Market Structure: Perfect Competition

Perfect Competition Many buyers and sellers Buyers and sellers are price takers Product is homogeneous Perfect mobility of resources Economic agents have perfect knowledge

Perfect Competition: Price Determination INDUSTRY FIRM

The MC is the cost of producing additional (marginal) units of output The MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises. Diagrammatic representation Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply. The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR Cost/Revenue At this output the firm is making normal profit. This is a long run equilibrium position. MC AC The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values. P = MR = AR Q1 Output/Sales

Perfect Competition Diagrammatic representation MC MC1 AC AC1 Because the model assumes perfect knowledge, the firm gains the advantage for only a short time before others copy the idea or are attracted to the industry by the existence of abnormal profit. If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again. Average and Marginal costs could be expected to be lower but price, in the short run, remains the same. Perfect Competition The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the grey area. Diagrammatic representation Now assume a firm makes some form of modification to its product or gains some form of cost advantage (say a new production method). What would happen? Cost/Revenue MC MC1 AC AC1 P = MR = AR Abnormal profit AC1 P1 = MR1 = AR1 Q1 Q2 Output/Sales

Perfect Competition: Price Determination

Perfect Competition: Short-Run Equilibrium Firm’s Demand Curve = Market Price = Marginal Revenue Firm’s Supply Curve = Marginal Cost where Marginal Cost > Average Variable Cost

Equilibrium in Perfect Competition Total Profits = TR -TC d = d(TR) - d(TC) = 0 dQ dQ dQ MR - MC = 0 MR = MC d(TR) = d(PQ) = P = MR dQ dQ

Perfect Competition: Short-Run Equilibrium

Perfect Competition: Short-Run Equilibrium

Losses and Shutdown Decision

Losses and Shutdown Decision

Losses and Shutdown Decision 12 Price, cost per unit 10 8 MC 6 C ATC 5 4 AVC 3.35 2 1 2 3 4 5 6 7 8 9 10 Quantity per period

Losses and Shutdown Decision 12 Price, cost per unit 10 8 MC 6 C ATC 5 4 AVC B 3.35 2 1 2 3 4 5 6 7 8 9 10 Quantity per period

Losses and Shutdown Decision Price, cost per unit MC C ATC 5 AVC B 3.35 A Quantity per period

Perfect Competition: Long-Run Equilibrium

Consumer Surplus Price per unit S P1 C Pe D Qe Quantity per period

PROFIT MAXIMISATION P = 45 - 0.5Q TC = Q3 - 8Q2 + 57Q + 2 d = 15Q -12 - 3Q2 dQ Q = 1 and Q = 4 d2 = -6Q + 15 dQ2 d2 = 9 d2 = -9 dQ2 dQ2

Advantages of Perfect Competition High degree of competition helps allocate resources to most efficient use Price = marginal costs Normal profit made in the long run Firms operate at maximum efficiency Consumers benefit

Monopoly Single seller and many buyers No close substitutes for product Significant barriers to resource mobility Control of an essential input (OPEC) Patents or copyrights (Medicines/drugs) Economies of scale at large output (China) Government franchise Abnormal profits in long run Possibility of price discrimination Prices in excess of MC

Monopoly Short-Run Equilibrium Demand curve for the firm is the market demand curve Firm produces a quantity (Q*) where marginal revenue (MR) is equal to marginal cost (MC)

Relation between Demand curve and Marginal Revenue Curve P = a - bQ TR = PQ = (a - bQ)Q = aQ - bQ2 MR = d(TR) = a - 2bQ dQ

Monopoly Short-Run Equilibrium D O Q MR

Monopoly Short-Run Equilibrium AC MC Pm D O Q Qm MR

Monopoly Short-Run Equilibrium

Monopoly Long-Run Equilibrium

Advantages: Disadvantages: Encourages R&D Encourages innovation Economies of scale can be gained – consumer may benefit Disadvantages: Exploitation of consumer – higher prices Potential for supply to be limited - less choice Potential for inefficiency

Social Cost of Monopoly

Monopolistic Competition Many sellers of differentiated (similar but not identical) products Limited monopoly power (based on the uniqueness of their product) Dominoes : quick delivery Maggi : 2 minutes Dettol : Hygiene Perfect mobility of resources Downward-sloping demand curve Increase in market share by competitors causes decrease in demand Easy entry and exit Differentiated products : Advertising costs

Monopolistic Competition Short-Run Equilibrium

Monopolistic Competition Long-Run Equilibrium Profit = 0

Monopolistic Competition Long-Run Equilibrium Cost with selling expenses Cost without selling expenses

In Mumbai, the movie market is monopolistically competitive In Mumbai, the movie market is monopolistically competitive. The long run demand equation & AC is given P = 5 – 0.002Q AC = 6 – 0.004Q + 0.000001Q2 To maximize profits, what should be the price & Q. (Q = 1000 & P = 3) How much profit will the firm earn? (0)

Few Examples Hyundai has taken Mahindra Renault to High Court objecting to Mahindra’s plan to launch a compact car with the name 'Sandero' alleging that Mahindra is trying to cash on its popular brand Santro. Asian Paints (label "Utsav”) vs Jaikishan Paints & Allied Products (label “ Utkarsh”) with similar name, color, layout.

Oligopoly -Characteristics Few sellers of a product Duopoly - Two sellers Pure oligopoly - Homogeneous product Differentiated oligopoly - Differentiated product Non-price competition Barriers to entry High degree of interdependence between firms Abnormal profits Potential for collusion?

Sources of Barriers to Entry Economies of scale (Exide: distribution, Walmart) Large capital investment required (Steel) Patented production processes (Drugs) Brand loyalty (Tata Salt) Control of a raw material or resource (Cement) Government franchise (Licenses)

Cartels Collusion Examples: OPEC De Beers Cooperation among firms to restrict competition in order to increase profits Market-Sharing Cartel Collusion to divide up markets Centralized Cartel Formal agreement among member firms to set a monopoly price and restrict output Examples: OPEC De Beers

Centralized Cartel

Weakness Firms can ask for an equitable distribution of profits. Cartel members have a strong incentive to cheat by selling more. Monopoly profits may attract other firms.