Prof.

Teresa Kamińska Microeconomics

5. THEORY OF COMPETITION

How to survive in the market?

Competition is the process in which enterprises – influenced by their environment

(rivals) – may set their quantity of supply and a price for a supplied commodity while
maximising their profits (neoclassical definition).

MARKET STRUCTURES (MODELS)

Quantity Economic
Market of Sort of Decision Market Factors’ outcome in
structure producers product making entry mobility the long run
Free
Perfect A great Homogenous - quantity entrance in complete Normal profit
competition deal standardised of output a long run
(infinite)
Monopolistic - quantity Free in a
competition A lot of differentiateof output long run incomplete Normal profit
- a price
- quantity
Several homogenous of output Bounded incomplete Economic
Oligopoly or - a price or no entry profit
differentiate
- quantity Entry is Economic
Monopoly One Homogenous of output blockaded incomplete profit
standardised - a price by
definition

No matter the market structure the firm’s goal is maximizing the economic profit
(short run) and maximizing the firm’s value (long run). If a firm is unable to
maximize the profit in the short run it should minimize its economic loss when
sources are available to finance the loss (implicit assumption). It is impossible to
support economic loss in the long run. The goal is achieved for an output level
when marginal revenue equals marginal cost, i.e. MR = MC, known as a golden
rule.

Three features of MR=MC rule:

1. Producing is preferable to shutting down
2. The rule is accurate to profit maximization for all firms regardless
the market structure
3. The rule can be restated as P=MC when applied to a purely
competition firm

Since a perfectly competitive firm is a price taker, it makes only a

decision of setting the level of sales (custom made production).

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Prof. Teresa Kamińska Microeconomics

Quantity Total Total Economic m.u.

per day Revenue Costs Profit TC
(dry (TR) (TC) (∏E = TR 350 TR
cleaned – TC)
clothes) 300
0 0 22 -22
1 25 45 -20 250
2 50 66 -16 A
3 75 85 -10 200
4 100 100 0 B
5 125 114 11 150
6 150 126 24
7 175 141 34 100
8 200 160 40
9 225 183 42 25
10 250 210 40
0 1 2 3 4 5 6 7 8 9 10 11 12 13 QC
11 275 245 30
m.u.
12 300 300 0
13 325 360 -35
42

0 4 9 12 QC
LE ∏E
-22

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Prof. Teresa Kamińska Microeconomics

In the short run a firm’s the best economic position (its equilibrium point)
dependent on a market situation can be as followed:

- The firm attains economic profit, if TR>TC or P>ATC,

a market an enterprise (a fixed plant)

PX m.u.
MC
S
ATC
PE PE d=MR=AR

0 QX 0 qe qx

m.u. TC TR

∏E

0 qe

When producing is preferable to shutting down, the competitive business that

wants to maximise profit or minimise its loss should produce at the point
where price equals marginal cost (P=MR P=MC).

Only under perfect competition, because of P=MR=AR the MR=MC

rule may be substituted by P=MC.

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Prof. Teresa Kamińska Microeconomics

- A firm attains normal profit, if TR=TC or P=ATC,

market enterprise
PX jp.
MC
S
S1 ATC

PE PE d=MR=AR
D

0 QX 0 qE qx

jp. TC

TR

0 qe

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Prof. Teresa Kamińska Microeconomics

- Minimises an economic loss, when TVC<TR<TC or AVC<P<ATC or

Le<TFC;

Market enterprise
PX m.u.
MC
S
S1 ATC

PE PE d=MR=AR
D AVC
D1

0 QX 0 qE qx

m.u. TC

TVC

TR

LE

0 qe

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Prof. Teresa Kamińska Microeconomics

TVC=TR or AVC=P or Le=TFC denotes a shut – down point,

market enterprise
PX m.u.
MC
S
S1 ATC

AVC
D
PE D1 PE d=MR=AR
D2

0 QX 0 qE qx

m.u.

TC

TVC

TR
LE

0 qe qx

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Prof. Teresa Kamińska Microeconomics

- for P <AVC or TR <TVC or Le>TFC the firm will supply zero.

market enterprise
PX m.u.

S MC
S1
S2 ATC

D AVC
PE D1 PE d=MR=AR
D2

0 QX 0 qE qx

m.u.
TC

TVC

LE
TR

0 qe qx

In the short run it pays to shut down (cease production) whenever the price falls below
the minimum of average variable cost (AVC).

Firms in all market structures will expand output if the gain in marginal revenue
exceeds the increase in marginal costs, and will contract output if the loss in revenue is
smaller than the reduction in costs.

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Prof. Teresa Kamińska Microeconomics

MC
ATC
P4 s
P3
AVC
P2
P1

0 q1 q2 q3 q4 qx

Firm in perfect competition

Break-even points
m.u.

Pareto optimal
allocative optimum MC
ATC
d=MR=AR

AVC

productive optimum (technical efficiency)

0 shut-down point

Considering below data that concern a firm operating in a perfectly competitive market
indicate the lowest possible price, which justifies
production in the short run.

qX 0 1 2 3 4 5
MC - 50 10 6 14 30

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Prof. Teresa Kamińska Microeconomics

PURE MONOPOLY

Five factors that may lead to this market structure:

exclusive control over key inputs

economies of scale

patents

network economies

government licenses or franchises.

P1 monopoly sacrifices TR = ∆P Q1
∆P I monopoly gains TR = ∆Q P2
P2
∆Q ⋅ P2 − ∆P ⋅ Q1
MR =
∆Q
II

D=d

0 Q1 ∆ Q Q2 Q

Once ∆P approaches zero, the expression for marginal revenue approaches

∆P
MR = P − Q
∆Q .
∆P
Solving equation of price elasticity of demand for ∆Q and substitute an outcome into
1
the above equation, we get MR = P (1 − E ) .
dp

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Prof. Teresa Kamińska Microeconomics

TOTAL REVENUE AND TOTAL COST FUNCTIONS

- a monopoly attains an economic profit if TR>TC or P>ATC

m.u.
36

m.u.

TR TC

12

TR

0 qE output (sales)
D=d
MR
0 1 2 3 4 5 6 7 8 9 10 11 12
MC
PE
ATC

MR D=d=AR
P = 12-QX
0 qE
P Q TR MR
12 0 0 -
11 1 11 11
10 2 20 9
9 3 27 7
8 4 32 5
7 5 35 3
6 6 36 1
5 7 35 -1
4 8 32 -3
3 9 27 -5
2 10 20 -7
1 11 11 -9
0 12 0 -11

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Prof. Teresa Kamińska Microeconomics

In monopoly there is no supply curve, since a price is endogenous, what means,

that the sales value does not respond to the price level directly; it is possible to sell
various amount of output at the same price or the same amount of output at
various prices.
Find the marginal revenue curves that correspond to the demand curves:
• P = 12 – 3Q
• P = 100 – 2Q

P − MC 1
Monopoly power is equal to L = =
P E dp ,

which could be interpreted as the profit – maximizing mark – up. For example, if
the price elasticity of demand facing a monopoly were equal to - 2, the profit –
maximizing mark – up would be ½, which implies that the profit – maximizing
price is twice marginal cost. The profit – maximizing mark – up grows smaller as
demand grows more elastic.

Because monopolies often earn economic profits, they have incentives to acquire
monopoly power. Activities aimed at creating or preserving monopoly power are
called rent – seeking activities. Expenditures on that sort of performance can
represent an important social costs of monopoly. The monopoly profit represents
the maximum a firm would be willing to spend on rent – seeking activities to
protect its monopoly.

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Prof. Teresa Kamińska Microeconomics

Normal profit, when TR=TC or P=ATC

m.u.
MC

ATC

PE

D=d=AR

MR

0 qE production (sale)

TC

TR

0 qE production (sale)

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Prof. Teresa Kamińska Microeconomics

A monopoly minimises an economic loss if TVC<TR<TC or AVC<P<ATC

or Le<TFC
m.u.

MC

ATC

AVC

MR D=d=AR

0 qE TC

m.u.
TVC

TR

qE Qx

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Prof. Teresa Kamińska Microeconomics

- TVC=TR or AVC=P or Le=TFC means a shut down point

m.u.

MC
ATC

AVC

MR D=d=AR
0 qE

m.u. TC

TVC

TR

0 qE Qx

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Prof. Teresa Kamińska Microeconomics

Gives up (ceases) a production if TVC>TR or AVC>P or Le>TFC

m.u.

MC ATC
AVC

MR D=d=AR

0 qE Qx
m.u. TC

TVC

TR

0 qE Qx

Basing on below data complete the table and illustrate both situations graphically

Firm’s position Market Edp in Economic Necessary

structure optimum outcome changes
1. MR=P>ATC=MC>AVC qx: ↑ ↓ no
Px: ↑ ↓ no
2. MR<AVC<P=MC<ATC qx: ↑ ↓ no
Px: ↑ ↓ no
.

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Prof. Teresa Kamińska Microeconomics

natural monopoly
m.u.

PE profit maximizing pricing rule

AC pricing rule

MC pricing rule
Pmax LAC

PO LMC

0 qE qmax qO

Price discrimination is a practice of charging different prices to different customers for

similar commodities because of differences in buyers’ willingness to pay (not because of
costs of production) . The key idea is to convert consumer surplus into economic profit.

Monopoly is able to discriminate the prices when the firm:

1. has got a market power (a diminishing demand function)
2. has got an information about various prices that customers are willing to pay for
the commodity
3. is able to prevent from its product resale for higher price (it is impossible or
impractical for buyers to trade among themselves).

Therefore monopoly is capable to discriminate prices in three ways:

first - degree price discrimination – the firm tries to price each unit at the
consumer’s reservation price (i.e. the consumer’s maximum willingness to pay)
for that unit

under second – degree price discrimination, the firm offers consumers a quantity
discount (the amount the consumer pays depends on the number of units he/she
purchases)

with third – degree price discrimination, the firm identifies different receiver
groups or segments in the market because of various price elasticity of demand.
The profit – maximizing firm sets a price for each segment of the market by
setting marginal revenue equal to marginal cost.

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Prof. Teresa Kamińska Microeconomics

First – degree price discrimination

m.u.
P1
P2 MC
P3
P4
P5
P6
P7
P8
P9
P10
PE E

AR

D=d=MR

0 1 2 3 4 5 6 7 8 9 10 qE Qx

Optimum when P = MC

Second – degree price discrimination

m.u.

P1=MR1
P1
P2=MR2
P2
MC
P3 P3 = MR3

0 q1 q2 q3 Q

Optimum when MC = MRn =Pn

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Prof. Teresa Kamińska Microeconomics

Subscription and a unit charge

pr =0.29 MC

0 33 h

If consumer’s surplus were bigger than subscription the consumer would be

willing to purchase the subscription.

Third – degree price discrimination

m.u.
segment I segment II

Pcl

Pcn
MC

DI MRI MRII DII

coal qcl qcn corn

optimum when ∑MR = MC= MRI = MRII

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