Lecture 2

• Perfect competition


  Industry characteristics: HHI = 0, homogeneous products, free entry and exit, all firms are price takers, perfect information
• Profit maximization in perfect competition

  MC = MR, P = MC, Profit = AR - ATC at Q*
• Persistent change in demand


  New firms enter, existing firms alter scale of operation, until long-run equilibrium is reached
• Shut-down condition


  If P (AR) < ATC, firm makes losses and should shut down. If P (AR) > SAVC, firm should continue operating
• Monopoly


  Single firm supplies entire market, no close substitutes, barriers to entry, firm's demand curve is market demand curve
• Determinants of monopoly


  • Structural (natural) barriers
  • Strategic barriers
• Structural (natural) barriers


  • Control of essential resources, geographical indications, marketing advantages, financial barriers, economies of scope and scale
• Strategic barriers


  • Limit pricing, predatory pricing, excess capacity, heavy advertising, product differentiation
• Monopolist's output and price decisions

  MR < AR, MR is twice the slope of AR, MR = 0 implies price elasticity of demand = -1
• Welfare costs of monopoly: Allocative inefficiency, Q_m < Q_c
• Factors determining the size of deadweight loss (DWL) under monopoly: Area of a triangle = 0.5 x Base x Height
• Key conditions for a perfectly competitive industry


  • HHI = 0
  • Homogenous products
  • Free entry and exit
  • All firms are price takers (therefore all face the same industry demand curve)
  • Perfect information in the market place (therefore consumers will only purchase from the lowest-cost firm)
• Demand at the level of the market and the firm

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• Supply function of the industry


  Sum of each firm's short run marginal cost (SRMC) function
• The MC function must be above the minimum point of the firm's short run average cost function for the supply function to be valid
• MC function


  $\Sigma n SRMC$

  Provided the MC function is above the minimum point of the firms short run average cost function;

  • why? To produce any output, firm must at least cover its short-run average costs (SRAC); minimum price a firm is willing to accept is determined by the intersection of SRMC and SRAC, and point above this show firms supply function
• Short-run quantity decision: revenue-cost approach 


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• From the previous diagram:
• Profit (π) maximization requires MC = MR
• In a perfectly competitive industry, P=MR
• In profit maximization: P= MC
• MC = MR does not mean that profits are earned
• Short-run quantity decision: marginal approach


  :

  
• MC = MR


  Yields Q*
• Profit


  The difference between AR (P) and ATC, at Q*
• Profit


  Encourages incumbents (firms already in the industry) to expand their supply in the short-run
• Profit


  Encourages new firms to enter the industry in the longer-run
• Achieving long-run equilibrium


  Total supply increases until long-run equilibrium is achieved
• Long-run equilibrium


  P(AR) min LRATC, when MC = MR
• Short-run equilibrium


  P(AR) min SRATC, when MC = MR
• UK 100 +10%
• Short-run equilibrium


  P(AR) = min SRATC, when MC = MR
• Effects of Entry and Exit on Market Price and Firm Profit


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• Effects of Entry and Exit on Market Price and Firm Profit


  :

  
• If change in demand is not persistent

  Incumbents alter their supply
• If change in demand is persistent


  New firms enter as well + existing firms alter their scale of operation, until equilibrium is reached
• The previous diagrams work in 'reverse': firms exit if losses are made, until equilibrium is reached
• Issues to consider


  • (a) is adjustment instantaneous?
  • (b) if all firms are identical' and there are no exit or entry costs, what might this imply
• Algebraic Example


  Cost function foe a frim operating in a perfectly competitive market with prevailing market price of 20 is C(Q) = 5 + Q^2

  1. Find the level of output that maximizes profits

  2. Calculate the profit earned

  
  

  1. MR = 20 = 2Q = MC, Q* = 10
  2. n* = 20Q - 5 - Q2, 20(10) -5 - (10)^2 = 95
• Cost function


  C(Q) = 5+Q^2