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Chapter 8 Perfect competition and pure monopoly©McGraw-Hill Companies, 2010
©McGraw-Hill Companies, 2010Perfect competition Characteristics of a perfectly competitive market: 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 ©McGraw-Hill Companies, 2010 2
The supply curve under perfect competition (1)Output SAVC SMC Q1 SATC P3 A C Q3 Above price P3 (point C), the firm makes profit above the opportunity cost of capital in the short run At price P3, (point C), the firm makes NORMAL PROFITS ©McGraw-Hill Companies, 2010 3
The supply curve under perfect competition (2)Output SAVC SMC Q1 SATC P3 A C Q3 Between P1 and P3, (A and C), the firm makes short-run losses, but remains in the market Below P1 (the SHUT-DOWN PRICE), the firm fails to cover SAVC, and exits ©McGraw-Hill Companies, 2010 4
The supply curve under perfect competition (3)Output SAVC SMC Q1 SATC P3 A C Q3 So the SMC curve above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE showing how much the firm would produce at each price level. ©McGraw-Hill Companies, 2010 5
©McGraw-Hill Companies, 2010The firm and the industry in the short run under perfect competition (1) Firm INDUSTRY SMC Output Q P SRSS D SAC P D=MR=AR Output 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 ©McGraw-Hill Companies, 2010 6
©McGraw-Hill Companies, 2010The firm and the industry in the short run under perfect competition (2) Firm INDUSTRY SAC P Output SMC D=MR=AR q P Output Q SRSS D The firm accepts price as given at P – and chooses output at q where SMC=MR to maximize profits ©McGraw-Hill Companies, 2010 7
©McGraw-Hill Companies, 2010Long-run equilibrium Firm INDUSTRY D=MR=AR LAC P* Output LMC q* SRSS D P* Output Q LRSS 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. ©McGraw-Hill Companies, 2010 8
Adjustment to an increase in market demand: the short runSuppose a perfectly competitive market starts in equilibrium at P0Q0. Output D SRSS Q0 P0 D' If market demand shifts to D'D' ... Q1 P1 in the short run the new equilibrium is P1Q1 ... – adjustment is through expansion of individual firms along their SMCs. ©McGraw-Hill Companies, 2010 9
Adjustment to an increase in market demand: the long runIn the long run, new firms are attracted by the supernormal Profits now being made here – and firms are able to adjust their input of fixed factors. D D' SRSS P1 – and the market finally settles at P2Q2. Q2 P2 LRSS If wages are bid up by this expansion, the long-run supply schedule is upward- sloping P0 D D' Q0 Q1 Output ©McGraw-Hill Companies, 2010 10
©McGraw-Hill Companies, 2010Monopoly 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. ©McGraw-Hill Companies, 2010 11
Profit maximization by a monopolistProfits are maximized where MC = MR at Q1P1. Output MC=MR P1 Q1 MC AC D = AR MR In this position, AR is greater than AC so the firm makes monopoly profits shown by the shaded area. Entry barriers prevent new firms joining the industry. ©McGraw-Hill Companies, 2010 12
Comparing monopoly with perfect competition (1)Suppose a competitive industry is taken over by a monopolist: Output D MR SRSS LRSS Q1 P1 A Competitive equilibrium is at A, with output Q1 and price P1. = LMC = SMC P2 The monopolist maximizes profits in the short run at MR = SMC at P2Q2. Q2 ©McGraw-Hill Companies, 2010 13
Comparing monopoly with perfect competition (2)Suppose a competitive industry is taken over by a monopolist: D MR SRSS LRSS Q1 P1 A = LMC = SMC Q2 P2 In the long run the firm can adjust other inputs ... at P3Q3. P3 Q3 to set MR = LMC Output ©McGraw-Hill Companies, 2010 14
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. ©McGraw-Hill Companies, 2010 15
©McGraw-Hill Companies, 2010A 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 P1 Q1 Output ©McGraw-Hill Companies, 2010 16
Discriminating monopolySuppose 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. ©McGraw-Hill Companies, 2010 17
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