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Lesson-34Acquiring and using Market PowersA Review of Perfect Competition and Monopoly
It is typical in microeconomic analysis to discuss perfect competition and monopoly. Thishandout is a basic review of these two extreme cases of market structure, but it is alsointends to motivate the further investigation of some related topics.
Perfect Competition
When defining what is meant by a "competitive market" one usually thinks of manyfirms, with each firm charging a low price. Each firm's price will be high enough toensure a "fair return" but also low enough to keep other firms from outselling them.A perfectly competitive industry is characterized in the short run as one with many smallfirms, each selling a homogeneous (standardized) product. In the long run, a perfectlycompetitive industry has no barriers to entry or exit. That is, firms may enter and exit theindustry as necessary.
What do these conditions directly imply about perfectly competitive industries?
 1. Selling a homogeneous product leads to one price for all firms.2. Many small firms imply that each firm produces for a small segment of theoverall market, so small in fact that no single firm can affect the market price. It isthe behavior of the market as a whole which determines the market price. In turn,the market price serves as the demand curve for each firm.3. Free entry into or exit from an industry implies that the industry's firms will makezero economic profits in the long run.
What do these conditions indirectly imply about perfectly competitive industries?
 1. Since firms cannot affect the market price, their marginal revenue will alwaysequal the market price.2. Firms adjust their output levels in order to maximize profits. They produce wheretheir marginal cost (of producing a specific output level) equals the market price.This implies further that the firm's marginal cost curve is its supply curve as well.3. Once the market price and output levels are set, we find that total economicsurplus is at a maximum. This results from the fact that each firm is producingwhere P = MC, which implies allocative efficiency.
Monopoly
In the popular board game Monopoly, the object is to eliminate one's competitors by buying up their property. That is, to become a monopolist. En route to this end, as a
 
  player buys up more and more property, their "profits" rise. In both the game and popular culture, monopolies are often characterized as high profit firms, made rich no doubt after charging exorbitant prices to hapless widows and children.By definition, a monopolized industry is an industry inhabited by only one firm. In thelong run, a monopolistic industry has high barriers to entry and exit. Entry and exit aremade difficult by either natural causes (e.g. cost conditions or trade secrets) or moreartificial ones (e.g. patents or government involvement).
What do these conditions directly imply about monopoly?
 1. With one firm meeting all of market demand, that one firm determines its ownmarket price.2. When firms may not freely enter or exit an industry, the economic profits of theindustry's firms are greater than or equal to zero in the long run. The actual profitlevel will depend upon the firm's average costs.
What do these conditions indirectly imply about monopoly?
 1. Since a monopolist can set its own price, that price will exceed the monopolist'smarginal revenue.2. A monopolist maximizes profits by producing where her marginal cost equals her marginal revenue.3. Since the firm's price will be greater than its marginal cost, total economic surplusis not at a maximum, implying allocative inefficiency.
Further Questions
While instructive in a theoretical context, these extreme cases aren't often observed in thereal world. We may then want to ask some deeper, more empirically driven questions.Here are some examples:1. Since perfectly competitive firms are unable to affect the market price and sincemonopolists operate without competition, we see that there is no strategicinteraction among firms within perfect competitive or monopoly markets.a. How would we model strategic interaction within a market? b. What effect does strategic interaction have on prices and output levels?2. Real firms compete in ways other than just setting a price or output level. For example, in the short run, firms may differentiate their product from that sold by acompetitor or firms may compete through innovation, affecting their rate of output growth over the long run.
 
 a. How do firms differentiate their products, and how does that productdifferentiation affect market outcomes? b. While some market structures may lead to allocative inefficiency, is it possible that through innovation these same markets may have higher ratesof innovation and achieve higher rates of output growth?3. Our previous analysis says little about how monopoly is achieved.a. Should it matter how firms come to dominate a market? b. What happens in monopoly markets when barriers are not so high as to prevent entry forever?
Innovation and Market Structure
One of the industries is a monopoly (industry A), the other is perfectly competitive(industry B). What is the incentive to innovate in these two industries? Assume that theindustries face identical demand and cost curves:
•
Industry demand: P = 100 - Q (monopolist's MR = 100 - 2Q)
•
Marginal Cost: MC = AC = $20
•
An inventor designs a way for each industry to lower unit costs by $10 per unit
A. Incentive to innovate = size of the inventor's royalty
 Suppose that our inventor can choose between selling the innovation to industry A or B.Whoever pays the biggest royalty gets the innovation. How much are they willing to pay?The answer is, no more than the change in their costs (i.e. $10 per unit). Therefore, we'llset the royalty fee at $10 per unit. The innovation would lower MC in both markets (toMC
2
), but the royalty fee would bring MC back to its pre-innovation level (to MC
1
).
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