Firms in competitive markets: Perfect Competition and Monopoly

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1 Lesson 6 Firms in competitive markets: Perfect Competition and Monopoly Henan University of Technology Sino-British College Transfer Abroad Undergraduate Programme 0

2 In this lesson, look for the answers to these questions: What is a perfectly competitive market? What is marginal revenue? How is it related to total and average revenue? How does a competitive firm determine the quantity that maximizes profits? When might a competitive firm shut down in the short run? Exit the market in the long run? 1

3 Why do monopolies arise? Why is MR < P for a monopolist? How do monopolies choose their P and Q? How do monopolies affect society s well-being? What can the government do about monopolies? What is price discrimination? What market structures lie between perfect competition and monopoly, and what are their characteristics? 2

4 Introduction: A Scenario Three years after graduating, you run your own business. You must decide how much to produce, what price to charge, how many workers to hire, etc. What factors should affect these decisions? Your costs How much competition you face We begin by studying the behavior of firms in perfectly competitive markets. 3

5 Characteristics of Perfect Competition 1. Many buyers and many sellers 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. Because of 1 & 2, each buyer and seller is a price taker takes the price as given. 4

6 The Revenue of a Competitive Firm Total revenue (TR) TR = P x Q Average revenue (AR) AR = TR Q = P Marginal Revenue (MR): The change in TR from selling one more unit. MR = TR Q 5

7 A C T I V E L E A R N I N G 1: Exercise Fill in the empty spaces of the table. Q P TR AR MR 0 $10 n.a. 1 $10 $10 2 $10 3 $ $10 $10 $40 $50 $10 6

8 A C T I V E L E A R N I N G 1: Answers Fill in the empty spaces of the table. Q P TR = P x Q AR = TR Q MR = TR Q $10 $10 $10 $10 $10 $10 $0 n.a. $10 Notice that MR = P $20 $10 $10 $30 $10 $40 $10 $50 $10 $10 $10 $10 $10 $10 7

9 MR = P for a Competitive Firm A competitive firm can keep increasing its output without affecting the market price. So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets. 8

10 Profit Maximization What Q maximizes the firm s profit? To find the answer, Think at the margin. If increase Q by one unit, revenue rises by MR, cost rises by MC. If MR > MC, then increase Q to raise profit. If MR < MC, then reduce Q to raise profit. 9

11 Profit Maximization (continued from earlier exercise) At any Q with MR > MC, increasing Q raises profit. At any Q with MR < MC, reducing Q raises profit. Q TR $ TC $ Profit $ MR $ MC $ Profit = MR MC $

12 MC and the Firm s Supply Decision Rule: MR = MC at the profit-maximizing Q. At Q a, MC < MR. So, increase Q to raise profit. Costs MC At Q b, MC > MR. So, reduce Q to raise profit. P 1 MR At Q 1, MC = MR. Changing Q would lower profit. Q a Q 1 Q b Q 11

13 MC and the Firm s Supply Decision If price rises to P 2, then the profitmaximizing quantity rises to Q 2. Costs MC The MC curve determines the firm s Q at any price. Hence, the MC curve is the firm s supply curve. P 2 MR 2 P 1 MR Q 1 Q 2 Q 12

14 Shutdown vs. Exit Shutdown: A short-run decision not to produce anything because of market conditions. Exit: A long-run decision to leave the market. A key difference: If shut down in SR, must still pay FC. If exit in LR, zero costs. 13

15 A Firm s Short-run Decision to Shut Down Cost of shutting down: revenue loss = TR Benefit of shutting down: cost savings = VC (firm must still pay FC) So, shut down if TR < VC. Divide both sides by Q: TR/Q < VC/Q So, firm s decision rule is: Shut down if P < AVC 14

16 A Competitive Firm s SR Supply Curve The firm s SR supply curve is the portion of its MC curve If P > AVC, then above AVC. firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0). Costs MC ATC AVC Q 15

17 The Irrelevance of Sunk Costs Sunk cost: a cost that has already been committed and cannot be recovered Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice. FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. So, FC should not matter in the decision to shut down. 16

18 A Firm s Long-Run Decision to Exit Cost of exiting the market: revenue loss = TR Benefit of exiting the market: cost savings = TC (zero FC in the long run) So, firm exits if TR < TC. Divide both sides by Q to write the firm s decision rule as: Exit if P < ATC 17

19 A New Firm s Decision to Enter Market In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC. Divide both sides by Q to express the firm s entry decision as: Enter if P > ATC 18

20 The Competitive Firm s Supply Curve The firm s LR supply curve is the portion of its MC curve above LRATC. Costs MC LRATC Q 19

21 A C T I V E L E A R N I N G 2A: Identifying a firm s profit Determine this firm s total profit. Costs, P A competitive firm MC Identify the area on the graph that represents the firm s profit. P = $10 $6 50 MR ATC Q 20

22 A C T I V E L E A R N I N G 2A: Answers profit per unit = P ATC = $10 6 = $4 Costs, P P = $10 $6 A competitive firm profit MC MR ATC Total profit = (P ATC) x Q = $4 x 50 = $ Q 21

23 A C T I V E L E A R N I N G 2B: Identifying a firm s loss Determine this firm s total loss, assuming AVC < $3. Costs, P A competitive firm MC ATC Identify the area on the graph that represents the firm s loss. $5 P = $3 30 MR Q 22

24 A C T I V E L E A R N I N G 2B: Answers Total loss = (ATC P) x Q = $2 x 30 = $60 Costs, P $5 P = $3 loss A competitive firm MC ATC loss per unit = $2 MR 30 Q 23

25 CONCLUSION: The Efficiency of a Competitive Market Profit-maximization: Perfect competition: So, in the competitive eq m: MC = MR P = MR P = MC Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. So, the competitive eq m is efficient, maximizes total surplus. In the next chapter, monopoly: pricing & production decisions, deadweight loss, regulation. 24

26 Monopoly Introduction A monopoly is a firm that is the sole seller of a product without close substitutes. In this part, we study monopoly and contrast it with perfect competition. The key difference: A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power. 25

27 Why Monopolies Arise The main cause of monopolies is barriers to entry other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E.g., DeBeers owns most of the world s diamond mines 2. The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws 26

28 Why Monopolies Arise 3. Natural monopoly: a single firm can produce the entire market Q at lower ATC than could several firms. Example: 1000 homes need electricity. Cost ATC is lower if one firm services all 1000 homes $80 than if two firms $50 each service 500 homes. 500 Electricity ATC slopes downward due to huge FC and small MC 1000 ATC Q 27

29 Monopoly vs. Competition: Demand Curves In a competitive market, the market demand curve slopes downward. but the demand curve for any individual firm s product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the competitive firm. P A competitive firm s demand curve D Q 28

30 Monopoly vs. Competition: Demand Curves A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P. Thus, MR P. P A monopolist s demand curve D Q 29

31 A C T I V E L E A R N I N G 1: A monopoly s revenue Moonbucks is the only seller of cappuccinos in town. The table shows the market demand for cappuccinos. Fill in the missing spaces of the table. What is the relation between P and AR? Between P and MR? Q P TR AR MR 0 $ n.a. 30

32 A C T I V E L E A R N I N G 1: Answers Here, P = AR, same as for a competitive firm. Here, MR < P, whereas MR = P for a competitive firm. Q P $ TR $ AR n.a. $ MR $

33 Moonbuck s D and MR Curves P, MR Q P $ MR $ $ Demand curve (P) MR Q 32

34 Understanding the Monopolist s MR Increasing Q has two effects on revenue: The output effect: Higher output raises revenue The price effect: Lower price reduces revenue To sell a larger Q, the monopolist must reduce the price on all the units it sells. Hence, MR < P MR could even be negative if the price effect exceeds the output effect (e.g., when Moonbucks increases Q from 5 to 6). 33

35 Profit-Maximization Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC. Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity. It finds this price from the D curve. 34

36 Profit-Maximization 1. The profitmaximizing Q is where MR = MC. Costs and Revenue P MC 2. Find P from the demand curve at this Q. MR D Q Quantity Profit-maximizing output 35

37 The Monopolist s Profit Costs and Revenue MC As with a competitive firm, the monopolist s profit equals P ATC ATC D (P ATC) x Q MR Q Quantity 36

38 A Monopoly Does Not Have an S Curve A competitive firm takes P as given has a supply curve that shows how its Q depends on P A monopoly firm is a price-maker, not a price-taker Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve. So there is no supply curve for monopoly. 37

39 The Welfare Cost of Monopoly Recall: In a competitive market equilibrium, P = MC and total surplus is maximized. In the monopoly eq m, P > MR = MC The value to buyers of an additional unit (P) exceeds the cost of the resources needed to produce that unit (MC). The monopoly Q is too low could increase total surplus with a larger Q. Thus, monopoly results in a deadweight loss. 38

40 The Welfare Cost of Monopoly Competitive eq m: quantity = Q C P = MC total surplus is maximized Monopoly eq m: quantity = Q M P > MC deadweight loss Price P P = MC MC Deadweight loss MC D MR Q M Q C Quantity 39

41 Public Policy Toward Monopolies Increasing competition with antitrust laws ban some anticompetitive practices, allow govt to break up monopolies Regulation Govt agencies set the monopolist s price For natural monopolies, MC < ATC at all Q, so marginal cost pricing would result in losses. If so, regulators might subsidize the monopolist or set P = ATC for zero economic profit. 40

42 Public Policy Toward Monopolies Public ownership Example: U.S. Postal Service Problem: Public ownership is usually less efficient since no profit motive to minimize costs Doing nothing The foregoing policies all have drawbacks, so the best policy may be no policy. 41

43 Price Discrimination Discrimination: treating people differently based on some characteristic, e.g. race or gender. Price discrimination: selling the same good at different prices to different buyers. The characteristic used in price discrimination is willingness to pay (WTP): A firm can increase profit by charging a higher price to buyers with higher WTP. 42

44 Price Discrimination in the Real World In the real world, perfect price discrimination is not possible: no firm knows every buyer s WTP buyers do not announce it to sellers So, firms divide customers into groups based on some observable trait that is likely related to WTP, such as age. 43

45 Examples of Price Discrimination Movie tickets Discounts for seniors, students, and people who can attend during weekday afternoons. They are all more likely to have lower WTP than people who pay full price on Friday night. Airline prices Discounts for Saturday-night stayovers help distinguish business travelers, who usually have higher WTP, from more price-sensitive leisure travelers. 44

46 Examples of Price Discrimination Quantity discounts A buyer s WTP often declines with additional units, so firms charge less per unit for large quantities than small ones. Example: A movie theater charges $4 for a small popcorn and $5 for a large one that s twice as big. 45

47 CONCLUSION: The Prevalence of Monopoly In the real world, pure monopoly is rare. Yet, many firms have market power, due to selling a unique variety of a product having a large market share and few significant competitors 46

48 Between Monopoly and Competition Two extremes Competitive markets: many firms, identical products Monopoly: one firm In between these extremes Oligopoly: only a few sellers offer similar or identical products. Monopolistic competition: many firms sell similar but not identical products. 47

49 LESSON SUMMARY For a firm in a perfectly competitive market, price = marginal revenue = average revenue. If P > AVC, a firm maximizes profit by producing the quantity where MR = MC. If P < AVC, a firm will shut down in the short run. If P < ATC, a firm will exit in the long run.. 48

50 LESSON SUMMARY A monopoly firm is the sole seller in its market. Monopolies arise due to barriers to entry, including: government-granted monopolies, the control of a key resource, or economies of scale over the entire range of output. A monopoly firm faces a downward-sloping demand curve for its product. As a result, it must reduce price to sell a larger quantity, which causes marginal revenue to fall below price. 49

51 LESSON SUMMARY Monopoly firms maximize profits by producing the quantity where marginal revenue equals marginal cost. But since marginal revenue is less than price, the monopoly price will be greater than marginal cost, leading to a deadweight loss. Policymakers may respond by regulating monopolies, using antitrust laws to promote competition, or by taking over the monopoly and running it. Due to problems with each of these options, the best option may be to take no action. 50

52 LESSON SUMMARY Monopoly firms (and others with market power) try to raise their profits by charging higher prices to consumers with higher willingness to pay. This practice is called price discrimination. 51