Chapter 05 Perfect Competition, Monopoly, and Economic versus Normal Profit McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Chapter Outline • From Perfect Competition to Monopoly • Supply Under Perfect Competition McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-2 1-2 From Perfect Competition to Monopoly • • • • Perfect Competition Monopolistic Competition Oligopoly Monopoly McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-3 1-3 Picking the Quantity to Maximize Profit The Perfectly P Competitive Case MC ATC AVC P* MR Q* Q Many Competitors McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-4 1-4 Picking the Quantity to Maximize Profit The Monopoly Case P MC ATC P* AVC D MR Q* Q No Competitors McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-5 1-5 Characteristics of Perfect Competition • a large number of competitors, such that no one firm can influence the price • the good a firm sells is indistinguishable from the ones its competitors sell • firms have good sales and cost forecasts • there is no legal or economic barrier to its entry into or exit from the market McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-6 1-6 Monopoly • The sole seller of a good or service • Some monopolies are generated because of legal rights (patents and copyrights) • Some monopolies are utilities (gas, water, electricity etc.) that result from high fixed costs McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-7 1-7 Monopolistic Competition • Monopolistic Competition: a situation in a market where there are many firms producing similar but not identical goods • Example : the fast-food industry McDonald’s has a monopoly on the “Happy Meal” but has much competition in the market to feed kids burgers and fries McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-8 1-8 Oligopoly • Oligopoly: a situation in a market where there are very few discernible competitors • Examples: • Satellite TV service (Direct TV, Dish Network) • Airlines (American, Delta etc.) McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-9 1-9 Which Model Fits Reality? • Perfect competition is rare outside agriculture though it fits some labor markets • Monopolies are common in utilities • Major branded companies are typically either in oligopolistic or monopolistically competitive industries McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-10 1-10 Examples of Different Market Forms Perfect Monopolisti Oligopoly Competitio c n Competitio n 1) 2) Agricultur 1) e 2) Lumber McGraw-Hill/Irwin Fast Food 1) Long Distance 2) Service Monopoly Cars and 1) Trucks Soft Drinks 2) Windows Operating system Local Residentia l electric power ©2012 The McGraw-Hill Companies, All Rights Reserved 5-11 1-11 Distinguishing Characteristics Between Market Forms Perfect Competition Monop Oligopoly olistic Compe tition Monopoly Number Many-often of Firms thousands or Severa l* Few* One Barriers None to Entry Few Substantial Insurmounta ble, at least in the short run Product Identical Similarit y Similar Similar or but not Identical identic al even millions N/A * The line between “several” and “few” is not definite McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-12 1-12 Concentration Ratios • There is no magic line that separates oligopoly from monopolistic competition • A “concentration ratio” measures the percentage of total market sales for the top firms (from firms to 100 firms) McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-13 1-13 Herschfeld-Herfindahl Index • Sum of Squared Market Share •0 Perfect Competition • 10,000 Monopoly • (10,000/N) N equally sized firms McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-14 1-14 Concentration Ratios For Various Manufacturing Industries Industry Group Concentration Ratios Largest Firms Largest Firms 50 Largest Firms Breakfast Cereals 78.4% 91.1% 100.0% Ice Cream 48.0 64.4 93.1 Beer 90.8 93.8 98.1 Clothing 17.3 21.3 38.7 Computers and Peripherals 40.5 65.2 88.3 Furniture 11.0 18.0 30.6 Long Distance 59.7 80.9 92.5 Cellular Service 61.7 81.7 90.0 McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-15 1-15 Supply Under Perfect Competition McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-16 1-16 Normal vs Economic Profit • Normal Profit : the level of profit that business owners could get in their next best alternative investment • Economic Profit: any profit above normal profit McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-17 1-17 Return on Equity For Various Industries Industry Rate of Return Net Income/(AssetsLiabilities) Agriculture 3.1% Manufacturing 21.8% Transportation and Public Utilities Retail Trade McGraw-Hill/Irwin 8.2% 16.1% ©2012 The McGraw-Hill Companies, All Rights Reserved 5-18 1-18 When and Why Economic Profits Go to Zero McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-19 1-19 Time Horizons • Short Run: the period of time where we cannot change things like plant and equipment • Long Run: the period of time where we can change things like plant and equipment McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-20 1-20 Market Forms and Economic Profits • Under perfect competition or monopolistic competition, economic profits go to zero because of the entry of new firms increases market supply and lowers prices • Economic profits are under no pressure to shrink under oligopoly or monopoly because entry doesn’t occur so prices not fall McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-21 1-21 Figure The Pressures on Price in Perfect Competition $ MC Long Run Pressure MR4 Short Run Pressure ATC AVC MR3 MR2 MR1 Q McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-22 1-22 Figure Points of Production in Perfect Competition $ MC MR4 ATC AVC MR3 MR2 MR1 Q McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-23 1-23 Figure Supply in Perfect Competition $ MC Supply ATC AVC Q McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies, All Rights Reserved 5-24 1-24 ... markets • Monopolies are common in utilities • Major branded companies are typically either in oligopolistic or monopolistically competitive industries McGraw-Hill/Irwin ©2012 The McGraw-Hill Companies,... 1) 2) Agricultur 1) e 2) Lumber McGraw-Hill/Irwin Fast Food 1) Long Distance 2) Service Monopoly Cars and 1) Trucks Soft Drinks 2) Windows Operating system Local Residentia l electric power ©2012... Substantial Insurmounta ble, at least in the short run Product Identical Similarit y Similar Similar or but not Identical identic al even millions N/A * The line between “several” and “few” is not definite