Chapter 9 Perfect competition and monopoly: The limiting cases of market structure

1. Chapter 9Perfect competition and monopoly:The limiting cases of market structure David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

2. Perfect competition Characteristics of a perfectly competition 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

3. £ SMC SATC C P3 SAVC P1 A Q1 Q3 Output The supply curve under perfect competition (1) • 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

4. £ SMC SATC C P3 SAVC P1 A Q1 Q3 Output The supply curve under perfect competition (2) • 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

5. £ SMC SATC C P3 SAVC P1 A Q1 Q3 Output The supply curve under perfect competition (3) • 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.

6. SMC £ £ SRSS SAC P P D=MR=AR D q Output Q Output The firm and the industry in the short run under perfect competition (1) Firm INDUSTRY 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.

7. Firm SMC £ SRSS £ P P D=MR=AR D q Q Output Output The firm and the industry in the short run under perfect competition (2) INDUSTRY SAC The firm accepts price as given at P – and chooses output at q where SMC=MR to maximize profits

8. Firm SMC £ SRSS £ SRSS1 SAC P P P1 D=MR=AR D q Q Output Output The firm and the industry in the short run under perfect competition (3) INDUSTRY At this price, profits are shown by the shaded area. These profits attract new entrants into the industry. As more firms join the market, the industry supply curve shifts to the right, and market price falls.

9. SMC £ £ SRSS SAC LRSS P* P* D=MR=AR D q* Q Output Output Long-run equilibrium Firm INDUSTRY 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) then the long-run supply curve will not be horizontal, but upward-sloping.

10. £ D' D SRSS P1 P0 D' D Q1 Q0 Output Adjustment to an increase in market demand:the short run Suppose a perfectly competitive market starts in equilibrium at P0Q0. If market demand shifts to D'D' ... in the short run the new equilibrium is P1Q1 ... – adjustment is through expansion of individual firms along their SMCs.

11. £ D' D SRSS P1 P2 LRSS P0 D' D And the market finally settles at P2Q2. Q1 Q2 Q0 Output Adjustment to an increase in market demand:the long run In the long run, new firms are attracted by the profits now being made here – and firms are able to adjust their input of fixed factors If wages are bid up by this expansion, the long-run supply schedule is upward- sloping

12. 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.

13. £ MC AC P1 AC1 shown by the shaded area D = AR MR MC=MR Q1 Output Profit maximization by a monopolist Profits are maximized where MC = MR at Q1P1. In this position, AR is greater than AC so the firm makes profits above the opportunity cost of capital Entry barriers prevent new firms joining the industry.

14. Competitive equilibrium is at A, with output Q1 and price P1. £ SRSS =SMC To the monopolist, LRSS is the LMC curve, and SRSS is the SMC curve P2 A LRSS P1 = LMC The monopolist maximizes profits in the short run at MR = SMC at P2Q2. D MR Q2 Q1 Output Comparing monopoly with perfect competition (1) Suppose a competitive industry is taken over by a monopolist:

15. £ SRSS =SMC P3 P2 A LRSS P1 At P3Q3. = LMC D MR Q3 Q2 Q1 Comparing monopoly with perfect competition (2) Suppose a competitive industry is taken over by a monopolist: In the long run, the firm can adjust other inputs ... to set MR = LMC Output

16. 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.

17. £ P1 LMC LAC D MR Q1 Output 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

18. 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