CHOOSING OUTPUT IN THE LONG RUN
Long-Run Competitive Equilibrium
Accounting Profit and Economic Profit
π = R − wL − rK
Zero Economic Profit
Firm is earning a normal return on its
investment, i.e.,
it is doing as well as it could
by investing its money elsewhere
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CHOOSING OUTPUT IN THE LONG RUN
Long-Run Competitive Equilibrium
• Firms Having Identical Costs
When all firms have identical costs, if too many firms enter the
industry for profit, industry SS curve will shift right, and P falls
• Firms Having Different Costs
When all firms do not have identical cost curves, distinction
between accounting and economic profit is important here,
For ex: if a patent is profitable, other firms in the industry will
pay to use it: increased value of a patent thus represents an
opportunity cost to the firm that holds it
CHOOSING OUTPUT IN THE LONG RUN
Long-Run Competitive Equilibrium
• The Opportunity Cost of Land
Firms earning positive accounting profit may be earning
zero economic profit, for example, a clothing store
happens to be located near a large shopping center. The
additional flow of customers can substantially increase the
store’s accounting profit because the cost of the land is
based on its historical cost
• Economic Rent
Amount that firms are willing to pay for an input less the
minimum amount necessary to obtain it
• PS in Competitive Market in LR:
PS that a firm earns on the output that it sells consists
of the economic rent that it enjoys from all its scarce inputs
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Output in the LONG RUN
Producer Surplus in the Long Run
Firms Earn Zero Profit in LR
• In LR equilibrium, all firms earn zero economic profit
• (a) IPL team in a moderate-sized city sells enough tickets so that P ($7)=MC= AC
• (b) Demand is greater in bigger city, so P ($10) is charged. Sales increases to the
point at which the AC of production + average economic rent is equal to P
• When the opportunity cost associated with owning the franchise is taken into
account, the team earns zero economic profit.
Price Determination in the Long Run
Firm can construct most appropriate scale of plant
least cost efficient production: minimum point on LRAC
Firm can enter or leave the industry for any profit/loss
Only Normal Profits in long run
in short run normal profit results unstable equilibrium
Least cost efficient production:
producing cheaply at minimum point on LRAC
competitors stay at minimum point on LRAC
Hall-Mark of Perfect Competition
firms operate at peak efficiency
intense competition
beneficial for the consumer
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Monopoly Markets ..!
Monopoly Market consists of one firm:
Firm is the market: sells all the industry output
no (close)substitutes
Monopolist
always with reference to region/geographical area
for ex: Doctor, Dry Cleaner or Medical Store
Differentiating by Regulated Monopoly
we had/have mostly govt. monopolies
Railways, Posts & Telegraphs & IOC for aviation
fuel (earlier Telephones)
regulations constrain the ability to price & fix output
Is Monopoly a Creation of Law ..!
Legal Restrictions
Railways, Airlines, Post & Telegraph, Public Utilities,
Atomic & Nuclear Power
Imposed through licensing, patency or copy rights
precludes other firms from producing same good
for ex: based on patents, when first introduced
DuPont had monopoly power in its production
Xerox had a monopoly on copying machines
Polaroid on instant cameras
Reynolds in ball-point pens
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Does Monopoly Emerge as a Control
Over Essential Resources ..!
Ownership of /Control Over Strategic Raw Materials
or., exclusive knowledge of production techniques
Oil, Coal, Iron Ores & Arable Land
for ex: DeBeers Diamond Company in South Africa
controls most of the world’s diamond production
American Tobacco Company (ATC)
controls 90 percent of US Tobacco production
Can you think of some private (nearly)monopolies in India?
Does Economies of Scale Induce Monopoly
Technology Exhibiting Substantial Economies of Scale
transport, electricity & communications
economies can be reached only at large scales of
output
Govt. provisioning to avoid exploitation of
consumers
Existing firms adopts limit pricing policy
combined
with
heavy
advertising/product
differentiation
creating new barriers to competition
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Does Economies of Scale Induce
Monopoly
Economies of Scale
for some industries economies of scale may operate
over a large range of outputs
but size of the market may not support more than one
plant of optimal size; supplying the entire market
such firm is called as NATURAL MONOPOLY
for ex: heavy industries: iron & steel, copper,
aluminum, & automobiles
high set up costs: fixed costs
profit enjoyed by increasing output
Monopoly Markets ..!
Characteristics
firm has the power to fix (control) the price
monopolist is “price-maker”
(P – MC): mark-up pricing
absence of substitutes: strong monopoly power
strength lies in successfully preventing others entry
Does a Monopolist can set price as s/he wishes to be?
“as much as I CAN” or “whatever market will bear”
firm’s ability to set its price is limited by the demand
curve for its product
depends on price elasticity of DD for its product
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Rule of Thumb Pricing: AR/MR/MC/Price
AR (DD curve) => downward sloping => P > MR
MR & Price Elasticity of Demand
MR = P + P(1/PeD)
MR & Price Elasticity of Demand
setting MR = MC => P + P(1/PeD) = MC
MR = P (1 – 1/PeD) = MC, So (P – MC)/P = –1/PeD
P = MC/(1 + 1/PeD)
Lerner Index of Monopoly Power
a monopolist price exceeds MC,
but by an amount that depends inversely on the PeD
L = (P – MC)/P = –1/PeD
L takes a value between 0 to 1
Profit Is Maximized When Marginal
Revenue Equals Marginal Cost
Chapter 10: Market Power: Monopoly and Monopsony
Q* level at which MR = MC.
For smaller output, Q1, it
sacrifices some profit because
the extra revenue that could be
earned from producing & selling
the units between Q1 and Q*
exceeds the cost of producing
them.
Similarly, expanding output from
Q* to Q2 would reduce profit
because the additional cost
would exceed the additional
revenue.
The Monopolist’s Output Decision
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e.
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Price & Output Determination ..!
What then sets the limit to pricing for a Monopoly?
assume firm’s DD is downward sloping linear curve
if P falls => MR from sale of additional units falls
MR reaches zero & becomes negative
assume MC is constant in short run
if firm charges ‘too high’ a price, P1, MR > MC
but firm will be forgoing some amount of marginal
profit
if firm sets at a ‘lower level’
MC > MR => firm will experience a marginal loss
price elasticity of demand for its product guides
Price & Output Determination ..!
Price Setting
ability of monopoly to set its price is further limited
by the possibility of rising MCs of production
increasing MC > decreasing MR
firm that exercises a monopoly power over its price
should not set its price at the highest possible level
Right Level: it should set at the ‘right level’
what is right level?
MR = MC
Monopoly automatically earns economic profit
either in short run or in long run
‘whether or not profit’ depends on DD
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Monopolist Produces on the Elastic
Region of DD Curve
Price increases
from PA to PB:
Change in TR:
Area I – Area II
Revenue Increases
& Cost Decreases
Increasing MC
in Relation to Decreasing MR
MR = MC Rule for a Monopoly
Rs.
MC
AC
Profits
DD
MR
Q
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