Chapter Perfect competition and monopoly: The limiting cases of market structure David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith Perfect competition Characteristics of a perfectly competition market many buyers and sellers – so no individual believes that their own action can affect 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 9.2 The supply curve under perfect competition (1) £ SMC P3 P1 C A SATC SAVC Q1 Q3 Output Above price P3 (point C), the firm makes profit above the opportunity cost of capital in the short run At price P3, (point C), the firm makes NORMAL PROFITS 9.3 The supply curve under perfect competition (2) Between P1 and P3, (A £ SMC P3 P1 C A SATC SAVC and C), the firm makes short-run losses, but remains in the market Below P1 (the SHUTDOWN PRICE), the firm fails to cover SAVC, and exits Q1 Q3 Output 9.4 The supply curve under perfect competition (3) £ SMC P3 P1 C A SATC So the SMC curve above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE – SAVC Q1 Q3 Output showing how much the firm would produce at each price level 9.5 The firm and the industry in the short run under perfect competition (1) Firm INDUSTRY SMC £ £ SRSS SAC P D=MR=AR P D q Output Q Output Market price is set at industry level at the intersection of demand and supply – the industry supply curve is the sum of the individual firm’s supply curves 9.6 The firm and the industry in the short run under perfect competition (2) Firm INDUSTRY SMC £ £ SRSS SAC P D=MR=AR P D q Output Q Output The firm accepts price as given at P – and chooses output at q where SMC=MR to maximize profits 9.7 The firm and the industry in the short run under perfect competition (3) Firm INDUSTRY SMC £ £ SRSS SRSS1 SAC P P D=MR=AR P D q Output Q Output 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 shifts to the right, and market price falls 9.8 Long-run equilibrium Firm INDUSTRY SMC £ SAC P* D=MR=AR £ SRSS LRSS P* D q* Output Q Output The market settles in long-run equilibrium when the typical firm just makes normal profit by setting LMC=MR at the minimum point of LAC Long-run industry supply is horizontal If the expansion of the industry pushes up input prices (e.g wages) then the long-run supply curve will not be horizontal, but upward-sloping 9.9 Adjustment to an increase in market demand: the short run £ D D' SRSS Suppose a perfectly competitive market starts in equilibrium at P0Q0 If market demand shifts to D'D' P1 in the short run the new equilibrium is P1Q1 P0 D Q0 Q D' Output – adjustment is through expansion of individual firms along their SMCs 9.10 Adjustment to an increase in market demand: the long run £ P1 P2 P0 D In the long run, new firms are attracted by the profits D' SRSS now being made here – and firms are able to adjust their input of fixed LRSS factors If wages are bid up by this expansion, the long-run supply schedule is upwardD' D sloping And the market finally Q0 Q1 Q2 Output settles at P2Q2 9.11 Monopoly A monopolist: – is the sole supplier of an industry’s product and the only potential supplier – – – is protected by some form of barrier to entry faces the market demand curve directly Unlike under perfect competition, MR is always below AR 9.12 Profit maximization by a monopolist £ MC P1 AC1 MR MC=MR Q1 D = AR Output Profits are maximized where MC = MR at Q1P1 In this position, AR is greater than AC AC so the firm makes profits above the opportunity cost of capital shown by the shaded area Entry barriers prevent new firms joining the industry 9.13 Comparing monopoly with perfect competition (1) Suppose a competitive industry is taken over by a monopolist: £ P2 P1 Competitive equilibrium =SMC is at A, with output Q1 and price P1 To the monopolist, LRSS is the LMC curve, and LRSS SRSS is the SMC curve = LMC The monopolist maximizes profits in the D short run at MR = SMC at P2Q2 Output SRSS A MR Q2 Q1 9.14 Comparing monopoly with perfect competition (2) Suppose a competitive industry is taken over by a monopolist: £ SRSS =SMC P3 P2 P1 A LRSS = LMC MR Q3 Q2 Q1 In the long run, the firm can adjust other inputs to set MR = LMC At P3Q3 D Output 9.15 Comparing monopoly with perfect competition (3) So we see that monopoly compared with perfect 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 9.16 A natural monopoly This firm enjoys substantial economies of scale relative to market demand £ LAC declines right up to market demand LMC Q1 MR the largest firm always enjoys cost leadership LAC P1 and comes to dominate the industry D Output It is a NATURAL MONOPOLY 9.17 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 air fare levels than tourists The monopolist may increase profits by charging 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 9.18 ... input prices (e.g wages) then the long-run supply curve will not be horizontal, but upward-sloping 9. 9 Adjustment to an increase in market demand: the short run £ D D'' SRSS Suppose a perfectly competitive... opportunity cost of capital in the short run At price P3, (point C), the firm makes NORMAL PROFITS 9. 3 The supply curve under perfect competition (2) Between P1 and P3, (A £ SMC P3 P1 C A SATC SAVC... the market Below P1 (the SHUTDOWN PRICE), the firm fails to cover SAVC, and exits Q1 Q3 Output 9. 4 The supply curve under perfect competition (3) £ SMC P3 P1 C A SATC So the SMC curve above SAVC