Price and Output Determination:
Pure and
Monopolistic Competition
Managerial Economics
Econ 340
Lecture 6
Christopher Michael
Trent University
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Topics
•
•
•
•
•
Market Structures
Pure Competition
Monopolistic Competition
Asymmetric Information
Adverse Selection
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Overview
• Pure competition is a standard against
which other market structures are
compared. The product is perfectly
undifferentiated.
• When there are many firms, but the product
is differentiated, the market is
monopolistically competitive.
» This brand competition may involve advertising
campaigns and large promotional expenditures to stress
often minor distinctions among products.
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What Went Wrong
With Xerox?
• After inventing chemical paper copiers, Xerox
enjoyed 15% growth rates in the 1960s and 70’s.
• As their patents expired, new rivals such as
Ricoh and Canon aimed their copiers at smaller
businesses and smaller volume users.
• Xerox continued to build all parts in-house and
suffered from serious price competition. Xerox’s
strategy led to erosion of its once dominant
status to that of an also-ran.
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The Relevant Market Concept
•
•
A market is a group of economic agents that interact in a
buyer-seller relationship. The number and size of the
buyers and sellers affect the nature of that relationship.
The relationship among firms is affected by:
a. The number of firms and their relative sizes.
b. Whether the product is differentiated or standardized.
c. Whether decisions by firms are independent or
coordinated (collusion).
d. Conditions of entry and exit
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A Continuum of Market
Structures: Competition
Pure Competition assumes:
1.
2.
3.
4.
A very large number of buyers and sellers
Homogeneous product (standardized)
Complete knowledge of all relevant market
information
Free entry and exit (no barriers)
These assumptions imply several things about
competitive markets, including price equals
marginal cost.
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A Continuum of Market
Structures: Monopoly
Monopoly assumes:
1.
2.
3.
4.
Only one firm in the market area
Low cross price elasticity with other products.
No interdependence with other competitors.
Substantial entry barriers
These assumptions imply several things about
monopolies, including that the monopoly price is
usually well above marginal cost. Monopoly is
discussed in full in Chapter 7.
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A Continuum of Market Structures:
Monopolistic Competition
Monopolistic competition assumes:
1.
2.
3.
4.
A large number of firms, some of which may be
dominant in size
Differentiated products
Independent decision making by individual firms
Easy entry and exit
These assumptions imply several things about
monopolistic competition, including that the price in the
long run is equal to average cost.
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A Continuum of Market Structures:
Oligopoly
Oligopoly assumes:
1.
2.
3.
Only a few firms in the market area
Products may be differentiated or
undifferentiated
There is a large degree of interdependence
with other competitors
Chapter 8 discusses oligopoly.
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Price-Output Determination
Under Pure Competition
Competitive firms attempt to maximize profits.
Competitive firms cannot charge more than the market
price of others, since their product is identical to all
others.
Hence, competitive firms are price
takers.
Total revenue, TR, is P·Q, where price is given.
Therefore, marginal revenue, MR, is price, P.
Profit is total revenue minus total cost ( = TR - TC).
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Profit maximization implies that each firm produces an
output where Price = Marginal Cost (P = MC).
» To produce more than this quantity implies that P
< MC, which is not the most profitable decision.
» To produce less than where P=MC, implies that
P > MC, and the firm could increase profits by
expanding output.
• In short run, a competitive firm may earn
economic profits.
• In long run, entry pushes price down to the minimum
point of the average cost curve, so that economic
profits are zero.
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Equilibrium Price in a
Competitive Market
• Equilibrium for each firm if
P = MC. Each firm is
“happy”
• Equilibrium for the industry
if: Demand equals Supply at
the going price
» When both occur, the market is
in a Competitive Equilibrium
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MC
MC
AC
D
a firm
the industry
CAN EARN ECON PROFITS
IN THE SHORT RUN
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A Competitive Equilibrium Implies
1.
2.
Competitive firm can earn positive
economic profits in the SR
If Price < AVC, firm will shut down
so-called “shut down price” is lowest AVC
MC
AC
Pmin AC
shut down price
3.
In LR, entry forces price down to the
minimum of the AC curve
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AVC
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Problem: The following is given:
For the industry:
QS = 3,000 + 200 P and
QD = 13,500 - 500 P
For the firm:
FC = 50
MC = 3 Q
FIND OPTIMAL output for this firm.
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Answer: Find equilibrium price. Set D = S
we see 3,000 + 200 P = 13,500 - 500 P. This
implies:
10,500 / 700 = P = $15.
At this price, the firm produces where
P = MC, so
15 = 3 Q
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Q=5
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Monopolistic Competition
• Monopolistic Competition
» MARKET STRUCTURE
• Many Firms and Many Buyers
• Easy Entry & Exit
• PRODUCT DIFFERENTIATION!!
• Historical Background
» Joan Robinson “Economics of Imperfect
Competition,” 1933
» Edward Chamberlin, “Theory of
Monopolistic Competition,” 1933
• Small Groups & Large Groups
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Product
Differentiation
Among Gas
Stations
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Product Differentiation
• Differentiation occurs when consumers perceive that a
product differs from its competition on any physical or
nonphysical characteristic, including price.
• Examples: restaurants, dealer-owned gas stations, video
rental stores, book & convenience stores, etc.
• Assumptions of the Model:
» Large number of firms
» Differentiated Product
» Conditions of Cost and Demand are Similar
» Easy Entry & Exit
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Basic Model of
Monopolistic Competition
MC
• In the Short Run
» produce where MR= MC
» price on the demand curve
• NOTICE:
PM
AC
» P > MC
» economic profits exist
P > AC
» there are incentives for entry
into this industry
SHORT-RUN DIAGRAM
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D
QM
MR
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Profits in the SR Induces Entry
• Entry in this industry “steals”
customers.
• Demand curve shifts inward
• RESULTS
» MR = MC (like monopoly)
P
» P = AC (like competition)
» Profits in LR are zero (like
competition)
» not at Least Cost Point of AC curve
(like monopoly)
MC
AC
D
D’
Q
LONG-RUN DIAGRAM
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MR
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Properties of Monopolistic Competition
• Inefficient Production
» EXCESS CAPACITY
• not at least cost
point of AC curve
» Could Avoid Excess
Capacity by JOINTLY
PRODUCING at the
same plant
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• Sears’ Kenmore and
Whirlpool built at same
factory.
• Does the expectation of
zero profits in the future
stifle innovation?
• Is there too much
product differentiation?
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Example
• To sell one more unit of output will cost the price of the
added message, k, divided by the marginal product of
a dollar of advertising (DQ/DA).
• If a radio message costs $1,000, and if that message
yields 5 new items sold, then the marginal cost of
advertising is $200, ($1,000 /marginal product of
advertising).
• If it costs $200 to sell one more car (MCA=$200), and
if the contribution of another car sold is $300 to profits,
then we should expand promotional expenses.
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What Went Wrong With
Amazon.com?
• Stocks only 1,000 books but displays 2.5
million
• Barnes & Noble and Borders are profitable,
but Amazon didn’t earn a profit
• Classic example of a business with low
barriers to entry
• Internet buyers are very price conscious, as
they can shop multiple sites with little effort
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Competitive Markets Under
Asymmetric Information
• Used car: who knows what about it?
• Asymmetric Information — unequal or
dissimilar knowledge among market
participants.
• Incomplete Information — uncertain
knowledge of payoffs, choices, or types of
opponents a market player faces.
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Search Goods versus
Experience Goods
• Search goods are products or services whose quality is
best detected through a market search.
• Experience goods are products and services whose
quality is undetected when purchased.
• Warranties and firm reputations are used to assure quality.
• But if someone is selling a used car, isn't it likely that the
car is no good? Is it a lemon?
» This is an explanation why used car prices are
so much lower than new car prices.
• If one firm defrauds customers, how do the reputable firms
signal that they are NOT like the fraudulent firm?
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Adverse Selection
and the Notorious Firm
• Suppose that a firm may decide to produce
a High Quality or Low Quality product,
and the buyer may decide to offer a High
Price or a Low Price.
• Since the firm fears that if it offers a High Quality
product but that buyers only offer a Low Price,
they only produce Low Quality products and
receive Low Prices.
• This is the problem of adverse selection
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Notorious Firm
Analysis
Payoffs in the boxes
are for the seller only
• Simultaneous decisions
BUYER
of buyer & seller
Hi Price Low Price
• A risk averse decision
High
by the firm is to make a
70
Quality 130
Low Quality product SELLER
• Best for the buyer is a
Low
150
90
Quality
low price, but a high
quality good. Worst for
We end in a trap of only
the buyer is a high price
poor quality goods at
but a low quality good.
low prices.
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Solutions to the Problem of
Adverse Selection
• Regulation (Disclosure Laws, Truth in Lending)
• Long term relationships, or reliance
relationships
• Brand names (a “hostage” to quality)
• Nonredeployable assets are assets that have
little value in another other use
Example: Dixie Cups made with paper-cup machinery
which cannot be used for other purposes — if Dixie Cups
leak, the company is in trouble
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