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The McGraw-Hill Companies, 2005

Chapter 8Perfect competition and pure monopoly

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,8th Edition, McGraw-Hill, 2005

PowerPoint presentation by Alex Tackie and Damian Ward

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The McGraw-Hill Companies, 20051

Perfect competition

many buyers and sellers

so no individual believes that their own action canaffect 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 competitive market

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The supply curve under perfect competition (1)

Above price P3 (point C),the firm makes profit

above the opportunitycost of capital in theshort run

At price P3, (point C), thefirm makes NORMAL

PROFITS

P1

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

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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

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The McGraw-Hill Companies, 20054

The supply curve under perfect competition (3)

showing how much the

firm would produce at

each price level.P1

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

So the SMC curve above

SAVC represents the

firms SHORT-RUN

SUPPLY CURVE

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The firm and the industry in the short run underperfect competition (1)

INDUSTRY

Output

Q

P

SRSS

D

Firm

SAC

P

Output

SMC

D=MR=AR

q

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The firm and the industry in the short run underperfect competition (1)

INDUSTRY

Output

Q

P

SRSS

D

Firm

Market price is set at industry level at the intersection ofdemand and supply

the industry supply curve is the sum of the individual firmssupply curves

SAC

P

Output

SMC

D=MR=AR

q

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The firm and the industry in the short run underperfect competition (2)

INDUSTRYFirm

The firm accepts price as given at P

and chooses output at q where SMC=MR to maximise profits

SAC

P

Output

SMC

D=MR=AR

qOutput

Q

P

SRSS

D

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The McGraw-Hill Companies, 20058

The firm and the industry in the short run underperfect competition (3)

INDUSTRY

Output

Q

P

SRSS

D

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 shiftsto the right, and market price falls.

SRSS1

P1

SAC

Firm

P

Output

SMC

D=MR=AR

q Q1

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Long-run equilibrium

INDUSTRYFirm

LAC

P*

Output

LMC

D=MR=AR

q*

The market settles in long-run equilibrium when the typicalfirm just makes normal profit by setting LMC=MR at the minimumpoint 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.

SRSS

D

Output

Q

P*LRSS

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Adjustment to an increase in market demand:

the short run

Suppose a perfectlycompetitive market startsin equilibrium at P0Q0.

If market demand shifts toD'D' ...

in the short run the newequilibrium is P1Q1 ...

adjustment is throughexpansion of individualfirms along their SMCs.

Q1

P1

Output

D

SRSS

Q0

P0

D

D'

D'

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The McGraw-Hill Companies, 200511

Adjustment to an increase in market demand:

the long run

In the long run, new firmsare attracted by the profitsnow being made here

Output

D

SRSS

Q0

P0

D

D'

D'

Q1

P1

and firms are able toadjust their input of fixedfactorsIf wages are bid up by thisexpansion, the long-runsupply schedule is upward-sloping

LRSS

and the market finallysettles at P2Q2.

Q2

P2

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Monopoly A monopolist:

is the sole supplier of an industrys product

and the only potential supplier

is protected by some form of barrier toentry

faces the market demand curve directly Unlike under perfect competition, MR is

always below AR.

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Profit maximisation by a monopolist

Profits are maximisedwhere MC = MR at Q1P1.

In this position, AR is

greater than ACso the firm makesprofits above theopportunity cost ofcapital shown by theshaded area.

Entry barriers preventnew firms joining theindustry.

Output

MC=MR

P1

Q1

MC

AC

D = ARMR

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Comparing monopoly with perfect

competition (1)Suppose a competitive industry is taken over by a monopolist:

Output

DMR

SRSS

LRSS

Q1

P1

A

Competitive equilibriumis at A, with output Q1and price P1.

To the monopolist, LRSSis the LMC curve, andSRSS is the SMC curve.

= LMC

=SMC

The monopolistmaximises profits in theshort run at MR = SMCat P2Q2.Q2

P2

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Comparing monopoly with perfect

competition (2)Suppose a competitive industry is taken over by a monopolist:

Output

In the long run the

firm can adjustother inputs ...

to set MR = LMC

at P3Q3.

P3

Q3

DMR

SRSS

LRSS

Q1

P1

A

= LMC

=SMC

Q2

P2

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Comparing monopoly with perfectcompetition (3)

So we see that monopoly compared withperfect 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.

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Anatural 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 dominatethe industry

It is a NATURAL

MONOPOLY.

LMC

LAC

DMR

P1

Q1 Output

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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 airfare levels than tourists.

The monopolist may increase profits bycharging 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.