Managing in Perfectly Competitive

and Monopolistic Markets

Perfect CompetitionConditions:

• Large number of buyers and sellers

• Homogeneous product

• Perfect knowledge

• Free entry and exit

• No government intervention

Key Implications:

• Flat firms’ demand determined by market equilibrium price

• Market participants are price takers without any market power to influence prices (have to charge MR = P = MC)

• In the short run firms earn profits or losses or shut down

• In the long run profit = normal = 0 (firms operate efficiently)

MonopolyConditions:

• Large number of buyers and one sellers

• Product without close substitutes

• Perfect knowledge

• Barriers to entry

• No government intervention

Key Implications:

• Downward sloping firm’s demand is market demand

• Firm has market power and determines market price (can charge P > MR = MC)

• In the short run monopoly earns profit or loss or shuts down

• In the long run profit > normal is sustainable indefinitely but even with profit = normal = 0 (monopoly does not operate efficiently)

Sources of Monopoly PowerNatural:• Economies of scale and excess capacity• Economies of scope and cost complementarities• Capital requirements, sales and distribution networks• Differentiated products and brand loyalty

Created:• Patents and other legal barriers (licenses)• Tying and exclusive contracts• Collusion (tacit or open)• Entry limit pricing (predatory pricing illegal)

Unrealistic? Why Learn?

• Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms

• It is a useful benchmark

• Explains why governments oppose monopolies

• Illuminates the “danger” to managers of competitive environments

• Importance of product differentiation• Sustainable advantage

Profit Maximization for Total Measures

Industry D (TR) = Firm D (TR)

T is maximized:• Where the slope of T is 0

(TR and TC are parallel or their slopes are equal).

dT / dQ = M = 0

2 such points (Q1, Q3) need additional condition:

2. d2T / dQ2 is negative ormax TR - TC => Q* = Q3.

Profit Maximization for per Unit Measures

T is maximized:• At Q where MR = MC.

2 points, need additional condition

• MR < MC for any Q > Q* = Q3

(Q* is one of FONC candidates)or when MC is increasing.

T = [(TR – TC)/Q]Q = (AR – AC)Q = (P – AC)Q Max T = area of the rectangle = (AR|Q* - AC|Q*)Q* = (P|Q* - AC|Q*)Q*

0MCMRdQ

dTC

dQ

dTR

dQ

dTM

A Numerical Example• Given estimates of

• P = 10 - Q

• C(Q) = 6 + 2Q

• Optimal output?• MR = 10 - 2Q = 2 = MC

• Q = 4 units

• Optimal price?• P = 10 - (4) = $6

• Maximum profits?• PQ - C(Q) = 6(4) - (6 + 8) = $10

= 0

Shut-Down Point

• In the long run all cost must be recovered.• In the short run fixed cost incurred before

production begins and do not change regardless of the level of production (even for Q = 0).

• Shut down only if: –TFC > T (total) AVC > P (per unit).

• TFC = AFC*Q = (SAC – AVC)*Q• Operate with loss if: 0 > T –TFC (total)

SAC > P AVC (per unit).• This is the third T maximizing condition.

Setting Price

FirmQf(units)

$

Df = Pf = AR = MR

MarketQM(106)

$

DM

SM

PM

Qf(units)

$ TR

Firm small part of industry:Industry D (TR) > Firm D (TR)

Firm’s D small segment of upward slopping Industry D

Choosing Output• To maximize total profit: T = TR - TC

FONC: dT /dQ = M = MR - MC = 0

In general (including monopoly) MR = MC.In perfect competition MR = P = MC.

• To maximize profit increase output (Q) until 1) MR = P = MC (at Q*), and2) for Q > Q* => MC > P (or MC is increasing)

=> M < 0=> TC < TR

• As long as: max T ≥ -TFC or P ≥ AVC

A Numerical Example

• Given estimates of• P = $10• C(Q) = 5 + Q2

• Optimal Price?• P = $10

• Optimal Output?• MR = P = $10 = 2Q = MC• Q = 5 units

• Maximum Profits?• PQ - C(Q) = 10(5) - (5 + 25) = $20

Profit > Normal

Normal Profit

• Normal profit is necessary for the firm to produce over the long run and is considered a cost of production

• Normal profit is required because investors expect a return on their investment.

• Profit < normal leads to exit in the long run.

• Profit > normal leads to entry in the long run.

• Profit = normal maintains the # of firms in the industry.

Shutdown

Short-Run Supply Under Perfect Competition

Effect of Entry on Market Price & Quantity

FirmQf

$

Df

MarketQM

$

D

S

Pe

S*

Pe* Df*

Entry

• Short run profits leads to entry• Entry increases market supply, driving down the market price and increasing the market quantity

Effect of Entry on Firms Output & Profit

$

Q

LACLMC

QL

Pe Df

Pe* Df*

Qf*

• Demand for individual firm’s product and hence its price shifts down• Long run profits are driven to zero

Perfect Competition in the Long Run

• Socially efficient output and price: MR = P = MC (no dead weight loss)• Efficient plant size: P = MC = min AC (all economies of scale exhausted)• Optimal resource allocation: T = Normal = 0 because P = min AC (because

of no market power or free entry opportunity cost equals TR )

Perfect Competition

Pri

ce

Quantity0

D = P = MR

QPC

PPC

S = MC > min AVC

Consumersurplus

Producersurplus

Efficientquantity

Inefficiency of Monopoly

Pri

ce

Quantity

PA

PM

0

D = PMR

QM QPC

PPC

Consumersurplus

Deadweightloss

Producersurplus

S = MC > min AVC

Monopoly’sgain

Monopoly in the Long Run with Greater than Normal and Normal Profit

• Socially inefficient: P > MR = MC (QM<QPC, PM>PPC, dead weight loss)

• Scale inefficient: P > MC = min AC (economies of scale still exist)

• Misallocated resources: even when T = normal = 0, P is still > min AC (because of market power or barriers to entry opportunity cost < TR)

• Encouraged R&D, benefits from natural monopolies, economies of scope and cost complementarity might offset inefficiencies

• You are a price taker, other firms charge $40 per unit?

• P = MR = 40 = 8Q = MC

=> Q* = 5 and P* = 40

• Max T = TR - C(Q*) = 40(5) - (125+4(5)2)

= 200 - 225 = -$25

• Expect exit in the long-run

• You are a monopolist with inverse demand P = 100 – Q?

• MR = 100 - 2Q = 8Q = MC

=> Q* = 10 and P* = 100 - Q = 100 - 10 = 90

• Max T = TR - C(Q*) = 90(10) - (125+4(100)) = 900 - 525 = $375

• No entry until barriers eliminated

Synthesizing ExampleC(Q) = 125 + 4Q2 => MC = 8Q is unaffected by market structure. What are profit maximizing output & price, and their implications if

Natural Monopoly

LAC

Quantity (millions of kilowatt-hours)

5

10

15

0 1 2 3 4

D=P

Pri

ce (

cent

s pe

r ki

low

att-

hour

)

Economies of scale exist over the entire LAC curve.

One firm distributes 4 million kWh at ¢5 a kWh.

This same total output costs ¢10 a kWh with two and ¢15 a kWh with four firms.

Natural monopoly: one firm meets the market demand at a lower cost than two or more firms.

Public utility commission ensures that P = LAC (not P associated with MR = MC), eliminating monopoly rent.

Break-Even AnalysisApproximation in absence of detailed data on revenue & costs.

Assume both TR & TC are linear.

At the Break-even output: TR = TC = TVC + TFC

P*QBE = AVC*QBE + TFC

(P – AVC)*QBE = TFC

QBE = TFC / (P – AVC)

P = $6, AVC = $3.6, TFC = $60KQBE = 60,000 / (6 – 3.6)QBE = $25,000

(P – AVC) unit contribution margin.

1 – P/AVC contribution margin ratio (fraction of P to recover TFC)