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MARKET STRUCTURE:

PERFECT AND IMPERFECT


COMPETITION
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E Distinguish the characteristics of a perfect competitive firm and a
monopoly
E Graphically show profit and loss in a perfect and imperfect market
E Discuss the profit maximising behaviour of firms in a perfect and
imperfect market
E Compare perfect competition against a monopoly in terms of price and
output decisions and efficiencies.
E Introduce how an imperfect market structure such as an oligopoly use
game theory to make price and output decisions.
Objectives of this lecture are to:
Perfect and Imperfect Competition
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Market: Refers to an institution where
buyers and sellers of a particular good or
service come together. Price serves as
the language of the market
Market structure: Is the characteristics
under which a market operates and it
allows market classification
Markets
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Characteristics of PC
are:
1 Many buyers and
sellers
1 No barriers to entry
and exit
1 Price taker
1 Homogenous
products
1 Profit maximiser
Characteristics of
monopoly are:
+ Only one supplier
+ Very high barriers to
entry
+ Price maker
+ Profit maximiser
+ Firms D curve =
Market D curve

Perfect and Imperfect Competition
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Imperfect Competition: Monopoly
BARRIERS TO ENTRY
Artificial

Patents
Legislations
Natural

Economies of Scale
High Fixed Cost
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PRICE TAKER:
1 No market power
1 Perfectly elastic
demand curve or
horizontal demand
curve
1 Each unit sold at the
same price
1 MR=AR=P=D

1 Total revenue is
linear
PRICE TAKER VS PRICE MAKER
PRICE MAKER:
eHas market power
eDownward sloping
demand curve
eOnly increases Q by
decreasing P
eMR < AR and
eAR = P = D
eTotal revenue
increases at a
decreasing rate
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Market Power
A firms ability to set a
price that is greater than the
marginal cost without
losing its entire share of the
market.
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Q P TR AR MR
1 10 10 10 NA
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10


Each unit sold at the same market price
PRICE TAKER: Perfect Competition
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Since P = AR = MR
wTotal revenue is linear
PRICE TAKER: Perfect Competition
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TR
($)
Q(Tens)
150
15
TR
PRICE TAKER: Perfect Competition
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P=AR=MR=DEMAND
Since price is constant, the
demand curve of a firm in
perfect competition is horizontal
(i.e. perfectly elastic).
PRICE TAKER: Perfect Competition
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P
Q(Hundreds)
10
S
D
Q(Tens)
P
15 10
D
10
20
Market Firm
D=P=MR=AR
PRICE TAKER: Perfect Competition
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To increase Q sold, Price has to decrease
Q P TR AR MR
1 10 10 10 na
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
PRICE MAKER: Monopoly
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eMR < AR
eTR increases at a decreasing rate
eAR = P = D
eDemand and marginal revenue are
downward sloping
eMarginal revenue is below the
demand curve

PRICE MAKER: Monopoly
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Q(Tens)
TR
TR
PRICE MAKER: Monopoly
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MR/
MC
Q(000)
AR=D
MR
PRICE MAKER: Monopoly
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D
Demand Comparisons
Quantity
Price
Monopoly View
Quantity
Price
Competitive View
D
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All firms in any market structures
are profit maximisers

PROFIT MAXIMISERS
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Profit Maximisation and Output Decisions

Profit maximising firms will produce a quantity
where
the gap between TR and TC is the greatest
or
Marginal Revenue = Marginal Cost
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Quantity produced where
the gap between TR and
TC is at its maximum
Q(000)
Q(000)
TR/TC
Profit/
Loss
9
9
12
12
4
4






TR
TC
Profit maximising quantity
Perfectly Competitive Firm
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MR/
MC
P=MR=AR=D
MC
5
8 10

MR > MC
Q
MR < MC
Q
Q(000)
Perfect Competitive Firm (Profit maximisation)
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Profit maximising quantity
Profit maximising
point, MC=MR
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Q(Tens)
Q(Tens)
TR/TC
Profit/
Loss
TR
TC




Monopoly (Profit maximisation)
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Q(Tens)
12
Q(Tens)
TR/TC
Profit/
Loss
9
9
12
4
4



TR
TC
Quantity produced
where the gap
between TR and TC is
at its maximum


Profit Maximising Quantity

Monopoly (Profit maximisation)
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8
MR/
MC
Q(000)
AR=D
MR
10
Profit Maximising Quantity (MC=MR)
MR > MC
Q


MR < MC
Q


MC
9
5
8
Monopoly (Profit maximisation)
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Profit Maximisation and Output Decisions
NOTE:
Marginal cost and marginal revenue may not be equal
at a given quantity because we use discrete quantities.

In this case the profit maximising level
of output is the quantity where marginal revenue is
just above marginal cost

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In the short run, if a firm is
making an economic loss, the
firm has two options to
minimise loss.
Profit Maximisation (Loss minimisation)
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The options to minimise loss are:
Produce at a loss
Temporarily Shut Down
Profit Maximisation (Loss minimisation)
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A firm will produce at a loss if
Price > Average variable cost

Recall: ATC= AFC + AVC
If P > AVC, by producing the firm
covers part of its fixed cost
Profit Maximisation (Loss minimisation)
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Firm will temporarily shut down if
Price < Average variable cost

ATC= AFC + AVC
If P < AVC, by producing the firm
is not only unable to cover all its
AVC but also faces its fixed cost
Profit Maximisation (Loss minimisation)
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Profit Maximisation and Output Decisions
SUMMARY:
All firms in any market structure are profit maximisers

Profit maximising firms will produce a quantity
where the gap between TR and TC is the greatest or
where MR = MC

Temporary shutting down in the short run if
P < AVC or producing at a loss if P > AVC

Finally, a firm will leave the industry if it is making
an economic loss in the long run
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Perfect and imperfect competition

In the short run, firms in
any market structure
can make economic profit,
normal profit or
economic loss

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Perfect Competition
Q
P=MR=AR=D
MC

5
10
ATC
Normal profit
Price = ATC
P
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P
Q
AR=D
MR
Monopoly
MC
ATC
P
Q

Normal Profit
Price = ATC

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Q
P=MR=AR=D
MC
5
P
ATC
Economic profit
Price > ATC
10

4

Perfect Competition
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P
Q
AR=D
MR
Monopoly
Economic Profit
Price > ATC


MC
P
Q

ATC
ATC
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P
Q
P=MR=AR=D
MC
5
Economic loss
Price < ATC
ATC

10

6
Perfect Competition
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Economic Loss
Price < ATC
P
Q
AR=D
MR
Monopoly
MC
ATC
P
Q
ATC

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Perfect and imperfect competition
In the long run, only monopoly can make
economic profit. Perfectly competitive firm
can not make economic profit. This is because
in a perfect competition there are no barriers
to entry and in a monopoly there are very high
barriers to entry.
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Since there are no barriers to entry in
perfect competition, if firms are making an
economic profit, in the long run new firms
will enter the market. This will increase
supply and decrease the price until only
normal profits are made. When normal
profits are made new firms will stop
entering the market.
Perfect and imperfect competition
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The next few slides will compare price
and output behaviour and efficiencies
of a perfectly competitive firm and a
monopoly.
Perfect and imperfect competition
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P
Q
AR=D
MR
Competition vs Monopoly
Q
c
P
c

Comp. firm produces Q
c WHERE
MC=AR=MR and charge P
c



MC
P
m
Q
m

Monopoly produces Q
m
where


MC=MR and charge P
m

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P
Q
AR=D
MR
Competition Vs. Monopoly
Q
c
P
c

MC
P
m
Q
m

Monopoly restricts quantity and charges a
higher Price than competitive firms.
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Perfect Competition
Allocative efficiency:
Producing an output level where
the marginal benefit to the
consumer of the last unit consumed
is equal to the marginal cost faced by
the firm in producing that
last unit.
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Perfect Competition
Allocative efficiency: is where
MARGINAL COST
EQUALS
MARGINAL BENEFIT.
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P
Q
AR=D=MB
MR
Competition Vs. Monopoly
Q
c
P
c

MC
P
m
Q
m
Unlike perfect competition, monopoly is not allocatively efficient.
It does not produce where marginal cost equals marginal benefit

Monopoly: MB > MC

Perfect competition: MB = MC
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Perfect Competition
Productive efficiency: Producing an
output level using, with the available
technology, the least cost
combination of inputs.
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Perfect Competition
PC firms are productively
efficient because the long run output
level is at the minimum point of the
long run average cost curve.
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P
Q
AR=D=MB
MR
Competition Vs. Monopoly
Q
c
P
c

MC
P
m
Q
m

LRAC
Unlike perfect competition, monopoly is not productively efficient.
It does not produce at the minimum point of the long run average cost curve.
Monopoly: LRAC

Perfect Competition:
Minimum LRAC
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p Small number of producers.
p Price maker
p High barriers to entry
p High degree of interdependency
Oligopoly
Characteristics of an oligopoly:
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Interdependency results in a
firm making a decision after
considering the reaction
of other firms.
Oligopoly
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Game theory: The study of how people make
decisions in situations where attaining their
goals depends on their interactions with others;
in economics, the study of the decisions of
firms in industries where the profits of each
firm depend on its interactions with other
firms.
LEARNING OBJECTIVE 2
Using Game Theory to Analyse
Oligopoly
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It recognises the characteristic of
mutual interdependence in an
oligopoly
Game theory is a method of
analysing strategic behaviour
Oligopoly
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Key characteristics of all games:
Rules that determine what actions are allowable.
Strategies that players employ to attain their
objectives in the game.
Payoffs that are the results of the interaction
among the players strategies.

Business strategy: Actions taken by a firm to
achieve a goal, such as maximising profits.
LEARNING OBJECTIVE 2
Using Game Theory to Analyse
Oligopoly
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A Duopoly Game: Price competition between
two firms
Payoff matrix: A table that shows the payoffs that
each firm earns from every combination of
strategies adopted by the firms.
Collusion: An agreement among firms to charge
the same price, or to otherwise not compete.
LEARNING OBJECTIVE 2
Using Game Theory to Analyse
Oligopoly
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Game Theory
FIRM A
F
I
R
M

B

HIGH PRICE LOW PRICE
H
I
G
H

P
R
I
C
E

L
O
W

P
R
I
C
E

$1000
$1000
$700
$700
$300
$1500
$300
$1500
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Game Theory
Cooperative outcome: Where players
in the game agree to cooperate
Both firms will charge a high price and make
$1000 each.
Both firms will charge a high price and make
$1000 each.
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Game Theory
Non-cooperative outcome: Where players
do not cooperate and instead
follow their own individual incentives.
Both firms will charge a low price and receive
$700 each.
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Maximin strategies:
Strategies chosen by players in a
game to maximise their minimum
expected pay-off from the game
Oligopoly
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A Duopoly Game: Price Competition between
Two Firms


LEARNING OBJECTIVE 2
Using Game Theory to Analyse
Oligopoly
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Product designs
Advertising
Location
Complementary services
Non-Price Competition
Some examples of non-price competition:
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Build customer loyalty
Increase customer satisfaction
Maintain or increase market share
Non-Price Competition
If successful, non-price competition
allows firms to:
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Check Your Knowledge
Q1. To maximise profit, which of the
following should a firm attempt to do?

a. Maximise revenue.
b. Minimise cost.
c. Find the largest difference between
total revenue and total cost.
d. All of the above simultaneously.
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Q1. To maximise profit, which of the
following should a firm attempt to do?

a. Maximise revenue.
b. Minimise cost.
c. Find the largest difference between
total revenue and total cost.
d. All of the above simultaneously.
Check Your Knowledge
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Q2. Refer to the figure below. One of the curves in
this figure is not necessary in order to determine
the profit-maximizing level of output. Which
curve can be discarded?

a. The marginal cost curve.
b. The demand curve.
c. The average total cost
curve.
d. All three curves must remain
in place in order to determine
which level of output maximizes profit.

Check Your Knowledge
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Q2. Refer to the figure below. One of the curves in
this figure is not necessary in order to
determine the profit-maximizing level of
output. Which curve can be discarded?

a. The marginal cost curve.
b. The demand curve.
c. The average total cost
curve.
d. All three curves must remain
in place in order to determine
hich level of output maximizes profit.

Check Your Knowledge
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Q3. Refer to the figure below. Which
demand curve is associated with the
shutdown point?
a. Demand 1
b. Demand 2
c. Demand 3
d. Demand 4
Check Your Knowledge
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Q3. Refer to the figure below. Which
demand curve is associated with the
shutdown point?
a. Demand 1
b. Demand 2
c. Demand 3
d. Demand 4
Check Your Knowledge
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Q4. Which of the following terms best
describes how the forces of competition will
drive the market price to the minimum
average cost of the typical firm?

a. Allocative efficiency.
b. Productive efficiency.
c. Decreasing-cost industry.
d. Competitive markdown.

Check Your Knowledge
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Q4. Which of the following terms best
describes how the forces of competition will
drive the market price to the minimum
average cost of the typical firm?

a. Allocative efficiency.
b. Productive efficiency.
c. Decreasing-cost industry.
d. Competitive markdown.

Check Your Knowledge
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Q5. In which of the following situations can a
firm be considered a monopoly?

a. When a firm is surrounded by other firms that
produce close substitutes.
b. When a firm can ignore the actions of all other
firms.
c. When a firm uses other firms prices in order to
price its products.
d. When barriers to entry are eliminated.

Check Your Knowledge
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Q5. In which of the following situations can a
firm be considered a monopoly?

a. When a firm is surrounded by other firms that
produce close substitutes.
b. When a firm can ignore the actions of all other
firms.
c. When a firm uses other firms prices in order to
price its products.
d. When barriers to entry are eliminated.

Check Your Knowledge
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Q6. Refer to the figure below. How much is the
amount of profit when the firm serves six
subscribers per month?

a. (42 27) x 6
b. (42 30) x 6
c. (30 27) x 6
d. $42.


Check Your Knowledge
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Q6. Refer to the figure below. How much is the
amount of profit when the firm serves six
subscribers per month?

a. (42 27) x 6
b. (42 30) x 6
c. (30 27) x 6
d. $42.


Check Your Knowledge
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