Lecture 8: PERFECT COMPETITION AND

MONOPOLY

February 18, 2020

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Motivation

Figure: Where do you go, Dragon fruit?

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Motivation

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Content

1. Perfect competition
1.1 Long-run equilibrium of perfectly competitive firm
1.2 Long-run supply curve of perfectly competitive industry

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Recall: Market structures

Definition of market
Market is a group of buyers and sellers of a particular good or service

Classification of market structures

Number of firms
Types of goods (Identical, similar or differentiated)
Barriers to Entry (and Exit)
Control over price (price setter, price maker, and price taker)

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Recall: Market types

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(a) Demand curve facing the firm
(b) Market demand curve

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Recall to p.18
Perfect competition: (a) Demand curve facing the firm
(b) Market demand curve

In (a) the demand curve facing the firm is perfectly elastic.

In (b) the market demand curve is downward sloping.

A perfectly competitive firm supplies only a small portion of the total

output of all the firms in an industry

→ the firm takes the market price of the product as given, choosing its
output on the assumption that the price will be unaffected by the output
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Profit maximization (Theory of profit - chapter 5)

Profit = Total Revenue - Total Cost

π(Q) = TR(Q) − TC (Q) (1)

π(Q) is maximized at the point at which an additional increment to

output leaves profit unchanged: ∆π/∆Q = π 0 (Q) = 0

∆π
= ∆TR/∆Q − ∆TC /∆Q = 0 (2)
∆Q | {z } | {z }
MR MC

Profit is maximized when MR - MC = 0, so that MR = MC

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Profit maximization: AB = Max(profit) at q*

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Marginal revenue curve = Demand curve (at firm-level)

The demand curve D facing an individual firm in a perfectly

competitive market is both its average revenue curve and its marginal
revenue curve.

Additional revenue = price (P = MR)

→ Along this demand curve, marginal revenue, average revenue, and price
are all equal.

To maximize profit, the competitive firm follows:

MC = MR = P

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Choosing output in the short run

How much output should a firm produce over the short run, when its
plant size is fixed (capital = constant, labour is changeable)?
A firm can use information about revenue and cost to make a
profit-maximizing output decision.

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Choosing output in the short run at q* (P=MC)

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Choosing output in the short run at q* (P=MC)

The profit of the firm is measured by the rectangle ABCD

Any change in output, whether lower at q1 or higher at q2, will lead to
lower profit.

Output Rule:
If a firm is producing any output, it should produce at the level at which
marginal revenue equals marginal cost.

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Shut down if P < AVCmin

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Breakeven point: P = ATCmin. Shut down if P <
AVCmin.

Sunkcost: Let bygones be bygones

Sunk cost a cost that has already been committed and cannot be
recovered.
The firm cannot recover its FC by temporarily stopping production. That
is, regardless of the quantity of output supplied (even if it is zero), the
firm still has to pay FC.
The FC are sunk in the short run, and the firm can ignore them when
deciding how much to produce. The firm’s short-run supply curve is the
part of the MC curve that lies above AVC, and the size of the FC does not
matter for this supply decision.

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The competitive firm’s and market’s short-run supply curve

A supply curve for a firm tells us how much output it will produce at
every possible price
Competitive firms will increase output to the point: P = MC

Competitive firms will shut down if P < AVCmin.

→ The firm’s supply curve is the portion of the MC curve for which MC >
AVC.

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The competitive firm’s and market’s short-run supply curve

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Choosing output in the long run

In the short run:

One or more of the firm’s inputs are fixed. This may limit the flexibility of
the firm to adapt its production process to new technological
developments, or to increase or decrease its scale of operation as economic
conditions change.

In the long run:

A firm can alter all its inputs, including plant size. It can decide to shut
down (i.e., to exit the industry) or to begin producing a product for the
first time (i.e., to enter an industry).

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Choosing output in the long run

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Choosing output in the long run

In the short-run:
Profit is the area ABCD

In the long-run:
The firm maximizes its profit by choosing the output at which price equals
long-run marginal cost LMC.
The firm increases its profit from ABCD to EFGD by increasing its output
in the long run.

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The industry’s long-run equilibrium and supply curve

Economic profit

π = TR − (wL + rK ) (3)
| {z }
=TC

Where: π is profit, TR is total revenue, w is wage, L is labour, r is rent, K

is capital (machines)

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The industry’s long-run equilibrium and supply curve

Zero economic profit

A firm is earning a normal return on its investment—i.e., it is doing as well
as it could by investing its money elsewhere.

Entry and exit

In a market with entry and exit, a firm enters when it can earn a positive
longrun profit and exits when it faces the prospect of a long-run loss.

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A long-run competitive equilibrium occurs when three
conditions hold:

1. All firms in the industry are maximizing profit.

2. No firm has an incentive either to enter or exit the industry because all
firms are earning zero economic profit.

3. The price of the product is such that the quantity supplied by the
industry is equal to the quantity demanded by consumers.

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A long-run competitive equilibrium

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A long-run competitive equilibrium

In (a) we see that firms earn positive profits because long-run average cost
reaches a minimum of $30 (at q2).

Positive profit encourages entry of new firms and causes a shift to the
right in the supply curve to S2, as shown in (b).

The long-run equilibrium occurs at a price of $30, as shown in (a), where

each firm earns zero profit and there is no incentive to enter or exit the
industry.

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The Industry’s Long-Run Supply Curve

Constant-cost industry Industry whose long-run supply curve is

horizontal.

Increasing-cost industry Industry whose long-run supply curve is upward

sloping.

Decreasing-cost industry Industry whose long-run supply curve is

downward sloping.

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Constant-cost industry

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Constant-cost industry

The long-run supply curve for a constant-cost industry is, a horizontal line
at a price that is equal to the long-run minimum average cost of
production.

At any higher price, there would be positive profit, increased entry,

increased short-run supply, and thus downward pressure on price.
Remember that in a constant-cost industry, input prices do not change
when conditions change in the output market.

Constant-cost industries can have horizontal long-run average cost curves.

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Increasing-cost industry

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Increasing-cost industry

In an increasing-cost industry, the long-run industry supply curve is

upward sloping. The industry produces more output, but only at the
higher price needed to compensate for the increase in input costs.

The term “increasing cost” refers to the upward shift in the firms’ long-run
average cost curves, not to the positive slope of the cost curve itself.

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Decreasing-cost industry

The industry supply curve can be downward sloping. In this case, the
unexpected increase in demand causes industry output to expand as
before. But as the industry grows larger, it can take advantage of its size
to obtain some of its inputs more cheaply.

For example: a larger industry may allow for an improved transportation

system or for a better, less expensive financial network. In this case, firms’
average cost curves shift downward (even if they do not enjoy economies
of scale), and the market price of the product falls. The lower market price
and lower average cost of production induce a new longrun equilibrium
with more firms, more output, and a lower price. Therefore, in a
decreasing-cost industry, the long-run supply curve for the industry is
downward sloping.
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