1.6 Perfect Competition
** This note is summarized by Hui Wang.
Important reference Study Guides of Stalla Review for CFA Exams
Learning Outcomes
The candidate should be able to:
a. describe the characteristics of perfect competition, explain why firms in a
perfectly competitive market are price takers, and differentiate between market
and firm demand curves;
b. determine the profit maximizing (loss minimizing) output for a perfectly
competitive firm, and explain marginal cost, marginal revenue, and economic
profit and loss;
c. describe a perfectly competitive firm’s short-run supply curve and explain the
impact of changes in demand, entry and exit of firms, and changes in plant size on
the long-run equilibrium;
d. discuss how a permanent change in demand or changes in technology affect price,
output, and economic profit.
The characteristics of perfect competition
The four key characteristics of perfect competition are:
(1) There are a large number of small firms in the market;
(2) The firms in the market all produce identical products;
(3) The firms have complete freedom of entry into or exit out of the industry;
(4) The firms in the market have perfect knowledge of prices and technology.
The above four characteristics mean that a given perfectly competitive firm is
unable to exert any control whatsoever over the market.
Market price in perfect competition
In a perfectly competitive industry, the market price is determined by the
intersection of the market demand curve and market supply curve. To determine
the equilibrium price and quantity, we need to find the price at which market
supply equals market demand.
Economic profit and revenue
Economic profit is the difference between total revenue and total cost. Total cost
is the opportunity cost of production, which includes normal profit, the minimum
profit necessary to attract and retain suppliers in a perfectly competitive market.
Note that only normal profit could be earned in perfectly competitive markets.
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A firm’s total revenue (TR) is the total money received from the sale of any given
quantity of output. It is calculated by taking the price of the sale times the quantity
sold. A firm’s marginal revenue (MR) is the change in total revenue resulting
from one additional unit of product sold.
The output decision of a perfectly competitive firm
Suppose a firm’s profit is π, then we have:
π= TR－TC
To find the quantity of output that will maximize the firm’s profit, we need to take
derivative of π with respect to Q and sets the result zero,
so,
Therefore, a firm that is seeking to maximize its profit should produce at the point
where its marginal revenue equals its marginal cost. Furthermore, the market price
a perfectly competitive firm faces equals its marginal revenue (the marginal
revenue of the firm is
).
Profit and losses in the short-run
In the short-run, a given perfectly competitive firm may not always achieve
maximum profit even if it satisfy the profit-maximizing rule (P=MC). It may incur
an economic loss or it may break even.
When a perfectly competitive firm incurs economic loss in short-run, it cannot
alter the scale of plant, all it can do is to produce at a loss or discontinue
production. It should be noted that even the firm shuts down a plant, it still incur
fixed costs. Whether the firm should shut down its plant depends on the
relationship between the market price and average variable cost. If the market
price is larger than the average variable cost, the firm’s revenue is greater to its
total variable costs, then the firm can use the additional revenue to pay down its
fixed costs. On the contrary, if the market price is less than the average variable
cost, the firm’s revenue is even not sufficient to compensate its variable cost, let
alone its fixed cost. Under this condition, the firm should stop production to avoid
incurring any variable costs. Shutdown point is a point of operations where a firm
is indifferent between continuing operations and shutting down temporarily. The
shutdown point is the combination of output and price where a firm earns just
enough revenue to cover its total variable costs.
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Short-run supply curve of the firm and industry
Price per
unit
of output
Marginal cost
P3
Average total cost
Average variable cost
P2
P1
0
Q1
Q2 Q3
Output
The short-run industry supply curve shows the quantity supplied by the industry at
each price when the plant size of each firm and the number of firms remain
constant. The quantity supplied at each market price in the industry is the sum of
the quantities supplied by all firms in the industry at that market price.
Long-run equilibrium of perfectly competitive firms
The long-run equilibrium position of the firm is at the point where its long-run
average total cost (or long-run average cost, because there is no fixed cost in the
long-run) curve equals the market price.
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Price
Long-run marginal
cost curve
Short-run average
cost curve
Long-run average
cost curve
Demand curve
Short-run marginal
cost curve
Q*
Quantity of output
Let’s summarize: in the long-rum equilibrium, the short-run marginal cost curve,
the long-run marginal cost curve, the short-run average cost curve, the long-run
average cost curve of a perfectly competitive firm all intersect with market price
at the same point, which is also the minimum point of the short-run average cost
curve and the long-run average cost curve.
Constant-cost industry and increasing-cost industry
A constant-cost industry is one whose long-run supply curve is horizontal at the
constant (average) cost of production. When the industry expands or contracts, the
long-run average cost of production does not change.
In an increasing-cost industry, the long-run industry supply curve is upwardsloping because expansion of the industry causes higher production cost and
resource prices. The primary reason for an increasing-cost industry is that an
increase in demand triggers higher production cost and an upward shirt of the
long-run average cost curve as new firms entering the industry drive up the prices
of key producing resources.
A decreasing-cost industry is one where the industry’s long-run supply curve is
downward-sloping: as the industry produces more output, the minimum average
cost of production for each firm decreases with the decrease in costs. It should be
noted that firms in a decreasing cost industry do not necessarily have economies
of scale in production; the decrease in costs may reflect lower input costs which
reduce the minimum level of the average cost as the industry expands. Input price
may decline as the industry expands if there are economies of scale in the
production of an important input.
Firms in an increasing-cost industry are experiencing external diseconomies,
which are external factors outside the control of a particular firm that raise the
firm’s costs as output in the rest of the industry increases. On the other hand, firms
in a decreasing-cost industry are experiencing external economies, which are
external factors outside the control a particular firm, and encompass positive
externalities that reduce the firm’s costs.
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Efficiency of a perfectly competitive economy
A perfectly competitive market is good for society because it forces firms to
achieve maximum efficiency (productive and allocative efficiency).
(1) Productive efficiency(P= minimum average total cost):
a. In the long-run equilibrium, firms in a perfectly competitive industry
produce at the minimum level of long-run average cost.
b. Consumers benefit from productive efficiency by paying the lowest
possible price under the prevailing technology constraint.
c. Firms in a perfectly competitive industry can only make a normal profit
(no economic profit) in the long-run, and normal profit is part of its
economic costs which is incorporated in its average total cost curve.
(2) Allocative efficiency (P=marginal cost)
a. In a perfectly competitive industry, resources are apportioned to firms in
such a way that only the most desirable products and services are produced.
b. In a perfectly competitive industry, net gains for the society cannot be
increased by altering the combination of goods produced. Put another way,
it is impossible to make someone better off without anyone else becoming
worse off.
c. Perfectly competitive markets can restore efficiency when disrupted by
changes in the economy, e.g. change in consumers’ tastes, raw materials
supply shock, or technology advances.
(3) Maximum consumer and producer surplus:
a. A level of output at which P=MC=lowest ATC, MR=MC, maximum
willingness to pay= minimum acceptable price, and combined consumer
and producer surplus are maximized.
Disadvantages of perfect competition
Although perfect competition is efficient in allocating resources, it has some
disadvantages:
(1) No scope for economies of scale: a lot of small firms in the industry are
producing relatively small amounts each. Industries with high fixed costs
would be particularly unsuitable to perfect competition.
(2) Undifferentiated products: products in a perfectly competitive industry are
identical and leave consumers with very limited choice.
(3) Lack of incentive for R&D: because in the long run, no firm in an perfectly
competitive industry can make abnormal profit, thus firms may not want to
invest in R&D.
(4) Externalities: if there are externalities in production or consumption there is
likely to be market failure without government intervention.
1.7 Monopoly
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Learning Outcomes
The candidate should be able to:
a. describe the characteristics of a monopoly, including factors that allow a
monopoly to arise, and monopoly price-setting strategies;
b. explain the relation between price, marginal revenue, and elasticity for a
monopoly, and determine a monopoly’s profit-maximizing price and quantity;
c. explain price discrimination, and why perfect price discrimination is efficient;
d. explain how consumer and producer surplus are redistributed in a monopoly,
including the occurrence of deadweight loss and rent seeking;
e. explain the potential gains from monopoly and the regulation of a natural
monopoly.
Characteristics of a monopoly
The four key characteristics of monopoly are:
(1) A single firm selling all output in a market.
(2) A unique product.
(3) Restrictions on entry into and exit out of the industry. A monopoly is generally
assured of being the only firm in a market because of following entry barriers:
a. Government license or franchise
b. Resource ownership
c. Patents and copyrights
d. High start-up cost
e. Decreasing average total cost.
(4) Specialized information about production techniques unavailable to other
potential producers.
Pricing and output decisions in monopoly
Under monopoly, profit maximizing rule that firms should set output at the point
where marginal cost equals marginal revenue also applies.
It should be noted that unlike firms in a perfectly competitive market, a
monopolist’s marginal revenue is no longer constant; nor is it equal to price. For
firms in either perfectly competitive market or a monopolistic market, we have
TR=P*Q
Then
Where MR is marginal revenue, P is price, and η is the price elasticity of demand.
For a monopolist, the demand curve it faces is downward sloping (a monopolist’s
demand curve is also the market demand curve, so just as the market demand curve
is downward sloping, a monopolist’s demand curve is also downward sloping), it
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has a negative finite η. Therefore, a monopolist’s marginal revenue is smaller than
the market price it faces.
In addition, a monopolist that seeks to maximize profit will not product where
marginal revenue is negative. With negative marginal revenue, selling another unit
of output will decrease total revenue. Furthermore, for the marginal revenue to be
negative, it requires η > －1. This means that a monopolist will not produce in the
inelastic range of its demand curve if it is maximizing profit.
Relative to perfectly competitive firms, a monopolist chooses a lower output and a
higher price. This higher price exceeds the monopolist’s marginal cost and thus
allows the monopolist to make economic profit.
Efficiency comparison
Under the perfectly competitive equilibrium, marginal social cost equals marginal
social benefit and the sum of consumer surplus and producer surplus is maximized;
firms are each producing at the lowest possible long-run average cost; the
allocation of resources are efficient. Under the monopolist equilibrium, the price a
monopolist charges is larger than the marginal social cost, the consumer surplus is
eroded by both producer surplus and deadweight loss; the allocation of resources is
not efficient.
Price discrimination
Price discrimination occurs when the same product is sold at more than one price.
Essentially there are two main conditions required for discriminatory pricing:
a. Differences in price elasticity of demand between markets
b. Barriers to prevent re-sell
There are three kinds of price discrimination:
(1) First-degree price discrimination, also known as perfect price discrimination.
Firm charges each buyer a price equal to that buyer’s maximum willingness to pay
(i.e. reservation price). The market is still efficient under first-degree price
discrimination.
(2) Second-degree price discrimination. Firm offers consumers different bundles
with different prices and the consumer selects the most preferred bundle. Seconddegree price discrimination is most common in utility pricing.
(3) Third-degree price discrimination. Firms charges different prices to different
groups of buyers. Three conditions must hold true for third-degree price
discrimination to succeed: 1) demand must be heterogeneous; 2) price
discriminator must be able to identify and segregate the different segments; 3)
markets must be successfully sealed.
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A firm that uses third-degree price discrimination should allocate in such a way
that the marginal revenue of both classes is equal. When this is true, the ratio of
the price in the first class to that in the second class equals
Where η1 is the price elasticity of demand in the first class and η2 is that in the
second class.
Gains from monopoly
Although relative to perfect competition, monopoly tends to produce a
combination of low output and high price, there can be some potential social
advantages result from monopoly:
(1) Incentives to innovation.
(2) Economies of scale and economies of scope.
Rent seeking
Economic rent is a measure of market power: the difference between what a factor
of production is paid and how much it would need to be paid to remain in its
current use. According to this definition, producer surplus is also a form of
economic rent.
In perfect competition, there are no economic rents, as new firms enter a market
and compete until prices fall to the extent that there is no economic rent at all.
Reducing rent does not change production decisions, so economic rent can be
taxed without any adverse impact on the real economy, assuming that it really is
rent.
Regulating natural monopoly
(1) Marginal cost pricing
A marginal cost pricing rule is imposed when the price regulator wants the
monopoly industry to achieve an efficient allocation of resources as the perfectly
competitive industry does.
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Price
and
cost
LRAC
Profit maximizing
P1
Marginal cost pricing
P2
MC
MR
0
Q1
D
Q2 Quantity of output
Without regulation, a monopolist chooses to produce at the quantity Q1 where its
marginal cost equals its marginal revenue; and charges a price P1. Under the
marginal cost pricing rule, the monopolist will have to produce the quantity Q2
and set the price of its product at P2. The marginal cost pricing rule is efficient,
because it sets marginal social cost equal to the marginal social benefit
(represents by the demand curve). But it should be noticed that, under marginal
cost pricing rule, the monopolist is incurring economic loss.
Usually, there are two ways for the monopolist’s to cover its cost under marginal
cost pricing rule: 1) pricing discrimination; 2) two-part tariff. However, it is not
always possible for a monopolist that is subjected to price regulation to cover its
loss in these ways, and this is where the government steps in to give the
monopolist a subsidy.
(2) Average cost pricing
The government sometimes uses the average cost pricing rule as an alternative to
regulate monopolist’s pricing behavior.
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Price
and
cost
LRAC
Profit maximizing
P1
Average cost pricing
P2
MC
0
Q1
MR
Q2 Quantity of output
Under average cost pricing rule, the price that a monopolist can charge is set to
equal to its total average cost, which is lower than its profit-maximizing price, but
the quantity of output is higher than its profit-maximizing output lever.
Consumers can benefit from the average cost pricing rule, because now they can
buy more goods or services at a lower price.
1.8 Monopolistic competition and Oligopoly
Learning Outcomes
The candidate should be able to:
a. describe the characteristics of monopolistic competition and an oligopoly;
b. determine the profit-maximizing (loss-minimizing) output under monopolistic
competition and an oligopoly, explain why long-run economic profit under
monopolistic competition is zero, and determine if monopolistic competition is
efficient;
c. explain the importance of innovation, product development, advertising, and
branding under monopolistic competition;
d. explain the kinked demand curve model and the dominant firm model, and
describe oligopoly games including the Prisoners’ Dilemma.
Characteristics of monopolistic competition
(1) Product differentiation.
(2) Relatively large number of sellers.
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(3) Easy entry and exit.
(4) Advertising.
Producing and pricing decisions under monopolistic competition
Because each firm in monopolistic competition produces a somewhat different
product, it faces a downward-sloping demand curve, which means that if the firm
raises its price slightly, it will lose some of its customers to other firms.
MC
Price
and
cost
P*
Economic
profit
ATC
Marginal revenue
=marginal cost
MR
0
Q*
Quantity of output
Firms in monopolistically competitive market also choose to produce at the point
where marginal revenue equals marginal cost. However, there is no guarantee that
a monopolistically competitive firm will make economic profit in the short run.
The short-run equilibrium for a monopolistically competitive firm can also be the
point where the firm minimizes its loss.
At the long-run equilibrium point, a monopolistic firm’s marginal cost equals
marginal revenue. The equilibrium price also equals the firm’s average total cost at
this point, thus the firm can only make normal profit and its economic profit is zero.
Efficiency of monopolistic competition
A monopolistically competitive firm chooses to produce at the point where its
average total cost is still decreasing. We say the firm has excess capacity if it
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produces below its efficient scale, which is the output level that minimizes its
average total cost.
Another thing needs to be noticed is that unlike perfect competition, where a firm’s
marginal cost equals the market price, a firm in monopolistic competition faces a
market price that is larger than its marginal cost. The difference between the
market price and the firm’s marginal cost is the firm’s markup. It seems the
markup has made consumers worse off because they need to pay a price that is
higher than the firm’s marginal cost. But the markup arises from product
differentiation and people value variety. The efficient degree of product variety is
the one for which the marginal social benefit of product variety equals its marginal
social cost.
Product development and marketing
The threat of new entrants makes firms in monopolistic competition keep trying to
develop new products. But innovating or developing a new product is a costly
activity. The firm needs to carry out the innovation and development to such a
degree that the marginal revenue the firm can get from developing a new product
equals the marginal cost to develop that new product.
However, the firm’s product development decision may not act in the best interest
of the society. For a firm’s production decision to benefit the society as a whole,
the marginal social benefit of the firm’s new or improved product must equal its
marginal social cost. We can use the price that consumers are willing to pay for a
new product as the marginal social benefit. As we’ve shown previously, a
monopolistically competitive firm’s marginal revenue is less than the market price,
therefore its product development may be below the efficient level. At the same
time, a firm’s R&D activities usually can generate external economies, that is other
firms can also benefit from a specific firm’s innovation.
Another thing with monopolistic competition is advertising. The quantity a firm
sells of its product is assumed to be a function of its price and the level of its
advertising expenditures. Furthermore, we assume that each additional dollar spent
on advertising yields smaller and smaller increases in sales-that is the advertising
expenditures exhibit diminishing marginal returns. How much should a profitmaximizing firm spend on advertising? The firm should set advertising
expenditures at the level where an extra dollar of advertising results in extra gross
profit equal to the extra dollar of advertising cost. Unless this is the case, the firm
can increase the firm’s total net profit by changing advertising expenditures. Firms
use advertising as a way to send signal to the consumers that their products are of
high-quality. Many firms also spend a lot of money to create and promote a brand
name. They rely on the brand name to transfer the quality information of their
products to consumers.
Selling costs and total cost
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Selling cost is the total cost of marketing, advertising, and selling a product. The
selling costs are fixed costs and do not vary with the quantity that a firm actually
sells. With the advertising activities and sales-promoting activities, the total cost
curve of a monopolistically competitive firm is above that of a similar but perfectly
competitive firm.
Suppose advertising is effective, then more firms will survive in the market by
advertising, this will finally decrease the demand faced by any single firm and
make the demand for any one firm’s product more elastic. The total effect of
advertising would be the upward shift of total cost curve and a decrease in markup
and the product’s price.
Characteristics of oligopoly
(1) Small number of large producers.
(2) Identical or differentiate products.
(3) Barriers to entry. As with natural monopolies, oligopolies usually stem from
some natural or legal barriers: 1) exclusive resource ownership; 2) patents and
copyrights; 3) government restrictions; 4) high start-up cost.
The kinked demand curve model
One traditional oligopoly model is the kinked demand curve model, in which each
firm believes that if it decreases its product’s price, its rivals will do the same; if it
raises its product’s price, its rivals will not follow.
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Price
and
cost
MC2
P
MC1
A
B
MR
0
Q
D
Quantity of output
Each firm in the oligopoly faces two market demand curves for its product. At high
prices, the firm faces the relatively elastic market demand curve, while at low
prices, the firm faces the relatively inelastic market demand curve. The kink in the
demand curve creates a break in the marginal revenue curve. As long as marginal
cost fluctuates between A and B, like the marginal cost curves MC1 and MC2, the
firm does not have incentive to change its price and its output.
One problem with the kinked demand curve model is that the model can only
explain observed phenomenon and is not predictive: the kinked demand curve only
suggests why prices remain sticky but gives no explanation about the mechanism
that establishes the kink and how the kink can reform once prices change. Another
problem is that when marginal cost increases by enough to cause the firm to
increase its price and if all other firms in the industry face the same increase in
marginal cost, they will all increase their prices together. This contradicts the
model’s assumption which states that each firm believes its rivals will not follow
its action when it increases its price.
Dominant firm oligopoly
The dominant firm model is the model that in some oligopolistic markets, one
large firm has a major share of total sales, and a group of smaller firms supply the
remaining demand of the market. The large firm has power to set a price that
maximizes its own profits. A dominant firm exists because it has lower marginal
cost than the other fringe firms.
Some basic concepts in game theory
Game theory is the study of the ways in which strategic interactions among rational
players produce outcomes with respect to the preferences of those players.
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(1) Game, all situations in which a participant act to maximize his or her utility
through anticipating the responses to his or her actions by one or more other
participants.
(2) Player, the entity that makes decisions in a game.
(3) Utility, the amount of welfare a player derives form the result of a game.
(4) Strategy, predetermined “program of play” that tells the player what actions to
take in response to every possible strategy other players might use.
(5) Payoffs, are numbers which represent the motivations of players. Payoffs may
represent profit, quantity, utility, or other continuous measures (cardinal
payoffs), or may simply rank the desirability of outcomes (ordinal payoffs).
(6) Payoff matrix, a table that shows the payoffs for every possible action by each
player for every possible action by each other player.
(7) Outcome, a set of moves or strategies taken by the players, or their payoffs
resulting from the actions or strategies taken by all players.
Prisoner’s dilemma
Imagine two criminals arrested under the suspicion of having committed a crime
together. However, the police do not have sufficient proof in order to have them
convicted. The two prisoners are isolated from each other. The two prisoners in
the game can choose between two strategies, either “confess” or “deny”. The idea
is that each player gains when both of them deny, but if only one of them denies,
the other confesses, the prisoner that confesses can gain more. If both of them
confess, both will lose. The dilemma resides in the fact that each prisoner has a
choice between only two options, but cannot make a good decision without
knowing what the other one will do.
Since the prisoners cannot communicate to each other, they both choose to
confess. Although the payoff for each player is worse than that if they both deny,
but this is the best choice when they do not know if they can trust the other
prisoner.
The conclusion drawn from “prisoner’s dilemma” can easily be applied to the
pricing behavior of firms in an oligopoly. Suppose there are only two firms in
some certain industry, and they have reached a collusive agreement to form a
cartel to restrict output, raise the price, and increase profits. The strategies that
each firm faces are comply and cheat. Although the profits for the cartel can be
maximized when each firm choose to comply, each firm has an incentive to cheat.
And the cartel ended up with the lowest profit with both firm cheating.
Dominant strategy
A strategy is dominant if, regardless of what any other players do, the strategy
earns a player a larger payoff than any other strategy. Therefore, a strategy is
dominant if it is always better than any other strategy, for any profile of other
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players’ actions. For example, the confess strategy in the prisoner’s dilemma is a
dominant strategy.
Nash equilibrium
A Nash equilibrium, named after John Nash, is a set of strategies, one for each
player, such that no player has incentive to change his or her action unilaterally.
Players are in equilibrium if a change in strategies by any one of them would lead
that player to earn less than if he or she remained with his or her current strategy.
Repeated game
When players interact by playing a similar stage game numerous times, the game is
called a repeated game. Unlike the games played once, a repeated game allows for
strategy to be contingent on past actions, thus allowing for reputation effects and
retribution. In infinitely repeated games, trigger strategies such as tit for tat can
encourage cooperation.
A trigger strategy is one in which the player initially cooperates but punishes the
opponent if a certain level of defection (i.e., the trigger) is observed. The level of
punishment and the sensitivity of the trigger vary with different trigger strategies:
a. Tit for tat, the punishment continues as long as the other player defects.
b. Tit for two tats, a forgiving strategy that punishes defects only when the
opponent has defected twice in a row.
c. Grim trigger, the punishment continues indefinitely after the other player
defects just once.
In a repeated game, one player’s defect will be punished in the next game, it is
more rational for the player chooses not to defect, which makes a cooperative
equilibrium more possible.
Sequential game
A sequential game is one in which players make decisions (or select strategies)
following a certain predefined order, and in which at least some players can
observe the actions of players who preceded them. If no players observe the
actions of previous players, then the game is simultaneous. If every player
observes the actions of every other player who has gone before him or her, the
game is one of perfect information. If some (but not all) players observe prior
actions, while others move simultaneously, the game is one of imperfect
information. Sequential games are represented by game trees and solved using the
concept of rollback, or subgame perfect equilibrium.
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Exercise Problems: (provided by Stalla PassMaster for CFA Exams.)
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EXPLANATION
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