Introductory Microeconomics EC10006

1
Introductory Microeconomics (EC10006)

• Topic 4 Perfect Competition Monopoly

2
I. Introduction

• MR MC rule requires knowledge of market
  structure
• One of the major influences on MR, and thus on
  its supply decision, is the degree of
  competitiveness the firm faces in the market.
• That is, the number of actual and potential
  competitors

3
I. Introduction

• This makes sense! If firm is the only player in
  the market, then we would expect it to behave
  differently than if it were one of (very) many
• In what follows we will examine the causes and
  effects of market structure

4
II. Taxonomy of Competition

• Microeconomics has tended to categorise the
  degree of competition a particular firm faces
  into three very precise and distinct categories
• A lot
• A bit
• None!

5
Figure 1 Taxonomy of Competition
Perfect Competition
Monopoly
Imperfect Competition

More Competition
Less Competition

Monopolistic Competition
Oligopoly

Collusive (i.e. Cartel)
Non-Collusive
6
III. Perfect Competition

• Market structure where competitive forces are at
  their greatest
• Definition A Perfectly Competitive (PC) market
  is one in which both buyers and sellers believe
  that their own buying or selling decisions have
  no effect on the market price
• Sometimes referred to as an atomistic market

7
III. Perfect Competition

• Formal Characteristics
• 1. (Very) Large number of buyers and sellers
• 2. Homogenous product
• 3. Free entry and exit (in long-run)
• 4. Perfect knowledge.
• Implication All firms face same, perfectly
  elastic, demand curve

8
Figure 2 Perfectly Elastic Demand
p
S0

E0
d0
p0
D0

0

Q0 Q

q
Industry
Representative Firm
9
III. Perfect Competition

• Why would firm not raise or lower price above or
  below p0?
• If p gt p0, then it would sell nothing because
  consumers have perfect knowledge and good is
  homogenous
• Conversely, no point in setting p lt p0 since it
  can sell as much as it wishes at p0

10
III. Perfect Competition

• Firms demand curve is also its AR and MR curve
• Recall
• AR TR / q
• MR ?TR / ?q
• Since demand is perfectly elastic, AR MR p

11
Figure 3 Demand AR MR
p
E0 E1
p0
d AR MR
q
q0 q1
0

12
III. Perfect Competition

• Consider short-run profit maximising rule
• First, we know that to maximise profit we need to
  set SMR SMC
• But, SMC must also be rising
• otherwise, profit (loss) is minimised
  (maximised)

13
Figure 4 Optimal Output
p
SMC
? min ? max
E0
E1
p0
d AR MR
q
0
q0 q1

14
III. Perfect Competition

• Thus, short-run profit maximising rule
• (1) MR SMC
• (2) SMC is rising
• But, it could always be in firm's interest to
  produce nothing!
• Is there a shut-down price?

15
Figure 5 Demand AR MR ? gt 0
p
SMC
Eo
SAC
p0
AR MR
PROFIT
SAVC
SAC0
q
0
q0
16
Figure 6 Demand AR MR ? 0
p
SMC
SAC
SAVC
E1
p1
AR MR
q
0
q1

17
Figure 7 Demand AR MR - TFC lt ? lt 0
p
SMC
SAC
E2
SAVC
SAC2
LOSS lt - TFC
p2
MR
q
0
q2

18
Figure 8 Demand AR MR ? - TFC lt 0
p
SMC
SAC
E3
SAVC
SAC3
LOSS TFC
p3
AR MR
q
0
q3

19
Figure 9 Demand AR MR ? lt - TFC lt 0
p
SMC
SAC
SAVC
SAC4
LOSS gt TFC
p4
AR MR
E4
q
0
q4

20
III. Perfect Competition

• Thus, short-run profit maximising rule
• MR SMC
• SMC is rising
• p gt SAVC
• Supply curve of the firm is that part of its SMC
  curve above minimum SAVC

21
III. Perfect Competition

• Note, short-run shutdown price p3
• ? (p3) p3q3 SAC(q3)q3
• SAVC(q3) SAC(q3)q3
  
• -AFC(q3)q3
• -TFC

22
III. Perfect Competition

• Thus, short-run supply curve of firm is that part
  of its SMC above minimum AVC
• Similarly, long-run supply curve is that party of
  LMC above minimum LAC
• i.e. long-run shutdown option is to leave the
  industry

23
Figure 10 Long-Run Shut-Down
p
LMC
LAC
p0
AR MR
q
0
q0

24
III. Perfect Competition

• Compare SR and LR supply curves
• SR supply curve of firm is that part of its SMC
  above minimum AVC similarly, long-run supply
  curve is that part of LMC above minimum LAC
• i.e. LR shutdown option is to leave the
  industry
• Note that SR supply curve lays below LR supply
  curve (recall Envelope) and is steeper

25
Figure 11 Long-Run Short-Run Supply
p
SSR
Min LAC
SLR
p1
p0
Min AVC
q
0

26
III. Perfect Competition

• SSR lays below SLR because LAC is envelope of
  SACs and SAVCs lay below SAC since SAC includes
  AFC
• SSR is steeper than SLR because it will always be
  less costly for firm to increase output when it
  can alter all inputs (i.e. K an L) appropriately
  (i.e. when it is in LR)
• Now, consider MR MC condition

27
III. Perfect Competition

• TR0 p0q0
• TR1 p1q1
• Thus
• ?TR ? TR1 - TR0 p1q1 - p0q0
• p1q1 - p0q0 (p1q0 - p1q0)
• p1q1 - p1q0 p1q0 - p0q0
• p1(q1 - q0) (p1 - p0)q0
  

28
III. Perfect Competition

• ?TR p1(q1 - q0) (p1 - p0)q0
• p1?q ?pq0
• Thus
• Consider small changes in (p, q) such that
  p1?p0, q1?q0 , and so (p0, p1) p and (q0, q1)
  q

29
III. Perfect Competition

• Thus
• Now, recall

30
III. Perfect Competition

• Thus
• Under perfect competition, E?? such that MR p
• Also, since MR MC in equilibrium, then

31
III. Perfect Competition

• Thus

32
III. Perfect Competition

• Lerner (1934) Index of Monopoly Power
• Note that under perfect competition, E?? such
  that p?MC
• Firms can only mark-up p over MC iff E lt ?

33
Figure 12 Elasticity of Demand and Slope of
(Inverse) Demand Curve
p

E0
dc
db
da
q
0


34
III. Perfect Competition

• Industry Supply
• SR industry supply curve (when factor prices are
  given) is the horizontal summation of each firms
  SMC curve above minimum AVC
• Similarly, LR industry supply curve (when factor
  prices are given) is horizontal summation of each
  firms LMC curve above minimum LAC

35
Figure 13 SR Industry Supply
p p p
p2


p1
p0

qa qb
Q
0
0
0
q0 q1 q2
q0 q1 q2 Q0
Q1 Q2
Firm A Firm B Industry
36
III. Perfect Competition

• Consider effect of an exogenous increase in
  industry demand for the good
• Increase in demand will increase each existing
  firms profit
• Existing firms increase SR supply by moving up
  their SMC curves

37
Figure 14a SR Industry Supply
p
p
SMC
SAC

e0
d0
E0
p0
D0

0

Q0
Q q0
q
Industry
Representative Firm
38
Figure 14b SR Industry Supply
p
p
SMC
SAC
e1

d1
E1
e0
d0
E0
p0
D1
D0

0

Q0 Q1
Q q0 q1
q
Industry
Representative Firm
39
III. Perfect Competition

• But, the existence of super-normal profits will
  attract other firms into the industry
• This will shift out industry (SR) supply curve
  and lead to a fall in the (perfectly elastic)
  demand facing individuals firms
• Industry supply is higher because of entry of new
  firms each firm produces same amount in new
  equilibrium (E2) as original firms produced in
  original equilibrium (E0)

40
Figure 14c SR Industry Supply
p
p
SMC
SAC
e1

d1
E1
e2 e0
d0
E0 E2
p0
D1
D0

0

Q0 Q1 Q2 Q
q0 q1
q
Industry
Representative Firm
41
III. Perfect Competition

• LR supply curve of industry is horizontal /
  perfectly elastic
• LR supply price of industry is equal to minimum
  LAC of constituent firms
• Thus, demand only determines quantity price is
  supply (i.e. cost) determined)

42
Figure 15 LR Industry Supply
p P
LMC
LAC

e
E
SLR
p
D



0 q
q 0 Q
Q
Representative Firm
Industry
43
III. Perfect Competition

• LR supply curve of industry is upward sloping in
  two situations
• 1. Factor prices increase with usage
• 2. Heterogeneous firms
• Consider each in turn

44
III. Perfect Competition

• Consider first the SR response of a
  representative firm and the industry to an
  increase in demand
• If factor prices increase with usage, then
  increase in demand induces each firm to increase
  output along its SMC curve
• But, increase in industry supply of output
  increases demand for / price of the variable
  input

45
III. Perfect Competition

• Increase in price of variable input shifts up
  vertically each firms SMC curve
• The expansion of output by each firm can thus be
  interpreted as a combination of a movement
  along and a shift of its SMC curve
• Similarly, the expansion of output by the
  industry - combination of a movement along /
  shift of the aggregation of constituent firms
  SMC curves

46
Figure 16 SR Industry Supply Factor prices
increase with usage
p
p
D1
?SSR
SSR
?SMC1

E1
e1
p1
?SMC0
SMC0
D0
SMC1
E0
p0
e0

0

q0 q1
q Q0 Q1
Q
Representative Firm
Industry
47
III. Perfect Competition

• In LR, free entry / exit implies each firm
  produces at minimum LAC
• If firms are equally efficient, then firms have
  same minimum LAC and industry supply is perfectly
  elastic
• Intuitively, whatever happens to demand, SR
  supply, and thus price, competitive forces ensure
  a normal-profit LR equilibrium such that LR
  supply is perfectly elastic at minimum LAC

48
III. Perfect Competition

• But this presumes factor prices are fixed
• What if factor prices increase with their usage?
• In this case, then LR expansion of output by the
  industry will increase the price of all factors
  such that each constituent firms LAC and LMC
  will shift-up

49
III. Perfect Competition

• Thus, LR industry response to increase in demand
  when factor prices increase with their usage is a
  combination of
• (i) a movement along a perfectly elastic LR
  supply curve (i.e. one determined by minimum LAC
  of equally efficient constituent firms, but
  where factor prices are held constant)
• (ii) a shift-up of such a curve (i.e. where
  factor prices are allowed to increase)
  

50
Figure 17 LR Industry Supply Factor prices
increase with usage
p
E1
E0
D1
D0
Q
0


51
III. Perfect Competition

• Consider also heterogeneous firms
• i.e. inter-firm differences in efficiency
• The earlier firms enter into an industry, the
  lower their cost curves subsequent firms are
  increasingly less efficient

52
III. Perfect Competition

• At any particular LR equilibrium price, p, the
  least efficient (i.e. marginal) firm is that
  firm which can make just normal profit at p
• The more efficient (i.e. intra-marginal) firms
  make positive profits at p and, thus, produce in
  the region of DRS

53
Figure 18 LR Industry Supply Heterogeneous Firms
p p p
LMC2
SLR

LMC1
LAC2

LAC1
E
e2
e1
p
LAC1
D

0
0
0
q1 q
q2 q Q
Q
(Intra-Marginal) Firm 1 (Marginal) Firm
2 Industry
54
IV. Monopoly

• Consider now the other extreme market environment
• Monopoly single seller
• The monopolist is the industry no distinction
  between firm and industry less need to
  distinguish SR and LR since entry / exit is less
  of an issue
• Consider monopolist's AR and MR curves

55
IV. Monopoly

• As with PC firm, demand curve is also the AR
  curve
• But since AR curve is downward sloping, MR curve
  lays below AR curve
• Intuitively, to sell more Q, monopolist has to
  cut p on all units of Q

56
Figure 19a AR and MR
p
TR1 p1 TR2 2p2 MR2 2p2 - p1 p2
- (p1-p2) lt p2
A
p1
B
p2
C
MR2
D AR
MR
Q
0

1 2
57
Figure 19b AR and MR
p
TR1 p1 TR2 2p2 MR2 2p2 - p1 p2
- (p1-p2) lt p2
A
p1
B
p2
p2
C
MR2
D AR
MR
Q
0

1 2
58
Figure 19c AR and MR
p
TR1 p1 TR2 2p2 MR2 2p2 - p1 p2
- (p1-p2) lt p2
A
p1
(p1-p2)
B
p2
p2
C
MR2
D AR
MR
Q
0

1 2
59
IV. Monopoly

• We will assume that the monopolist, like PC firms
  and industries, faces increasing and then
  decreasing returns to both factors and scale
  i.e. U-Shaped SAC / LAC
• N.B. Monopoly that faces IRS always is termed a
  Natural Monopoly
• Monopolist's profit can be supernormal (most
  likely), normal or negative

60
Figure 20a Monopolist LR Equilibrium p gt 0
p
LMC
p0
LAC
Profit
LAC0
D AR
MR
Q
0
Q0
61
Figure 20b Monopolist LR Equilibrium p lt 0
p
LMC
LAC
LAC0
Loss
p0
D AR
MR
Q
0
Q0
62
Figure 20c Monopolist LR Equilibrium p 0
p
LMC
LAC

p0 LAC0
D AR
MR
Q
0
Q0
63
IV. Monopoly

• Consider efficiency
• Allocative Efficiency (AE)
• p MC
• Productive Efficiency (PE)
• IRS are exhausted such that LAC is minimised

64
IV. Monopoly

• (Non-Discriminating) monopolist is never AE and
  (extremely) unlikely to be PE
• PE would require MR curve to cross MC at minimum
  AC
• It can happen, but infinitely small chance!

65
Figure 21 Monopolist LR Equilibrium Productive
efficiency is possible, but very unlikely!
p
LMC
pmes
LAC
LACmes
D AR
MR
Q
0
Qmes
66
IV. Monopoly

• Allocative Efficiency requires marginal (social)
  benefit (MSB) to equal marginal (social) cost
  (MSC)
• Define MSC MPC MEC
• MSB MPB MEB
• i.e. marginal social benefit (cost) equals
  marginal private benefit (cost) plus marginal
  external benefit (costs)

67
IV. Monopoly

• Private benefits (costs) are those enjoyed
  (incurred) by agent producing or consuming) the
  good
• External benefits (costs) are the non-price
  effects on the production or consumption of other
  members of society
• Assume (for now!) that MEC MEB 0 such that
  allocative efficiency requires MPC MPB

68
IV. Monopoly

• Now
• MPC LMC of monopolist
• MPB price consumers willing to pay for good
• Thus, the MPB can be derived from the
  monopolist's Demand AR curve
• Recall, the (inverse) demand curve sets out
  consumer's reservation price vis. the maximum
  price the consumer is willing to pay

69
Figure 22 D MPB
p
A
p1
B
p2
C
p3
D MPB
Q
0

Q1 Q2
Q3
70
IV. Monopoly

• It is apparent that the monopolist produces less
  output than the socially optimal (allocatively
  efficient) level
• Monopolist maximises profit by setting MR MC
• Allocative efficiency is achieved when p MC
• Since p lt MR, it must be the case that monopolist
  output is less than socially optimal

71
Figure 23 Monopolist LR Equilibrium DWL ABC
p
Privately Optimal
LMC MPC
Socially Optimal
A
p0
B
LAC
LAC0
D AR MPB
C
MR
Q
0
Q0 Q1
72
IV. Monopoly

• Consider the (overnight) monopolisation of a PC
  industry
• The constituent firms of the industry become
  manufacturing plants for the monopolist
• Assume that the SLR ?LMC of the PC industry
  becomes the monopolist's LMC curve (N.B.
  heterogeneous firms thus SLR is upward sloping)

73
IV. Monopoly

• Define social welfare (SW) as sum of consumer
  surplus (CS) and producer surplus (PS)
• SW PS CS
• Note No concern with equity!
• Define CS as excess of what consumers are willing
  to pay over what they actually pay PS as excess
  of what producers actually receive over what they
  are willing to receive

74
Figure 22a Monopoly and PC
p
A
SLR
CS
Perfect Competition CS ABC PS BCD SW ABD
B
C
pc
PS
D
D AR
Q
0
Qc

75
Figure 22a Monopoly and DWL
p
A
LMC
E
G
pm
Monopoly CS AEG PS GEFD SW AEFD DWL EBF
B
C
pc
F
D
D AR
MR
Q
0
Qm Qc

76
Figure 22a Monopoly and DWL
p
A
LMC
E
G
pm
Monopoly ?CS -GEHC - EBH ?PS GEHC - BHF ?SW
-EBF - BHF
B
C
H
pc
F
D
D AR
MR
Q
0
Qm Qc

77
IV. Monopoly

• But this is a static analysis - i.e. the
  instantaneous effects of monopolisation what
  happens to cost over time, i.e. dynamic effects?
• Two scenarios
• (i) Liebenstein X-Inefficency (pessimistic)
• (ii) Schumpeter RD (optimistic)
• Balance of argument - empirical issue

78
Figure 22a Monopoly and DWL
p
A
LMC
Liebenstein
E
B
pm
B
C
pc
Schumpeter
F
D
D AR
MR
Q
0
Qm Qc

79
IV. Monopoly

• To summarise monopolies would appear to be
  harmful to society in sense that they lead to DWL
  (i.e. consumers lose more than producers gain)
• Perhaps some benefits over time (RD), but that
  is an empirical issue
• There is an argument, however, that if we are to
  have monopolies, then we should make them as
  powerful as possible!

80
IV. Monopoly

• Price Discrimination (PD)
• Selling different units of the same good at
  different prices
• Two basic approaches to PD
• Charging different prices to different consumers
  for same units of the good
• Charging same consumers different prices for
  different units of the good

81
IV. Monopoly

• Three main types of PD
• First-Degree (Perfect)
• Second-Degree
• Third-Degree
• Consider each in turn

82
IV. Monopoly

• First-Degree (Perfect) Price Discrimination
• Monopolist charges each consumer maximum price
  willing to pay for each unit of the good thus
  demand curve is also MR curve, since only reduce
  p on additional units of Q
• Monopolist produces socially optimal Q (i.e. p
  MC) and is thus allocatively efficient (DWL 0)
  but completely inequitable (CS 0)

83
Figure 23 First Degree (Perfect) Price
Discrimination
p
A
p1
A'
LMC
p2
A''
Perfect PD CS 0 PS ABC SW ABC DWL 0
PS
B
p
C
D MR
Q
0
1 2 Q

84
IV. Monopoly

• Second-Degree Price Discrimination
• Multipart tariff consumer chooses quantity of
  good wishes to consume at a given price after
  paying a rent for the right to receive any supply
  at all
• E.g. Utilities - gas, electricity, water
• Can (almost) replicate first-degree PD profit and
  produce socially-optimal level of output

85
Figure 23 Second-Degree Price Discrimination
p
A

LMC
Tariff
Multipart Tariff Rental Tariff ABD PS ABC SW
ABC DWL 0
B
D
p
C
D MR
Q
0
Q

86
IV. Monopoly

• Third-Degree Price Discrimination
• Monopolist sells good at different prices to
  different groups of consumers
• Monopolist must be able to identify distinct
  markets
• Geographical, age, gender, race

87
IV. Monopoly

• Assume monopolist sells identical good to two
  markets (A and B)
• Assume costs of producing and supplying good to
  either market are identical
• E.g. Cinema selling seats in Bath to students and
  lecturers who have distinct reservations prices
  and elasticities of demand from each other

88
Figure 24a Third-Degree Price Discrimination
p p p
LMC


ARB
AR
MR
MRB
ARA

MRA
0
0
0
Market A Market B Market A B
Lecturers Students
89
IV. Monopoly

• Assume first that price-discrimination is illegal
• The cinema will maximise profit by setting
  (aggregate) MR LMC
• Thus, sells seats in total at
  a common price of
• to lecturers and to students

90
Figure 24b Third-Degree Price Discrimination

p p p
LMC


AR
ARB
MRB
MR
ARA

MRA
0
0
0
Market A Market B Market A B
Lecturers Students
91
IV. Monopoly

• Assume now that price discrimination is legal
• Setting a common price implies that MRA ? MRB
• Thus, the monopolist can increase its revenue
  (and since production costs are independent of
  the market supplied, its profit) by transferring
  Q from the low MR market to the high MR market

92
Figure 24c Third-Degree Price Discrimination

p p p
LMC


ARB
AR
MR
MRB
ARA

MRA
0
0
0
Market A Market B Market A B
Lecturers Students
93
IV. Monopoly

• As Q is withdrawn from the low MR market, p and
  MR in that market rise
• And vice versa, as Q is transferred to the high
  MR market, p and MR in that market fall profit
  is maximised when MRA MRB

94
Figure 24d Third-Degree Price Discrimination
p p p
LMC


AR
ARB
MRB
ARB
MR

MRA
0
0
0
Market A Market B Market A B
Lecturers Students
95
IV. Monopoly

• Intuitively, lecturers have relatively inelastic
  demand, thus it is optimal to raise the price
  they face, since relatively little demand is lost
• Conversely, students have relatively elastic
  demand, thus it is optimal to lower the price
  they face since demand increases substantially

96
IV. Monopoly

• Recall
• Thus

97
IV. Monopoly

• Recall
• Thus
• If MRA MRB, but EA lt EB, then pA gt pB

98
IV. Monopoly

• For all this to work
• Group making up sub-markets must have distinct
  elasticities of demand
• Third-degree price discrimination must be legal
• There must be no arbitrage between the groups
  (i.e. usually used in service industries)

99
IV. Monopoly

• Finally
• Note that the monopolist does not have a supply
  curve
• No one-to-one mapping between price and quantity
  supplied

100
Figure 23 Monopolist does not have a supply curve
p
LMC
E0
E1
p0

AR1
MR1
AR0
MR0
Q
0
Q0 Q1