Perfect Competition and Monopoly

Perfect Competition
Conditions:
Large number of buyers and sellers
Homogeneous product
Perfect knowledge
Free entry and exit
No government intervention

Key Implications:
Flat firms demand determined by market equilibrium price
Market participants are price takers without any market power to
influence prices (have to charge MR = P = MC)
In the short run firms earn profits or losses or shut down
In the long run profit = normal = 0 (firms operate efficiently)
 Unrealistic? Why Learn?

Many small businesses are price-takers.

Decision rules for such firms are similar to
those of perfectly competitive firms
It is a useful benchmark
Explains why governments oppose monopolies
Illuminates the danger to managers of competitive
environments
Importance of product differentiation
Sustainable advantage
 Setting Price $ TR

Qf(units)
$ $
SM

Df = Pf = AR = MR
PM

DM

QM(106) Qf(units)
Market Firm
 Setting Output
To maximize total profit: T = TR - TC
FONC: dT /dQ = M = MR - MC = 0
In general (including monopoly) MR = MC.
In perfect competition MR = P = MC.

To maximize profit increase output (Q) until

1) MR = P = MC (at Q*), and
2) for Q > Q* => MC > MR
=> M < 0
=> TC < TR
or MC is increasing
 A Numerical Example
Given estimates of
P = $10
C(Q) = 5 + Q2
Optimal Price?
P = $10
Optimal Output?
MR = P = $10 = 2Q = MC
Q = 5 units
Maximum Profits?
PQ - C(Q) = 10(5) - (5 + 25) = $20
Profit > Normal
 Normal Profit
Normal profit is necessary for the firm to produce over
the long run and is considered a cost of production

Normal profit is required because investors expect a

return on their investment.

Profit < normal leads to exit in the long run.

Profit > normal leads to entry in the long run.

Profit = normal maintains the # of firms in the industry.

 Shut-Down Point
In the long run all cost must be recovered.
In the short run fixed cost incurred before
production begins and do not change regardless
of the level of production (even for Q = 0).
Shut down only if: TFC > T (total)
P < AVC (per unit).
TFC = AFC*Q = (SAC AVC)*Q
Operate with loss if: 0 > T > TFC (total)
SAC > P AVC (per unit).
This is the third T maximizing condition.
Shutdown
 Short-Run Supply
Under Perfect Competition
Effect of Entry on Market Price & Quantity

$ $
S
Entry S*

Pe Df
Pe* Df*

QM Qf
Market Firm

Short run profits leads to entry

Entry increases market supply, driving down the market price
and increasing the market quantity
Effect of Entry on Firms Output & Profit
LMC
$
LAC

Pe Df

Pe* Df*

QL Qf* Q

Demand for individual firms product and

hence its price shifts down
Long run profits are driven to zero
 Perfect Competition in the Long Run

Socially efficient output and price: MR = P = MC (no dead weight loss)

Efficient plant size: P = MC = min AC (all economies of scale exhausted)
Optimal resource allocation: T = Normal = 0, for P = MC = min AC
(opportunity cost = TR, lowered by free entry)
 Monopoly
Conditions:
Large number of buyers and one sellers
Product without close substitutes
Perfect knowledge
Barriers to entry
No government intervention

Key Implications:
Downward sloping firms demand is market demand
Firm has market power and determines market price
(can charge P > MR = MC)
In the short run monopoly earns profit or loss or shuts down
In the long run profit > normal is sustainable indefinitely but even
with profit = normal = 0 (monopoly does not operate efficiently)
 Sources of Monopoly Power
Natural:
Economies of scale and excess capacity
Economies of scope and cost complementarities
Capital requirements, sales and distribution networks
Differentiated products and brand loyalty

Created:
Patents and other legal barriers (licenses)
Tying and exclusive contracts
Collusion (tacit or open)
Entry limit pricing (predatory pricing illegal)
 Natural Monopoly
Economies of scale exist
over the entire LAC curve.
Price (cents per kilowatt-hour)

15 One firm distributes 4

million kWh at 5 a kWh.

This same total output costs

10 a kWh with two and
10 15 a kWh with four firms.

Natural monopoly: one firm

meets the market demand at
5 LAC a lower cost than two or
more firms.
D=P
Public utility commission
0 1 2 3 4 ensures that P = LAC (not P
associated with MR = MC),
Quantity (millions of kilowatt-hours) eliminating monopoly rent.
 Perfect Competition
Price
Consumer
surplus

S = MC > min AVC

PPC

Producer Efficient D = P = MR
surplus quantity

0 QPC Quantity
Inefficiency of Monopoly

Price
Consumer
surplus

S = MC > min AVC

PM
Deadweight
PPC loss
Monopoly
gain

MR Producer D=P
surplus

0 QM QPC Quantity
 Monopoly in the
Long Run with
Greater than Normal
and Normal Profit
Socially inefficient: P > MR = MC
(QM<QPC, PM>PPC, dead weight loss)
Scale inefficient: P > MC = min AC
(economies of scale still exist)
Misallocated resources: even when
T = normal = 0, P is still > min AC
(because of market power or barriers
to entry opportunity cost < TR)

Encouraged R&D, benefits from natural

monopolies, economies of scope and cost
complementarity might offset inefficiencies
 Synthesizing Example
C(Q) = 125 + 4Q2 => MC = 8Q is unaffected by market structure.
What are profit maximizing output & price, and their implications if

You are a price taker, other You are a monopolist with

firms charge $40 per unit? inverse demand P = 100 Q?

P = MR = 40 = 8Q = MC MR = 100 - 2Q = 8Q = MC

=> Q* = 5 and => Q* = 10 and

P* = 40 P* = 100 - Q = 100 - 10 = 90

Max T = TR - C(Q*) Max T = TR - C(Q*)

= 40(5) - (125+4(5)2) = 90(10) - (125+4(100))
= 200 - 225 = -$25 = 900 - 525 = $375

Expect exit in the long-run No entry until barriers eliminated