MODULE 4
Market morphology:
• 1. Concept of market
• 2. Perfect competition- Features and price determination
under short-run and long run
• 3. Monopoly- Features and price determination, Sources
of monopoly and price discrimination
• 4. Monopolistic competition- Features and overview
• 5. Oligopoly- Features and types of oligopoly
competition
1
Introduction: A Scenario
Three years after graduating, you run your
own business. You must decide how much to
produce, what price to charge, how many
workers to hire, etc.
• What factors should affect these decisions?
– Your costs (studied in preceding chapter)
– How much competition you face
We begin by studying the behavior of firms in
perfectly competitive markets.
2
Perfect Competition
3
Look for the answers to these questions:
• What is a perfectly competitive market?
• What is marginal revenue? How is it related to
total and average revenue?
• How does a competitive firm determine the
quantity that maximizes profits?
• When might a competitive firm shut down in the
short run? Exit the market in the long run?
• What does the market supply curve look like in
the short run? In the long run?
4
What is a Competitive Market?
Perfectly competitive market:
1. Market with many buyers and sellers
2. Trading identical products
– Because of the first two: each buyer and
seller is a price taker (takes the price as
given)
3. Firms can freely enter or exit the market
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Introduction
• Monopoly
– A firm that is the sole seller of a product
without close substitutes
– Has market power
• The ability to influence the market price of the
product it sells
• A competitive firm has no market power
– Arise due to barriers to entry
• Other firms cannot enter the market to
compete with it
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Monopolistic
• when many companies offer
competing products or services that
are similar, but not perfect,
substitutes.
• The market for novels fits neither
the competitive nor the monopoly
model.
• Oxymoron?
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Oligopoly Market
• Oligopoly, there is a small
number of firms that control the
market. A key characteristic of
an oligopoly is that none of
these firms can keep the
other(s) from having significant
influence over the market.
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Figure 1 The Four Types of Market Structure
Number of
Firms?
Many
firms
Type of
Products?
One Few Differentiated Identical
firm firms products products
Monopolistic Perfec
Monopoly Oligopoly Competition t
Competition
• Tap water • Tennis balls • Novels • Wheat
• Cable TV • Crude oil • Movies • Milk
Railway
Copyright © 2004 South-Western
The Competitive Firm
• Perfect competition
– Firm is a price taker.
– Price is set in the market.
– Firm is too small to affect the market.
The Competitive Firm
• The Firm’s Demand Curve under Perfect
Competition
– Perfectly Elastic (Horizontal)
– Can sell as much as it wants at the market
price.
Demand Curve for a Firm under Perfect Competition
D Industry S
supply
curve
Price per Bushel
A B C E Industry
$3 $3 demand
in Chicago
curve
Firm’s demand
curve
S
D
0 1 2 3 4 0 100 200 300 400
Truckloads of Corn Total Sales in Chicago
Sold by Farmer Jasmine in Thousands of Truckloads
per Year per Year
(a) (b)
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Perfectly Elastic Demand
Price Taker Role
Total Revenue = P x Q
Average Revenue = P
Marginal Revenue = P
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P) Quantity Total Marginal
(Average Revenue) Demanded (Q) Revenue (TR) Revenue (MR)
$131 0 $ 0
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P) Quantity Total Marginal
(Average Revenue) Demanded (Q) Revenue (TR) Revenue (MR)
$131 0 $ 0
] $131
131 1 131
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P) Quantity Total Marginal
(Average Revenue) Demanded (Q) Revenue (TR) Revenue (MR)
$131 0 $ 0
] $131
131 1 131]
131
131 2 262
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P) Quantity Total Marginal
(Average Revenue) Demanded (Q) Revenue (TR) Revenue (MR)
$131 0 $ 0
] $131
131 1 131]
131
131 2 262]
131
131 3 393
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P) Quantity Total Marginal
(Average Revenue) Demanded (Q) Revenue (TR) Revenue (MR)
$131 0 $ 0
] $131
131 1 131]
131
131 2 262]
131
131 3 393]
131
131 4 524
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P) Quantity Total Marginal
(Average Revenue) Demanded (Q) Revenue (TR) Revenue (MR)
$131 0 $ 0
] $131
131 1 131]
131
131 2 262]
131
131 3 393]
131
131 4 524]
131
131 5 655]
131
131 6 786]
131
131 7 917]
131
131 8 1048]
131
131 9 1179]
131
131 10 1310
DEMAND, MARGINAL REVENUE, AND TOTAL
REVENUE IN PURE COMPETITION
1179
TR
1048
Price and revenue
917
786
655
524
393
262
131
P = MR
0
1 2 3 4 5 6 7 8 9 10
Quantity Demanded (sold)
The Competitive Firm
• Short-Run Equilibrium for the Perfectly
Competitive Firm
▪ Marginal revenue = Price
▪ Profit-maximizing level of output: MC =
MR
▪ So, a perfectly competitive firm should
maximize profit by producing the output
where Price = Marginal Cost
The Competitive Firm
• D = MR = AR at all levels of output
• D = MR = AR = MC at the equilibrium
level of output
Short-Run Equilibrium of the Perfectly Competitive Firm
Revenue and Cost per Bushel
MC AC
B
$3.00
D = MR = AR
2.25
A
1.50
0 50,000
Bushels of Corn per Year
Profit Maximization
• What Q maximizes a firm’s profit?
– Think at the margin
– If Q increases by one unit
• Revenue rises by MR, cost rises by MC
• Compare marginal revenue with marginal
cost
– If MR > MC: increase Q to raise profit
– If MR < MC: decrease Q to raise profit
– Maximize profit for Q where MR = MC
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Profit Maximization
(continued from earlier exercise)
At any Q with
MR > MC, ∆Contribution
Q TR TC Profit MR MC = MR –
increasing Q
MC
raises profit. 0 $0 $5 –$5
$10 $4 $6
1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
3 30 23 7
MR < MC, 10 10 0
reducing Q 4 40 33 7
10 12 –2
raises profit. 5 50 45 5
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MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
Costs
So, increase Q
to raise profit. MC
At Qb, MC > MR.
So, reduce Q
to raise profit. P1 MR
At Q1, MC = MR.
Changing Q
would lower profit. Q
Qa Q1 Qb
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MC and the Firm’s Supply Decision
If price rises to P2, the MC curve is the
then the firm’s supply curve.
profit-maximizing Costs
quantity rises to Q2. MC
The MC curve P2 MR2
determines the
firm’s Q at any
price. P1 MR
Hence, the MC
curve is the firm’s
Q
supply curve Q1 Q2
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Shutdown vs. Exit
• Shutdown:
– A short-run decision not to produce
anything because of market conditions.
• Exit:
– A long-run decision to leave the market.
• A key difference:
– If shut down in SR, must still pay FC.
– If exit in LR, zero costs.
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Short-run Decision to Shut Down
• Should a firm shut-down in the short run?
– Cost of shutting down = revenue loss
= TR
– Benefit of shutting down = cost savings
= VC
(because the firm must still pay FC)
• Shut down if TR < VC, or P < AVC
• P*Q<VC = P<VC/Q= P<AVC
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The Irrelevance of Sunk Costs
• Sunk cost
– A cost that has already been committed
and cannot be recovered
– Should be ignored when making decisions
– You must pay them regardless of your
choice
– In the short run, FC are sunk costs
• So, FC should not matter in the decision to
shut down
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A Firm’s Long-Run Decision
• Should a firm exit or enter in the long run?
– Cost of exiting market = revenue loss = TR
– Benefit of exiting market = cost savings = TC
(remember, FC = 0 in long run)
• Firm’s long-run decision
– Exit the market if: TR < TC
(same as: P < ATC)
– Enter the market if: TR > TC
(same as: P > ATC)
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Figure An Increase in Demand in the Short Run
and Long Run (a)
(a) Initial Condition
Market Firm
Price Price
1. A market begins in 2. …with the firm
long-run equilibrium… earning zero profit.
Short-run supply, S1 MC
ATC
A Long-run
P1 P1
supply
Demand, D1
0 Q1 Quantity 0 Quantity
(market) (firm)
•The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium,
each firm makes zero profit, and the price equals the minimum average total cost.
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Figure 8 An Increase in Demand in the Short
Run
and Long Run (b)
(b) Short-Run Response
Market Firm
Price Price
3. But then an increase in
4. …leading to
demand raises the price…
short-run profits.
S1 MC
ATC
B
P2 P2
A Long-run
P1 P1
supply
D2
D1
0 Q1 Q2 Quantity 0 Quantity
(market) (firm)
•Panel (b) shows what happens in the short run when demand rises from D1 to D2. The
equilibrium goes from point A to point B, price rises from P1 to P2, and the quantity sold in the
market rises from Q1 to Q2. Because price now exceeds average total cost, each firm now makes
a profit, which over time encourages new firms to enter the market.
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Figure 8 An Increase in Demand in the Short
Run
and Long Run (c)
(c) Long-Run Response
Market Firm
Price Price 6. …restoring long-run
5. When profits induce entry, supply
increases and the price falls,… equilibrium.
S1 MC
S2 ATC
B
P2
A C Long-run
P1 P1
supply
D2
D1
0 Q1 Q2 Q3 Quantity 0 Quantity
(market) (firm)
•This entry shifts the short-run supply curve to the right from S1 to S2, as shown in panel (c). In
the new long-run equilibrium, point C, price has returned to P1 but the quantity sold has
increased to Q3. Profits are again zero, and price is back to the minimum of average total cost,
but the market has more firms to satisfy the greater demand.
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Summary
• A competitive firm is a price taker
– Its revenue is proportional to the amount of
output it produces.
– P = MR = AR
– The firm’s marginal-cost curve is its supply curve
• Short run: a firm cannot recover its FC
– Shut down temporarily if P < AVC
• Long run: the firm can recover both FC and VC
– Exit if P < ATC
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Summary
• In a market with free entry and exit, profit is
driven to zero in the long run.
– All firms produce at efficient scale, P = min ATC
– The number of firms adjusts to satisfy the
quantity demanded at this price.
• Changes in demand have different effects over
different time horizons.
– Short run, an increase in demand raises prices
and leads to profits (a decrease in demand
lowers prices and leads to losses).
– Long run: zero-profit equilibrium
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