Introductory Microeconomics (ES10001)

Introductory Microeconomics (ES10001) Topic 4: Perfect Competition & Monopoly

1. Introduction • MR = MC rule requires knowledge of market structure • One of the major influences on MR, and thus on its supply decision, is the degree of competitiveness the firm faces in the market. • That is, the number of actual and potential competitors

1. Introduction • This makes sense! If firm is the only player in the market, then we would expect it to behave differently than if it were one of (very) many • In what follows we will examine the causes and effects of market structure

2. Taxonomy of Competition • Microeconomics has tended to categorise the degree of competition a particular firm faces into three very precise and distinct categories: • A lot; • A bit; • None!

Figure 1: Taxonomy of Competition Perfect Competition Monopoly Imperfect Competition More Competition Less Competition Monopolistic Competition Oligopoly Collusive (1.e. Cartel) Non-Collusive

3. Perfect Competition • Market structure where competitive forces are at their greatest • Definition: A Perfectly Competitive (PC) market is one in which both buyers and sellers believe that their own buying or selling decisions have no effect on the market price • Sometimes referred to as an ‘atomistic’ market

3. Perfect Competition • Formal Characteristics 1. (Very) Large number of buyers and sellers; 2. Homogenous product; 3. Free entry and exit (in long-run); 4. Perfect knowledge. • Implication: All firms face same, perfectly elastic, demand curve

Figure 2: Perfectly Elastic Demand p S0 E0 d0 p0 D0 0 Q0Qq Industry Representative Firm

3. Perfect Competition • Why would firm not raise or lower price above or below p0? • If p > p0, then it would sell nothing because consumers have perfect knowledge and good is homogenous • Conversely, no point in setting p < p0 since it can sell as much as it wishes at p0

3. Perfect Competition • Firm’s demand curve is also its AR and MR curve • Recall: • AR = TR / q • MR = ΔTR / Δq • Since demand is perfectly elastic, AR = MR = p

Figure 3: Demand = AR = MR p E0 E1 p0 d = AR = MR q q0q1 0

3. Perfect Competition • Consider short-run profit maximising rule • First, we know that to maximise profit we need to set SMR = SMC • But, SMC must also be rising … • … otherwise, profit (loss) is minimised (maximised)

Figure 4: Optimal Output p SMC π min π max E0 E1 p0 d = AR = MR q 0 q0q1

3. Perfect Competition • Thus, short-run profit maximising rule (1) MR = SMC (2) SMC is rising • But, it could always be in firm's interest to produce nothing! • Is there a ‘shut-down’ price?

Figure 5: Demand = AR = MR π > 0 p SMC Eo SAC p0 AR =MR PROFIT SAVC SAC0 q 0 q0

Figure 6: Demand = AR = MR π = 0 p SMC SAC SAVC E1 p1 AR = MR q 0 q1

Figure 7: Demand = AR = MR - TFC < π < 0 p SMC SAC E2 SAVC SAC2 LOSS < - TFC p2 MR q 0 q2

Figure 8: Demand = AR = MR π = - TFC < 0 p SMC SAC E3 SAVC SAC3 LOSS = TFC p3 AR = MR q 0 q3

Figure 9: Demand = AR = MR π < - TFC < 0 p SMC SAC SAVC SAC4 LOSS > TFC p4 AR = MR E4 q 0 q4

3. Perfect Competition • Thus, short-run profit maximising rule MR = SMC SMC is rising p > SAVC • Supply curve of the firm is that part of its SMC curve above minimum SAVC

Figure 8: Demand = AR = MR π = - TFC < 0 p SMC SAC E3 SAVC SAC3 LOSS = TFC p3 AR = MR q 0 q3

Figure 8: p SMC SAVC p3 AR = MR q 0

Figure 8: p SR Supply Min AVC q 0

3. Perfect Competition • Note, short-run ‘shutdown’ price = p3 =SAVC(q3) • π(p3) = p3*q3 – SAC(q3)*q3 = [SAVC(q3) – SAC(q3)]*q3 = -AFC(q3)*q3 = -TFC

3. Perfect Competition • Thus, short-run supply curve of firm is that part of its SMC above minimum AVC • Similarly, long-run supply curve is that party of LMC above minimum LAC • 1.e. long-run ‘shutdown’ option is to leave the industry

Figure 10: Long-Run Shut-Down p LMC LAC p0 AR = MR q 0 q0

3. Perfect Competition • Compare SR and LR supply curves • SR supply curve of firm is that part of its SMC above minimum AVC; similarly, long-run supply curve is that part of LMC above minimum LAC • 1.e. LR ‘shutdown’ option is to leave the industry • Note that SR supply curve lays below LR supply curve (recall ‘Envelope’) and is steeper

Figure 11: Long-Run & Short-Run Supply p SSR Min LAC SLR p1 p0 Min AVC q 0

3. Perfect Competition • SSR lays below SLR because LAC is envelope of SAC’s and SAVC’s lay below SAC since SAC includes AFC • SSR is steeper than SLR because it will always be less costly for firm to increase output when it can alter all inputs (1.e. K an L) appropriately (1.e. when it is in LR) • Now, consider MR = MC condition

3. Perfect Competition • TR0 = p0q0 TR1 = p1q1 • Thus: • ΔTR =TR1 - TR0 = p1q1 - p0q0 = p1q1 - p0q0 + (p1q0 - p1q0) = p1q1 - p1q0 + p1q0 - p0q0 = p1(q1 - q0) + (p1 - p0)q0

3. Perfect Competition • ΔTR = p1(q1 - q0) + (p1 - p0)q0 = p1Δq + Δpq0 • Thus: • Consider ‘small’ changes in (p, q) such that p1 ≈ p0,q1 ≈ q0 , and so (p0, p1)≈ p and (q0, q1) ≈ q

3. Perfect Competition • Thus: • Now, recall:

3. Perfect Competition • Thus: • Under perfect competition, E = ∞ such that MR= p • Also, since MR = MC in equilibrium, then:

3. Perfect Competition • Thus:

3. Perfect Competition • Lerner (1934) ‘Index of Monopoly Power’ • Note that under perfect competition, E = ∞ such that p = MC • Firms can only ‘mark-up’p over MC iff E < ∞

Figure 12: Elasticity of Demand and Slope of (Inverse) Demand Curve p E0 dc db da q 0

3. Perfect Competition • Industry Supply • SR industry supply curve (when factor prices are given) is the horizontal summation of each firm’s SMC curve above minimum AVC • Similarly, LR industry supply curve (when factor prices are given) is horizontal summation of each firm’s LMC curve above minimum LAC

Figure 13: SR Industry Supply ppp p2 p1 p0 qaqbQ 0 q0q1q2 q0q1q2Q0Q1Q2 0 0 Firm AFirm BIndustry

3. Perfect Competition • Consider effect of an exogenous increase in industry demand for the good • Increase in demand will increase each existing firm’s profit • Existing firms increase SR supply by moving up their SMC curves

Figure 14a: SR Industry Supply p p SMC SAC e0 E0 d0 p0 D0 0 Q0Q q0q Industry Representative Firm

Figure 14b: SR Industry Supply p p SMC SAC e1 E1 d1 e0 E0 d0 p0 D1 D0 0 Q0Q1 Q q0q1q Industry Representative Firm

3. Perfect Competition • But, the existence of super-normal profits will attract other firms into the industry • This will shift out industry (SR) supply curve and lead to a fall in the (perfectly elastic) demand facing individuals firms • Industry supply is higher because of entry of new firms; each firm produces same amount in new equilibrium (E2) as original firms produced in original equilibrium (E0)

Figure 14c: SR Industry Supply p p SMC SAC e1 E1 d1 e2 = e0 E0 E2 d0 p0 D1 D0 0 Q0Q1 Q2 Q q0q1q Industry Representative Firm

3. Perfect Competition • LR supply curve of industry is horizontal / perfectly elastic • LR supply price of industry is equal to minimum LAC of constituent firms • Thus, demand only determines quantity; price is supply (1.e. cost) determined)

Figure 15: LR Industry Supply p P LMC LAC e* E* SLR p* D 0 q* q 0 Q*Q Representative Firm Industry

3. Perfect Competition • LR supply curve of industry is upward sloping in two situations: 1. Factor prices increase with usage 2. Heterogeneous firms • Consider each in turn

3. Perfect Competition • Consider first the SR response of a representative firm and the industry to an increase in demand • If factor prices increase with usage, then increase in demand induces each firm to increase output along its SMC curve • But, increase in industry supply of output increases demand for / price of the variable input

3. Perfect Competition • Increase in price of variable input shifts up vertically each firm’s SMC curve • The expansion of output by each firm can thus be interpreted as a combination of a ‘movement along’ and a ‘shift of’ its SMC curve • Similarly, the expansion of output by the industry - combination of a ‘movement along’ / ‘shift of’ the aggregation of constituent firms’SMC curves

Figure 16: SR Industry Supply Factor prices increase with usage p p D1 ∑SSR SSR ∑SMC1 E1 e1 p1 ∑SMC0 SMC0 D0 SMC1 E0 p0 e0 0 q0q1 q Q0Q1Q Representative Firm Industry

3. Perfect Competition • In LR, free entry / exit implies each firm produces at minimum LAC • If firms are equally efficient, then firms have same minimum LAC and industry supply is perfectly elastic • Intuitively, whatever happens to demand, SR supply, and thus price, competitive forces ensure a normal-profit LR equilibrium such that LR supply is perfectly elastic at minimum LAC

Introductory Microeconomics (ES10001)