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
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Chapter 9
Perfect competition and monopoly:
The limiting cases of market structure
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
9.1
Perfect competition
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
Characteristics of a perfectly competition market
9.2
The supply curve under perfect competition (1)
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
P1
£
Output
SAVC
SMC
Q1
SATC
P3
A
C
Q3
9.3
The supply curve under perfect competition (2)
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
P1
£
Output
SAVC
SMC
Q1
SATC
P3
A
C
Q3
9.4
The supply curve under perfect competition (3)
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.
P1
£
Output
SAVC
SMC
Q1
SATC
P3
A
C
Q3
9.5
The firm and the industry in the short
run under perfect competition (1)
INDUSTRY
Output
£
Q
P
SRSS
D
Firm
SAC
P
£
Output
SMC
D=MR=AR
q
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.
9.6
The firm and the industry in the short
run under perfect competition (2)
INDUSTRY
Output
£
Q
P
SRSS
D
SAC
Firm
P
£
Output
SMC
D=MR=AR
q
The firm accepts price as given at P
– and chooses output at q where SMC=MR to maximize profits
9.7
The firm and the industry in the short
run under perfect competition (3)
INDUSTRY
Output
£
Q
P
SRSS
D
SAC
Firm
P
£
Output
SMC
D=MR=AR
q
At this price, profits are shown by the shaded area.
These profits attract new entrants into the industry.
As more firms join the market, the industry supply curve shifts
to the right, and market price falls.
SRSS1
P1
9.8
Long-run equilibrium
INDUSTRY
Output
£
Q
P*
SRSS
D
Firm
SAC
P*
£
Output
SMC
D=MR=AR
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)
then the long-run supply curve will not be horizontal, but upward-sloping.
9.9
Adjustment to an increase in market demand:
the short run
Suppose a perfectly
competitive market starts
in equilibrium at P0Q0.
If market demand shifts to
D'D' ...
Output
£
D
SRSS
Q0
P0
D
D'
D'
in the short run the new
equilibrium is P1Q1 ...
– adjustment is through
expansion of individual
firms along their SMCs.Q1
P1
9.10
Adjustment to an increase in market demand:
the long run
In the long run, new firms
are attracted by the profits
now being made here
Output
£
D
SRSS
Q0
P0
D
D'
D'
Q1
P1
– and firms are able to
adjust their input of fixed
factors
If wages are bid up by this
expansion, the long-run
supply schedule is upward-
sloping
LRSS
And the market finally
settles at P2Q2.
Q2
P2
9.11
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.
9.12
AC1
shown by the shaded area
Profit maximization by a monopolist
Profits are maximized
where MC = MR at Q1P1.
In this position, AR is
greater than AC
so the firm makes
profits above the
opportunity cost of
capital
Entry barriers prevent
new firms joining the
industry.
Output
£
P1
Q1
MC
AC
D = AR
MRMC=MR
9.13
Comparing monopoly with perfect
competition (1)
Suppose a competitive industry is taken over by a monopolist:
Output
DMR
SRSS
LRSS
£
Q1
P1
A
Competitive equilibrium
is at A, with output Q1
and price P1.
To the monopolist, LRSS
is the LMC curve, and
SRSS is the SMC curve
= LMC
=SMC
The monopolist
maximizes profits in the
short run at MR = SMC
at P2Q2.
Q2
P2
9.14
Comparing monopoly with perfect
competition (2)
Suppose a competitive industry is taken over by a monopolist:
Output
DMR
SRSS
LRSS
£
Q1
P1
A
= LMC
=SMC
Q2
P2
In the long run, the
firm can adjust
other inputs ...
to set MR = LMC
At P3Q3.
P3
Q3
9.15
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.
9.16
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
DMR
P1
£
Q1 Output
9.17
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