IMPERFECT MARKET

COMPETITION
CONTENTS

 Monopoly:
- Short-run and long-run price and

- Output determination;

- Comparison with perfect competition

 Monopolistic competition:

- Meaning and importance;

- Short-run and long-run price and

- Output determination
MONOPOLY

 Definition:
A pure Monopolist is defined as a single seller of
a product. I.e. 100% of market share. In the UK a
firm is said to have Monopoly power if it has
more than 25% of Market share
 MONOPOLY
Basic Properties
 One firm in industry
 Profit-maximiser
 Faces market demand curve
 One product
 No close substitutes
 Price-maker
 No restrictions on resources
 Barriers to entry/exit
 Asymmetric information
 Opportunity for economic profits in long-run
equilibrium.
 Examples of Monopoly
 Electricity utilities,
 Gas
 Water
 Public Transport
 Telecommunications
BARRIERS TO ENTRY

 Monopoly
– Sole supplier of a product
with no close substitutes
 Barriers to entry
1. Legal restrictions
2. Economies of scale
3. Control of essential
resources
BARRIERS TO ENTRY

1. Legal restrictions
– Patents and invention
incentives
• Patent – exclusive right
for 20 years
– Licenses and other entry
restrictions
• Federal license
• State license
BARRIERS TO ENTRY

2. Economies of scale
– Natural monopoly
– Downward-sloping LRAC
curve
• One firm can supply
market demand at a
lower ATC per unit than
could two firms
 Exhibit 1
Economies of Scale as a
Barrier to Entry
$
A monopoly sometimes emerges naturally
when a firm experiences economies of scale
as reflected by a downward-sloping long-run
average cost curve.
Cost per unit

Long-run
average cost One firm can satisfy market
demand at a lower average cost
per unit than could two or more
firms, each operating at smaller
Quantity rates of output.
per period
BARRIERS TO ENTRY

3. Control of essential resources

– Alcoa (aluminum)
– Professional sports leagues
– China (pandas)
– DeBeers Consolidated Mines
(diamonds)
MONOPOLY

 Monopoly
– Local
– National
– International
 Long-lasting
monopolies
– Rare
– Economic profit attracts competitors
– Technological change
REVENUE FOR THE MONOPOLIST

 Monopoly
– Supplies the market demand
• Downward-slopping D (law of D)
• To sell more: must lower P on all
units sold
 Total revenue TR=p*Q
 Average revenue AR=TR/Q
– For monopolist: p=AR
 Demand D: also AR curve
 Exhibit 2
A Monopolist’s Gain and Loss in Total
Revenue from Selling One More Unit
Increase quantity supplied from 3 to 4 diamonds:
• Gain in total revenue: $6,000
$7,000
Loss
• Loss in revenue: $250 per piece
6,750
• selling four diamonds for $6,750
each instead of $7,000 each
Dollars per

D = Average revenue
diamond

Gain
• MR = gain – loss =
$27,000(4*6,750) -$ 21000 (3*7000)
= $6,000
• MR ($6,000)<P($6,750)
1-carat diamonds per day
0 3 4
REVENUES IN IMPERFECT MARKETS
Quantity Price Total Marginal Average
Revenue Revenue Revenue
0 -
1 5 5 - 5
2 4 8 3 4
3 3 9 1 3
4 2 8 -1 2
5 1 5 -3 1
REVENUE FOR THE MONOPOLIST

 Marginal revenue MR=∆TR/∆Q

– For monopolist: MR<p
– Declines, can be negative
 MR curve
– Downward sloping
– Below D=AR curve
 TR curve
• Reaches maximum where
MR=0
 Revenue for DeBeers, a Monopolist

To sell more, the

monopolist must lower
Exhibit 3

the price on all units

sold. Because the
revenue lost from selling
all units at a lower price
must be subtracted from
the revenue gained from
selling another unit, MR
is less than price. At
some point, MR turns
negative, as shown here
when the price is
reduced to $3,500.
 Exhibit 4
Monopoly Demand and
Marginal Total Revenue
Dollars per diamond

Elastic
Unit elastic
$3,750
Inelastic (a) Demand and marginal revenue

D price elastic, as p falls

0
MR D=Average revenue MR>0, TR increases
1-carat diamonds
16 32 per day D price inelastic, as p falls
MR<0, TR decreases
$60,000

(b) Total revenue

Total dollars

Total revenue
D unit elastic
MR=0, TR is maximum

1-carat diamonds
0 16 32 per day
REVENUE FOR THE MONOPOLIST

 D curve: p=AR
 Where D elastic, as price falls
– TR increases
– MR>0
 Where D inelastic, as price falls
– TR decreases
– MR<0
 Where D unit elastic
– TR is maximized; MR=0
 FIRM’S COSTS AND PROFIT
MAXIMIZATION

 Monopolist
 Choose the price
 OR the quantity
 ‘Price maker’
 Profit maximization
 TR minus TC
 Supply quantity where TR exceeds
TC by the greatest amount
 MR equals MC
 Exhibit 5
Short-run Costs and Revenue for a Monopolist
 Exhibit 6
Marginal cost Monopoly Costs and Revenue
Dollars per diamond

Average total cost

a
$5,250
Profit b
4,000 A profit-maximizing monopolist
e supplies 10 diamonds per day
and charges $5,250 per
MR D=Average revenue
diamond.
Diamonds per day
0 10 16 32 Profit = $12,500
(profit per unit × Q)
Maximum Total cost
profit
$52,500
Maximize profit where TR
exceeds TC by the greatest
Total dollars

40,000 Total revenue amount: Q=10

Maximum profit =
15,000 TR-TC = $12,500

Diamonds per day

0 10 16 32
 SHORT-RUN LOSSES; SHUTDOWN
DECISION

 If p>ATC
 Economic profit
 If ATC>p>AVC
 Economic loss
 Produce in short run
 If p<AVC: AVC curve above D curve
 Economic loss
 Shut down in short run
 The Monopolist Minimizes Losses in the Short Run

Marginal cost For Q, ATC is at point a

P<ATC, monopolist suffers

a loss
Average total cost
a
For Q, price=p at point b,
Loss Average variable cost on D curve
p
b
Dollars per unit

MR=MC at point e:
c quantity Q

Monopolist continue to
e Demand=Average revenue produce because p>AVC
Marginal revenue (AVC is at point c)

0 Q Quantity per period

 LONG-RUN PROFIT
MAXIMIZATION

 Short-run profit
 No guarantee of long-run profit
 High barriers that block new entry
 Economic profit
 Erase a loss or increase profit
 Adjust the scale of the firm
 If unable to erase a loss
 Leave the market
 Monopoly and Allocation
of Resources

 Perfect competition
– Long run equilibrium
– Constant-cost industry
– Marginal benefit (p) = MC
– Allocative efficient market
– Max social welfare
– Consumer surplus
 Monopoly and Allocation
of Resources

 Monopoly
– Marginal benefit (p) > MC
– Restrict Q below what would
maximize social welfare
– Smaller consumer surplus
– Economic profit
– Deadweight loss of monopoly
• Allocative inefficiency
 Exhibit 8
Perfect Competition and Monopoly in constant costs

a
MC Monopoly
Dollars per unit

m Qm where MRm=MC (point b)

pm
pm on D (point m)
b c Consumer surplus: ampm
pc MRp=ARp=D
Economic profit: pmmbpc
D=AR Deadweight loss: mbc
MRm
Quantity Monopoly
0 Qm Qc
per period
higher price
Perfect competitive industry lower quantity
Qc where MRp = MC at point c
Consumer surplus: acpc
PROBLEMS ESTIMATING DEADWEIGHT LOSS

 Deadweight loss might be lower

– Lower price and average cost
• Substantial economies of scale
– Price below the profit maximizing value
• Public scrutiny, political pressure
• Avoid attracting competition
PROBLEMS ESTIMATING DEADWEIGHT LOSS

 Deadweight loss might be higher

– Secure and maintain monopoly position
• Use resources; social waste
• Influence public policy
– Inefficiency
– Slow to adopt new technology
– Reluctant to develop new products
– Lack innovation
PRICE DISCRIMINATION
 Charge different prices to different groups of
consumers
 Conditions
– Downward sloping D curve
– At last two groups of consumers
• Different price elasticity of demand
– Ability to charge different prices
• At low cost
– Prevent reselling of the product
FORMS OF PRICE DISCRIMINATION
 First-Degree price discrimination – practice of
charging each customer his reservation price
(Max. price that a customer is willing to pay for a
good.)
- perfect price discrimination
 Exhibit
Monopoly perfect first degree price discrimination

consumer surplus when

Dollars per unit

Pm is charged
pm MC

variable profit when single

pc price Pm is charged (area
between MR and MC

MRm
additional profit from
Quantity perfect price
0 Qm Qc
per period discrimination(area
between demand curve
and MC curve)
 Exhibit
Monopoly perfect first degree price discrimination in practice

Different prices- some

Dollars per unit

p1
customers may benefit
p2 MC
(P3, P4)
p3

MRm
Quantity
0 Qm
per period
A MODEL OF PRICE
DISCRIMINATION
 Two groups of consumers
– One group (A): less elastic D
– The other (B): more elastic D
 Maximize profit
– MR=MC in each market
– Lower price for group (B)
SECOND DEGREE PRICE DISCRIMINATION
 Charging different prices per unit for different
quantities of the same good or service ( discounts
on bulk purchases)
- Expansion of output and lowering cost.
THIRD DEGREE PRICE DISCRIMINATION
 Dividing consumers into two or more groups with
different elastic demand curves and charging
different prices to the groups
Price Discrimination with Two Groups of Consumers
(a) (b)
per unit
Dollars

Dollars per unit

$3.00

LRAC, MC $1.50
LRAC, MC
1.00 1.00
MR D MR’ D’

0 400 Quantity per period 0 500 Quantity per period

A monopolist facing two groups of consumers with different demand elasticities may be able to practice price
discrimination to increase profit or reduce loss. With marginal cost the same in both markets, the firm
charges a higher price to the group in panel (a), which has a less elastic demand than group in panel (b).
EXAMPLES OF PRICE
DISCRIMINATION
 Airline travel
– Businesspeople (business class)
• Less elastic D; Higher price
– Same class, different prices
• Discount fares; weekend stay
 IBM laser printer
– 5 pages/minute: home; cheaper
– 10 pages/minute: business; expensive
 Amusement parks
– Out-of-towners: less elastic D
MONOPOLISTIC COMPETITION
 Characteristics
– Many producers
– Low barriers to entry
– Slightly different products
• A firm that raises prices: lose some
customers to rivals
– Some control over price ‘Price makers’
• Downward sloping D curve
– Act independently
MONOPOLISTIC COMPETITION
 Product differentiation
– Physical differences
• Appearance; quality
– Location
• Spatial differentiation
– Services
– Product image
• Promotion; advertising
SHORT-RUN PROFIT MAX. OR
LOSS MIN.
– Demand D
– Marginal revenue MR
– Average total cost ATC
– Average variable cost AVC
– Marginal cost MC
 Maximize profit
– Produce the quantity: MR=MC
– Price: on D curve
MAX. PROFIT OR MIN. LOSS IN
SHORT-RUN
– If p>ATC
• Economic profit
– If ATC>p>AVC
• Economic loss
• Produce in short run
– If p<AVC: AVC curve above D curve
• Economic loss
• Shut down in short run
 Exhibit
Monopolistic Competitor in the Short Run
(a) Maximizing short-run profit (b) Minimizing short-run loss
MC MC
ATC
c

Dollars per unit

Dollars per unit

c
b ATC Loss AVC
p p b
Profit c
c

D D
e e
MR MR

Quantity Quantity
0 q 0 q
per period per period
(a) Economic profit = (p–c)×q (b) Economic loss = (c–p)×q
The firm produces the output at which MR=MC (point e) and charges
the price indicated by point b on the downward sloping D curve.
ZERO ECONOMIC PROFIT IN
THE LONG RUN

 Short run economic profit

– New firms enter the market
– Draw customers away from other firms
– Reduce demand facing other firms
– Profit disappears in long run
• Zero economic profit
ZERO ECONOMIC PROFIT IN
THE LONG RUN

 Short run economic loss

– Some firms exit the market
– Their customers switch to other firms
– Increase demand facing the remaining firms
– Loss is erased in the long run
• Zero economic profit
 Exhibit
Long-Run Equilibrium in Monopolistic
Competition
per unit
Dollars

MC
Economic profit in short run:
- new firms enter the industry in the
ATC long run
b - reduces the D facing each firm
p
- Each firm’s D shifts leftward until:
-MR=MC (point a) and
a D -D is tangent to ATC curve: point b
- Economic profit = 0 at output q
No more firms enter; the industry is in
MR long-run equilibrium.

0 q Quantity per period

The same long-run outcome occurs if firms suffer a short-run loss.
Firms leave until remaining firms earn just a normal profit.
MONOPOLISTIC VS. PERFECT
COMPETITION

 Both
– Zero economic profit in long run
– MR=MC for quantity
• where D is tangent to ATC
 Perfect competition
– Firm’s demand: horizontal line
– Produces at minimum average cost
– Productive and allocative efficiency
MONOPOLISTIC VS. PERFECT
COMPETITION

 Monopolistic competition
– Downward sloping D
– Don’t produce at minimum average cost
• Excess capacity
• Could increase output
– Lower average cost
– Increase social welfare
– Produces less, charges more
 Exhibit
Perfect Competition Versus Monopolistic Competition
in Long-Run Equilibrium
(a) Perfect competition (b) Monopolistic competition
MC MC

ATC p’ ATC
p
d=MR=AR

Dollars per unit

Dollars per unit

MR
Quantity Quantity
0 q 0 q’
per period per period
Cost curves are assumed the same. The monopolistically competitive firm produces less output and charges
a higher price than does a perfectly competitive firm. Neither earns economic profit in the long run.