CH8

1

Chapter 8:

Perfect Competition and Monopoly

Four Basic Market Types

• Perfect Competition (no market power)– Large number of relatively small buyers and sellers– Standardized product– Very easy market entry and exit– Nonprice competition not possible

• Monopoly (absolute market power subject to government regulation)– One firm, firm is the industry– Unique product or no close substitutes– Market entry and exit difficult or legally impossible– Nonprice competition not necessary

Four Basic Market Types• Monopolistic Competition (market power based on product

differentiation)– Large number of relatively small firms acting independently– Differentiated product– Market entry and exit relatively easy– Nonprice competition very important

• Oligopoly (market power based on product differentiation and/or the firm’s dominance of the market)– Small number of relatively large firms that are mutually

interdependent– Differentiated or standardized product– Market entry and exit difficult– Nonprice competition very important among firms selling

differentiated products

Four Basic Market Types

Pricing and Output Decisions in Perfect Competition

• The Basic Business Decision: entering a market on the basis of the following questions:– How much should we produce?– If we produce such an amount, how much profit

will we earn?– If a loss rather than a profit is incurred, will it be

worthwhile to continue in this market in the long run (in hopes that we will eventually earn a profit) or should we exit?


• Key assumptions of the perfectly competitive market– The firm operates in a perfectly competitive

market and therefore is a price taker.– The firm makes the distinction between the short

run and the long run.– The firm’s objective is to maximize its profit in the

short run. If it cannot earn a profit, then it seeks to minimize its loss.

– The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.


• Perfectly Elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the going market price.

• Firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product.

• No limit to the total revenue that the firm can gain in a perfectly competitive market.


• Total Revenue-Total Cost approach:– Compare the total revenue and total cost schedules and find

the level of output that either maximizes the firm’s profits or minimizes its loss.

• Marginal Revenue – Marginal Cost Approach– A firm that wants to maximize its profit (or minimize its loss)

should produce a level of output at which the additional revenue received from the last unit is equal to the additional cost of producing that unit. In short, MR=MC.

– For the perfectly competitive firm, the MR=MC rule may be restated as P=MC.• This is because P=MR in perfectly competitive markets.


• The point where P=MR=MC is the optimal output (Q*)

• Profit = TR – TC =(P - AC) · Q*


• The firm incurs a loss. At the optimum output level price is below average cost.

• However, since price is greater than average variable cost, the firm is better off producing in the short run, because it will still incur fixed costs greater than the loss.


• Contribution Margin (CM): the amount by which total revenue exceeds total variable cost.

• CM = TR – TVC• If the contribution

margin is positive, the firm should continue to produce in the short run in order to defray some of the fixed cost.


• Shutdown Point: the lowest price at which the firm would still produce.

• At the shutdown point, the price is equal to the minimum point on the AVC. This is where selling at the price results in zero contribution margin.

• If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs.


• In the long run, the price in the competitive market will settle at the point where firms earn a normal profit.– Economic profit invites entry of new firms which

shifts the supply curve to the right, puts downward pressure on price and reduces profits.

– Economic loss causes exit of firms which shifts the supply curve to the left, puts upward pressure on price and increases profits.


• Observations in perfectly competitive markets:– The earlier the firm enters a market, the better its

chances of earning above-normal profit (assuming a strong demand in the market).

– As new firms enter the market, firms that want to survive and perhaps thrive must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors.

– Firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation instead.

Pricing and Output Decisions in Monopoly Markets

• A monopoly market consists of one firm.• The firm is the market.• Has the power to establish any price it wants.• However, the firm’s ability to set price is

limited by the demand curve for its product, and in particular, the price elasticity of demand.


• Assume demand is linear. It is downward sloping because the firm is a price setter.

• Assume MC is constant.

• Choose output where MR=MC, set price at P*.


• Demand is the same as before, as is MR.

• MC is upward sloping, which shows diminishing returns.

• Set output where MR=MC

Implications of Perfect Competition and Monopoly for Decision Making

• Perfectly competitive market– Most important lesson is that it is extremely difficult to

make money.– Must be as cost efficient as possible.– It might pay for a firm to move into a market before others

start to enter.• Monopoly market– Most important lesson is not to be complacent or arrogant

and assume their ability to earn economic profit can never be diminished.

– Changes in economics of a business eventually break down a dominating company’s monopolistic power.

CH8

Documents

Transcript of CH8