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Lesson 6
Firms in competitive markets:
Perfect Competition and
Monopoly
Henan University of Technology
Sino-British College
Transfer Abroad Undergraduate Programme
1
In this lesson, look for the answers to these
questions:
What is a perfectly competitive market?
What is marginal revenue? How is it related to
total and average revenue?
How does a competitive firm determine the
quantity that maximizes profits?
When might a competitive firm shut down in the
short run? Exit the market in the long run?
2
Why do monopolies arise?
Why is MR < P for a monopolist?
How do monopolies choose their P and Q?
How do monopolies affect society’s well-being?
What can the government do about monopolies?
What is price discrimination?
What market structures lie between perfect
competition and monopoly, and what are their
characteristics?
3
Introduction: A Scenario
Three years after graduating, you run your own
business.
You must decide how much to produce, what price
to charge, how many workers to hire, etc.
What factors should affect these decisions?
• Your costs
• How much competition you face
We begin by studying the behavior of firms in
perfectly competitive markets.
4
Characteristics of Perfect Competition
1. Many buyers and many sellers
2. The goods offered for sale are largely the same.
3. Firms can freely enter or exit the market.
Because of 1 & 2, each buyer and seller is a
“price taker” – takes the price as given.
5
The Revenue of a Competitive Firm
Total revenue (TR)
Average revenue (AR)
Marginal Revenue (MR):
The change in TR from
selling one more unit.
∆TR
∆QMR =
TR = P x Q
TR
QAR = = P
A C T I V E L E A R N I N G 1:
ExerciseFill in the empty spaces of the table.
6
$50$105
$40$104
$103
$102
$10$101
n.a.$100
TRPQ MRAR
$10
A C T I V E L E A R N I N G 1:
AnswersFill in the empty spaces of the table.
7
$50$105
$40$104
$103
$10
$10
$10
$10$102
$10$101
n.a.
$30
$20
$10
$0$100
TR = P x QPQ∆TR
∆QMR =
TR
QAR =
$10
$10
$10
$10
$10
Notice that
MR = P
8
MR = P for a Competitive Firm
A competitive firm can keep increasing its output
without affecting the market price.
So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.
MR = P is only true for
firms in competitive markets.
9
Profit Maximization
What Q maximizes the firm’s profit?
To find the answer,
“Think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
If MR > MC, then increase Q to raise profit.
If MR < MC, then reduce Q to raise profit.
10
Profit Maximization
505
404
303
202
101
45
33
23
15
9
$5$00
Profit =
MR – MCMCMRProfitTCTRQAt any Q with
MR > MC,
increasing Q
raises profit.
5
7
7
5
1
–$5
10
10
10
10
–2
0
2
4
$6
12
10
8
6
$4$10
(continued from earlier exercise)
At any Q with
MR < MC,
reducing Q
raises profit.
11
P1 MR
MC and the Firm’s Supply Decision
At Qa, MC < MR.
So, increase Q
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit.
At Q1, MC = MR.
Changing Q
would lower profit. Q
Costs
MC
Q1Qa Qb
Rule: MR = MC at the profit-maximizing Q.
12
P1 MR
P2 MR2
MC and the Firm’s Supply Decision
If price rises to P2,
then the profit-
maximizing quantity
rises to Q2.
The MC curve
determines the
firm’s Q at any price.
Hence,
Q
Costs
MC
Q1 Q2
the MC curve is the
firm’s supply curve.
13
Shutdown vs. Exit
Shutdown:
A short-run decision not to produce anything
because of market conditions.
Exit:
A long-run decision to leave the market.
A key difference:
• If shut down in SR, must still pay FC.
• If exit in LR, zero costs.
14
A Firm’s Short-run Decision to Shut Down
• Cost of shutting down:
revenue loss = TR
• Benefit of shutting down:
cost savings = VC
(firm must still pay FC)
So, shut down if TR < VC.
Divide both sides by Q: TR/Q < VC/Q
So, firm’s decision rule is:
Shut down if P < AVC
15
The firm’s SR
supply curve is
the portion of
its MC curve
above AVC.
Q
Costs
A Competitive Firm’s SR Supply Curve
MC
ATC
AVC
If P > AVC, then
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).
16
The Irrelevance of Sunk Costs
Sunk cost: a cost that has already been
committed and cannot be recovered
Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed
costs whether it produces or shuts down.
So, FC should not matter in the decision to shut
down.
17
A Firm’s Long-Run Decision to Exit
• Cost of exiting the market:
revenue loss = TR
• Benefit of exiting the market:
cost savings = TC
(zero FC in the long run)
So, firm exits if TR < TC.
Divide both sides by Q to write the firm’s
decision rule as:
Exit if P < ATC
18
A New Firm’s Decision to Enter Market
In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ATC
19
The firm’s
LR supply curve
is the portion of
its MC curve
above LRATC.
Q
Costs
The Competitive Firm’s Supply Curve
MC
LRATC
A C T I V E L E A R N I N G 2A:
Identifying a firm’s profit
Determine
this firm’s
total profit.
Identify the
area on the
graph that
represents
the firm’s
profit.
20
Q
Costs, P
MC
ATC
P = $10 MR
50
$6
A competitive firm
profit
A C T I V E L E A R N I N G 2A:
Answers
21
Q
Costs, P
MC
ATC
P = $10 MR
50
$6
A competitive firm
profit per unit
= P – ATC
= $10 – 6
= $4
Total profit
= (P – ATC) x Q
= $4 x 50
= $200
A C T I V E L E A R N I N G 2B:
Identifying a firm’s loss
Determine
this firm’s
total loss,
assuming
AVC < $3.
Identify the
area on the
graph that
represents
the firm’s
loss.
22
Q
Costs, P
MC
ATC
A competitive firm
$5
P = $3 MR
30
lossMRP = $3
A C T I V E L E A R N I N G 2B:
Answers
23
Q
Costs, P
MC
ATC
A competitive firm
loss per unit = $2
Total loss
= (ATC – P) x Q
= $2 x 30
= $60$5
30
24
CONCLUSION: The Efficiency of a Competitive Market
Profit-maximization: MC = MR
Perfect competition: P = MR
So, in the competitive eq’m: P = MC
Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
So, the competitive eq’m is efficient, maximizes
total surplus.
In the next chapter, monopoly: pricing &
production decisions, deadweight loss, regulation.
25
Monopoly Introduction
A monopoly is a firm that is the sole seller of a
product without close substitutes.
In this part, we study monopoly and contrast it
with perfect competition.
The key difference:
A monopoly firm has market power, the ability
to influence the market price of the product it
sells. A competitive firm has no market power.
26
Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws
27
Why Monopolies Arise
3. Natural monopoly: a single firm can produce
the entire market Q at lower ATC than could
several firms.
Q
Cost
ATC
1000
$50
Example: 1000 homes
need electricity. Electricity
ATC slopes
downward due
to huge FC and
small MC
ATC is lower if
one firm services
all 1000 homes
than if two firms
each service
500 homes. 500
$80
28
Monopoly vs. Competition: Demand Curves
In a competitive market,
the market demand curve
slopes downward.
but the demand curve
for any individual firm’s
product is horizontal
at the market price.
The firm can increase Q
without lowering P,
so MR = P for the
competitive firm.
D
P
Q
A competitive firm’s
demand curve
29
Monopoly vs. Competition: Demand Curves
A monopolist is the only
seller, so it faces the
market demand curve.
To sell a larger Q,
the firm must reduce P.
Thus, MR ≠ P.
D
P
Q
A monopolist’s
demand curve
A C T I V E L E A R N I N G 1:
A monopoly’s revenue
Moonbucks is
the only seller of
cappuccinos in town.
The table shows the
market demand for
cappuccinos.
Fill in the missing
spaces of the table.
What is the relation
between P and AR?
Between P and MR?
30
Q P TR AR MR
0 $4.50
1 4.00
2 3.50
3 3.00
4 2.50
5 2.00
6 1.50
n.a.
A C T I V E L E A R N I N G 1:
Answers
Here, P = AR,
same as for a
competitive firm.
Here, MR < P,
whereas MR = P
for a competitive
firm.
31
1.506
2.005
2.504
3.003
3.502
1.50
2.00
2.50
3.00
3.50
$4.004.001
n.a.
9
10
10
9
7
4
$ 0$4.500
MRARTRPQ
–1
0
1
2
3
$4
32
Moonbuck’s D and MR Curves
-3
-2
-1
0
1
2
3
4
5
0 1 2 3 4 5 6 7 Q
P, MR
MR
$
Demand curve (P)
1.506
2.005
2.504
3.003
3.502
4.001
$4.500
MRPQ
–1
0
1
2
3
$4
33
Understanding the Monopolist’s MR
Increasing Q has two effects on revenue:
• The output effect:
Higher output raises revenue
• The price effect:
Lower price reduces revenue
To sell a larger Q, the monopolist must reduce the
price on all the units it sells.
Hence, MR < P
MR could even be negative if the price effect
exceeds the output effect
(e.g., when Moonbucks increases Q from 5 to 6).
34
Profit-Maximization
Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC.
Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to
pay for that quantity.
It finds this price from the D curve.
35
Profit-Maximization
1. The profit-
maximizing Q
is where
MR = MC.
2. Find P from
the demand
curve at this Q.
Quantity
Costs and
Revenue
MR
D
MC
Profit-maximizing output
P
Q
36
The Monopolist’s Profit
As with a
competitive firm,
the monopolist’s
profit equals
(P – ATC) x Q
Quantity
Costs and
Revenue
ATC
D
MR
MC
Q
P
ATC
37
A Monopoly Does Not Have an S Curve
A competitive firm
takes P as given
has a supply curve that shows how its Q depends
on P
A monopoly firm
is a “price-maker,” not a “price-taker”
Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.
So there is no supply curve for monopoly.
38
The Welfare Cost of Monopoly
Recall: In a competitive market equilibrium,
P = MC and total surplus is maximized.
In the monopoly eq’m, P > MR = MC
• The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC).
• The monopoly Q is too low –
could increase total surplus with a larger Q.
• Thus, monopoly results in a deadweight loss.
39
P = MC
Deadweight
loss
P
MC
The Welfare Cost of Monopoly
Competitive eq’m:
quantity = QC
P = MC
total surplus is
maximized
Monopoly eq’m:
quantity = QM
P > MC
deadweight loss Quantity
Price
D
MR
MC
QM QC
40
Public Policy Toward Monopolies
Increasing competition with antitrust laws
• ban some anticompetitive practices,
allow govt to break up monopolies
Regulation
• Govt agencies set the monopolist’s price
• For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
• If so, regulators might subsidize the monopolist
or set P = ATC for zero economic profit.
41
Public Policy Toward Monopolies
Public ownership
• Example: U.S. Postal Service
• Problem: Public ownership is usually less
efficient since no profit motive to minimize costs
Doing nothing
• The foregoing policies all have drawbacks,
so the best policy may be no policy.
42
Price Discrimination
Discrimination: treating people differently based
on some characteristic, e.g. race or gender.
Price discrimination: selling the same good
at different prices to different buyers.
The characteristic used in price discrimination
is willingness to pay (WTP):
• A firm can increase profit by charging a higher
price to buyers with higher WTP.
43
Price Discrimination in the Real World
In the real world, perfect price discrimination is
not possible:
• no firm knows every buyer’s WTP
• buyers do not announce it to sellers
So, firms divide customers into groups
based on some observable trait
that is likely related to WTP, such as age.
44
Examples of Price Discrimination
Movie tickets
Discounts for seniors, students, and people
who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help
distinguish business travelers, who usually have
higher WTP, from more price-sensitive leisure
travelers.
45
Examples of Price Discrimination
Quantity discounts
A buyer’s WTP often declines with additional
units, so firms charge less per unit for large
quantities than small ones.
Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s
twice as big.
46
CONCLUSION: The Prevalence of Monopoly
In the real world, pure monopoly is rare.
Yet, many firms have market power, due to
• selling a unique variety of a product
• having a large market share and few significant
competitors
47
Between Monopoly and Competition
Two extremes
• Competitive markets: many firms, identical
products
• Monopoly: one firm
In between these extremes
• Oligopoly: only a few sellers offer similar or
identical products.
• Monopolistic competition: many firms sell
similar but not identical products.
48
LESSON SUMMARY
For a firm in a perfectly competitive market,
price = marginal revenue = average revenue.
If P > AVC, a firm maximizes profit by producing
the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.
If P < ATC, a firm will exit in the long run. .
49
LESSON SUMMARY
A monopoly firm is the sole seller in its market.
Monopolies arise due to barriers to entry,
including: government-granted monopolies, the
control of a key resource, or economies of scale
over the entire range of output.
A monopoly firm faces a downward-sloping
demand curve for its product. As a result, it must
reduce price to sell a larger quantity, which causes
marginal revenue to fall below price.
50
LESSON SUMMARY
Monopoly firms maximize profits by producing the
quantity where marginal revenue equals marginal
cost. But since marginal revenue is less than
price, the monopoly price will be greater than
marginal cost, leading to a deadweight loss.
Policymakers may respond by regulating
monopolies, using antitrust laws to promote
competition, or by taking over the monopoly and
running it. Due to problems with each of these
options, the best option may be to take no action.
51
LESSON SUMMARY
Monopoly firms (and others with market power) try
to raise their profits by charging higher prices to
consumers with higher willingness to pay. This
practice is called price discrimination.