Robin Naylor, Department of Economics, Warwick 1 In this lecture, we consider what factors influence whether there will be a large or a small number of firms in a market. We also consider the specific issues arising when there is a ‘natural monopoly’ in a market. Topic 5 Market structure, efficiency and failure Lecture 19

Robin Naylor, Department of Economics, Warwick 2 Topic 5 Market structure, efficiency and failure Lecture 19 X p D X1X1 Minimum Efficient Scale refers to the smallest quantity at which the LAC attains its minimum level. LAC 1 LAC 2 X2X2 Firm 1 Firm 2 LAC 3 Firm 3 X3X3

Robin Naylor, Department of Economics, Warwick 3 Topic 5 Market structure, efficiency and failure Lecture 19 X p D X1X1 LAC 1 Suppose Firm 1 is producing X 1. If there are no other firms in the market, what price can Firm 1 charge? Will it make a super- normal profit? LAC 1 Note that output at X 1 is called Minimum Efficient Scale (MES).

Robin Naylor, Department of Economics, Warwick 4 Topic 5 Market structure, efficiency and failure Lecture 19 X p D X1X1 LAC 1 Suppose Firm 1 is producing X 1. If there are no other firms in the market, what price can Firm 1 charge? Will it make a super- normal profit? LAC 1 Note that output at X 1 is called Minimum Efficient Scale (MES). p1p1

Robin Naylor, Department of Economics, Warwick 5 Topic 5 Lecture 19 X p D X1X1 LAC 1,2 Firm 1 is producing X 1. Suppose now that Firm 2 enters the market and is identical to Firm 1 and produces the same amount, X 1. What is total output? What price can be charged? Can each firm make a super-normal profit? X1X1 2X 1 LAC 1,2

Robin Naylor, Department of Economics, Warwick 6 Topic 5 Lecture 19 X p D X1X1 LAC 1,2 Firm 1 is producing X 1. Suppose now that Firm 2 enters the market and is identical to Firm 1 and produces the same amount, X 1. What is total output? What price can be charged? Can each firm make a super-normal profit? X1X1 2X 1 LAC 1,2 P 1,2

Robin Naylor, Department of Economics, Warwick 7 Topic 5 Lecture 19 X p D 3X 1 LAC 1 What if 3 identical firms are each producing X 1 ? Can they each at least break even? X1X1 X1X1 X1X1

Robin Naylor, Department of Economics, Warwick 8 Topic 5 Lecture 19 X p D LAC 1 X1X1 3X 1 P 1,2 P 1,2,3

Robin Naylor, Department of Economics, Warwick 9 Topic 5 Lecture 19 X p D LAC 1 How many (identical) firms in this market can each produce X 1 and each break even? X1X1

Robin Naylor, Department of Economics, Warwick 10 Topic 5 Lecture 19 X p D LAC 1 How many (identical) firms in this market can each produce X 1 and each break even? X1X1 X1X1 X1X1 3X 1 4X 1 5X 1 9X 1

Robin Naylor, Department of Economics, Warwick 11 Topic 5 Lecture 19 X p D LAC 1 Suppose now that there is a reduction in market demand. How many firms (with identical costs as before), each producing X 1, can at least break even? X1X1 D’

Robin Naylor, Department of Economics, Warwick 12 Topic 5 Lecture 19 X p D LAC 1 Suppose now that there is a reduction in market demand. How many firms (with identical costs as before), each producing X 1, can at least break even? X1X1 D’ 6X 1

Robin Naylor, Department of Economics, Warwick 13 Topic 5 Lecture 19 X p D LAC 1 What can you conclude about what determines the number of firms that we will find in a market? From this analysis, we see three crucial determinants... X1X1

Robin Naylor, Department of Economics, Warwick 14 Topic 5 Lecture 19 X p D LAC 1 We have seen the importance of: (i) the extent of demand. Now consider: (ii) MES (iii) Minimum LAC X1X1 LAC 1 ’ X 1 ’ LAC 1 If MES is at X 1 ’ instead of X 1, how many firms can survive?

Robin Naylor, Department of Economics, Warwick 15 Topic 5 Lecture 19 X p D LAC 1 We have seen the importance of: (i) the extent of demand. Now consider: (ii) MES (iii) Minimum LAC X1X1 LAC 1 ’ X 1 ’ LAC 1 If MES is at X 1 ’ instead of X 1, how many firms can survive? 2X 1 ’ P 1,2

Robin Naylor, Department of Economics, Warwick 16 Topic 5 Lecture 19 X p D LAC 1 We have seen the importance of: (i)the extent of demand. (ii)MES Now consider: (iii) Minimum LAC X1X1 LAC 1 LAC 1 ’ That is, what if the LAC curve shift upward, with no change in MES? How many firms can survive?

Robin Naylor, Department of Economics, Warwick 17 Topic 5 Lecture 19 X p D LAC 1 What if the LAC curve shift upward, with no change in MES? Whereas 9 firms could survive previously (see Slide 10), now only 5 can survive. X1X1 LAC 1 LAC 1 ’ 5X 1 6X 1 9X 1

Robin Naylor, Department of Economics, Warwick 18 Topic 5 Lecture 19 X p D LAC 1 Consider the case in which only 1 firm can survive this is called: Natural Monopoly MES=X 1 What will be the profit-maximising price and output of this Natural firm?

Robin Naylor, Department of Economics, Warwick 19 Topic 5 Lecture 19 X p D LAC 1 What will be the profit-maximising price and output of this Natural Monopoly firm? X1X1 LMC 1 MR X* mon p mon LAC mon X*: MR=MC Super-normal profit is given by area A=X*[p mon - LAC mon ]

Robin Naylor, Department of Economics, Warwick 20 Topic 5 Lecture 19 X p D=MB LAC 1 What will be the Welfare Loss associated with this Natural Monopoly firm? X1X1 LMC 1 MR X* mon p mon LAC mon X* soc Welfare Loss is given by the area between the LMC and Demand curves.

Robin Naylor, Department of Economics, Warwick Topic 5 Lecture Now read B&B 4 th Ed., pp , ,