2 Learning Outcomes Upon completion of this chapter, you will be able to: Explain how firms in perfect competition determine output and why firms are price takers Explain how monopolists determine price and output and why they are price makers Use simple calculus to calculate the profit maximisation output for perfect competitive firms and monopolists Compare perfect competition with monopoly from the point of social efficiency Explain the managerial implications of perfect competition and monopoly.
3 Price-Output Decisions of Firms Basic Business Decisions: What Output level to produce to max Profits? What Price to charge? At these levels of P & Q, what is profit level? The answer depends on the structure (organization) of the market If firm incurs losses: should it continue operating in the short-run (and in the long run, hoping that things may change) or should firm close down and exit the market? What if firm s objective is to maximise revenue? What values for P & Q?
4 Market Structure Spectrum More Competitive Less Competitive Perfect Competition Monopolistic Competition Oligopoly Monopoly
5 Comparative Characteristics of Markets Perfect Competition Monopolistic Competition Oligopoly Monopoly Number & Nature of Sellers Many (small sellers) Independent Many (small to medium) Few (large) Inter-dependent One Price No control Some control Considerable control Absolute control Nature of Product Homogeneous (no differentiation) Some differentiation Sometimes but not always No substitutes Barriers to entry None Low Considerable Entry is blocked Profit Potential Normal Profits in LR Some profits in SR & LR Considerable Profits in SR & LR Large Profits in SR & LR Product Promotion & Advertising None or minimal Considerable Heavy Some but not directed at rivals, but to increase sales
6 Characteristics of Perfect Competition many sellers so no individual believes that their own action can affect market price firms take price as given so face a horizontal demand curve the product is homogeneous (identical, similar) perfect customer information/knowledge about price, product features & quality, location of sellers, etc free entry and exit of firms Perfect mobility of resources Examples: - Stock Market - Wheat market
7 Perfect Competition Based on these characteristics of PC: Firms are price takers Each firm produces a very small % of entire market Non-price competition activities are not necessary or possible Each firm s demand curve is horizontal (perfectly elastic) This means that P = AR = MR
8 Demand Curve in PC Horizontal demand curve: P = AR = MR buyers will buy ALL that firm can sell at the going market price. firm s MR is same for each additional unit of product equal to the price of the product. Let s prove this: Recall that TR = P * Q AR = TR / Q AR = (P * Q ) / Q Thus P=AR MR = dtr / dq = d(p * Q) / dq. Since firms are price-takers, P does not change, P ( dq/dq) = P Thus P=MR
9 PC: P & Q Determination Prices are determined in the market Consider the following demand and supply functions: Qd = P Qs = P At equilibrium, Qd = Qs P = P 20P = 200 P e = 10 Q e = 150
10 Firm Decisions in Perfect Competition Competitive Industry Competitive Firm S P e =10 E D=P=AR=MR Q e =150 D Q Q The firm accepts P e = 10 as given, and decides what output to produce where MR = MC to maximize profits.
11 Total Revenue, Total Cost & Profit Total revenue: Average revenue: Marginal revenue: TR = P*Q AR = TR / Q MR = ΔTR / ΔQ. Total cost: Average total cost: Average variable cost: Marginal cost: TC = TFC + TVC ATC = TC / Q AVC = TVC / Q MC = ΔTC / ΔQ. Π = TR TC Max Π = Max(TR TC)
12 PC: SR Profit Maximization Total Revenue-Total Cost approach: Compare the total revenue and total cost schedules and find the level of output that either maximizes the firm s profits or minimizes its loss. Profit = TR TC =(P - AC) Q* Marginal Revenue Marginal Cost Approach To maximize profit firm produces where the additional revenue (MR) received from the last unit is equal to the additional cost (MC) of producing that unit. That is, where MR=MC. In perfect competition, the optimal output (Q*) is where P=MR=MC (since P=MR in perfectly competitive markets)
13 PC: Hypothetical Data Q TR= P * Q TC=ATC *Q Π= TR- TC AR ATC MR= ΔTR/ΔQ MC= ΔTC/ΔQ
15 PC: SR Profit Max: Marginal Approach MR = MC at Q =5 and P= 10. At this Q, ATC 1 = 8. Thus the firm makes a per unit profit of 2, or total profits of 10.
16 PC: SR Profit Maximization If firm s costs are represented by ATC 2, where MR = MC, ATC 2 > P losses. The decision Rule is: If P > AVC stay in operations. If P < AVC close down.
17 Contribution Margin Contribution Margin the amount by which price or average revenue (or total revenue) exceeds average variable cost (total variable cost). CM = AR(=P) AVC or TR TVC If AR(=P) > AVC CM is positive, and the firm should continue to produce in the short run This way, it covers part of its fixed costs. If AR(=P) < AVC CM is negative, so the firm should shut down.
18 Shutdown Point: Shut-down Point This is the lowest price at which the firm would still produce. At the shutdown point, the price is equal to the minimum point on the AVC. At the shutdown point, P = AVC and this results in zero contribution margin. If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. In this case it would be better for the firm to shut down and accept the losses that are equal to its fixed costs.
19 PC: SR Decision with Losses Assume now that at the point where MR = MC, costs are represented by ATC 2 where ATC 2 > P and the firm is making losses. The decision Rule is: As long as P > AVC stay in operations. If P < AVC close down. $ MC ATC AVC 1 P* P=MR AVC 2 Q* Q
20 PC: SR Supply Curve MC = S SR $ P 3 E 3 P 3 = MR 3 P 2 E 2 P 2 = MR 2 P 1 P 0 E 0 E 1 AVC P 1 = MR 1 P 0 = MR 0 Shut-down point Q
21 PC: Industry Supply Curve $ MC 1 =S SR1 MC 2 =S SR2 S MKT P 3 P 2 P 1 P Q
22 PC: Long-Run Equilibrium Quantity is set by the firm so that short-run: Price = Marginal Cost = Average Total Cost At the same quantity, long-run: Price = Marginal Cost = Average Cost Economic Profit = 0
23 PC: Long-Run Equilibrium Industry Firm S 1 S 2 At D 1, typical firm is making profits (AR>LRAC) LRAC P 1 P 2 E 1 E 2 D Q Q Q* In short run (with market price at P 1 ) firms in PC make profits. As a result, new firms will enter and industry, and the supply curve will shift to the right. This will lead to a new Equilibrium point and cause Price to fall. The new firm demand curve is tangent to the firm s LRAC. Economic Profit = 0 } D 1 D 2 With D 2, typical firm is making ZERO economic profits (AR=LRAC)
24 Monopoly Single seller that produces a product with no close substitutes Many buyers Absolute control on prices Large profit potential Entry is blocked; in other words, there are barriers to entry Examples: CYTA (?), EAC, POST OFFICE
25 Barriers to Entry Economies of Scale (Natural Monopolies) Ownership/Control of Key Resources/Inputs or Sales Outlets Legal Protection (licensing agreements, patents, copyrights, franchise agreements) Large Capital Investment Requirements Brand Loyalty
26 Monopoly: P & Q decisions in SR Demand curve for the firm is the market demand curve Number of buyers in the market (the population) is same as customer base of monopolist To max Profits, firm produces a quantity (Q*) where MR=MC
27 Demand & MR Curves Price 100 MR curve has twice the slope of the Demand curve. Demand function: P=a-bQ slope is b TR function: P*Q = (a-bq)q = aq-bq 2 MR =dtr/dq = a-2b slope is -2b P=100 10Q MR=100 20Q 5 10 Quantity
28 Monopoly: P & Q decisions in SR Firm produces π-max. quantity Q* where MR=MC, subject to checking the following condition: if price is above ATC firm produces Q* at a profit. if price is between ATC and AVC firm produces Q* at a loss. if price is below AVC (P < AVC) which means that price does not cover average variable cost, (i.e., contribution margin is negative) then the firm should shut down (Q*=0).
29 Profit Making Monopoly
30 Loss Making Monopoly
31 Demand, MR & Total Revenue Price & MR 8 E P > 1 Demand Curve TR = P * Q. Maximum TR occurs at Q TR *, where MR = 0. MR lies below P (AR). At output levels greater than QTR*, MR is negative. Monopolist will always produce at elastic portion of D-curve. TR MR Q Total Revenue Curve Q TR * Q
32 Monopoly vs. Perfect Competition If a monopolist buys up all the firms in a competitive industry, then the industry s D-curve becomes the monopolist s D-curve, and the industry s S-curve becomes the monopolist s MC curve. Optimum Q* (where MR=MC) for monopolist is now Q 2 (not Q 1 reached in the market under perfect competition). Monopolist
33 Stage 1: Market under Perfect Competition Price Consumer Surplus Equilibrium (D=S): Optimum market outcome under PC. Social MR=Social MC. Socially efficient outcome. P C S LR D Q C Q
34 Price Stage 2: Market taken over by Monopoly π-max.: Optimum outcome in Monopoly where MR=MC. P* and Q M * are π-max. values. P* P C MC LR MR D Q M * Q C Q
35 Stage 2: Loss of Consumer Surplus Price New Consumer Surplus Loss of Consumer Surplus P* Deadweight Loss P C MC LR MR D Q* Q C Q
36 Monopoly vs. Perfect Competition So we see that monopoly compared with perfect competition implies: higher price lower output Under Monopoly there is loss of efficiency for the economy Efficiency means: Price = MC Smaller consumer surplus Does the consumers always lose from monopoly? Among other things, this depends on whether the monopolist faces the same cost structure There may be the possibility of economies of scale. Technological innovations may benefit society
37 Managerial Implications Perfect Competition Profit potential in Perfect Competition is very low Being cost efficient is key to survival Timing of entering the market is key for making SR profits. Failure rate is high because of overestimating demand potential Monopoly IT revolution (internet, e-commerce) and market changes reduce the pricing power of monopolies Barriers to entry are less effective Deregulation & privatizations lead to the extinction of monopolies Generic brands increase competition
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