Market Structure: Perfect Competition and Monopoly

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1 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly OVERVIEW One of the most important decisions made by a manager is how to price the firm s product. If the firm is a profit maximizer, the price charged must be consistent with the realities of the market and economic environment within which the firm operates. Remember, price is determined through the interaction of supply and demand. A firm s ability to influence the selling price of its product stems from its ability to influence the market supply and, to a lesser extent, on its ability to influence consumer demand. One important element in the firm s ability to influence the economic environment within which it operates is the nature and degree of competition. A firm operating in an industry with many competitors may have little control over the selling price of its product because its ability to influence overall industry output is limited. In this case, the manager will attempt to maximize the firm s profit by minimizing the cost of production by employing the most efficient mix of productive resources. On the other hand, if the firm has the ability to significantly influence overall industry output, or if the firm faces a downward-sloping demand curve for its product, then the manager will attempt to maximize profit by employing an efficient input mix and by selecting an optimal selling price. Market structure refers to the competitive environment within which a firm operates. Economists divide market structure into four basic types: Perfect competition, monopolistic competition, oligopoly, and monopoly. Perfect competition and monopoly represent opposite ends of the competitive spectrum. Managerial Economics: Theory and Practice 113 Copyright 2003 by Academic Press. All rights of reproduction in any form reserved.

2 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly The characteristics of a perfectly competitive industry are a large number of sellers and buyers, a standardized product, complete information about market prices, and complete freedom of entry into and exit from the industry. A perfectly competitive firm produces a minuscule proportion of the total industry output. Thus, although the market demand curve is downward sloping, the demand curve from the perspective of the individual firm is perfectly elastic (horizontal). A perfectly competitive firm can sell as much as it wants at an unchanged price. A perfectly competitive firm has no market power, and is said to be a price taker. Total revenue is defined as price (P) times output. Marginal revenue (MR) is defined as the increase (decrease) in total revenue given an increase (decrease) in output. For a perfectly competitive firm, marginal revenue is identically equal to the selling price. Since, MR = P, then MR = ATR (average total revenue). All profit-maximizing firms produce at an output level where marginal revenue equals marginal cost (MC), i.e., MR = MC. Since MR = P 0,the profit-maximizing condition for a perfectly competitive firm is P 0 = MC. If price is greater than average total cost, then a perfectly competitive firm earns positive economic profits, which will attract new firms into the industry and shifts the market supply curve to the right and drives down the selling price. If price is less than average total cost, then the firm generates economic losses, which cause firms to exit the industry and shift the market supply curve to the left and drive up the selling price. When P 0 = ATC, then a perfectly-competitive firm breaks even, i.e., earns zero economic profits. At this break-even price, the industry is in long-run competitive equilibrium, which implies that P 0 = MC = ATC. Finally, since MC = ATC per unit costs is minimized, i.e., perfectly competitive firms produce efficiently in the long run. In the short run, a perfectly competitive firm earning an economic loss will remain in business as long as price is greater than average variable cost (AVC). This is because the firm s revenues cover all of its fixed cost and part of its variable cost. When P 0 < AVC, the firm will shut down because revenues cover only part of its variable cost and none of its fixed cost.when P 0 = AVC, then the firm is indifferent between shutting down and remaining in business. This is because in either case the firm s economic loss is equivalent to its total fixed cost. This price is called the shutdown price. The characteristics of a monopolistic industry are a single firm, a unique product, absolute control over supply within a price range, and highly restrictive entry into or exit from the industry. Unlike the perfectly competitive firm, a monopoly faces the downward sloping market demand curve, which implies that the selling price is negatively related to the output of the firm. A monopolist has market power and is said to be a price maker.

3 WSG8 7/7/03 4:34 PM Page 115 Multiple Choice Questions 115 A profit-maximizing monopolist will produce at an output level where MR = MC. Unlike a perfectly competitive firm, selling price is always greater than the marginal revenue, i.e., P > MR. Like a perfectly competitive firm, the monopolist earns an economic profit when P > ATC. Unlike a perfectly competitive firm, this condition is both a short-run and a longrun competitive equilibrium since new firms are unable to enter the industry to increase supply, lower selling price, and compete away the monopolist s economic profits. Finally, since MC < ATC, per unit costs are not minimized, i.e., monopolists produce inefficiently in the long run. A natural monopoly is a firm that is able to satisfy total market demand at a per unit cost of production that is less than an industry comprising two or more firms. Collusion refers to a formal agreement among producers in an industry to coordinate pricing and output decisions to limit competition and maximize collective profits. MULTIPLE CHOICE QUESTIONS 8.1 Perfect competition is characterized by: A. Large number of firms; heterogeneous product; easy entry and exit. B. Large number of firms; homogeneous product; incomplete information. C. Large number of firms; homogeneous product; easy entry and exit. D. Few firms; homogeneous product; difficult entry and exit. E. Few firms; differentiated product; easy entry and exit. 8.2 Firms in perfectly-competitive industries may be characterized as: A. Price takers. B. Price creators. C. Price makers. D. Price setters. E. Price negotiators. 8.3 A firm operating in a perfectly-competitive industry faces a demand that is: A. Vertical. B. Horizontal. C. Downward sloping. D. Upward sloping.

4 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly 8.4 In the short run, perfectly-competitive firms may earn: A. Positive economic profit. B. Positive accounting profit. C. Normal profit. D. Negative economic profit. E. All of the above. 8.5 To maximize profit, a perfectly-competitive firm should produce up to the output level where: A. MR = MC. B. P = MR. C. P = MC. D. P = ATC. E. A and C are correct. 8.6 To maximize profit, a perfectly-competitive firm should produce up to the output level where: I. The addition to total cost is equal to the selling price of the product. II. The cost of producing the last unit of output is equal to the selling price of the product. III. Marginal profit is zero. Which of the following is correct? A. I only. B. II only. C. III only. D. I and II only. E. I and III are correct. 8.7 In the short run, a profit-maximizing perfectly-competitive firm will definitely earn positive economic profits when: A. P = MC. B. MR = MC. C. P > ATC. D. P > AVC. E. A and B are correct. 8.8 A profit-maximizing perfectly-competitive firm will break even when: A. P = MC. B. MR = MC. C. AVC = ATC. D. P = ATC.

5 WSG8 7/7/03 4:34 PM Page 117 Multiple Choice Questions A profit-maximizing perfectly-competitive firm will shut down when: A. p < 0. B. P < MC. C. P < ATC. D. P < AVC If P < MC, then a profit-maximizing perfectly-competitive firm can increase its economic profit by: A. Increasing output. B. Decreasing output. C. Reducing total fixed cost. D. Lowering wage rates. E. B, C, and D are correct Suppose that a profit-maximizing perfectly-competitive firm is able to sell all of its output for $10 per unit. If the firm total cost equation is TC = Q + 0.5Q 2, then this firm: A. Is earning positive economic profit. B. Is earning negative economic profit. C. Should increase the selling price of its product. D. Should shut down. E. Both B and D are correct In the short run, the supply curve of a profit-maximizing perfectlycompetitive firm is: A. The MC curve above the ATC curve. B. The MC curve above the AVC curve. C. The ATC curve above the MC curve. D. The AVC curve above the MC curve. E. The ATC curve If a typical firm in a perfectly-competitive industry is earning a negative economic profit, then we can expect: A. Some firms to exit the industry. B. The market price of the product to rise. C. The market supply curve to shift to the left. D. Industry supply to fall. E. All of the above Suppose that a profit-maximizing, perfectly-competitive firm can sell its entire output for $30. The firm s marginal cost, average variable cost, and average total cost are $20, $25, and $35, respectively.

6 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly I. This firm should shut down. II. This firm should continue to produce. III. This firm should increase its output. IV. This firm is earning an economic loss. Which of the following is correct? A. I and IV only. B. III only. C. IV only. D. II and III only In the long run, a profit-maximizing, perfectly-competitive firm will product at an output level where: A. P = MC = ATC. B. P = MC > ATC. C. MR > MC > ATC. D. P > ATC In the long run, a profit-maximizing, perfectly-competitive firm will earn: A. A normal rate of return. B. Positive economic profit. C. Negative economic profit. D. Accounting profit that is greater than economic profit The function form of the total revenue equation for a perfectlycompetitive firm: A. Is quadratic. B. Is cubic. C. Is logarithmic. D. Is linear. E. Varies from firm to firm A profit-maximizing firm produces at an output level where the: A. Slope of the total revenue curve is greater than the slope of the total cost curve. B. Slope of the total revenue curve is less than the slope of the total cost curve. C. Slope of the total revenue curve is the same as the slope of the total cost curve. D. Slope of the marginal revenue curve is the same as the slope of the marginal cost curve.

7 WSG8 7/7/03 4:34 PM Page 119 Multiple Choice Questions Monopolies are often referred to as: A. Price takers. B. Price creators. C. Price makers. D. Price setters. E. Price negotiators To maximize profit, a profit-maximizing monopolist should produce at an output level where: A. MR = MC. B. P = MR. C. P = MC. D. P = ATC. E. A and C are correct For a profit-maximizing monopolist: A. P > MR. B. P = MR. C. P > MC. D. P = ATC. E. Both A and C are correct Monopolies may derive their market power from: A. Patent rights. B. Control of productive resources. C. Economies of scale. D. Government franchise. E. All of the above Natural monopolies exist because: A. The marginal revenue curve intersects the average total cost curve at its minimum point. B. A single firm is able to satisfy market demand at lower per unit cost than several firms. C. They earn substantial economics profits, which enable them buy out competitors. D. They own the patent rights to a product Consider Figure 1, which depicts an industry that is dominated by a single firm. The profit maximizing price and output level are: A. $10 and 50 units. B. $20 and 60 units. C. $22 and 50 units. D. $25 and 50 units.

8 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly 8.25 Consider Figure 1, which depicts an industry that is dominated by a single firm. At the profit-maximizing level of output, the firm s total cost is: A. $500. B. $1,000. C. $1,100. D. $1,200. E. None of the above. FIGURE Consider Figure 1, which depicts an industry that is dominated by a single firm. At the profit-maximizing level of output, the firm s total profit is: A. $150. B. $250. C. $750. D. $1,250. E. None of the above Consider Figure 1, which depicts a perfectly competitive industry comprised of 20 perfectly identical firms. The total output of each firm in the industry is: A. 2 units. B. 3 units. C. 4 units. D. 5 units. E. None of the above Consider Figure 1, which depicts a perfectly competitive industry comprise of 20 perfectly identical firms. Each firm in the industry is earning an economic profit of: A. $0. B. $7.50. C. $ D. $ E. $ Consider Figure 1, which depicts a perfectly competitive industry comprise of 20 perfectly identical firms. This industry is in:

9 WSG8 7/7/03 4:34 PM Page 121 Multiple Choice Questions 121 A. Short-run competitive equilibrium. New firm s will enter the industry, which will result in a decline in the market price and an increase in the output level. B. Short-run competitive equilibrium. Some firm s will exit the industry, which will result in an increase in the market price and an decline in the output level. C. Long-run competitive equilibrium. Firms will neither enter nor exit the industry and the market price and output level will remain unchanged. D. Long-run competitive equilibrium. Each firm in the industry will earn above normal profits The demand curve for a product produced by a monopolist is most likely: A. Vertical. B. Horizontal. C. Downward sloping. D. The monopolist does not face a demand curve since price is a function of the number of units produced The demand equation for a product sold by a profit-maximizing monopolist is Q = P. If the monopolist s total cost equation is TC = Q + 0.5Q 2, then the firm s profit-maximizing price is: A. $ B. $ C. $ D. $ E. None of the above The market demand for the output of a monopoly is Q = P. The monopolist s total cost of production is TC = Q + 2.5Q 2. The monopolist s maximum profit is: A. $50. B. $100. C. $250. D. $400. E. None of the above In the long run, monopolies generally: A. Earn an economic profit. B. Earn a normal rate of return. C. Earn zero economic profit. D. Break even.

10 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly 8.34 A monopolist is currently maximizing its profits. An increase in total fixed cost will cause the monopolist to: A. Increase output. B. Decrease output. C. Lower total variable cost. D. Do nothing. E. This question cannot be answered with the information provided The Lerner index is a: A. Measure of monopoly power. B. Measure of industrial concentration. C. Measure of total deadweight loss. D. None of the above The Lerner index is: A. Always equal to unity for a monopolist. B. Always equal to zero for a perfectly-competitive firm. C. The negative inverse of the price elasticity of demand. D. Both B and C are correct At the profit-maximizing level of output a firm s marginal cost is $8. If the selling price is $16, then the price elasticity of demand for the firm s product is: A B C D At the profit-maximizing level of output a firm s marginal cost is $8. If the selling price is $16, then measure of the firm s monopoly power as measured by the Lerner index is: A B C D Suppose that a group of venture capitalists organize a syndicate to acquire every firm in a perfectly competitive industry. The most likely result will be: A. A higher price and greater output. B. A higher price and lower output. C. No change in price or output. D. A lower price and greater output. E. A lower price and lower output.

11 WSG8 7/7/03 4:34 PM Page 123 Shorter Problems Suppose that a group of venture capitalists organize a syndicate to acquire every firm in a perfectly competitive industry. The most likely result will be: A. An increase in consumer surplus. B. A decrease in consumer surplus. C. A decrease in consumer deadweight loss. D. A decrease in producer deadweight loss. E. A decline in per unit cost of production. SHORTER PROBLEMS 8.1 The Safari Company produces a line lightweight hiking boots. Safari s total monthly cost equation is TC = 1, Q Q 2 where Q represents a pair of hiking boots. Suppose that Safari can sell as many pair of hiking boots that it produces for $100. A. Determine Safari s profit-maximizing monthly production of hiking boots. B. What is Safari s monthly profit? 8.2 The supply and demand curves for a perfectly-competitive market are: Q D = 32,500-25P Q S = P A. What are the market-equilibrium price and quantity? B. Suppose that the firms in this industry enter into a collusive agreement to form a monopoly. If the monopolist is a profit maximizer, then what is the new price and industry output? 8.3 A perfectly-competitive firm s total cost function is TC = 4, Q - 25Q Q 3 where Q represents units of output produced. Below what price should the firm shut down its operations? 8.4 The market-determined price in a perfectly competitive industry is P = $5. The total cost equation of an individual firm in this industry is TC = Q + 0.1Q 2 Calculate the value of the Lerner index for this firm.

12 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly 8.5 The demand equation for a product sold by a monopolist is P = Q The total cost equation of the firm is TC = Q + 0.5Q 2 Calculate the value of the Lerner index for this firm. 8.6 Suppose that a firm s long-run average total cost curve is: LRATC = Q + 0.5Q 2 Determine the long-run, profit-maximizing price and output level for a perfectly-competitive firm. 8.7 The demand equation confronting a profit-maximizing monopolist is Q = P A. Calculate the monopolist s total-revenue-maximizing price and output level. At this output level, calculate the price-elasticity of demand. What is the value of the Lerner index? B. Suppose that the monopolist s total cost equation is TC = Q. Calculate the monopolist s profit-maximizing price and output level. At this output level, calculate the price-elasticity of demand. What is the value of the Lerner index? LONGER PROBLEMS 8.1 Suppose that the supply and demand equations for a perfectlycompetitive market are: Q D = P Q S = P A. Calculate the market-equilibrium price and quantity. B. Suppose that there are 25 firms in the industry. How much does each firm in the industry produce? C. Suppose that the total cost equation of each firm in the industry is TC = Q + 0.2Q 2. Is each firm producing at its profitmaximizing level of output? If not, when how should each firm alter its production? D. Is each firm in the industry in long-run competitive equilibrium?

13 WSG8 7/7/03 4:34 PM Page 125 Answers to Multiple Choice Questions A monopolist that faces the following market demand and total cost functions: Q = P TC = Q + 2.5Q 2 A. What is the profit-maximizing price (P m ) and output (Q m ) for this firm? B. At this price and quantity combination, how much is consumer surplus? C. How much economic profit is the monopolist earning? D. Suppose that government regulators require that the monopolist set the selling price of their product at the long-run perfectlycompetitive rate. At this price, what is consumer surplus? ANSWERS TO MULTIPLE CHOICE QUESTIONS 8.1 C. 8.2 A. 8.3 B. 8.4 E. 8.5 E. 8.6 E. 8.7 C. 8.8 D. 8.9 D B B B E D A A D C C A E E B D C A B A C C C D A D A D C B B B.

14 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly SOLUTIONS TO SHORTER PROBLEMS 8.1 A. p=tr - TC = 100Q - 1,250-10Q Q 2 =-1, Q Q 2 dp/dq = Q = 0, i.e., the first-order condition for p maximization. Q* = 900 pair of hiking boots per month. d 2 p/dq 2 =-0.1 < 0, i.e., the second-order condition for p maximization is satisfied. B. p=-1, (900) (900) 2 = $39,250 per month 8.2 A. Q D = Q S 32,500-25P = P 60P = 33,000 P* = $550 Q* = 32,500-25(550) = (550) = 18,750 B. P = 1, Q TR = PQ = (1, Q)Q = 1,300Q Q 2 MR = 1, Q The industry supply curve is the sum of the individual firms marginal cost curves. P = (500/35) + (1/35)Q = MC To maximize profit, the monopolist will produce where MR = MC. 1, Q = 500/35 + 1/35Q Q* = 1, P* = 1, (1,285.71) = $1, TVC = 800Q - 25Q Q 3 AVC = TVC/Q = Q + 0.2Q 2 davc/dq = Q = 0, i.e., the first-order condition for AVC minimization. d 2 AVC/dQ 2 = 0.4 > 0, i.e., the second-order condition for AVC minimization is verified. Q* = 62.5

15 WSG8 7/7/03 4:34 PM Page 127 Solutions to Shorter Problems 127 A profit-maximizing firm produces at the output level where P = MC. P = MC = dtvc/dq = Q + 0.6Q 2 = (62.5) + 0.6(62.5) 2 = $18.75 If the price falls below $18.75 per unit, then the firm should shut down. 8.4 p=tr - TC = 5Q - (10 + 2Q + 0.1Q 2 ) = Q - 0.1Q 2 The profit-maximizing output level is dp/dq = 3-0.2Q = 0 i.e., the first-order condition for p maximization. d 2 p/dq 2 = 0.2 > 0, i.e., the second-order condition for p maximization is verified. Q* = 15 MC = dtc/dq = Q = (15) = 5 The value of the Lerner index is -1/e P = (P - MC)/P = (5-5)/5 = 0/5 = 0 Thus, this perfectly-competitive firm has no monopoly power. The firm s proportional markup over marginal cost is zero, i.e., the firm is earning zero economic profit. 8.5 p=tr - TC = PQ - TC = (75-4.5Q)Q - ( Q + 0.5Q 2 ) = Q - 5Q 2 dp/dq = 50-10Q = 0, i.e., the first-order condition for p maximization. d 2 p/dq 2 =-10 < 0, i.e., the second-order condition for p maximization is satisfied. Q* = 5 P* = (5) = $52.5 MC = dtc/dq = 25 + Q = = 30 The value of the Lerner index is -1/e P = (P - MC)/P = ( )/52.5 = 9/16 = This firm enjoys monopoly power. The firm s proportional markup over marginal cost is 52.9 percent, i.e., the firm is earning positive economic profit.

16 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly 8.6 In the long run, perfectly competitive firms will produce at the minimum point on the LRATC curve. dlratc/dq = Q = 0, i.e., the first-order condition for LRATC minimization. d 2 LRATC/dQ 2 = 1 > 0, i.e., the second-order condition for LRATC minimization is verified. Q* = 20 Since the demand curve is horizontal and tangent to LRATC, then the selling price is equal to the minimum value of LRATC, i.e., LRATC = (20) + 0.5(20) 2 = 50 = P* 8.7 A. P = 50-2Q TR = 50Q - 2Q 2 dtr/dq = 50-4Q = 0, i.e., the first-order condition for TR maximization. d 2 TR/dQ 2 =-4 < 0, i.e., the second-order condition for TR maximization is satisfied. Q* = 12.5 P* = 50-2(12.5) = $25 e P = (dq/dp)(p/q) = -0.5(25/12.5) = -1 Lerner index = 1/-e P = 1 B. p=tr - TC TR = PQ = (50-2Q)Q = 50Q - 2Q 2 p=(50q - 2Q 2 ) - ( Q) = Q - 2Q 2 dp/dq = 30-4Q = 0, i.e., the first-order condition for p maximization. d 2 p/dq 2 =-4 < 0, i.e., the second-order condition for p maximization is satisfied. Q* = 7.5 P* = 50-2(7.5) = $35 e P = (dq/dp)(p/q) = -0.5(35/7.5) = Lerner index = 1/-e P = SOLUTIONS TO LONGER PROBLEMS 8.1 A. Q D = Q S P = P 80P = 1,600 P* = $20 Q* = (20) = (20) = 625

17 WSG8 7/7/03 4:34 PM Page 129 Solutions to Longer Problems 129 B. 625/25 = 25, i.e., each firm in the industry produces 25 units of output. C. TR = PQ = 20Q p=tr - TC = 20Q - (5 + 10Q + 0.2Q 2 ) = Q - 0.2Q 2 dp/dq = Q = 0, i.e., the first-order condition for p maximization. Q* = 25 d 2 p/dq 2 =-0.4 < 0, i.e., the second-order condition for p maximization is verified. Since each firm in the industry is producing at the profitmaximizing level of output then there is currently no reason to alter the current level of production. D. If a perfectly-competitive firm is in long-run competitive equilibrium then P = ATC at the profit-maximizing level of output. ATC = TC/Q = (5 + 10Q + 0.2Q 2 )/Q = 5Q Q = 5(25) (25) = 15.2 π 20 = P* Alternatively, an individual firm in a perfectly-competitive industry is in long-run competitive equilibrium when p = 0.At the current level of output, the profit of each firm is p* = (25) - 0.2(25) 2 = $120 Since each firm is earning a positive economic profit, then new firms will enter the industry, which will increase industry supply and result in lower prices. This process will continue until each firm earns zero economic profit. Since the MC curve of each firm is upward sloping, then as total industry output increases, the output of each individual firm declines. 8.2 A. P = Q TR = PQ = 125Q Q 2 p=tr - TC = (125Q Q 2 ) - (500-55Q + 2.5Q 2 ) = Q - 15Q 2 dp/dq = Q = 0, i.e., the first-order condition for p maximization. d 2 p/dq 2 =-30 < 0, i.e., the second-order condition for p maximization is satisfied.

18 WSG8 7/7/03 4:34 PM Page Market Structure: Perfect Competition and Monopoly Q m * = 6 P m * = (6) = $50 B. Consumer Surplus = 0.5(125 - P m )Q m = 0.5(125-50)6 = $225 C. p* = (6) - 15(6) 2 = $40 D. The perfectly-competitive, long-run equilibrium price is P = MC = ATC minimum ATC = TC/Q = (500-55Q + 2.5Q 2 )/Q = 500Q Q datc/dq = -500Q = 0, i.e., the first-order condition for ATC minimization. Q* = d 2 p/dq 2 = 1,000Q -3 = 1,000/(14.14) 3 > 0, i.e., the second-order condition for ATC minimization is satisfied. P pc * = 500Q Q = 500(14.14) (14.14) = $15.71 Q pc = (15.71) = 8.74 Consumer Surplus = 0.5(125 - P pc )Q pc = 0.5( )8.74 = $477.60

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