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BUSINESS ECONOMICS

Sessions 9 & 10: Market Structure Analysis I: Perfect Competition & Monopoly
2. 2.1 Post Work Learning Objectives In developing a framework for understanding the profit maximizing behaviour of firms under different market structures, this session has the following learning objectives: (i) to understand the managerial implications of profit maximization in a Competitive Market to highlight the effect of changes in demand and supply conditions on profit maximization in a Competitive Market to understand the managerial implications of profit maximization in a Monopoly Market.

(i)

(ii)

2.2 2.2.1

Summary Profit Maximization in a Competitive Market  Market structure describes the competitive environment in the market for any good or service  Competitive environment of a market is determined by three characteristics, namely, Number of Buyers / Sellers; Nature of the product (standardized or differentiated); and Entry conditions. As such, four broad market structures are defined: Perfect

Competition, Monopolistic, Oligopoly and Monopoly.

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 A business firm’s profits are maximized at prices where MR = MC. Under each of the above market structures. The lower the AC curve relative to the price. In other words. in Monopolistic.  In a Perfectly Competitive Market. In a Perfectly Competitive Market. the supply curve 2 . a business firm’s profit maximizing ‘output’ and ‘prices’ differ as the nature of the demand and supply curves vary. the demand curve is downward sloping. But. The industry price is the firm’s price or demand curve. Oligopoly and Monopoly markets the price elasticity is lower (as compared to Perfectly Competitive Market) and as such. Industry demand (downward sloping) and supply curves determine the equilibrium market price and quantity. no single firm can influence the industry price by increasing or decreasing the quantity supplied. the higher the profits earned. the price elasticity is infinity and therefore the demand curve is horizontal. 2. As there are a number of firms operating in this market. the profits by a firm earned depends on the cost structure. With more firms in the industry.2 Profit Maximization and Changes in Demand and Supply Conditions  In a competitive market. Since MR curve is derived from the firm’s demand curve and MC curve is the supply curve. at the given industry price.2. This would imply that cost efficient firms earn higher profits while cost inefficient firms incur losses. changes in demand and supply factors will influence the profits earned by the firm.  The profit maximizing output for a single firm would be where MR = MC: Since the price is given. positive economic profits attract firms into the industry. the firm has to decide how much output to supply.

a monopoly firm generally earns supernormal profits.  In case.2.  Thus. Profits are maximized at Price where MR = MC. there is a single industry and firm demand curve which is downward sloping.e. This implies the firm can fix either price or quantity. on the falling part of the AC curve). As such.e. Since the equilibrium price is greater than MC. Consequently.  Corresponding to the demand curve. 2. In the long run. given their cost structures. However. the MR curve is derived with depicts the revenue implications of the changes in prices by the firm.  Profit maximizing monopoly firms are considered to be cost inefficient as they generally operate under excess capacity conditions (i.shifts to the right. there is only one operating firm. P = AC = MC. influences the profits of firms.3 Profit Maximization in Monopoly Market  In a monopoly market. With unchanging demand conditions. the market price falls leading to a downward shift in the firm’s demand curve. a 3 . economic losses characterize the industry. firms exit resulting in the leftward shift of the industry supply curve and a consequent rise in price. the equilibrium price of the industry would be such that all firms would be earning only normal profits i. changes in supply conditions as also the changes in demand conditions influence the industry price which in turn. the firms’ economic profits fall assuming unchanging cost structure.

there could also be situations where monopolist can also incur economic losses. Re-state each one correctly. The competitive firm sets price equal to marginal cost. A firm’s shutdown point comes where price is less than minimum average cost.monopolist can earn higher profits if there are improvements in cost structure (i. Interpret this dialogue: A: “How can competitive profits be zero in the long run? Who will work for nothing?” 4 . b) c) d) e) 2. Any other cost concept is irrelevant for supply decisions.3 Readings Handout 5: Competition & Monopoly Chapter 10: Text Book 2. and downward sloping MC curves. The P=MC rule for competitive industries holds for upwardsloping. Since the entry/exit conditions are difficult. Learning Activity Explain why each of the following statements about profit-maximizing competitive firms is incorrect.e. 2.4 1. a) A competitive firm will produce output up to the point where price equals average variable cost. horizontal. A firm’s supply curve depends only on its marginal cost. downward shift in AC curve).

B: “It is only excess profits that are wiped out by competition. no less?” 3. (a) If a competitive firm is in short-run equilibrium. Managers get paid for their work. must it also be in short-run equilibrium? 4. (a) Can a monopolist incur losses in the short run? Why? (b) Can a monopolist earning short-run profits increase those profits in the long run? Why? (c) Would an monopolist ever operate in the inelastic portion of the demand curve it faces? Why? 5 . must it also be in long-run equilibrium? (b) If a competitive firm is in long-run equilibrium. owners get a normal return on capital in competitive long-run equilibrium-no more.