MODULE

Microeconomics 2

Lecture 5

Perfect Competition
and Monopoly
 Contents

1 Perfect
Competition

2 Monopoly

Lecture 5: Perfect Competition and Monopoly Slide 2

 1
PERFECT COMPETITION
 The Goal of Profit Maximization
• Economic profit: the difference between total revenue
and total cost, where total cost includes all costs—both
explicit and implicit—associated with resources used by
the firm.
• Accounting profit is simply total revenue less all explicit
costs incurred.
– Does not subtract the implicit costs.
• Economists assume that the goal of firms is to maximize
economic profit.

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 The Goal of Profit Maximization

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 Economic vs. Accounting Profits
• Using our earlier illustration, suppose a firm produces 100 units of
output per week by using 10 units of capital and 10 units of labor.
The weekly price of each factor is $10/unit, and the output sells for
$2.50/unit. Now suppose that the firm owns half of its capital and
rents its other 5 units of capital. What would be the firm’s economic
and accounting profit for the week?

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 Economic vs. Accounting Profits

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 The Four Conditions For Perfect
Competition
1. Firms Sell a Standardized Product
– The product sold be one firm is assumed to be a perfect
substitute for the product sold by any other.
2. Firms Are Price Takers
– This means that the individual firm treats the market price of the
product as given.
3. Free Entry and Exit
– With Perfectly Mobile Factors of Production in the Long Run
4. Firms and Consumers Have Perfect Information

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 The Short-Run Condition For Profit
Maximization
• To maximize profit the firm will choose that level of output
for which the difference between total revenue and total
cost is largest.
• Marginal revenue: the change in total revenue that
occurs as a result of a 1-unit change in sales.
• To maximize profits the firm should produce a level of
output for which marginal revenue is equal to marginal
cost on the rising portion of the MC curve.

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 Revenue, Cost, and Economic Profit

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 The Profit-Maximizing Output Level in
the Short Run

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 The Shutdown Condition
• Shutdown condition: if price falls below the minimum of
average variable cost, the firm should shut down in the
short run.
• The short-run supply curve of the perfectly competitive
firm is the rising portion of the short-run marginal cost
curve that lies above the minimum value of the average
variable cost curve.

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 The Short-Run Supply Curve of a Perfectly
Competitive Firm

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 The Short-Run Competitive Industry
Supply Curve

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 Industry Supply Curve
• Suppose an industry has 200 firms, each with supply
curve P = 100 + 1,000Qi. What is the industry supply
curve?

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 Short-Run Price and Output Determination under Pure
Competition

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 Short-Run Competitive Equilibrium
• Even though the market demand curve is downward
sloping, the demand curve facing the individual firm is
perfectly elastic.
• Breakeven point: the point at which price equal to the
minimum of average total cost.
– The lowest price at which the firm will not suffer
negative profits in the short run.

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 A Short-Run Equilibrium Price that
Results in Economic Losses

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 Short-Run Competitive Equilibrium Is
Efficient
• Allocative efficiency: a condition in which all possible gains from
exchange are realized.

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 Producer Surplus
• A competitive market is efficient when it maximizes the
net benefits to its participants.
• Producer surplus: the dollar amount by which a firm
benefits by producing a profit-maximizing level of output.

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 Producer Surplus

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 Producer Surplus

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 The Total Benefit from Exchange in a
Market

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 Consumer and Producer Surplus
• Suppose there are two types of users of fireworks: careless and
careful. Careful users never get hurt, but careless ones sometimes
injure not only themselves, but also innocent bystanders. The short-
run marginal cost curves of each of the 1,000 firms in the fireworks
industry are given by MC = 10 + Q, where Q is measured in pounds
of cherry bombs per year and MC is measured in dollars per pound
of cherry bombs. The demand curve for fireworks by careful users is
given by P = 50 − 0.001Q (same units as for MC). Legislators would
like to continue to permit careful users to enjoy fireworks. But since
it is impractical to distinguish between the two types of users, they
have decided to outlaw fireworks altogether. How much better off
would consumers and producers be if legislators had the means to
effect a partial ban?

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 Consumer and Producer Surplus

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 Adjustments in the Long Run
• Positive economic profit creates an incentive for outsiders to enter
the industry.
• As additional firms enter the industry, the industry supply curve
shifts to the right.
• This adjustment will continue until these two conditions are met:
(1) Price reaches the minimum point on the LAC curve
(2) All firms have moved to the capital stock size that gives rise to
a short-run average total cost curve that is tangent to the LAC
curve at its minimum point.

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 Adjustments in the Long Run

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 Adjustments in the Long Run

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 Adjustments in the Long Run

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 The Invisible Hand
• Why are competitive markets attractive from the perspective of
society as a whole?
– Price is equal to marginal cost.
• The last unit of output consumed is worth exactly the same to
the buyer as the resources required to produce it.
– Price is equal to the minimum point on the long-run average cost
curve.
• There is no less costly way of producing the product.
– All producers earn only a normal rate of profit.
• The public pays not a penny more than what it cost the firms
to serve them.

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 The Long-Run Competitive Industry
Supply Curve
• Constant cost Industries: long-run supply curve is a horizontal
line at the minimum value of the LAC curve.
• Increasing cost industries: long-run supply curve is upward
sloping.
• Decreasing cost industries: long-run supply curve is downward-
sloping.

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 The Long-Run Competitive Industry
Supply Curve

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 How Changing Input Prices Affect Long-
Run Supply
• Pecuniary diseconomy: a rise in production cost that occurs
when an expansion of industry output causes a rise in the prices of
inputs.
– Upward sloping long-run industry supply curve
• Pecuniary economy: case in which the prices of inputs may fall
significantly with expanding industry output.
– Downward sloping long-run industry supply curve

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 How Changing Input Prices Affect Long-
Run Supply

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 The Elasticity Of Supply
• Price elasticity of supply: the percentage change in quantity
supplied that occurs in response to a 1 percent change in product
price.

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 Price Supports as a Device for Saving
Family Farms

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 Price Supports as a Device for Saving
Family Farms

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The Illusory Attraction of Taxing Business

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 2
MONOPOLY
 Defining Monopoly
• Monopoly: a market structure in which a single seller of a
product with no close substitutes serves the entire
market.
– A monopoly has significant control over the price it
charges.

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 Five Sources Of Monopoly
1. Exclusive Control over Important Inputs
2. Economies of Scale
3. Patents
4. Network Economies
5. Government Licenses or Franchises

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 Natural Monopoly

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 The Profit-Maximizing Monopolist
• The monopolist’s goal is to maximize economic profit.
– In the short run, this means to choose the level of
output for which the difference between total revenue
and short-run total cost is greatest.

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 The Monopolist’s Total Revenue
Curve
• As price falls, total revenue for the monopolist
does not rise linearly with output.
– Instead, it reaches a maximum value at the quantity
corresponding to the midpoint of the demand curve
after which it again begins to fall.
– Total revenue reaches its maximum value when the
price elasticity of demand is unity.

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 The Monopolist’s Total Revenue
Curve

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 The Monopolist’s Total Revenue
Curve

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 The Monopolist’s Total Revenue
Curve

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 Marginal Revenue
• Optimality condition for a monopolist: a monopolist
maximizes profit by choosing the level of output where
marginal revenue equals marginal cost.

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 Marginal Revenue

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 Marginal Revenue

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 Marginal Revenue and Elasticity
• The less elastic demand is with respect to price,
the more price will exceed marginal revenue.
– For all elasticity values less than 1 in absolute value
marginal revenue will be negative.
– For all elasticity values larger than 1 in absolute value
marginal revenue will be positive.

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 Marginal Revenue and Elasticity

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 Marginal Revenue Curve
• Find the marginal revenue curve that corresponds to the
demand curve P = 12 − 3Q.

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 Graphical Interpretation of the Short-Run Profit
Maximization Condition

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 Profit Maximization
• A monopolist faces a demand curve of P = 100 − 2Q and
a short-run total cost curve of TC = 640 + 20Q. The
associated marginal cost curve is MC = 20. What is the
profit-maximizing price? How much will the monopolist
sell, and how much economic profit will it earn at that
price?

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 Profit Maximization

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 The Profit-Maximizing Monopolist
• If a monopolist’s goal is to maximize profits, she will never
produce an output level on the inelastic portion of her
demand curve.
• The profit-maximizing level of output must lie on the
elastic portion of the demand curve.

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 The Profit-Maximizing Monopolist
• Shutdown condition for a monopolist: cease
production whenever average revenue is less than
average variable cost at every level of output.

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 A Monopolist Has No Supply Curve
• The monopolist is a price maker.
– When demand shifts rightward elasticity at a given
price may either increase or decrease, and vice-versa.
• So there can be no unique correspondence between
the price a monopolist charges and the amount she
chooses to produce.
• Monopoly has a supply rule, which is to equate marginal
revenue and marginal cost.

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 Adjustments in the Long Run

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 Price Discrimination
• Price discrimination: a practice where the monopolist
charge different prices to different buyers.
• Third-degree price discrimination: charging different
prices to buyers in completely separate markets.
• First-degree price discrimination is the term used to
describe the largest possible extent of market
segmentation.

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 Sale in Different Markets

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 Profits in Two Different Markets
• A monopolist has marginal costs MC = Q and home
market demand P = 30 − Q. The monopolist can also sell
to a foreign market at a constant price PF = 12. Find and
graph the quantity produced, quantity sold in the home
market, quantity sold in the foreign market, and price
charged in the home market. Explain why the
monopolist’s profits would fall if it were to produce the
same quantity but sell more in the home market.

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 Profits in Two Different Markets

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 Price Discrimination
• Price discrimination is feasible only when it is impossible,
or at least impractical, for buyers to trade among
themselves.
• Arbitrage: the purchase of something for costless risk-
free resale at a higher price.

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 Price Discrimination

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 Price Discrimination

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 Price Discrimination
• Second-degree price discrimination: price
discrimination where the same rate structure is available
to every consumer and the limited number of rate
categories tends to limit the amount of consumer surplus
that can be captured.

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 Price Discrimination

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 The Hurdle Model of Price
Discrimination

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 The Efficiency Loss From Monopoly
• Deadweight loss from monopoly: the loss of efficiency
due to the presence of a monopoly.
– Is the result of failure to price discriminate perfectly.

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 The Efficiency Loss From Monopoly

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 Public Policy Toward Natural
Monopoly
• State ownership and management
• State regulation of private monopolies
• Exclusive contracting for natural monopoly
• Vigorous enforcement of antitrust laws
• A laissez-faire policy toward natural monopoly

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 Public Policy Toward Natural
Monopoly

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 State Ownership and Management
• The government is not bound to earn at least a normal
profit and can set a price equal to marginal cost and
absorb economic losses out of general tax revenues.
• Unattractive features of state ownership:
– Weakens incentives for cost-conscious efficient
management
– X-inefficiency: a condition in which a firm fails to
obtain maximum output from a given combination of
inputs

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 State Regulation of Private
Monopolies

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 A Laissez-Faire Policy toward Natural
Monopoly

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The Impact of Innovation on Profits
• Suppose the current lightbulb design lasts 1,000 hours.
Now the lightbulb monopolist discovers how to make a
bulb that lasts 10,000 hours for the same per-bulb cost of
production. Will the monopolist introduce the new bulb?

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The Impact of Innovation on Profits

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