You are on page 1of 8

Economists assume that there are a number of different buyers and sellers in the marketplace.

This means that we have competition in the market, which allows price to change in response to changes in supply and demand. Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a buyer can choose a cheaper substitute instead. In a market with many buyers and sellers, both the consumer and the supplier have equal ability to influence price.

In some industries, there are no substitutes and there is no competition. In a market that has only one or few suppliers of a good or service, the producer(s) can control price, meaning that a consumer does not have choice, cannot maximize his or her total utility and has have very little influence over the price of goods. A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra. In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well. There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits.

Perfect Competition
In competitive markets there are: 1. Many buyers and sellers - individual firms have little effect on the price.

2. Goods offered are very similar - demand is very elastic for individual firms. 3. Firms can freely enter or exit the industry - no substantial barriers to entry. Competitive firms have no market power. Recall that businesses are trying to maximize profits, and Profit = Total Revenue (TR) - Total Cost (TC).

Revenue in a Competitive Business

Businesses in competitive markets take the market price (P) as given (price takers). How much does the business receive for a typical unit is known as the "average revenue" (AR) and is equal to TR/Q = (P x Q)/Q = Price. So average revenue is equal to price, and is constant. How much additional revenue does the firm get if it sells one additional unit? To answer this question, we take a look at "marginal revenue" (MR) which is equal to the change in TR divided by the change in quantity. Note that this too is equal to price, so the marginal revenue is constant as well, and is equal to average revenue.

Profit Maximization
To maximize profit, we need to know the revenue and costs of the business. Profit is maximized when marginal revenue = marginal cost, and marginal cost is rising. To see why, recall that marginal revenue is the additional revenue from 1 additional unit. Marginal cost is the additional cost from 1 additional unit. When MR > MC, revenue is increasing faster than costs and the firm should increase production. When MR < MC, revenue from the additional unit is less than additional cost, and the firm should decrease production. As such, A firm maximizes profits when MR = MC. So what happens to output at various prices? Since MC is upward sloping, as price increases, quantity produced will increase too. As price falls, quantity produced falls. In each case, the marginal cost curve determines how much the firm is willing to produce at each price, so it translates into the supply curve.

Shutting Down a Company (temporary)

A company is considered to have shut down, if it temporary ceases production but keeps fixed capital. A company has exit the industry when it has made a permanent decision to leave the industry. The decision to temporarily shut down a business depends on a few factors. Recall that ATC = AVC + AFC. So average fixed cost is the vertical distance between average variable cost and average total cost. Now if a business shuts down, its total revenue becomes zero, and its total cost equals the fixed cost. So the company should continue producing its product, as long as it covers its variable costs. This way, total revenue is greater than total variable cost, because losses are then less than TFC. Basically, shut down when P (AR = MR) < AVC, to minimize the losses and so the company's short-run supply curve = MC curve above AVC. The firm therefore produces where profit equals marginal cost. Another way to put this is that sunk costs are sunk. Fixed costs are sunk, and therefore cannot be recovered by shutting down in the short run. The decision to continue producing depends on revenues

and variable costs. If average revenue is greater than average variable cost, then the business should continue to produce. It is rational to continue producing, so long as AVC < P < ATC.

When to Leave An Industry (permanent)

A business should leave the industry when revenue is less than cost of operating in the long run. In other words, exit if total revenue is less than total cost (P < ATC). In competitive markets, a company will make zero economic profits in the long run. If companies are making more than zero economic profits, it will encourage other firms to enter the industry to share in these profits. In other words, enter if total revenue is greater than total cost (P > AC). If companies are making zero economic profits, there is no entry and no exit, which is a long run condition.

Monopoly Competition
A monopoly is a single producer of a product which does not have close substitute. A monopoly is characterized by barriers to entry. Sources of a monopoly include:

Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers diamond monopoly). Exclusive Right Given by Government - patents, copyrights, franchises (pharmaceutical companies, research, authors). Falling Average Total Cost - making one company more efficient than others (also known as a natural monopoly), arising from economies of scale over the relevant range of output. Public Utilities - electricity, cable television. and water provision.

Pricing and Production Decisions

A monopoly is a large enough business to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve. A monopoly faces a downward-sloping demand curve and the market demand is the companys demand. Monopolists are still constrained by the negative relationship between price and quantity demanded. With fraud becoming more widespread, it's important to do a criminal background check prior to engaging in business activities.

Revenue for a Monopoly

A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower its price. There are two effects on total revenue (profit x quantity): 1. Output effect - gains more revenue because it sells more. 2. Price effect - gains less revenue because it gets less from each unit sold because of the lower price. Marginal revenue (MR) can even turn negative if price falls enough to reduce total revenue, even though the company sells more. What determines value of MR? It depends on whether the fall in price is larger

than the increase in quantity. In other words, it depends on the elasticity of demand. Note that MR = P [1-1/abs. E]. When E > 1, MR > 0 because output effect > price effect When E < 1, MR < 0 because price effect > output effect When E = 1, MR = 0 because price effect = output effect

Profit Maximization
Recall that the objective of a business is to maximize profits. As such, a company should produce where profit is at a maximum. In marginal terms, 1. If MC < MR, producing 1 more unit will add more to TR than to TC, so the monopoly should increase quantity. 2. If MC > MR, producing 1 more unit will add more to TC than to TR, so the monopoly should decrease quantity. 3. Only when MR = MC (and MC cuts MR from below) is profit maximized. A monopolist will generally produce less than a socially efficient level of output, and charge too high a price. Are the above normal profits of monopoly a social cost? Not usually, since profit is still part of surplus but has been transferred from consumers to producers. Social cost arises from inefficiently low output which leads to the dead weight loss. However, if the monopolist uses some of its normal profits to lobby in order to maintain a monopoly (rent seeking), then this can be a welfare cost to society.

Price Discrimination
Price discrimination is selling the same good to different customers/markets at different prices. Examples include movie tickets, airline tickets, and discount coupons. In order to practice price discrimination, there must be easy to separate customer into groups. These groups are determined based on their elasticities to demand. The company must also be able to prevent resales between groups, as well as arbitrage, which is buying where a good is cheap and selling where it is expensive. Price Discrimination can increase the profit of monopolies, since they can charge a higher price to those with less elastic demand, and a lower price to those with more elastic demand. In this manner, a business does not have to lower prices to all buyers in order to sell more goods.

Oligopoly Market Structure

Between the definitions of perfect competition and pure monopoly lie oligopolies and monopolistic competition. An oligopoly is where there are a few sellers with similar or identical products. Monopolistic competition has many companies with similar but not identical products. Each firm has monopoly power over what it produces, but products are close substitutes, such as cigarettes, CDs, and computer games. Examples of oligopolies include crude oil businesses and auto manufacturers.

The main key to behavior in an oligopoly, is that companies must take into account what other companies will do. In perfect competition, firms are price-takers and can ignore other firms. In a monopoly, there is only one firm, and it does not take into account what competitors will do. Oligopolist are torn between: 1. cooperating to increase profits by obtaining the monopoly outcome, or; 2. competing to try to gain an advantage over competitors.

Duopolies and Cartels

A duopoly is when there are only two businesses in a market. Their best outcome is to cooperate and agree to restrict output to the monopoly quantity, where price is greater than margical cost, and profit is maximized. A great example of a duopoly is Coca-Cola and Pepsi Co. Usually, a duopoly trying to maximize profits will produce more than a monopolist but less than a competitive industry. Duopolies come from collusion where firms agree to share output and set prices such as in a cartel. A cartel is a group of companies acting in unison, such as OPEC. If the competing companies cannot agree, then they may end up with the competitive position with profits equal to zero. Cartels are known to restrict output quantities in order to raise prices, and consequently profits.

Size of an Oligopoly and the Market Outcome

Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it. As the number of companies increases, the more the industry resembles a competitive outcome, since each company has a smaller effect on the outcome. The mentality where each company tends to think only of its own profits and strategic behavior is reduced. Each company will increase production as long as price is greater than marginal cost. As the number of companies increases, we tend to move towards a perfectly competitive outcome.

Monopolistic Competition
Monopolistic competition has characteristics of both competition and monopoly. Similar to competition, it has many firms, and free exit and entry. Similar to monopoly, the products are differentiated and each company faces a downward sloping demand curve. Since the company has a differentiated product, it is like a monopolist and faces a negatively-sloped demand curve. In the short-run,

marginal revenue is always less than demand profit is maximized where MR = MC profit = (price - average total cost) x quantity

The short-run equilibrium in monopolistic competition is the same as for a monopolist, and businesses may make positive, zero, or negative profits in the short run.

Long Run Equilibrium

In the long run, entry and exit are both possible. If profit is greater than zero, businesses will enter, and each company's market share will fall because of more variety. As a result, each companys demand curve will decrease, along with price and quantity. If profit is less than zero, businesses will exit, and each companys market share will increase. This will cause the remaining companies' demand curves to increase, along with the price and quantity. If profit is equal to zero, there will be no entry into or exit from the industry. In the long run, all the companies' economic profits must be zero.

Monopolistic Competition and Welfare

Let's compare a company in monopolistic competition with a company in perfect competition, where both are in a long-run equilibrium. In both cases, profit equals zero. The two main differences between the two are: 1. Excess Capacity o companies in perfect competition produce where ATC is at a minimum (efficient scale) o companies in monopolistic competition produce where quantity of output is smaller, and on a downward sloping part of ATC (excess capacity) o could increase capacity and lower average costs 2. Make-up Over Marginal Cost o for a competitive firm, price = marginal cost o for a monopolistic competition firm, price > marginal cost o there is a mark-up above MC even though the firm makes zero profits

Efficient Outcomes and Externalities

When price is greater than marginal cost, the value that consumers place on the last unit is greater than the cost, so the good is under-produced. This leads to a deadweight loss like a monopolist. The number of businesses in the industry may be inefficient, and each time a new business enters, it creates externalities such as,

Product Variety Externality - consumers get a wider choice of products, and an increase in consumer surplus which is a positive externality Business-Stealing Externality - this is a negative externality whereby other businesses lose customers

Since companies do not take these into account, there are no guarantees that there is an optimum number of them in the industry. This means that there may be too few or too many products available on the market.

Product Differentiation through Advertising

Companies that wish to differentiate products often use advertising. Advertising is common with differentiated consumer products, and much less common with homogeneous goods. Forms of

advertising include television, radio, direct mail, billboards, etc. Advertising has a wide range of costs and benefits. One cost of advertising, is that it may be mostly aimed at manipulating tastes of consumers without conveying any useful information. Advertising may also try to create differentiation within products that are actually very similar. Also, advertising tries to make demand curves less elastic, and impedes competition. This then leads to a high markup over marginal cost. Some benefits to advertising, is that it does convey some useful information such as prices, new products, locations, etc. Advertising may also foster competition by giving more information on pricing and availability. Advertising may also be a signal of quality, because willingness to spend money to advertise products may be a sign that the company has confidence in its quality. This makes it rational for consumers to try such products even if content of ads is minimal. EXAMPLES Pure Competition
- low barriers to entry, many choices, no business has dominance sdc - many companies competing and nobody has a significant advantage examples small bars and restaurants variety stores, convenience stores nail salons, barbers small grocery stores doughnut shops professional services (dentist, doctor, architects)

- very similar products, few sellers, small firms follow lead of big firms, fairly inelastic demand sdc - many barriers to establishing a business so only the oldest and biggest businesses are operating examples - all the businesses are big and of equal size o o o o o banking industry automotive manufacturers gasoline retail companies insurance companies telecommunications companies

- one single large seller with no close competition and no alternate substitutes examples

sdc - the definition of a Monopoly, some say, is that it is bigger than all other competition combined software companies like Microsoft local telephone in Canada (Bell) Hydro services LCBO Canada Post

s Monopolistic Competition
- sellers feel they do have some competition sdc - there is one big company dominating the market with a few medium or smaller sized companies examples Google

(there used to be "pure competition" until Google grew very big and became dominant) Walmart