Perfect Competition and Monopoly

Outline of Lecture

• Perfect Competition

  • Perfect Competition as a Price taker

  • Profit maximising output

  • Short-run equilibrium

  • Long-run equilibrium

• Monopoly

  • How monopoly arises

  • Single price monopolist output and price decision

  • Monopoly compared with Perfect Competition

  • Price discrimination

Perfect Competition

True or False Questions

• A firm should close down if it is making losses. (False)

• A firm maximises profit if it is producing at its minimum ATC. (False)

Market Structures

• Four types:

  • Perfect competition

  • Monopoly

  • Monopolistic competition

  • Oligopoly

• Perfect competition → Monopolistic competition → Oligopoly → Monopoly (Continuum from more to less competition and less to more concentration)

• Perfect Competition:

  • Many sellers

  • Homogeneous product

  • No barriers to entry

  • Examples: None

• Monopolistic Competition:

  • Many sellers

  • Differentiated product

  • No barriers to entry

  • Examples: Most retails & restaurants

• Oligopoly:

  • Few sellers

  • Homogeneous or Differentiated product

  • May be considerable barriers to entry

  • Examples: Most manufacturing sectors

• Monopoly:

  • One seller

  • No close substitutes

  • Yes, barriers to entry

  • Examples: Some public utilities

Perfect Competition (PC)

• Price taker

  • The PC firm is a price taker and cannot influence the price of the good or service that it produces.

  • In Perfect Competition, marginal revenue = price (MR = P)

Perfect Competition (PC) - Determining Profit-Maximising Output

• Two methods to determine Profit-maximising output

  • Total revenue minus Total cost (TR – TC)

  • Marginal analysis (MR = MC) (Focus on this)

Perfect Competition (PC) - Marginal Analysis Cases

• What is the firm’s profit maximising output if the market price is:

  • Case 1: $8?

  • Case 2: $4?

  • Case 3: $2?

• Profit maximising condition: MR = MC

• Case 1: If P = $8

  • If MR > MC ? Increase output

  • If MR < MC? Reduce output

  • profit maximising output is 10.

Perfect Competition (PC) - If MR > MC

• At Q=9, MR=8 is greater than MC=4.

• The firm should increase output.

Perfect Competition (PC) - If MR < MC

• At Q=11, MR=8 is less than MC=9.

• The firm should reduce output.

Perfect Competition (PC) - Economic Profit in Diagram

• Need ATC

• ATC = {TC}{Q}

• TR = $80

• TC = $51

• Profit = $80 – $51 = $29

Perfect Competition (PC) - Case 2: P = $4

• P < ATC and firm is making losses.

• If P = $4 (MR = MC = 4), Q = 9

Perfect Competition (PC) - Numerical Justification

• If firm shuts down, it faces a loss equivalent to TFC =$15 per day.

• If it continues to produce at P=$4 and Q=9, then:

  • TR = 4
    eq 9 = 36

  • TC = 4.9
    eq 9 = 44

  • It faces a loss of 36 - 44 = $8 per day.

Perfect Competition (PC) - Note

• So, TR=36 can cover its TVC=29, and part of TFC=15.

• Loss = 36 – 44 = $8 per day.

• But the firm should continue to operate as long as it can cover the variable costs and recover part of its fixed costs.

Perfect Competition (PC) - AVC

• We verify this by looking at AVC.

• As long as P > AVC, the firm can continue to minimise losses.

Perfect Competition (PC) - Shutdown case: P = $2

• Case 3: If P = $2 (MR = MC = 2)

  • Q = 7

  • P < min AVC

  • The firm should shutdown as the firm cannot cover the variable costs and recover its fixed costs.

  • If firm produces,

    • TR = 2
      eq 7=$14

    • TC = $36

    • Loss = $22

  • If firm shuts down, it will face TFC=$15

Perfect Competition (PC) - Firm's Supply Curve

• Firm’s supply curve is the same as the MC curve at prices above the minimum point of AVC.

Perfect Competition (PC) - Short Run Market Equilibrium

• Economic profits

Perfect Competition (PC) - Long Run Market Equilibrium

• Normal or Zero-economic profits

Perfect Competition (PC) - Short Run Market Equilibrium

• Economic loss

Perfect Competition (PC) - Long Run Market Equilibrium

• Normal or Zero-economic profits

• But why do some firms leave and others don’t?

Perfect Competition (PC) - Efficiency

• Why Perfect Competition is the Perfect market and efficient.

Testing Your Understanding

• Consider a coffee producer currently producing 6 tons of coffee per month. The ATC is $10 and rising; the selling price is constant at $12. If the MC of coffee is (a) $11 (b) $13 should you increase/decrease output?

Testing Your Understanding - Solution

• Current output = 6, P = $12 and ATC is $10 and rising

• (a) If MC = $11 < MR = $12: increase output

• (b) If MC = $13 > MR = $12: decrease output

Monopoly

Market Structures

• Four types:

  • Perfect competition

  • Monopoly

  • Monopolistic competition

  • Oligopoly

• Perfect competition → Monopolistic competition → Oligopoly → Monopoly (Continuum from more to less competition and less to more concentration)

  • Perfect Competition:

    • Many sellers

    • Homogeneous product

    • No barriers to entry

    • Examples: None

  • Monopolistic Competition:

    • Many sellers

    • Differentiated product

    • No barriers to entry

    • Examples: Most retails & restaurants

  • Oligopoly:

    • Few sellers

    • Homogeneous or Differentiated product

    • May be considerable barriers to entry

    • Examples: Most manufacturing sectors

  • Monopoly:

    • One seller

    • No close substitutes

    • Yes, barriers to entry

    • Examples: Some public utilities

Monopoly - How Monopoly Arises

• No close substitutes

• Barriers to entry

  • Natural

    • Economies of Scale (i.e., natural monopoly)

  • Ownership

    • Control of a scarce input (e.g., Previously, DeBeers diamond syndicate controlled supply of highest quality diamonds in the world).

  • Legal

    • Govt franchises/licenses (Utilities; Casinos)

    • Patents

Single Price Monopolist Output and Price Decision

• Suppose you own the only tree nursery in town.

• Given the D for and MC of operating the nursery, what are your profit maximisation output & price?

Single Price Monopolist Output and Price Decision - Profit Maximization Condition

• Profit maximization condition? MR=MC

• As we have MC, we now need to calculate MR

Single Price Monopolist Output and Price Decision - Demand and MR

• Illustrating demand and MR in a diagram

Single Price Monopolist Output and Price Decision - MR = MC

• Where MR=MC,

• profit maximizing price and output are

Single Price Monopolist Output and Price Decision - Economic Profit

• If we include a hypothetical ATC, we can illustrate the economic profit as shown in the shaded green area.

Monopoly and Perfect Competition

• Suppose in the long run, firms under PC sell at price Pc.

• Consumer surplus and producer surplus are maximised.

Monopoly and Perfect Competition - Merged Firms

• Suppose now all firms decide to merge and monopolised by one producer.

• Underproduction creates a deadweight loss.

• Consumer surplus shrinks while producer surplus expands.

Price Discrimination

Monopoly - Economic Profit

• Suppose a single-price monopolist makes an economic profit of $4.8 million.

Monopoly - Increasing Profit

• After taking EFB231, the owner of an airline ponders … How can I increase my profit? Maybe I can capture the consumer surplus using Price Discrimination.

Monopoly - Discriminating Among Groups

• Discriminating among groups of buyers

• This type of price discrimination works when each group has a different average willingness to pay for the good or service.

Monopoly - Key Idea Behind Price Discrimination

• The key idea behind price discrimination is to convert consumer surplus into economic profit.

  • Discriminating among groups of buyers

    • The firm offers different prices to different types of buyers, based on things like age, employment status or some other easily distinguished characteristic.

    • Example: Airfares, cinema tickets, public transport

  • Discriminating among/between units of a Good

    • The firm charges the same prices to all its customers but offers a lower price per unit for a larger number of units bought.

    • Example: Toilet rolls, fresh milk (1L, 2L)

Between-Group Price Discrimination Study

• A study on between-group price discrimination

• Puller, S.L., Taylor, L.M., 2012. Price discrimination by day-of-week of purchase: Evidence from the U.S. airline industry. Journal of Economic Behavior & Organization. 84:801-812.

  • Setting:

    • Compared tickets on the same airline and route that are purchased on different days of the week.

  • Considerations: day of week of travel, the ticket restrictions, the demand characteristics of the flights and the number of days in advance that the ticket is purchased.

  • Findings:

    • That fares are 5% lower when purchased on the weekend.

    • That weekend purchasers are more likely to be price-elastic leisure travelers.

Discrimination Between Two Types of Travelers

• Consider two groups: Business travelers and leisure travelers

• No price discrimination

Discrimination Between Two Types of Travelers - With Price Discrimination

• With price discrimination

Discrimination Between Two Types of Travelers - Profit Increase

• By equalising MR (for each group) to MC, profit can be increased.

  • With price discrimination:

    1. Business travellers:

       • TR = P
         eq Q = 180
         eq 100 = $18,000

       • TC = ATC
         eq Q = 70
         eq 100 = $7,000

       • Profit = TR - TC = $11,000

    2. Leisure travellers:

       • TR = P
         eq Q = 140
         eq 100 = $14,000

       • TC = ATC
         eq Q = 70
         eq 100 = $7,000

       • Profit = TR - TC = $7,000

    3. Total profit = $11,000 + $7,000 = $18,000

  • Without price discrimination: (150
    eq 200) - (70
    eq 200) = $16,000

Review of Today’s Lecture

• Perfect Competition

  • Perfect Competition as a Price taker

  • Profit maximising output

  • Short-run equilibrium

  • Long-run equilibrium

• Monopoly

  • How monopoly arises

  • Single price monopolist output and price decision

  • Monopoly compared with Perfect Competition

  • Price discrimination