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Pure Competition
Monopolistic Competition Oligopoly Monopoly
Number of Firms
Barriers to Entry
Non-price Competition
Price Taker/Maker
Product type
Many small Many small A few large one
Diff or Homog oneDifferentiatedHomogeneous
large largenonenone
maker makertaker/seekertaker
yes yesyesno
Considers action or reaction of other firms
Need to stress differences?
Long run profits possible?
Ability to influence market price?
As important as price?
1. Many Sellers2. Identical Products
Characteristics?
4. No Non-Price competition
6. Price Taker
3. Easy Entry and Exit
5. SR profits/losses, no LR profits
Output
Price Firm
Output
Price Market
Perfect Competition• Market supply & demand determine price.• The firm’s demand will be perfectly
elastic. • Firms can sell as much as they want at P• Above P, they lose business• Below P they lose revenue.
P
Marketdemand
Marketsupply
Firm’sdemand
P
Firms must take the market price
$120
110
100
90
80
70
60
50
40
30
20
10
01 2 3 4 5 6 7 8 Number of Cakes
Marg
inal C
ost
an
d M
arg
inal R
even
ue
Marcia’s Marginal Cost and Marginal Revenue
Profits
Losses
• The two conditions necessary for long-run equilibrium in a price-taker market are depicted here.
• At the price established in the market, firms in the industry earn zero economic profit
• The quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1.
Output
Price Firm
P1
q1
MC ATC
d1
Long-run Equilibrium
Output
Price Market
P1
D
Ssr
Q1
Normal Profit
Earn economic profit MR > ATC
MR = ATC
Short Run Profits
Short Run Losses
Shut DownFirm can’t cover AVC, minimize
losses by shutting down
MR < AVC
Output
Price Firm
MC
ATC
AVC
P3
Firm covers AVC, but not AFC:
MR < ATC, but MR > AVC
MR
Output
Price Firm
MC
ATC
AVC
• The marginal cost curve (MC) is the firm’s supply curve.
• At P2 MR = MC at q2.
• Below MC = AVC, the firm will shut down Output = 0 below P1,,
• At P3 MR = MC at q3.
The Supply Curve
P2
P3
q2 q3
P1
q1
MC is the firm’s
Supply Curve
Output
Price
Output
Price
• Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D1 to D2 … market price increases to
P2 …
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
d1
An Increase in Market Demand
shifting the firm’s demand curve upward. At the higher price, firms expand output to q2 and earn short-run profits.• Economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2.
P2 d2
q2
D2
S2
Q2
P2
Output
Price
Output
Price
• After the increase in market supply, a new equilibrium is established at the original market price P1 and a larger rate of output (Q3).• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profits are driven down to zero.
The Adjustment
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
d1
P2 d2
q2
D2
S2
Q2
P2
Slr
Q3
d1
Output
Price
Output
Price
A Decrease in Demand
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
d1
P2 d2
q2 Q2
P2
• If, instead, something causes market demand for toothpicks to decrease from D1 to D2 … the market price falls to
P2 shifting the firm’s demand curve downward, leading to a reduction in output to q2. The firm is now making losses.
• Short-run losses cause some competitors to exit the market, and others to reduce the scale of their operation, shifting the market supply curve from S1 to S2.
S2
D2
Output
Price
Output
Price
The Adjustment:
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
P2 d2
d1
q2
D2
S2
Q2
P2
• After the decrease in market supply, a new equilibrium is established at the original market price P1 and a smaller rate of output Q3.• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profit returns to zero.• Note the long-run market supply curve is flat Slr.
Q3
Slrd1
1. One Seller 2. One Product
4. Non-Price competition
6. Price Maker (to maximize profits)
3. Blocked Entry (and exit?)
5. LR profits/losses
Barriers to Entry1. economies of scale
2. government licensing
3. Patents
4. control over an essential resource
A Natural Monopoly Graph
Q
Average Cost
Q0.5
C1
Q1Q0.33
C0.5
C0.33
ATC
• One firm producing Q1 has average cost C1
• If two firms share the market, each produces Q0.5 and has average cost C0.5• If three firms share the market, each produces Q0.33 has average cost C0.33
d
Price
Quantity/time
P2
P1
MRq1 q2
Increase inTotal Revenue
Reduction inTotal Revenue
Marginal Revenue of a Monopolist• Initial price P1 & output q1.
Total revenue (TR) = P1 * q1.1. As price falls from P1 to P2,
output increases from q1 to q2,
two conflicting influences on TR.1. TR will rise because of an increase in the number of units sold (q2 - q1) * P2.
2. TR will decline [(P1 - P2) * q1] as q1 units once sold at the higher price (P1) are now sold at the lower price (P2). • Depending on the size of the shaded regions, total revenue may increase or decrease.
The Welfare Loss from a Monopoly
MC
Q
P
D
QM
PM
• The welfare loss from a monopoly is represented by the triangles B and D
• The rectangle C is a transfer of surplus from the consumer to the monopolist
• The area A represents the opportunity cost of diverted resources, which is not a loss to society MR
PPC
QPC
A
BDC
Price
Quantity/time
d
P
MR
q
MC
ATC
C B
A
with price determined by the height of the demand curve at that level of output, P.
Price and Output Under Monopoly• Expand output as long
as MR > MC. (P goes down)
MR > MCMR < MC
• Output level q will result …
• At q the average total cost per unit for that scale of output is C.
• As P > C (price > ATC) the firm is making economic profits equal to the area PABC.
Economicprofits
• A monopolist will set output equal to q, where MR = MC
When a Monopolist Incurs Losses
d
P
MR
q
MC
ATC
C A
B
Price
Quantity/time
Short-runlosses
• At this level of output, the price that the monopolist charges does not cover the average total cost of producing the output ( P < C ).
• Whenever the ATC curve lies always above the demand curve, the monopolist will incur short-run losses.• In this diagram the firm is making economic losses equal to the shaded area, CABP.
D
P0
MRQ0
LRATC
MCP1
P2
Q1 Q2
Regulation of a MonopolistPrice
Quantity/time
• An unregulated monopolist produces where MR = MC (Q0) and charge price P0.• From an efficiency viewpoint, this output is too small and the price is too high. 1. average cost pricing
The monopolist is forced to reduce its price to P1 the expand output to Q1.
2. marginal cost pricing
-Force output to be expanded to Q2 where P = MC
- P = cost to produce
-Forces LR losses.
Average costpricing
Marginal costpricing
Price Discrimination• Sellers may gain from price discrimination
by charging:• higher prices to groups of customers with
more inelastic demand • lower prices to groups of customers with
more elastic demand
• Price discrimination generally leads to more output and additional gains from trade.
The Economics of Price Discrimination
• If the airline charges all customers the same price, profits will be maximized where MC = MR. Here the airline charges everyone $400 and sells 100 seats.
Price
Quantity/timeSingle price
$400
$200
$300
$100
$500
$600
$700
MC
D100
MR
Net operating revenue($300*100) = $30,000
• Consider a hypothetical market for airline travel where the Marginal Cost per traveler is $100.
• This generates Net Operating Revenue of $30,000 or (total revenues) $40,000 – (operating costs) $10,000.
Price
Quantity/timeSingle price
$400
$200
$300
$100
$500
$600
$700
MC
D100
MR
Net operating revenue($300*100) = $30,000
The Economics of Price Discrimination• By charging higher prices to consumers with less
elastic demand and lower prices to those with more elastic demand it will increase net operating revenue.
• If the airline charges $600 to business travelers (who have a highly inelastic demand) and $300 to other travelers (who have a more elastic demand), it can increase its Net Operating Revenue to $42,000.
Price
Quantity/timePrice Discrim.
$400
$200
$300
$100
$500
$600
$700
MC
D
Net operating revenuefrom business travelers($500*60) = $30,000
Net operating revenuefrom all others($200*60) = $12,000
60 120
• Firms face low entry barriers• Differentiated Products
-they face a downward sloping demand curve-no Long Run Profits-Non-price Competition
• Price Taker• Many Small Firms
Monopolistic Competition
Product Differentiation• Price-searchers produce differentiated
products – products that differ in design, dependability, location, ease of purchase, etc.• Rival firms produce similar products (good
substitutes) and therefore each firm confronts a highly elastic demand curve.
• Advertising increases ATC
• The goals of advertising are to increase demand and make demand more inelastic
• The increase in cost of a monopolistically competitive product is the cost of “differentness”
Price and Output• A profit-maximizing price searcher will
expand output as long as marginal revenue exceeds marginal cost.• Price will be lowered and output expanded
until MR = MC
• The price charged by a price searcher will be greater than its marginal cost.
d
MR
MC
ATC
Price and Output: Short Run Profit
Quantity/timeq
C
EconomicProfits
• A monopolistic competitor maximizes profits by producing where MR = MC, at output level q and charges a price P along the demand curve for that output level.• At q the average total cost is C.
• Because the price is greater than the average total cost per unit (P > C) the firm is making economic profits equal to the area ( [ P - C ] * q )
• What impact will economic profits have if this is a typical firm?
Price
P
• Because entry and exit are free, competition will eventually drive prices down to the level of ATC.
Quantity/timeq
P
d
MR
MC
ATC
Price and Output: Long Run
• When profits (losses) are present, the demand curve will shift inward (outward) until the zero profit equilibrium is restored.• The price searcher establishes its output level where MC = MR.• At q the average total cost is equal to the market price. Zero economic profit is present. No incentive for firms to either enter or exit the market is present.
C = P
Price
Q
P
ATCBreak even
Q
MC
D
MR
A monopolistic firm can earn profits, losses, or break even in the short run
Determining Profits Graphically: Monopolistic Competition
Losses
Break even
Profits
P
ATCLosses
ATCProfits
ATCL
ATCP
Price
Quantity/Time
Pure Comp Mono comp
Price
Quantity/Time
d
MC
ATC
dMR
MC
ATC
P2
q2
P1
q1
• LR equilibrium for both.• P = ATC and there are no economic profits.• In monopolistic competition, firms face a
downward-sloping demand curve, its profit-maximizing price exceeds MC.
• In Monopolistic Competition, output is too small to minimize ATC in long-run equilibrium.
Comparing Markets
Price
Quantity/Time
Pure Comp Mono comp
Price
Quantity/Time
d
Price MC
ATC
d
MC
ATC
P2
P1
Price
MRq2
q1
• Even though the two markets have the same cost structure, the price in the monopolistic competitor’s market is higher than that in the price-taker’s market ( P2 > P1 ).
• Some consider this price discrepancy a sign of inefficiency; others perceive it as a premium society pays for variety and convenience (product differentiation).
Comparing Price Taker Markets
1. Few Sellers2. Differentiated or Identical Products
Characteristics?
4. Non-Price competition
6. Price Maker
3. Difficult Entry and Exit
5. LR profits/losses
• Oligopolies are made up of a small number of firms in an industry
• Oligopolistic firms are mutually interdependent
• In any decision a firm makes, it must take into account the expected reaction of other firms
• Oligopolies can be collusive or noncollusive
• Firms may engage in strategic decision making where each firm takes explicit account of a rival’s expected response to a decision it is making
16-32
Empirical Measures of Industry Structure
• The concentration ratio is a firm’s percentage of total industry sales
• This gives more weight to firms with large market shares than does the concentration ratio measure
• The Herfindahl index is the sum of the squared value of the a firm’s share in the industry
concentration ratio
Herfindahl index
Game Theory or Strategic Interaction
• Cooperative games are games in which players can form coalitions and can enforce the will of the coalition on its members
• Sequential games are games where players make decisions one after another, chess, for example
• A non-cooperative game is a game in which each player is out for him- or herself and agreements are either not possible or not enforceable
• Simultaneous move games are games where players make their decisions at the same time as other players, for example, the prisoner’s dilemma
D
A B
C
high
high
low
low
$57
$55
$55
$60
$59
$50
$69 $58
price
quantity
D=AR
Current Price and Quantity
MR
elastic
inelastic
P TR
P TRMC1
MC2MC3
Q
P
a. Formal Agreement to set Pricesb. OPEC
1. Overt Collusion
a. Secret agreements2. Covert Collusion
b. Electric switch makers in the 50s
a. Agree on price then use non-price competitionb. Types of agreements
3. Gentlemen’s Agreements
2) Cost-Plus Pricing
1) Price Leadership - GM
- Set price based on ATC at 85% capacity
-dominant firm set price-others follow
2. Firms may cheat in non-price ways – free services3. Requires barriers to remain high
1. More firms, more likely to cheat
5. Illegal - use Gentlemen’s agreements
4. Unstable demand/business cycles
6. Difficult to hold the price
Comparison of Market Structures
Monopoly OligopolyMonopolistic Competition
Perfect Competition
No. of firms One Few Many Almost infinite
Barriers to entry Significant Significant Few None
Pricing decisions MC = MRStrategic pricing
MC = MR MC = MR = P
Output decisionsMost output restriction
Output restricted
Output restricted,
product differentiation
No output restriction
InterdependenceNo
competitorsInterdependent
decisions Each firm
independentEach firm
independent
LR profit Possible Possible None None
P and MC P > MC P > MC P > MC P = MC