MODULE 6

Managing in Competitive, Monopolistic, and

Monopolistically Competitive Markets

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 Learning Objectives
1. Identify the conditions under which a firm operates as perfectly competitive,
monopolistically competitive, or a monopoly.
2. Identify sources of (and strategies for obtaining) monopoly power.
3. Apply the marginal principle to determine the profit-maximizing price and
output.
4. Show the relationship between the elasticity of demand for a firm’s product and
its marginal revenue.
5. Explain how long-run adjustments impact perfectly competitive, monopoly, and
monopolistically competitive firms; discuss the ramifications of each of these
market structures on social welfare.
6. Decide whether a firm making short-run losses should continue to operate or
shut down its operations.
7. Illustrate the relationship between marginal cost, a competitive firm’s short-run
supply curve, and the competitive industry supply; explain why supply curves do
not exist for firms that have market power.
8. Calculate the optimal output of a firm that operates two plants and the optimal
level of advertising for a firm that enjoys market power.
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 Perfect Competition

Perfect Competition
• Perfectly competitive markets are characterized by:
– The interaction between many buyers and sellers that are
“small” relative to the market.
– Each firm in the market produces a homogeneous (identical)
product.
– Buyers and sellers have perfect information.
– No transaction costs.
– Free entry into and exit from the market.
• The implications of these conditions are:
– a single market price is determined by the interaction of
demand and supply
– firms earn zero economic profits in the long run.
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8-3
 Perfect Competition
Demand at the Market and Firm
Price
Levels Under Perfect
Price
Competition
Market Firm
S

𝑃𝑒 𝐷𝑓 = 𝑃𝑒

0 Market Firm’s
output output

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 Perfect Competition

Short-Run Output Decisions

• The short run is a period of time over which
some factors of production are fixed.
• To maximize short-run profits, managers must
take as given the fixed inputs (and fixed costs),
and determine how much output to produce
by changing the variable inputs.

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 Perfect Competition
Revenue, Costs, and Profits for a
Perfectly Competitive Firm
Costs
$
Revenue

B
Maximum
profits
Slope of
Slope of
A E

0 𝑄∗ Firm’s output

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 Perfect Competition

Competitive Firm’s Demand

• The demand curve for a competitive firm’s
product is a horizontal line at the market
price. This price is the competitive firm’s
marginal revenue.

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 Perfect Competition

Profit Maximization under Perfect

$
Competition 𝐴𝑇𝐶 𝑀𝐶

𝑃𝑒 𝐷 𝑓 = 𝑃 𝑒=𝑀𝑅
Profits
𝐴𝑇𝐶 ( 𝑄 )
∗

0 𝑄∗ Firm’s output

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 Perfect Competition

Competitive Output Rule

• To maximize profits, a perfectly competitive
firm produces the output at which price
equals marginal cost in the range over which
marginal cost is increasing.

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 Perfect Competition

Competitive Output Rule In Action

• The cost function for a firm is .
• If the firm sells output in a perfectly competitive
market and other firms in the industry sell output at a
price of $20, what price should the manager of this
firm charge? What level of output should be produced
to maximize profits? How much profit will be earned?
• Answer:
– Charge $20.
– Since marginal cost is , equating price and marginal cost
yields: units.
– Maximum profits are: .

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 Perfect Competition

Short-Run Loss Minimization

$ 𝐴𝑇𝐶
𝑀𝐶 𝐴𝑉𝐶

𝐴𝑇𝐶 ( 𝑄∗ )
𝑃𝑒 Loss 𝐷 𝑓 = 𝑃 𝑒=𝑀𝑅

0 𝑄∗ Firm’s output

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 Perfect Competition

The Shut-Down Case 𝐴𝑇𝐶

𝑀𝐶 𝐴𝑉𝐶
$

Loss if shut down

𝐴𝑇𝐶 ( 𝑄∗ )
Fixed Cost
𝐴𝑉𝐶 ( 𝑄 ∗)
𝑃𝑒 𝐷 𝑓 = 𝑃 𝑒=𝑀𝑅
Loss if produce

0 𝑄∗ Firm’s output

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 Perfect Competition

Short-Run Output Decision Under

Perfect Competition
• To maximize short-run profits, a perfectly
competitive firm should produce in the range
of increasing marginal cost where , provided
that . If , the firm should shut down its plant to
minimize it losses.

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 Perfect Competition
Short-Run Firm Supply Curve for a
𝑀𝐶
$ CompetitiveShort-run
Firm supply
curve for individual firm
𝐴𝑉𝐶
𝑃1

𝑃0

0 𝑄0 𝑄1 Firm’s output

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 Perfect Competition

The Short-Run Firm and Industry

Supply Curves
• The short-run supply curve for a perfectly
competitive firm is its marginal cost curve
above the minimum point on the curve.

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 Perfect Competition

The Market Supply Curve

P
Individual firm’s
supply curve
Market supply
𝑀𝐶𝑖 curve
S

$12

$10

0 1 500 Market output

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 Perfect Competition

Long-Run Decisions: Entry and Exit

Price
The Market andPrice
Firm’s Demand
𝑆2
𝑆0
𝐸 𝑥𝑖𝑡 𝐸 𝑛𝑡𝑟𝑦 𝑆1
←
𝑃2 → 𝐷 𝑓 = 𝑃 2=𝑀𝑅 2
0
Exit
𝑃 𝐷 𝑓 = 𝑃 0=𝑀𝑅 0
1 Entry
𝑃 𝐷 𝑓 = 𝑃1 =𝑀𝑅 1

D
0 Market 0 Firm’s
output output

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 Perfect Competition

Long-Run Competitive Equilibrium

$
𝑀𝐶

𝐴𝐶
Long-run competitive
equilibrium

𝑃 𝑒 𝐷 𝑓 = 𝑃 𝑒=𝑀𝑅

0 𝑄∗ Firm’s output

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 Perfect Competition

Long-Run Competitive Equilibrium

• In the long run, perfectly competitive firms
produce a level of output such that

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 Monopoly

Monopoly and Monopoly Power

• Monopoly: A market structure in which a single
firm serves an entire market for a good that has
no close substitutes.
• Sole seller of a good in a market gives that firm
greater market power than if it competed
against other firms.
– Implication:
• market demand curve is the monopolist’s demand curve.
– However, a monopolist does not have unlimited
market power.

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 Monopoly
The Monopolist’s Demand
Monopolist’s power is constrained
Price
by the demand curve.

0 A
𝑃

B
𝑃1

𝐷 𝑓 = 𝐷𝑀

0 𝑄0 𝑄1 Output

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 Monopoly

Sources of Monopoly Power

• Economies of scale: exist whenever long-run average
costs decline as output increases.
– Diseconomies of scale: exist whenever long-run average
costs increase as output increases.
• Economies of scope: exist when the total cost of
producing two products within the same firm is lower
than when the products are produced by separate
firms.
• Cost complementarity: exist when the marginal cost of
producing one output is reduced when the output of
another product is increased.
• Patents and other legal barriers
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 Elasticity of Demand and Monopoly

Total Revenues
Price Revenue
Maximum revenues
Elastic

Unitary

0 Unitary 𝑅0
𝑃

Inelastic Elastic Inelastic

0 𝑄0 Q 0 𝑄0 Firm’s
MR output

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 Monopoly

Marginal Revenue and Elasticity

• The monopolist’s marginal revenue function is

, where is the elasticity of demand for the

monopolist’s product and is the price charged.
– For
• when .
• when .
• when .

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 Monopoly

Marginal Revenue and Linear

Demand
• Given an linear inverse demand function

, where , the associated marginal revenue is

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 Monopoly

Marginal Revenue In Action

• Suppose the inverse demand function for a
monopolist’s product is given by . What is the
maximum price per unit a monopolist can
charge to be able to sell 3 units? What is
marginal revenue when ?
• Answer:
– The maximum price the monopolist can charge for
3 units is: .
– The marginal revenue at 3 units for this inverse
linear demand is: .

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 Monopoly

Monopoly Output Rule

• A profit-maximizing monopolist should
produce the output, , such that marginal
revenue equals marginal cost:

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 Monopoly

Costs, Revenues, and Profits Under

$
Monopoly Cost function

Revenue function

Slope of
Slope of
Maximum
profit

0 𝑀 Output
𝑄

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 Monopoly

Profit Maximization Under Monopoly

Price MC

ATC

𝑃𝑀
Profits
)

Demand

𝑄𝑀 Quantity
MR

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 Monopoly

Monopoly Pricing Rule

• Given the level of output, , that maximizes
profits, the monopoly price is the price on the
demand curve corresponding to the units
produced:

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 Monopoly

Monopoly In Action
• Suppose the inverse demand function for a
monopolist’s product is given by and the cost
function is . Determine the profit-maximizing
price, quantity and maximum profits.
• Answer:
– Profit-maximizing output is found by solving: .
– The profit-maximizing price is: .
– Maximum profits are: .

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 Monopoly

The Absence of a Supply Curve

• Recall, firms operating in perfectly competitive
markets determine how much output to
produce based on price ().
– Thus, a supply curve exists in perfectly competitive
markets.
• A monopolist’s market power implies .
– Thus, there is no supply curve for a monopolist, or
in markets served by firms with market power.

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 Monopoly

Multiplant Decisions
• Often a monopolist produces output in different
locations.
– Implications: manager has to determine how much
output to produce at each plant.
• Consider a monopolist producing output at two
plants:
– The cost of producing units at plant 1 is , and the cost
of producing at plant 2 is .
– When the monopolist produces a homogeneous
product, the per-unit price consumers are willing to pay
for the total output produced at the two plants is ,
where .
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 Monopoly
Multiplant Output Rule
• Let be the marginal revenue of producing a
total of units of output. Suppose the marginal
cost of producing units of output in plant 1 is
and that of producing units in plant 2 is . The
profit-maximizing rule for the two-plant
monopolist is to allocate output among the
two plants such that:

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 Monopoly
Implications of Entry Barriers
• A monopolist may earn positive economic
profits, which in the presence of barriers to
entry prevents other firms from entering the
market to reap a portion of those profits.
– Implication: monopoly profits will continue over
time provided the monopoly maintains its market
power.
• Monopoly power, however, does not
guarantee positive profits.

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 Monopoly

A Monopolist Earning Zero Profits

Price MC
ATC

𝑃 𝑀 = 𝐴𝑇𝐶¿ ¿

Demand

𝑄𝑀 Quantity
MR

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 Monopoly

Deadweight Loss of Monopoly

• The consumer and producer surplus that is
lost due to the monopolist charging a price in
excess of marginal cost.

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 Monopoly

Deadweight Loss of Monopoly

Price

MC
𝑀
𝑃
𝐶 Deadweight loss
𝑃

Demand
MR

𝑄𝑀 𝑄𝐶 Quantity

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 Monopolistic Competition

Monopolistic Competition
• An industry is monopolistically competitive if:
– There are many buyers and sellers.
– Each firm in the industry produces a differentiated
product.
– There is free entry into and exit from the industry.
• A key difference between monopolistically
competitive and perfectly competitive markets is that
each firm produces a slightly differentiated product.
– Implication: products are close, but not perfect,
substitutes; therefore, firm’s demand curve is downward
sloping under monopolistic competition.

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 Monopolistic Competition
Profit-Maximization under
Monopolistic Competition
Price MC

ATC

𝑃∗
Profits
𝐴𝑇𝐶 ¿ ¿

Demand

𝑄∗ Quantity
MR

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 Monopolistic Competition

Profit-Maximization Rule for

Monopolistic Competition
• To maximize profits, a monopolistically
competitive firm produces where its marginal
revenue equals marginal cost.
• The profit-maximizing price is the maximum
price per unit that consumers are willing to
pay for the profit-maximizing level of output.
• The profit-maximizing output, , is such that
and the profit-maximizing price is .

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 Monopolistic Competition
Long-Run Equilibrium
• If firms in monopolistically competitive
markets earn short-run
– profits, additional firms will enter in the long run
to capture some of those profits.
– losses, some firms will exit the industry in the long
run.

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Effect of Entry on a Monopolistically
Monopolistic Competition

Competitive Firm’s
Price MC Demand
ATC

𝑃∗ Due to entry of new

firms selling other brands

Demand1 Demand0

𝑄∗ Quantity of Brand X
MR1 MR0

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 Monopolistic Competition

Long-Run Equilibrium under

Price
Monopolistic Competition
MC

Long-run monopolistically
competitive equilibrium ATC

𝑃∗

Demand1

𝑄∗ Quantity of Brand X
MR1

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 Monopolistic Competition

The Long-Run and Monopolistic

Competition
• In the long run, monopolistically competitive
firms produce a level of output such that:

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 Monopolistic Competition

Implications of Product
Differentiation
• The differentiated nature of products in
monopolistically competitive markets implies
that firms in these industries must continually
convince consumers that their products are
better than their competitors.

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 Monopolistic Competition

Implications of Product Differentiation

• Two strategies monopolistically competitive firms use to
persuade consumers:
– Comparative advertising: form of advertising where a firm attempts
to increase the demand for its brand by differentiating its product
from competing brands
• Brand equity
– Niche marketing: a marketing strategy where goods and services are
tailored to meet the needs of a particular segment of the market.
• Green marketing
• Successful differentiation and branding strategies can make
managers brand myopic, resting on the brand’s past laurels
and in doing so missing opportunities to enhance its brand

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 Optimal Advertising Decisions

Optimal Advertising Decisions

• How much should a firm spend on advertising
to maximize profits?
– Depends, in part, on the nature of the industry.
– The optimal amount of advertising balances the
marginal benefits and marginal costs.
• Profit-maximizing advertising-to-sales ratio is:

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