Chapter 12: Perfect Competition

Slide 2

What Is Perfect Competition?

Perfect competition is a market in which
§ Many firms sell identical products to many buyers.
§ There are no restrictions to entry into the industry.
§ Established firms have no advantages over new ones.
§ Sellers and buyers are well informed about prices.

Slide 3

What Is Perfect Competition?

Price Takers
In perfect competition, each firm is a price taker.
A price taker is a firm that cannot influence the price of a good or service.
No single firm can influence the price—it must “take” the equilibrium market price.
Each firm’s output is a perfect substitute for the output of the other firms, so the demand for
each firm’s output is perfectly elastic.
Slide 4

What Is Perfect Competition?

Economic Profit and Revenue

The goal of each firm is to maximize economic profit, which equals total revenue minus total
cost.
Total cost is the opportunity cost of production, which includes normal profit.
A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P ´ Q.
A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in
the quantity sold.
Slide 9

The Firm’s Output Decision

Marginal Analysis and Supply Decision
The firm can use marginal analysis to determine the profit-maximizing output.
Because marginal revenue is constant and marginal cost eventually increases as output
increases, profit is maximized by producing the output at which marginal revenue, MR, equals
marginal cost, MC.
 Economic profit= revenue – cost
=(PxQ)- TVC-FC
Slide 11
= (PxQ)- (AVCxQ) -TFC
=Q(P-AVC)-TFC
The Firm’s Output Decision AVC= TVC\ Q
TVC= AVCxQ
Temporary Shutdown Decision
If the firm makes an economic loss, it must decide whether to exit the market or to stay in the
market.
If the firm decides to stay in the market, it must decide whether to produce something or to
shut down temporarily.
The decision will be the one that minimizes the firm’s loss.

Slide 20

Output, Price, and Profit in the Short Run

Profits and Losses in the Short Run
In the short run maximum profit is not always a positive economic profit.
To determine whether a firm is making an economic profit or incurring an economic loss, we
compare the firm’s average total cost at the profit-maximizing output with the market price.
Slide 21

Output, Price, and Profit in the Short Run

Slide 22

Output, Price, and Profit in the Long Run

Entry and Exit in the long run

New firms enter an industry in which existing firms make an economic profit.
Firms exit an industry in which they incur an economic loss.
Firms will continue to enter or exit the market until economic profits are zero.

Slide 26

Competition and Efficiency

Equilibrium and Efficiency

In competitive equilibrium, resources are used efficiently—the quantity demanded equals the
quantity supplied, so marginal social benefit equals marginal social cost.
The gain from trade for consumers is measured by consumer surplus.
The gain from trade for producers is measured by producer surplus.
Total gains from trade equal total surplus.
In long-run equilibrium total surplus is maximized.
 Worksheet Chapter 12 Perfect Competition
The market for paper is perfectly competitive and there are 1,000 firms that produce paper.
The costs for each producer are given in the table below and the market price is 8.40.
Output Marginal cost Average variable Average total cost
(boxes per (dollars per cost (dollars per box)
week) additional box) (dollars per box)
200 6.40 7.80 12.80
250 7.00 7.00 11.00
300 7.65 7.10 10.43
350 8.40 7.20 10.06
400 10.00 7.50 10.00
450 12.40 8.00 10.22
500 20.70 9.00 11.00

a.) What is the profit maximizing output produced by each firm?

b.) What is the economic profit made by each firm in the short run?
c.) In the short run, will firms shut down?
d.) What is the economic profit made by each firm in the long run?

Solution

a.) Each firm produces where marginal costs equal marginal revenue. Since marginal revenue is
equal to the market price. This is the case at 350 boxes per week. (Remember marginal
revenue is equal to the market price.)

b.) Profit=TR-TC=P*Q-ATC*Q=(8.40*350)-(10.06*350)=-581

c.) Firms shut down if P<AVC. Firms stay open if P>AVC. Firms are indifferent if P=AVC.

At 350 boxes P=8.40 and AVC=7.20. Hence, the firm will stay open.

d.) In the long run firms make zero economic profit.

 Chapter 13: Monopoly
Slide 3

Monopoly and How It Arises

A monopoly is a market:
§ That produces a good or service for which no close substitute
exists
§ In which there is one supplier that is protected from competition
by a barrier preventing the entry of new firms.
Slide 5

Monopoly and How It Arises

Barriers to Entry
A constraint that protects a firm from potential competitors is called a
barrier to entry.
Three types of barriers to entry are
§ Natural
§ Ownership
§ Legal
Slide 6

Monopoly and How It Arises

Natural Barriers to Entry

Natural barriers to entry create natural monopoly.

A natural monopoly is a market in which economies of scale enable

one firm to supply the entire market at the lowest possible cost. For
example, water supply, electricity, trains…
Slide 7

Monopoly and How It Arises

Ownership Barriers to Entry
An ownership barrier to entry occurs if one firm owns a significant
portion of a key resource.
During the 90s, De Beers owned over 80 percent of the world’s
diamonds and was considered a monopoly. Since then, the monopoly
has been dismantled.

Slide 8

Monopoly and How It Arises

Legal Barriers to Entry
Legal barriers to entry create a legal monopoly.
A legal monopoly is a market in which competition and entry are restricted by the
granting of a
§ Public franchise (like the U.S. Postal Service, a public franchise to deliver
first-class mail)
§ Government license (like a license to practice law or medicine)
§ Patent or copyright
Slide 9

Monopoly and How It Arises

Monopoly Price-Setting Strategies
For a monopoly firm to determine the quantity it sells, it must choose the
appropriate price.
There are two types of monopoly price-setting strategies:
A single-price monopoly is a firm that must sell each unit of its output for the
same price to all its customers.
Price discrimination is the practice of selling the same units of a good or service
for different prices. Many firms price discriminate, but not all of them are
monopoly firms.
Slide 10

A Single-Price Monopoly’s Output and Price Decision

Price and Marginal Revenue
A monopoly is a price setter, not a price taker like a firm in perfect
competition.
The reason is that the demand for the monopoly’s output is the market
demand.
To sell a larger output, a monopoly must set a lower price.
Slide 11

A Single-Price Monopoly’s Output and Price Decision

Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.

Marginal revenue, MR, is the change in total revenue that results from
a one-unit increase in the quantity sold.
For a single-price monopoly, marginal revenue is less than price at each
level of output. That is,
MR < P.

Slide 17

A Single-Price Monopoly’s Output and Price Decision

Price and Output Decision

The monopoly selects the profit-maximizing quantity in the same
manner as a competitive firm, where MR = MC.
The monopoly sets its price at the highest level at which it can sell the
profit-maximizing quantity.
Slide 18

A Single-Price Monopoly’s Output and Price Decision

The firm produces the output at which MR

= MC and sets the price at which it can sell
that quantity.
The ATC curve tells us the average total
cost.
Economic profit is the profit per unit
multiplied by the quantity produced—the
blue rectangle.

Slide 19

A Single-Price Monopoly’s Output and Price Decision

The monopoly might make an economic profit, even in the long run,
because barriers to entry protect the firm from market entry by
competitor firms.

Slide 23

Single-Price Monopoly and Competition Compared

Compared to perfect competition, monopoly

produces a smaller output and charges a
higher price.
 Chapter 14: Monopolistic Competition
Slide 3

What Is Monopolistic Competition?

Monopolistic competition is a market structure in which

§ A large number of firms compete.
§ Each firm produces a differentiated product.
§ Firms compete on product quality, price, and marketing.
§ Firms are free to enter and exit the industry.

Slide 4

Monopolistic Competition
Large Number of Firms
The presence of a large number of firms in the market implies:
§ Each firm has only a small market share and therefore has limited
market power to influence the price of its product.
§ Each firm is sensitive to the average market price, but no firm
pays attention to the actions of others. So, no one firm’s actions
directly affect the actions of others.
§ Collusion, or conspiring to fix prices, is impossible.

Slide 5

What Is Monopolistic Competition?

Product Differentiation
A firm in monopolistic competition practices product differentiation if
the firm makes a product that is slightly different from the products of
competing firms.
Slide 8

Price and Output in Monopolistic Competition

The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its marketing
program produces the profit-maximizing quantity (the quantity at
which MR = MC).
Price is determined from the demand for the firm’s product and is the
highest price that the firm can charge for the profit-maximizing
quantity.
Slide 9

Price and Output in Monopolistic Competition

The firm in monopolistic competition

operates like
a single-price monopoly.
The firm produces the quantity at
which MR equals MC and sells that
quantity for the highest possible
price.
Slide 10

Price and Output in Monopolistic Competition

Long Run: Zero Economic Profit
In the long run, economic profit induces entry.
And entry continues as long as firms in the industry earn an economic
profit—as long as (P > ATC).
In the long run, a firm in monopolistic competition maximizes its profit
by producing the quantity at which its marginal revenue equals its
marginal cost, MR = MC.

Slide 11

Price and Output in Monopolistic Competition

As firms enter the industry, each existing firm loses some of its market
share.
The demand for its product decreases and the demand curve for its
product shifts leftward.
The decrease in demand decreases the quantity at which MR = MC and
lowers the maximum price that the firm can charge to sell this quantity.
Price and quantity fall with firm entry until P = ATC and firms earn zero
economic profit.
 Worksheet Chapter 14 Monopolistic Competition

Use the following figure, which shows the situation facing a producer of running shoes, to
answer the questions below.

1.) What quantity does the profit maximizing firm produce and what price does it charge?
2.) What is its economic profit?
3.) In the long run, how does the number of firms producing running shoes change?
4.) What is the firm’s economic profit in the long run?
 Solution
1.) To maximize profit, the firm produces the quantity at which marginal revenue equals
marginal cost, so it produces 100 pairs a week. The firm charges the highest price that
enables it to sell the 100 pairs of shoes. As read from the demand curve, the firm
charges $80 a pair.

2.) Economic profit equals total revenue minus total cost. The price is $80 a pair and the
quantity sold is 100 pairs, so total revenue is $8,000. Average total cost is $60 a pair, so
total cost equals $6,000. Economic profit equals $8,000 minus $6,000, so the firm makes
an economic profit of $2,000 a week.

3.) The firm is making an economic profit. This profit attracts entry into the market so the
number of firms increases.
4.) In the long run, the firm makes zero economic profit.
 Chapter 15: Oligopoly
Slide 3

What Is Oligopoly?

Oligopoly is a market structure in which

§ Natural or legal barriers prevent the entry of new firms.
§ A small number of firms compete.

Slide 4

What Is Oligopoly?

Because an oligopoly market has only a few firms, they are

interdependent and face a temptation to cooperate.
Interdependence: With a small number of firms, each firm’s profit
depends on every firm’s actions.
Temptation to Cooperate: Firms in oligopoly face the temptation to
form a cartel.
A cartel is a group of firms acting together to limit output, raise price,
and increase profit. Cartels are illegal.

Slide 5

Oligopoly Games
Game theory is a tool for studying strategic behavior, which is behavior
that takes into account the expected behavior of others and the mutual
recognition of interdependence.
All games have four common features:
§ Rules
§ Strategies
§ Payoffs
§ Outcome
Slide 11

Oligopoly Games
Outcome
If a player makes a rational choice in pursuit of his own best interest, he
chooses the action that is best for him, given any action taken by the
other player.
If both players are rational and choose their actions in this way, the
outcome is an equilibrium called a Nash equilibrium—first proposed by
John Nash.
Finding the Nash Equilibrium
The following slides show how to find the Nash equilibrium.

Slide 15

Oligopoly Games
Collusion
Suppose that the two firms enter into a collusive agreement.
A collusive agreement is an agreement between two (or more) firms to
restrict output, raise the price, and increase profits.
Such agreements are illegal in most countries and are undertaken in
secret.
Firms in a collusive agreement operate a cartel.
 Worksheet Chapter 15 Oligopoly
Consider a game with two players who cannot communicate with each other and in which each
player is asked a question. The players can answer the question honestly or lie. If both answer
honestly, each receives $100. If one player answers honestly and the other lies, the liar receives
$500 and the other player gets nothing. If both lie, then each receives $50.

a.) Describe the strategies of this game.

b.) Construct a payoff matrix.
c.) What is the Nash Equilibrium of this game? Explain your answer with the help of a
decision tree.