Pure Competition

Monopolistic Competition Oligopoly Monopoly

Number of Firms

Barriers to Entry

Non-price Competition

Price Taker/Maker

Product type

Many small Many small A few large one

Diff or Homog oneDifferentiatedHomogeneous

large largenonenone

maker makertaker/seekertaker

yes yesyesno

Considers action or reaction of other firms

Need to stress differences?

Long run profits possible?

Ability to influence market price?

As important as price?

1. Many Sellers2. Identical Products

Characteristics?

4. No Non-Price competition

6. Price Taker

3. Easy Entry and Exit

5. SR profits/losses, no LR profits

Output

Price Firm

Output

Price Market

Perfect Competition• Market supply & demand determine price.• The firm’s demand will be perfectly

elastic. • Firms can sell as much as they want at P• Above P, they lose business• Below P they lose revenue.

P

Marketdemand

Marketsupply

Firm’sdemand

P

Firms must take the market price

$120

110

100

90

80

70

60

50

40

30

20

10

01 2 3 4 5 6 7 8 Number of Cakes

Marg

inal C

ost

an

d M

arg

inal R

even

ue

Marcia’s Marginal Cost and Marginal Revenue

Profits

Losses

• The two conditions necessary for long-run equilibrium in a price-taker market are depicted here.

• At the price established in the market, firms in the industry earn zero economic profit

• The quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1.

Output

Price Firm

P1

q1

MC ATC

d1

Long-run Equilibrium

Output

Price Market

P1

D

Ssr

Q1

Normal Profit

Earn economic profit MR > ATC

MR = ATC

Short Run Profits

Short Run Losses

Shut DownFirm can’t cover AVC, minimize

losses by shutting down

MR < AVC

Output

Price Firm

MC

ATC

AVC

P3

Firm covers AVC, but not AFC:

MR < ATC, but MR > AVC

MR

Output

Price Firm

MC

ATC

AVC

• The marginal cost curve (MC) is the firm’s supply curve.

• At P2 MR = MC at q2.

• Below MC = AVC, the firm will shut down Output = 0 below P1,,

• At P3 MR = MC at q3.

The Supply Curve

P2

P3

q2 q3

P1

q1

MC is the firm’s

Supply Curve

Output

Price

Output

Price

• Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D1 to D2 … market price increases to

P2 …

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

An Increase in Market Demand

shifting the firm’s demand curve upward. At the higher price, firms expand output to q2 and earn short-run profits.• Economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2.

P2 d2

q2

D2

S2

Q2

P2

Output

Price

Output

Price

• After the increase in market supply, a new equilibrium is established at the original market price P1 and a larger rate of output (Q3).• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profits are driven down to zero.

The Adjustment

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

P2 d2

q2

D2

S2

Q2

P2

Slr

Q3

d1

Output

Price

Output

Price

A Decrease in Demand

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

P2 d2

q2 Q2

P2

• If, instead, something causes market demand for toothpicks to decrease from D1 to D2 … the market price falls to

P2 shifting the firm’s demand curve downward, leading to a reduction in output to q2. The firm is now making losses.

• Short-run losses cause some competitors to exit the market, and others to reduce the scale of their operation, shifting the market supply curve from S1 to S2.

S2

D2

Output

Price

Output

Price

The Adjustment:

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

P2 d2

d1

q2

D2

S2

Q2

P2

• After the decrease in market supply, a new equilibrium is established at the original market price P1 and a smaller rate of output Q3.• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profit returns to zero.• Note the long-run market supply curve is flat Slr.

Q3

Slrd1

1. One Seller 2. One Product

4. Non-Price competition

6. Price Maker (to maximize profits)

3. Blocked Entry (and exit?)

5. LR profits/losses

Barriers to Entry1. economies of scale

2. government licensing

3. Patents

4. control over an essential resource

A Natural Monopoly Graph

Q

Average Cost

Q0.5

C1

Q1Q0.33

C0.5

C0.33

ATC

• One firm producing Q1 has average cost C1

• If two firms share the market, each produces Q0.5 and has average cost C0.5• If three firms share the market, each produces Q0.33 has average cost C0.33

d

Price

Quantity/time

P2

P1

MRq1 q2

Increase inTotal Revenue

Reduction inTotal Revenue

Marginal Revenue of a Monopolist• Initial price P1 & output q1.

Total revenue (TR) = P1 * q1.1. As price falls from P1 to P2,

output increases from q1 to q2,

two conflicting influences on TR.1. TR will rise because of an increase in the number of units sold (q2 - q1) * P2.

2. TR will decline [(P1 - P2) * q1] as q1 units once sold at the higher price (P1) are now sold at the lower price (P2). • Depending on the size of the shaded regions, total revenue may increase or decrease.

The Welfare Loss from a Monopoly

MC

Q

P

D

QM

PM

• The welfare loss from a monopoly is represented by the triangles B and D

• The rectangle C is a transfer of surplus from the consumer to the monopolist

• The area A represents the opportunity cost of diverted resources, which is not a loss to society MR

PPC

QPC

A

BDC

Price

Quantity/time

d

P

MR

q

MC

ATC

C B

A

with price determined by the height of the demand curve at that level of output, P.

Price and Output Under Monopoly• Expand output as long

as MR > MC. (P goes down)

MR > MCMR < MC

• Output level q will result …

• At q the average total cost per unit for that scale of output is C.

• As P > C (price > ATC) the firm is making economic profits equal to the area PABC.

Economicprofits

• A monopolist will set output equal to q, where MR = MC

When a Monopolist Incurs Losses

d

P

MR

q

MC

ATC

C A

B

Price

Quantity/time

Short-runlosses

• At this level of output, the price that the monopolist charges does not cover the average total cost of producing the output ( P < C ).

• Whenever the ATC curve lies always above the demand curve, the monopolist will incur short-run losses.• In this diagram the firm is making economic losses equal to the shaded area, CABP.

D

P0

MRQ0

LRATC

MCP1

P2

Q1 Q2

Regulation of a MonopolistPrice

Quantity/time

• An unregulated monopolist produces where MR = MC (Q0) and charge price P0.• From an efficiency viewpoint, this output is too small and the price is too high. 1. average cost pricing

The monopolist is forced to reduce its price to P1 the expand output to Q1.

2. marginal cost pricing

-Force output to be expanded to Q2 where P = MC

- P = cost to produce

-Forces LR losses.

Average costpricing

Marginal costpricing

Price Discrimination• Sellers may gain from price discrimination

by charging:• higher prices to groups of customers with

more inelastic demand • lower prices to groups of customers with

more elastic demand

• Price discrimination generally leads to more output and additional gains from trade.

The Economics of Price Discrimination

• If the airline charges all customers the same price, profits will be maximized where MC = MR. Here the airline charges everyone $400 and sells 100 seats.

Price

Quantity/timeSingle price

$400

$200

$300

$100

$500

$600

$700

MC

D100

MR

Net operating revenue($300*100) = $30,000

• Consider a hypothetical market for airline travel where the Marginal Cost per traveler is $100.

• This generates Net Operating Revenue of $30,000 or (total revenues) $40,000 – (operating costs) $10,000.

Price

Quantity/timeSingle price

$400

$200

$300

$100

$500

$600

$700

MC

D100

MR

Net operating revenue($300*100) = $30,000

The Economics of Price Discrimination• By charging higher prices to consumers with less

elastic demand and lower prices to those with more elastic demand it will increase net operating revenue.

• If the airline charges $600 to business travelers (who have a highly inelastic demand) and $300 to other travelers (who have a more elastic demand), it can increase its Net Operating Revenue to $42,000.

Price

Quantity/timePrice Discrim.

$400

$200

$300

$100

$500

$600

$700

MC

D

Net operating revenuefrom business travelers($500*60) = $30,000

Net operating revenuefrom all others($200*60) = $12,000

60 120

• Firms face low entry barriers• Differentiated Products

-they face a downward sloping demand curve-no Long Run Profits-Non-price Competition

• Price Taker• Many Small Firms

Monopolistic Competition

Product Differentiation• Price-searchers produce differentiated

products – products that differ in design, dependability, location, ease of purchase, etc.• Rival firms produce similar products (good

substitutes) and therefore each firm confronts a highly elastic demand curve.

• Advertising increases ATC

• The goals of advertising are to increase demand and make demand more inelastic

• The increase in cost of a monopolistically competitive product is the cost of “differentness”

Price and Output• A profit-maximizing price searcher will

expand output as long as marginal revenue exceeds marginal cost.• Price will be lowered and output expanded

until MR = MC

• The price charged by a price searcher will be greater than its marginal cost.

d

MR

MC

ATC

Price and Output: Short Run Profit

Quantity/timeq

C

EconomicProfits

• A monopolistic competitor maximizes profits by producing where MR = MC, at output level q and charges a price P along the demand curve for that output level.• At q the average total cost is C.

• Because the price is greater than the average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] * q )

• What impact will economic profits have if this is a typical firm?

Price

P

• Because entry and exit are free, competition will eventually drive prices down to the level of ATC.

Quantity/timeq

P

d

MR

MC

ATC

Price and Output: Long Run

• When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored.• The price searcher establishes its output level where MC = MR.• At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present.

C = P

Price

Q

P

ATCBreak even

Q

MC

D

MR

A monopolistic firm can earn profits, losses, or break even in the short run

Determining Profits Graphically: Monopolistic Competition

Losses

Break even

Profits

P

ATCLosses

ATCProfits

ATCL

ATCP

Price

Quantity/Time

Pure Comp Mono comp

Price

Quantity/Time

d

MC

ATC

dMR

MC

ATC

P2

q2

P1

q1

• LR equilibrium for both.• P = ATC and there are no economic profits.• In monopolistic competition, firms face a

downward-sloping demand curve, its profit-maximizing price exceeds MC.

• In Monopolistic Competition, output is too small to minimize ATC in long-run equilibrium.

Comparing Markets

Price

Quantity/Time

Pure Comp Mono comp

Price

Quantity/Time

d

Price MC

ATC

d

MC

ATC

P2

P1

Price

MRq2

q1

• Even though the two markets have the same cost structure, the price in the monopolistic competitor’s market is higher than that in the price-taker’s market ( P2 > P1 ).

• Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation).

Comparing Price Taker Markets

1. Few Sellers2. Differentiated or Identical Products

Characteristics?

4. Non-Price competition

6. Price Maker

3. Difficult Entry and Exit

5. LR profits/losses

• Oligopolies are made up of a small number of firms in an industry

• Oligopolistic firms are mutually interdependent

• In any decision a firm makes, it must take into account the expected reaction of other firms

• Oligopolies can be collusive or noncollusive

• Firms may engage in strategic decision making where each firm takes explicit account of a rival’s expected response to a decision it is making

16-32

Empirical Measures of Industry Structure

• The concentration ratio is a firm’s percentage of total industry sales

• This gives more weight to firms with large market shares than does the concentration ratio measure

• The Herfindahl index is the sum of the squared value of the a firm’s share in the industry

concentration ratio

Herfindahl index

Game Theory or Strategic Interaction

• Cooperative games are games in which players can form coalitions and can enforce the will of the coalition on its members

• Sequential games are games where players make decisions one after another, chess, for example

• A non-cooperative game is a game in which each player is out for him- or herself and agreements are either not possible or not enforceable

• Simultaneous move games are games where players make their decisions at the same time as other players, for example, the prisoner’s dilemma

D

A B

C

high

high

low

low

$57

$55

$55

$60

$59

$50

$69 $58

price

quantity

D=AR

Current Price and Quantity

MR

elastic

inelastic

P TR

P TRMC1

MC2MC3

Q

P

a. Formal Agreement to set Pricesb. OPEC

1. Overt Collusion

a. Secret agreements2. Covert Collusion

b. Electric switch makers in the 50s

a. Agree on price then use non-price competitionb. Types of agreements

3. Gentlemen’s Agreements

2) Cost-Plus Pricing

1) Price Leadership - GM

- Set price based on ATC at 85% capacity

-dominant firm set price-others follow

2. Firms may cheat in non-price ways – free services3. Requires barriers to remain high

1. More firms, more likely to cheat

5. Illegal - use Gentlemen’s agreements

4. Unstable demand/business cycles

6. Difficult to hold the price

Comparison of Market Structures

Monopoly OligopolyMonopolistic Competition

Perfect Competition

No. of firms One Few Many Almost infinite

Barriers to entry Significant Significant Few None

Pricing decisions MC = MRStrategic pricing

MC = MR MC = MR = P

Output decisionsMost output restriction

Output restricted

Output restricted,

product differentiation

No output restriction

InterdependenceNo

competitorsInterdependent

decisions Each firm

independentEach firm

independent

LR profit Possible Possible None None

P and MC P > MC P > MC P > MC P = MC