2 Chapter Outline Perfect competition Monopoly Monopolistic competition Chapter OverviewChapter OutlinePerfect competitionDemand at the market and firm levelsShort-run output decisionsLong-run decisionsMonopolyMonopoly powerSources of monopoly powerMaximizing profitsImplications of entry barriersMonopolistic competitionConditions for monopolistic competitionProfit maximizationLong-run equilibriumImplications of product differentiationOptimal advertising decisions
3 Key Conditions Perfectly competitive markets are characterized by: Perfect CompetitionKey ConditionsPerfectly competitive markets are characterized by:The interaction between many buyers and sellers that are “small” relative to the market.Each firm in the market produces a homogeneous (identical) product.Buyers and sellers have perfect information.No transaction costs.Free entry into and exit from the market.The implications of these conditions are:a single market price is determined by the interaction of demand and supplyfirms earn zero economic profits in the long run.
4 Demand at the Market and Firm Levels In Action Perfect CompetitionDemand at the Market and Firm Levels In ActionPricePriceMarketFirmS𝑃 𝑒𝐷 𝑓 = 𝑃 𝑒DMarketoutputFirm’soutput
5 Short-Run Output Decisions Perfect CompetitionShort-Run Output DecisionsThe short run is a period of time over which some factors of production are fixed.To maximize short-run profits, managers must take as given the fixed inputs (and fixed costs), and determine how much output to produce by changing the variable inputs.
6 Short-Run Profit Maximization: Revenue-Cost Approach In Action Perfect CompetitionShort-Run Profit Maximization: Revenue-Cost Approach In ActionCosts𝐶 𝑄$Revenue𝑅=𝑃×𝑄BMaximumprofitsSlope of 𝐶 𝑄 =𝑀𝐶Slope of 𝑅=𝑀𝑅=𝑃AE𝑄 ∗Firm’s output
7 Competitive Firm’s Demand Perfect CompetitionCompetitive Firm’s DemandThe demand curve for a competitive firm’s product is a horizontal line at the market price. This price is the competitive firm’s marginal revenue.𝐷 𝑓 =𝑃=𝑀𝑅
9 Competitive Output Rule Perfect CompetitionCompetitive Output RuleTo maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing.𝑃=𝑀𝐶 𝑄
10 Competitive Output Rule In Action Perfect CompetitionCompetitive Output Rule In ActionThe cost function for a firm is 𝐶 𝑄 =5+ 𝑄 2 . If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, what price should the manager of this firm charge? What level of output should be produced to maximize profits? How much profit will be earned?MC=2Q
11 Short-Run Loss Minimization In Action Perfect CompetitionShort-Run Loss Minimization In Action$𝐴𝑇𝐶𝑀𝐶𝐴𝑉𝐶𝐴𝑇𝐶 𝑄 ∗Loss𝑃 𝑒𝐷 𝑓 = 𝑃 𝑒 =𝑀𝑅𝑄 ∗Firm’s output
12 The Shut-Down Case In Action Perfect CompetitionThe Shut-Down Case In Action𝐴𝑇𝐶𝑀𝐶𝐴𝑉𝐶$Loss if shut down𝐴𝑇𝐶 𝑄 ∗Fixed Cost𝐴𝑉𝐶 𝑄 ∗𝑃 𝑒𝐷 𝑓 = 𝑃 𝑒 =𝑀𝑅Loss if produce𝑄 ∗Firm’s output
13 Short-Run Output Decision Perfect CompetitionShort-Run Output DecisionTo maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where 𝑃=𝑀𝐶, provided that 𝑃≥𝐴𝑉𝐶. If 𝑃<𝐴𝑉𝐶, the firm should shut down its plant to minimize it losses.
14 Short-Run Firm Supply Curve In Action Perfect CompetitionShort-Run Firm Supply Curve In Action𝑀𝐶$Short-run supplycurve for individual firm𝐴𝑉𝐶𝑃 1𝑃 0𝑄 0𝑄 1Firm’s output
15 Firm’s Short-Run Supply Curve Perfect CompetitionFirm’s Short-Run Supply CurveThe short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the 𝐴𝑉𝐶 curve.
16 Market Supply Curve In Action Perfect CompetitionMarket Supply Curve In ActionPIndividual firm’ssupply curveMarket supplycurve𝑀𝐶 𝑖S$12$105001Market output
19 Long-Run Competitive Equilibrium Perfect CompetitionLong-Run Competitive EquilibriumIn the long run, perfectly competitive firms produce a level of output such that𝑃=𝑀𝐶𝑃=𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝐴𝐶
20 Monopoly and Monopoly Power A market structure in which a single firm serves an entire market for a good that has no close substitutes.Sole seller of a good in a market gives that firm greater market power than if it competed against other firms.Implication:market demand curve is the monopolist’s demand curve.However, a monopolist does not have unlimited market power.
21 Monopolist’s Demand In Action MonopolyMonopolist’s Demand In ActionMonopolist’s power is constrainedby the demand curve.PriceA𝑃 0B𝑃 1𝐷 𝑓 = 𝐷 𝑀𝑄 0𝑄 1Output
22 Sources of Monopoly Power Economies of scaleEconomies of scopeCost complementarityPatents and other legal barriers
24 Elasticity of Demand and Total Revenues In Action MonopolyElasticity of Demand and Total Revenues In ActionPriceRevenueMaximum revenues𝑃 0 × 𝑄 0ElasticUnitaryUnitary𝑅 0Total RevenueCurve𝑃 0InelasticElasticInelasticD𝑄 0𝑄 0QFirm’soutputMR
25 Marginal Revenue and Elasticity MonopolyMarginal Revenue and ElasticityThe monopolist’s marginal revenue function is𝑀𝑅=𝑃 1+𝐸 𝐸, where 𝐸 is the elasticity of demand for the monopolist’s product and 𝑃 is the price charged.For 𝑃>0𝑀𝑅>0 when 𝐸<−1.𝑀𝑅=0 when 𝐸=−1.𝑀𝑅<0 when −1<𝐸<0.
26 Marginal Revenue and Linear Demand MonopolyMarginal Revenue and Linear DemandGiven an linear inverse demand function𝑃 𝑄 =𝑎+𝑏𝑄, where 𝑎>0 𝑎𝑛𝑑 𝑏<0, the associated marginal revenue is𝑀𝑅 𝑄 =𝑎+2𝑏𝑄
27 Marginal Revenue In Action MonopolyMarginal Revenue In ActionSuppose the inverse demand function for a monopolist’s product is given by 𝑃=10−2𝑄. What is the maximum price per unit a monopolist can charge to be able to sell 3 units? What is marginal revenue when 𝑄=3?Answer:The maximum price the monopolist can charge for 3 units is: 𝑃=10−2 3 =$4.The marginal revenue at 3 units for this inverse linear demand is: 𝑀𝑅=10− =−$2.
28 MonopolyOutput RuleA profit-maximizing monopolist should produce the output, 𝑄 𝑀 , such that marginal revenue equals marginal cost:𝑀𝑅 𝑄 𝑀 =𝑀𝐶 𝑄 𝑀
29 Costs, Revenues, and Profit In Action MonopolyCosts, Revenues, and Profit In Action𝐶 𝑄Cost function$𝑅=𝑃 𝑄 ×𝑄Revenue functionSlope of𝑅=𝑀𝑅MaximumprofitSlope of𝐶 𝑄 =𝑀𝐶Output𝑄 𝑀
30 Profit Maximization In Action MonopolyProfit Maximization In ActionPriceMC𝑃𝑟𝑜𝑓𝑖𝑡𝑠=𝑃 𝑀 −𝐴𝑇𝐶 𝑄 𝑀 × 𝑄 𝑀ATC𝑃 𝑀Profits𝐴𝑇𝐶(𝑄 𝑀 )DemandQuantity𝑄 𝑀MR
31 MonopolyPricing RuleGiven the level of output, 𝑄 𝑀 , that maximizes profits, the monopoly price is the price on the demand curve corresponding to the 𝑄 𝑀 units produced:𝑃 𝑀 =𝑃 𝑄 𝑀
32 MonopolyMonopoly In ActionSuppose the inverse demand function for a monopolist’s product is given by 𝑃=100−2𝑄 and the cost function is 𝐶 𝑄 =10+2𝑄. Determine the profit-maximizing price, quantity and maximum profits.Answer:MR=100-4QMC=2
33 Absence of a Supply Curve MonopolyAbsence of a Supply CurveRecall, firms operating in perfectly competitive markets determine how much output to produce based on price (𝑃=𝑀𝐶).Thus, a supply curve exists in perfectly competitive markets.A monopolist’s market power implies 𝑃>𝑀𝑅=𝑀𝐶.Thus, there is no supply curve for a monopolist, or in markets served by firms with market power.
34 MonopolyMultiplant DecisionsOften a monopolist produces output in different locations.Implications: manager has to determine how much output to produce at each plant.Consider a monopolist producing output at two plants:The cost of producing 𝑄 1 units at plant 1 is 𝐶 𝑄 1 , and the cost of producing 𝑄 2 at plant 2 is 𝐶 𝑄 2 .When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is 𝑃 𝑄 , where 𝑄= 𝑄 1 + 𝑄 2 .
35 Multiplant Output Rule MonopolyMultiplant Output RuleLet 𝑀𝑅 𝑄 be the marginal revenue of producing a total of 𝑄= 𝑄 1 + 𝑄 2 units of output.Suppose the marginal cost of producing 𝑄 1 units of output in plant 1 is 𝑀𝐶 1 𝑄 1 and that of producing 𝑄 2 units in plant 2 is 𝑀𝐶 2 𝑄 2 .The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that:𝑀𝑅 𝑄 = 𝑀𝐶 1 𝑄 1𝑀𝑅 𝑄 = 𝑀𝐶 2 𝑄 2
36 Implications of Entry Barriers MonopolyImplications of Entry BarriersA monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits.Implication: monopoly profits will continue over time provided the monopoly maintains its market power.Monopoly power, however, does not guarantee positive profits.
37 Zero-Profit Monopolist In Action MonopolyZero-Profit Monopolist In ActionPriceMCATC𝑃 𝑀 = 𝐴𝑇𝐶(𝑄 𝑀 )DemandQuantity𝑄 𝑀MR
38 Deadweight Loss of Monopoly The consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost.
39 Deadweight Loss of Monopolist In Action MonopolyDeadweight Loss of Monopolist In ActionPriceMC𝑃 𝑀Deadweight loss𝑃 𝐶DemandMRQuantity𝑄 𝑀𝑄 𝐶
40 Monopolistic Competition: Key Conditions An industry is monopolistically competitive if:There are many buyers and sellers.Each firm in the industry produces a differentiated product.There is free entry into and exit from the industry.A key difference between monopolistically competitive and perfectly competitive markets is that each firm produces a slightly differentiated product.Implication: products are close, but not perfect, substitutes; therefore, firm’s demand curve is downward sloping under monopolistic competition.
42 Profit-Maximization Rule Monopolistic CompetitionProfit-Maximization RuleTo maximize profits, a monopolistically competitive firm produces where its marginal revenue equals marginal cost.The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the profit-maximizing level of output.The profit-maximizing output, 𝑄 ∗ , is such that 𝑀𝑅 𝑄 ∗ =𝑀𝐶 𝑄 ∗ and the profit-maximizing price is 𝑃 ∗ =𝑃 𝑄 ∗ .
43 Monopolistic Competition Long-Run EquilibriumIf firms in monopolistically competitive markets earn short-runprofits, additional firms will enter in the long run to capture some of those profits.losses, some firms will exit the industry in the long run.
44 Entry in Monopolistically Competitive Market In Action Monopolistic CompetitionEntry in Monopolistically Competitive Market In ActionPriceMCATCDue to entry of newfirms selling other brands𝑃 ∗Demand1Demand0Quantity of Brand X𝑄 ∗MR1MR0
45 Long-Run Monopolistically Competitive Equilibrium In Action Monopolistic CompetitionLong-Run Monopolistically Competitive Equilibrium In ActionPriceMCLong-run monopolisticallycompetitive equilibriumATC𝑃 ∗Demand1Quantity of Brand X𝑄 ∗MR1
46 Long-Run and Monopolistic Competition In the long run, monopolistically competitive firms produce a level of output such that:𝑃>𝑀𝐶𝑃=𝐴𝑇𝐶>𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠
47 Implications of Product Differentiation Monopolistic CompetitionImplications of Product DifferentiationThe differentiated nature of products in monopolistically competitive markets implies that firms in these industries must continually convince consumers that their products are better than their competitors.Two strategies monopolistically competitive firms use to persuade consumers:Comparative advertisingNiche marketing
48 ConclusionFirms operating in a perfectly competitive market take the market price as given.Produce output where 𝑃=𝑀𝐶.Firms may earn profits or losses in the short run.… but, in the long run, entry or exit forces economic profits to zero.A monopoly firm, in contrast, can earn persistent profits provided that the source of monopoly power is not eliminated.A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits in the long run.