Presentation is loading. Please wait.

Presentation is loading. Please wait.

ECON 101: Introduction to Economics - I

Similar presentations


Presentation on theme: "ECON 101: Introduction to Economics - I"— Presentation transcript:

1 ECON 101: Introduction to Economics - I
Lecture 8 – Perfect Competition and Pure Monopoly

2 ©McGraw-Hill Education, 2014
Perfect 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 Education, 2014 2

3 What Is Perfect Competition?
How Perfect Competition Arises Perfect competition arises when: the firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the market. each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm’s good they buy.

4 What Is Perfect 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.

5 What Is Perfect Competition?
Figure below illustrates a firm’s revenue concepts. Part (a) shows that market demand and market supply determine the market price that the firm must take. The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.

6 What Is Perfect Competition?
The demand for a firm’s product is perfectly elastic because one firm’s sweater is a perfect substitute for the sweater of another firm. The market demand is not perfectly elastic because a sweater is a substitute for some other good.

7 What Is Perfect Competition?
A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces. So the firm must decide: 1. How to produce at minimum cost 2. What quantity to produce 3. Whether to enter or exit a market We start by looking at the firm’s output decision.

8 The Firm’s Output Decision
At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. At intermediate output levels, the firm makes an economic profit. At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day.

9 The Firm’s Output Decision
If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

10 The Firm’s Output Decision
Temporary Shutdown Decision If the firm makes an economic loss, it must decide to exit the market or to stay in the market. If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily. The decision will be the one that minimizes the firm’s loss. Temporary shutdown. In our experience, this topic is the hardest for the students to understand. You can help them with the intuition by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Why? Your students will easily figure out that total revenue is less than total variable cost and equivalently that price is less than average variable cost. The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar.

11 The Firm’s Output Decision
Loss Comparisons The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR). Economic loss = TFC + TVC – TR = TFC + (AVC – P) x Q If the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm incurs an economic loss equal to TFC. This economic loss is the largest that the firm must bear. Temporary shutdown. In our experience, this topic is the hardest for the students to understand. You can help them with the intuition by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Why? Your students will easily figure out that total revenue is less than total variable cost and equivalently that price is less than average variable cost. The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar.

12 The Firm’s Output Decision
The Shutdown Point A firm’s shutdown point is the price and quantity at which it is indifferent between producing and shutting down. This point is where AVC is at its minimum. It is also the point at which the MC curve crosses the AVC curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. The firm incurs a loss equal to TFC from either action.

13 The Firm’s Output Decision
The shutdown point. Minimum AVC is $17 a sweater. If the price is $17, the profit-maximizing output is 7 sweaters a day. The firm incurs a loss equal to the red rectangle. When to increase and when to decrease output. Students need repeated reminders that to determine whether a firm can increase profit by changing output, price, and marginal cost are the only things to consider. Questions that throw average total cost into the mix often cause confusion.

14 Output, Price, and Profit in the Short Run
Profits and Losses in the Short Run Maximum profit is not always a positive economic profit. To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost at the profit-maximizing output with the market price. Figure 12.8 on the next slide shows the three possible profit outcomes.

15 Output, Price, and Profit in the Short Run
In part (c) price is less than average total cost and the firm incurs an economic loss—economic profit is negative. 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 make a positive economic profit in the short run.

16 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 Education, 2014 16

17 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 the market ©McGraw-Hill Education, 2014 17

18 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 Education, 2014 18

19 The Firm’s Output Decision
The Firm’s Supply Curve A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But at a price below the shutdown point, the firm produces nothing.

20 The Firm’s Decisions How the firm’s supply curve is constructed.
If price equals minimum AVC, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T. If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC. If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC. The blue curve in part (b) traces the firm’s short-run supply curve.

21 ©McGraw-Hill Education, 2014
The 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 Education, 2014 21

22 ©McGraw-Hill Education, 2014
The 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 Education, 2014 22

23 ©McGraw-Hill Education, 2014
Long-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 Education, 2014 23

24 Adjustment to an increase in market demand: the short run
Suppose 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. D' ©McGraw-Hill Education, 2014 24

25 Adjustment to an increase in market demand: the long run
In 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 Education, 2014 25

26 Entry to and exit from the industry
Given the long-run average cost curve depicted in the figure when the price is P1, a firm in the market makes supernormal profits. New firms may then enter the market. The main effect of this entry is that more firms will produce in the market and so the market supply will shift to the right. ©McGraw-Hill Education, 2014 26

27 ©McGraw-Hill Education, 2014
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. ©McGraw-Hill Education, 2014 27

28 Monopoly and How It Arises
How Monopoly Arises A monopoly has two key features: No close substitutes Barriers to entry No Close Substitute If a good has a close substitute, even if it is produced by only one firm, that firm effectively faces competition from the producers of the substitute. A monopoly sells a good that has no close substitutes.

29 Monopoly and How It Arises
Barriers to Entry A constraint that protects a firm from potential competitors are called barriers to entry. Three types of barriers to entry are Natural Ownership Legal

30 Monopoly and How It Arises
Natural Barriers to Entry Natural barriers to entry create natural monopoly. A natural monopoly is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost. Ownership Barriers to Entry An ownership barrier to entry occurs if one firm owns a significant portion of a key resource. During the last century, De Beers owns 90 percent of the world’s diamonds.

31 Monopoly and How It Arises
Legal Barriers to Entry Legal barriers to entry create a legal monopoly. A legal monopoly is a market in which competition and entry are restricted by the granting of a Public franchise (like the U.S. Postal Service, a public franchise to deliver first-class mail) Government license (like a license to practice law or medicine) Patent or copyright

32 Monopoly and How It Arises
Monopoly Price-Setting Strategies For a monopoly firm to determine the quantity it sells, it must choose the appropriate price. There are two types of monopoly price-setting strategies: A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers. Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

33 Profit maximization by a monopolist
Profits 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 Education, 2014 33

34 Profit-maximizing monopoly
©McGraw-Hill Education, 2014 34

35 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 Education, 2014 35

36 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 ... And priceat P3Q3. P3 Q3 to set MR = LMC Output ©McGraw-Hill Education, 2014 36

37 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 Education, 2014 37

38 Single-Price Monopoly and Competition Compared
Redistribution of Surpluses Some of the lost consumer surplus goes to the monopoly as producer surplus.

39 ©McGraw-Hill Education, 2014
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 P1 Q1 Output ©McGraw-Hill Education, 2014 39

40 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: 1. Identify and separate different buyer types. 2. Sell a product that cannot be resold. Price differences that arise from cost differences are not price discrimination. Price discrimination may not be fair, but it is efficient Be sure that the students understand that aside from equity considerations, resources will be allocated more efficiently in a monopoly market under any price discrimination scenario than under a single-price scenario.

41 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. ©McGraw-Hill Education, 2014 41

42 Concluding comments (1)
In a competitive market each buyer and seller is a price taker. For a firm operating in a perfectly competitive market its price is equal to marginal revenue. Adding at each price the quantities supplied by each firm, we obtain the industry supply curve. In long-run equilibrium, the marginal firm makes only normal profits. A profit-maximizing monopolist will select the level output at which marginal revenue and cost are equal. ©McGraw-Hill Education, 2014 42

43 Concluding comments (2)
Compared to a perfectly competitive market, a monopoly creates a deadweight loss. A discriminating monopolist charges different prices to different customers. ©McGraw-Hill Education, 2014 43


Download ppt "ECON 101: Introduction to Economics - I"

Similar presentations


Ads by Google