McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 05 Perfect Competition, Monopoly, and Economic versus. Normal Profit

1- 2 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-2 Chapter Outline From Perfect Competition to Monopoly Supply Under Perfect Competition

1- 3 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-3 From Perfect Competition to Monopoly Perfect Competition Monopolistic Competition Oligopoly Monopoly

1- 4 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-4 Picking the Quantity to Maximize Profit The Perfectly Competitive Case MC ATC AVC MR Q* P* P Q Many Competitors

1- 5 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-5 AVC MR D MC ATC Q* P* P Q No Competitors Picking the Quantity to Maximize Profit The Monopoly Case

1- 6 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-6 Characteristics of Perfect Competition a large number of competitors, such that no one firm can influence the price the good a firm sells is indistinguishable from the ones its competitors sell firms have good sales and cost forecasts there is no legal or economic barrier to its entry into or exit from the market

1- 7 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-7 Monopoly The sole seller of a good or service. Some monopolies are generated because of legal rights (patents and copyrights). Some monopolies are utilities (gas, water, electricity etc.) that result from high fixed costs.

1- 8 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-8 Monopolistic Competition Monopolistic Competition: a situation in a market where there are many firms producing similar but not identical goods. Example : the fast-food industry. McDonald’s has a monopoly on the “Happy Meal” but has much competition in the market to feed kids burgers and fries.

1- 9 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-9 Oligopoly Oligopoly: a situation in a market where there are very few discernible competitors Examples: Satellite TV service (Direct TV, Dish Network) Airlines (American, Delta etc.)

1- 10 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-10 Which Model Fits Reality? Perfect competition is rare outside agriculture though it fits some labor markets. Monopolies are common in utilities. Major branded companies are typically either in oligopolistic or monopolistically competitive industries.

1- 11 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-11 Examples of Different Market Forms Perfect Competition Monopolistic Competition OligopolyMonopoly 1)Agriculture 2)Lumber 1)Fast Food 2)Long Distance Service 1)Cars and Trucks 2)Soft Drinks 1)Windows Operating system 2)Local Residential electric power

1- 12 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-12 Distinguishing Characteristics Between Market Forms Perfect Competition Monopol istic Competi tion OligopolyMonopoly Number of Firms Many-often thousands or even millions Several*Few*One Barriers to Entry NoneFewSubstantialInsurmountable, at least in the short run Product Similarity IdenticalSimilar but not identical Similar or Identical N/A * The line between “several” and “few” is not definite

1- 13 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-13 Concentration Ratios There is no magic line that separates oligopoly from monopolistic competition. A “concentration ratio” measures the percentage of total market sales for the top firms (from 4 firms to 100 firms).

1- 14 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-14 Herschfeld-Herfindahl Index Sum of Squared Market Share 0 Perfect Competition 10,000 Monopoly (10,000/N) N equally sized firms

1- 15 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-15 Concentration Ratios For Various Manufacturing Industries Industry GroupConcentration Ratios 4 Largest Firms8 Largest Firms50 Largest Firms Breakfast Cereals 78.4%91.1%100.0% Ice Cream Beer Clothing Computers and Peripherals Furniture Long Distance Cellular Service

1- 16 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-16 Supply Under Perfect Competition

1- 17 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-17 Normal vs. Economic Profit Normal Profit : the level of profit that business owners could get in their next best alternative investment Economic Profit: any profit above normal profit

1- 18 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-18 Return on Equity For Various Industries IndustryRate of Return Net Income/(Assets- Liabilities) Agriculture 3.1% Manufacturing 21.8% Transportation and Public Utilities 8.2% Retail Trade 16.1%

1- 19 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-19 When and Why Economic Profits Go to Zero

1- 20 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-20 Time Horizons Short Run: the period of time where we cannot change things like plant and equipment Long Run: the period of time where we can change things like plant and equipment

1- 21 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-21 Market Forms and Economic Profits Under perfect competition or monopolistic competition, economic profits go to zero because of the entry of new firms increases market supply and lowers prices. Economic profits are under no pressure to shrink under oligopoly or monopoly because entry doesn’t occur so prices do not fall.

1- 22 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-22 Figure 2 The Pressures on Price in Perfect Competition $ Q MC ATC AVC MR 3 MR 1 MR 2 MR 4 Long Run Pressure Short Run Pressure

1- 23 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-23 Figure 3 Points of Production in Perfect Competition $ Q MC ATC AVC MR 4 MR 3 MR 2 MR 1

1- 24 ©2012 The McGraw-Hill Companies, All Rights ReservedMcGraw-Hill/Irwin 5-24 Figure 4 Supply in Perfect Competition $ Q MC ATC AVC Supply