Transcript Principles of Economics Third Edition by Fred Gottheil

Chapter 11
Price and Output in Monopoly,
Monopolistic Competition, and
Perfect Competition
© 2005 Thomson
Economic Principles
Price, output and economic
profit under conditions of
monopoly
Price, output and economic
profit for the firm in
monopolistic competition
Normal profit
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Economic Principles
Price, output and economic
profit for the firm in perfect
competition
The perfectly competitive
firm’s supply curve
Market supply in perfect
competition
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Economic Principles
The Schumpeterian illustration
of low price and high efficiency
under conditions of monopoly
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Monopoly Price and Output
Monopolists are distinguished
from other types of entrepreneurs
by their market position—not by
their motivation, morality,
strategy or objective.
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Monopoly Price and Output
Price-maker
• A firm conscious of the fact that its own
activity in the market affects price. The
firm has the ability to choose among
combinations of price and output.
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EXHIBIT 1
MARKET DEMAND FOR ICE
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Exhibit 1: Market Demand for Ice
Which price and quantity choices
does the ice company have
available in Exhibit 1?
• The ice company has unlimited choices. It
is a price maker and can choose any
combination of price and output it wants.
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Exhibit 1: Market Demand for Ice
Which price and quantity choices
does the ice company have in
Exhibit 1?
• Although the ice company can charge
higher prices, the company must recognize
that at higher prices, fewer tons of ice
will be demanded.
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Exhibit 1: Market Demand for Ice
Which price and quantity choices
does the ice company have in
Exhibit 1?
• The company uses the MR = MC rule to
determine what combination of price and
output will maximize profit.
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Price and Output Under Monopoly
Recall the MR = MC Rule:
• Expand production if MR > MC.
• Profit is maximized when MR = MC.
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Price and Output Under Monopoly
Marginal cost (MC) is the increase in
total cost when an additional unit of
output is added to production.
Marginal revenue (MR) is the change
in total revenue generated by the sale
of one additional unit of goods
and services.
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Price and Output Under Monopoly
Economic profit
• A firm’s total revenue minus its total explicit
and implicit costs.
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EXHIBIT 2
COST AND REVENUE SCHEDULES FOR THE
NICK RUDD ICE COMPANY
Note: Figures are rounded to the nearest dollar.
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Exhibit 2: Cost and Revenue Schedule
for the Nick Rudd Ice Company
1. What is the company’s
economic profit when 50 tons of
ice are produced?
• Economic profit = total revenue - total cost
= $(13,750 - 8,500) = $5,250.
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Exhibit 2: Cost and Revenue Schedule
for the Nick Rudd Ice Company
2. Since the company is a pricemaker, should it charge the
highest price possible?
• No. The highest price possible does not
necessarily generate the most profit.
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Exhibit 2: Cost and Revenue Schedule
for the Nick Rudd Ice Company
3. At what output should the
company be producing in order
to maximize profit?
• The company should be producing 300
tons of ice in order to maximize profit.
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Exhibit 2: Cost and Revenue Schedule
for the Nick Rudd Ice Company
3. At what output should the
company be producing in order
to maximize profit?
• This is the output level where MR = MC.
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Maximum Profit, but Less than
Maximum Efficiency
• The profit-maximizing output is not
necessarily the most efficient output.
• There may be output levels that have a
lower average total cost (ATC).
• The firm is interested in maximum
profit, however, not maximum efficiency.
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EXHIBIT 3
PRICE AND OUTPUT DETERMINATION
IN MONOPOLY
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Exhibit 3: Price and Output
Determination in Monopoly
What is the total profit for the profitmaximizing firm in Exhibit 4?
• The profit-maximizing firm produces
where MR = MC. This point is at a quantity
of 300 in Exhibit 4.
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Exhibit 3: Price and Output
Determination in Monopoly
What is the total profit for the profit
maximizing firm in Exhibit 4?
• At quantity 300, the price (read off the
demand curve) is $150. The average total
cost (read off the ATC curve) is $52.
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Exhibit 3: Price and Output
Determination in Monopoly
What is the total profit for the profit
maximizing firm in Exhibit 4?
• Total profit = $(150-52) × 300 = $29,400.
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Price and Output in
Monopolistic Competition
• One way that a new firm can break
into a market is through product
differentiation.
• The trick is to differentiate the
product enough to claim uniqueness,
yet keep it close enough to existing
competition.
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EXHIBIT 4
RUDD’S DEMAND CURVE AS NEW FIRMS
ENTER THE MARKET
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Exhibit 4: Rudd’s Demand Curve
as New Firms Enter the Market
As new firms enter a market, the
demand curve for the existing
firms becomes:
i. More elastic
ii. Less elastic
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Exhibit 4: Rudd’s Demand Curve
as New Firms Enter the Market
As new firms enter a market, the
demand curve for the existing
firms becomes:
i. More elastic
ii. Less elastic
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Exhibit 4: Rudd’s Demand Curve
as New Firms Enter the Market
As new firms enter a market, the
demand curve for the existing
firms becomes:
i. More elastic—More substitutes become available,
which increases the price elasticity of demand.
ii. Less elastic
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EXHIBIT 5
RUDD’S PRICE AND OUTPUT IN A MONOPOLISTICALLY COMPETITIVE MARKET
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Exhibit 5: Rudd’s Price and
Output in a Monopolistically
Competitive Market
1. How does the ice company
determine the best output level to
produce after new firms have
entered the market?
• The ice company determines its
production level the same way it did
before—it uses the MR=MC rule.
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Exhibit 5: Rudd’s Price and
Output in a Monopolistically
Competitive Market
2. Is Rudd’s better off or worse
off in the monopolistically
competitive market?
• Rudd’s is worse off. Under monopolistic
competition, economic profit declines.
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Exhibit 5: Rudd’s Price and
Output in a Monopolistically
Competitive Market
3. Are consumers better off or
worse off in the monopolistically
competitive market?
• Consumers are better off. The price they
pay is lower and the quantities they buy
are greater.
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Price and Output in
Monopolistic Competition
• As long as there is economic
profit to be made, firms will
continue to enter a market.
• The limit to further entry is the
point where the demand curve is
tangent to the ATC curve.
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EXHIBIT 6
RUDD’S LONG-RUN EQUILIBRIUM PRICE AND
OUTPUT IN MONOPOLISTIC COMPETITION
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Exhibit 6: Rudd’s Long-Run
Equilibrium Price and Output in
Monopolistic Competition
1. At what output level is profit
maximized in Exhibit 6?
• Profit is maximized at an output level
of 150.
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Exhibit 6: Rudd’s Long-Run
Equilibrium Price and Output in
Monopolistic Competition
2. What are price and average
total cost at this output level?
• Both price and average total cost are $82.
The demand curve is tangent to the ATC
curve.
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Exhibit 6: Rudd’s Long-Run
Equilibrium Price and Output in
Monopolistic Competition
3. What is Rudd’s economic
profit at this output level?
• Economic profit = $(82-82) × 150 = 0.
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Exhibit 6: Rudd’s Long-Run
Equilibrium Price and Output in
Monopolistic Competition
4. If economic profit is zero,
should Rudd’s produce at some
other output?
• No. The MR = MC rule always signals the
firm’s most profitable output level, even if
the profit is zero. Every other output level
in this case would yield a loss.
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Price and Output in
Monopolistic Competition
Normal profit
• The entrepreneur’s opportunity cost. It
is equal to or greater than the income an
entrepreneur could receive employing his
or her resources elsewhere. Normal profit
is included in the firm’s costs.
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Price and Output in
Monopolistic Competition
Even though the economic profit
of a firm may be zero, the firm
still generates a normal profit—a
wage—for the entrepreneur. The
normal profit is at least as much as
the entrepreneur can earn
elsewhere.
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Price and Output in Perfect
Competition
• There is no product
differentiation in a perfectly
competitive market.
• Firms in perfect competition
are typically modest in size.
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EXHIBIT 7A
THE COMPETITIVE FIRM’S COST
STRUCTURE
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EXHIBIT 8B
THE COMPETITIVE FIRM’S COST
STRUCTURE
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Exhibit 7: The Competitive
Firm’s Cost Structure
How does ATC change as the firm
changes output from 4.5 to 6.0 in
Exhibit 8?
• At an output of 4.5, the firm achieves its
minimum ATC of $47.
• ATC increases to $55 when the firm
increases output to 6.0.
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Price and Output in Perfect
Competition
Price-taker
• A firm that views market price as a
given and considers any activity on its
own part as having no influence on that
price.
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Price and Output in Perfect
Competition
For firms in perfect competition,
price always equals marginal
revenue (P = MR).
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EXHIBIT 8A
DEMAND AND SUPPLY FOR ICE IN A
PERFECTLY COMPETITIVE MARKET
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EXHIBIT 8B
DEMAND AND SUPPLY FOR ICE IN A
PERFECTLY COMPETITIVE MARKET
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Exhibit 8: Demand and Supply for Ice
in a Perfectly Competitive Market
1. What is the equilibrium price
and quantity demanded in panel a
of Exhibit 8?
• The equilibrium price is $78 and the
quantity demanded is 440.
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Exhibit 8: Demand and Supply for Ice
in a Perfectly Competitive Market
2. Why is the firm’s demand
curve horizontal?
• The firm is a price-taker. The firm must
charge the equilibrium price regardless of
the quantity it produces.
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Exhibit 8: Demand and Supply for Ice
in a Perfectly Competitive Market
3. Should a firm in perfect
competition increase its price in
order to generate more profit?
• No. If the firm increases its price by even a
penny, then the firm will not be able to sell
any product.
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Short-Run Equilibrium Price and Output
for the Firm in Perfect Competition
• Economic profit will attract new
producers to a market.
• As new producers enter the
market, the supply curve shifts to
the right, forcing the equilibrium
price to fall.
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Short-Run Equilibrium Price and Output
for the Firm in Perfect Competition
• Each producer must adjust its
output to maximize profit at the
new equilibrium price.
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EXHIBIT 9A
THE PERFECTLY COMPETITIVE FIRM IN THE
SHORT RUN
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EXHIBIT 9B
THE PERFECTLY COMPETITIVE FIRM IN THE
SHORT RUN
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Exhibit 9: The Perfectly Competitive
Firm in the Short-Run
1. How does a price-taker know
what output maximizes profit?
• The price-taker uses the MR = MC rule.
Since MR is always equal to price, the firm
must determine the output where MC is
equal to price.
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Exhibit 9: The Perfectly Competitive
Firm in the Short-Run
2. What is the economic profit
received by the firm in Exhibit 9?
• Economic profit = $(78 - 51) × 5.5 = $148.50.
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EXHIBIT 10 EFFECTS OF A SHIFT IN MARKET SUPPLY
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Exhibit 10: Effects of a Shift
in Market Supply
1. How does the equilibrium price
change as the supply curve shifts
from S to S to S in Exhibit 10?
1
2
3
• The short-run equilibrium price changes
from $78 at S1 to $60 at S2 and to $47 at S3.
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Exhibit 10: Effects of a Shift
in Market Supply
2. How does the change in price
affect the economic profit of firms?
• With each decrease in price, economic
profit decreases. At an output of 4.5 tons,
price equals ATC. Economic profit is zero.
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Long-Run Equilibrium Price and Output
for the Firm in Perfect Competition
The long-run equilibrium position
of firms in perfect competition is
identified by P = MR = MC = ATC.
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EXHIBIT 11
THE MARKET AND FIRM IN LONG-RUN
EQUILIBRIUM
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Exhibit 11: The Market and Firm
in Long-Run Equilibrium
At what point along the ATC
curve does the firm in perfect
competition end up producing in
the long run?
• The firm produces at the lowest point on
its ATC curve.
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EXHIBIT 12 ANATOMY OF THE FIRM’S LONG-RUN
SUPPLY CURVE
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Exhibit 12: Anatomy of the Firm’s
Long-Run Supply Curve
Where does the supply curve
begin for the firm in Exhibit 13?
• The supply curve begins at the point where
MC = ATC on its marginal cost curve.
• Any point on the supply curve below that
point will result in loss to the firm.
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Long-Run Equilibrium Price and Output
for the Firm in Perfect Competition
The market supply curve is the
aggregation of the long-run MC
curves of the firms in the market.
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EXHIBIT 13 ANATOMY OF THE MARKET SUPPLY CURVE
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Exhibit 13: Anatomy of the Market
Supply Curve
When P = $100, what is the total
market supply?
• At P = $100, 150 firms are willing to
supply 6 tons each.
• Market supply = 150 firms × 6 tons =
900 tons.
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EXHIBIT 14 THE INNOVATOR FIRM IN PERFECT
COMPETITION
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Exhibit 14: The Innovator Firm in
Perfect Competition
Complete this sentence:
Innovation results in _____
economic profit in the long-run.
i. Higher
ii. The same
iii. Lower
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Exhibit 14: The Innovator Firm in
Perfect Competition
Complete this sentence:
Innovation results in _____
economic profit in the long-run.
i. Higher
ii. The same
iii. Lower
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Exhibit 14: The Innovator Firm in
Perfect Competition
Complete this sentence:
Innovation results in _____
economic profit in the long-run.
i. Higher
ii. The same—Economic profit may initially rise,
but it will return to zero in the long-run.
iii. Lower
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EXHIBIT 15 CONSTANT AND INCREASING RETURNS
TO SCALE
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Exhibit 15: Constant and
Increasing Returns to Scale
How does ATC change between
panel a and panel b in Exhibit 15?
• In panel a, constant returns to scale, the
minimum ATC is the same for small and
large firms.
• In panel b, increasing returns to scale,
ATC falls as firm size and output increase.
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The Schumpeter Hypothesis
• According to economist Joseph
Schumpeter, bigness can be an
advantage for an innovating firm.
• The economies of scale and low
average costs of production available
to big firms may allow them to charge
prices that are actually lower than
those charged by small, competitive
firms.
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The Schumpeter Hypothesis
• Monopoly profits permit these firms
to experiment with new technologies
that ultimately lead to more efficient
production.
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The Schumpeter Hypothesis
• Other economists, such as Alfred
Marshall, disagree.
• They contend that the large number
of small firms that undertake
innovation will lead to the greatest
efficiency in production over time.
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EXHIBIT 16 MONOPOLY AND PERFECT
COMPETITION: SCHUMPETER’S VIEW
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Exhibit 16: Monopoly and Perfect
Competition: Schumpeter’s View
1. What is price and quantity for
the competitive firm in panel a?
• Price is $25.
• With 200 firms in the market, quantity
supplied to the market is 4,000.
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Exhibit 16: Monopoly and Perfect
Competition: Schumpeter’s View
2. How does the competitive firm’s
price and quantity compare to the
monopoly in panel b?
• The monopoly’s price is $20—$5 less than the
competitive firm’s price.
• The monopoly’s output quantity is 10,000 —
6,000 greater than the competitive
firm’s output.
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