Profit Maximisation under

Perfect Competition

and Monopoly

Profit Maximisation under

Perfect Competition

and Monopoly

Alternative Market StructuresAlternative Market Structures

• Classifying markets (by degree of competition)

– number of firms

– freedom of entry to industry

• free, restricted or blocked?

– nature of product

• homogeneous or differentiated?

– nature of demand curve

• degree of control the firm has over price

• Classifying markets (by degree of competition)

– number of firms

– freedom of entry to industry

• free, restricted or blocked?

– nature of product

• homogeneous or differentiated?

– nature of demand curve

• degree of control the firm has over price

Alternative Market StructuresAlternative Market Structures

• The four market structures

– perfect competition

– monopoly

– monopolistic competition

– oligopoly

• The four market structures

– perfect competition

– monopoly

– monopolistic competition

– oligopoly

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Alternative Market StructuresAlternative Market Structures

• The four market structures

– perfect competition

– monopoly

– monopolistic competition

– oligopoly

• Structure conduct performance

• The four market structures

– perfect competition

– monopoly

– monopolistic competition

– oligopoly

• Structure conduct performance

Perfect CompetitionPerfect Competition

• Assumptions

– firms are price takers

– freedom of entry of firms to industry

– identical products

– perfect knowledge

• Distinction between short and long run

– normal profits

– supernormal profits

• Assumptions

– firms are price takers

– freedom of entry of firms to industry

– identical products

– perfect knowledge

• Distinction between short and long run

– normal profits

– supernormal profits

Perfect CompetitionPerfect Competition

• Short-run equilibrium of the firm

– Price

• given by market demand and supply

– Output

• where P = MC

– Profit

• (AR – AC) × Q

• possible supernormal profits

• Short-run equilibrium of the firm

– Price

• given by market demand and supply

– Output

• where P = MC

– Profit

• (AR – AC) × Q

• possible supernormal profits

O

£

(b) Firm

Q (thousands)

O

(a) Industry

P

Q (millions)

S

D

Pe

MC

ARD = AR

= MR

Qe

AC

AC

Short-run equilibrium of industry and firm under perfect competition

Short-run equilibrium of industry and firm under perfect competition

Qe

P1

D1 = AR1

= MR1

AR1

O O

(a) Industry

P £

Q (millions)

S

D

(b) Firm

MC AC

AC

Q (thousands)

Loss minimising under perfect competitionLoss minimising under perfect competition

D2

Short-run shut-down pointShort-run shut-down point

O O

(a) Industry

P £

P2

Q (millions)

S

(b) Firm

AR2

D2 = AR2

= MR2

MC AC

AVC

Q (thousands)

Perfect CompetitionPerfect Competition

• Short-run equilibrium of the firm (cont.)

– short-run supply curve of firm

• the MC curve

• Short-run supply curve of industry

– sum of supply curves of firms

• Short-run equilibrium of the firm (cont.)

– short-run supply curve of firm

• the MC curve

• Short-run supply curve of industry

– sum of supply curves of firms

Perfect CompetitionPerfect Competition

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

O O

P £

Q (millions)

S1

D

LRAC

PL

P1

QL

Se

AR1 D1

ARL DL

Q (thousands)

Long-run equilibrium under perfect competitionLong-run equilibrium under perfect competition

New firms enterSupernormal profitsProfits return

to normal

(a) Industry (b) Firm

Perfect CompetitionPerfect Competition

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

£

Q O

(SR)AC

(SR)MC

LRAC

AR = MR

DL

LRAC = (SR)AC = (SR)MC = MR = AR

Long-run equilibrium of the firm under perfect competitionLong-run equilibrium of the firm under perfect competition

Perfect CompetitionPerfect Competition

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

– long-run industry supply curve

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

– long-run industry supply curve

Perfect CompetitionPerfect Competition

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

– long-run industry supply curve

– incompatibility of economies of scale with perfect competition

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

– long-run industry supply curve

– incompatibility of economies of scale with perfect competition

Perfect CompetitionPerfect Competition

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

– long-run industry supply curve

– incompatibility of economies of scale with perfect competition

• Does the firm benefit from operating under perfect competition?

• The long run

– long-run equilibrium of the firm

• all supernormal profits competed away

• LRAC = AC = MC = MR = AR

– long-run industry supply curve

– incompatibility of economies of scale with perfect competition

• Does the firm benefit from operating under perfect competition?

MonopolyMonopoly

• Defining monopoly

– importance of market power

– concentration ratios

• Defining monopoly

– importance of market power

– concentration ratios

Concentration ratios in the UKConcentration ratios in the UK

MonopolyMonopoly

• Barriers to entry

– economies of scale

– product differentiation and brand loyalty

– lower costs for an established firm

– ownership/control of key factors or outlets

– legal protection

– mergers and takeovers

– aggressive tactics

• Barriers to entry

– economies of scale

– product differentiation and brand loyalty

– lower costs for an established firm

– ownership/control of key factors or outlets

– legal protection

– mergers and takeovers

– aggressive tactics

MonopolyMonopoly

• The monopolist's demand curve

– downward sloping

– MR below AR

• The monopolist's demand curve

– downward sloping

– MR below AR

-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

AR and MR curves for a monopolyAR and MR curves for a monopolyQ

(units)

1234567

P =AR(£)8765432

ARAR

, MR

(£

)

Quantity

-4

-2

0

2

4

6

8

1 2 3 4 5 6 7

Q(units)

1234567

P =AR(£)8765432

TR(£)

8141820201814

MR(£)

6420

-2-4

MR

AR

, MR

(£

)

Quantity

AR

AR and MR curves for a monopolyAR and MR curves for a monopoly

MonopolyMonopoly

• Equilibrium price and output

– MC = MR

• Equilibrium price and output

– MC = MR

Profit maximising under monopolyProfit maximising under monopoly

MR

£

Q O

MC

Qm

MonopolyMonopoly

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

Profit maximising under monopolyProfit maximising under monopoly

MR

£

Q O

MC

Qm

£

Q O

MC

AC

Qm

MR

AR

AC

AR

Profit maximising under monopolyProfit maximising under monopoly

£

Q O

MC

AC

Qm

MR

AR

AC

AR

Total profit

Profit maximising under monopolyProfit maximising under monopoly

MonopolyMonopoly

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

MonopolyMonopoly

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

AR = D

MC

MR

£

Q O Q1

P1

Monopoly

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

£

Q O

MC ( = supply under perfect competition)

Q1

MR

P1

P2

Q2

AR = D

Comparison withPerfect competition

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

MonopolyMonopoly

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

• short run and long run

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

• short run and long run

MonopolyMonopoly

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

• short run and long run

– costs under monopoly

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

• short run and long run

– costs under monopoly

£

Q O Q1

MR

P1

MCmonopoly

AR = D

Equilibrium of industry under perfect competition and monopoly: with different MC curves

Equilibrium of industry under perfect competition and monopoly: with different MC curves

£

Q O

MC ( = supply)perfect competition

Q1

MR

P1

P2

Q2

MCmonopoly

AR = D

x

Q3

P3

Equilibrium of industry under perfect competition and monopoly: with different MC curves

Equilibrium of industry under perfect competition and monopoly: with different MC curves

MonopolyMonopoly

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

• short run and long run

– costs under monopoly

– innovation and new products

• Equilibrium price and output

– MC = MR

– measuring level of supernormal profit

• Monopoly versus perfect competition

– lower output at a higher price

• short run and long run

– costs under monopoly

– innovation and new products

Contestable MarketsContestable Markets

• Importance of potential competition– low entry costs

– low exit costs

• Perfectly contestable markets

• Contestable markets & natural monopolies

• The importance of costless exit– absence of sunk costs

– hit-and-run competition

• Assessment of the theory

• Importance of potential competition– low entry costs

– low exit costs

• Perfectly contestable markets

• Contestable markets & natural monopolies

• The importance of costless exit– absence of sunk costs

– hit-and-run competition

• Assessment of the theory