4. Competitive Markets for Goods and Services & Monopoly¶

Competitive Markets for Goods and Services ¹¶

Perfect Competition¶

Price takers: Individuals or firms who must take the market price as given.
Perfect competition:
- It is a model of the market based on the assumption that a large number of firms produce identical goods consumed by a large number of buyers.
- It assumes that it is easy for new firms to enter the market and for existing firms to leave.
- It assumes that buyers and sellers have complete information about market conditions.
- No market fully meets the conditions set out in these assumptions.
Assumption of perfect competition:
- Both individual buyers and sellers are price takers, they accept the price determined by the market, and have no influence on that price.
- The price is determined by the interaction of demand and supply only.
- A price-taking consumer assumes that he or she can purchase any quantity at the market price without affecting that price.
- Similarly, a price-taking firm assumes it can sell whatever quantity it wishes at the market price without affecting the price.
- Identical goods:
  - One unit of the good or service cannot be differentiated from any other on any basis.
  - There are no brand preferences or consumer loyalty.
  - Goods are homogeneous, meaning that they are all alike.
- Large number of buyers and sellers:
  - There are so many buyers and sellers that none of them has any influence on the market price regardless of how much any of them purchases or sells.
- Ease of entry and exit:
  - It implies an even greater degree of competition.
  - Firms in a market must deal not only with the large number of competing firms but also with the possibility that still more firms might enter the market.
  - If entry is easy, then the promise of high economic profits will quickly attract new firms.
  - Easy exit assures the point of easy entry; if it was hard to exit, people would not enter, even if entry was easy.
- Complete information:
  - No one seller has any information about production methods that is not available to all other sellers.
  - If one seller had an advantage over other sellers, perhaps special information about a lower-cost production method, then that seller could exert some control over market price and the seller would no longer be a price taker.
  - If buyers did not know about prices offered by different firms in the market, then a firm might be able to sell a good or service for a price other than the market price and thus could avoid being a price taker.

Output Determination in the Short Run¶

The price is very much like the weather: they may complain about it, but in perfect competition there is nothing any of them can do about it.
Total revenue (TR) is the market price (P) times the quantity the firm produces (Q). TR = P x Q.
Total revenue curve:
- It is a curve that puts the total revenue of a firm on the vertical axis and the quantity of output on the horizontal axis.
- It is a straight line that slopes upward.
- The slope of a total revenue curve is particularly important.
  - It equals the change in the vertical axis (total revenue) divided by the change in the horizontal axis (quantity) between any two points.
  - It defines the rate at which total revenue changes as the quantity of output changes.
Marginal Revenue (MR):
- It is the change in revenue that results from a one-unit increase in output.
- It is the slope of the total revenue curve.
- For a perfectly competitive firm, the marginal revenue curve is a horizontal line at the market price.
- MR=P for a perfectly competitive firm.
Average Revenue (AR):
- It is the revenue per unit sold.
- It is the total revenue divided by the quantity of output.
- \(AR=\frac{TR}{Q}=\frac{P \times Q}{Q}=P\).
More generally, we can say that any perfectly competitive firm faces a horizontal demand curve at the market price.
Profit:
- A firm’s economic profit is the difference between total revenue and total cost.
- Economic profit is the vertical distance between the total revenue and total cost curves (revenue minus costs).
- Maximizing profits happens when the slope of the total revenue curve equals the slope of the total cost curve.
The marginal decision rule:
- A profit-maximizing firm should increase output until the marginal benefit of an additional unit equals the marginal cost.
- The marginal benefit of selling an additional unit is measured as marginal revenue.
- Finding the output at which marginal revenue equals marginal cost is thus an application of our marginal decision rule.
Economic profit per unit: The difference between price and average total cost.
Economic loss: The amount by which a firm’s total cost exceeds its total revenue.
Shutdown point: The minimum level of average variable cost, which occurs at the intersection of the marginal cost curve and the average variable cost curve.

Output Determination in the Long Run¶

Economic profit equals total revenue minus total cost, where cost is measured in the economic sense as opportunity cost. An economic loss (negative economic profit) is incurred if total cost exceeds total revenue.
Explicit costs: Charges that must be paid for factors of production such as labor and capital.
Accounting profit: Profit computed using only explicit costs.
Implicit cost: A cost that is included in the economic concept of opportunity cost but that is mot an explicit cost.
Economic profits in a system of perfectly competitive markets will, in the long run, be driven to zero in all industries.
Constant-cost industry: Industry in which expansion does not affect the prices of factors of production.
Increasing-cost industry: Industry in which the entry of new firms bids up the prices of factors of production and thus increases production costs.
Decreasing-cost industry: Industry in which production costs fall in the long run as firms enter.
Long-run industry supply curve: A curve that relates the price of a good or service to the quantity produced after all long-run adjustments to a price change have been completed.

Perfect Competition ²¶

Perfect Competition:
- Many buyers and sellers.
- Identical products or services.
- Every agent (seller or buyer) is knows perfect information (everything about the market).
- No barriers to entry or exit.
Examples of perfect markets:
- Water market.
- Crude energy market.
In Real life, markets go close to perfect competition but never reach it.

Long-run Economic Profit for Perfectly Competitive Firms ³¶

The Equilibrium price from the supply and demand curve (of the market) represents the marginal revenue (MR) for the firm.
MR intersects the marginal cost (MC) curve at the quantity of output that maximizes the firm’s profit.
Marginal profit is the difference between the marginal revenue and the average total cost (ATC).
Total profit is the area between the price and the average total cost (ATC) curve, it is Q times the difference between price and ATC.
New company Enters the market:
- It increases the supply, thus reducing the equilibrium price (P).
- The new equilibrium price (P) is the new marginal revenue (MR) for the firm, which is lower than the previous one.
- Marginal profit is now lower, until it reaches zero (break-even point) at the point where P, MC, and ATC intersect.
- Lowering the profits promotes some firms to exit the market, reducing the supply and increasing the price back to the equilibrium.

Monopoly ⁴¶

Monopoly firm is likely to produce less and charge more for what it produces than firms in a competitive industry.

Nature of Monopoly¶

Monopoly: A firm that that is the only producer of a good or service for which there are no close substitutes and for which entry by potential rivals is prohibitively difficult.
Causes of Monopoly:
- Barriers to entry.
- Economies of scale:
  - Natural monopoly: A firm that confronts economies of scale over the entire range of outputs demanded in its industry. E.g. water, gas, and electricity suppliers to homes.
  - Long run average cost (LRAC) curve increases while production icreases.
  - It makes sense, as supplying one more house is easy after reaching the first house in the neighborhood.
  - Such company has lower costs that any rival who is recent or just entered the market.
- Advantages of location:
  - E.g. a gas station in the middle of the desert.
  - The place is isolated and the only one in the area.
- High sunk costs:
  - Sunk costs are costs of establishing a business that cannot be recovered if the firm goes out of business.
  - Example of sunk costs: A market that requires extensive marketing and advertising to enter, that money is lost if the firm goes out of business and cannot be recovered or re-sold.
- Ownership or dominant control of a key resource used in production:
  - The Aluminum Company of America (ALCOA) gained monopoly power through its ownership of virtually all the bauxite mines in the world (bauxite is the source of aluminum).
  - The International Nickel Company of Canada at one time owned virtually all the world’s nickel.
  - De Beers acquired rights to nearly all the world’s diamond production,
- Government restrictions:
  - Special rights granted by the government to a single firm.
  - E.g. taxi and bus companies, to cable television companies, and to providers of telephone services, electricity, natural gas, and water.

Monopoly Model¶

We will answer that question in the context of the marginal decision rule: a firm will produce additional units of a good until marginal revenue equals marginal cost.

Assessing Monopoly Power¶

A monopoly firm determines its output by setting marginal cost equal to marginal revenue.
It then charges the price at which it can sell that output, a price determined by the demand curve.
That price exceeds marginal revenue; it therefore exceeds marginal cost as well.
Issues related to power:
- Efficiency:
  - Efficiency requires that consumers confront prices that equal marginal costs.
  - Because of high price, customers will consume less of the goods than it is economically efficient.
  - There are deadweight losses in the market, due to the lost demand caused by the high price.
- Equity:
  - Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay.
  - The monopoly charges a price that is higher than the actual price causing a loss in consumer surplus.
  - Customer are the ones who loses here, while monopoly gains.
- Concentration of power:
  - A decentralized, competitive market constantly tests the ability of firms to satisfy consumers, pushes them to find new products and new and better production methods, and whittles away economic profits.

Monopolies vs. Perfect Competition ⁵¶

Monopoly is the opposite of perfect competition.
Monopoly:
- One seller.
- Unique product or service (only one).
- No competition.
- High barriers to entry.
- The one seller is the price maker (setter).
Monopoly is also hard to find in real life, but some markets are close to it.
Examples of monopolies:
- Utility suppliers (electricity, water, etc.) as it is needs infrastructure that delivers the service before entering the market.
- Telecom providers: expensive requirements to build the infrastructure.
- Book Sellers in a school: the only place to buy books required by professors.

Economic Profit for a Monopoly ⁶¶

MR curve goes down as the quantity of output goes up, as it follows the demand curve.
Demand price at the point where MR equals MC is the price the monopoly will charge, it is usually higher than the price in a perfect competition market.

References¶

Rittenberg, L. & Tregarthen, T. (2009). Principles of Economics. Flat World Knowledge. Chapter 9: Competitive Markets for Goods and Services. https://my.uopeople.edu/pluginfile.php/1894544/mod_book/chapter/527789/Principles%20Of%20Economics%20Chapter%2009.pdf ↩
Khan Academy. (2019, March 4). Perfect competition | Microeconomics | Khan Academy [Video]. YouTube https://youtu.be/B_49lQxwMaM ↩
Khan Academy. (2019, March 12). Long-run economic profit for perfectly competitive firms | Microeconomics | Khan Academy [Video]. YouTube https://youtu.be/Xx5-O8kDMvU ↩
Rittenberg, L. & Tregarthen, T. (2009). Principles of Economics. Flat World Knowledge. Chapter 10: Monopoly. https://my.uopeople.edu/pluginfile.php/1894547/mod_book/chapter/527796/Principles%20Of%20Economics%20Chapter10.pdf ↩
Khan Academy. (2019, March 15). Monopolies vs. perfect competition | Microeconomics | Khan Academy [Video]. YouTube https://youtu.be/PgDrR2wj_Jc ↩
Khan Academy. (2019, March 15). Economic profit for a monopoly | Microeconomics | Khan Academy [Video]. YouTube https://youtu.be/PEFEnss--mU ↩

4. Competitive Markets for Goods and Services & Monopoly¶

Competitive Markets for Goods and Services 1¶

Perfect Competition¶

Output Determination in the Short Run¶

Output Determination in the Long Run¶

Perfect Competition 2¶

Long-run Economic Profit for Perfectly Competitive Firms 3¶

Monopoly 4¶

Nature of Monopoly¶

Monopoly Model¶

Assessing Monopoly Power¶

Monopolies vs. Perfect Competition 5¶

Economic Profit for a Monopoly 6¶

References¶

Competitive Markets for Goods and Services ¹¶

Perfect Competition ²¶

Long-run Economic Profit for Perfectly Competitive Firms ³¶

Monopoly ⁴¶

Monopolies vs. Perfect Competition ⁵¶

Economic Profit for a Monopoly ⁶¶