Economics Notes: Monopoly, Perfect Competition, Monopolistic Competition, and Oligopoly

Monopoly

Monopoly and How It Arises

• A monopoly is a market that:
  • Produces a good or service with no close substitutes.
  • Has one supplier protected from competition by barriers to entry.

How Monopoly Arises

• Key features:
  • No close substitutes.
  • Barriers to entry.

No Close Substitutes

• A monopoly sells a good with no close substitutes, facing less competition.

Barriers to Entry

• Barriers to entry protect a firm from potential competitors.
• Three types:
  • Natural
  • Ownership
  • Legal

Natural Barriers to Entry

• Natural barriers lead to natural monopoly.
• A natural monopoly is a market where economies of scale allow one firm to supply the entire market at the lowest possible cost.
• One firm can produce 4 million units at 5 cents per unit, while two firms producing 2 million units each would cost 10 cents per unit.
• In a natural monopoly, economies of scale are achieved even when market demand is met; the LRAC curve slopes downward as it meets the demand curve.

Ownership Barriers to Entry

• An ownership barrier occurs when one firm owns a significant portion of a key resource (e.g., De Beers owning 90% of the world’s diamonds).

Legal Barriers to Entry

• Legal barriers create legal monopolies.
• A legal monopoly is a market where competition is restricted by:
  • Public franchise (e.g., U.S. Postal Service for first-class mail).
  • Government license (e.g., licenses for law or medicine).
  • Patent or copyright.

Monopoly Price-Setting Strategies

• To determine quantity sold, a monopoly firm must choose the appropriate price.
• Two types of strategies:
  • Single-price monopoly: Sells each unit at the same price to all customers.
  • Price discrimination: Sells different units at different prices.
• Many firms price discriminate, but not all are monopolies.

A Single-Price Monopoly’s Output and Price Decision

Price and Marginal Revenue

• A monopoly is a price setter, unlike firms in perfect competition.
• The demand for the monopoly’s output is the market demand; to sell more, it must lower the price.
• If a monopoly sets a price of $16 and sells 2 units.
• If the firm cuts the price to $14 to sell 3 units, it gains $14 of total revenue on the 3rd unit, so marginal revenue is $10$. The marginal revenue curve passes through the midpoint between 2 and 3 units at $10$.
• For a monopoly, marginal revenue is less than price (MR < P) at each quantity.

Marginal Revenue and Elasticity

• A single-price monopoly's marginal revenue is related to the elasticity of demand.
• If demand is elastic, a fall in price increases total revenue, and marginal revenue is positive.

Price and Output Decision

• Monopolies face the same technology constraints as competitive firms but a different market constraint.
• Monopolies produce the profit-maximizing quantity where marginal revenue equals marginal cost ($MR = MC$).
• The price is set at the highest level at which the profit-maximizing quantity can be sold.
• The monopoly maximizes profit by producing where total revenue minus total cost is greatest.
• A monopoly might make an economic profit even in the long run due to barriers to entry.
• A monopoly incurring an economic loss might shut down temporarily or exit the market in the long run.

Single-Price Monopoly and Competition Compared

Comparing Price and Output

• Compares price and quantity in perfect competition and monopoly
• Perfect Competition: Equilibrium occurs where quantity demanded equals quantity supplied at quantity QC and price PC.
• Monopoly: Equilibrium output (QM) occurs where marginal revenue equals marginal cost ($MR = MC$). Price is determined by the demand curve.
• Compared to perfect competition, monopoly produces less output and charges a higher price.

Efficiency Comparison

• Perfect competition is efficient where marginal social benefit equals marginal social cost ($MSB = MSC$).
• Monopoly is inefficient because price exceeds marginal social cost (P > MSC), so marginal social benefit exceeds marginal social cost (MSB > MSC), creating a deadweight loss.

Redistribution of Surpluses

• Some consumer surplus is transferred to the monopoly as producer surplus.

Rent Seeking

• Economic rent is any surplus (consumer, producer, or economic profit).
• Rent-seeking is pursuing wealth by capturing economic rent, either by:
  • Buying a monopoly (transfers rent to the creator).
  • Creating a monopoly (using resources in political activity).

Price Discrimination

Two Ways of Price Discriminating

• Discrimination:
  • Among groups of buyers (e.g., restrictions on airline tickets).
  • Among units of a good (e.g., quantity discounts, but not those reflecting lower costs).

A Price-Discriminating Airline

• A single-price airline sells 8,000 trips a week at $120, generating consumer and producer surplus.
• The airline has a producer surplus of $640,000$.

Monopoly Regulation

Regulation

• Rules administered by a government agency to influence prices, quantities, and entry.
• Two theories about how regulation works:
  *Social interest theory: Political and regulatory processes eliminate deadweight loss.
  *Capture theory: Regulation serves the self-interest of the producer, who captures the regulator/government to maximize economic profit by charging high prices.

Perfect Competition

What Is Perfect Competition?

• Many firms sell identical products to many buyers.
• No restrictions to entry.
• Established firms have no advantages over new ones.
• Sellers and buyers are well-informed about prices.

How Perfect Competition Arises

• The firm’s minimum efficient scale is small relative to market demand.
• Each firm produces a good or service with no unique characteristics (e.g., fruits, vegetables).

Price Takers

• Firms are price takers and cannot influence the market price.
• Each firm’s output is a perfect substitute for others, so demand is perfectly elastic.

Economic Profit and Revenue

• Each firm aims to maximize economic profit (total revenue minus total cost).
• Total cost includes the opportunity cost of production, including normal profit.
• Total revenue equals price (P) multiplied by quantity (Q): $P \times Q$.
• Marginal revenue is the change in total revenue from a one-unit increase in quantity sold.
• Market demand and supply determine the market price the firm must take.
• If the market price of a sweater is $25$, the firm sells 9 sweaters and makes total revenue of $225$.
• The firm can sell any quantity at the market price, so marginal revenue equals the market price.

The Firm’s Decisions

• Perfectly competitive firms maximize economic profit given constraints, deciding:
  1. How to produce at minimum cost.
  2. What quantity to produce.
  3. Whether to enter or exit the market.

The Firm’s Output Decision

• At low output, the firm incurs an economic loss due to fixed costs.
• At intermediate output, the firm makes an economic profit.
• At high output, the firm incurs an economic loss due to diminishing returns.
• The firm maximizes economic profit by producing 9 sweaters a day.

Marginal Analysis and Supply Decision

• Profit is maximized when marginal revenue (MR) equals marginal cost (MC).
• If MR > MC, economic profit increases if output increases.
• If MR < MC, economic profit decreases if output increases.
• If $MR = MC$, economic profit is maximized.

Temporary Shutdown Decision

• If the firm makes an economic loss, it must decide whether to exit or stay, and whether to produce or shut down temporarily.

Loss Comparisons

• Economic loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR):$\text{Economic loss} = TFC + TVC - TR = TFC + (AVC - P) \times Q$
• If the firm shuts down ($Q = 0$), it still pays TFC and incurs an economic loss equal to TFC.

The Shutdown Point

• The shutdown point is the price and quantity at which the firm is indifferent between producing and shutting down (at minimum AVC).
• At the shutdown point, the firm incurs a loss equal to TFC.
• Minimum AVC is $17$ a sweater; at this price, the profit-maximizing output is 7 sweaters a day, and the firm incurs a loss equal to the red rectangle.

Output, Price, and Profit in the Short Run

Market Supply in the Short Run

• The short-run market supply curve shows the quantity supplied by all firms at each price when the plant size and the number of firms are constant.
• At the shutdown price ($17$), some firms produce the shutdown quantity (7 sweaters), and others produce zero; the market supply curve is horizontal.

Short-Run Equilibrium

• Short-run market supply and demand determine the market price and output.

A Change in Demand

• An increase in demand shifts the curve rightward, increasing price and quantity.
• A decrease in demand shifts the curve leftward, decreasing price and quantity.

Profits and Losses in the Short Run

• Maximum profit is not always positive; compare ATC at the profit-maximizing output with the market price.
• If price equals ATC, the firm makes zero economic profit (breaks even).
• If price exceeds ATC, the firm makes a positive economic profit.
• If price is less than ATC, the firm incurs an economic loss.

Output, Price, and Profit in the Long Run

• In the short-run, a firm might make a profit, break even, or incur a loss.
• In long-run equilibrium, firms break even because firms can enter or exit the market.

Competition and Efficiency

Equilibrium and Efficiency

• In competitive equilibrium, resources are used efficiently where quantity demanded equals quantity supplied ($MSB = MSC$).
• Consumer surplus measures the gain from trade for consumers.
• Producer surplus measures the gain from trade for producers.
• Total surplus (the total gains from trade) is maximized in long-run equilibrium.

Efficiency in the Sweater Market

• Along the market demand curve ($D = MSB$), consumers are efficient.
• Along the market supply curve ($S = MSC$), producers are efficient.
• At market equilibrium, marginal social benefit equals marginal social cost, allocating resources efficiently and maximizing total surplus.

Monopolistic Competition

What is Monopolistic Competition?

• Market Structure with:
  • Large number of firms competing
  • Each firm produces a differentiated product
  • Firms compete on product quality, price and marketing
  • Firms are free to enter and exit the industry

Monopolistic Competition: Large Number of Firms

• Implies that:
  • Each firm has a small market share with limited power to influence price
  • Each firm is sensitive to the average market price
  • No one firm's actions directly affect the actions of others

Entry and Exit

• No barriers to entry exist. Cannot make an economic profit in the long run.
• Examples: audio/video equipment, clothing, jewelry, computers, and sporting goods.

Price and Output in Monopolistic Competition

Short-Run Output and Price Decision

• Firm produces profit-maximizing quantity where Marginal revenue equals Marginal cost ($MR = MC$).
• Price is the highest price the firm can charge for the profit-maximizing quantity
• Firm makes an economic profit when Price is greter than Average total cost (P > ATC
• Operates like a single-price monopoly.

Profit Maximizing Might Be Loss Minimizing

• A firm might incur an economic loss in the short run
• At the profit-maximizing quantity, Price less than Average total cost (P < ATC.

Long Run: Zero Economic Profit

• In the long run, economic profit induces entry as long as firms in the industry earn an economic profit ( As long as Price is greter than Average total cost (P > ATC).
• Maximizes its profit by producing the quantity at which marginal revenue equals marginal cost ($MR = MC$.
• As firms enter the industry, market share is lost.
• New firm entry decreases demand and lowers the maximum price that a rm can charge. Price and Quantity fall until $P = ATC$
• each firm earns zero economic profit in the long run.
• Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run.
• firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs

Oligopoly

What Is Oligopoly?

• A market structure where:
  • Natural or legal barriers prevent entry of new firms.
  • A small number of firms compete.

Barriers to Entry

• Natural Duopoly:
  • $ATC_1$ represents the average total cost curve for a single firm.
  • The lowest possible price is achieved at the minimum efficient scale of $ATC_1$.
  • Two firms can efficiently meet the market demand (D).

Small Number of Firms

• Interdependence: Each firm’s profit depends on the actions of other firms.
• Temptation to Cooperate: Oligopolies may form cartels to limit output, raise prices, and increase profit (illegal).

Oligopoly Games

What Is a Game?

• Game theory studies strategic behavior, considering others' expected behavior and interdependence.

The Prisoners’ Dilemma

• A scenario illustrating the complexities of strategic decision-making.

Rules

• Two prisoners, Art and Bob, are held separately and cannot communicate.
• If one confesses to a serious crime, he gets 1 year, while the accomplice gets 10 years.
• If both confess, each gets 3 years.
• If neither confesses, each gets 2 years for a minor crime.

Strategies

• Art and Bob each have two options:
  1. Confess.
  2. Deny.
• Possible outcomes:
  1. Both confess.
  2. Both deny.
  3. Art confesses and Bob denies.
  4. Bob confesses and Art denies.

Payoffs

• A payoff matrix shows the outcomes for each player's actions.

Outcome

• Rational choice leads to the best action given the other player’s action.
• Nash Equilibrium: An equilibrium where each player chooses the best action, given the actions of others.

The Dilemma

• Each prisoner knows it’s best if both deny, but it’s always in each one's interest to confess.

A Bad Outcome

• The Nash equilibrium is not the best outcome (both could get 2 years if they both denied), but rational self-interest prevents this.