1. 11 PERFECT COMPETITION CHAPTER
Notes and teaching tips: 2, 4, 6, 14, 25, 29, 32, 34, 62, 91.
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Competition
Perfect competition is an industry in which:
Many firms sell identical products to many buyers.
There are no restrictions to entry into the industry.
Established firms have no advantages over new ones.
Sellers and buyers are well informed about prices.
The range of market types. Remind the students of what they learned in Chapter 9 about the spectrum of markets that range from perfect competition to monopoly.
The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a fancier model!
Economists use the model of “perfect competition” in a similar way to understand our economic world. Emphasize to students that although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.
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Competition
Price Takers
In perfect competition, each firm is a price taker.
A price taker is a firm that cannot influence the price of a good or service.
No single firm can influence the price—it must “take” the equilibrium market price.
Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.
Price taking. Be sure to spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are price takers: They can offer to sell for a lower price, but they’re giving profits away; and they can ask for a higher price, but no one will pay. You might like to note that if the market is not in equilibrium, the firm isn’t a price taker. If there is a shortage, firms can get away with a higher price and they ask for more. That’s how prices rise. If there is a surplus, firms offer a lower price to move their product. That’s how prices fall. But in equilibrium, there is nothing to do but take the going price. And competitive markets get to equilibrium fast.
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4. Demand Facing a Single Firm in a Perfectly Competitive Market
If a representative firm in a perfectly competitive industry raises the price of its output above $2.45, the quantity demanded of that firms output will drop to zero. Each firm faces a perfectly elastic demand curve, d.
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5. Total and Marginal Revenue
Total revenue is the total amount that a firm takes in from the sale of its product: The price per unit times the quantity of output the firm decides to produce (P x q).
Marginal revenue is the additional revenue that a firm takes in when it increases output by one additional unit.
In perfect competition, P = MR.
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6. The Firm’s Decisions in Perfect Competition
One way to find the profit maximizing output is to look at the firm’s the total revenue and total cost curves.
Profit is maximized when the firm produces 9 sweaters a day.
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7. Comparing Costs and Revenues to Maximize Profit
The firm can use marginal analysis to determine the profit-maximizing output.
The profit maximizing perfectly competitive firm will produce up to the point where the price of its output is just equal to the short run marginal cost; the level of output where:
P* = MC or MR = MC.
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8. The Profit-Maximizing Level of Output for a Perfectly Competitive Firm
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Minimizing Losses
Operating profit (or loss) or net operating revenue is total revenue minus total variable cost
(TR - TVC).
Firms suffering losses fall into two categories:
Those that find it advantageous to shut down operations immediately and suffer losses equal to fixed costs
Those that continue to operate in the short run to minimize losses
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Firm Suffering Economic Losses But Showing an Operating Profit in the Short Run
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Shutdown Point
The shutdown point is the lowest point on the average variable cost curve.
When price falls below the minimum point on AVC, total revenue is insufficient to cover variable costs and the firm will shut down and bear losses equal to fixed costs.
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12. The Firm’s Decisions in Perfect Competition
To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firm’s average total cost, ATC, at the profit maximizing output with the market price.
Operating a business at a loss. Students often have a hard time understanding why operating at an economic loss can be the best action. The key is appreciating that:
The firm’s short-run decisions are made after some irrevocable commitments have generated sunk costs.
The firm considers only avoidable costs when making decisions. Unavoidable costs have no impact on the decision.
So for the firm to produce its revenues need only exceed avoidable costs, not total costs.
The profit maximization goal doesn’t require the firm to earn a positive economic profit in the short run.
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13. Short-Run Supply Curve of a Perfectly Competitive Firm
The short-run supply curve of a competitive firm is that portion of its marginal cost curve that lies above its average variable cost curve.
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14. Short-Run Industry Supply Curve
The short run industry supply curve is the horizontal sum of the marginal cost curves (above AVC) of all the firms in an industry.
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In the long run, the firm may: Enter or exit an industry; Change its plant size
As new firms enter an industry, industry supply increases. The industry supply curve shifts rightward.
As the plant size increases, short-run supply increases, the price falls, and economic profit decreases.
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Firms Expand Along in the Long Run When Increasing Returns to Scale Are Available
Firms will continue to expand as long as there are economies of scale to be realized, and new firms will continue to enter as long as economic profits are being earned.
Firms will be pushed by competition to produce at their optimal scales and the price will be driven to the minimum point on the LRAC curve. Profits will be driven to zero.
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17. Long-run Competitive Equilibrium
Long-run equilibrium occurs in a competitive industry when:
Economic profit is zero, so firms neither enter nor exit the industry.
Long-run average cost is at its minimum, so firms don’t change their plant size.
Long-run competitive equilibrium exists when:
P = SRMC = SRAC = LRAC
and economic profit is equal to zero.
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18. Competition and Efficiency
Along the demand curve D = MB the consumer is efficient.
Along the supply curve S = MC the producer is efficient
The quantity Q* and price P* are the competitive equilibrium values.
So competitive equilibrium is efficient.
MB=MC
The consumer gains the consumer surplus (the area below the demand curve and above the price) and the producer gains the producer surplus (the area below the price and above the marginal cost curve)
The sum of the two surpluses is maximized and the efficient quantity is produced.
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19. 12 MONOPOLY CHAPTER Notes and teaching tips: 4, 17, 35, 51, 60, 71.
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Market Power
Market power and competition are the two forces that operate in most markets.
Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale.
A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.
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21. Demand in Monopoly Markets
With only one firm in the monopoly market, there is no distinction between the firm and the industry.
In a monopoly, the firm is the industry and therefore faces the industry demand curve.
The total quantity supplied is what the firm decides to produce.
For a monopolist, an increase in output involves not just producing more and selling it, but also reducing the price of its output in order to sell it.
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22. Marginal Revenue Facing a Monopolist
At every level except one unit, the monopolist’s marginal revenue is below price. This is because to sell more output and raise total revenue the firm lowers the price for all units sold.
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23. Price and Output Choice for a Profit-Maximizing Monopolist
The profit-maximizing level of output for a monopolist is the one where MR = MC.
Beyond that point, where marginal cost exceeds marginal revenue, the firm would reduce its profits.
Relative to a competitively organized industry, a monopolist restricts output, charges higher prices, and earns economic profits.
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24. Single-Price Monopoly and Competition Compared
Compared to perfect competition, monopoly restricts output and charges a higher price.
Because marginal revenue is less than price at each output level,
QM < QC and PM > PC.
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25. Single-Price Monopoly and Competition Compared
Monopoly is inefficient because price exceeds marginal cost so marginal benefit exceeds marginal cost.
On all output levels for which marginal benefit exceeds marginal cost, a deadweight loss is incurred.
Monopoly is inefficient. The inefficiency of monopoly is one of the key propositions in this chapter.
Because P > MR, and because MR = MC, P > MC—single-price monopoly under-produces and creates deadweight loss.
Rent seeking uses further resources so potentially the social cost of monopoly is the sum of the deadweight loss and the economic profit that a monopoly might earn.
Adam Smith described the situation thus: “People in the same trade seldom meet together, even for merriment and diversion, but the conversation ends in some contrivance to raise prices.”
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26. Single-Price Monopoly and Competition Compared
The social cost of monopoly may exceed the deadweight loss through an activity called rent seeking, which is any attempt to capture consumer surplus, producer surplus, or economic profit.
The resources used in rent seeking can exhaust the monopoly’s economic profit and leave the monopoly owner with only normal profit.
Average total cost increases and the profits disappear to become part of the enlarged deadweight loss from rent seeking.
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Price Discrimination
Price discrimination is the practice of selling different units of a good or service for different prices.
To be able to price discriminate, a monopoly must:
Identify and separate different buyer types
Sell a product that cannot be resold
Price differences that arise from cost differences are not price discrimination.
By price discriminating, the firm can increase its profit.
In doing so, it converts consumer surplus into economic profit.
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Price Discrimination
With perfect price discrimination:
Output increases to the quantity at which price equals marginal cost.
Economic profit increases above that earned by a single-price monopoly.
Deadweight loss is eliminated.
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Price Discrimination
Efficiency and Rent Seeking with Price Discrimination
The more perfectly a monopoly can price discriminate, the closer its output gets to the competitive output (P = MC) and the more efficient is the outcome.
But this outcome differs from the outcome of perfect competition in two ways:
The monopoly captures the entire consumer surplus.
The increase in economic profit attracts even more rent-seeking activity that leads to an inefficient use of resources.
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Market Power
Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can.
Figure illustrates a natural monopoly.
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31. The Problem of Regulating a Monopoly
An unregulated monopolist produces where MC = MR, at 400,000 units.
If prices were set at MC (marginal cost pricing) the firm would always suffer a loss.
A compromise would be to set prices at $0.75 (average cost pricing) which covers costs and allows a normal profit rate.
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32. 13 MONOPOLISTIC COMPETITION AND OLIGOPOLY CHAPTER
Notes and teaching tips: 2, 7, 12, 18, 35, 44, 52, 71, 72, 76, 78, 79, 80, 81, 82, 83, 103, 108, 109, and 112.
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33. Monopolistic Competition
Monopolistic competition is a common form of industry structure in Canada, characterized by:
a large number of firms, none of which can influence market price by virtue of size alone
some degree of market power achieved through the production of differentiated products
no barriers to entry or exit
Firms in monopolistic competition practice product differentiation, which means that each firm makes a product that is slightly different from the products of competing firms.
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34. Output and Price in Monopolistic Competition
The firm produces the quantity at which marginal revenue equals marginal cost and sells that quantity for the highest possible price.
It earns an economic profit (as in this example) when P > ATC.
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35. Monopolistically Competitive Firm at Long-Run Equilibrium
In the long run, economic profit induces entry.
As new firms enter the monopolistically competitive industry the demand curves of profit-making firms begin to shift left.
The process continues until profits are eliminated and the demand curve is just tangent to the average total cost curve.
Firms in monopolistic competition are inefficient and operate with excess capacity.
Price is greater than marginal cost, greater than the perfectly competitive solution.
The long-run equilibrium quantity of output is to the left of the minimum of ATC.
Output is less than capacity output.
A firm’s capacity output is the output at which average total cost is at its minimum.
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36. Product Development and Marketing
Innovation and Product Development
To keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development.
Marketing
A firm’s marketing program uses advertising and packaging as the two principal methods to market its differentiated products to consumers.
With advertising, the firm produces 130 units of output at an average total cost of $160.
The advertising expenditure shifts the average total cost curve upward, but the firm operates at a higher output and lower ATC than it would without advertising.
But advertising can increase a firm’s demand and profits in the short run only.
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Oligopoly
Oligopoly is a form of industry structure characterized by:
a few firms, each large enough to influence market price
differentiated or homogeneous products
firms behaving in a way that depends to a great extent on the behaviour of other firms
Oligopoly Models:
The Collusion Model
The Cournot Model
The Kinked Demand Model
The Price Leadership Model
Game Theoretic Models
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38. Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms.
The large firm operates as a monopoly, setting its price and output to maximize its profit.
The small firms act as perfect competitors, taking as given the market price set by the dominant firm.
The profit maximizing quantity for the large firm is 10 units. The price charged is $1.00.
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39. Oligopoly and Economic Performance
Market concentration leads to pricing above marginal cost and output below the efficient level.
Entry barriers prevent the efficient flow of resources between firms and industries.
Product differentiation may lead to efficiency losses.
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Game Theory
Game theory analyzes oligopolistic behaviour as a complex series of strategic moves and reactive countermoves among rival firms.
In game theory, firms are assumed to anticipate rival reactions.
What Is a Game?
All games share four features:
Rules
Strategies
Payoffs
Outcome
A dominant strategy in game theory is a strategy that is best no matter what the opposition does.
Nash equilibrium is the result in game theory, when all players play their best strategy given what their competitors are doing.
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41. Payoff Matrix for an Advertising Game
The dominant strategy for A and B is to advertise.
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42. The Prisoner’s Dilemma
The dominant strategy is for both Rocky and Ginger to confess.
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Contestable Markets
A market in which entry and exit are costless.
Because entry is cheap, firms are continually faced with competition or the threat of competition.
In contestable markets, firms behave like perfectly competitive firms.
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