Perfect Competition, Monopoly, Monopolistic Competition, Oligopoly PDF

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Perfect Competition transcript notes for video lecture for economics for management purposes for Western Governors University...

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The Four Types of Market Structure Monopoly is one firm. Example: utilities companies. Oligopoly is a few firms and examples include tennis balls and cigarettes. Many firms are the monopolistic competition and includes novels and movies and perfect competition that sales identical products like milk and wheat. Perfect Competition A perfectly competitive market is a market with many buyers and sellers, homogenous products traded, buyers and sellers are “price-takers” and the firm has decision over the quantity of product they produce the price for that product. They are price takers, a going price in the market, so the seller can sell for the same price as everyone else, but also everyone else is selling the same product for the same price. If the price they are offering is less than what you are wanting to sell for, then nobody is going to buy your product over the cheaper competition because there is no demand at a higher price. If you charge less than everyone else and the price is driven down to the lowest possible point where the firms could break even. There is relative ease in entering and exiting the marketplace. Both of the markets that involve competition are relatively easy to enter and exit. The goal of the firm is to maximize profit, (pi) which is equal to total revenue (TR) minus total cost (TC). Total revenue (TR) is equal to price times quantity. The first thing to recognize is average revenue. In order to get average revenue, the total revenue is divided by quantity. (AR=TR/Q). Because TR=PxQ, when the price is multiplied by the quantity then divided by quantity, the only thing left is price, omitting the quantity. With marginal revenue, the actual equation for marginal revenue is equal to the change in total revenue divided by the change in quantity, such as relative to the increase in production. So, average revenue is equal to price and marginal revenue is equal to price. When marginal is talked about in economics, it means the next unit. For example, if there was a firm producing a hundred units of chairs and wanted to consider making the next chair, how much revenue would we make from that next chair? The change in overall revenue, or total revenue, is divided by the change quantity. So if the overall total revenue goes up by a $100, then that is the increase in revenue from that next unit of production. We’d compare the change in price for the additional unit to the additional costs incurred in order to see if it’s worthwhile to produce an additional unit. When determining where the firm should produce, remember that the firm is trying to maximize profit, which means a capital system. What are the rules where the firm can see that they’re achieving a maximization profit? There are two different approaches. The first approach is the total revenue, total cost approach that looks at the place where the gap between total revenue in total cost is the largest. If there is a typical product market, we might find that if we produce across this quantity, when the total cost curve crosses the total revenue curve, the largest portion of the gap created by the TC and TR crossings is the optimal point to produce. The second approach is the marginal revenue to marginal cost approach, which is an equilibrium where the marginal revenue equals the marginal costs. The point where the marginal cost and the marginal revenue meet, should be in line with q1, the optimal point to produce. The area to the left is telling us that the benefit of producing those units is greater than the cost, means there is profit. The objective is to take advantage of all the profit opportunity without overestimating it and crossing over to the right of

the Q1 spot, because when the q1 is crossed over to the right, it costs more to make each additional unit. Then the only benefit is to sell. The shutdown decision is a situation in which firms may find themselves if they are up against constraint. The shutdown is the short-run decision not to produce anything during a specific period of time because of the current market conditions. Firms can’t avoid fixed costs (sunk costs). The product the firm produces has cyclical trends for the demand and are therefore subject to the seasons, so they only have certain times of the year they can produce. Agriculture sees this a lot. Because of the fluctuation of demand, there has to be a point where the decision is made to cut down labor force when there is a temporary shut down until things pick back up again. These companies aren’t going out of business, they still have fixed costs they have to pay that aren’t avoidable. Variable costs may be avoidable because they are usually in conjunction with their production. The choice to shutdown is going to be something to look at with variable costs. The rules for the shutdown decision is to shut down temporarily when the total revenue is less than the variable costs. Total revenue / quantity is equal to price times quantity / quantity and the quantity cancels out, leaving the price. Variable costs divided by quantity give us the average variable costs. The decision then is summarized as a reduced for equation by saying if the prices are less than the average variable costs, it’s a signal that the firm needs to be temporarily shutdown. Example: If a firm shuts down in the short-run, how should it determine when to reverse this decision? In the short run, the firm produces on the MC curve if Price is greater than the Average Variable cost, but shuts down when price is less than the average variable costs. If, at the point where the marginal cost meets average variable costs, prices can be captured above that point, then they can stay producing, otherwise they need to shut down. Variable costs are looked at with the short-run shutdown, and total cost is looked in the longrun exit analysis. Short run is classically defined as a period of less than a year. Long-Run Exit Analysis: Looking at the overall revenues and comparing them to the overall cost. The market exit rule is Total Revenue is less than total cost. If the total revenues are below total costs, then there is no way to stay completely out of bankruptcy indefinitely. Revenues have to be higher than the incurred costs. Total revenue equals price times quantity divided by quantity which summarizes to total revenue is equal to price. The average total cost is the total cost divided by quantity. So, the rule for the market entry is if prices are greater than average total cost there is a signal that profit is available when one decides to enter the market.

Monopolies Monopoly is characterized by only one seller, one company selling the product and there are no close substitutes. This is the area where economists will often find they debate whether a specific company is a monopoly, because if someone can find products that are considered to be close substitutes then this is an invalid observation. The company isn’t a monopoly if there is something that can be substituted in a close manner. Theoretically, we can imagine a world in which there is just one company producing a product where there’s no close substitutes. Monopolies get to control the quantity of the product that they make and push out into the market, but they also get to control the price. Monopolies are price

makers. When monopolies determine how much and at what price the products are, they arrive at a situation where they can maximize profit. As long as the company gets to a situation where they are competing fair and they are the only company out there, with no bullying or pushing out people through means other than competitive fair play, then the monopolies will arrive at a situation where they fully maximize profit. Its very hard to get in and compete against monopolistic companies because of significant barriers to entry. Barriers to entry may be proprietary processes, or technological knowledge that is very difficult to reverse engineer or the monopoly companies have access to resources no one else has, like the hundreds of millions or billions of dollars in capital to get the technology and machines in place to start producing products of a similar kind. Because its hard to compete against them, monopolies tend to remain in power for a really long time. So, to compare perfect competition to monopoly, perfect competition doesn’t have an influence on price because they are price takers and monopolies are price makers. The size of the firm relative to the market perfect competition is very, very small, whereas monopolies are the whole market. The shape of the demand curve for a perfect competition model is horizontal. Monopolies have a downward sloping demand curve, which means there is an inverse relationship between the price of a product and the quantity demanded by consumers. So if someone wants something more expensive they can’t afford as much as they would be able to afford of a product that costs less. That’s why there is a downward slope with a monopoly. If a firm is in a perfectly competitive world, they are going to be able to make decisions on how much product is made and how much to push out onto the shelves. Monopolies have to make choices on both quantity and price. They determine how much of a product is made and what the price of the product is, which will allow for them to arrive at a situation where they can maximize profit. Demand Curves for Competitive and Monopoly Firms For competitive firm demand curves, the demand curve is completely horizontal. The supply curve for a perfectly competitive demand curve starts at zero and climbs upward to the right in a diagonal direction. The supply curve is talking about the firm and the demand curve is talking about the consumer. There are two entities that want different things. This equilibrium is where the market settles, the compromise of the market and the consumer. The profit maximization for a monopoly curve shows a monopoly maximizing profit by choosing the quantity at which marginal revenue equals marginal cost (point a) then uses the demand curve to find the price that will induce consumers to buy that quantity (point b). The supply curve is going to share the marginal cost curve and is where production decisions are made and is very close, if not right on the marginal cost. The marginal cost is upward sloping and the marginal revenue is downward sloping. Point a is where the marginal cost meets the marginal revenue. MR=MC and the firm would want to find equilibrium and produce there. To find the monopoly price, find the place where MR=MC and draw a line straight down until the horizontal axis is met to get the maximum quantity to produce. Anything to the left of the quantity max point results in a loss of potential profit. Anything to the right of the max quantity point, results moving past the optimal quantity to produce. If you are to the right of the quantity point then there will be marginal costs that are greater than the marginal revenue, which won’t be profit maximizing. Now, start at the equilibrium point, where the monopoly price and the quantity meet and move up until the demand curve point is met. This is the best price to charge for the product. If monopolies were to raise the price, (point c), then the quantity would lower and are no longer maximizing profit because demand is consumer and supply is the firm. Monopolies only have a certain amount of power but doesn’t have complete power in the sense that they aren’t taking the money out of the account; the consumer still decides to buy the product.

Monopolies can only charge monopoly price, any higher and profit max won’t be met. Now, its true that a monopoly price is higher than what a firm with more competition would charge. Because of competition, prices come down to P3 and at point D is where supply meets demand. More competition would lead to lower prices and higher quantities of the product produced.

The Monopolist’s Profit Remember, profit is equal to total revenue minus cost. Total revenue is the monopoly price and is calculated by price times quantity. Average total cost is total cost divided by quantity. The Monopolists’ profit is the area between Monopolist price (E) and point B down tot the Average total cost (D) and point c. The total cost is going to be subtracted off the total cost, which is going to be all of the costs at this point of production in the shaded area. Deadweight Loss This says that if we were to compare two circumstances: one that is a monopoly and the other where competition exists. Competition would be located below the monopoly price on the vertical axis. Consumer surplus is the area above the competition line and below the demand curve and producer surplus is the area below the competition line and above the supply curve. Total surplus is the whole triangle combining both the consumer and supplier surplus. If monopolists get to set the prices where they want, we land at the point where monopoly price and monopoly quantity meet, trying to get above the equilibrium point where marginal revenue equals marginal cost, where we produce on the line that connects the points where MR=MC and the equilibrium point; this is the monopoly quantity. The deadweight loss is what is missed out on all of that area surplus that would have been realized under a competitive market. So, monopolists maximize the profit. They do the best they possibly can, but society in the short term loses out on the area of surplus because it was never generated. This is deadweight loss. Competition vs. Monopoly: Comparison Summary Similarities: Both have goals of maximizing profits, the rule for maximizing is MR=MC and there can be economic profit earnings in the short run. The differences between competition and monopoly: competition has many different firms and monopolies have one firm; competition’s marginal revenue is MR=P and monopoly’s marginal price is MR MC; competition produces welfare-maximizing level of output and monopolies don’t; there is long run entry for competition markets and no entry in the long run for monopolies; competitions can earn economic profits in the long run and monopolies can’t; with competition, there is no price discrimination, with monopolies, there is. Monopolistic Competition This is a hybrid between competition and monopoly. This is sometimes referred to as imperfect competition. There are many sellers and product differentiation. The monopolistic competition model is the most pervasive in the US other Western countries. These types of firms are going to have some degree of pricing influence and is contingent on how good they are at trying to stimulate demand through marketing and advertising campaigns. Entry and exit are relatively easy in monopolistic

competition. With so many companies out there, there are going to be are going to be similar products, so what makes one company preferred over another company’s product? Its all about how the companies promote and advertise their products to entice others to buy them. Advertising is key in the monopolistic competition market; differentiated products. Price is greater than marginal costs, giving strong incentive to advertise product and make consumers aware of what all is out there and why its special and different in a lot of different styles. Monopolistic competition firms usually spend 10-20% of revenue in any given period on advertising and marketing campaigns to enurse there’s sufficient demand for the next period. Monopolistic competition and monopolies similarities for both include maximize profits, earn economic profits in the short run, marginal revenue equal marginal for both markets, P>MC for both, price and both are not price takers, they both don’t produce welfare-maximizing level of output, monopolistic competition has deadweight, not as much as monopolies,however. The differences between Monopolistic competition and monopoly Monopolistic competition and perfect competition similarities include earning profits in the short run, having many numbers of firms, have entry in the long run and can’t earn profit in the long run. Oligopoly (The Prisoner’s Dilemma) Oligopoly is characterized by having a small group of sellers, minimum of two sellers. A few key firms are highly influential and products in this market can actually be either homogenous (the same) or differentiated. There is natural tension that exists when in a circumstance between two different forces. One is a cooperation, doing what is best for the group and the other force is what is best in the selfinterest of the competition (what’s best for me?) The Prisoner’s Dilemma Game theory was introduced by John Nash as an analysis procedure looking at human behavior in circumstances that are usually considered strategic in nature. Oligopoly starts with duopoly, where price is determined by market demand: if one firm increases production, this will impact the price for the whole market. There are two choices: collude and form a cartel (monopoly) to maximize total market profit) or don’t collude (self-interest) and have higher profits for individual firm profits but have difficulty with agreements. Example: There are two firms and they recognize that the price is going to be determined by the market demand. If one firm increases what they produce, its going to impact the price for the other firms in the market. So, they can get together and work it out and come to a realization that they are the only two firms in the market. If they were to settle on a price, they could both maximize the overall profits experienced in the market and the profits would be split and the two firms would go their separate ways and make an agreement (collude). This is illegal and in most Western countries; this would essentially operate like a monopoly. This is the “we idea”. And this would maximize the profit in the total market. The second choice is to get the other firm to quit because the other firm might outcompete the first firm, and if the firm dissolves then there is only one firm in the market, so that firm “wins”. The firm is pursuing their own self-interest. The potential for higher profits as a firm is actually higher, which is an incentive, but on the other hand, its difficult to agree and the other firm could cheat. Then the illegal aspect is present in that there are anti-trust laws that forbid bullying another firm into dissolving and the other firm cheating. Because of the potential of getting discovered and going to jail for a white collar crime, option two might be better. Nash Equilibrium states that each economic actor chooses best strategy in the consideration of other actors. Each entity that we consider is going to choose their best strategy, having given consideration to

the other actors and a pay off matrix. The dominant strategy is where it would be best for a player to do one specific strategy regardless of what the other guy does. It becomes very, very unlikely for a third firm to exist and pull off a cartel formation because probabilistically, when a third party enters, the statistical likelihood of pulling off a cartel where all three agree on setting the price like a monopoly is close to zero. When the number of sellers increase in an oligopoly, competitive market characteristics are taken on, price approaches Marginal Cost (MC) and the quantity produced approaches socially efficient level. The prisoner’s dilemma example: starts off with two characters, Bonnie and Clyde who are robbing banks and get caught and arrested. When they get to the prison, they are taken into two separate rooms to be questioned and are told there has been enough circumstantial evidence that could hold the two robbers for a year. The detectives get the robbers to make a deal by ousting the other person. The two choices in the model is that they both confess or remain silent. If they both remain silent, they both get a year sentence. Bonnie asks if she were to cooperate and expose Clyde, because if she doesn’t then she is going to get 20 years in prison. The collective times are really high for both of them, but because they both were in separate rooms, leaving Clyde to think if he doesn’t talk and Bonnie does, he is going to be in prison for twenty years. So, regardless of what happens, Clyde is better off confessing individually, because he is co...