The Assumptions of Perfect Competition

• Large numbers of buyers and sellers
• Each individual firm sells a sufficiently small proportion of total market output, its decisions have no impact on market price
• Price taker Firm that has no influence over market price and thus takes the price as given
• Free entry and exit
• Free entry (or exit) Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry. Firms (suppliers) can easily enter or exit a market.
• Product Homogeneity
• When the products of all of the firms in a market are perfectly substitutable with one another—that is, when they are homogeneous—no firm can raise the price of its product above the price of other firms without losing most or all of its business.
• In contrast, when products are heterogeneous, each firm has the opportunity to raise its price above that of its competitors without losing all of its sales.

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• Perfect information

1

Profit Maximization

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• Recall the profit function: Π = TR(y) – TC(y)
• TC(y) = C(y) +FC , where C(y) is the minimized cost function
• TR(y) = Py
• P is a constant
• MR = P
• The only choice variable is output
• First Order Condition: MR=MC
• Implies that the supply curve is the same as the MC curve

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Short-Run Profit Maximization �

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• Profit is maximized at the output level where MR=MC.

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• If MR>MC, profits would increase if output were increased.
• If MR<MC, profits would increase if output were decreased.
• MR=P

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3

The Firm’s Supply Decision

P^e = MR

Q^f*

ATC

P^e

Profit = (P^e - ATC) × Q^f*

Should this Firm Sustain Short Run Losses or Shut Down?

ATC

P^e = MR

Q^f*

ATC

P^e

Profit = (P^e - ATC) × Q^f* < 0

Operating at a Loss in the Short-Run

• If ATC>P at the output-level where
• MC=MR =P=> profit is negative

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• Two choices:
• Temporarily shut-down
• Permanently go-out-of-business

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• Question: Which choice will yield smaller loss?

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Shutdown Decision Rule

Decision rule:

• A firm should shutdown when P < min AVC.
• Continue operating as long as P ≥ min AVC.

Firm’s Short-Run Supply Curve: MC Above Min AVC

Q^f*

P ^{min AVC}

8-9

A Competitive Firm’s Short-Run Supply Curve

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Short-Run Market Supply Curve

• The market supply curve is the summation of each individual firm’s supply at each price.

Firm 1

Firm 2

5

Market

Q

Q

Q

P

P

P

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8-11

Short-Run Industry Equilibrium

Market demand

Short-run industry�supply

p_s^e

Y_s^e

Y

Short-run equilibrium price clears the�market and is taken as given by each firm.

y₁

y₂

y₃

ATC

ATC

ATC

MC

MC

MC

y₁^*

y₂^*

y₃^*

p_s^e

Firm 1

Firm 2

Firm 3

y₁

y₂

y₃

ATC

ATC

ATC

MC

MC

MC

y₁^*

y₂^*

y₃^*

p_s^e

Firm 1

Firm 2

Firm 3

Firm 1 wishes�to remain in�the industry.

Firm 2 wishes�to exit from�the industry.

Firm 3 is�indifferent.

Π₁ > 0

Π₂ < 0

Π₃ = 0

Long-Run Industry Supply

• In the long-run every firm now in the industry is free to exit and firms now outside the industry are free to enter.
• The industry’s long-run supply function must account for entry and exit as well as for the supply choices of firms that choose to be in the industry.
• How is this done?

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

Suppose the industry initially contains�only two firms.

Mkt.�Supply

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

Then the market-clearing price is p₂.

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

y₂*

Then the market-clearing price is p₂.�Each firm produces y₂* units of output.

S²(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

y₂*

Π > 0

Each firm makes a positive economic�profit, inducing entry by another firm.

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

Market supply shifts outwards.

y₂*

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₂

p₂

Market supply shifts outwards.�Market price falls.

y₂*

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Each firm produces less.

y₃*

p₃

S²(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Each firm produces less.�Each firm’s economic profit is reduced.

y₃*

p₃

Π > 0

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Each firm’s economic profit is positive.�Will another firm enter?

y₃*

p₃

Π > 0

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Market supply would shift outwards again.

y₃*

p₃

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₃

Market supply would shift outwards again.�Market price would fall again.

y₃*

p₃

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₄

Each firm would produce less again.

y₄*

p₄

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₄

Each firm would produce less again. Each�firm’s economic profit would be negative.

y₄*

Π < 0

p₄

S⁴(p)

S³(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p₄

Each firm would produce less again. Each�firm’s economic profit would be negative.�So the fourth firm would not enter.

y₄*

Π < 0

p₄

Long-Run Industry Supply

• The long-run number of firms in the industry is the largest number for which the market price is at least as large as min ATC(y).

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• In the case of Perfect Competition each firm is really small and the number of firms is large, so P=min ATC(y)
• This implies that in a perfectly competitive market profits are zero

S(p)

Mkt. Demand

ATC(y)

MC(y)

y

A “Typical” Firm

The Market

p

p

Y

p’

y*

p’

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A long-run competitive equilibrium occurs when three conditions hold:

1. All firms in the industry are maximizing profit.
2. No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit.
3. The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by consumers.

The Long-Run Industry Supply Curve

• The long-run relationship between price and industry output

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• It depends on whether input prices are constant, increasing, or decreasing as the industry expands or contracts

33

The Long-Run Industry Supply Curve

• Constant-cost industry: an industry in which
• expansion of output does not bid up input prices
• long-run average production cost per unit remains unchanged, and
• the long-run industry supply curve is horizontal

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• Increasing-cost industry: an industry in which
• expansion of output leads to higher long-run average production costs
• the long-run industry supply curve slopes upward

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• Decreasing-cost industry: an industry in which
• the long-run industry supply curve slopes downward

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CONSTANT-, INCREASING-, AND DECREASING-COST INDUSTRIES: COFFEE, OIL, AND AUTOMOBILES

You have been introduced to industries that have constant, increasing, and decreasing long-run costs.

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The supply of coffee is extremely elastic in the long run. The reason is that land for growing coffee is widely available and the costs of planting and caring for trees remains constant as the volume grows. Thus, coffee is a constant-cost industry.

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The oil industry is an increasing cost industry because there is a limited availability of easily accessible, large-volume oil fields.

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Finally, a decreasing-cost industry. In the automobile industry, certain cost advantages arise because inputs can be acquired more cheaply as the volume of production increases.

The Industry’s Long-Run Supply Curve

Constant-Cost Industry

constant-cost industry Industry whose long-run supply curve is horizontal.

LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY

In (b), the long-run supply curve in a constant-cost industry is a horizontal line S_L. When demand increases, initially causing a price rise, the firm initially increases its output from q₁ to q₂, as shown in (a). But the entry of new firms causes a shift to the right in industry supply. Because input prices are unaffected by the increased output of the industry, entry occurs until the original price is obtained (at point B in (b)).

The long-run supply curve for a constant-cost industry is, therefore, a horizontal line at a price that is equal to the long-run minimum average cost of production.

The Industry’s Long-Run Supply Curve

Increasing-Cost Industry

increasing-cost industry Industry whose long-run supply curve is upward sloping.

LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY

In (b), the long-run supply curve in an increasing-cost industry is an upward-sloping curve S_L. When demand increases, initially causing a price rise, the firms increase their output from q₁ to q₂ in (a). In that case, the entry of new firms causes a shift to the right in supply from S₁ to S₂.

Because input prices increase as a result, the new long-run equilibrium occurs at a higher price than the initial equilibrium.

In an increasing-cost industry, the long-run industry supply curve is upward sloping.

• Monopoly – a market with a single seller
• Monopoly power – some ability to set price above marginal cost
• Price maker – a monopoly that supplies the total market and can choose any price along the market demand curve that it wants

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The Monopolist’s Demand and Marginal Revenue Curves

• Demand curve
• market demand
• average revenue
• Marginal revenue:
• effect on total revenue due to change in output
• decreases as output increases
• less than price when demand curve slopes downward

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39

The Monopolist’s AR Curve

40

Monopoly

AVERAGE AND MARGINAL REVENUE

Average and marginal revenue are shown for the demand curve �P = 6 − Q.

Average Revenue and Marginal Revenue

marginal revenue Change in revenue resulting from a one-unit increase in output.

Consider a firm facing the following demand curve: P = 6 − Q; MR is the derivative of TR with respect to Q

TOTAL, MARGINAL, AND AVERAGE REVENUE

Profit Maximizing in Monopoly

We can also see algebraically that Q* maximizes profit. Profit π is the difference between revenue and cost, both of which depend on Q:

As Q is increased from zero, profit will increase until it reaches a maximum and then begin to decrease. Thus the profit-maximizing Q is such that the incremental profit resulting from a small increase in Q is just zero (i.e., Δπ /ΔQ = 0). Then

44

Profit-Maximization: Total and Per-Unit Curves

45

Profit Maximization

46

Profit-Maximizing Output of a Monopoly

• Marginal revenue is always less than price when the demand curve slopes downward.

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• Profit is maximized where MR=MC:
• If MR>MC, then profits will increase if output is increased.
• If MR<MC, then profits will increase if output is decreased.

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47

Monopoly

An Example

EXAMPLE OF PROFIT MAXIMIZATION

Part (a) shows total revenue R, total cost C, and profit, the difference between the two.

Part (b) shows average and marginal revenue and average and marginal cost.

Marginal revenue is the slope of the total revenue curve, and marginal cost is the slope of the total cost curve.

The profit-maximizing output is Q* = 10, the point where marginal revenue equals marginal cost.

At this output level, the slope of the profit curve is zero, and the slopes of the total revenue and total cost curves are equal.

The profit per unit is $15, the difference between average revenue and average cost. Because 10 units are produced, total profit is $150.

Monopoly

With limited knowledge of average and marginal revenue, we can derive a rule of thumb that can be more easily applied in practice. First, write the expression for marginal revenue:

Note that the extra revenue from an incremental unit of quantity, Δ(PQ)/ΔQ, has two components:

• Producing one extra unit and selling it at price P brings in revenue (1)(P) = P.
• But because the firm faces a downward-sloping demand curve, producing and selling this extra unit also results in a small drop in price ΔP/ΔQ, which reduces the revenue from all units sold (i.e., a change in revenue Q[ΔP/ΔQ]).

Thus

Monopoly

(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand, 1/E_d, measured at the profit-maximizing output, and

Now, because the firm’s objective is to maximize profit, we can set marginal revenue equal to marginal cost:

which can be rearranged to give us

(10.1)

Equivalently, we can rearrange this equation to express price directly as a markup over marginal cost:

(10.2)

Monopoly Demand, Marginal Revenue, and Total Revenue

51

Monopoly Power

Measuring Monopoly Power

Remember the important distinction between a perfectly competitive firm and a firm with monopoly power: For the competitive firm, price equals marginal cost; for the firm with monopoly power, price exceeds marginal cost.

Lerner Index of Monopoly Power Measure of monopoly power calculated as excess of price over marginal cost as a fraction of price.

Mathematically:

This index of monopoly power can also be expressed in terms of the elasticity of demand facing the firm.

(10.4)

Monopoly Power

The Rule of Thumb for Pricing

FIGURE 10.8

ELASTICITY OF DEMAND AND PRICE MARKUP

The markup (P − MC)/P is equal to minus the inverse of the elasticity of demand.

If the firm’s demand is elastic, as in (a), the markup is small and the firm has little monopoly power.

The opposite is true if demand is relatively inelastic, as in (b).

The Social Costs of Monopoly Power

DEADWEIGHT LOSS FROM MONOPOLY POWER

The shaded rectangle and triangles show changes in consumer and producer surplus when moving from competitive price and quantity, P_c and Q_c, to a monopolist’s price and quantity, P_m and Q_m.

Because of the higher price, consumers lose A + B and producer gains A − C. The deadweight loss is B + C.

Monopolistic Competition and Oligopoly

Monopolistic Competition Market in which firms can enter freely, each producing its own brand or version of a differentiated product.

Oligopoly Market in which only a few firms compete with one another, and entry by new firms is impeded.

Price and Output Under Monopolistic Competition

• Monopolistic competition – a market characterized by:
• unrestricted entry and exit
• a large number of independent sellers producing differentiated products (substitute but not perfect)

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• Differentiated product – a product that consumers view as different from other similar products.

56

Determination of Market Equilibrium

• The demand curve facing each firm is downward-sloping but fairly elastic, reflecting a firm’s market power.

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• Differs from a monopoly:
• Firm demand curve is not the market demand.
• Entry into the market is not restricted.

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• Firms compete on product differentiation as well as price.

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• Long-run equilibrium:
• attained as a result of firms entering (or leaving) the industry in response to profit incentives.
• Price > MC
• zero economic profit

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57

Perfect Competition – Monopoly - Monopolistic Competition

Short-Run Monopolistic Competition

D

MR

Q^M

P^M

Profit

ATC

Quantity of Brand X

Long-Run Monopolistic Competition

D

MR

Q*

P*

Quantity of Brand X

MR¹

D¹

Entry

P¹

Q¹

Long Run Equilibrium

(P = AC, so zero profits)

8-60

Monopolistic Competition and Economic Efficiency

COMPARISON OF MONOPOLISTICALLY COMPETITIVE EQUILIBRIUM AND PERFECTLY COMPETITIVE EQUILIBRIUM

Under perfect competition, price equals marginal cost.

The demand curve facing the firm is horizontal, so the zero-profit point occurs at the point of minimum average cost.

Monopolistic Competition and Economic Efficiency

COMPARISON OF MONOPOLISTICALLY COMPETITIVE EQUILIBRIUM AND PERFECTLY COMPETITIVE EQUILIBRIUM

Under monopolistic competition, price exceeds marginal cost.

Thus there is a deadweight loss, as shown by the yellow-shaded area.

The demand curve is downward-sloping, so the zero profit point is to the left of the point of minimum average cost.

In both types of markets, entry occurs until profits are driven to zero.

Monopolistic Competition

Is monopolistic competition then a socially undesirable market structure that should be regulated? The answer—for two reasons—is probably no:

1. In most monopolistically competitive markets, monopoly power is small. Usually enough firms compete, with brands that are sufficiently substitutable, so that no single firm has much monopoly power. Any resulting deadweight loss will therefore be small. And because firms’ demand curves will be fairly elastic, average cost will be close to the minimum

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2. Any inefficiency must be balanced against an important benefit from monopolistic competition: product diversity. Most consumers value the ability to choose among a wide variety of competing products and brands that differ in various ways. The gains from product diversity can be large and may easily outweigh the inefficiency costs resulting from downward-sloping demand curves

Oligopoly

In oligopolistic markets, the products may or may not be differentiated.

What matters is that only a few firms account for most or all of total production.

In some oligopolistic markets, some or all firms earn substantial profits over the long run because barriers to entry make it difficult or impossible for new firms to enter.

Examples of oligopolistic industries include automobiles (in some countries), steel, aluminum, petrochemicals, electrical equipment, and computers.

Welfare Economics

• Welfare economics is the study of how the allocation of resources affects economic well-being.
• Buyers and sellers receive benefits from taking part in the market.
• The equilibrium in a market maximizes the total welfare of buyers and sellers.

Consumer Surplus

• Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.
• CS = MB - P

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Producer Surplus

• Producer surplus is the amount a seller is paid for a good minus the seller’s cost.
• PS = P – MC

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Social Welfare

• Social Welfare is defined as TS = CS + PS
• Recall
• CS = MB(buyers) – P
• PS = P – MC(sellers)
• =>TS = MB(buyers) – MC (sellers)

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• Efficiency is the property of maximizing the total surplus received by all members of society.

Competitive Equilibrium is Efficient

Excise Tax

• Per-unit tax on the sale of a given good

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• Question: Should we impose the tax on buyers or sellers?

Tax imposed on Buyers

Tax imposed on Sellers

Excise Tax

How the Tax Burden is Divided

Tax Revenue

Welfare Effects of Excise Tax

Welfare Effects of Excise Tax

International Trade

• Closed Economy
• Does not trade with other countries
• Domestic price P ≠ P_w (world price)
• Small Open Economy
• Trades with other countries
• But too small to have impact on the world price
• => P = P_w
• Import-Export Decision
• Import if P > P_w
• Export if P < P_w

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Exporting Small Open Economy

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Welfare Effects of Exports

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Importing Small Open Economy

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Welfare Effects of Imports

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Other Benefits of International Trade

• Increased Variety of Goods

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• Lower costs through Economies of Scale

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• Increased Competition

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• Flow of Ideas

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Arguments for Restricting Trade

• Destroys domestic jobs
• Yet it creates jobs abroad

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• National Security

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• Infant-Industry Protection
• Temporary protective policy in cases when a domestic industry is being restructured or is just starting to grow

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• Unfair Competition
• Foreign governments may be stimulating their domestic firms via tax breaks for example

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Tariff

• A tax on goods produced abroad and sold domestically (tax on imports)

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• Purpose: to stimulate more domestic production

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• Effect: create a gap between domestic and world price in an importing country

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Import Quota