Managing in Perfectly Competitive
and Monopolistic Markets
Perfect Competition
Conditions:
• Large number of buyers and sellers
• Homogeneous product
• Perfect knowledge
• Free entry and exit
• No government intervention
Key Implications:
• Flat firms’ demand determined by market equilibrium price
• Market participants are price takers without any market power to
influence prices (have to charge MR = P = MC)
• In the short run firms earn profits or losses or shut down
• In the long run profit = normal = 0 (firms operate efficiently)
Monopoly
Conditions:
• Large number of buyers and one sellers
• Product without close substitutes
• Perfect knowledge
• Barriers to entry
• No government intervention
Key Implications:
• Downward sloping firm’s demand is market demand
• Firm has market power and determines market price
(can charge P > MR = MC)
• In the short run monopoly earns profit or loss or shuts down
• In the long run profit > normal is sustainable indefinitely but even
with profit = normal = 0 (monopoly does not operate efficiently)
Sources of Monopoly Power
Natural:
• Economies of scale and excess capacity
• Economies of scope and cost complementarities
• Capital requirements, sales and distribution networks
• Differentiated products and brand loyalty
Created:
• Patents and other legal barriers (licenses)
• Tying and exclusive contracts
• Collusion (tacit or open)
• Entry limit pricing (predatory pricing illegal)
Unrealistic? Why Learn?
• Many small businesses are “price-takers,” and
decision rules for such firms are similar to those of
perfectly competitive firms
• It is a useful benchmark
• Explains why governments oppose monopolies
• Illuminates the “danger” to managers of competitive
environments
• Importance of product differentiation
• Sustainable advantage
Profit Maximization for Total Measures
Industry D (TR) = Firm D (TR)
T is maximized:
• Where the slope of T is 0
(TR and TC are parallel
or their slopes are equal).
dT / dQ = M = 0
2 such points (Q1, Q3) need
additional condition:
2. d2T / dQ2 is negative or
max TR - TC => Q* = Q3.
Profit Maximization for per Unit Measures
T is maximized:
• At Q where MR = MC.
dT dTR dTC
M 


 MR  MC  0
dQ dQ dQ
2 points, need additional condition
•
MR < MC for any Q > Q* = Q3
(Q* is one of FONC candidates)
or when MC is increasing.
T = [(TR – TC)/Q]Q
= (AR – AC)Q = (P – AC)Q
Max T = area of the rectangle
= (AR|Q* - AC|Q*)Q*
= (P|Q* - AC|Q*)Q*
A Numerical Example
• Given estimates of
• P = 10 - Q
• C(Q) = 6 + 2Q
• Optimal output?
• MR = 10 - 2Q = 2 = MC
• Q = 4 units
• Optimal price?
• P = 10 - (4) = $6
• Maximum profits?
• PQ - C(Q) = 6(4) - (6 + 8) = $10
=0
Shut-Down Point
• In the long run all cost must be recovered.
• In the short run fixed cost incurred before
production begins and do not change regardless
of the level of production (even for Q = 0).
• Shut down only if: –TFC > T
(total)
AVC > P
(per unit).
• TFC = AFC*Q = (SAC – AVC)*Q
• Operate with loss if: 0 > T  –TFC
(total)
SAC > P  AVC (per unit).
• This is the third T maximizing condition.
Setting Price
$
TR
Firm small part of industry:
Industry D (TR) > Firm D (TR)
Firm’s D small segment of
upward slopping Industry D
$
Qf(units)
$
SM
Df = Pf = AR = MR
PM
DM
QM(106)
Market
Firm
Qf(units)
Choosing Output
• To maximize total profit: T = TR - TC
FONC: dT /dQ = M = MR - MC = 0
In general (including monopoly) MR = MC.
In perfect competition MR = P = MC.
• To maximize profit increase output (Q) until
1) MR = P = MC (at Q*), and
2) for Q > Q* => MC > P (or MC is increasing)
=> M < 0
=> TC < TR
• As long as:
max T ≥ -TFC
or
P ≥ AVC
A Numerical Example
• Given estimates of
• P = $10
• C(Q) = 5 + Q2
• Optimal Price?
• P = $10
• Optimal Output?
• MR = P = $10 = 2Q = MC
• Q = 5 units
• Maximum Profits?
• PQ - C(Q) = 10(5) - (5 + 25) = $20
Profit > Normal
Normal Profit
• Normal profit is necessary for the firm to produce over
the long run and is considered a cost of production
• Normal profit is required because investors expect a
return on their investment.
• Profit < normal leads to exit in the long run.
• Profit > normal leads to entry in the long run.
• Profit = normal maintains the # of firms in the industry.
Shutdown
Short-Run Supply
Under Perfect Competition
Effect of Entry on Market Price & Quantity
$
$
S
Entry
S*
Pe
Pe*
Df
Df*
D
QM
Market
Firm
Qf
• Short run profits leads to entry
• Entry increases market supply, driving down the market price
and increasing the market quantity
Effect of Entry on Firms Output & Profit
LMC
$
LAC
Pe
Df
Pe*
Df*
QL Qf*
• Demand for individual firm’s product and
hence its price shifts down
• Long run profits are driven to zero
Q
Perfect Competition in the Long Run
• Socially efficient output and price: MR = P = MC (no dead weight loss)
• Efficient plant size: P = MC = min AC (all economies of scale exhausted)
• Optimal resource allocation: T = Normal  = 0 because P = min AC
(because of no market power or free entry opportunity cost equals TR )
Price
Perfect Competition
Consumer
surplus
S = MC > min AVC
PPC
Producer
surplus
0
Efficient
quantity
QPC
D = P = MR
Quantity
Price
Inefficiency of Monopoly
PA
Consumer
surplus
S = MC > min AVC
PM
Deadweight
loss
PPC
Monopoly’s
gain
MR
0
QM
Producer
surplus
QPC
D=P
Quantity
Monopoly in the
Long Run with
Greater than Normal
and Normal Profit
• Socially inefficient: P > MR = MC
(QM<QPC, PM>PPC, dead weight loss)
• Scale inefficient: P > MC = min AC
(economies of scale still exist)
• Misallocated resources: even when
T = normal  = 0, P is still > min AC
(because of market power or barriers
to entry opportunity cost < TR)
• Encouraged R&D, benefits from natural
monopolies, economies of scope and cost
complementarity might offset inefficiencies
Synthesizing Example
C(Q) = 125 + 4Q2 => MC = 8Q is unaffected by market structure.
What are profit maximizing output & price, and their implications if
• You are a price taker, other
firms charge $40 per unit?
• You are a monopolist with
inverse demand P = 100 – Q?
• P = MR = 40 = 8Q = MC
• MR = 100 - 2Q = 8Q = MC
=> Q* = 5 and
P* = 40
=> Q* = 10 and
P* = 100 - Q = 100 - 10 = 90
• Max T = TR - C(Q*)
= 40(5) - (125+4(5)2)
= 200 - 225 = -$25
• Max T = TR - C(Q*)
= 90(10) - (125+4(100))
= 900 - 525 = $375
• Expect exit in the long-run
• No entry until barriers eliminated
Price (cents per kilowatt-hour)
Natural Monopoly
Economies of scale exist
over the entire LAC curve.
One firm distributes 4
million kWh at ¢5 a kWh.
15
This same total output costs
¢10 a kWh with two and
¢15 a kWh with four firms.
10
5
LAC
Natural monopoly: one firm
meets the market demand at
a lower cost than two or
more firms.
D=P
0
1
Public utility commission
ensures that P = LAC (not P
2
3
4
associated with MR = MC),
Quantity (millions of kilowatt-hours) eliminating monopoly rent.
Break-Even Analysis
Approximation in absence of
detailed data on revenue & costs.
Assume both TR & TC are linear.
At the Break-even output:
TR = TC = TVC + TFC
P*QBE = AVC*QBE + TFC
(P – AVC)*QBE = TFC
QBE = TFC / (P – AVC)
P = $6, AVC = $3.6, TFC = $60K
QBE = 60,000 / (6 – 3.6)
QBE = $25,000
(P – AVC) unit contribution margin.
1 – P/AVC contribution margin ratio
(fraction of P to recover TFC)