Perfect Competition: Lipsey & Chrystal Economics 13E

Lipsey & Chrystal
Perfect Competition
Chapter 7
LIPSEY & CHRYSTAL

ECONOMICS 13e
© Richard Lipsey & Alec Chrystal, 2015. All rights reserved.

Learning Outcomes
• A monopolist sets marginal cost equal to marginal

revenue, but marginal cost is less than price.
• Output is lower under monopoly than under
perfect competition.
• Profit can be increased for a monopolist if it is
possible to charge different prices to different
customers or in separate markets.
Lipsey & Chrystal: Economics, 13th edition

• Pure profits exist in the long run under
monopoly, so long as there are entry barriers.
• Cartel can increase the profits of colluding
firms, but individual members have incentives
to break away.

INTRODUCTION - MONOPOLY
A Single-Price Monopolist: price discrimination

• A monopoly is an industry containing a single firm.
• The monopoly firm maximises its profits by equating
marginal cost to marginal revenue, which is less than
price.
• Production under monopoly is less than it would be
under perfect competition, where marginal cost is
equated to price.

The Allocative Inefficiency of Monopoly

• Monopoly is allocatively inefficient.
• By producing less than the perfectly competitive output it
transfers some consumers’ surplus to its own profits and
also causes deadweight loss of surplus that would have
resulted from the output that is not produced.

A Multi-Price Monopolist
• If a monopolist can discriminate among either different
units or different customers, it will always sell more and
earn greater profits than if it must charge a single price.
• For price discrimination to be possible, the seller must be
able to distinguish individual units bought by a single
buyer or to separate buyers into classes among whom
resale is impossible.

Long-run Monopoly Equilibrium

• A monopoly can earn positive profits in the long run if
there are barriers to entry.
• These may be man-made, such as patents or exclusive
franchises, or natural, such as economies of large-scale
production.

Cartels as Monopolies
• The joint profits of all firms in a perfectly competitive
industry can always be increased if they agree to restrict
output.
• After agreement is in place, each firm can increase its
profits by violating the agreement. If they all do this,
profits are reduced to the perfectly competitive level.

Total, Average and Marginal Revenue
Price Quantity Total Revenue Marginal Revenue

p=AR q TR=p*q MR = TR/q
(£) (£) (£) (£)
9.10 9 81.90
8.10
9.00 10 90.00
7.90
8.90 11 97.90

The Effect on Revenue of an Increase in
Quantity Sold
Price
p0
p1
Reduction Addition to
in revenue revenues
q0 q1 Quantity

Total, Average and Marginal Revenue
 Marginal revenue is less than price because price must be

lowered to sell an extra unit.
 For example, consider the marginal revenue of the eleventh unit.
 It is total revenue when eleven units are sold (£97.90) minus total
revenue when 10 units are sold (£90.00) which is £7.90.
 This is less than the £8.90 at which the eleventh unit is sold
because the price on all previous 10 units must be cut by £0.10 to
raise sales by one unit.

The Effect on Revenue of an Increase
in Quantity Sold
 Because the demand curve has a negative slope, marginal

revenue is less than price.
 A reduction of price from p0 to p1 increases sales by one unit from
q0 to q1 units.
 The revenue from the extra unit sold is shown as the medium
blue area.
 To sell this unit, it is necessary to reduce the price on each of the
q0 units previously sold.
 The loss in revenue is shown as the dark blue area.
 Marginal revenue of the extra unit is equal to the difference
between the two areas.

Revenue curves and demand elasticity
Elasticity
10 greater Unity elasticity
than one >1 =1
£ per unit
Elasticity between
zero and one
0 <  <1
AR
5
50 100
-10 MR
Quantity
250
TR
£
0 50 100 Quantity

Revenue curves and demand elasticity
 Rising TR, positive MR, and elastic demand all go together.

 In this example, for outputs from 0 to 50 units, marginal revenue is
positive, elasticity is greater than unity, and total revenue is rising.
 Falling TR negative MR and inelastic demand all go together. In
this example, for outputs from 50 to 100 units, marginal revenue is
negative, elasticity is less than unity, and total revenue is falling.
(All elasticities refer to absolute not algebraic values.)

The Equilibrium of a Monopoly in the
short run
MC
£ per unit
ATC
p0
c0 AVC
MR
D = AR
0 q0 Quantity
Profit-maximizing quantity

The Equilibrium of a Monopoly
 The monopoly produces the output q0 where marginal revenue

equals marginal cost (rule 2).
 At this output, the price of p0 (which is determined by the
demand curve) exceeds the average variable cost (rule 1).
 Total profit is the profit per unit of p0-c0 multiplied by the output
of q0, which is the yellow area.

No Supply Curve under Monopoly
£ per unit
D”
p1 MC
p0
D’
MR” MR’
0 q0 Quantity
The same output at different prices

No Supply Curve under Monopoly
 The demand curves D’ and D’’ both have marginal revenue curves
that intersect the marginal cost curve at output q0.
 But because the demand curves are different, q0 is sold at:
 p0 when the demand curve is D’ and at p1 when the demand curve is D’’.
 Thus under monopoly there is no unique relation between price and
the quantity sold.

A multi-plant monopoly
• So far we have implicitly assumed that the

monopoly firm produces all of its output in a
single plant.
• The analysis can easily be extended to a
multi-plant monopolist.

• For example, that the firm has two plants.
How will it allocate production between them?

• For example, that the firm has two plants.
How will it allocate production between them?
• The answer is that any given output will be

allocated between the two plants so as to
equate their marginal costs.

Note!
The monopoly firm’s marginal cost curve is

the horizontal sum of the marginal cost
curves of its individual plants.

The allocative inefficiency of monopoly
• When the monopoly maximizes its profits it

chooses an output where marginal cost is
less than price.
• As a result, consumers’ surplus is less than it
would be if the output were raised until
marginal cost equalled price.
• In this way, the monopoly firm gains at the
expense of consumers.

• It follows that there is a conflict between the
private interest of the monopoly producer and
the public interest of all the nation’s
consumers.
• This creates a rational case for government
intervention to prevent the formation of
monopolies if possible, and, if that is not
possible, to control their behaviour.

The deadweight loss of monopoly
MC [monopoly] = S [competition]
Price
5 Em
pm
Ec
6 1 Competitive price
p0
2
7
MR
0 qm q0 Quantity

 At the perfectly competitive equilibrium Ec consumers’ surplus is the

sum of the areas 1, 5, and 6.
 When the industry is monopolized, price rises to pm, and consumers
surplus falls to area 5.
 Consumers lose area 1 because that output is not produced.
 They lose area 6 because the price rise has transferred it to the
monopolist.
 Producers’ surplus in the competitive equilibrium is the sum of the
areas 7 and 2.

 When the market is monopolized and price rises to pm, the surplus
area 2 is lost because the output is not produced.
 However the monopolist gains area 6 from consumers. Area 6 is
known to be greater than 2 because pm maximizes the monopolist
profits.
 Thus although the monopolist gains, society loses areas 1 and 2.
 Areas 1 and 2 are the deadweight loss resulting from monopoly and
account for its allocative inefficiency.

Price discriminating monopoly
• So far we have assumed that the monopoly

firm charges the same price for every unit of
its product, no matter where or to whom it
sells that product.
• We now show that a monopoly firm will also
find it profitable to sell different units of the
same product at different prices whenever it
gets the opportunity.

• Price discrimination occurs when a seller
charges different prices for different units of
the same product for reasons not associated
with differences in cost.
• Not all price differences represent price
discrimination!

Note!
If price differences reflect cost differences,

they are not discriminatory.
In contrast, when a price difference is based

on different buyers’ valuations of the same
product, price discrimination does occur.

Why is price discrimination profitable?
• Why should it be profitable for a firm to sell

some units of its output at a price that is well
below the price that it receives for other units
of its output?

Why is price discrimination profitable?
• Why should it be profitable for a firm to sell

some units of its output at a price that is well
below the price that it receives for other units
of its output?
• Answer:
– Persistent price discrimination is profitable either
because different buyers are willing to pay
different amounts for the same product or because
one buyer is willing to pay different amounts for
different units of the same product.

A Price-discriminating Monopolist
D
Price
pm MR
1
pd
S = MC
2 3
0 qm qd qc
Quantity

A Price-discriminating Monopolist
 Initially the monopolist produces output qm which it sells at

pm where MC = MR instead of the competitive output qc
where MC equals demand (which is consumers’ marginal
utility).
 The deadweight loss is the sum of the three areas labelled
1, 2, and 3.
 A second group of consumers is then isolated from the first
(the first group continue to buy qm at pm).

 This new group who would buy nothing at the
original price of pm, will buy an amount that would
increase total output to qd at a price of pd.
 The monopoly firm’s profits now rise by the area
2, which is the difference between its cost curve
and the price pd that is charged to the new group
who buy the amount between qm and qd.
 Consumers’ surplus rises by the area labelled 1
and total deadweight loss falls to the area
labelled 3.

Long run monopoly equlibirum
• In all industries, including those that are both

monopolized and those that are perfectly
competitive, profits and losses provide
incentives for entry and exit.

• If a profit-maximizing monopoly firm is
suffering losses in the short run, it will
continue to operate as long as it can cover its
variable costs.
• In the long run, however, it will leave the
industry unless it can find a scale of
operations at which its full opportunity costs
can be covered.

• If the monopoly firm is making profits, other
firms will wish to enter the industry in order to
earn more than the opportunity cost of their
capital.

Entry barriers
• Impediments that prevent entry are called

entry barriers; they may be either natural or
created.
If a monopoly firm’s profits are to persist in

the long run, effective entry barriers must
prevent the entry of new firms into the
industry.

Barriers to entry
• Barriers to entry can be:

– Natural barriers, i.e. natural monopoly
– Policy-created barriers
• Patents
• Government intervention/legislation/regulation
– Marketing/branding

Significance of entry barriers
• Because there are no entry barriers in perfect

competition, profits cannot persist in the long
run.
Profits attract entry, and entry erodes

profits.

• In monopoly, however, profits can persist in
the long run whenever there are effective
barriers to entry.
Entry barriers frustrate the adjustment

mechanism that would otherwise push
profits towards zero in the long run.

Creative destruction
• In the very long run, technology changes.

• New ways of producing old products are
invented, and new products are created to
satisfy both familiar and new wants.
• This has important implications for entry.

• A monopoly that succeeds in preventing the
entry of new firms capable of producing its
current product will sooner or later find its
barriers circumvented by innovations.

• Joseph Schumpeter (1883–1950) argued that
entry barriers were not a serious problem in
the very long run.
• According to Schumpeter, the possibility of
obtaining monopoly profits provides a major
incentive for people to risk their money by
financing inventions and innovations.

• Schumpeter called the replacement of an
existing monopoly by one or more new
entrants through the invention of new
products or new production techniques the
process of creative destruction.
• He argued that this process precludes the
very long run persistence of barriers to entry
into industries that earn large profits.

Note!
The presence of potentially large profits in a

monopolistic industry creates incentives
for development of new technologies that
break down entry barriers and eliminate
monopolies.

Cartels as monopolies
• A second way in which a monopoly can arise

is for the firms in an industry to agree to
cooperate with one another—to behave as if
they were a single seller—in order to
maximize joint profits by eliminating
competition among themselves.
• Such a group of firms is called a cartel.

The effects of cartelization
• Perfectly competitive firms take the market

price as given and increase their output until
their marginal cost equals price.
• In contrast, a monopoly firm knows that
increasing its output will depress the market
price.
• Taking account of this, the monopolist
increases its output only until marginal
revenue is equal to marginal cost.

• All the firms in an industry can achieve the
same result by grouping together into what is
called a cartel to take collective action to
reduce output and drive up price.
• They can agree to restrict industry output to
the level that maximizes their joint profits.

Conflicting forces affecting cartels
MR
p1 ATC MC
S
p1
£ per unit
E
£ per unit
p0 E
p0
D
0 Q1 Q0 q1 q0 q2
Quantity [thousands of tons] Quantity [tons]
[i]. Market equilibrium [ii]. Firm equilibrium

Conflicting forces affecting cartels (i)
the market
 Initially the market is in competitive equilibrium, with price p0 and

quantity Q0.
 The cartel is formed and enforces quotas on individual firms that
are sufficient to reduce the industry’s output to Q1, the output that
maximizes the joint profits of the cartel members.
 Price rises to p1.

Conflicting forces affecting cartels (ii) an
individual firm
 (Note the change in scale from figures (i) and (ii).

 Initially the individual firm is producing output q0 and is just
covering its total costs at price p0.
 When the cartel restricts production the typical firm’s quota
is q1.
 The firm’s profits rise from zero to the amount shown by the
dark blue area.

Conflicting forces affecting cartels (ii) an
individual firm
 Once price is raised to p1 however, the individual firm would

like to increase output to q2, where marginal cost is equal to
the price set by the cartel.
 This would allow the firm to earn profits shown by the blue
hatched area.
 But if all firms violate their quotas in this way, industry
output will rise above Q1, market price will fall, and the profit
earned by each and every firm will fall.

Summary
• A monopoly has power over the market in

which it sells.
• Monopolies faced with a large number of
consumers can force up the market price by
restricting their output.
• As a result, monopolies are rarely left alone
by government, and monopoly profits create
incentives for others to invent new products.

Perfect Competition: Lipsey & Chrystal Economics 13E

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Lipsey & Chrystal

LIPSEY & CHRYSTAL

© Richard Lipsey & Alec Chrystal, 2015. All rights reserved.

• A monopolist sets marginal cost equal to marginal

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

A Single-Price Monopolist: price discrimination

Lipsey & Chrystal: Economics, 13th edition

The Allocative Inefficiency of Monopoly

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

Long-run Monopoly Equilibrium

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

Price Quantity Total Revenue Marginal Revenue

(£) (£) (£) (£)

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

 Marginal revenue is less than price because price must be

Lipsey & Chrystal: Economics, 13th edition

 Because the demand curve has a negative slope, marginal

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

 Rising TR, positive MR, and elastic demand all go together.

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

 The monopoly produces the output q0 where marginal revenue

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

• So far we have implicitly assumed that the

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

• The answer is that any given output will be

Lipsey & Chrystal: Economics, 13th edition

The monopoly firm’s marginal cost curve is

Lipsey & Chrystal: Economics, 13th edition

• When the monopoly maximizes its profits it

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

 At the perfectly competitive equilibrium Ec consumers’ surplus is the

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

• So far we have assumed that the monopoly

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

If price differences reflect cost differences,

In contrast, when a price difference is based

Lipsey & Chrystal: Economics, 13th edition

• Why should it be profitable for a firm to sell

Lipsey & Chrystal: Economics, 13th edition

• Why should it be profitable for a firm to sell

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

 Initially the monopolist produces output qm which it sells at

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

• In all industries, including those that are both

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

Lipsey & Chrystal: Economics, 13th edition

• Impediments that prevent entry are called