BU224 Agenda 2011 Welcome to the Seminar Week 7. Perfect Competition & Monopoly Week 7. Assignment Questions ? Comments? Prof Rod Biasca

2 of 28 Types of Market Structure In order to develop principles and make predictions about markets and how producers will behave in them, economists have developed four principal models of market structure:  perfect competition  monopoly  oligopoly  monopolistic competition

3 of 28 Types of Market Structure Are Products Differentiated? How Many Producers Are There? Oligopoly Perfect competition No One Few Many Yes Monopolistic competition Not applicable Monopoly This system of market structures is based on two dimensions:  The number of producers in the market (one, few, or many)  Whether the goods offered are identical or differentiated Differentiated goods are goods that are different but considered somewhat substitutable by consumers (think Coke versus Pepsi).

4 of 28 Perfect Competition  A price-taking producer is a producer whose actions have no effect on the market price of the good it sells.  A price-taking consumer is a consumer whose actions have no effect on the market price of the good he or she buys.  A perfectly competitive market is a market in which all market participants are price-takers.

5 of 28 Two Necessary Conditions for Perfect Competition 1)For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share.  A producer’s market share is the fraction of the total industry output accounted for by that producer’s output. 2)An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent.  A good is a standardized product, also known as a commodity, when consumers regard the products of different producers as the same good.

6 of 28 Free Entry and Exit  There is free entry and exit into and from an industry when new producers can easily enter into or leave that industry.  Free entry and exit ensure:  that the number of producers in an industry can adjust to changing market conditions, and,  that producers in an industry cannot artificially keep other firms out.

7 of 28 The Optimal Output Rule  The optimal output rule says that profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to its marginal revenue.

8 of 28 Short-Run Costs for Jennifer and Jason’s Farm

9 of 28 Costs and Production in the Short Run $ MC ATC MR= P C Break even price Minimum-cost output Price, cost of bushel Quantity of tomatoes (bushels) Minimum average total cost At point C (the minimum average total cost), the market price is $14 and output is 4 bushels of tomatoes (the minimum-cost output). This is where MC cuts the ATC curve at its minimum. Minimum average total cost is equal to the firm’s break-even price.

10 of 28 Profitability and the Market Price The farm is profitable because price exceeds minimum average total cost, the break-even price, $14. The farm’s optimal output choice is (E)  output of 5 bushels. The average total cost of producing bushels is (Z on the ATC curve)  $14.40 The vertical distance between E and Z: farm’s per unit profit, $18.00 − $14.40 = $3.60 Total profit:5 × $3.60 = $ MC Profit ATC MR= P C Z E Market Price = $ $18 Price, cost of bushel Quantity of tomatoes (bushels) Minimum average total cost Break even price

11 of 28 Profitability and the Market Price The farm is unprofitable because the price falls below the minimum average total cost, $14. The farm’s optimal output choice is (A)  output of 3 bushels. The average total cost of producing bushels is (Y on the ATC curve)  $14.67 The vertical distance between A and Y: farm’s per unit loss, $14.67 − $10.00 = $4.67 Total profit:3 × $4.67 = approx. $ MC Loss ATC MR= P C A Y Market Price = $ $14.67 Price, cost of bushel Quantity of tomatoes (bushels) Minimum average total cost Break even price

12 of 28 Profit, Break-Even or Loss  The break-even price of a price-taking firm is the market price at which it earns zero profits.  Whenever market price exceeds minimum average total cost, the producer is profitable.  Whenever the market price equals minimum average total cost, the producer breaks even.  Whenever market price is less than minimum average total cost, the producer is unprofitable.

13 of 28 The Short-Run Individual Supply Curve The short-run individual supply curve shows how an individual producer’s optimal output quantity depends on the market price, taking fixed cost as given. A firm will cease production in the short run if the market price falls below the shut- down price, which is equal to minimum average variable cost $ MC ATC AVC C B A E Minimum average variable cost Short-run individual supply curve Shut-down price Price, cost of bushel Quantity of tomatoes (bushels)

14 of 28 Monopoly Our First Departure from Perfect Competition…  A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly, e.g. De Beers.  The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power.

15 of 28 What a Monopolist Does M C S D Q C Q M Quantity Price P M P C 2. … and raises price. 1. Compared to perfect competition, a monopolist reduces output… Equilibrium is at C, where the price is P C and the quantity is Q C. A monopolist reduces the quantity supplied to Q M, and moves up the demand curve from C to M, raising the price to P M.

16 of 28 Comparing the Demand Curves of a Perfectly Competitive Producer and a Monopolist (a)Demand Curve of an Individual Perfectly Competitive Producer D C Price (b)Demand Curve of a Monopolist D M Market price Quantity An individual perfectly competitive firm cannot affect the market price of the good  it faces a horizontal demand curve DC, as shown in panel (a). A monopolist, on the other hand, can affect the price (sole supplier in the industry)  its demand curve is the market demand curve, DM, as shown in panel (b). To sell more output it must lower the price; by reducing output it raises the price. Price

17 of 28 How a Monopolist Maximizes Profit  An increase in production by a monopolist has two opposing effects on revenue:  A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold.  A price effect. In order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.  The quantity effect and the price effect are illustrated by the two shaded areas in panel (a) of the following figure based on the numbers on the table accompanying it.

18 of 28 A Monopolist’s Demand, Total Revenue, and Marginal Revenue Curves A MR TR D (a) 9 20 $1,000 –200 – Quantity of diamonds (b) $5,000 4,000 3,000 2,000 1,000 Total Revenue B C Demand and Marginal Revenue Total Revenue Price, cost, marginal revenue of demand Price effect = -$450 Quantity effect = +$500 Marginal revenue = $50 Quantity effect dominates price effect. Price effect dominates quantity effect. 10 Quantity of diamonds

19 of 28 The Monopolist’s Profit-Maximizing Output and Price  To maximize profit, the monopolist compares marginal cost with marginal revenue.  If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less. So the monopolist maximizes its profit by using the optimal output rule:  At the monopolist’s profit-maximizing quantity of output: MR = MC

20 of 28 The Monopolist’s Profit-Maximizing Output and Price The price De Beers can charge per diamond is found by going to the point on the demand curve directly above point A, (point B here)—a price of $600 per diamond. It makes a profit of $400 × 8 = $3,200. The optimal output rule: the profit maximizing level of output for the monopolist is at MR = MC, shown by point A, where the MC and MR curves cross at an output of 8 diamonds. B C MR Monopoly profit MC  ATC D $1, –200 –400 0 Quantity of diamonds A P C P M Q M Q C Price, cost, marginal revenue of demand Monopolist’s optimal point Perfectly competitive industry’s optimal point

21 of 28 Monopoly Versus Perfect Competition P = MC at the perfectly competitive firm’s profit- maximizing quantity of output P > MR = MC at the monopolist’s profit-maximizing quantity of output Compared with a competitive industry, a monopolist does the following:  Produces a smaller quantity : QM < QC  Charges a higher price : PM > PC  Earns a profit

22 of 28 The average total cost of QM is shown by point C. Profit is given by the area of the shaded rectangle. The Monopolist’s Profit Profit = TR − TC = (P M × Q M ) − (ATC M × Q M ) = (P M − ATC M ) × Q M In this case, the MC curve is upward sloping and the ATC curve is U-shaped. The monopolist maximizes profit by producing the level of output at which MR = MC, given by point A, generating quantity QM. It finds its monopoly price, PM, from the point on the demand curve directly above point A, point B here. Q M Quantity P M ATC M C D MR A B MC ATC Price, cost, marginal revenue Monopoly profit

23 of 28 Monopoly and Public Policy  By reducing output and raising price above marginal cost, a monopolist captures some of the consumer surplus as profit and causes deadweight loss. To avoid deadweight loss, government policy attempts to prevent monopoly behavior.  When monopolies are “created” rather than natural, governments should act to prevent them from forming and break up existing ones.  The government policies used to prevent or eliminate monopolies are known as antitrust policy.

24 of 28 Monopoly Causes Inefficiency Panel (b) depicts the industry under monopoly: the monopolist decreases output to QM and charges PM. Consumer surplus (blue triangle) has shrunk because a portion of it has been captured as profit (light blue area). Total surplus falls: the deadweight loss (orange area) represents the value of mutually beneficial transactions that do not occur because of monopoly behavior. (a)Total Surplus with Perfect Competition(b)Total Surplus with Monopoly D MC =ATC ATC Quantity Q C P C Q M P M D MR Quantity Price, cost Profit Deadweigh t loss Consumer surplus with perfect competition Consumer surplus with monopoly Price, cost, marginal revenue

25 of 28 Unregulated and Regulated Natural Monopoly Panel (b) shows what happens when the monopolist must charge a price equal to average total cost, the price P R *. Output expands to Q R *, and consumer surplus is now the entire blue area. The monopolist makes zero profit. This is the greatest consumer surplus possible when the monopolist is allowed to at least break even, making P R * the best regulated price. (a)Total Surplus with an Unregulated Natural Monopolist (b)Total Surplus with a Regulated Natural Monopolist Q M Q R P M D MC MR ATC Quantity P R Consume r surplus Q M Q * R P M D MC MR ATC Quantity P * R Price, cost, marginal revenue Profit Consume r surplus

26 of 28 Price Discrimination  Up to this point we have considered only the case of a single-price monopolist, one who charges all consumers the same price. As the term suggests, not all monopolists do this.  In fact, many if not most monopolists find that they can increase their profits by charging different customers different prices for the same good: they engage in price discrimination.  Example: Airline Tickets: If you are willing to buy a nonrefundable ticket a month in advance and stay over a Saturday night, the round trip may cost only $150, but if you have to go on a business trip tomorrow, and come back the next day, the round trip might cost $550.

27 of 28 The Logic of Price Discrimination  Price discrimination is profitable when consumers differ in their sensitivity to the price. A monopolist would like to charge high prices to consumers willing to pay them without driving away others who are willing to pay less.  It is profit-maximizing to charge higher prices to low-elasticity consumers and lower prices to high elasticity ones.

28 of 28 ►ECONOMICS IN ACTION Sales, Factory Outlets, and Ghost Cities  Have you ever wondered why department stores occasionally hold sales? Or why there are “factory outlet” stores along America’s highways? This is because the sellers—who are often oligopolists or monopolistic competitors—are engaged in a subtle form of price discrimination.  The stores in effect are able to price-discriminate between high- elasticity and low-elasticity customers.  Customers flying from Chicago to LA will find a ticket cheaper than those flying from Chicago to Salt Lake City because the former route has a choice of many airlines making demand elastic while the latter route has less alternatives making demand less elastic. Why don’t passengers buy tickets from Chicago to LA but get off at Salt Lake City (Ghost City)?  The airlines makes restrictions and by doing so enforce the separation of markets necessary to allow price discrimination.