1. Chapter 8 Perfect competition and pure monopoly
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Perfect competition
Characteristics of a perfectly competitive market:
many buyers and sellers
so no individual believes that their own action can affect market price
firms take price as given
so face a horizontal demand curve
the product is homogeneous
perfect customer information
free entry and exit of firms
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3. The supply curve under perfect competition (1)
Output
SAVC
SMC Q1
SATC P3 A C Q3
Above price P3 (point C), the firm makes profit above the opportunity cost of capital in the short run
At price P3, (point C), the firm makes NORMAL PROFITS
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4. The supply curve under perfect competition (2)
Output
SAVC
SMC Q1
SATC P3 A C Q3
Between P1 and P3, (A and C), the firm makes short-run losses, but remains in the market
Below P1 (the SHUT-DOWN PRICE), the firm fails to cover SAVC, and exits
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5. The supply curve under perfect competition (3)
Output
SAVC
SMC Q1
SATC P3 A C Q3
So the SMC curve above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE
showing how much the firm would produce at each price level.
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The firm and the industry in the short run under perfect competition (1)
Firm
INDUSTRY
SMC
Output Q P
SRSS D
SAC P
D=MR=AR
Output
Market price is set at industry level at the intersection of demand and supply
– the industry supply curve is the sum of the individual firm’s supply curves
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The firm and the industry in the short run under perfect competition (2)
Firm
INDUSTRY
SAC P
Output
SMC
D=MR=AR q P
Output Q
SRSS D
The firm accepts price as given at P
– and chooses output at q where SMC=MR to maximize profits
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Long-run equilibrium
Firm
INDUSTRY
D=MR=AR
LAC P*
Output
LMC q*
SRSS D P*
Output Q
LRSS
The market settles in long-run equilibrium when the typical firm just makes normal profit by setting LMC=MR at the minimum point of LAC. Long-run industry supply is horizontal.
If the expansion of the industry pushes up input prices (e.g. wages) the long-run supply curve will not be horizontal, but upward-sloping.
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9. Adjustment to an increase in market demand: the short run
Suppose a perfectly
competitive market starts
in equilibrium at P0Q0.
Output D
SRSS Q0 P0 D'
If market demand shifts to
D'D' ... Q1 P1
in the short run the new
equilibrium is P1Q1 ...
– adjustment is through
expansion of individual
firms along their SMCs.
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10. Adjustment to an increase in market demand: the long run
In the long run, new firms are attracted by the supernormal
Profits now being made here – and firms are able to adjust their input of fixed factors. D D'
SRSS P1
– and the market finally
settles at P2Q2. Q2 P2
LRSS
If wages are bid up by this
expansion, the long-run
supply schedule is upward-
sloping P0 D D' Q0 Q1
Output
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Monopoly
A monopolist:
is the sole supplier of an industry’s product
and the only potential supplier
is protected by some form of barrier to entry
faces the market demand curve directly.
Unlike under perfect competition, MR is always below AR.
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12. Profit maximization by a monopolist
Profits are maximized
where MC = MR at Q1P1.
Output
MC=MR P1 Q1 MC AC
D = AR MR
In this position, AR is
greater than AC
so the firm makes
monopoly profits
shown by the shaded area.
Entry barriers prevent
new firms joining the
industry.
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13. Comparing monopoly with perfect competition (1)
Suppose a competitive industry is taken over by a monopolist:
Output D MR
SRSS
LRSS Q1 P1 A
Competitive equilibrium
is at A, with output Q1
and price P1.
= LMC
= SMC P2
The monopolist
maximizes profits in the
short run at MR = SMC
at P2Q2. Q2
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14. Comparing monopoly with perfect competition (2)
Suppose a competitive industry is taken over by a monopolist: D MR
SRSS
LRSS Q1 P1 A
= LMC
= SMC Q2 P2
In the long run the
firm can adjust
other inputs ...
at P3Q3. P3 Q3
to set MR = LMC
Output
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15. Comparing monopoly with perfect competition (3)
So we see that monopoly compared with perfect competition implies:
higher price
lower output
Does the consumer always lose from monopoly?
Among other things, this depends on whether the monopolist faces the same cost structure.
there may be the possibility of economies of scale.
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A natural monopoly
This firm enjoys substantial economies of scale relative to market demand
LAC declines right up to market demand
the largest firm always enjoys cost leadership
and comes to dominate the industry
It is a NATURAL MONOPOLY.
LMC
LAC D MR P1 Q1
Output
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17. Discriminating monopoly
Suppose a monopolist supplies two separate groups of customers
with differing elasticities of demand
e.g. business travellers may be less sensitive to air fare levels than tourists.
The monopolist may increase profits by charging higher prices to the businessmen than to tourists.
Discrimination is more likely to be possible for goods that cannot be resold
e.g. dental treatment.
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