Perfect competition Essay

The focus today’s lecture is the examination of how price and output is determined in a monopoly market. Pure monopoly is a single firm producing a product for which there are no close substitutes. It is important for us to understand pure monopoly since this form of economic activity accounts for a large share of output and it provides us with an insight into the more realistic market structure of monopolistic competition and oligopoly. It is characterised by: †¢ a single seller producing a product with no close substitutes. The firm and the industry are the same. The product is unique – there is no close substitute for it. You either buy the product or go without. †¢ effective barriers to entry into the market (legal, technological, economic). These barriers block new firms from entering the industry, blocking potential competition. †¢ the firm is a price maker; faces a downward sloping demand curve for its product (this demand curve is the market demand curve). The firm has considerable control over price since it controls the quantity supplied and can cause price to change by varying the amount supplied. †¢ effective barriers to entry One special type of monopoly is a natural monopoly, a monopoly that arises because of the existence of economies of scale over the entire relevant range of output and competition is impractical, e. g. , water, electricity. These industries are usually given exclusive rights by the government, with the proviso that government regulates the operations to prevent abuses of monopoly power. A larger firm will always be able to produce output at a lower cost than could a smaller firm. The pressure of competition in such an industry would result in a long-run equilibrium in which only a single firm can survive (since the largest firm can produce at a lower cost and can charge a price that is less than the ATC of smaller firms). Natural monopolies have low MC and it is to their advantage to expand output. Barriers to entry The absence of competition in an industry is due largely to barriers to entry. Barriers to entry may take different forms: 1. economies of scale: costs – efficient, low cost producers are usually large firms operating under conditions of economies of scale, where AC falls over a range of output. 2. Legal barriers: Patents and Licences – government creates legal barriers in giving patents and licences. Patents: this is the exclusive right to control a product for a number of years, protecting the inventor from rival competitors who did not spend any money and time in its development. Licences: the issuing of licences by the government limits entry into an industry. 3. ownership of critical raw materials: a firm that owns a critical raw material can block the creation of rival firms. 4. unfair competition – rivals may be eliminated and the entry blocked by aggressive, cut-throat tactics such as pressure on resource suppliers and banks to withhold materials and credit, aggressive price cutting designed to bankrupt competitors. Unfair competition is illegal or borders on illegality. Under conditions of economies of scale, large firms can produce output at a lower cost than can smaller firms. Assume that the ATC curve of all firms in the industry is ATCo; however, one firm has become larger than the others, thereby producing at a lower ATC. This larger firm can sell its output at a lower price (at P’) at which point smaller firms will experience economic losses. At Po, smaller firms would receive zero economic profit. At P’ the larger firm will receive zero economic profit, but smaller firms would receive economic losses and so leave the industry or merge with others. This situation will continue until only one large firm remains. This gives us a â€Å"natural monopoly†. A large firm can operate as a regulated monopoly in which the government regulated the prices that could be charged for product/services. [pic] A firm may acquire monopoly power by having sole ownership of a raw material. Firms can also raise the sunk costs associated with entry into an industry to help discourage entry by new firms. Sunk costs are costs that cannot be recovered upon exit from an industry – advertising expenditures. If firms know that they’d lose a large amount in the form of sunk costs, they may hesitate to enter an industry. Large sunk costs are also difficult to finance. Patents and licenses provide two types of barriers to entry that are created by the government. While patent protection is necessary to ensure that there are sufficient incentives for firms to engage in research and development expenditures, it also provides the patent holder with some degree of monopoly power. A local monopoly is a monopoly that exists in a specific geographical area. Monopoly Demand, AR, MR, TR, and elasticity The demand curve facing a monopoly firm is the market demand curve (firm is the market). Since the market demand curve is a downward sloping curve, marginal revenue will be less than the price of the good. The monopolist can increase its sales only by lowering its price. This is different from the perfectly competitive firm which faces a perfectly elastic demand curve at the market price. Recall that MR is: †¢ positive when demand is elastic, †¢ equal to zero when demand is unit elastic, and †¢ negative when demand is inelastic. We will examine the implications of a downward sloping demand curve. i) P > MR – the monopolist can only increase sales if price falls, this causes MR < P (AR) for all output except the first. The falling MR means that TR will increase at a decreasing rate. Since it must lower price to sell more, the firm’s MR lies below its demand curve. ii). Price elasticity Recall the TR test for price elasticity of demand. TR tests tells us that when demand is elastic (inelastic), a decline in price will increase (decrease) TR. A monopolist or other imperfectly competitive firm will not chose to lower price into the inelastic segment of its demand curve, this will reduce TR and increase production costs, thereby lowering profits. The relationships between demand, MR and TR curves are shown in the diagram below, TR is maximized at the level of output at which demand is unit elastic (and MR = 0). Since the objective is to maximize its profit, the firm will look at its costs and revenue in determining its output level. As long as TR is increasing, MR is positive. When TR is at its maximum, MR = 0 and when TR is decreasing, MR is negative. [pic] Note that, as in all other market structures, AR = P of the good. (AR = TR/Q = (PxQ)/Q = P. ) This means that the price given by the demand curve is the average revenue that the firm receives at each level of output. iii) Cost Data The price-quantity combination depends not only on the MR and demand data, but also on costs. Profit-maximising firms produce the level of output where MC = MR (as long as P > AVC). For the monopoly firm, MR = MC at an output level of Qo and firm will charge Po. Since Po > ATCo at this level of output, the firm receives economic profit. These monopoly profits, though, differ from those received by a perfectly competitive firm in that these profits will persist in the long run (due to the barriers to entry that characterize a monopoly industry). [pic] A monopoly firm may experience losses (see diagram below) if P < ATC. The economic losses equal to the shaded area. Since price is above AVC, it will continue operations in the short run, but will leave the industry in the long run. [pic] A monopoly firm will shut down in the short run if the price falls below AVC. [pic] It may be a widely held view that a monopolist can charge any price s/he wants, but the firm is constrained by the demand for its product. If a monopoly firm wishes to maximizes its profit, it must select the level of output at which MR = MC. An increase in the price above this level would reduce the profits received by the firm. Some misconceptions about monopoly pricing i) One common misconception is that the monopolist will charge the highest price it can get. This is not true. Monopolist may not seek higher prices since these bring in smaller than maximum profit. Total profit = TR – TC, and these depend on the quantity sold, price and unit cost. ii) The monopolist is more concerned with maximum total profit, not maximum unit profits. He accepts a lower than maximum per unit profit since additional sales will more than make up for the lower unit profits, e. g., willing to sell 5 units at a profit of $30 per unit (total profit = $150) than 4 units at a profit of $70 (total profit = $140). Economic effects of monopoly It will be profitable for the monopolist to sell a smaller quantity and charge a higher price than would a competitive producer. The profit maximizing output will result in an under allocation of resources since the restricted output uses fewer resources. Given the same costs, a monopolist will find it profitable to charge a higher price, produce a smaller output and mis-allocate resources compared with a perfectly competitive industry. X-efficiency: occurs when a firm’s actual costs of producing any output are greaterthan the minimum possible costs. Price discrimination and dumping Firms operating in markets other than those of perfect competition are able to increase their profits by engaging in price discrimination, where higher prices are charged to those customers who have the most inelastic demand for the product. It takes place when a given product is sold at more than one price and these price differences are not justified by cost differences. Necessary conditions for price discrimination include: i) Monopoly power: the firm control output and price (not be a price taker); ii) separation of buyers – the firm must be able to sort customers according the their elasticity of demand or willingness to pay for the product, and iii) no reselling – resale of the product must not be feasible – cannot buy low and sell high.. The diagram below illustrates how price discrimination may be used in the market for airline travel. Vacation travelers are likely to have a more elastic demand than business travelers. The optimal price is higher for business travelers than for vacation travelers. Airlines engage in price discrimination by offering low price â€Å"super saver† fares that require a weekend stay and tickets to be purchased 2-4 weeks in advance. These conditions are much more likely to be satisfied by individuals traveling for vacation purposes. This helps to ensure that the customers with the most elastic demand pay the lowest price for this commodity. [pic] Other examples of price discrimination include daytime and evening telephone rates, child and senior citizen discounts at restaurants and movie theaters, and cents-off coupon in Sunday newspapers. When countries practice price discrimination by charging different prices in different countries, they are often accused of dumping in the low-price countries. Predatory dumping occurs if a country charges a low price initially in an attempt to drive out domestic competitors and then raises the price once the domestic industry is destroyed. Consequences of discrimination The monopolist will be able to increase profits by engaging in discriminatory price practices. Monopolist will produce a larger output than a non-discriminating monopolist. Comparison of perfect competition and monopoly The diagrams below show a perfectly competitive market and the loss in consumer and producer surplus that results when a perfectly competitive industry is replaced by a monopoly. The introduction of a monopoly firm causes the price to rise from P(pc) to P(m), while the quantity of output falls from Q(pc) to Q(m). The higher price and reduced quantity in the monopoly industry causes consumer surplus to fall by the trapezoidal area ACBP(pc). This does not all represent a cost to society, though, since the rectangle P(m)CEP(pc) is transferred to the monopolist as additional producer surplus. The net cost to society is equal to the blue shaded triangle CBF. This net cost of a monopoly is called deadweight loss. It is a measure of the loss of consumer and producer surplus that results from the lower level of production that occurs in a monopoly industry. [pic] Some economists argue that the threat of potential competition may encourage monopoly firms to produce more output at a lower price than the model presented above suggests. This argument suggests that the deadweight loss from a monopoly is smaller when barriers to entry are less effective. Fear of government intervention (in the form of price regulation or antitrust action) may also keep prices lower in a monopoly industry than would otherwise be expected. A related point is that it is unreasonable to compare outcomes in a perfectly competitive market with outcomes in monopoly market that results from economies of scale. While competitive firms may produce more output than a monopoly firm with the same cost curves, a large monopoly firm produces output at a lower cost than could smaller firms when economies of scale are present. This reduces the amount of deadweight loss that might be expected to occur as a result of the existence of a monopoly. On the other hand, deadweight loss may understate the cost of monopoly as a result of either X-inefficiency or rent-seeking behavior on the part of monopolies. X-inefficiency occurs if monopolies have less incentive to produce output in a least-cost manner since they are not threatened with competitive pressures. Rent-seeking behavior occurs when firms expend resources to acquire monopoly power by hiring lawyers, lobbyists, etc. in an attempt to receive governmentally granted monopoly power. These rent-seeking activities do not benefit society as a whole and divert resources away from productive activity. Regulation of natural monopoly A monopoly firm can produce at a lower cost per unit of output than could any smaller firms in a natural monopoly industry. In this case, the government generally regulates the price that a monopoly firm can charge. The diagram below illustrates alternative regulatory strategies in such an industry. If the government leaves the monopolist alone, it will maximize its profits by producing Q(m) units of output and charging a price of P(m). Suppose, instead, though, that the government attempts to emulate a perfectly competitive market by setting the price equal to marginal cost. This would occur at a price of P(mc) and a quantity of output of Q(mc). Since this is a natural monopoly, though, the average cost curve declines over the relevant range of output. If average costs are declining, marginal costs must be less than average costs (this relationship between marginal and average costs was discussed in detail in Chapter 9). Thus, if the price equals marginal costs, the price will be less than average total costs and the monopoly firm will experience economic losses. This pricing strategy could only exist in the long run if the government subsidized the production of this good. [pic] An alternative pricing strategy is to ensure that the owners of the monopoly receive only a â€Å"fair rate of return† on their investment rather than monopoly profits. This would occur if the price were set at P(f). At this price, it would be optimal for the firm to produce Q(f) units of output. As long as the owners receive a fair rate of return, there would be no incentive for this firm to leave the industry. Roughly speaking, this is the pricing strategy that regulators use in establishing prices for utilities, cable services, and the prices of other services produced in regulated monopoly markets.