BUSINESS ECONOMICS

Sessions 9 & 10: Market Structure Analysis I: Perfect Competition & Monopoly
2. 2.1 Post Work Learning Objectives In developing a framework for understanding the profit maximizing behaviour of firms under different market structures, this session has the following learning objectives: (i) to understand the managerial implications of profit maximization in a Competitive Market to highlight the effect of changes in demand and supply conditions on profit maximization in a Competitive Market to understand the managerial implications of profit maximization in a Monopoly Market.

(i)

(ii)

2.2 2.2.1

Summary Profit Maximization in a Competitive Market Market structure describes the competitive environment in the market for any good or service Competitive environment of a market is determined by three characteristics, namely, Number of Buyers / Sellers; Nature of the product (standardized or differentiated); and Entry conditions. As such, four broad market structures are defined: Perfect

Competition, Monopolistic, Oligopoly and Monopoly.

Under each of the above market structures, a business firms profit maximizing output and prices differ as the nature of the demand and supply curves vary. In a Perfectly Competitive Market, the price elasticity is infinity and therefore the demand curve is horizontal. But, in Monopolistic, Oligopoly and Monopoly markets the price elasticity is lower (as compared to Perfectly Competitive Market) and as such, the demand curve is downward sloping.

A business firms profits are maximized at prices where MR = MC. Since MR curve is derived from the firms demand curve and MC curve is the supply curve, changes in demand and supply factors will influence the profits earned by the firm.

In a Perfectly Competitive Market, Industry demand (downward sloping) and supply curves determine the equilibrium market price and quantity. The industry price is the firms price or demand curve. As there are a number of firms operating in this market, no single firm can influence the industry price by increasing or decreasing the quantity supplied. In other words, at the given industry price, the firm has to decide how much output to supply.

The profit maximizing output for a single firm would be where MR = MC: Since the price is given, the profits by a firm earned depends on the cost structure. The lower the AC curve relative to the price, the higher the profits earned. This would imply that cost efficient firms earn higher profits while cost inefficient firms incur losses.

2.2.2

Profit Maximization and Changes in Demand and Supply Conditions In a competitive market, positive economic profits attract firms into the industry. With more firms in the industry, the supply curve

shifts to the right.

With unchanging demand conditions, the

market price falls leading to a downward shift in the firms demand curve. Consequently, the firms economic profits fall

assuming unchanging cost structure. In case, economic losses characterize the industry, firms exit resulting in the leftward shift of the industry supply curve and a consequent rise in price. Thus, changes in supply conditions as also the changes in demand conditions influence the industry price which in turn, influences the profits of firms, given their cost structures. In the long run, the equilibrium price of the industry would be such that all firms would be earning only normal profits i.e. P = AC = MC.

2.2.3

Profit Maximization in Monopoly Market In a monopoly market, there is only one operating firm. As such, there is a single industry and firm demand curve which is downward sloping. This implies the firm can fix either price or quantity. Corresponding to the demand curve, the MR curve is derived with depicts the revenue implications of the changes in prices by the firm. Profits are maximized at Price where MR = MC. Since the equilibrium price is greater than MC, a monopoly firm generally earns supernormal profits. Profit maximizing monopoly firms are considered to be cost inefficient as they generally operate under excess capacity conditions (i.e. on the falling part of the AC curve). However, a 3

monopolist can earn higher profits if there are improvements in cost structure (i.e. downward shift in AC curve). Since the

entry/exit conditions are difficult, there could also be situations where monopolist can also incur economic losses.

2.3

Readings Handout 5: Competition & Monopoly Chapter 10: Text Book

2.4 1.

Learning Activity Explain why each of the following statements about profit-maximizing competitive firms is incorrect. Re-state each one correctly. a) A competitive firm will produce output up to the point where price equals average variable cost. A firms shutdown point comes where price is less than minimum average cost. A firms supply curve depends only on its marginal cost. Any other cost concept is irrelevant for supply decisions. The P=MC rule for competitive industries holds for upwardsloping, horizontal, and downward sloping MC curves. The competitive firm sets price equal to marginal cost.

b)

c)

d)

e) 2.

Interpret this dialogue: A: How can competitive profits be zero in the long run? Who will work for nothing?

B: It is only excess profits that are wiped out by competition. Managers get paid for their work; owners get a normal return on capital in competitive long-run equilibrium-no more, no less? 3. (a) If a competitive firm is in short-run equilibrium, must it also be in long-run equilibrium? (b) If a competitive firm is in long-run equilibrium, must it also be in short-run equilibrium?

4.

(a) Can a monopolist incur losses in the short run? Why? (b) Can a monopolist earning short-run profits increase those profits in the long run? Why? (c) Would an monopolist ever operate in the inelastic portion of the demand curve it faces? Why?