1. Perfect Competition and Monopoly

2. Perfect Competition Conditions: Large number of buyers and sellers
Homogeneous product
Perfect knowledge
Free entry and exit
No government intervention
Key Implications:
Flat firms’ demand determined by market equilibrium price
Market participants are price takers without any market power to influence prices (have to charge MR = P = MC)
In the short run firms earn profits or losses or shut down
In the long run profit = normal = 0 (firms operate efficiently)

3. Unrealistic? Why Learn?
Many small businesses are “price-takers”. Decision rules for such firms are similar to those of perfectly competitive firms
It is a useful benchmark
Explains why governments oppose monopolies
Illuminates the “danger” to managers of competitive environments
Importance of product differentiation
Sustainable advantage

4. Setting Price $ TR Qf(units) $ $ DM SM Df = Pf = AR = MR PM QM(106)
Firm
Market

5. Setting Output
To maximize total profit: T = TR - TC FONC: dT /dQ = M  = MR - MC = 0 In general (including monopoly) MR = MC. In perfect competition MR = P = MC.
To maximize profit increase output (Q) until 1) MR = P = MC (at Q*), and 2) for Q > Q* => MC > MR => M < => TC < TR
or MC is increasing

6. A Numerical Example Given estimates of Optimal Price? Optimal Output?
C(Q) = 5 + Q2
Optimal Price?
Optimal Output?
MR = P = $10 = 2Q = MC
Q = 5 units
Maximum Profits?
PQ - C(Q) = 10(5) - (5 + 25) = $20

7. Profit > Normal

8. Normal Profit
Normal profit is necessary for the firm to produce over the long run and is considered a cost of production
Normal profit is required because investors expect a return on their investment.
Profit < normal leads to exit in the long run.
Profit > normal leads to entry in the long run.
Profit = normal maintains the # of firms in the industry.

9. Shut-Down Point In the long run all cost must be recovered.
In the short run fixed cost incurred before production begins and do not change regardless of the level of production (even for Q = 0).
Shut down only if: –TFC > T (total) P < AVC (per unit).
TFC = AFC*Q = (SAC – AVC)*Q
Operate with loss if: 0 > T > –TFC (total) SAC > P  AVC (per unit).
This is the third T maximizing condition.

10. Shutdown

11. Short-Run Supply Under Perfect Competition

12. Effect of Entry on Market Price & Quantity
Firm Qf $ Df
Market QM D S Pe S*
Pe*
Df*
Entry
Short run profits leads to entry
Entry increases market supply, driving down the market price and increasing the market quantity

13. Effect of Entry on Firms Output & Profit$ Q
LAC
LMC QL Pe Df
Pe*
Df*
Qf*
Demand for individual firm’s product and hence its price shifts down
Long run profits are driven to zero

14. Perfect Competition in the Long Run
Socially efficient output and price: MR = P = MC (no dead weight loss)
Efficient plant size: P = MC = min AC (all economies of scale exhausted)
Optimal resource allocation: T = Normal  = 0, for P = MC = min AC (opportunity cost = TR, lowered by free entry)

15. Monopoly Conditions: Large number of buyers and one sellers
Product without close substitutes
Perfect knowledge
Barriers to entry
No government intervention
Key Implications:
Downward sloping firm’s demand is market demand
Firm has market power and determines market price (can charge P > MR = MC)
In the short run monopoly earns profit or loss or shuts down
In the long run profit > normal is sustainable indefinitely but even with profit = normal = 0 (monopoly does not operate efficiently)

16. Sources of Monopoly Power
Natural:
Economies of scale and excess capacity
Economies of scope and cost complementarities
Capital requirements, sales and distribution networks
Differentiated products and brand loyalty
Created:
Patents and other legal barriers (licenses)
Tying and exclusive contracts
Collusion (tacit or open)
Entry limit pricing (predatory pricing illegal)

17. Natural Monopoly 15 10 5 LAC D=P 1 2 3 4
Economies of scale exist over the entire LAC curve. One firm distributes 4 million kWh at ¢5 a kWh. This same total output costs ¢10 a kWh with two and ¢15 a kWh with four firms. Natural monopoly: one firm meets the market demand at a lower cost than two or more firms. Public utility commission ensures that P = LAC (not P associated with MR = MC), eliminating monopoly rent. 15
Price (cents per kilowatt-hour) 10 5
LAC
D=P 1 2 3 4
Quantity (millions of kilowatt-hours) 10

18. Perfect Competition S = MC > min AVC PPC D = P = MR QPC Price
Consumer
surplus
Price
S = MC > min AVC
PPC
Producer
surplus
Efficient
quantity
D = P = MR
QPC
Quantity 60

19. Inefficiency of Monopoly
Consumer
surplus
Price
S = MC > min AVC PM
Deadweight
loss
PPC
Monopoly
gain
Producer
surplus MR
D = P QM
QPC
Quantity 61

20. Monopoly in the Long Run with Greater than Normal and Normal Profit
Socially inefficient: P > MR = MC (QM<QPC, PM>PPC, dead weight loss)
Scale inefficient: P > MC = min AC (economies of scale still exist)
Misallocated resources: even when T = normal  = 0, P is still > min AC (because of market power or barriers to entry opportunity cost < TR)
Encouraged R&D, benefits from natural monopolies, economies of scope and cost complementarity might offset inefficiencies

21. Synthesizing Example
C(Q) = Q2 => MC = 8Q is unaffected by market structure.
What are profit maximizing output & price, and their implications if
You are a price taker, other firms charge $40 per unit?
P = MR = 40 = 8Q = MC => Q* = 5 and P* = 40
Max T = TR - C(Q*) = 40(5) - (125+4(5)2)
= = -$25
Expect exit in the long-run
You are a monopolist with inverse demand P = 100 – Q?
MR = Q = 8Q = MC => Q* = 10 and
P* = Q = = 90
Max T = TR - C(Q*) = 90(10) - (125+4(100)) = = $375
No entry until barriers eliminated