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MARKET TYPES ASSUMPTIONS STRUCTURE POSSIBILITIES COUSES EFFECTS
What Is A Competitive Market? A perfectly competitive market has the following characteristics: There are many buyers and sellers in the market. 2) The goods offered by the various sellers are the same (identical). 3) Firms can freely enter or exit the market. 4) Information is perfect. Buyers and sellers know all prices offered, . . . 1)
What Is A Competitive Market? As a result of these characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have no impact on the market price. Each buyer and seller takes the market price as given. Ex: Gasoline, fish, eggs, pencils, tomatoes, etc.
What Is A Competitive Market? Buyers and sellers must accept the price determined by the market. No single seller has market power (the power to influence the market price).
“Demand Faced By A Competitive Firm” versus “Market Demand” Price Pm Demand faced by one competitive firm QTY (ones) QTY (millions) Market Demand
The Revenue of a Competitive Firm Total revenue for a firm is the market price times the quantity sold. TR = P Q
Table 1 Total, Average, and Marginal Revenue for a Competitive Firm Copyright© 2004 South-Western
The Revenue of a Competitive Firm Marginal revenue is the change in total revenue when an additional unit is sold. MR = TR / Q
The Revenue of a Competitive Firm 1. Only in a competitive market, marginal revenue equals the price of the good. This is because a firm in a competitive market can sell as much as it wants at the constant market price. 2. If a monopolist or oligopolist sells more, this causes the price of the good to fall. Ex 1: Think of crude oil price and OPEC. Ex 2: Consider a downward sloping demand curve.
Profit Maximization and The Competitive Firm’s Supply Curve The goal of a competitive firm is to maximize profit. This means that the firm wants to produce the quantity that maximizes the difference between total revenue and total cost.
Table 2 Profit Maximization: A Numerical Example Copyright© 2004 South-Western
Profit Maximization and The Competitive Firm’s Supply Curve Profit maximization occurs at the quantity where marginal revenue equals marginal cost.
Profit Maximization And The Competitive Firm’s Supply Curve When MR > MC, profit is increasing, so must produce more. When MR < MC, profit is decreasing, so must produce less. When MR = MC, profit is constant, so this is the point where profit is maximized.
Figure 1 Profit Maximization for a Competitive Firm Costs and Revenue The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC MC 2 P = MR 1 = MR 2 P = AR = MR MC 1 0 Q 1 QMAX Q 2 Quantity Copyright © 2004 South-Western
Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve Price P 2 This section of the firm’s MC curve is also the firm’s supply curve. MC ATC P 1 AVC 0 Q 1 Q 2 Quantity Copyright © 2004 South-Western
The Firm’s Short-Run Decision to Shut Down A shutdown refers to a short-run decision to stop production temporarily because the firm’s revenue cannot even cover variable costs. Exit refers to a long-run permanent decision to leave the market. A firm exits the market if it makes negative economic profit in the long-term.
The Firm’s Short-term Decision to Shut Down The firm ignores its fixed costs (= sunk costs) when deciding to shut down or not in the short-term, but considers them when deciding whether to exit or not in the long-term. Fixed costs are costs that have already been committed and cannot be recovered in the short-term. example: rent and lease contracts.
The Firm’s Short-Run Decision to Shut Down The firm shuts down if its revenue is less than its variable costs: Shut down if TR < VC Shut down if TR / Q < VC / Q Shut down if P < AVC
Figure 3 The Competitive Firm’s Short Run Supply Curve Costs If P > ATC, the firm will continue to produce at a profit. Firm’s short-run supply curve MC ATC If P > AVC, firm will continue to produce in the short run. AVC Firm shuts down if P< AVC 0 Quantity Copyright © 2004 South-Western
The Firm’s Long-Run Decision to Exit or Enter a Market In the long run, a firm exits the market if the profit is negative. Exit if TR < TC if TR/Q < TC/Q if P < ATC A new firm Enters the market if profit is positive, or if: P > ATC
Figure 4 The Competitive Firm’s Long-Run Supply Curve Costs Firm’s long-run supply curve Firm enters if P > ATC MC = long-run S ATC Firm exits if P < ATC 0 Quantity Copyright © 2004 South-Western
THE SUPPLY CURVE IN A COMPETITIVE MARKET The competitive firm’s long-run supply curve is the part of its marginal-cost curve that lies above average total cost.
Figure 5 Profit as the Area between Price and Average Total Cost (a) A Firm with Profits Price MC ATC Profit P ATC P = AR = MR 0 Quantity Q (profit-maximizing quantity) Copyright © 2004 South-Western
Figure 5 Profit as the Area between Price and Average Total Cost (b) A Firm with Losses Price MC ATC P P = AR = MR Loss 0 Q (loss-minimizing quantity) Quantity Copyright © 2004 South-Western
FIRM VERSUS MARKET SUPPLY Market supply equals the sum of the quantities supplied by all firms in the market.
The Short Run: Market Supply with a Fixed Number of Firms For any given price, each firm supplies a quantity of output so that its marginal cost equals price. The market supply curve adds up the individual firms’ marginal cost curves.
Figure 6: SR Market Supply with a Fixed Number of Firms (a) Individual Firm Supply (b) Short Run Market Supply Price SR MC Supply $2. 00 1. 00 0 100 200 Quantity (firm) 0 100, 000 200, 000 Quantity (market) Copyright © 2004 South-Western
The Long Run: Market Supply with Entry and Exit Long run equilibrium is reached when there are no more entries or exits in the market. Firms will enter or exit the market until profit approaches to zero. Then longrun equilibrium happens when profit equals zero. Then at the long run equilibrium, price must be equal to the minimum of average total cost.
The Long Run: Market Supply with Entry and Exit Then long-run market supply curve is horizontal at price = min(ATC). At the long-run equilibrium, firms operate at their efficient scale (scale that minimizes ATC).
Figure 7 Market Supply with Entry and Exit (a) Firm’s Zero-Profit Condition (b) Long Run Market Supply Price SR MC Supply ATC LR P = minimum ATC Supply Demand, D 1 0 Quantity (firm) 0 Quantity (market) Copyright © 2004 South-Western
Why Do Competitive Firms Stay in Business If They Make Zero Profit? Remember that accounting (nominal) profit is positive even if economic profit is zero. The firm making zero economic profit means the firm is doing the best it can and there is no other alternative that will give better profit. If there was, current economic profit would be negative. See example in notes.
Exercise: A Shift in Demand Short Run and Long Run Consequences An increase in demand raises price and quantity in the short run. Firms earn profits because price now exceeds average total cost.
Figure 8 An Increase in Demand in the Short Run and Long Run (a) Initial Condition Market Firm Price MC ATC P 1 Short-run supply, S 1 P 1 A Long-run supply Demand, D 1 0 Quantity (firm) 0 Q 1 Quantity (market)
Figure 8 An Increase in Demand in the Short Run and Long Run (b) Short-Run Response Market Firm Price Profit MC ATC P 2 B P 2 P 1 S 1 A D 2 Long-run supply D 1 0 Quantity (firm) 0 Q 1 Q 2 Quantity (market) Copyright © 2004 South-Western
Figure 8 An Increase in Demand in the Short Run and Long Run (c) Long-Run Response Market Firm Price MC ATC P 1 B P 2 P 1 S 2 C A Long-run supply D 2 D 1 0 Quantity (firm) 0 Q 1 Q 2 Q 3 Quantity (market) Copyright © 2004 South-Western
Imperfect Market Imperfect competition is a market situation where individual firms have a measure of control over the price of the commodity in an industry. a firm that can affect the market price of its output can be classified as an imperfect competitor. Normally, imperfect competition arises when an industry's output is supplied only by one, or a relatively small number of firms.
Imperfect Market An imperfect market is a situation where individual firms have some measure of control or discretion over the price of the commodity in an industry This imperfect competition does not necessarily mean that a firm can arbitrarily put any price on its commodity an imperfect competitor does not have absolute power over price Aside from discretion over price, imperfect competitors may or may not have product differentiation/variation
Demand curve faced by firm The firm under an imperfect market faces the market demand curve or part of it. In either case, the firm faces a downward sloping demand curve This implies that if the firm wants to sell more, it should lower the price; if it wishes a higher price, he should restrict output. In contrast, a perfectly competitive firm, since it has no control over price, faces a horizontal demand curve.
Sources of market imperfection Imperfect competition often arises when an industry’s output is supplied by one or a small number of firms. This may be traced to the existence of barriers to entry and the existence of significant differences or advantages in cost conditions.
Barriers to Entry Barriers to entry – natural or artificial constraints that prevent other firms from entering the industry legal restrictions like patents and exclusive franchises; existence of advantages in cost conditions – demand for commodity may be too small, firm’s production function may exhibit increasing returns to scale (LAC curve shows economies of scale over all profitable output levels).
P Price MC k AC D Q 0 Quantity FIGURE 7. 2. Marginal cost and average cost curves of a firm in a natural monopoly relative to market demand. A natural monopoly arises when increasing returns to scale (decreasing average cost) makes most efficient plant size (at point k) large relative to market demand. In this case, the market can only support one firm in the industry. In the region of increasing returns, the marginal cost lies below the average cost.
Imperfect Markets Monopoly – market situation where a single seller exists and has complete control over an industry e. g. , Meralco is sole distributor of electric power in Metro Manila Oligopoly – market structure with few sellers; e. g. , cement and automobile industries, firms operating in an oligopolistic market situation may either collude or act independently Monopolistic competition – occurs when there are many sellers producing differentiated products firms have slight control over the price of the commodity and they advertise
The Truth Behind Monopolies being a monopolist does not ensure the firm instant profit; it is not true that the firm can impose any price it wants; maximum price is dictated by market demand; and a monopolist cannot maximize profit at the inelastic portion of the market demand curve.
Demand MR Curves of the Monopolist Price P D 0 Q MR Quantity FIGURE 7. 4. Demand marginal revenue curves faced by the monopolist. In contrast to perfectly competitive firms, the marginal revenue is lower than, not equal to, the price of the last unit sold. For the firm to sell one more unit of output, it must not only lower the price of the last unit but also reduce the price of all previous units. Thus, the additional revenue falls faster than the price.
Table 7. 1. Demand for output, P, TR and MR of a monopolist. Q P TR MR 0 200 0 - 1 198 198 2 196 392 194 3 194 582 190 4 192 768 186 5 190 950 182 6 188 128 178 7 186 1302 174 8 184 1472 170 9 182 1638 166 10 1800 162 11 178 1958 12 176 2112 154
Price and Marginal Revenue of a Monopolist Note that P MR, unlike pure competition. P is also the AR curve, hence as price drops, MR is less than price On a linear demand curve, MR decreases twice as fast as the demand curve.
Short-run Profit Maximization Firm will try to produce output that will maximize profit. Maximum profit is at the largest vertical difference between total revenue TR and total cost TC. At maximum vertical difference, slopes of TR and TC are equal, hence, MR=MC. Firm will produce (at MR=MC) unless price falls below AVC.
Table 7. 2. Profit-maximizing output of a monopolist Q P TR MR TC MC 0 200 0 - 500 - -500 1 198 198 589 89 -391 2 196 392 194 660 71 -268 9 182 1638 166 1168 114 470 10 1800 162 1330 162 470 11 178 1958 1550 220 408 12 176 2112 154 1850 300 262 13 174 2262 150 2262 412 0
TR, TC 4, 500 TC Total revenue, total cost 4, 000 3, 500 3, 000 TR 2, 500 2, 000 1, 500 1, 000 500 Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Quantity Total revenue and total cost curves of the monopolist. At output levels equal to 4 and 13, the monopolist breaks even; total cost equals total revenue. At output levels greater than 4 but less than 13, the monopolist makes a profit. At Q = 10, the firm maximizes its profits. FIGURE 7. 5.
The profit curve 600 500 400 300 Profits 200 100 0 -100 Q 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Q* -200 -300 -400 -500 -600 Quantity FIGURE 7. 6. Profit curve of the monopolist. The monopolist’s profit curve is bellshaped. At output levels less than and greater than the profit-maximizing level, Q*, total profits of the monopolist show a decline.
Profit Maximization: Per Unit Curves Any firm who aims to maximize profit will evaluate whether it pays to increase output or not. This is achieved by comparing MR with MC When added revenue is greater than added cost(MR>MC), the firm will increase output When added revenue is less than added cost(MR
Profit is maximum at Q* where MR=MC. Price will be set at P* as given by the demand curve. P MC AC P* Profit D=AR 0 Q Q* MR
Is MC curve the supply curve? Note: the MC curve of the monopolist does not reflect the short run supply curve since the monopolist does not produce output at the levels where MC = P It produces output at MR=MC to maximize profit. But MR is always less than P.
Does a monopolist always make a profit? P MC AC P* Loss No! D=AR 0 Q Q* MR
Inefficiency of a monopolist The price set by monopolist is greater compared to that under pure competition. Hence some consumers are unable to purchase the commodity implying some welfare loss The level of output under monopoly is lower compared to that under pure competition.
Consumer surplus Price The demand curve shows the maximum willingness to pay by consumers. The price line shows what consumers have to pay. Consumer surplus P 0 D Q 0 Quantity
Producer surplus Price The supply curve shows what firms have to recover in costs to continue to produce. . S The price line shows what firms receive. P 0 Producer surplus D Q 0 Quantity
Deadweight loss in monopoly P F MC A Price P* E AC B G C D 0 Q* Q MR Quantity FIGURE 7. 8. Deadweight loss. The area ABC represents the decline in total welfare (the reduction in both consumer surplus and producer surplus) associated with a monopoly. ABC is the deadweight loss.
Regulation of a monopoly Lump sum tax –is a fixed amount of tax levied on a producer The tax increases the firm’s fixed cost but not the variable cost The firm’s marginal cost is not affected (does not change) The change in fixed cost however affects total cost and average cost Specific tax – is a tax proportional to level of output produced. Affects the firm’s variable cost, average cost and marginal cost Price regulation – a set price imposed by the government to enhance the welfare of the consumers, a regulatory body can impose a price equal to MC.
P MC Price (in pesos) P* e h ACLST a g AC b f c D 0 Q* Q MR Quantity FIGURE 7. 9. Lump sum tax regulation. The imposition of a lump sum tax affects only the average cost of the firm. It is borne completely by the monopolist and has no effect at all on the firm’s level of output and price.
P MCST Price MC PST P* a ACST b i e c j m AC h f g k D 0 QST Q* Q MR Quantity FIGURE 7. 10. Specific tax regulation. The imposition of a specific tax affects both the average cost and the marginal cost of the firm. As a result, the monopolist increases the price of the commodity while decreasing the amount of the output it produces. Thus, the deadweight loss increases.
P MC a Price (in pesos) P* PMC b c e AC h f g MR 0 Q* D Q QMC Quantity FIGURE 7. 11. Price regulation. Under price regulation, the optimal levels of price and output are determined by the intersection of the demand curve and the marginal cost curve. The deadweight loss is transformed into a net welfare gain for society.
A Summary of Market Structures 63
Managerial Economics & Business Strategy Basic Oligopoly Models
9 -65 Oligopoly Environment Relatively few firms, usually less than 10. Duopoly - two firms Triopoly - three firms The products firms offer can be either differentiated or homogeneous. Firms’ decisions impact one another. Many different strategic variables are modeled:
Market Structure The number of firms, price, profits, and other properties of markets vary, depending on whether the market is monopolistic, oligopolistic, monopolistically competitive, or competitive Game Theory When there are relatively few firms in a market, firms take in to account how their actions affect other firms and how other firms action affect them. Economist use a set of tools called game theory to analyze conflicts and cooperation between them. Cooperative oligopoly models If firms successfully coordinate their actions, they can collectively behave like a oligopoly The group of firms that explicitly agree to coordinate their activities is called a Cartel. These firm may agree on how much each firm will sell or on a common price, by cooperating and behaving like a monopoly, The members of a Cartel collectively earn monopoly profit- the maximum possible profit. OPEC is the best example of Cartel Model
Non-cooperative Oligopoly How explain Oligopoly if they behave Independently Sweezy (Kinked-Demand) Model Nash equilibrium Cournot Model Bertrand Model Stackelberg Model
Non-cooperative Oligopoly Your actions affect the profits of your rivals. Your rivals’ actions affect your profits. How will rivals respond to your actions?
An Example You and another firm sell differentiated products. How does the quantity demanded for your product change when you change your price?
P D 2 (Rival matches your price change) PH P 0 PL D 1 (Rival holds its price constant) QH 1 QH 2 Q 0 QL 2 QL 1 Q
“Kinked” Demand Curve P Where do p* and q* come from? Elastic p* Inelastic D or d Q* or q* Q or q
Cournot Model Market in which firms sets its output simultaneously and let the market determine the price Cournet models explain how oligopoly firms behave if they choose how much to produce at the same time. Air line example two air lines other cannot obtain landing rights, both airports. How many passengers does each airline choose to carry? To answer this question we determine the Nash equilibrium for this model, the Nash equilibrium in which firm choose quantities is also called a Cournet equilibrium.
Stackelberg Model In the Curnet model, both firms make their output decisions at the same time. In a Stakelberg model leader firm chooses its output level before its identical rivals. Market out put is greater than if firms choose their output simultaneously, and a leader makes higher profit than the other firm. Naturally if one firm enter the market before another He get the more benefit. Bertrand Model Bertrand argued that oligopolies set prices, and then consumers decide how many units to buy. The resulting Nash equilibrium is called a Bertrand equilibrium.
Four Market Structures The focus of this lecture is the four market structures. Students will learn the characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Using the cost schedule from the previous lecture, the idea of profit maximization is explored. OBJECTIVES 1. Identify various market structures and their characteristics. 2. Be able to category firms into four market structures. 3. Describe the effects of imperfect competition upon the market and the firm. 4. Understand the pricing structure of the four structures. TOPICS Please read all the following topics. PERFECT COMPETITION CONT. PERFECT COMPETITION EXAMPLE PURE MONOPOLY EXAMPLE PRICE DISCRIMINATION MONOPOLISTIC COMPETITION OLIGOPOLY TECHNOLOGICAL DEVELOPMENT ECONOMIC EFFICIENCY
Perfect Competition Pure or perfect competition is rare in the real world, but the model is important because it helps analyze industries with characteristics similar to pure competition. This model provides a context in which to apply revenue and cost concepts developed in the previous lecture. Examples of this model are stock market and agricultural industries. Characteristics 1. Many sellers: there are enough so that a single seller’s decision has no impact on market price. 2. Homogenous or standardized products: each seller’s product is identical to its competitors’. 3. Firms are price takers: individual firms must accept the market price and can exert no influence on price. 4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry. Demand The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears that way to the individual firms, since they must take the market price no matter what quantity they produce. Therefore, the firm’s demand curve is a horizontal line at the market price. Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output. Since the price is constant in the perfect competition. The increase in total revenue from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect competition.
Profit-Maximizing Output Short Run Analysis In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting output. Firms should produce if the difference between total revenue and total cost is profitable (EP >0), or if the loss is less than the fixed cost (EP>- FC). The firm should not produce, but should shut down in the short run if its loss exceeds its fixed costs. By shutting down, its loss will just equal those fixed costs. Fixed cost in real life would be rent of the office, business license fees, equipment lease, etc. These cost would have to be paid with or without any output. Therefore, fixed cost would be the loss of shut down at any time. If by producing one unit of output, this loss could be lowered, then this unit should be produced to minimize the loss. However, if by producing one unit of output, this loss would be higher , then this unit should not be produced. The firm should shut down, just pay for the fixed cost. If EP< - FC firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < - FC, market price, P, must be lower than the minimum AVC. If EP> - FC, firm should produce. That is when market price is greater than minimum AVC. Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output. If MR > MC, then the firm should continue to produce. If MR = MC, then the firm should stop producing the additional unit. As the additional unit’s MC would be higher according to law of diminishing returns, MR would be less than MC; that is, the firm would loss profit by producing additional units. Therefore, this is the profit maximizing output level. If MR < MC, then the firm should lower its output. In conclusion: The shutdown point is the level of output and price at which the firm just covers its total variable cost. If the MR of the product is less than the minimum average variable cost (min AVC), the firm will shut down because this action minimizes the firm’s loss. In this case, the firm’s economic loss equals its total fixed costs. If MR < min AVC, then each additional unit produced would increase the loss. For pure competition, MR is equal to price as the firm is facing a perfectly elastic demand. Therefore, for short run, if Price < min AVC, then the firm should shut down. If Price > min AVC, then the firm should produce. Price and MC are compared to find the profit maximizing or loss minimizing output level. The supply curve of the pure competition firms would be the portion of the MC curve above the min AVC. 1. If EP < - FC or Market P < Min AVC, firm should shut down. Output = 0 , and EP = -FC
Perfect Competition Cont. Following the rules discussed in the previous section. Here is an example. Firms fixed cost is $100, its min AVC is $55. If market price is 50 which is less than min AVC, the firm would loss $5 more by producing each unit. If the firm produces one unit, its total loss would be $5 plus $100 fixed cost. If the firm decides to shut down, its loss would be only $100 as the firm does not need to pay for the variable cost. Shut down would be the loss minimization strategy. If the market price is 60, the firm would lose $5 less by producing each unit. If the firm produces one unit, its total cost would be fixed cost less $5, which is $95. The firm is better off by producing, not shutting down. When the market price is higher than the minimum AVC, MR and MC should be compared to find out the optimal level of output. Long Run Analysis Obviously, the firm cannot be in loss for long. Three assumptions are made for the long run analysis: 1. Entry and exit are the only long run adjustments. 2. Firms in the industry have identical cost curves. 3. The industry is in constant return to scale. In long run, if economic profits are earned, firms enter the industry, which increases the market supply, causing the product price to go down. Until zero economic profits are earned, then the supply will be steady. If losses are incurred in the short run, firms will leave the industry which decreases the market supply, causing the product price to rise until losses disappear. This model is one of zero economic profits in long run. The long run equilibrium is achieved, the product price will be exactly equal to, and production will occur at, each firm’s point of minimum average total cost.
Efficiency Analysis 1. Productive efficiency: occurs where P= min ATC. Perfect competitive firms will achieve productive efficiency as firms must use the least-cost technology or they won't survive. 2. Allocative efficiency: occurs where P = MC. Price represent the benefit that society gets from additional units of a product, MC represents the cost to society of other goods given up to produce this product. Dynamic adjustments will occur in this market structure when changes in demand, supply or technology occurs. Perfect competitive firms will achieve this efficiency. Since no explicit orders are given to the industry, "the Invisible Hand" works in this system. Even though both efficiencies are achieved in this system, the consumers are facing standard products, making shopping to be no fun at all. On the other hand, the consumers will receive the highest consumer surplus in this structure as the long run market price will be at the min ATC. Producers will receive the lowest producer surplus as consumers can easily find substitutes.
An Example The following data represents a cost function of a perfect competitive firm: TP or Q AFC AVC ATC MC 0 1 60 45 105 45 2 30 42. 5 72. 5 40 3 20 40 60 35 4 15 37. 5 52. 5 30 5 12 37 49 35 6 10 37. 5 40 7 8. 57 38. 57 47. 14 45 8 7. 5 40. 63 48. 13 55 9 6. 67 43. 33 50 65 10 6 46. 5 52. 5 75 If the market price, P < 37; this firm's output Q = 0; firm's economic profit, EP = -60 If the market price, P > 37, this firm's output Q > 0; firms' economic profit , EP= TR - TC. For example, when P = 65, Q = 9, EP = $65 x 9 - 50 X 9 = 135
An Example Cont. By given the market demand at various price level, a market equilibrium price could be found. TP or Q AFC AVC ATC MC 0 1 60 45 105 45 2 30 42. 5 72. 5 40 3 20 40 60 35 4 15 37. 5 52. 5 30 5 12 37 49 35 6 10 37. 5 40 7 8. 57 38. 57 47. 14 45 8 7. 5 40. 63 48. 13 55 9 6. 67 43. 33 50 65 10 6 46. 5 52. 5 75 One firm's output level (column 2 in the above table) is obtained by comparing P and MC. Since all firms are having the same cost function, the market output level is the sum of individual firms' output (column 4 in the above table). By comparing the market supply and market demand, we can find the market equilibrium at: P= 46 and Q = 10500 At this level, each firm is losing 8 dollars, indicating a contraction in this industry. Some firms may leave in the long run, causing the market supply to decrease and equilibrium price will increase to the break-even level. PRICE Qs (1 firm's output) PROFIT Qs(1500 firms in the market) / market supply Qd / market demand 26 0 -60 0 17000 32 0 -60 0 15000 38 5 -55 7500 13500 41 6 -39 9000 12000 46 7 -8 10500 56 8 63 12000 9500 66 9 144 13500 8000 (assuming identical cost function for all firms)
Pure Monopoly Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Examples are public utilities and professional sports leagues. Characteristics 1. A single seller: the firm and industry are synonymous. 2. Unique product: no close substitutes for the firm’s product. 3. The firm is the price maker: the firm has considerable control over the price because it can control the quantity supplied. 4. Entry or exit is blocked. Barriers to Entry Economies of scale is the major barrier. This occurs where the lowest unit cost and, therefore, low unit prices for consumers depend on the existence of a small number of large firms, or in the case of monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. Public utilities are known as natural monopolies because they have economies of scale in the extreme case. More than one firm would be inefficient because the maze of pipes or wires that would result if there were competition among water companies or cable companies. Legal barriers also exist in the form of patents and licenses, such as radio and TV stations. Ownership or control of essential resources is another barrier to entry, such as the professional sports leagues that control player contracts and leases on major city stadiums. It has to be noted that barrier is rarely complete. Think about the telephone companies a couple decades ago; there was no substitute for the telephone. Nowadays, cellular phones are very popular. It creates a substitute for your house phone, causing the traditional telephone companies to lose their monopoly position. Demand Curve Monopoly demand is the industry or market demand is therefore downward sloping. Price will exceed marginal revenue because the monopolist must lower price to boost sales and cannot price discriminate in most cases. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output. The marginal revenue curve is below the demand curve.
Profit –Maximizing Output & Efficiency Profit –Maximizing Output: The MR = MC rule will still tell the monopolist the profit – maximizing output. The monopolist cannot charge the highest price possible, it will maximize profit where TR minus TC is the greatest. This depends on quantity sold as well as on price. The monopolist can charge the price that consumers will pay for that output level. Therefore, the price is on the demand curve. Losses can occur in monopoly, although the monopolist will not persistently operate at loss in the long run. Monopolies will sell at a smaller output and charge a higher price than would pure competitive producers selling in the same market. Income distribution is more unequal than it would be under a more competitive situation, unless the government regulates the monopoly and prevents monopoly profits. If a monopoly creates substantial economic inefficiency and appears to be long-lasting, antitrust laws could be used to break up the monopoly. Efficiency: 1. Productive efficiency: occurs where P= min ATC. Monopoly firms will not achieve productive efficiency as firms will produce at an output which is less than the output of min ATC. X-inefficiency may occur since there is no competitive pressure to produce at the minimum possible costs. 2. Allocative efficiency: occurs where P = MC. This efficiency is not achieved because price( what product is worth to consumers) is above MC (opportunity cost of product). It is possible that monopoly is more efficient than many small firms. Economies of scale (natural monopoly) may make monopoly the most efficient market model in some industries. However, X-inefficiency and rent-seeking cost (lobbying, legal fees, etc. ) can entail substantial costs, causing inefficiency. Producer surplus is significant due to lack of competition, consumer surplus may be minimized. This market structure will not contribute to a fair income distribution of our society.
An Example In this example, the cost function is the same as the one used in the perfect competition example. You can see from the following analysis that the output level and market price are different in monopoly. The output level is lower than output of the perfect competitive firm; and price is higher than the price of perfect competitive firm. TP or Q AFC AVC ATC MC 0 1 60 45 105 45 2 30 42. 5 72. 5 40 3 20 40 60 35 4 15 37. 5 52. 5 30 5 12 37 49 35 6 10 37. 5 40 7 8. 57 38. 57 47. 14 45 8 7. 5 40. 63 48. 13 55 9 6. 67 43. 33 50 65 10 6 46. 5 52. 5 75 Pd Qd TR MR EP 115 1 100 -5 83 2 166 66 21 71 3 213 47 33 63 4 252 39 42 55 It is possible for this firm to continue earning this profit in the long run as there are no competition in the market. 0 100 By comparing the MR and MC unit by unit, we can find this firm's output at: Q = 4, and P= 63. This is the profit maximization output level, with EP = 42. 0 0 5 275 23 30 48 6 288 13 3 42 7 294 6 -35. 98 37 8 296 2 -89. 04 33 9 297 1 -153 29 10 290 -7 -235
Price Discrimination Price discrimination is selling a good or service at a number of different prices, and the price differences is not justified by the cost differences. In order to price discriminate, a monopoly must be able to 1. be able to segregate the market 2. make sure that buyers cannot resell the original product or services. Perfect price discrimination is a price discrimination that extracts the entire consumer surplus by charging the highest price that consumer are willing to pay for each unit. As a result, the demand curve becomes the MR curve for a perfect price discriminator. Firms capture the entire consumer surplus and maximize economic profit.
Monopolistic Competition Monopolistic competition refers to a market situation with a relatively large number of sellers offering similar but not identical products. Examples are fast food restaurants and clothing stores. Characteristics 1. A lot of firms: each has a small percentage of the total market. 2. Differentiated products: variety of the product makes this model different from pure competition model. Product differentiated in style, brand name, location, advertisement, packaging, pricing strategies, etc. 3. Easy entry or exit. Demand Curve The firm’s demand curve is highly elastic, but not perfectly elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes; it is less elastic than pure competition, because the seller’s product is differentiated from its rivals.
Profit - Maximizing Output The MR = MC rule will give the firms the profit – maximizing output. The price they charge would be on the demand curve. In the long run, the situation will tend to be breaking even for firms. Firms can enter the industry easily and will if the existing firms are making an economic profit. As firms enter the industry, the demand curve facing by an individual firm shift down, as buyers shift some demand to new firms until the firm just breaks even. If the demand shifts below the break-even point, some firms will leave the industry in the long run. Therefore, most monopolistic competitive firms should experience break-even in the long run theoretically. In reality, some firms experience profit as they able to distinguish themselves from the others and build a loyal customer base; such as some name brand apparel companies. Some firms experience lost in long run but may continue the business as they are still earning normal profit. These firm owners usually like the flexible life style and willing to earn a normal profit that is lower than their opportunity cost. Price exceeds marginal cost in the long run, suggesting that society values additional units which are not being produced. Average costs may also be higher than under pure competition, due to advertising cost involved to attract customers from competitors. The various types, styles, brands and quality of products offers consumers choices. However, economic inefficiency is the result. The excess capacity (producing at the quantity that a firm produces is less than the quantity at which ATC is a minimum) exists in this industry.
Oligopoly exits where few large firms producing a homogeneous or differentiated product dominate a market. Examples are automobile and gasoline industries. Characteristics 1. Few large firms: each must consider its rivals’ reactions in response to its decisions about prices, output, and advertising. 2. Standardized or differentiated products. 3. Entry is hard: economies of scale, huge capital investment may be the barriers to enter. Demand Curve Facing competition or in tacit collusion, oligopolies believe that rivals will match any price cuts and not follow their price rise. Firms view their demands as inelastic for price cuts, and elastic for price rise. Firms face kinked demand curves. This analysis explains the fact that prices tend to be inflexible in some oligopolistic industries.
Efficiency & Advertisement 1. Productive efficiency: occurs where P= min ATC. Monopolistic competitive firms will not achieve productive efficiency as firms will produce at an output which is less than the output of min ATC. Product differentiation is the major cause of excess capacity. 2. Allocative efficiency: occurs where P = MC. This efficiency is not achieved because price( what product is worth to consumers) is above MC (opportunity cost of product). Advertisement is very crucial for each firm in this market structure as firms need exposure to get consumer's attention. However, too much spending will result in higher cost, and lower profit. Price, product attributes, and advertisement are three main factors that producers have to consider. The perfect combination cannot be forecasted easily.
Game Theory & Cartel Game theory suggests that collusion is beneficial to the participating firms. Collusion reduces uncertainty, increases profits, and may prohibit entry of new rivals. Consider the following payoff matrix in which the numbers indicate the profit in millions of dollars for a duopoly (GM and Ford) based on either a high-price or a low-price strategy. This example illustrated that GM or Ford will earn the highest individual profit when each adopts low price strategy while other firm continues with the higher price strategy (in B or C). But firms will earn the highest total profit when both adopt the high price strategy (A). When firms form a cartel, they are acting as one entity (A). They will perform as they are a large monopoly, earning the highest total profit possible. However, members do have an incentive to cheat as individuals can increase their own profits by cheating in short run (B or C). When other members are aware of the cheating, they may carry out the same practice, sometimes it may result in a price war and all members loss (D). Duopoly GM Ford High-price Low-price Profit Analysis High-price A: GM=$50 M Ford=$50 M C: GM=$20 M Ford=$60 M Low-price B: GM=$60 M Ford=$20 M D: GM=$30 M Ford=$30 M GM Profit Earns $50 M Ford Profit Earns $50 M Total profit in the industry $50 + $50 =$100 M B: GM lowers price and Ford continues with high price strategy Increased to $60 M Dropped to $20 M $60 + $20 =$80 M C: Ford lowers price and GM continues with high price strategy Dropped to $20 M Increased to $60 M $20 + $60 =$80 M D: Both firms adopt low price strategy Earns $30 M $30 + $30 =$60 M A: Both firms adopt high price strategy The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries agreed on the output amount and working together to control the world’s crude oil supply. In US, anti-trust law has set up guidelines for corporations to follow to avoid collusion of large firms in the same industry and protect consumer rights.
Technological Development Technological advance is a three-step process that shifts the economy‘s production possibilities curve outward enabling more production of goods and services. 1. Invention: is the discovery of a product or process and the proof that it will work. 2. Innovation: is the first successful commercial introduction of a new product, the first use of a new method, or the creation of a new form of business enterprise. 3. Diffusion: is the spread of innovation through imitation or copying. Expenditures on research and development (R&D) include direct efforts by business toward invention, innovation, and diffusion. Government also engages in R&D, particularly for national defense. Finding the optimal amount of R&D is an application of basic economics: marginal benefit and marginal cost analysis. Optimal R&D expenditures occur when the interest rate cost of funds is equal to the expected rate of return. Many projects may be affordable but not worthwhile because the marginal benefit is less than marginal cost. Often the R&D spending decision is complex because the estimation of future benefits is highly uncertain while costs are immediate and more clear-cut.
The Role of Market Structure 1. Pure competition: the small size of competitive firms and the fact hat they earn zero economic profit in the long run leads to serious questions as to whether such producers can finance substantial R&D programs. The firms in this market structure would spend no significant amount. However, firms of the same industry may gather their resources and develop R&D programs. 2. Monopolistic competition: there is a strong profit incentive to engage in product development in this market structure as the firms depend on product differentiation to stand out from a large number of rivals. However, most firms remain small which limits their ability to secure inexpensive financing for R&D and any economic profits are usually temporary. Therefore, spending on R&D is limited in this market structure. 3. Oligopoly: many of the characteristics of oligopoly are conducive to technical advances including: their large size, ongoing economic profits, the existence of barriers to entry and a large volume of sales. Firms in oligopoly spent the highest amount on R&D among the four different market structures. 4. Pure monopoly: monopoly has little incentive to engage in R&D as the profit is protected by absolute barriers to entry, the only reason for R&D would be defensive – to reduce the risk of a new product or process which would destroy the monopoly.
Economic Efficiency Economics is a science of efficiency in the use of scarce resources. Efficiency requires full employment of available resources and full production. Full employment means all available resources should be employed. Full production means that employed resources are providing maximum satisfaction for our material wants. Full production implies two kinds of efficiency: 1. Allocative efficiency means that resources are used for producing the combination of goods and services most wanted by society. For example, producing computers with word processors rather than producing manual typewriters. 2. Productive efficiency means that least costly production techniques are used to produce wanted goods and services. Full efficiency means producing the "right" (Allocative efficiency) amount in the "right "way (productive efficiency). Pure competition: Productive efficiency occurs where price is equal to minimum average total cost (min ATC); at this point firms must use the lease-cost technology or they won’t survive. Under pure competition, this outcome will be achieved, as the long run equilibrium price of pure competitive firms would be at the min ATC. Allocative efficiency occurs where price is equal to marginal cost ( P=MC), because price is society’s measure of relative worth of a product at the margin or its marginal benefit. And the marginal cost of producing product X measures the relative worth of the other goods that the resources used in producing an extra unit of X could otherwise have produced. In short, price measures the benefit that society gets from additional units of good X, and the marginal cost of this unit of X measures the sacrifice or cost to society of other goods given up to produce more of X. Under pure competition, this outcome will be achieved. Dynamic adjustments will occur automatically in pure competition when changes in demand or in resources supply, or in technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P=MC occurs.
Efficiency Cont. Non-perfect competition: Price of non-perfect competitive firms will exceed marginal cost, because price exceeds marginal revenue and the firms produce where marginal revenue (MR) and marginal cost are equal. Then the firms can charge the price that consumers will pay for that output level. Allocative efficiency is not achieved because price (what product is worth to consumers) is above marginal cost (opportunity cost of product). Ideally, output should expand to a level where P=MC, but this will occur only under pure competitive conditions where P = MR. Productive efficiency is not achieved because the firms’ output is less than the output at which average total cost is minimum. Economies of scale (natural monopoly) may make monopoly the most efficient market model in some industries. Xinefficiency, the inefficiency that occurs in the absence of fear of entry and rivalry, may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain government –granted monopoly privileges. Such rent-seeking may entail substantial cost (lobbying, legal fees, public relations advertising etc. ) which are inefficient. There are several policy options available when monopoly creates substantial economic inefficiency: 1. Antitrust laws could be used to break up the monopoly if the monopoly’s inefficiency appears to be long-lasting. 2. Society may choose to regulate its prices and operations if it is a natural monopoly. 3. Society may simply ignore it if the monopoly appears to be short-lived because of changing conditions or technology. Efficiency Vs technological advances: Allocative efficiency is improved when technological advance involves a new product that increases the utility consumers can obtain from their limited income. Process innovation can lower production cost and improve productive efficiency. Innovation can create monopoly power through patents or the advantages of being first, reducing the benefit to society from the innovation. Innovation can also reduce or even disintegrate existing monopoly power by providing competition where there was none. In this case economic efficiency is enhanced because the competition drives prices down closer to marginal cost and minimum average total cost.