1. Chapter 6 The Two Extremes: Perfect Competition and Pure Monopoly

2. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-2 Learning Objectives List the four characteristics of a perfectly competitive market. Describe how a perfect competitor makes the decision to stay in business or to go out of business. List the characteristics of monopoly. Explain the difference between marginal revenue for a perfect competitor and marginal revenue for a pure monopolist.

3. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-3 Market Structures Market structure relates to the number, size, and interaction of firms in a particular market. One extreme market structure is perfect competition, when there are literally thousands of sellers.

4. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-4 Market Structures (cont.) At the other extreme is pure monopoly, when there is only one seller of a good for which there are no close substitutes. In between, there are varying degrees of what is called imperfect competition (duopoly, oligopoly, and monopolistic competition).

5. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-5 Characteristics of a Perfectly Competitive Market There are a very large number of relatively small buyers and sellers. The product sold by each seller is virtually identical to the product sold by other sellers. Firms can easily enter or exit the industry. Everybody involved has good information about price and product qualities.

6. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-6 Demand Curve Faced by a Perfect Competitor A perfect competitor is a price taker. He takes the prices determined by market forces. Therefore, the demand curve faced by the individual firm in this market is perfectly elastic. This means that customers will buy all that any individual firm might want to produce at the going market price and none at a higher price.

7. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-7 Figure 6-2: Demand Curve Facing the Perfect Competitor

8. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-8 How Much Should You Produce? The decision on how much to produce is similar to all decisions in economics. Never do anything past the point at which marginal benefit equals marginal cost. A perfect competitor produces up to the point at which marginal benefit equals marginal cost, or the point at which the price per unit equals marginal cost.

9. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-9 Profit Maximization This decision-making process is really one in which the perfect competitor maximizes profits. If the perfect competitor produced a larger quantity, marginal costs would exceed the price per unit. If the firm stops producing before marginal benefit equals marginal cost, then it is forgoing potential profits on additional units of output.

10. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-10 Marginal Revenue Marginal benefit here refers to the firm’s marginal revenue, defined as the change in total revenues when there is a one-unit change in production and sales. Marginal revenue is equal to unit price at all rates of output for perfect competitors.

11. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-11 Figure 6-3: The Perfect Competitor Determines How Much to Produce

12. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-12 Maximizing Profits Profit maximization occurs at the rate of output at which marginal revenue equals marginal cost. For a perfectly competitive firm, this is at the intersection of the demand schedule, d, and the marginal cost curve, MC. As was seen in Figure 6-3.

13. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-13 Figure 6-4: Showing Short-Run Economic Profits

14. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-14 When Should a Perfect Competitor Shutdown? Whenever a perfect competitor is sustaining economic losses in the short run, it must compare the cost of producing, while incurring these losses, with the cost of shutting down. Whenever total revenues exceed total variable costs, the perfect competitor should still keep production going.

15. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-15 Perfect Competitors Generally Make Zero Economic Profits In the short run, even in a perfectly competitive industry, an individual firm might make positive economic profits. These profits tend to disappear in the long run. That is, in the long run, because of so much competition, those who remain in a perfectly competitive industry end up making zero economic profits.

16. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-16 Pure Monopoly A pure monopoly is a market with a sole producer of a specific good or service for which there are no close substitutes and, no competitors. By definition, the pure monopolist is the entire industry. Therefore, this firm faces the entire market demand curve.

17. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-17 Types of Monopolies 1.Natural Monopoly: usually arises when there are large economies of scale relative to the market demand, such that one firm can produce at a lower average cost than can be achieved by multiple firms.

18. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-18 Types of Monopolies 2.Technological Monopoly: Someone who invents something that allows for the creation of a unique product often has a technological monopoly. Normally, the government provides a patent that gives the creator exclusive right to manufacture, rent, or sell that invention for 20 years.

19. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-19 Types of Monopolies 3.Government Monopoly: Governments—federal, state, and local—often create their own monopolies. That is, they decide that no one else but them lawfully may provide the production of a good or service.

20. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-20 Barriers to Entry For any amount of monopoly power to continue to exist in the long run, the market must be closed to entry in some way. Two of the barriers to entry that have allowed firms to reap monopoly profits in the long run are: –Ownership of Resources –Government Regulations.

21. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-21 What Kind of Demand Curve Does the Monopolist Face? A pure monopolist is the sole supplier of one product, good, or service. It represents the entire industry. Consequently, a pure monopolist faces a demand curve that is the one for the entire market. This is a downward sloping demand curve.

22. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-22 Marginal Revenue for the Monopolist Because a pure monopolist faces the market downward-sloping demand curve, it can only sell more by charging less for all units sold. Consequently, for a pure monopolist, marginal revenue is always less than price.

23. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-23 How the Monopolist Maximizes Profits A monopolist always produces at that rate at which marginal revenue equals marginal cost. However, for the monopolist, marginal revenue is always less than price.

24. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-24 Why Monopolies Are Considered “Bad” Competition leads to lower prices. Monopoly, in contrast, implies no competition. The result, then, is that monopolists tend to charge higher prices than would competitors, if they existed.

25. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.6-25 Key Terms and Concepts barriers to entry economies of scale government monopoly marginal revenue market structure natural monopolies patent perfect competition price setter price taker pure monopoly technological monopoly