Microeconomics I - FTU 2015/3/16

The four types of market structure

Basic Microeconomics

Chapter 6
Competition and Monopoly

By Tran Thi Kieu Minh, MSc.

Economists who study industrial organization divide markets into four types:
monopoly, oligopoly, monopolistic competition, and perfect competition.

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Perfectly Competitive Markets

1. Price Taking
6.I. Perfectly Competitive Market  The individual firm sells a very small share of the total
market output and, therefore, cannot influence market price.
Characteristics  The individual consumer buys too small a share of industry
Competitive Firm output to have any impact on market price.
Profit Maximization 2. Product Homogeneity
Short-run Supply Curve  The products of all firms are perfect substitutes.
Competitive Market Supply Curve  Product quality is relatively similar as well as other product
characteristics
3. Free Entry and Exit
 Buyers can easily switch from one supplier to another.
 Suppliers can easily enter or exit a market.

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The competitive Firm – The Price Taker Profit maximization for a competitive firm
MC(q)  MR  AR  P
Price
Firm Price Industry Costs
and The firm maximizes profit
S Revenue by producing the quantity
at which marginal cost MC
equals marginal revenue.
D=AR=MR Pe MC2 ATC
Pe
P=MR1=MR2 P=AR=MR
AVC
D
Q MC1
q1 q2 Qe Q
 Market output (Q) and firm output (q); Market demand (D) and firm demand (d)
 Demand curve faced by an individual firm is a horizontal line at the market 0 Q1 QMAX Q2 Quantity
price Pe
At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production
 Firm’s sales have no effect on market price increases profit. At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so
 Average revenue = Pe reducing production increases profit. The profit-maximizing quantity QMAX is found where
the horizontal price line intersects the marginal-cost curve.
 Marginal revenue = Pe
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A competitive firm gets loss A competitive

$
firm gets loss
Costs MC(q)  MR  AR  P
and ATC*
Revenue ATC ATC
MC MC

ATC* AVC
P=MR* P=AR=MR
AVC AVC*

P=MR* P=AR=MR

0 Q* Quantity 0 Q* Quantity
 Short-run decision not to produce anything during a specific
period of time because of current market conditions
 Firm still has to pay fixed costs
7 8  Shut down if TR<VC (P<AVC)

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Case study: Near-empty restaurants and

off-season miniature golf
The competitive firm’s short-run supply curve
 Restaurant – stay open for lunch?
Costs
1. In the short run, the MC  Fixed costs
firm produces on the
MC curve if P>AVC,...  Not relevant
ATC
 Are sunk costs in short run

AVC  Variable costs – relevant

 Shut down if revenue from lunch < variable costs
2. ...but
shuts down  Stay open if revenue from lunch > variable costs
if P<AVC.
 Operator of a miniature-golf course
 Ignore fixed costs
0 Quantity  Stay open if revenue > variable costs
In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC) above
average variable cost (AVC). If the price falls below average variable cost, the firm is
better off shutting down.
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Competitive Market Supply Curve Quiz1

 A competitive Firm ABC has average production cost ($) of
 Short run: market supply with a fixed number of firms
 Short run – number of firms is fixed 75
ATC  2  q 
 Each firm – supplies quantity where P = MC q
 What is the short-run supply curve of the firm?
 For P > AVC: supply curve is MC curve  If market price is $30, what is the optimum quantity of the
 Market supply firm? How much is the maximum profit?
 Add up quantity supplied by each firm  What is the firm’s decision if market price decreases to $10?
Explain.

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Quiz 2
 A competitive market of a good A has 1000 similar sellers,
each has production cost of: 6.2. Monopoly
1 2
TC  q  5q  8 Monopoly ‘s Characteristics
2 Demand and Marginal Revenue
:  20000  500P
 Market demand of good A is Q
Profit maximization
 What is the market supply curve of good A? Monopoly Price
 What is the equilibrium price and quantity? Market power
 What is the optimum selling quantity of each seller? The Welfare Cost

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Monopoly Barriers to entry

1. Firm that is the sole seller of a product without  Monopoly resources
 A key resource required for production is owned by a single firm
close substitutes  Higher price
2. Price maker  Government regulation
 Government-created monopolies
3. Barriers to entry  Patent and copyright laws
 Higher prices; Higher profits
 Monopoly resources  The production process
 Government regulation  A single firm can produce output at a lower cost than can a larger number of
producers
 The production process  Natural monopoly
 Arises because a single firm can supply a good or service to an entire market
at a smaller cost than could two or more firms
 Economies of scale over the relevant range of output

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Demand of Product and Monopoly’s Revenue

A monopoly’s revenue
 Demand of Product = Market Demand  Total revenue: TR = PxQ Price
 Downward sloping demand curve = f (Q) x Q
 Market demand curve: P = f (Q) = a - bQ  Average revenue: AR =
(b) A Monopolist’s Demand Curve
TR/Q
Price
 Marginal revenue:
 MR = △TR/△Q = Demand
TR’(Q) = a – 2bQ
 Can be negative 0 Quantity of output
 Always: MR < P
Demand
 MR curve – is below the MR

demand curve
0 Quantity of output 18
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Profit maximization for a monopoly The monopolist’s profit

Costs
Costs 2. . . . and then the demand curve shows the and
price consistent with this quantity. Marginal cost
and Revenue
Revenue Marginal cost

1. The intersection of the marginal-revenue

curve and the marginal-cost curve Monopoly E B
B Average total cost
Monopoly determines the profit-maximizing quantity . . . price
price
Average total cost Monopoly
A profit
Average Demand
Demand total
cost D C

Marginal revenue
Marginal revenue
0 QMAX Quantity
0 Q1 QMAX Q2 Quantity
A monopoly’s profit
A monopoly maximizes profit by choosing the quantity at which marginal revenue equals Profit = TR – TC = (P – ATC) ˣ Q
19 marginal cost (point A). It then uses the demand curve to find the price that will induce 20
consumers to buy that quantity (point B).

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Monopoly Power Monopoly Price

 A firm's market power: its ability to price above marginal dTR d ( P.Q ) dP
MR    QP
cost. dQ dQ dQ
 Lerner index, named after the American economist Abba dP Q 1
Lerner (1903-1982), was formalized in 1934.  MR  P (1   )  P (1  )
dQ P EDP
 P  MC
L
P  MR=MC
 The index ranges from a high of 1 to a low of 0, with higher
numbers implying greater market power. 1 MC
 For a perfectly competitive firm (where P=MC), L=0; such a
P(1  )  MC  P 
EDP 1
firm has no market power. (1  )
EDP
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The deadweight loss QA

DWL   ( P  MC ).dQ

Monopoly has no supply curve C,R

CS PS
C,R
Q*

Marginal cost
 No relationship 1:1 for price and quantity. Deadweight
loss
Marginal cost

Monopoly
 Change in demand can make:
Competitive
price
price

 Change in price but quantity Demand Demand

 Chang in quantity but price Marginal revenue Marginal revenue

 Changes in both quantity and price 0 Efficient
quantity
Quantity 0 Monopoly Efficient Quantity
quantity quantity

 Monopoly
 Produces less than the socially efficient quantity of output
 Charge P>MC
 Deadweight loss: Triangle betweendemand curve and MC curve
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Quiz 3
 A monopolist has MC = 4 + Q and Fixed Cost of $1000. He
faces the demand of P = 160 – Q (P & C: $/kg, Q : kg) 6.3. Monopolistic Competition
a. What are the optimum quantity and price of the
Characteristics
monopoly? How much is the maximum profit?
Profit maximizing
b. How much is the consumer surplus created by this
Social Welfare
monopoly?
c. How much is the DWL?
d. Government places a tax of $4/kg for the product of the
monopoly. How does profit change?
e. Graph the results

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Monopolistic competition Monopolistic competitors in the short run

(a) Firm makes (b) Firm makes losses
Price profit Price
1. Many sellers ATC
MC MC
2. Product differentiation ATC ATC
Price
 Price maker, not price takers Price
ATC
 Downward sloping demand curve Profit Demand Losses
3. Free entry and exit
Demand
MR
MR
0 Profit- Quantity 0 Loss- Quantity
maximizing minimizing
quantity quantity
Monopolistic competitors, like monopolists, maximize profit by producing the
quantity at which marginal revenue equals marginal cost. The firm in panel (a)
27 makes a profit because, at this quantity, price is above average total cost. The firm
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in panel (b) makes losses because, at this quantity, price is less than average total
cost.

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Microeconomics I - FTU 2015/3/16

Advertising
Monopolistic competition: between perfect competition& monopoly
 When firms Market structure

 Sell differentiated products Perfect

competition
Monopolistic
competition Monopoly

 At price above marginal cost Features that all three market

structures share
Goal of firms Maximize Maximize Maximize
 Then, they have incentive to advertise Rule for maximizing profits profits profits
Can earn economic profits in MR = MC MR = MC MR = MC
 To attract more buyers the short run?
Features that monopolistic Yes Yes Yes
competition shares with
monopoly
Price taker? Yes No No
Price P = MC P > MC P > MC
Produces welfare-maximizing
level of output? Yes No No
Features that monopolistic
competition shares with
competition Many Many One
Number of firms Yes Yes No
Entry in long run?
29 30 Can earn economic profits in No No Yes
long run?

Oligopoly

1. Only a few sellers

IV. Oligopoly  Tension between cooperation and self-interest
 Is best off cooperating
Characteristics  Acting like a monopolist
Collusion – Form a Cartel  Produce a small quantity of output
Not form a cartel  Charge P >MC
 Each - cares only about its own profit
 Powerful incentives not to cooperate
2. Offer similar or identical products
3. Interdependent

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Form a Cartel
OPEC and the world oil market

 Collusion: Agreement among firms in a market for

 OPEC - successful at maintaining cooperation and high prices
Quantities to produce or Prices to charge  From 1973 to 1985: increase in price
 Cartel: Group of firms acting in unison  Mid-1980s - member countries began arguing about production levels
 OPEC - ineffective at maintaining cooperation
 Produce monopoly quantity  Decrease in price
 Charge monopoly price  OPEC
 Difficult to reach & enforce an agreement  Tries to set production levels for each of the member countries
 Problem
 The countries - want to maintain a high price of oil
 Each member of the cartel
 Tempted to increase its production
 Get a larger share of the total profit
 Cheat on agreement
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Do not form a cartel Do not form a cartel

 As the number of sellers in an oligopoly grows larger  The equilibrium for an oligopoly
 Oligopolistic market - looks more like a competitive  Nash equilibrium
market  Economic actors interacting with one another
 Price - approaches marginal cost  Each choose their best strategy
 Quantity produced – approaches socially efficient  Given the strategies that all the other actors have chosen
level  Dominant Strategies
 Game Theory

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Jack and Jill’s Oligopoly Game

Jack and Jill’s Oligopoly Game
The demand schedule for water Jack’s decision
Total revenue High production: 40 Gallons Low production: 30 Gallons
Quantity Price (and total profit)
Jack gets Jack gets
0 gallons $120 $0 High $1,600 profit $1,500 profit
10 110 1,110 production:
20 100 2,000 40 Gallons Jill gets Jill gets
30 90 2,700 Jill’s $1,600 profit $2,000 profit
40 80 3,200 Decision
50 70 3,500 Jack gets Jack gets
60 60 3,600 Low $2,000 profit $1,800 profit
70 50 3,500 production:
80 40 3,200 30 Gallons Jill gets Jill gets
90 30 2,700 $1,500 profit $1,800 profit
100 20 2,000
110 10 1,100
120 0 0 In this game between Jack and Jill, the profit that each earns from selling water
depends on both the quantity he or she chooses to sell and the quantity the other
37 chooses to sell.
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