Firms in Markets The Four Types of

Firms in Markets

The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Monopoly • Tap water • Cable TV Few firms Oligopoly • Tennis balls • Crude oil Differentiated products Monopolistic Competition • Novels • Movies Identical products Perfect Competition • Wheat • Milk

WHAT IS A COMPETITIVE MARKET • A perfectly competitive market has the following characteristics: – There are many buyers and sellers in the market. – The goods offered by the various sellers are largely the same. – Firms can freely enter or exit the market.

WHAT IS A COMPETITIVE MARKET • As a result of its characteristics, the perfectly competitive market has the following outcomes: – The actions of any single buyer or seller in the market have a negligible impact on the market price. – Each buyer and seller takes the market price as given.

WHAT IS A COMPETITIVE MARKET • A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. – Buyers and sellers must accept the price determined by the market.

The Revenue of a Competitive Firm • Total revenue for a firm is the selling price times the quantity sold. TR = (P Q) • Total revenue is proportional to the amount of output. • Average revenue tells us how much revenue a firm receives for the typical unit sold. • Average revenue is total revenue divided

The Revenue of a Competitive Firm • In perfect competition, average revenue equals the price of the good.

The Revenue of a Competitive Firm • Marginal revenue is the change in total revenue from an additional unit sold. • For competitive firms, marginal revenue equals the price of the good. MR = TR/ Q

Table 14 -1: Total, Average, and Marginal Revenue for a Competitive Total Firm Average Marginal Quantity (in litres) Price (Q) (P) 1 2 3 4 5 6 7 8 $6 6 6 6 Revenu e (TR = P x Q) (AR = TR/ Q) (MR = ∆TR/∆Q) $6 12 18 24 30 36 42 48 $6 6 6 6

PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE • The goal of a competitive firm is to maximize profit, which equals total revenue minus total cost. • This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

Table 14 -2: Profit Maximization: A Numerical Example Quantity (in litres) Total Revenue Marginal Cost Change in Profit Total Cost Profit (Q) (TR) (TC) (TR - TC) (MR = ∆TR/∆Q) (MC = ∆TC/∆Q) (MR - MC) 0 1 2 3 4 5 6 7 8 $0 6 12 18 24 30 36 42 48 $3 5 8 12 17 23 30 38 47 -$3 1 4 6 7 7 6 4 1 $6 6 6 6 $2 3 4 5 6 7 8 9 $4 3 2 1 0 -1 -2 -3

Figure 14 -1: Profit Maximization for a Competitive Firm The firm maximizes profit by producing Costs and Revenue the quantity at which marginal cost equals marginal revenue. MC MC 2 ATC P = MR 1 = MR 2 P = MR AVC MC 1 0 Q 1 Q MAX Q 2 Quantity

MONOPOLY • While a competitive firm is a price taker, a monopoly firm is a price maker. • A firm is considered a monopoly if. . . – it is the sole seller of its product. – its product does not have close substitutes.

Why Monopolies Arise • The fundamental cause of monopoly is barriers to entry. • Barriers to entry have three sources: – Ownership of a key resource. – The government gives a single firm the exclusive right to produce some good. – Costs of production make a single producer more efficient than a large number of producers.

Figure 15 -1: Economies of Scale as a Cause of Monopoly Cost Average total cost 0 Quantity of Output

Pricing and Production Decisions • Monopoly versus Competition – Monopoly • • Is the sole producer Faces a downward-sloping demand curve Is a price maker Reduces price to increase sales – Competitive Firm • • Is one of many producers Faces a horizontal demand curve Is a price taker Sells as much or as little at same price

Figure 15 -2: Demand Curves for Competitive and Monopoly Firms (b) Monopoly (a) Competitive Firm Price Demand 0 Quantity of Output

A Monopoly’s Revenue • Total Revenue P Q = TR • Average Revenue TR/Q = AR = P • Marginal Revenue TR/ Q = MR

Table 15 -1: A Monopoly’s Total, Average, and Marginal Revenue. Quantity of Water Price Total Revenue Average Revenue (Q) (P) (TR = P x Q) (AR = P x Q) 0 $ 11 $0 ------ 1 10 10 $ 10 2 9 18 9 3 8 24 8 4 7 28 7 5 6 30 6 6 5 30 5 7 4 28 4 8 3 24 3 Marginal Revenue (MR = ∆TR/∆Q) $ 10 8 6 4 2 0 -2 -4

A Monopoly’s Revenue • A Monopoly’s Marginal Revenue – A monopolist’s marginal revenue is always less than the price of its good. • The demand curve is downward sloping. • When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases.

A Monopoly’s Revenue • A Monopoly’s Marginal Revenue – When a monopoly increases the amount it sells, it has two effects on total revenue (P Q). • The output effect—more output is sold, so Q is higher. • The price effect—price falls, so P is lower.

Price Figure 15 -3: The Demand Marginal Revenue Curves for a Monopoly 11 10 9 8 7 6 5 4 Demand (average revenue) 3 Marginal revenue 2 1 0 – 1 1 2 3 4 5 6 7 8 – 2 – 3 – 4 Quantity of Water

Profit Maximization • A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. • It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Figure 15 -4: Profit Maximization for a Monopoly Costs and Revenue 2. … and then the demand curve shows the price consistent with this quantity. 1. The intersection of the MR curve and the MC curve determines the profit maximizing quantity… B Monopoly price Average total cost A Demand Marginal cost Marginal revenue 0 Q 1 QMAX Q 2 Quantity

Profit Maximization • Comparing Monopoly and Competition – For a competitive firm, price equals marginal cost. P = MR = MC – For a monopoly firm, price exceeds marginal cost. P > MR = MC

A Monopoly’s Profit • Profit equals total revenue minus total costs. – Profit = TR - TC – Profit = (TR/Q - TC/Q) Q – Profit = (P - ATC) Q • The monopolist will receive economic profits as long as price is greater than average total cost.

Figure 15 -5: The Monopoly’s Profit Costs and Revenue Marginal cost E Monopoly price B Average total cost Monopoly profit Demand Average total cost D C Marginal revenue 0 QMAX Quantity

MONOPOLISTIC COMPETITION • Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.

MONOPOLISTIC COMPETITION • Types of Imperfectly Competitive Markets – Monopolistic Competition • Many firms selling products that are similar but not identical. • Markets that have some features of competition and some features of monopoly. – Oligopoly • Only a few sellers, each offering a similar or identical product to the others.

MONOPOLISTIC COMPETITION • Attributes of Monopolistic Competition – Many sellers – Product differentiation – Free entry and exit

MONOPOLISTIC COMPETITION • Many Sellers – There are many firms competing for the same group of customers. • Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc. • Product Differentiation – Each firm produces a product that is at least slightly different from those of other firms. – Rather than being a price taker, each firm faces a downward-sloping demand curve.

MONOPOLISTIC COMPETITION • Free Entry or Exit – Firms can enter or exit the market without restriction. – The number of firms in the market adjusts until economic profits are zero.

• The Monopolistically Competitive Firm in the Short Run – Short-run economic profits encourage new firms to enter the market. This: • Increases the number of products offered. • Reduces demand faced by firms already in the market. • Incumbent firms’ demand curves shift to the left. • Demand for the incumbent firms’ products fall, and their profits decline.

The Monopolistically Competitive Firm in the Short Run • The Monopolistically Competitive Firm in the Short Run – Short-run economic losses encourage firms to exit the market. This: • Decreases the number of products offered. • Increases demand faced by the remaining firms. • Shifts the remaining firms’ demand curves to the right. • Increases the remaining firms’ profits.

Figure 17 -1: Monopolistic Competitors in the Short Run (a) Firm Makes Profit (b) Firm Makes Losses Price MC MC ATC Average total cost Price Average total cost Losses Profit Demand MR MR Profitmaximizing quantity Quantity 0 Lossminimizing quantity Quantity

Monopolistic Competition Versus Perfect Competition • There are two noteworthy differences between monopolistic and perfect competition—excess capacity and markup.

Figure 17 -3: Monopolistic versus Perfect Competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price MC MC ATC Markup Price ATC Marginal cost P = MR P = MC Demand MR Quantity Efficient produced scale Quantity 0 Quantity produced = efficient scale Quantity