Ch 8

• Perfect Competition


  • Characteristics and profit outlook
  • Effect of new entrants
• Monopolies


  • Sources of monopoly power
  • Maximizing monopoly profits
  • Pros and cons
• Monopolistic Competition


  • Profit maximization
  • Long run equilibrium
• Perfect Competition Environment


  • Many buyers and sellers
  • Homogeneous (identical) product
  • Perfect information on both sides of market
  • No transaction costs
  • Free entry and exit
• Firms are "price takers"

  P = MR
• Many small businesses are "price-takers," and 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
• Managing a Perfectly Competitive Firm: Setting Price

  1. Firm sets Q

  2. Firm sets $

  3. Market sets Q

  4. Market sets $
• Profit-Maximizing Output Decision


  • MR = MC
  • Set P = MC to maximize profits
• Break Even Point


  • Price equals minimum of average total cost
  • Price passes through intersection between MC and ATC curve
• Firm will not shut down in the short run if at least VC are covered
• Shutdown Decision Rule


  • Firm should continue to operate if operating loss is less than fixed costs
  • Firm should shut down when P < min AVC
• Short-Run Output Decision Under Perfect Competition

  Firm should produce in range of increasing marginal cost where P >= min AVC
• Firm's Short-Run Supply Curve

  MC curve above minimum point on AVC curve
• Long Run Adjustments


  • If barriers to entry, profits will persist
  • If free entry, other firms enter and drive profits to zero
• Effect of Entry on Firm's Output and Profit

  1. Short run profits lead to entry

  2. Entry increases market supply, drives down price, increases quantity

  3. Firm reduces output to maximize profit

  4. Long run profits are zero
• Features of Long Run Competitive Equilibrium

  • P = MC (socially efficient output)
  • P = minimum AC (efficient plant size)
  • Zero profits (earning just enough to offset opportunity cost)
• Monopoly


  • A market structure with a single firm serving the entire market
  • Sole seller gives greater market power than competition
• Monopolist does not have unlimited market power
• Managing a Monopoly


  Market power permits pricing above MC, but quantity sold depends on price set
• "Natural" Sources of Monopoly Power

  • Economies of scale
  • Diseconomies of scale
  • Economies of scope
  • Cost complementarity
• "Created" Sources of Monopoly Power

  • Patents and other legal barriers
  • Collusion
  • Special contractual arrangements
  • Tying contracts
  • Exclusive contracts
• Marginal Revenue for a Monopolist


  Interpretation of the MR equation
• Profit Maximization


  1. Produce where MR = MC

  2. Charge price on demand curve corresponding to that quantity
• There is no supply curve for a monopolist or firms with market power
• Multiplant Decisions


  Determine optimal output at each plant to maximize profits
• Multiplant Output Rule


  1. Allocate output so MR = MC at each plant

  2. Set price equal to P(Q) where Q = Q1 + Q2
• Implications of Entry Barriers

  Monopolist may earn positive profits over time if market power is maintained
• Monopoly power does not guarantee positive profits
• Why Government Dislikes Monopoly

  • P > MC (too little output at too high a price)
  • Deadweight loss of monopoly
• Arguments for Monopoly


  • Beneficial effects of economies of scale, scope, and cost complementarities may outweigh negative effects of market power
  • Encourages innovation
• Monopolistic Competition: Environment and Implications

  • Numerous buyers and sellers
  • Differentiated products
  • Firms face downward sloping demand curve
  • Free entry and exit leads to zero profits in long run
• Managing a Monopolistically Competitive Firm

  • Firms have market power to price above MC, but demand is more elastic than a monopolist
  • Free entry and exit affects profitability
• Monopolistic Competition: Profit Maximization


  Maximize profits like a monopolist (produce where MR = MC, charge price on demand curve)
• Long Run Adjustments


  With free entry, other firms enter and steal market share until profits are zero
• Monopolistic Competition: Good, Bad, Unfortunate

  Good: Product variety

  Bad: P > MC, excess capacity, unexploited economies of scale

  Unfortunate: P = ATC > minimum of average costs, zero profits in long run
• Optimal Advertising Decisions


  Advertise to the point where additional revenue equals additional cost

  Advertising-to-sales ratio = advertising elasticity / own-price elasticity