© The McGraw-Hill Companies, 2008 Chapter 8 Perfect competition and pure monopoly David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008 PowerPoint presentation by Alex Tackie and Damian Ward

© The McGraw-Hill Companies, 2008 Perfect competition 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 Characteristics of a perfectly competitive market

© The McGraw-Hill Companies, 2008 The supply curve under perfect competition (1) Above price P 3 (point C), the firm makes profit above the opportunity cost of capital in the short run At price P 3, (point C), the firm makes NORMAL PROFITS P1P1 £ Output SAVC SMC Q1Q1 SATC P3P3 A C Q3Q3

© The McGraw-Hill Companies, 2008 The supply curve under perfect competition (2) Between P 1 and P 3, (A and C), the firm makes short-run losses, but remains in the market Below P 1 (the SHUT- DOWN PRICE), the firm fails to cover SAVC, and exits P1P1 £ Output SAVC SMC Q1Q1 SATC P3P3 A C Q3Q3

© The McGraw-Hill Companies, 2008 The supply curve under perfect competition (3) –showing how much the firm would produce at each price level. P1P1 £ Output SAVC SMC Q1Q1 SATC P3P3 A C Q3Q3 So the SMC curve above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE

© The McGraw-Hill Companies, 2008 The firm and the industry in the short run under perfect competition (1) INDUSTRY Output £ Q P SRSS D Firm 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 SAC P £ Output SMC D=MR=AR

© The McGraw-Hill Companies, 2008 The firm and the industry in the short run under perfect competition (2) INDUSTRYFirm The firm accepts price as given at P – and chooses output at q where SMC=MR to maximise profits SAC P £ Output SMC D=MR=AR q Output £ Q P SRSS D

© The McGraw-Hill Companies, 2008 The firm and the industry in the short run under perfect competition (3) INDUSTRY Output £ Q P SRSS D 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. SRSS 1 P1P1 SAC Firm P £ Output SMC D=MR=AR q Q1Q1

© The McGraw-Hill Companies, 2008 Long-run equilibrium INDUSTRYFirm LAC P* £ Output LMC D=MR=AR q* 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) the long-run supply curve will not be horizontal, but upward-sloping. SRSS D Output £ Q P* LRSS

© The McGraw-Hill Companies, 2008 Adjustment to an increase in market demand: the short run Suppose a perfectly competitive market starts in equilibrium at P 0 Q 0. If market demand shifts to D'D'... in the short run the new equilibrium is P 1 Q 1... – adjustment is through expansion of individual firms along their SMCs. Q1Q1 P1P1 Output £ D SRSS Q0Q0 P0P0 D D'

© The McGraw-Hill Companies, 2008 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 Output £ D SRSS Q0Q0 P0P0 D D' Q1Q1 P1P1 – 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 LRSS – and the market finally settles at P 2 Q 2. Q2Q2 P2P2

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 Profit maximisation by a monopolist Profits are maximised where MC = MR at Q 1 P 1. In this position, AR is greater than AC so the firm makes profits above the opportunity cost of capital shown by the shaded area. Entry barriers prevent new firms joining the industry. Output MC=MR £ P1P1 Q1Q1 MC AC D = AR MR

© The McGraw-Hill Companies, 2008 Comparing monopoly with perfect competition (1) Suppose a competitive industry is taken over by a monopolist: Output D MR SRSS LRSS £ Q1Q1 P1P1 A Competitive equilibrium is at A, with output Q 1 and price P 1. To the monopolist, LRSS is the LMC curve, and SRSS is the SMC curve. = LMC = SMC The monopolist maximises profits in the short run at MR = SMC at P 2 Q 2. Q2Q2 P2P2

© The McGraw-Hill Companies, 2008 Comparing monopoly with perfect competition (2) Suppose a competitive industry is taken over by a monopolist: Output In the long run the firm can adjust other inputs... to set MR = LMC at P 3 Q 3. P3P3 Q3Q3 D MR SRSS LRSS £ Q1Q1 P1P1 A = LMC = SMC Q2Q2 P2P2

© The McGraw-Hill Companies, 2008 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.

© The McGraw-Hill Companies, 2008 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. LMC LAC D MR P1P1 £ Q1Q1 Output

© The McGraw-Hill Companies, 2008 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.