Transcript Parkin-Bade Chapter 11

PERFECT
COMPETITION
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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.
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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.
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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.
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Total and Marginal Revenue
Total revenue is the total amount that a firm takes in from the sale of its
product: The price per unit times the quantity of output the firm
decides to produce (P x q).
Marginal revenue is the additional revenue that a firm takes in when it
increases output by one additional unit.
In perfect competition, P = MR.
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The Firm’s Decisions in Perfect
Competition
One way to find the profit
maximizing output is to
look at the firm’s the total
revenue and total cost
curves.
Profit is maximized when
the firm produces 9
sweaters a day.
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Comparing Costs and Revenues to
Maximize Profit
The firm can use marginal analysis to determine the profitmaximizing output.
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.
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The Profit-Maximizing Level of Output for a Perfectly
Competitive Firm
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Minimizing Losses
Operating profit (or loss) or net operating revenue is total
revenue minus total variable cost
(TR - TVC).
Firms suffering losses fall into two categories:
 Those that find it advantageous to shut down
operations immediately and suffer losses equal to
fixed costs
 Those that continue to operate in the short run to
minimize losses
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Firm Suffering Economic Losses But Showing an Operating Profit in the
Short Run
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Shutdown Point
The shutdown point is the lowest point on the average
variable cost curve.
When price falls below the minimum point on AVC,
total revenue is insufficient to cover variable costs
and the firm will shut down and bear losses equal to
fixed costs.
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The Firm’s Decisions in Perfect
Competition
To determine whether a firm is earning an economic profit or incurring
an economic loss, we compare the firm’s average total cost, ATC, at
the profit maximizing output with the market price.
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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.
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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.
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•
In the long run, the firm may:
Enter or exit an industry;
Change its plant size
As new firms enter an industry, industry
supply increases. The industry supply
curve shifts rightward.
As the plant size increases,
short-run supply increases,
the price falls, and
economic profit decreases.
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Firms Expand Along in the Long Run When Increasing Returns to
Scale Are Available
Firms will continue to expand as long as there are economies of scale to be realized, and new firms
will continue to enter as long as economic profits are being earned.
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.
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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.
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Competition and Efficiency
Along the demand curve D = MB the
consumer is efficient.
Along the supply curve S = MC the
producer is efficient
The quantity Q* and price P* are the
competitive equilibrium values.
So competitive equilibrium is efficient.
MB=MC

The consumer gains the consumer
surplus (the area below the demand
curve and above the price) and the
producer gains the producer surplus
(the area below the price and above the
marginal cost curve)

The sum of the two surpluses is
maximized and the efficient
quantity is produced.
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MONOPOLY
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Market Power
Market power and competition are the two forces that
operate in most markets.
Market power is the ability to influence the market, and in
particular the market price, by influencing the total quantity
offered for sale.
A monopoly is an industry that produces a good or
service for which no close substitute exists and in which
there is one supplier that is protected from competition by
a barrier preventing the entry of new firms.
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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.
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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.
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Price and Output Choice for a ProfitMaximizing 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.
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Single-Price Monopoly and Competition
Compared
Compared to perfect
competition, monopoly
restricts output and
charges a higher price.
Because marginal
revenue is less than price
at each output level,
QM < QC and PM > PC.
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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.
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Single-Price Monopoly and Competition
Compared
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.
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.
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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.
By price discriminating, the firm can
increase its profit.
In doing so, it converts consumer
surplus into economic profit.
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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.
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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 rentseeking activity that leads to an inefficient use of
resources.
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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 illustrates a natural
monopoly.
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The Problem of Regulating a Monopoly
• An unregulated
monopolist produces
where MC = MR, at
400,000 units.
• If prices were set at
MC (marginal cost
pricing) the firm
would always suffer a
loss.
• A compromise would
be to set prices at
$0.75 (average cost
pricing) which covers
costs and allows a
normal profit rate.
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MONOPOLISTIC
COMPETITION
AND OLIGOPOLY
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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
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.
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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.
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Monopolistically Competitive Firm at
Long-Run Equilibrium
In the long run, economic profit induces
entry.
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.
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.
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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.
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.
But advertising can increase a firm’s demand
and profits in the short run only.
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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
• Oligopoly Models:
 The Collusion Model
 The Cournot Model
 The Kinked Demand Model
 The Price Leadership Model
 Game Theoretic Models
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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.
The profit maximizing quantity for the large firm is 10 units. The price charged is $1.00.
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Oligopoly and Economic Performance
 Market concentration leads to pricing above
marginal cost and output below the efficient level.
 Entry barriers prevent the efficient flow of
resources between firms and industries.
 Product differentiation may lead to efficiency
losses.
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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
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.
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Payoff Matrix for an Advertising Game
The dominant strategy for A and B is to advertise.
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The Prisoner’s Dilemma
The dominant strategy is for both Rocky and
Ginger to confess.
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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.
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