Chapter 8: Perfect Competition and Monopoly

Natural monopoly

A business that naturally becomes a monopoly because it drives the competition out of business. Electrical power.

Oligopoly

A few firms that are interdependent (the actions of one affects the others). (Auto makers, airlines, tv networks).

Perfect competition is perfect to the economist for two reasons:

1. It creates incentives to the firm to produce at the lowest possible cost 2. it creates the best possible allocation of resources.

Perfectly competitive industries are characterized by four basic assumptions:

1. Many small firms. There are so many firms in a competitive industry that none is able to influence the market. There are also a large number of consumers, none of which are able to influence the market. 2. Homogenous products. The products produced in a competitive industry are identical. Consumers cannot differentiate one firm's product from that of any other. 3. Easy entry and exit. No barriers exist for the creation of a competitive firm, nor are there legal or other restrictions on the closing of such a firm. 4. Perfect information. All the business and consumers in the market have essentially perfect information. This means that they know what prices are, what products are available, and that the products of the firms are identical.

Monopoly industries are characterized by three basic assumptions:

1. One seller. There is only one seller of the good. 2. No close substitutes. 3. Complete barriers to entry. Restrictions to the creation of a competing business exist, and are so strong that no competing business can be started.

Sherman Act (1890)

1. Outlawed contracts or other agreements that were in "restraint of trade." 2. Made illegal monopolies, attempts to monopolize and conspiracy to monopolize.

Clayton Act (1914)

1. Outlawed price discrimination except in certain cases such as when actual cost differences exist. 2. Outlawed exclusive dealing and tying contracts. 3. It prevented acquisition of competitors and it banned interlocking directorates.

Two rules we need to know:

1. Output that will maximize profits or minimize losses: MC = MR. 2. Amount of Profit or Loss: Compare Price to cost per unit (ATC). If -- ATC > Market Price: Loss -- ATC = Market Price: Normal profit, but no economic profit. -- Market Price > ATC: Both normal profit and economic profit.

Four reasons why a monopoly may exist:

1. legal restrictions 2. control of natural resources 3. natural monopoly 4. network externalities

Legal restrictions

1. public franchise (a biz that has been granted a license by a government that gives it the monopoly right to sell a good within the city or county. ex: electrical power, cable TV, and local telephone companies) 2. patent ( the legal right to be the sole seller of a good you invent or create for a period of years. )

Conditions that must exist before price discrimination can be used

1. the firm must be able to identify its consumers and charge them different prices. 2. The firm must be a price searcher with some monopoly power. 3. Arbitrage must not be possible. Arbitrage is the purchase of a good for the purpose of reselling it to another consumer.

The profit maximizing output for a business that charges one price will always be where

MC = MR. (d= MR)

In perfect competition P =

MC. Because the price of the good is constant, the marginal revenue is constant at the price. Son in a competitive market, MR = MC is the same as P = MC. Thus the profit maximizing price and quantity for the firm will create allocative efficiency.

Monopolistic Competition

Many small firms producing differentiated (not identical) products. Easy business to start. (Restaurants, hair stylists).

Monopoly

One firm. (Electrical power, cable TV).

The economist knows two things about prices in the competitive industry:

There is only one price, and it is set by unbridled supply and demand. Knowing that suggests to the economist that the consumer will receive that maximum possible benefits the market has to offer.

Demand curve in a perfect competition is what?

a flat line, m=0, the firm takes the price it is given.

Industry

a group of businesses that competes for the same consumers with products viewed as substitutes.

If wheat farmers are earning economic profit, then other farmers

have an incentive to switch their crop to wheat from whatever they had been growing. As farmers change from other crops to wheat, the supply curve will shift to the right. Since economic profit equals revenue minus opportunity cost, and a lower price and quantity mean lower revenue, the economic profit of the firm will decline. The opposite will occur if the wheat farmers are losing money.

Network Externalities

occurs when the value of a good increases as the number of users of it increases.

Economists classify industries into four market structures:

perfect competition, monopoly, monopolistic competition, and oligopoly.

Economists call firms in perfect competition _______

price takers. This means that they are unable to influence the price changed, and must accept whatever price comes from the market.

As economists, we want to analyze the competitive industry along four linked dimensions:

price, output, costs, and profit.

If the price of the good is fixed, and the firm has no control over it, the only way for the business to maximize its profits is to

produce at the lowest possible cost.

Price discrimination

the practice of charging more than one price to different buyers of the same good.

The firms can only survive in the long run if

the price is no lower than the lowest possible average total cost. That is, the price must remain equal to or above the minimum cost per unit of producing the wheat or other good.

The value to the last consumer is measured by

the price they paid.

Control of natural resources

Can be a commodity, such as diamonds, or a geographical area such as a harbor.

First Degree Price Descrimination

Discrimination by individual buyer (so giving a different price to different people)

Third Degree Price Discrimination

Discrimination by market (Ex. senior discount, prices of identical medicines are lower in MX than in the US)

Second Degree Price Discrimination

Discrimination by quantity (Ex. rent 9 videos, get the next one free)

Changes in supply and demand in the market for wheat will change the price of wheat.

Suppose, for example, the firm is producing wheat, and that consumer demand for wheat increases. This shifts the market demand curve for wheat to the right (perhaps a substitute for wheat increased in price). The market price of wheat will rise, and the equilibrium quantity of wheat purchased by all consumers will increase. How does this affect the single farm in the wheat industry? 8-3, the demand curve faced by the individual farmer shifts upward (increases). From the economist's perspective, both the price and the marginal revenue for the farmer have increased. There is a new point where marginal revenue and marginal cost meet. The firm will respond to the increased demand in the market by increasing production. The firm should be better off, because it can sell more wheat at a higher price.

Resource allocative efficiency/allocative efficiency

The value of a good to consumers is exactly equal to the value of the resources used to create it.

No firm in a competitive industry has any influence individually over the price of the good they produce and sell because

all the goods are identical, so price is the only factor that might differentiate them.

If the businesses in the industry are earning economic profits in the short run, new entrants will

begin to produce the good. The new entrants will increase the pressure on the existing firms to cut costs.

The area between the demand curve and the equilibrium price is

consumer surplus.

Economics put normal profit ino

cost. The first $100k in profit the business earns will be part of ATC (bc it's the normal profit), not above and beyond ATC. If the firm earns profit above $100K, then profit will appear above ATC, which is economic profit.

IN a competitive industry the demand, price, and marginal revenue of each firm are

equal.

Perfect competition is called this because

it has the maximum amount of competition possible, which results in outcomes economists view as highly desirable for consumers and for society as a whole.

The value of the resources used to create a good is measured by

its marginal cost.

In a competitive industry, because the price is fixed, the marginal revenue of a good and

its price are equal.

Why is monopoly bad?

lowers consumer surplus

Perfect competition

many small firms producing identical products. Easy businesses to start. Also called competitive markets. (Farming).

Price discrimination changes what?

marginal revenue curve of the multiple price monopoly firm is identical to the demand curve.

When price is equal to marginal cost

resource allocative efficiency exists.

A single price monopoly will maximize its profit by

restricting the output available for sale, which will artificially inflate the price of the good. (lowers consumer surplus)

If supply increases:

supply curve shifts right, lowering the market price and increasing the equilibrium quantity of wheat sold. The increased competition lowers the equilibrium price of wheat, which shifts the firm's demand curve (and marginal revenue) downward.

To discover whether or not the firm is making profits, and how much the profit is, we need to compare

the average revenue to average total cost (ATC).

Consumer surplus

the difference between the price a consumer pays and the highest price they would have paid.

Productive efficiency occurs

when firms produce goods at the lowest possible average total cost. This will happen in the long run in perfect competition.