INDUSTRIAL
ORGANIZATION
PERFECT COMPETITION
Chapter 12
Costs and Supply Decisions
• How much should a firm supply?
• Firms and their managers should attempt to maximize profits
(Profits = Revenues – Costs)
• Select a pricing strategy that induces a demand for a product that
generates highest revenue relative to the cost of production of that
level of supply.
• Profits depends on response of revenues to changes in
production quantities.
Perfect Competition/ Price Taking
• We think of some markets as characterized by perfect
competition
• In competitive markets, no firm has the market power to set their
own price.
• Firms in perfectly competitive markets take their price as
given.
China Price Download
Characteristics of Competitive
Markets
• Non-differentiated goods
• Large number of firms
• All firms are small relative to the market
• Free entry and exit.
MES and Market
Structure
$
•
•
•
•
Non-differentiated goods
Large number of firms
All firms are small relative to the market
Free entry and exit.
Many “small” firms
in the market.
Q
• If MES is relatively small in comparison with market demand:
Revenues and Perfect
Competition
• Revenues = Price * Quantity
• Average Revenue = Price
• Marginal Revenue is the extra revenue generated by
selling an extra good.
• If production by a firm doesn’t shift the price, marginal revenue is
the price.
• In competitive markets, MR = P.
Profit Maximization: Short Run
• In the short-run, firm may only have a limited number of
avenues along which they may vary production.
• Cost of producing each good is likely to increase. But as long
as the extra revenue that the good brings in exceeds the
extra cost, it will be profitable to produce it.
• Maximize profits by producing up to that point that marginal
cost rises to the price. Beyond that, producing more goods
only subtracts from profits.
P
Produce Less
>
=
<
Produce More
MC
Increase Production until
marginal cost reaches the price level.
P
MC
Total Costs are ATC*Q
P
Profits
ATC
Revenues
Costs
Q*
Revenues are price × quantity
Q
Profits = Revenues - Costs
Profit Maximization: Price is 80
Output
Average
Total
(Loaves)
Costs
2.00
535
10.00
115
20.00
75
30.00
68
40.00
70
50.00
75
60.00
82
Marginal
Marginal
Costs Revenues Revenues Profits
160.00
-910.00
15.00
80.00
800.00
-350.00
35.00
80.00
1600.00
100.00
55.00
80.00
2400.00
350.00
75.00
80.00
3200.00
400.00
95.00
80.00
4000.00
250.00
115.00
80.00
4800.00
-100.00
What if prices drop?
MC
P
P
Breakeven point
ATC
-Profits
Costs
P'
Revenues
Q**
Q
Q*
• The average total cost of production (when marginal
cost equals price) is above the new lower price.
• If the firm sets production at a level such that price equals marginal cost,
but that is the best they can do in the short run.
• Firms only decision is to vary production costs along those dimensions
that are available.
• Should the firm shut down?
• No. The firm has paid costs which cannot be retrieved [SUNK COSTS].
Since the firm cannot change this, they should ignore these sunk costs in
making their marginal decision.
• As long as prices exceeds variable costs, produce.
Profit Maximization: Price is 60
Output
Average
Total
(Loaves)
Costs
2.00
535.00
Average
Variable
Costs
35
10.00
115.00
15
20.00
75.00
25
30.00
68.33
35
40.00
70.00
45
50.00
75.00
55
60.00
81.67
65
Marginal
Marginal
Costs Revenues Revenues Profits
120.00
-950.00
10.00
60.00
600.00
-550.00
35.00
60.00
1200.00
-300.00
55.00
60.00
1800.00
-250.00
75.00
60.00
2400.00
-400.00
95.00
60.00
3000.00
-750.00
115.00
60.00
3600.00
-1300.00
When should the firm
stop production in the short-run?
MC
P
Breakeven point
ATC
P
AVC
P'
Dropout point
Q**
Q
Profit Maximization: Price is < 10
Output
Average
Total
(Loaves)
Costs
2.00
535
Average
Variable
Costs
35
10.00
115
15
20.00
75
25
30.00
68
35
40.00
70
45
50.00
75
55
60.00
82
65
Dropout!
Marginal
Marginal
Costs Revenues Revenues Profits
20.00
-1050.00
10.00
10.00
100.00
-1050.00
35.00
10.00
200.00
-1300.00
55.00
10.00
300.00
-1750.00
75.00
10.00
400.00
-2400.00
95.00
10.00
500.00
-3250.00
115.00
10.00
600.00
-4300.00
Adjustment in the Long Run
• In the longer run, firms are able to adjust the size
of their plant. (adjust the number of machines in
the factory, adjust the number of oil rigs).
• If profits are positive. Firms will seek to build new
equipment as they compete for profits.
• If profits are negative, firms will shut down
equipment and sell it, or possibly go out of
business.
• Firms will adjust their physical plant until they are
making profits again.
Profit maximization and the supply curve
• In the short-run, firms produce up to that point
where price equal marginal cost.
• Supply curve is the sum of the supply curves of
the different firms in the market.
• In the long-run, capacity will be adjusted to the
point where profits are zero (i.e. where marginal
cost equals average total cost).
• Long run ATC curve is collection of points where
MC = ATC and is the long-run supply curve.
Firm Level Supply Curve:
Short Run
Dropout point is the
minimum of the firm
level supply function.
P
SFirm 1
MC
P2
SR ATC
SR AVC
Dropout
Point
P1
q1
q2
Output
In the short run, MC curve is the relationship between firm price and production
Firm Level Supply Curve:
Short Run
P
SFirm 2
SR ATC
MC
Output
Industry Level Supply Curve:
Short Run
P
SFirm 1
+SFirm 2 +SFirm 3
SIndustry
Output
In the short run, the sum of the MC curves is the relationship between price and industry
production
Short Run Response to Increase in Demand
Increase Variable Inputs
P
D
SIndustry
2
P**
1
P*
D'
Q*
Q**
Output
Firm Level Supply Curve: Short Run
Short-run profits attract new entrants
P
2
P**
SFirm 1
SR ATC
Profits
1
P*
MC
q* q**
Output
In the short run, MC curve is the relationship between price and firm production
New Entrants in the Long Run
Supply Increases and Price Drops
P
D
SIndustry+SFirm N+ 1
2
P**
P***
3
1
P*
D'
Q* Q** Q***
Output
Firm Level Response
to New Entrants: Reduce Output
P
2
SFirm 1
P**
SR ATC
3
P***
Profits
1
P*
MC
q* q*** q**
Output
But as long as price is above minimum of ATC, there will still be profits and entry.
New Entrants as Long as Profits at MES
Supply Increases and Price Drops
P
D
+SFirm N+ 1 +…+SFirm N+ J
SIndustry
2
P**
3
P**
P*
1
4
D'
Q* Q** Q*** Q**** Output
Firm Level Response to New
Entrants: Reduce Output
P
2
SFirm 1
P**
3
SR ATC
P***
1,4
P*
MC
q* q***q**
Output
In the short run, MC curve is the relationship between firm price and production
Long Run, Supply is Flat along MES of New Entrants
P
D
SIndustry
+SIndustry
2
P**
P**
P*
1
4
D'
SLR
Q* Q** Q*** Q****Output
Long Run Equilibrium
• Firms are making zero profits.
• Firms will be producing at their minimum efficient scale
and at a minimum of ATC, thus operating at their efficient
low cost level of production.
Long Run Supply Curve
• If all firms are exactly the same, then new firms have
same MES as old firms and supply curve is flat.
• In some cases, like oil drilling, new firms may have higher
MES than old firms and supply curve is upward sloping.
• Long run supply curve is flatter, more elastic than shortterm supply curve.
Accounting vs. Economic Profits
• Profits are revenues less costs.
• Economic profits are revenues less explicit and
implicit costs.
• Economic profits attract competition so they typically
don’t last.
• Perfectly competitive firms make zero economic
profits.
• Accounting profits are just large enough to cover
opportunity cost of equity capital/owner time.
• Returns at perfectly competitive firms cover
market return.
MONOPOLY
Chapter 13
Market Power
• Market power is the ability of a firm to affect the
market price of a good to their advantage. In
declining order.
• Monopoly – A single producer without competition
• Oligopoly Power – A small number of producers
sometimes acting in concert.
• Monopolistic Competition – Firms selling
differentiated products.
Price effects
• There is a demand curve relating the quantity of a product
•
•
•
•
that can be sold at a given price.
Invert the concept: For each quantity, there is a price that
the market may bear.
Change the quantity and change that price
For price taking firm, marginal revenue is equal to price.
For a firm with market power, marginal revenue must
include the change in the price that results from a change
in quantity.
P
MR  P 
QP
Q
Example
Demand,
Revenue,
Marginal
Revenue
Output
Price
Revenue
Marginal Revenue
10,000.00
33.0 330,000.0
13.7
20,000.00
23.3 466,690.5
10.5
30,000.00
19.1 571,576.8
8.8
40,000.00
16.5 660,000.0
7.8
50,000.00
14.8 737,902.4
7.0
60,000.00
13.5 808,331.6
6.5
70,000.00
12.5 873,097.9
6.0
80,000.00
11.7 933,381.0
5.7
90,000.00
11.0 990,000.0
5.4
100,000.00
10.4 1,043,551.6
P 35.0
Example
Demand
30.0
25.0
20.0
15.0
MR
10.0
5.0
0.0
10
20
30
40
Price
50
60
70
80
Marginal Revenue
90
Q
Monopolist
• Maximize Revenues by choosing an output level such that
•
•
•
•
marginal revenue equals marginal cost.
Price will exceed marginal cost. Monopolists will make
greater profits than a competitive firm.
Monopolists will charge higher prices and produce less
output than a competitive industry.
Profits should attract new entrants to the market.
Monopoly can only survive if there are some barriers to entry.
Monopolist: Constant Cost
Price
P*
Profit
MC = ATC
Revenues
D
Cost
MR
QMono
QPC
Output
Price
10,000
33.0
20,000
23.3
30,000
19.1
40,000
16.5
50,000
14.8
60,000
13.5
70,000
12.5
80,000
11.7
90,000
11.0
Marginal
Marginal
Revenue Revenue Cost
Cost
Profit
330000
80000
250000
13.66905
8
466690.5
160000
306690.5
10.48863
8
571576.8
240000
331576.8
8.842323
8
660000
320000
340000
7.790243
8
737902.4
400000
337902.4
7.042918
8
808331.6
480000
328331.6
6.476632
8
873097.9
560000
313097.9
6.028302
8
933381
640000
293381
5.661905
8
990000
720000
270000
Monopolist: General Case
MC
Price
ATC
P*
Profits
Revenues
D
MR
Costs
Q*
Output
Efficiency: Completion
Price
MC
Consumer Surplus
PPC
Producer Surplus
D
MR
Q*
Output
Efficiency: Monopoly
Price
Consumer
Surplus
MC
Producer surplus eats
up some of consumer
surplus at higher
price.
Falling output
eliminates some
surplus
PMO
PPC
Deadweight Loss
Producer Surplus
D
MR
Q** Q*
Output
A. Barriers to Entry
• Total Control over Vital Resource
• Alcoa in the aluminum market
• DeBeers in Diamond market
B. No close
substitutes is
necessary for monopoly to be a
useful description.
Legal
• Patents or Secret Formula:
• Xerox: Controlled photocopying
• Regulations: Jockey Club, SDTM
• Gambling is a legally restricted monopoly
Natural Monopoly
• Returns to Scale at MES
• TownGas is an regulated monopoly supplier of a particular type of
piped natural gas (may have competition from LNG)
Price Discrimination
• Demand curve is the price customers are willing to pay.
• Some customers are willing to pay a very high price. If
monopolists could tailor a price to each customer they
could make maximum profits.
Monopolist: Price Discrimination
Price
P1*
P2*
Profit
Profit
MC
MR2
MR
Q1 +Q2
D
Output
Monopolist: Perfect Price Discrimination
Tailor a price for every customer
Price
Absorb all surplus
P1*
P2*
P3*
P4*
Profit
MC
MR
Q1
D
Output
Natural Monopoly
• Under certain technologies, there are efficiency gains from
concentrating production in a single firm. This occurs if (longrun) costs for a single firm are declining at any production
level.
• If firms compete on price, then they will make a loss. ATC is
declining when MC<ATC. If firms charge marginal price, they
will make a loss and drop out.
• Eventually production involves 1 firm. Firm will naturally
exercise market power and earn profits.
• Natural monopoly features technology with large fixed costs.
Monopolist: High Fixed Costs
Profits under Monopoly
Price
P*
Profits
ATC
MC
D
MR
QMono
Output
Regulation
• Government may step in, usually to put a
maximum price level. Should be minimum
amount necessary to get the firm to operate small
decisions that lead to a competitive outcome.
• Average cost pricing is the lowest price consistent
with long-term market participation.
• Information Problem. A single decision maker
may not have full access to enough information.
Firms have an incentive to overstate costs to
regulators.
.
Regulation: Marginal Cost Pricing
Under efficient price cap,
price equals marginal
cost, output increases and
the firm incurs losses.
Price
P*
ATC
MC
Losses
D
MR
QMono
QPC
Output
Regulation: Average Cost Pricing
Price
Put cap on prices sufficiently far above
MC to cover fixed costs
P*
ATC
MC
D
MR
QMono
QREG
Output
Monopoly
P
600
D
500
Average
Cost
Pricing
ATC
400
MC
300
200
MR
Competition
100
0
0
50
100
150
200
250
Q
MONOPOLISTIC COMPETITION
Chapter 14
Monopolistic Competition
• Most firms produce a good that is (to a certain extent)
unique. No other good has the exact same properties.
• Coke, Pepsi, President’s Choice
• To the extent that you are a unique producer, you will have
some market power.
• Price elasticity of individual products are larger than total
category. But not infinite as in the case of commodity
goods.
Monopolistic Competition: Short-term
Price
MC
ATC
P*
D
MR
Q*
Output
Characteristics of Monopolistically
Competitive Markets
• Differentiated Products Download
• Free Entry into very similar markets.
• Fixed costs of setting up production
• Individual firms face downward sloping demand curve and
a falling average total cost curve.
• They would sell more if they could at the going rate but lowering
their prices to sell more would lead to losses.
No Barriers to Entry
• What happens if new firms can enter?
• If there are profits to be had, entrepreneurs will enter
markets to provide close substitutes for profit making
goods.
• New goods splitting the market and better substitutes
means lower, flatter demand curve.
Monopolistic Competition: Entry of Competitors
Price
MC
ATC
P*
P**
Profits
MR
MR′ D′
Q**
Q*
D
Output
Monopolistic Competition vs. Perfect
Competition
• On a market-by-market basis, perfect competition will
offer greater efficiency both in terms of minimizing
deadweight losses and encouraging an efficient
production scale.
• Monopolistic Competition only occurs with differentiated
products.
• Greater variety generated by this market may compensate for loss
of efficiency.
Monopolistic Competition: Long-term
Price
MC
ATC
Profits
P*
D′
MR′′
Q*
D′′
Output
MR′
Monopolistic Competition vs. Perfect
Competition
• Similar: Both have many firms, both have zero profits and
P = ATC.
• Different:
• P > MC : On the margin, monopolistically competitive firms want
more customers. Greater variety generated by this market may
compensate for loss of efficiency.
• MC < ATC: Firm is operating at a level that does not minimize total
costs.
Unprofitable Monopolistic Competition:
Short-term
Price
MC
ATC
P*
MR
Q*
D
Output
Variety and Monopolistic Competition
• Given that most markets have the “feel” of monopolistic
competition, do we have too many firms or is variety it’s
own reward?
• Does advertising create phony differentiation or provide
information?
Monopolistic Competition and
Entrepreneurship
• New markets are frequently developed.
• For many goods, the only barriers to entry is imagination.
• Entrepreneurs develop new ideas for new goods. The
pay-off for entrepreneurship are short-run monopoly
profits. (Ted Turner and CNN). Only in rare cases will
firms be able to make long-term monopolistic profits.
Consequences of Market Power
• One clear consequence of the existence of market power is
that prices are higher than marginal cost and output is
smaller than perfect competition.
• Additional consequences of the presence of market power
may be:
• Complacency by firms managers (i.e. standard corporate governance
measures do not generate efficiency)
• Rent-seeking: Firms may put effort into constructing artificial barriers
to entry rather than producing goods.
Measures of Market Power
• Four Firm Concentration Ratio – Fraction of sales
attributable to the top 4 firms.
• Herfindahl –Hirschman Index – Sum of squares of market
shares of Top 50 firms.
Sales of Firm i
si 
Total Industry Sales
Markups
• For price taking firm, marginal revenue is equal to price.
• For a firm with market power, marginal revenue must
include the change in the price that results from a change
in quantity.
MR 
MR  P 
{P  Q}
P
 P
QP
Q
Q
P
Q
P P  P (1  1
Q
elasticity
D
)
Markups
• If a market is competitive, then price will equal marginal
cost. For monopolist, the P > MR = MC
P  MC
P , are a measure of the market power
• Net markups,
of a firm or industry referred to as the Lerner index
MC  MR  P (1  1
P  MC 1
)

P
P
P
The less elastic the demand curve, the higher the market
power. Firm has more pricing power if good has fewer
substitutes.
Learning Outcomes
Students should be able to
• Characterize a perfectly competitive market.
• Calculate total revenue, marginal revenue and profit for
a firm in a competitive market.
• Describe the supply curve in a competitive market in
both the short and long run.
• Characterize the relationship between price, marginal
revenue, marginal cost, average total cost, and profits
in a monopolistic market.
• Measure the degree of market power with the Lerner
index.
• Describe 4 barriers to entry that may enable monopoly
power.