1. 11-1 © 2003 Pearson Education Canada Inc. PERFECT COMPETITION 11 CHAPTER © 2003 Pearson Education Canada Inc. 11-1

2. 11-2 © 2003 Pearson Education Canada Inc. Competition Perfect competition is an industry in which:  Many firms sell identical products to many buyers.  There are no restrictions to entry into the industry.  Established firms have no advantages over new ones.  Sellers and buyers are well informed about prices.

3. 11-3 © 2003 Pearson Education Canada Inc. Competition Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the price of a good or service. No single firm can influence the price—it must “take” the equilibrium market price. Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

4. 11-4 © 2003 Pearson Education Canada Inc. Demand Facing a Single Firm in a Perfectly Competitive Market If a representative firm in a perfectly competitive industry raises the price of its output above $2.45, the quantity demanded of that firms output will drop to zero. Each firm faces a perfectly elastic demand curve, d.

5. 11-5 © 2003 Pearson Education Canada Inc. Comparing Costs and Revenues to Maximize Profit The profit maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to the short run marginal cost; the level of output where: P* = MC or MR = MC.

6. 11-6 © 2003 Pearson Education Canada Inc. The Profit-Maximizing Level of Output for a Perfectly Competitive Firm

7. 11-7 © 2003 Pearson Education Canada Inc. Short-Run Supply Curve of a Perfectly Competitive Firm The short-run supply curve of a competitive firm is that portion of its marginal cost curve that lies above its average variable cost curve.

8. 11-8 © 2003 Pearson Education Canada Inc. Short-Run Industry Supply Curve The short run industry supply curve is the horizontal sum of the marginal cost curves (above AVC) of all the firms in an industry.

9. 11-9 © 2003 Pearson Education Canada Inc. Firms Expand Along in the Long Run When Increasing Returns to Scale Are Available Firms will be pushed by competition to produce at their optimal scales and the price will be driven to the minimum point on the LRAC curve. Profits will be driven to zero.

10. 11-10 © 2003 Pearson Education Canada Inc. Long-run Competitive Equilibrium Long-run equilibrium occurs in a competitive industry when:  Economic profit is zero, so firms neither enter nor exit the industry.  Long-run average cost is at its minimum, so firms don’t change their plant size. Long-run competitive equilibrium exists when: P = SRMC = SRAC = LRAC and economic profit is equal to zero.

11. 11-11 © 2003 Pearson Education Canada Inc. MONOPOLY 12 CHAPTER © 2003 Pearson Education Canada Inc.12-11

12. 11-12 © 2003 Pearson Education Canada Inc. Market Power How Monopoly Arises A monopoly has two key features:  No close substitutes  Barriers to entry Legal or natural constraints that protect a firm from potential competitors are called barriers to entry.

13. 11-13 © 2003 Pearson Education Canada Inc. Demand in Monopoly Markets With only one firm in the monopoly market, there is no distinction between the firm and the industry.  In a monopoly, the firm is the industry and therefore faces the industry demand curve.  The total quantity supplied is what the firm decides to produce. For a monopolist, an increase in output involves not just producing more and selling it, but also reducing the price of its output in order to sell it.

14. 11-14 © 2003 Pearson Education Canada Inc. Marginal Revenue Facing a Monopolist At every level except one unit, the monopolist’s marginal revenue is below price. This is because to sell more output and raise total revenue the firm lowers the price for all units sold.

15. 11-15 © 2003 Pearson Education Canada Inc. Price and Output Choice for a Profit- Maximizing Monopolist The profit-maximizing level of output for a monopolist is the one where MR = MC. Beyond that point, where marginal cost exceeds marginal revenue, the firm would reduce its profits. Relative to a competitively organized industry, a monopolist restricts output, charges higher prices, and earns economic profits.

16. 11-16 © 2003 Pearson Education Canada Inc. Competition and Efficiency Figure 11.12 illustrates an efficient outcome in a perfectly competitive industry. Along the demand curve D = MB the consumer is efficient. Along the supply curve S = MC the producer is efficient.

17. 11-17 © 2003 Pearson Education Canada Inc. Competition and Efficiency The quantity Q* and price P* are the competitive equilibrium values. So competitive equilibrium is efficient. The consumer gains the consumer surplus, and the producer gains the producer surplus.

18. 11-18 © 2003 Pearson Education Canada Inc. Single-Price Monopoly and Competition Compared Monopoly is inefficient because price exceeds marginal cost so marginal benefit exceeds marginal cost. On all output levels for which marginal benefit exceeds marginal cost, a deadweight loss is incurred.

19. 11-19 © 2003 Pearson Education Canada Inc. Single-Price Monopoly and Competition Compared Rent Seeking The social cost of monopoly may exceed the deadweight loss through an activity called rent seeking, which is any attempt to capture consumer surplus, producer surplus, or economic profit. Rent seeking is not confined to a monopoly. There are two forms of rent seeking activity to pursue monopoly: Buy a monopoly—transfers rent to creator of monopoly. Create a monopoly—uses resources in political activity.

20. 11-20 © 2003 Pearson Education Canada Inc. Single-Price Monopoly and Competition Compared The resources used in rent seeking can exhaust the monopoly’s economic profit and leave the monopoly owner with only normal profit. Average total cost increases and the profits disappear to become part of the enlarged deadweight loss from rent seeking.

21. 11-21 © 2003 Pearson Education Canada Inc. Price Discrimination Price discrimination is the practice of selling different units of a good or service for different prices. To be able to price discriminate, a monopoly must:  Identify and separate different buyer types  Sell a product that cannot be resold Price differences that arise from cost differences are not price discrimination.

22. 11-22 © 2003 Pearson Education Canada Inc. Price Discrimination By price discriminating, the firm can increase its profit. In doing so, it converts consumer surplus into economic profit.

23. 11-23 © 2003 Pearson Education Canada Inc. Price Discrimination With perfect price discrimination: Output increases to the quantity at which price equals marginal cost. Economic profit increases above that earned by a single-price monopoly. Deadweight loss is eliminated.

24. 11-24 © 2003 Pearson Education Canada Inc. Price Discrimination Efficiency and Rent Seeking with Price Discrimination The more perfectly a monopoly can price discriminate, the closer its output gets to the competitive output (P = MC) and the more efficient is the outcome. But this outcome differs from the outcome of perfect competition in two ways:  The monopoly captures the entire consumer surplus.  The increase in economic profit attracts even more rent- seeking activity that leads to an inefficient use of resources.

25. 11-25 © 2003 Pearson Education Canada Inc. Market Power Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. Figure 12.1 illustrates a natural monopoly.

26. 11-26 © 2003 Pearson Education Canada Inc. The Problem of Regulating a Monopoly An unregulated monopolist produces where MC = MR, at 400,000 units. If prices were set at MC the firm would always suffer a loss. A compromise would be to set prices at $0.75 which covers costs and allows a normal profit rate.

27. 11-27 © 2003 Pearson Education Canada Inc. MONOPOLISTIC COMPETITION AND OLIGOPOLY 13 CHAPTER 13-27© 2003 Pearson Education Canada Inc.

28. 11-28 © 2003 Pearson Education Canada Inc. Monopolistic Competition Monopolistic competition is a common form of industry structure in Canada, characterized by:  a large number of firms, none of which can influence market price by virtue of size alone  some degree of market power achieved through the production of differentiated products  no barriers to entry or exit

29. 11-29 © 2003 Pearson Education Canada Inc. Monopolistic Competition Product Differentiation Firms in monopolistic competition practice product differentiation, which means that each firm makes a product that is slightly different from the products of competing firms.

30. 11-30 © 2003 Pearson Education Canada Inc. Output and Price in Monopolistic Competition The firm produces the quantity at which marginal revenue equals marginal cost and sells that quantity for the highest possible price. It earns an economic profit (as in this example) when P > ATC.

31. 11-31 © 2003 Pearson Education Canada Inc. Output and Price in Monopolistic Competition Long Run: Zero Economic Profit  In the long run, economic profit induces entry.  As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward.  The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell this quantity.  Price and quantity fall with firm entry until P = ATC and firms earn zero economic profit.

32. 11-32 © 2003 Pearson Education Canada Inc. Monopolistically Competitive Firm at Long-Run Equilibrium As new firms enter the monopolistically competitive industry the demand curves of profit-making firms begin to shift left. The process continues until profits are eliminated and the demand curve is just tangent to the average total cost curve.

33. 11-33 © 2003 Pearson Education Canada Inc. Economic Efficiency and Resource Allocation for Monopolistic Competition Firms in monopolistic competition are inefficient and operate with excess capacity. Price is greater than marginal cost, greater than the perfectly competitive solution. The long-run equilibrium quantity of output is to the left of the minimum of ATC. Output is less than capacity output.  A firm’s capacity output is the output at which average total cost is at its minimum.

34. 11-34 © 2003 Pearson Education Canada Inc. Product Development and Marketing Innovation and Product Development  To keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development. Marketing  A firm’s marketing program uses advertising and packaging as the two principal methods to market its differentiated products to consumers.

35. 11-35 © 2003 Pearson Education Canada Inc. Product Development and Marketing  With advertising, the firm produces 130 units of output at an average total cost of $160.  The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.

36. 11-36 © 2003 Pearson Education Canada Inc. Product Development and Marketing  But advertising can increase a firm’s demand and profits in the short run only.  Economic profit leads to entry, which decreases the demand for each firm’s product in the long run.  To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are efficient.

37. 11-37 © 2003 Pearson Education Canada Inc. Oligopoly Oligopoly is a form of industry structure characterized by:  a few firms, each large enough to influence market price  differentiated or homogeneous products  firms behaving in a way that depends to a great extent on the behaviour of other firms

38. 11-38 © 2003 Pearson Education Canada Inc. Oligopoly Models The Collusion Model The Cournot Model The Kinked Demand Model The Price Leadership Model Game Theoretic Models

39. 11-39 © 2003 Pearson Education Canada Inc. Collusion Model  A collusive agreement is an agreement between two (or more) firms to restrict output, raise price, and increase profits.  Such agreements are illegal in Canada and are undertaken in secret.  Firms in a collusive agreement operate a cartel. Cartel refers to a group of firms that gets together and makes joint price and output decisions in order to maximize joint profits.

40. 11-40 © 2003 Pearson Education Canada Inc. Assumptions of the Cournot Model There are two firms in the industry - a duopoly. Each firm takes the output of the other firm as given. Both firms maximize profits.

41. 11-41 © 2003 Pearson Education Canada Inc. The Kinked Demand Curve Oligopoly Model If the firm increases its price the demand will fall off quite quickly. If the firm drops its price the other firms follow and quantity demanded does not change as much. Demand is elastic above P* and inelastic below P*. If MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesn’t maximize profit.

42. 11-42 © 2003 Pearson Education Canada Inc. Oligopoly Dominant Firm Oligopoly In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. The large firm operates as a monopoly, setting its price and output to maximize its profit. The small firms act as perfect competitors, taking as given the market price set by the dominant firm.

43. 11-43 © 2003 Pearson Education Canada Inc. Oligopoly The profit maximizing quantity for the large firm is 10 units. The price charged is $1.00.

44. 11-44 © 2003 Pearson Education Canada Inc. Game Theory Game theory analyzes oligopolistic behaviour as a complex series of strategic moves and reactive countermoves among rival firms. In game theory, firms are assumed to anticipate rival reactions. What Is a Game? All games share four features:  Rules  Strategies  Payoffs  Outcome

45. 11-45 © 2003 Pearson Education Canada Inc. Dominant Strategy and Nash Equilibrium A dominant strategy in game theory is a strategy that is best no matter what the opposition does. Nash equilibrium is the result in game theory, when all players play their best strategy given what their competitors are doing.

46. 11-46 © 2003 Pearson Education Canada Inc. Payoff Matrix for an Advertising Game The dominant strategy for A and B is to advertise.

47. 11-47 © 2003 Pearson Education Canada Inc. The Prisoner’s Dilemma The dominant strategy is for both Rocky and Ginger to confess.

48. 11-48 © 2003 Pearson Education Canada Inc. Contestable Markets A market in which entry and exit are costless. Because entry is cheap, firms are continually faced with competition or the threat of competition. In contestable markets, firms behave like perfectly competitive firms.

49. 11-49 © 2003 Pearson Education Canada Inc. MONOPOLISTIC COMPETITION AND OLIGOPOLY 13 CHAPTER THE END 13-49© 2003 Pearson Education Canada Inc.