Understanding Market Structures: Perfect Competition vs. Monopoly, Exercises of Microeconomics

Download Understanding Market Structures: Perfect Competition vs. Monopoly and more Exercises Microeconomics in PDF only on Docsity! Microeconomics Topic 7: “Contrast market outcomes under monopoly and competition.” Reference: N. Gregory Mankiw’s Principles of Microeconomics, 2nd edition, Chapter 14 (p. 291-314) and Chapter 15 (p. 315-347). Types of Market Structure A market is a set of sellers and buyers whose behavior affects the price at which a good is sold. In this review we'll see that the type of market a firm operates in has a large impact on the firm's behavior. Firms have no control over price under perfect competition. But firms have tremendous control over price in a monopoly setting. Economists describe different types of markets by: (1) the number of firms (2) whether the products of different firms are identical or different (3) how easy it is for new firms to enter the market. The four major types of markets can be viewed on a continuum. Perfect Competition Monopolistic Competition Oligopoly Monopoly Figure 7-1 Perfect competition is at one extreme with many small firms selling identical products. Monopoly is at the other extreme with just one firm. The intermediate cases are monopolistic competition (which involves many small sellers producing slightly differentiated products) and oligopoly (which involves a small number of large firms). Most U.S. firms operate under monopolistic competition (e.g., novels, movies, clothing, etc.) or oligopoly (tennis balls, crude oil, automobiles, etc.). However, this review will focus on the two extremes: perfect competition and monopoly. There are three conditions required for perfect competition. (1) Numerous small firms and customers. The decisions of individual producers and buyers do not affect the price of the good. (2) Homogeneity of product. The products offered by sellers are identical. For example, wheat of a particular grade is homogeneous (while ice cream is not). If the product is homogeneous, consumers don't care from which firm they buy the good because their products are identical. (3) Freedom of entry and exit. There are no barriers to enter the industry, so new firms can compete with old ones relatively easily. They do not have to match the advertising of the existing firms to secure customers. Nor are there large fixed costs that require large investments in equipment before production can start. There is also freedom to exit, so firms can leave the industry if the business proves unprofitable. These three conditions are infrequently met, so perfect competition is pretty rare in the U.S. One good example is a company's stock. There are millions of buyers and sellers, the shares are identical, and entry into the market is easy. Other examples include fishing and farming. If this market structure is so rare, then why are we bothering to study it? First, perfect competition often provides a reasonable approximation of what happens in markets that are less than perfectly competitive. Second, perfect competition is the standard by which all other markets are judged. We will see that markets work most efficiently under perfect competition. It insures that the economy produces what consumers want while using society’s scarce resources most effectively. By studying perfect competition, we will see what an ideally functioning market system can accomplish. Later on, we will see how far monopolies deviate from this ideal. The Perfectly Competitive Firm and its Demand Curve Under perfect competition, the firm must accept the price determined in the market. The firm is a price taker --it can produce as much or as little as it likes without affecting the market price. Each firm must match the price offered by its competitors because the products are identical. Otherwise, consumers will shift their purchases to another firm. The price in the industry as a whole, which is comprised of all the individual firms and consumers, is determined by supply and demand. For a basic discussion of supply-and- demand, see the notes for Micro Topics 3 and 4. Figure 7-2 shows how a single firm’s demand curve results from the price on the market as a whole. Thus, the highest profit is attained at the output level where P = MC. Graphically, it looks like this: MR MC Q* P* P Q Figure 7-3 In our example, there is no quantity where MR = MC exactly, so we want to get as close as we can. Profit is highest when MR ≥ MC at the output of Q = 50,000 bushels. (If the next 10,000 bushels were produced, profit would fall by $70,000 because the MR is $8 while the MC is $15.) So, in our example, P* = 8 and Q* = 50,000 in Figure 7-3. To find the profit at the chosen quantity, just use Profit = TR – TC. But to see the amount of profit graphically, we will express profit in a different way. Since ATC = TC/Q by definition (as explained in the Micro Topic 6 notes), it must also be true that TC = ATC × Q. We also know that TR = P x Q. So now we can say: Profit = TR – TC = P × Q – ATC × Q = (P – ATC) × Q What does this mean? (P – ATC) is the profit per unit of output, and you multiply this by the number of units sold (Q) to get profit. In our example, ATC = TC/Q = $300,000/50,000 = $6 and P = $8, so the profit per unit is $2. Multiply this by Q = 50,000 to get a profit of $100,000. Graphically, profit looks like this: MR MC Q* P* P Q ATC ATC* Figure 7-4 Notice that we didn’t need the ATC curve to find the profit-maximizing quantity Q*, but we do need ATC to show the amount of profit made. The profit is equal to the shaded rectangle, which you should notice is the quantity Q* multiplied by the profit per unit, (P* - ATC*). Profits versus Losses In both Table 7-1 and Figure 7-4, we have a firm making profit. The firm makes profits if P > ATC. But if P < ATC, the firm incurs losses. Suppose the price of a bushel is $4 and the relevant data is displayed for a farm below. Table 7-2 Quantity (1,000's bushels) Total Revenue ($1,000's) Marginal Revenue (dollars) Total Cost ($1,000's) Marginal Cost (dollars) Total Profit ($1,000's) 0 0 ------ 35 ------ -35 10 40 4 65 3.0 -25 20 80 4 90 2.5 -10 30 120 4 125 3.5 -5 40 160 4 170 4.5 -10 50 200 4 220 5.0 -20 60 240 4 275 5.5 -35 70 280 4 335 6.0 -55 In Table 7-2, there is no point where MR = MC exactly, but the closest point is where MR ≥ MC at 30,000 bushels. This level of output minimizes the firm’s losses. The total loss is $5,000, which equals the per unit loss (ATC - P) of $0.167 x the quantity of 30,000. Graphically, it looks like this: P* ATC MC MR Q* P Q ATC* Figure 7-5 The shaded area in Figure 7-5 shows losses. Since the ATC curve lies above the price, it is clear that the firm is losing money. But it would lose even more money if it produced a quantity other than Q*. This means that MR = MC is still the right decision rule to use when selecting the firm’s output level. The Shutdown Decision It is possible, however, that it would be better for the firm to produce nothing at all. Firms can't endure losses forever. The decision to shut down involves a comparison between short-run fixed costs (FC) and variable costs (VC). These concepts are explained in the Micro Topic 6 notes. Recall that the FC cannot be avoided in the short run. The firm must pay its FC whether it stays open or shuts down. If the firm shuts down, TR = 0 and VC = 0, but the FC (or sunk costs) remains. Sometimes it is better to remain in operation until the fixed costs expire. There are three rules that govern the shutdown decision. Note: these rules hold for all firms (including monopoly) and not just perfectly competitive firms. Rules for deciding whether to stay open or shut down Rule 1: If TR > TC, then the firm earns positive profits, so it should remain open in both the short run and the long run. Typical Corn Farmer Corn Industry MC ATC P P Q Q D SS0 SS1 $8 $6 72 50 50 45 A B a b Figure 7-6 At point a, the typical corn farmer is earning short-run profits. This encourages new firms to enter the industry, which shifts the short-run market supply curve (SS) out, thereby reducing the market price from $8 to $6. Entry continues until all profits are competed away and we reach the long-run equilibrium point b. At this point, the typical firm earns zero profits and produces where P = MC = ATC. Note: there are no profits in the long run. If short-run profits exist then new firms enter and force the price down until all of the profits are competed away. On the other hand, short-run losses encourage existing firms to leave the industry, which forces prices up until all losses are gone. In the long run, competitive firms produce where P = MC = ATC. Graphically, this occurs at the minimum point on the ATC curve (point b). Another way to think about all of this is in terms of a long-run market supply curve. The short-run market supply curves in Figure 7-6 only take into account the firms already in an industry. A long-run market supply curve, on the other hand, takes entry and exit into account. The long-run market supply curve will naturally be flatter (more elastic) than a short-run market supply curve, because entry-and-exit means that more firms respond to any change in price. For example, suppose a shift in demand causes the market price to rise, which creates profits. In the short run, only existing firms can take advantage of the rise in price by increasing their output. But in the long run, more firms enter the industry, so there is a larger effect on total output. You will not be expected to derive a long-run market supply curve. But you should understand that when firms have a longer period of time to adjust, the supply curve would be flatter. Zero Economic Profit Under Perfect Competition Why do firms stay in the industry if profits are zero in the long run? Because we are talking about economic profit, which is not the same as accounting profit. A firm making zero economic profit would be making positive accounting profit. For more explanation of this topic, see the notes for Micro Topic 1. Zero economic profit indicates that firms are earning the normal economy-wide rate of profit (in the accounting sense). An industry whose capital receives a higher rate of return than capital invested elsewhere attracts capital into the industry. This shifts the short-run market supply curve out and reduces prices until economic profit equals zero. If capital invested in an industry receives a lower return than capital invested elsewhere, then funds dry up in the industry. This shifts the short-run market supply curve inward, which raises prices until economic profits return to zero. Perfect Competition and Economic Efficiency Perfect competition leads to great efficiency for two reasons. First, the price ends up being equal to a firm’s marginal cost (P = MC), as explained earlier. This means that customers keep buying more of the product as long as the dollar value of consuming the good is greater than the additional cost of producing it. If the price were higher than MC, customers would buy less of the product, even though consuming more would produce added benefits greater than the added costs. That would be inefficient. Second, in the long run competitive firms must produce where price equals the lowest point on their ATC curve. This means the product is produced at the lowest possible cost per unit. To put it another way, the output of competitive industries is produced at the lowest possible cost to society. Monopoly We have just described an idealized market system in which all firms are perfectly competitive. Now we turn to one of the blemishes of the market system -- the possibility that some industries may be monopolized -- and the consequences of such a flaw in the market system. Definition of a pure monopoly: (1) There is only one firm in the industry. (2) There are no close substitutes for the good the firm produces. (3) There is some reason why the entry and survival of a competing firm is unlikely. Thus, even the sole provider of natural gas in a city is not considered a pure monopoly, since other firms provide substitutes like heating oil and electricity. Pure monopolies are rare in the real world, because most firms face competition from firms producing substitute products. If there is only one railroad, it still competes with bus lines, trucking companies, and airlines. The producer of a brand of soda may be the only supplier of that particular soda, but it competes with other soda makers. If pure monopoly is so rare, then why do we bother to study it? Because like perfect competition, pure monopoly is easier to analyze than the more common market structures of oligopoly (i.e., a fewer large producers) or monopolistic competition (i.e., many small firms producing slightly differentiated products). In addition, the “evils of monopoly” stand out more clearly when we consider monopoly in its purest form. This clarity will allow us to understand why governments rarely allow unfettered monopolies to exist. Causes of Monopoly: Barriers to Entry Preservation of a monopoly requires keeping potential rivals out of the market. There must be some specific impediment to the establishment of new firms in the industry -- such impediments are called “barriers to entry.” Some examples are: (1) Government-created monopolies: Monopolies are established if the government prevents other firms from entering the industry. For example, a local government might license only one cable TV supplier or one food stand operator in a public stadium. Another example of a government-created monopoly is a patent. To encourage inventiveness, the government gives the exclusive production rights for a period of time (usually 20 years) to the inventors of certain products. As long as the patent remains in effect, the firm has a protected monopoly. For example, for many years Xerox had a monopoly in plain paper copying. Pharmaceutical companies get monopolies on the drugs they develop. (2) Control of a scarce resource or input: If a good is produced only by using a rare input, a company that gains control of the source of that input can establish a monopoly position for itself. For example, the DeBeers diamond syndicate controls the supply of the highest quality diamonds in the world. (3) Natural monopoly: A natural monopoly is an industry in which the advantages of large scale production make it possible for a single firm to supply the entire market output at a lower average total cost than a larger number of firms producing smaller quantities. As a result, one firm will “naturally” emerge as a monopolist in this kind of industry. Utilities like electricity and water are often natural monopolies. The Monopolist's Supply Decision We now consider the actions taken by monopoly in the absence of government intervention. First, it is important to understand that a monopoly does not have a supply curve. Unlike a perfectly competitive firm, a monopoly does not take the market price as given and then react to the price. Instead, it has the power to select the point on the market demand curve (a price-quantity pair) that maximizes its profits. 1 $140 140 $140 70 $60 70 2 107 214 74 120 50 94 3 92 276 62 166 46 110 4 80 320 44 210 44 110 5 66 330 10 253 43 77 6 50 300 -30 298 45 2 We can use Table 7-4 to bring out two important points. (1) By comparing columns 2 and 4 we see that P > MR after the first unit of output. (2) By comparing columns 4 and 6 we see that profit is the highest ($110) at 4 units of output where MR = MC = $44. Although the monopolist chooses a price-quantity pair on the demand curve to maximize profit, this does not mean that the monopolist earns positive profits. If it is inefficient and has high costs, or if demand is too low, it may incur losses and eventually shut down. However, if the monopoly does make economic profits, it can maintain these profits in the long run. Profits are not competed away by the entry of new firms as in the perfectly competitive industry, because there are barriers to entry now. Comparison of Monopoly and Perfect Competition We can now compare and contrast perfectly competition and monopoly. We will see that monopoly is inefficient in comparison to the idealized market structure of perfect competition. There are two main problems with monopoly, and they correspond to the two main benefits of perfect competition explained earlier. We found that P = MC and P = lowest ATC under perfect competition. Both of these conditions fail under monopoly. (1) Monopoly restricts output to raise price above marginal cost. Compared with the ideal of perfect competition, the monopolist restricts quantity and charges a higher price. Imagine a court order that breaks apart a monopoly into a large number of perfectly competitive firms and that the industry demand and costs stay the same. These are somewhat unrealistic assumptions, but it allows us to compare the long-run price-quantity pair selected by monopoly versus perfect competition. Consider Figure 7-9 below. Q P MC D MR Qm Qc Pc Pm C M Figure 7-9 0 B The monopolist would maximize profit by picking quantity Qm and price Pm (point M). But as we learned earlier, perfect competition would result in price equal to MC. The only place on the demand curve where price equals MC is at quantity Qc and price Pc, so point C would result from perfect competition. By comparing points M and C, we can see that the monopolist produces less output and charges a higher price than the perfectly competitive industry with the same demand and cost conditions. This is troubling, because it means that monopoly leads to an inefficient resource allocation. It would make sense to produce the units between Qm and Qc, because producing them would generate greater added value to consumers than added cost to producers. This is true because the demand curve is higher than the MC curve for units Qc - Qm. Thus, resources are allocated inefficiently under monopoly, because too few resources are being used to produce the monopolized good. The reduction in welfare associated with the reduced monopoly output is called "deadweight loss." Graphically, the deadweight loss is the triangular area below the demand curve, above the MC, and between Qm and Qc. In Figure 7-9, the area MCB measures deadweight loss. (2) A monopolist's profits persist. Barriers to entry create the second major difference between perfect competition and monopoly. Profits are competed away by entry into a perfectly competitive market. In the long run, firms can only hope to cover their costs, including the opportunity cost of capital and labor supplied by the firm's owners. But positive economic profits can persist under monopoly, if it is protected from competition by barriers to entry. The monopolist can grow rich at the expense of their customers. Such accumulation of wealth is objectionable to most people, and therefore monopoly is widely condemned. As a consequence, monopolies are often regulated by governmental agencies that try to limit the profits they can earn.