Organization of industries

1. Perfect Competition
The characteristics of perfect competition:
 All the firms in the market produce a homogeneous product.
 There is a large number of independent firms.
 Each seller is small relative to the total market.
 There are no barriers to entry or exit.
 Price takers are firms that take the market price as given. In a perfectly competitive
market, each producer is a price taker because production decisions cannot
influence the market price.
 Although the market demand curve is downward sloping, under perfect
competition, each firm faces a perfectly elastic (horizontal) demand curve and,
therefore, its marginal revenue at any output level equals the market price.
 A profit maximizing firm will produce the quantity, Q*, when MC = MR.

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Economic Profit and Revenue
- The goal of each firm is to maximize economic profit, which equals total revenue
minus total cost.
- Total cost is the opportunity cost of production, which includes normal profit.
- A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P Q.
- A firm’s marginal revenue is the change in total revenue that results from a one-
unit increase in the quantity sold.

The demand for a firm’s product is perfectly elastic because one firm’s sweater is a
perfect substitute for the sweater of another firm.
The market demand is not perfectly elastic because a sweater is a substitute for some
other good.
Marginal Analysis and Supply Decision
The firm can use marginal analysis to determine the profit-maximizing output.
Because marginal revenue is constant and marginal cost eventually increases as
output increases, profit is maximized by producing the output at which marginal
revenue, MR, equals marginal cost, MC.

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The Firm’s Output Decision
 If MR > MC, economic profit increases if output increases.
 If MR < MC, economic profit decreases if output increases.
 If MR = MC, economic profit decreases if output changes in either direction, so
economic profit is maximized.

The profit maximizing (loss minimizing) output for a perfectly competitive company
- Firms maximize profits by producing the quantity for which marginal revenue
equals marginal cost. Because marginal revenue for a price-taker firm is equal to
the market price, price-taker firms maximize profits at the output level for which
the marginal cost equals the market price.
- Economic profit or loss equals total revenues less the opportunity cost (implicit and
explicit costs) of production, which includes a normal profit. Economic profit is zero
in the long run for a firm in a perfectly competitive market.
- A price-taker firm should continue to operate if the market price is temporarily less
than its average total cost but greater than its average variable cost, but the firm
should shut down temporarily if price is less than average variable cost. A firm that
believes price will always be less than average total cost should go out of business.

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Output, Price, and Profit in the Short Run

In part (a) price equals average total cost and the firm makes zero economic profit
(breaks even).

In part (b), price exceeds average total cost and the firm makes a positive economic
profit.

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In part (c) price is less than average total cost and the firm incurs an economic loss—
economic profit is negative.

In short-run equilibrium, a firm might make an economic profit, break even, or incur an
economic loss.
In long-run equilibrium, firms break even because firms can enter or exit the market
because of Entry and Exit condition:
o New firms enter an industry in which existing firms make an economic profit.
o Firms exit an industry in which they incur an economic loss.

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A Closer Look at Entry

 When the market price is $25 a sweater, firms in the market are making economic
profit.
 New firms have an incentive to enter the market.
 When they do, the market supply increases and the market price falls.
 Firms enter as long as firms are making economic profits.
 In the long run, the market price falls until firms are making zero economic profit.
A Closer Look at Exit

 When the market price is $17 a sweater, firms in the market are incurring economic
loss.
 Firms have an incentive to exit the market.
 When they do, the market supply decreases and the market price rises.
 Firms exit as long as firms are incurring economic losses.
 In the long run, the price continues to rise until firms make zero economic profit.

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An Increase in Demand

 An increase in demand shifts the market demand curve rightward.

 The price rises and the quantity increases.
 Starting from long-run equilibrium, firms make economic profits.
 The market demand curve shifts rightward, the market price rises, and each firm
increases the quantity it produces.
 The market price is now above the firm’s minimum average total cost, so firms
make economic profit.
 Economic profit induces some firms to enter the market, which increases the
market supply and the price starts to fall.
 As the price falls, the quantity produced by all firms starts to decrease and each
firm’s economic profit starts to fall.
 Eventually, enough firms have entered for the supply and increased demand to be
in balance and firms make zero economic profit. Firms no longer enter the market.

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 A decrease in demand has the opposite effects.
 A decrease in demand shifts the demand curve leftward.
 The price falls and the quantity decreases.
 Firms incur economic losses.
 Economic loss induces exit.
 The short-run market supply curve shifts leftward.
 As the market supply decreases, the price stops falling and starts to rise.
 With a rising price, each firm increases its output as it moves along up its marginal
cost curve (supply curve).
 A new long-run equilibrium occurs when the price has risen to equal minimum ATC.
 Firms make zero economic profit, and firms have no incentive to exit the market.
 In the new equilibrium, a smaller number of firms produce the equilibrium quantity.

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Technological Advances Change Supply

 Starting from a long-run equilibrium, when a new technology becomes available

that lowers production costs, the first firms to use it make economic profit.
 But as more firms begin to use the new technology, market supply increases and
the price falls.
 When a new technology becomes available, the ATC and MC curves shift
downward.
 Firms that use the new technology make economic profit
 Economic profit induces some new-technology firms to enter the market.
 The market supply increases and the price starts to fall.
 With the lower price, old-technology firms incur economic losses.
 Some exit the market; others switch to the new technology.
 Eventually all firms are using new technology.
 The market supply has increased and firms are making zero economic profit.

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 2. Monopoly
The characteristics of a monopoly:
 Monopoly is characterized by one seller of a specific, well-defined product that has
no good substitutes and high barriers to entry. Barriers to entry include economies
of scale, government licensing and legal barriers, patents or exclusive rights of
production, and resource control.
 Monopoly price-setting strategies include charging a single profit-maximizing price
and price discrimination, where different prices are charged to different groups of
customers.
 Price and Marginal Revenue
o A monopoly is a price setter, not a price taker like a firm in perfect competition.
o The reason is that the demand for the monopoly’s output is the market demand.
o To sell a larger output, a monopoly must set a lower price.
o For a single-price monopoly, marginal revenue is less than price at each level of
output. That is, MR < P.
The relation between price, marginal revenue, and elasticity for a monopoly and
determine a monopoly's profit-maximizing price and quantity.
- Like all firms, monopolists maximize profits by producing the quantity where
marginal revenue equals marginal cost.
- Monopolists are price searchers (face downward sloping demand curves) and have
imperfect information about demand, so they must experiment with different prices
(search) to find the profit maximizing price/quantity. This price/quantity will
always be in the elastic range of the demand curve for the firm's product. Once
again, the profit maximizing output for a monopolistic firm is the one for which MR =
MC. As shown in Figure 1, the profit maximizing output is Q*, with a price of P*, and
an economic profit equal to (P* - ATC*) x Q*.

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Price discrimination and perfect price discrimination is efficient
Price discrimination is the practice of charging different consumers different prices for
the same product or service .example are different prices for airline tickets based on
whether Saturday-night stay is involved (separates business travelers and leisure
travelers)and different prices for movie tickets based on age.

As long as these conditions are met, firm profits can be increased through price
discrimination.
Figure 2 illustrates how price discrimination can increase the total quantity supplied
and increase economic profits compared to a single-price pricing strategy.
For simplicity, we have assumed no fixed costs and constant variable costs so that MC
= ATC.

- In panel (a), the single profit-maximizing price is $100 at a quantity of 80 (where MC

= MR), which generates a profit of $2,400.
- In panel (b), the firm is able to separate consumers, charges one group $110 and
sells them 50 units, and sells an additional 60 units to another group (with more
elastic demand) at a price of $90. Total profit is increased to $3,200, and total
output is increased from 80 units to 110 units.

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Compared to the quantity produced under perfect competition, the quantity produced
by a monopolist reduces the sum of consumer and producer surplus by an amount
represented by the triangle labeled deadweight loss (DWL) in panel (a) of Figure 2.
Consumer surplus is reduced not only by the decrease in quantity but also by the
increase in price relative to perfect competition.
Monopoly is considered inefficient because the reduction in output compared to
perfect competition reduces the sum of consumer and producer surplus.
Since marginal benefit is greater than marginal cost, less than the efficient quantity of
resources are allocated to the production of the good.
Price discrimination reduces this inefficiency by increasing output toward the quantity
where marginal benefit equals marginal cost.
Note that the deadweight loss is smaller in panel (b). The firm gains from those
customers with inelastic demand while still providing goods to customers with more
elastic demand. This may even cause production to take place when it would not
otherwise.
An extreme (and largely theoretical) case of price discrimination is perfect price
discrimination.
If it were possible for the monopolist to charge each consumer the maximum they are
willing to pay for each unit, there would be no deadweight loss, since a monopolist
would produce the same quantity as under perfect competition.
With perfect price discrimination, there would be no consumer surplus. It would all be
captured by the monopolist
Explain how consumer and producer surplus are redistributed in a monopoly, including
the occurrence of deadweight loss and rent seeking.

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Figure 3 illustrates the difference in allocative efficiency between monopoly and
perfect competition.
Under perfect competition, the industry supply curve, S, is the sum of the supply
curves of the many competing firms in the industry. The perfect competition
equilibrium price and quantity are at the intersection of the industry supply curve and
the market demand curve, D. The quantity produced is Qpc at an equilibrium price Ppc.
Since each firm is small relative to the industry, there is nothing to be gained by
attempting to decrease output in an effort to increase price.

The important thing to note here is that when compared to a perfectly competitive
industry, the monopoly firm will produce less total output and charge a higher price.
Recall from our review of perfect competition that the efficient quantity is the one for
which the sum of consumer surplus and producer surplus is maximized. In Figure 3, this
quantity is where S = D, or equivalently, where marginal cost (MC) = marginal benefit
(MB). Monopoly creates a deadweight loss relative to perfect competition because
monopolies produce a quantity that does not maximize the sum of consumer surplus
and producer surplus. A further loss of efficiency results from rent seeking when
producers spend time and resources to try to acquire or establish a monopoly.

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Single-Price Monopoly and Competition Compared

- Total surplus, the sum of consumer surplus and producer surplus, is maximized.
- The quantity produced in perfect competition is efficient.

- Figure 13.6(b) shows the inefficiency of monopoly.

- Because price exceeds marginal social cost, marginal social benefit exceeds
marginal social cost, … and a deadweight loss arises.
- Redistribution of Surpluses: Some of the lost consumer surplus goes to the
monopoly as producer surplus.

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 3. Monopolistic Competition
The characteristics of monopolistic competition :

 Firms in monopolistic competition face downward-sloping demand curves (they are

price searchers). Their demand curves are highly elastic because competing
products are perceived by consumers as close substitutes.
The Firm’s Short-Run Output and Price Decision
A firm that has decided the quality of its product and its marketing program produces
the profit-maximizing quantity (the quantity at which MR = MC).
Price is determined from the demand for the firm’s product and is the highest price
that the firm can charge for the profit-maximizing quantity.

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- The firm in monopolistic competition operates like a single-price monopoly.
- The firm produces the quantity at which MR equals MC and sells that quantity for
the highest possible price.
- It makes an economic profit (as in this example) when P > ATC.
- Profit Maximizing Might Be Loss Minimizing
- A firm might incur an economic loss in the short run.
Here is an example.

- At the profit-maximizing quantity, P < ATC and the firm incurs an economic loss.

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Long Run: Zero Economic Profit
- In the long run, economic profit induces entry.
- And entry continues as long as firms in the industry earn an economic profit—as
long as (P > ATC).
- In the long run, a firm in monopolistic competition maximizes its profit by producing
the quantity at MR = MC.
- As firms enter the industry, each existing firm loses some of its market share.
- The demand for its product decreases.
- The decrease in demand decreases the quantity at which MR = MC and lowers the
maximum price that the firm can charge to sell this quantity.
- As new firms enter, the firm's price and quantity fall until P = ATC and each firm
earns zero economic profit.
Figure shows a firm in monopolistic competition in long-run equilibrium.

Monopolistic Competition and Perfect Competition

- Two key differences between monopolistic competition and perfect competition
are
o Excess capacity
o Markup
- A firm has excess capacity if it produces less than the quantity at which ATC is a
minimum.
- A firm’s markup is the amount by which its price exceeds its marginal cost.

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- In long-run equilibrium, firms in monopolistic competition produce less than the
efficient scale—the quantity at which ATC is a minimum.
- They operate with excess capacity.
- The downward-sloping demand curve for their products drives this result.
- Firms in monopolistic competition operate with positive markup.
- Again, the downward-sloping demand curve for their products drives this result.
- In contrast, firms in perfect competition have no excess capacity and no markup.
- The perfectly elastic demand curve for their products drives this result.
Is Monopolistic Competition Efficient?
- Price equals marginal social benefit.
- The firm’s marginal cost equals marginal social cost.
- Because price exceeds marginal cost, marginal social benefit exceeds marginal
social cost, so ...
- In the long run, the firm in monopolistic competition produces less than the efficient
quantity.

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Making the Relevant Comparison
- The markup (price minus marginal cost) arises from product differentiation.
- People value product variety, but product variety is costly.
- The efficient degree of product variety is the one for which the marginal social
benefit from product variety equals its marginal social cost.
- The loss that arises excess capacity is offset by the gain that arises from having a
greater degree of product variety.
The importance of innovation, product development, advertising, and branding
under monopolistic competition.
 Product innovation is a necessary activity as firms in monopolistic competition
pursue economic profits.
Firms that bring new and innovative products to the market are confronted with
less-elastic demand curves, enabling them to increase price and earn economic
profits.
However, close substitutes and imitations will eventually erode the initial economic
profit from an innovative product.
Thus, firms in monopolistic competition must continually look for innovative product
features that will make their products relatively more desirable to some consumers
than those of the competition.
 Advertising expenses are high for firms in monopolistic competition.
This is to inform consumers about the unique features of their products and to
create or increase a perception of differences between products that are actually
quite similar.
We just note here that advertising costs for firms in monopolistic competition are
greater than those for firms in perfect competition and those that are monopolies.
 Brand names provide information to consumers by providing them with signals
about the quality of the branded product.
Many firms spend a significant portion of their advertising budget on brand name
promotion. Seeing the brand name Toyota on an automobile likely tells a consumer
more about the quality of a newly introduced automobile than an inspection of the
automobile itself would reveal.

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Selling Costs and Total Costs
Selling costs, such as advertising expenditures, fancy retail buildings, etc. are fixed
costs.
Average fixed costs decreases as output increases, so selling costs increase average
total cost at any given quantity but do not change marginal cost.
Selling efforts such as advertising are successful if they increase the demand for the
firm’s product.

- With no advertising, this firm produces 25 units of output at an average total cost
of $60.
- Advertising costs might lower the average total cost by increasing the quantity
produced and spreading their fixed costs over the larger output.

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- With advertising, the firm can produce 100 units of output at an average total cost
of $40.
- Advertising expenditure shifts the ATC curve upward, but …
- the firm operates at a larger output and lower average total cost than it would
without advertising.

- Advertising might also shrink the markup.

- Figure shows that with no advertising, the demand for a firm’s output is not very
elastic and its markup is large.

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- Figure shows that if all firms advertise, the demand for a firm’s output becomes
more elastic.
- The firm produces a larger quantity, its price falls, and its markup shrinks.

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 4. Oligopoly
Oligopoly is a form of market competition characterized by:
 A small number of sellers.
 Interdependence among competitors (decisions made by one firm affect the
demand, price, and profit of others in the industry).
 Significant barriers to entry which often include large economies of scale.
 Products may be similar or differentiated.
In contrast to a monopolist, oligopolists are highly dependent upon the actions of their
rivals when making business decisions. Price determination in the auto industry is a
good example.
The kinked demand curve model and the dominant firm oligopoly model
One traditional model of oligopoly, the kinked demand curve model, is based on the
assumption that an increase in a firm's product price will not be followed by its
competitors, but a decrease in price will. According to the kinked demand curve model,
each firm believes that it faces a demand curve that is more elastic (flatter) above a
given price (the kink in the demand curve) than it is below the given price. The kinked
demand curve model is illustrated in Figure 3. The "kink" price is at price PK,where a
firm produces QK.

- A firm believes that if it raises its price above PK, its competitors will remain at PK,
and it will lose market share because it has the highest price.
- Above PK, the demand curve is considered to be relatively elastic, where a small
price increase will result in a large decrease in demand.
- On the other hand, if a firm decreases its price below PK, other firms will match the
price cut, and all firms will experience a relatively small increase in sales relative to
any price reduction.
- Therefore, QK is the profit-maximizing level of output.

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Another traditional oligopoly model, the dominant firm oligopoly model is based on an
assumption that one firm is the low-cost producer in the industry and, thus, has the
ability to effectively set the market price, which higher-cost producers then take as
given.

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