Chapter 4

HOW DO FIRMS COMPETE?

MARKETS AND POLICY
MONOPLOY POWER AND FIRM’S REVENUE

 The extent to which a firm can exercise influence over its

market depends both on the nature of the demand for its
products and on the kind of competition it faces in the
market.

 Monopoly Power (Market Power): A firm has monopoly

power if it has some choice in setting the price of its product
and its decision about how much to supply influences the
price it can charge.

 Firms are particularly likely to exercise such monopoly

power if they are large relative to the size of the market as a
whole.

 Pure Monopoly: A pure monopoly exists when a single firm

is the sole supplier in a market.

 Figure 4.2 (page 86) shows the demand curve facing a

supplier of a product in a market where firms have some
monopoly power.

 The demand of a firm’s goods is a function of the price. If

price rises, quantity demanded will fall.

 The demand curve for a firm’s goods determines the total

revenue the firm would earn at each price it might set.

 A firm’s total revenue is calculated as folloes:

TR = P. Q

 The average revenue (AR) is the revenue per unit sold.

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 Average revenue is total revenue divided by quantity
demanded.

AR = TR = P
Q
 Average revenue is equal to price. Each point on the
demand curve shows the average revenue (equals price) of
the firm for each quantity demanded. It follows that the
demand curve (D) of the firm is also its average revenue.

 ‘Marginal’ concept identifies the effects of small changes in

one variable (such as quantity demanded) on another
variable (such as total revenue).

 Marginal Revenue (MR): Marginal revenue is the change in

total revenue resulting from the sale of an additional unit of
output.

 Do Exercise 4.1 Page 88.

 Based on Exercise 4.1, what is the relationship between

marginal revenue (MR), average revenue (AR) and total
revenue as price falls (TR)?

 As price (=AR) falls, quantity demanded rise.

 Total revenue (TR) increases as demand rises.

 Marginal revenue (MR) falls as quantity demanded

rises.

 Figure 4.3 (page 89) shows that marginal revenue (MR) is

less than average revenue (AR) at each quantity demanded.

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 This relationship between marginal and average revenue is
implied by the downward slope of the demand curve.
Average revenue (price) declines as quantity rises.
Marginal revenue must therefore be less than average
revenue. The marginal revenue is the price (average
revenue) of the extra unit less the revenue lost by reducing
the prices of all the others in order to raise demand.

THE PRICE ELASTICITY OF DEMAND

 Price Elasticity of Demand: The price elasticity of demand

measures the responsiveness of the quantity demanded of a
product to changes in its price.

Price elasticity of demand = % change in quantity demanded

% change in price

 Price elasticity of demand is generally negative as price and

quantity demanded move in opposite directions.

 Do Exercise 4.2 Page 90.

 Elastic Demand: Demand is price elastic if the price

elasticity is greater than 1.

 Inelastic Demand: Demand is price inelastic if the price

elasticity is less than 1.

 Unit Elastic Demand: Demand is unit elastic if the price

elasticity =1.

 The firm’s most important concern is to be with the effect

of the price decrease on its total revenue.

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 Total revenue (TR) will increase if a small percentage
change in price causes a large percentage change in sales
(elastic demand).

 Total revenue (TR) will decrease if a large percentage

change in price causes a small percentage change in sales
(inelastic demand).

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MARGINAL AND AVERAGE COSTS

 The average cost curve traces average or unit costs of

production at different levels of output, in the short and
long run.

 The firm’s total cost (TC) at each level of output is the

quantity produced (Q) multiplied by average cost (AC):

TC = AC . Q
 Marginal cost (MC) is the change in total cost incurred as a
result of producing an additional unit of output.

 Figure 4.5 (page 93) shows the relationship between average

cost and marginal cost. At levels of output below Q1 ,
average cost falls as output increases. Marginal cost is less
than average cost. At Q1, average cost is at its minimum.
Above Q1, average cost starts to rise and marginal cost is
above average cost.

 Figure 4.5 illustrates that the marginal cost curve crosses

the average cost curve at its lowest point.

THE PROFIT MAXIMIZING MONOPLOIST

 We assume that the firm has one objective of maximizing its

profits or the difference between total costs and total
revenues.

 The firm’s constraint: the demand function of its product.

The firm’s aim is to choose the price/quantity combination
that maximizes profits.

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 If the marginal revenue is higher than the marginal cost,
the addition to total revenue is larger than the addition to
total cost and profit rises. Total revenue has increased by
more than total cost.

 If marginal cost is larger than marginal revenue, then

producing and selling the additional unit has reduced
profits.

 Profits are maximized when MR = MC.

 Figure 4.7 (page 96) shows the profit maximization by a

pure monopolist. What output will the monopolist choose
to maximize profits?

 The monopolist chooses to produce Q1 where the marginal

revenue curve crosses the marginal cost curve at point A.

 The monopolist’s demand curve (average demand curve) is

D = AR. If the firm wishes to sell Q1 it will charge P1. A
higher price will leave the firm with unsold gods, while a
profit maximizing firm will not charge a lower price, since
that would reduce revenue.

 The firm will make total profits equal to the area BCEF.
The vertical distance BF (=CE) measures the profit per unit
(the difference between the price P1 and average cost). The
horizontal distance BC (=FE) is equal to Q1, the output
produced. Total profits are BF times BC, the area of the
rectangle BCEF.

 At output levels below Q1 the marginal revenue curve is

above the marginal cost curve. So increasing output

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 towards Q1 will add to profits. At output levels above Q1
marginal revenue is below marginal cost, so reducing
output will reduce costs more than it reduces revenue,
hence profits will rise.

 Q1 is the firm’s profit maximizing output. The firm has no

incentive to change its output. Q1 is therefore the firm’s
equilibrium output and P1 the equilibrium price.

 Equilibrium is a situation from which there is no incentive

for change.

 A pure monopolist will always set a price above marginal

cost. The mark-up of price over marginal cost represents
an indicator of the extent of monopoly power in the market.
This can be measured as:

P - MC
P

This measure is sometimes called the ‘degree of monopoly’.

ECONOMIES OF SCALE AND BARRIERS TO ENTRY

 One of the most important sources of monopoly power is

economies of scale. In this case, the firm’s long-run average
cost (LRAC) curve is downward sloping: average cast falls
as output rises.

 The firm’s combination of low average costs and high

output become a barrier to entry to other firms.

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 Figure 4.8 (page 99) shows the long-run average cost curve
and the demand curve for a single firm that monopolizes its
market.

 Average costs fall as the scale of the firm’s operation is

increased, up to the point of minimum efficient scale A at
output level Q1.

 Beyond A, costs per unit of output are constant. The

market demand curve is D1 and the firm supplies the whole
market.

 We assume that Q1 and P1 are the profit maximizing price

and quantity for the monopolist.

 Suppose that a new firm sets up production sufficient to

supply a small part of current demand (Q2). Figure 4.8
shows that at that level of output its average costs are
considerably higher (AC2) than those of the established firm
(AC1).

MONOPOLISIC COMPETITION

 The model of monopolistic competition builds on the pure

monopoly model, but drops the assumption that new firms
cannot enter the market. It shows that entry of new firms
can result in the disappearance of supernormal profits, but
there are some less satisfactory effects on costs.

 Figure 4.11 (page 105) shows the equilibrium of a firm in

monopolistic competition in the long run.