes
deadweight loss of surplus that would have resulted from the output
that is not produced.
Summary
• A monopolist sets marginal cost equal to marginal
revenue, but marginal cost is less than price.
• Output is lower under monopoly than under perfect
competition.
• Profit can be increased for a monopolist if it is possible
to charge different prices to different customers or in
separate markets.
• Pure profits exist in the long run under monopoly, so
long as there are entry barriers.