1. Competition and Market Power
Chapter 5
Competition and Market Power

2. Chapter Objectives Perfect competition Market structure
Monopolistic competition
Oligopoly
Monopoly
Market power

3. The Role of Competition
Competition plays a key role in a market economy.
Companies are forced to deliver to consumers the product they want at the lowest cost.
Competition in the market leads to more production, more innovation, lower costs, and higher living standards.

4. Perfect Competition
The highest degree of competition is found in a perfectly competitive market.
This is an extreme type of market structure rarely found in the real world.
In perfect competition, all buyers and sellers are price takers.
In this case, buyers and sellers do not set the price of their product, but take the price as given.
Prices are determined by the market.

5. Conditions Necessary for Perfect Competition
For a market to be perfectly competitive, the following conditions must hold:
First, products have to be standardized or homogenous so there is little difference between them.
Second, sellers and buyers must be well-informed about what all the other sellers are charging.

6. Conditions Necessary for Perfect Competition
Third, a market with perfect competition will have many sellers and many buyers.
No buyer or seller is large enough to have an impact on the price.
In national or global markets, buyers and sellers are in different parts of the country or the world.

7. Examples of Perfect Competition
Most markets do not meet all three of the conditions necessary for perfect competition.
But today’s economy is moving more toward perfect competition as more markets become global.
Agricultural markets are the best examples of perfect competition.
There are many buyers and sellers, products are standardized, and no buyer or seller can set the price.

8. Profit Maximization in Perfect Competition
Remember, profit maximization occurs at the output level, where marginal revenue (MR) equals marginal cost (MC).
In perfect competition, the marginal revenue received from selling one more unit of output is simply equal to the price (P).
So in perfect competition the firm will produce at the point where price equals marginal cost.
Profit maximization occurs at P=MC.

9. Profit Maximization for a Computer Maker
Assuming a firm can sell its computer for $500, the firm will maximize profits by producing 4000 computers. At this output level, P=MC.
Output (no. of computers)
Marginal cost (dollars)
Marginal revenue (dollars)
1000
200
500
2000
300
3000
400
4000
5000
600

10. Profit Maximization by a Single Business in a Competitive Market
700
Marginal cost curve
(also individual supply
curve)
600
Market price
500 A
400
Price (dollars)
300
Profit maximization
output
200
100
1000
2000
3000
4000
5000
6000
Output (number of computers)

11. Market Supply with Ten Identical Businesses
700
Market supply curve
(with ten identical
businesses)
600
Market price
500 A
400
Price (dollars)
300
Profit maximization
output
200
100
10000
20000
30000
40000
50000
60000
Output (number of computers)

12. Market Equilibrium in Perfect Competition
In perfect competition, the price is set in the market.
This table shows market demand and supply for computers. At a price of $500, quantity demanded equals quantity supplied.
Price (dollars)
Quantity demanded
Quantity supplied
200
70000
10000
300
60000
20000
400
50000
30000
500
40000
600

13. Graphing Market Equilibrium
700
600
Market supply curve
(with ten identical
businesses)
Market price
500 A
400
Price (dollars)
300
200
100
20000
40000
60000
80000
Output (number of computers)

14. Perfect Competition in Long Run
In perfect competition, the existence of profits attract competition as new firms enter the market.
In some industries, barriers to entry make it difficult for firms to enter a market.
Barriers to entry include government regulation, availability of land, capital investment required, etc.

15. Perfect Competition in Long Run
Barriers to entry are insignificant in perfectly competitive markets.
Thus, in a market with perfect competition and no barriers to entry, profits will trend toward zero in the long run.
This is because new firms enter the industry, causing the supply curve to shift to the right and the market price to fall.

16. New Entrants Drive Down the Market Price

17. Consequence of No Barriers to Entry
If there are no barriers to entry, only the low cost producers survive in the long run.
The low cost providers will drive down the price to the point at which the high cost producers will not be able to make a profit.
These firms will then simply leave the industry (the shutdown decision), since costs exceed revenues.
This trend to low cost producers is evident in such industries as retail, apparel and furniture.

18. Escaping Perfect Competition
Businesses try to avoid extreme competition evident in perfectly competitive markets.
To do this, businesses try to differentiate their product from rivals.
This gives firms some power over price.
Firms differentiate through product design and advertising.
Advertising enables a firm to establish a brand name.

19. Market Structure
Economists classify markets into different types, or market structures.
Classification depends on:
the intensity of competition in the markets.
the number of buyers and sellers.
whether the product is similar or differentiated.

20. Market Structure There are four market structures in the economy:
Perfect competition
Monopolistic competition
Oligopoly
Monopoly

21. Monopolistic Competition
Monopolistic competition is characterized by a large number of sellers with similar but not standardized products.
Monopolistic competition is the most common market structure in today’s economy.
Restaurants and gasoline stations are good examples.
Monopolistic competitive firms are not price-takers and the firms face a downward-sloping demand curve.

22. Profit Maximization with Monopolistic Competition
In the case of perfect competition, the profit maximization rule is that price equals marginal cost (MC).
In this case, price is equal to marginal revenue (MR) since the business can sell as much as it likes at the market price.
In monopolistic competition, MR is below price.
The reason MR is below price is that business must cut the price to everyone to sell another unit.

23. Profit Maximization with Monopolistic Competition
The business gains more revenue from new sales, but loses on products it is already selling.
A monopolistic competitive firm maximizes product at the output level where marginal revenue equals marginal cost (MR=MC).
In the long run, monopolistic competition starts looking more and more like perfect competition as more businesses enter the market.

24. MR and MC and Profit Maximization for Car Dealer
Cars sold per day
Price per car (dollars)
Total revenue (dollars)
Marginal revenue (dollars)
Marginal cost (dollars) 1
30,000
24,000 2
29,000
58,000
28,000
25,000 3
84,000
26,000 4
27,000
108,000 5
130,000
22,000

25. Oligopoly
An oligopoly occurs when there are a small number of sellers (usually 4 or less) in a market producing similar products.
This is a common market structure in manufacturing and the airlines.
Oligopolists can compete very intensely.
In this case, the market looks very much like perfect competition, with prices under downward pressure and profits very low.

26. Oligopoly
But oligopolistic firms may engage in illegal collusion, working together to keep the price of their product high.
Oligopolistic firms often engage in implicit collusion, where they do not communicate directly about price.
In this case, one company (the market leader) sets the price.
There is a tendency for parties in a collusive arrangement to cheat on the deal.

27. Monopoly
A monopoly is a market where there is only one seller, and buyers have no good alternatives.
Monopoly is the extreme opposite of perfect competition.
A monopolist can push up price due to its control over a market.
But to do so, it must restrict output.
Why? Because of the law of demand:
Higher prices result in lower quantity demanded.

28. Monopoly
The extent to which a monopolist can raise price depends on the elasticity of demand.
If demand is very inelastic, the monopolist has the ability to substantially raise price above the competitive level.
But if demand is elastic, the pricing power of the monopolist is limited as consumers will cut purchases a lot in response to higher prices.
Monopolies in recent years have been undermined by globalization and technology.

29. Benefits of Perfect Competition
Perfect competition is viewed to be the most beneficial market structure because:
Business produces products consumers want to purchase.
Business produces products at their lowest cost.
Since businesses are price takers, they will automatically increase their output when price exceeds marginal cost.

30. Downside of Market Power
Monopoly, monopolistic competition, and oligopoly are all sellers with some degree of market power.
Market power is the ability to raise prices above the level in perfect competition.
Thus, firms with market power will produce less and charge a higher price than a perfectly competitive firm.
This leads to higher profits for the firm with market power.