Chapter 5
Perfect Competition, Monopoly
and Economic Vs Normal Profit
Chapter Objectives
After reading this chapter you should be able to
 Distinguish between perfect competition and monopoly and between normal and
economic profit.
 Understand why economic profit disappears under perfect competition but not
under monopoly.
 Know why, under perfect competition, the supply curve from Chapter 2 is
marginal cost.
From Perfect Competition to Monopoly
•Perfect Competition
•Monopolistic Competition
•Oligopoly
•Monopoly
Picking Quantity to Maximize Profit: Comparing Monopoly and Perfect
Competition
Drawing Tips
1) There will be two diagrams side by
side.
2) Draw an MC-ATC-AVC set of cost
curves.
Teaching Tips
1) Alert students to the side-by-side
nature of the graphs.
2) Alert students to draw this graph
big.
Drawing Tip
1) Draw in a Marginal Revenue
curve.
2) Label the quantity where
MC=MR as Q*
3) Label the Price as P*
Drawing Tips
1) Draw in the second graph.
2) Draw the same MC-ATC-AVC
set of cost curves.
Drawing Tips
1) Draw in the Downward sloping
demand curve.
2) Draw the MR curve (making sure
to cut the horizontal intercept of
D in half).
Teaching Tip
Remind students of 2) above.
Drawing Tip
1) Mark the quantity where MC=MR
as Q*
2) Go up to the demand curve to get
P*
Teaching Tip
1) Be sure to emphasize that the
quantity is where MC=MR, NOT
THE PRICE
2) Emphasize that price is read off the
demand curve.
Characteristics of Perfect Competition
•a large number of competitors, such that no one firm can influence the price,
•the good a firm sells is indistinguishable from the ones its competitor sells,
•firms have good sales and cost forecasts
•there is no legal or economic barrier to its entry into or exit from the market
Teaching Tip
Let students discuss the kinds of firms that match these assumptions. Go through several industries trying
to see if the assumptions for perfect competition are satisfied in that industry.
Other Market Forms
Monopoly



The sole seller of a good or service.
Some monopolies are generated because of legal rights (patents and copyrights).
Some monopolies are utilities (gas, water, electricity etc.) that result from high fixed
costs.
Monopolistic Competition

Monopolistic Competition: a situation in a market where there are many firms
producing similar but not identical goods.
 Example : the fast-food industry. McDonald’s as a monopoly on the “Happy
Meal” but has much competition in the market to feed kids burgers and fries.
Oligopoly


Oligopoly: a situation in a market where there are very few discernible competitors
Examples
 Satellite TV service (Direct TV, Dish Network)
 Airlines (American, Delta etc.)
Which Model Fits Reality?



Perfect competition is rare outside agriculture though it fits some labor markets.
Monopolies are common in utilities
Major branded companies are typically either in oligopolistic or monopolistically
competitive industries.
Teaching Tips
1) Go back to the idea of the simplifying assumption from Chapter 1 and let students discuss
whether using Perfect Competition for models is a good use of that concept for an issue
like Rent Control or Minimum Wage.
2) Begin to get students comfortable with the ease-of-understanding vs. realism tradeoff that
exists.
Table 1
Examples of Different Market Forms
Perfect Competition
1) Agricultural
Products
2) Lumber
Monopolistic
Competition
1) Fast Food
2) Long Distance
Service
Oligopoly
Monopoly
1) Cars and Trucks
2) Soft Drinks
1) Operating Systems
2) Local residential
electric power
Table 2
Distinguishing Characteristics Between Market Forms
Perfect
Monopolistic
Oligopoly
Competition
Competition
Number of Firms Many-often
Several*
Few*- usually
thousands or
two to five
even millions
Barriers to Entry None
Few
Substantial
Monopoly
One
Insurmountable,
at least in the
short run
NA
Product
Identical
Similar but not
Similar or
similarity
identical
Identical
* there is dispute as to the line that separates Monopolistic Competition and Oligopoly
Concentration Ratios


there is no magic line that separates oligopoly from monopolistic competition.
a “concentration ratio” measures the percentage of total market sales for the top
firms (from 4 firms to 100 firms).
Table 3
Concentration Ratios For Various Manufacturing Industries
Industry Group
Concentration Ratios
4 Largest Firms
8 Largest Firms
50 Largest Firms
Breakfast Cereals
92.9%
93.5%
100.0%
Ice Cream
32.3
48.7
88.3
Beer
89.7
93.4
96.7
Clothing
17.6
23.2
38.8
Computers and
37.0
52.1
86.3
Peripherals
Furniture
11.2
17.6
37.2
Long Distance
47.0
74.9
95.4
Cellular Service
51.4
74.6
88.0
Sources: http://www.census.gov/epcd/www/concentration.html
http://www.census.gov/epcd/www/pdf/97conc/c97s51-sz.pdf
Supply Under Perfect Competition
Normal vs. Economic Profit


Normal Profit : the level of profit that business owners could get in their next
best alternative investment
Economic Profit: any profit above normal profit
Teaching Tip
Try to get students to see that for a small business owner “normal profit” would be how much they
would earn working for someone else plus the interest they would get on the money they invested in
their business.
Industry
Table 4
Return of Equity for Corporations In Various Industries
1997
Rate of Return*
Agriculture
Manufacturing
Transportation and Public Utilities
Wholesale and Retail Trade
8.2%
14.5%
9.3%
13.3%
* (Net Income/(Assets-Liabilities))
When and Why Economics Profit Go to Zero
Time Horizons


Short Run: the period of time where we cannot change things like plant and
equipment
Long Run : the period of time where we can change things like plant and
equipment
Market Forms and Economic Profit

Under Perfect Competition or Monopolistic Competition economic profits go to
zero because of the entry of new firms increases market supply and lowers prices.
 Economic Profits are under no pressure to shrink under Oligopoly or Monopoly
because entry doesn’t occur so prices do not fall.
Teaching Tips
If you have agriculture students or “farmer’s kids” in your class let those students discuss what would
happen if a certain crop began to be highly profitable. Get them to see that entry would drive price
lower and economic profits to zero.
Pressure on Price in Perfect Competition
Drawing Tip
Draw an ATC-AVC-MC diagram
Drawing Tips
1) Put an MR line lower than the
minimum of AVC.
2) Note that there would be upward
pressure on price in both the short
run (the short arrow) and the long
run (the longer arrow).
Drawing Tips
1) Put an MR line lower than the
minimum of ATC but above the
minimum of AVC.
2) Note that there would not be
upward pressure on price in the
short run (no short arrow).
3) Note that there would be upward
pressure on price in the long run
(the long arrow).
Teaching Tip
Remind students why there is not short run
pressure, i.e. that firms would stay in
business at this price because they are losing
less than their fixed costs.
Drawing Tips
Put an MR line right at the minimum of
ATC.
Teaching Tip
Note that there would not be upward
pressure on price in either the short run
or long run.
Drawing Tips
1) Put an MR line above the minimum
of ATC.
2) Note that there would be downward
pressure on price in both the short
run (the short arrow) and the long
run (the longer arrow).
Points of Production in Perfect Competition
Drawing Tip
Draw a ATC-AVC-MC diagram.
Drawing Tips
1) Draw an MR line lower than the
minimum of AVC.
2) Mark the point on the vertical axis on
that MR line.
Teaching Tip
Note that the reason for the point in 2) above is
that the firm shuts down.
Drawing Tips
1) Draw an MR line between the
minimum of ATC and AVC
2) Place a point where MC=MR
Drawing Tips
1) Draw an MR line at the minimum of
ATC
2) Place a point where MC=MR
Drawing Tips
1) Draw an MR line above the
minimum of ATC.
2) Place a point where MC=MR
Teaching Tip
Emphasize that above the minimum of AVC you are simply placing points on MC.
Supply is Marginal Cost out of the Minimum of AVC
Drawing Tips
1) Draw an ATC-AVC-MC
diagram
2) Darken the portion of the MC
curve above the minimum of
AVC and label that supply.
Back of the Chapter Questions
Question 1) For a monopolist
a) Price equals Marginal Revenue.
b) Price is less than Marginal Revenue.
c) Price is greater than Marginal Revenue.
Question 2) For a market to be characterized by perfect competition there must be
a) a large number of firms with no one able to influence price.
b) freedom of entry and exit.
c) indistinguishable products being sold.
d) all of the above
Question 3) There will be long-run pressure on the price to fall whenever
a) P>ATC
b) P=ATC
c) P<ATC
d) P<AVC
e) c) and d)
Question 4) Normal Profit is what a firm
a) usually makes.
b) needs to make to maintain the incentive to remain in the industry.
c) is zero in the long run.
d) a) and b)
Question 5) For a Perfect Competitor
a) Price equals Marginal Revenue.
b) Price is less than Marginal Revenue.
c) Price is greater than Marginal Revenue.
Question 6) The assumption under perfect competition of a “homogeneous product”
means that
a) the good one firm produces is exactly the same as the good another firm
produces.
b) the good one firm produces is very different from the good another produces.
c) that no firm can charge more than another for its product.
d) that no buyer will pay more for one firm’s good than another’s.
Question 7) The assumption under perfect competition of a firm that has no market power
means that
a) that firms are free to leave the market any time and there is no power keeping
them there.
b) the good one firm produces is very different from the good another produces.
c) the good one firm produces is exactly then same as the good another firm
produces.
d) that no buyer will pay more for one firm’s good than another’s.
Question 8) The fast food industry can be modeled best using the model of
a) monopolistic competition.
b) oligopoly.
c) perfect competition.
d) monopoly.
Question 9) The local residential electrical power industry can be best model using the
model of
a) monopolistic competition.
b) oligopoly.
c) perfect competition.
d) monopoly.