Week Three: Competition and Welfare

Week Three
Competition and Welfare

PLAN
• Perfect Competition Model
• Monopoly model
• Monopolistic Competition
• Monopoly power and Welfare
• Structure-conduct-performance
• Concentration and its determinants
• Measuring market power
• Oligopoly
All firms are assumed to maximise profit.
They must operate on their cost curves, i.e. minimise

costs for any level of output.
But they also need to choose the right level of output.

Profit = Revenue – Total Cost
Price x Quantity
A pure competitor is a price taker, so the

market price is given.
(‘Given’ means constant with respect to
output, not constant over time.)
Total Cost
Revenue
$
At what level of
output is profit
maximised?
Q* Quantity
Total Cost
Revenue
$
Slope = MC Profit is maximised

where the two lines
are parallel…
…where their slopes

are equal.
Slope = price
Q* Quantity
Price, Marginal, and Average Costs
200
180
160 Profit-maximising
output level in the
140 short run, where
P=MC
120
Price
?VC/?Q
$
100
AVC
ATC
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Output
200
180
160 Shut-down price,

where revenue
140
doesn't even cover
120
variable cost
Price
?VC/?Q
$
100
AVC
ATC
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Output
200
180
160
Break-even price,
140
where revenue just
covers total costs
120
Price
?VC/?Q
$
100
AVC
ATC
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Output
The pure competitor’s decision rule:
In the short run, produce the level of output at which
price equals marginal cost…
If price is below average total cost but above average

variable cost, continue to follow the above rule in the
short run, but cease production in the long run.
If price is below average variable cost, cease

production now.
The part of the marginal
200
cost curve above the
180
average variable cost
160 curve is the firm’s ‘supply
140 curve’.
120
?VC/?Q
$
100 AVC
ATC
80
60
40
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Output
A firm’s
MC MC curve
$95
21 Quantity
A firm’s
MC supply
curve
$95
21 Quantity
Price
per kg Supply
Curves for two
12 firms
9
36 5 8
Quantity
Price
per kg
12
9
Short run
Market Supply
Schedule
3 5 6 8 14
Quantity
Ave. But in the long run, competition forces
Cost price down to minimum AC...
($) MC
AC
Output
Q*
Long run supply schedule in standard
Price case industry (firms have identical,
rising AC schedules)
($)
AC*
Output
The industry initially in equilibrium,
Price supplying Q0…
($)
AC*
Do
Output
Q0
Demand increases...
Price
($)
AC*
D0
D0
Output
Q0
Price rises to P’. Quantity
Price supplied increases as existing
firms move up their MC curves
($)
P'
AC*
D0
D0
Output
Q0 Q'
But the higher price attracts
Price new entrants willing to supply
at AC* and price falls....
($)
P'
AC*
D1
Do
Output
Q0 Q'
...until long run equilibrium is
Price restored with a larger number
of firms each supplying Q*
($)
AC*
D1
D0
Output
Q0 Q1
FIRM INDUSTRY
Price Price
S
MC
Pe Pe
Firm Q Industry Q
Firm's Industry's
Price Demand Price Demand
Schedule Schedule S
MC
Pe D Pe
Quantity Quantity
PLAN
• Monopoly model
• Oligopoly
Price
Firm and Industry
Demand Schedule
D
Quantity
A monopoly is the sole producer in a

Quantity
market. The firm is the industry.
Price monopoly can choose either its
price or the quantity it wants to
sell…in choosing one it
automatically chooses the other.
Quantity
Price If the Monopoly sets price at P0 it
will sell Q0.
If it decides to sell Q0, the market

.will set the price at P0
P0
Quantity
Q0
The monopoly's output decision: algebraic approach
The monopoly's Problem: Choose Q to max. П(Q)
  TR  TC
  P(Q)Q  TC (Q)
  (a  bQ)Q  FC  cQ
Linear Constant
demand variable
schedule cost
  (a  bQ)Q  FC  cQ
  aQ  bQ  FC  cQ
2
To maximise the function with respect to Q:

d
 a  2bQ  c  0
dQ
Marginal a  2bQ  c Marginal
Revenue Cost
a  2bQ  c
2bQ  a  c
ac
The profit-
maximising
level of
Q 
output
2b
The monopoly's output decision: numerical example
  TR  TC
  P(Q)Q  TC (Q)
  (100  2Q)Q  500  20Q
Linear Cost Function:

demand TC =500+20Q
schedule:
P=100-2Q
  (100  2Q)Q  500  20Q
  100Q  2Q  500  20Q

2
To maximise the function with respect to Q:

d
 100  4Q  20  0
dQ
Marginal 100  4Q  20 Marginal
Revenue Cost
100  4Q  20
4Q  80
The profit-
maximising
level of
Q  20
output
Price
100
Slope = -2
Quantity
50
Total Revenue: TR = 100Q - 2Q2
1250
Quantity
0 25
TC = 500 + 20Q
500
Quantity
0 ? 50
TC = 500 + 20Q
500
Quantity
0 20 50
P = 100 - 2Q
Price
100
80
800
Quantity
10 50
P = 100 - 2Q
Price
100
80
78
858
Quantity
10 11 50
P = 100 - 2Q
Price
858 - 800 = 58
100
80 Marginal Revenue
78
858
Quantity
10 11 50
P = 100 - 2Q
Price 858 - 800 = 58
100
Revenue lost by reducing the
80 20 price on the first ten units.
78
78 Revenue gained from sale

of one extra unit at $78
Quantity
10 11 50
Quantity Price Revenue M.R.
0 100 0
1 98 98 98 MR falls
2 96 192 94 twice as fast
3 94 282 90 as price
. . . .
10 80 800
11 78 858 58
. . . .
24 52 1248
25 50 1250 2 MR
26 48 1248 -2 becomes
. . . negative at
the midpoint
P = 100 - 2Q TR = 100Q - 2Q2
Price
MR = 100 - 4Q
100
Quantity
50
P = 100 - 2Q
Price
100 MR = 100 - 4Q
Marginal Revenue Schedule

50
1250
Quantity
25 50
P = 100 - 2Q
Price
MR = 100 - 4Q
100
1250
Quantity
25 50
P = 100 - 2Q
Price
MR = 100 - 4Q
100
20 MC
Quantity
? 25 50
P = 100 - 2Q
Price
100 To maximize profit, the

monopoly sets price at…
?
20 MC
Quantity
20 25 50
P = 100 - 2Q
Price
100
The monopoly sets
price at $60.
60
Profit
20 MC
Quantity
20 25 50
P = 100 - 2Q
Price
100
60
Profit
20 MC
Quantity
20 25 50
PLAN
• Monopoly model
• Oligopoly
Pure Monopoly
Competition
Monopolistic
Competition
Pure Monopolistic Monopoly
Competition Competition
Number of Many Many One
Sellers
Homogeneous Yes No NA
Product?
Barriers to No No Yes
entry?
Downward-sloping demand curve
Price of reflects a degree of market
a meal power.
AC
PS* MC
ACS
MR
Q S* Number of meals
Price of
a meal
AC
PS* MC
Profit
ACS
MR
Price of
a meal
AC
MC
PS*
ACS
MR
Price of
a meal
AC
MC
PS*
Profit
ACS
MR
Long-run equilibrium
Price of
a meal All firms earning zero profits
AC
MC
PL*= AC
MR
QL* Number of meals
$
AC
MC
AVC
P3
P2
P1
10 20 30 40 Output
$
AC
MC
AVC
P1
P2
10 20 30 40 Output
PLAN
• Monopoly model
• Oligopoly
I would be prepared to pay $300 for a plane ticket
to Melbourne
Someone offers to sell me a ticket for $200.

I am paying $200 for something that I value at
$ 300. Thus I obtain a 'profit' (surplus) of $100 from
the transaction.
Consumer Surplus:
the difference between the maximum

price that customers would pay
(represented by the demand schedule)
and the price they actually pay.
Price of Sydney Melbourne ticket is = $ 200
Customer Reservation Consumer

Price Surplus
1 400 200
2 300 100
3 200 0
4 100 0
Price of
Plane
Ticket DEMAND SCHEDULE
400
300
200
100
1 2 3 4
Price of
Plane
Ticket CONSUMER SURPLUS
400
300
200 Price
100
1 2 3 4
Price Consumer Surplus: area between
demand curve and price line
Po
Demand
Qo
Price Increase in consumer surplus when
price changes from Po to P1
Po
P1
Demand
Qo Q1
Price
Area A: Income redistributed from
producers to consumers
Po
A B
P1
Demand
Qo Q1
Price
Area A: Income redistributed from
producers to consumers
Area B: surplus of new

consumers (who couldn't
Po afford to buy at Po)
A B
P1
Demand
Qo Q1
I would be prepared to knit and sell a woollen
sweater for $ 200.
Someone offers me $ 300 to knit a sweater.
I am getting $ 300 for something that I value at

$ 200. Thus I obtain a profit (surplus) of $ 100 from
the transaction.
PRODUCER SURPLUS: The difference between

what a producer would be prepared to accept and
what they actually get for a good.
PERSON COST OF PROD. SURPLUS
JUMPER IF PRICE = 300
Alfonso 400 0
Anastasia 300 0
Vladimir 200 100
Don 100 200
TOTAL 300
Price of
Woollen
Sweater SUPPLY SCHEDULE
400
300
200
100
1 2 3 4
Price of
Woollen
PRODUCERS’ SURPLUS
Sweater
400
300 Price
200
100
1 2 3 4
Price Producer Surplus: area between
supply curve and price line
Supply
Po
Qo
A producer will supply quantity Q if:
Revenue > Variable Cost
Therefore:
Producer’s surplus = Revenue - Variable Cost
Recall that:
Profit = Revenue - Variable Cost – Fixed Cost
Therefore:
Producer’s Surplus = Profit + Fixed Cost
Price Total Surplus or W elfare: consumer
surplus plus producer surplus
Supply
Po
Demand
Qo
Price Note that when P = MC, total
surplus is maximized.
Supply
Po
Demand
Qo
Price Suppose the Govt imposes a
price ceiling of Pc.....
Supply
Po
Pc
Demand
Qo
Price ...leading producers to reduce
output to Qc...
Supply
Po
Pc
Demand
Qc Qo
Price New Consumer
Surplus
Supply
Po
Pc
Demand
New Producer
SurplusQc Qo
P = 100 - 2Q
Price
100
Consumer
surplus
60
Profit
20 MC
Quantity
20 25 50
P = 100 - 2Q
Price
Consumer surplus
100 transferred to producer
60 Lost consumer surplus

(deadweight welfare loss)
Profit
20 MC
Quantity
20 25 40 50
PLAN
• Monopoly model
• Oligopoly
Structure Conduct Performance
Whether the How it Whether the market

market is behaves, in produces an
competitive, particular efficient outcome,
monopoly, how firms set in terms of profits or
oligopoly etc. their prices social welfare.
How How do firms Can a person obtain

concentrated use their the good, who wants
is the ‘market it enough to pay for
industry? power’? the cost of
production?
Downward-sloping demand curve
Price of reflects a degree of market
a meal power.
P* MC
Why market
DWL power is a
MC problem
How we measure Q* Number of meals

market power
The questions:
1.If structure depends mostly on concentration, how

do we measure concentration?
2. What determines concentration?
3. If conduct refers to the exercise of market power,

how do we measure market power?
4. What gives a firm market power? How much does it

really depend on concentration, as measured by the
concentration ratio? What other factors cause some
firms to have more market power than others?
PLAN
• Monopoly model
• Oligopoly
Four-firm concentration ratio:
the share of the four largest firms in total sales.
FIRM Sales ($
billions)
A 42 42  27  16  12
B 27 114
C 16
D 12  0.76
E 8
F 6
G 3
Total 114
Which of these industries is the most concentrated?
Case
Firm 1 2 3 Herfindahl-
A 25 70 100 Hirschmann
Index
B 25 10 0
C 25 10 0
Sales of Firm A
D 25 10 0 wA 
Total sales
Total 100 100 100
HHI 625 4900 10000

HHI  10,000  wA  wB  wC  wD
2 2 2 2

What determines the concentration of an industry?
If it’s caused by barriers to entry, then we need to consider

the specifics: natural advantages, legally conferred
advantages, secrets.
If there are no barriers to entry, then (as illustrated in the

‘firm numbers’ spreadsheet), it depends on fixed costs.
For any given level of fixed costs we can speak of an

‘equilibrium concentration’, i.e. the degree of concentration
that forces profits down to zero.
Marginal and Average Cost
200.0
180.0
160.0
140.0
Marginal Cost, Average Cost
120.0
100.0
80.0
C
60.0
40.0
B
A
20.0
0.0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Output
Cost Function
2500
2000
1500
Cost
1000 C
B
500 A
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26
Output
Short run cost curves for many levels of fixed capital
Total Cost
Output
Short run cost curves for many levels of fixed capital
Total Cost
Envelope of the
short-run curves
In the long-run, the firm can vary all

factors of production to minimise the cost
of producing its chosen output level.
Output
Hence, this is a long-run total cost curve.
Total Cost
Envelope of the
short-run curves
In the long-run, the firm can vary all

factors of production to minimise the cost
of producing its chosen output level.
Output
Average
Total Cost
Output
Short run average cost curves for many levels of fixed capital
Average
Total Cost
Envelope of the
short-run curves
Output
Hence, this is a long-run
Average average total cost curve.
Cost
Falling Costs Rising Costs

(Economies of (Diseconomies
Scale) of Scale)
MES Output
Minimum Efficient Scale
Cost
structure
Concentration
Size of the
market
How many firms
can supply Dm at
Average min. average cost?
Cost
Market Demand
Minimum
Average
Cost
Dm
Output
If MES is very high, the
Average industry is a natural monopoly.
Cost
Market Demand
Minimum
Average
Cost
Dm
Output
If MES is very low, the market
has room for many firms.
Average Market Demand
Cost
Firms are a price-takers
Minimum
Average
Cost
Dm
Output
PLAN
• Monopoly model
• Oligopoly
Lerner Index
P  MC
P
Suppose Marginal Cost = 30, Price = 40
P  MC 60  40  33%

MC 60
 1
MR  P1   Relation of MR, price and elasticity
 
 1
MC  P1   Profit-maximisation
  assumption: MR  MC
MC  1 
 1  
P  
MC  1
1  1  1  
P  
P  MC 1
 Lerner Index
P 
P  MC 1

P 
P  MC
  0 No markup
MC
P  MC
 1 1 100% markup
MC
P  MC Huge markup!
 0 
MC
PLAN
• Monopoly model
• Oligopoly

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Week Three

Competition and Welfare

They must operate on their cost curves, i.e. minimise

But they also need to choose the right level of output.

A pure competitor is a price taker, so the

Slope = MC Profit is maximised

…where their slopes

160 Shut-down price,

If price is below average total cost but above average

If price is below average variable cost, cease

A monopoly is the sole producer in a

If it decides to sell Q0, the market

The monopoly's Problem: Choose Q to max. П(Q)

The monopoly's Problem: Choose Q to max. П(Q)

To maximise the function with respect to Q:

The monopoly's Problem: Choose Q to max. П(Q)

The monopoly's Problem: Choose Q to max. П(Q)

  (100  2Q)Q  500  20Q

Linear Cost Function:

The monopoly's Problem: Choose Q to max. П(Q)

  (100  2Q)Q  500  20Q

  100Q  2Q  500  20Q

To maximise the function with respect to Q:

The monopoly's Problem: Choose Q to max. П(Q)

78 Revenue gained from sale

Marginal Revenue Schedule

100 To maximize profit, the

Someone offers to sell me a ticket for $200.

the difference between the maximum

Customer Reservation Consumer

Area B: surplus of new

Someone offers me $ 300 to knit a sweater.

I am getting $ 300 for something that I value at

PRODUCER SURPLUS: The difference between

60 Lost consumer surplus

Whether the How it Whether the market

How How do firms Can a person obtain

How we measure Q* Number of meals

1.If structure depends mostly on concentration, how

2. What determines concentration?

3. If conduct refers to the exercise of market power,

4. What gives a firm market power? How much does it

the share of the four largest firms in total sales.

If it’s caused by barriers to entry, then we need to consider

If there are no barriers to entry, then (as illustrated in the

For any given level of fixed costs we can speak of an

In the long-run, the firm can vary all

In the long-run, the firm can vary all

Falling Costs Rising Costs

Firms are a price-takers

Suppose Marginal Cost = 30, Price = 40

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