McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 5 Perfect Competition, Monopoly, and Economic vs. Normal Profit

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline From Perfect Competition to Monopoly Supply Under Perfect Competition

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. From Perfect Competition to Monopoly Perfect Competition Monopolistic Competition Oligopoly Monopoly

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Picking the Quantity to Maximize Profit The Perfectly Competitive Case MC ATC AVC MR Q* P* P Q Many Competitors

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. AVC MR D MC ATC Q* P* P Q No Competitors Picking the Quantity to Maximize Profit The Perfectly Competitive Case

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics of Perfect Competition a large number of competitors, such that no one firm can influence the price the good a firm sells is indistinguishable from the ones its competitors sell firms have good sales and cost forecasts there is no legal or economic barrier to its entry into or exit from the market

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly The sole seller of a good or service. Some monopolies are generated because of legal rights (patents and copyrights). Some monopolies are utilities (gas, water, electricity etc.) that result from high fixed costs.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopolistic Competition Monopolistic Competition: a situation in a market where there are many firms producing similar but not identical goods. Example : the fast-food industry. McDonald’s has a monopoly on the “Happy Meal” but has much competition in the market to feed kids burgers and fries.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Oligopoly Oligopoly: a situation in a market where there are very few discernible competitors Examples –Satellite TV service (Direct TV, Dish Network) –Airlines (American, Delta etc.)

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Which Model Fits Reality? Perfect competition is rare outside agriculture though it fits some labor markets. Monopolies are common in utilities Major branded companies are typically either in oligopolistic or monopolistically competitive industries.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Examples of Different Market Forms Perfect Competition Monopolistic Competition OligopolyMonopoly 1)Agriculture 2)Lumber 1)Fast Food 2)Long Distance Service 1)Cars and Trucks 2)Soft Drinks 1)Windows Operating system 2)Local Residential electric power

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Distinguishing Characteristics Between Market Forms Perfect Competition Monopolistic Competition OligopolyMonopoly Number of Firms Many-often thousands or even millions Several*Few*One Barriers to Entry NoneFewSubstantialInsurmountable, at least in the short run Product Similarity IdenticalSimilar but not identical Similar or Identical N/A * The line between “several” and “few” is not definite

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Concentration Ratios there is no magic line that separates oligopoly from monopolistic competition. a “concentration ratio” measures the percentage of total market sales for the top firms (from 4 firms to 100 firms).

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Concentration Ratios For Various Manufacturing Industries Industry GroupConcentration Ratios 4 Largest Firms8 Largest Firms50 Largest Firms Breakfast Cereals92.9%93.5%100.0% Ice Cream Beer Clothing Computers and Peripherals Furniture Long Distance Cellular Service

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply Under Perfect Competition

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Normal vs. Economic Profit Normal Profit : the level of profit that business owners could get in their next best alternative investment Economic Profit: any profit above normal profit

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Return on Equity For Various Industries IndustryRate of Return Net Income/(Assets- Liabilities) Agriculture 8.0% Manufacturing 14.6% Transportation and Public Utilities 10.6% Wholesale and Retail Trade 12.9%

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. When and Why Economic Profits Go to Zero

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Time Horizons Short Run: the period of time where we cannot change things like plant and equipment Long Run : the period of time where we can change things like plant and equipment

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Forms and Economic Profits Under perfect competition or monopolistic competition, economic profits go to zero because of the entry of new firms increases market supply and lowers prices. Economic profits are under no pressure to shrink under oligopoly or monopoly because entry doesn’t occur so prices do not fall.

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 2 The Pressures on Price in Perfect Competition $ Q MC ATC AVC MR 3 MR 1 MR 2 MR 4 Long Run Pressure Short Run Pressure

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 3 Points of Production in Perfect Competition $ Q MC ATC AVC MR 4 MR 3 MR 2 MR 1

McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 4 Supply in Perfect Competition $ Q MC ATC AVC Supply