c hapter 11 price and output in monopoly, monopolistic competition, and perfect competition © 2002...

CChapter 11hapter 11

Price and Output in Monopoly, Monopolistic Competition, and

Perfect Competition

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• Price, output and economic profit under conditions of monopoly

• Price, output and economic profit for the firm in monopolistic competition

• Normal profit

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• Price, output and economic profit for the firm in perfect competition

• The perfectly competitive firm’s supply curve

• Market supply in perfect competition

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• The Schumpeterian illustration of low price and high efficiency under conditions of monopoly

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Price and Output Price and Output Under MonopolyUnder Monopoly

• Monopolists are distinguished from other types of entrepreneurs by their market position -- not by their motivation, morality, strategy or objective.

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Price-maker

A firm conscious of the fact that its own activity in the market affects price. The firm has the ability to choose among combinations of price and output.

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EXHIBIT 1 MARKET DEMAND FOR ICE

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Exhibit 1: Market Exhibit 1: Market Demand for IceDemand for Ice

Which price and quantity choices does the ice company have available in Exhibit 1?

• The ice company has unlimited choices. It is a price maker and can choose any combination of price and output it wants.

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Which price and quantity choices does the ice company have in Exhibit 1?

• Although the ice company can charge higher prices, the company must recognize that at higher prices, fewer tons of ice will be demanded.

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Which price and quantity choices does the ice company have in Exhibit 1?

• The company uses the MR=MC rule to determine what combination of price and output will maximize profit.

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Recall the MR=MC Rule:

• Expand production if MR>MC.

• Profit is maximized when MR=MC.

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Marginal cost (MC) is the increase in total cost when an additional unit of output is added to production.

Marginal revenue (MR) is the change in total revenue generated by the sale of one additional unit of goods and services.

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EXHIBIT 2 PRICE AND REVENUE SCHEDULE FOR THE NICK RUDD ICE COMPANY

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Exhibit 2: Price and Exhibit 2: Price and Revenue Schedule for Revenue Schedule for

the Nick Rudd Ice the Nick Rudd Ice CompanyCompany

What is the marginal revenue per ton when the ice company increases production of ice from 200 to 250 tons?

• The marginal revenue per ton is $75.

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• Marginal revenue=(change in total revenue)/(change in quantity).

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• Marginal revenue=[$(43,750-40,000)]/(250-200)=$3,750/50=$75.

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Economic profit

A firm’s total revenue minus its total explicit and implicit costs.

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EXHIBIT 3 COST AND REVENUE SCHEDULES FOR THE NICK RUDD ICE COMPANY

Note: Figures are rounded to the nearest dollar.

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Exhibit 3: Cost and Exhibit 3: Cost and Revenue Schedule for Revenue Schedule for


1. What is the company’s economic profit when 50 tons of ice are produced?

• Economic profit = total revenue- total cost = $(13,750-8,500)=$5,250.

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2. Since the company is a price-maker, should it charge the highest price possible?

• No. The highest price possible does not necessarily generate the most profit.

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3. At what output should the company be producing in order to maximize profit?

• The company should be producing 300 tons of ice in order to maximize profit.

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3. At what output should the company be producing in order to maximize profit?

• This is the output level where MR=MC.

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Maximum Profit, but Maximum Profit, but Less than Maximum Less than Maximum

EfficiencyEfficiency• The profit-maximizing output is not necessarily the most efficient output.

• There may be output levels that have a lower average total cost (ATC).

• The firm is interested in maximum profit, however, not maximum efficiency.

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EXHIBIT 4 PRICE AND OUTPUT DETERMINATION IN MONOPOLY

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Exhibit 4: Price and Exhibit 4: Price and Output Determination Output Determination

in Monopolyin MonopolyWhat is the total profit for the profit-maximizing firm in Exhibit 4?

• The profit-maximizing firm produces where MR=MC. This point is at a quantity of 300 in Exhibit 4.

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in Monopolyin MonopolyWhat is the total profit for the profit maximizing firm in Exhibit 4?

• At quantity 300, the price (read off the demand curve) is $150. The average total cost (read off the ATC curve) is $52.

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in Monopolyin MonopolyWhat is the total profit for the profit maximizing firm in Exhibit 4?

• Total profit=$(150-52)*300=$29,400.

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Price and Output in Price and Output in Monopolistic Monopolistic CompetitionCompetition

• One way that a new firm can break into a market is through product differentiation.

• The trick is to differentiate the product enough to claim uniqueness, yet keep it close enough to existing competition.

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EXHIBIT 5 RUDD’S DEMAND CURVE AS NEW FIRMS ENTER THE MARKET

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Exhibit 5: Rudd’s Exhibit 5: Rudd’s Demand Curve as New Demand Curve as New

Firms Enter the MarketFirms Enter the MarketAs new firms enter a market, the demand curve for the existing firms becomes:

i. More elastic.

ii. Less elastic.

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i. More elastic.

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i. More elastic.

More substitutes become available, which increases the price elasticity of demand.

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EXHIBIT 6 RUDD’S PRICE AND OUTPUT IN A MONOPO-LISTICALLY COMPETITIVE MARKET

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Exhibit 6: Rudd’s Price Exhibit 6: Rudd’s Price and Output in a and Output in a Monopolistically Monopolistically

Competitive MarketCompetitive Market1. How does the ice company determine the best output level to produce after new firms have entered the market?

• The ice company determines its production level the same way it did before -- it uses the MR=MC rule.

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Competitive MarketCompetitive Market2. Is Rudd’s better off or worse off in the monopolistically competitive market?

• Rudd’s is worse off. Under monopolistic competition, economic profit declines.

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Competitive MarketCompetitive Market3. Are consumers better off or worse off in the monopolistically competitive market?

• Consumers are better off. The price they pay is lower and the quantities they buy are greater.

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• As long as there is economic profit to be made, firms will continue to enter a market.

• The limit to further entry is the point where the demand curve is tangent to the ATC curve.

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EXHIBIT 7 RUDD’S LONG-RUN EQUILIBRIUM PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION

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Exhibit 7: Rudd’s Long-Exhibit 7: Rudd’s Long-Run Equilibrium Price Run Equilibrium Price

and Output in and Output in Monopolistic CompetitionMonopolistic Competition

1. At what output level is profit maximized in Exhibit 7?

• Profit is maximized at an output level of 150.

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2. What are price and average total cost at this output level?

• Both price and average total cost are $82. The demand curve is tangent to the ATC curve.

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3. What is Rudd’s economic profit at this output level?

• Economic profit = $(82-82)*150=0.

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4. If economic profit is zero, should Rudd’s produce at some other output?• No. The MR=MC rule always signals the firm’s most profitable output level, even if the profit is zero. Every other output level in this case would yield a loss.

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Normal profit

The entrepreneur’s opportunity cost. It is equal to or greater than the income an entrepreneur could receive employing his or her resources elsewhere. Normal profit is included in the firm’s costs.

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Even though the economic profit of a firm may be zero, the firm still generates a normal profit -- a wage -- for the entrepreneur. The normal profit is at least as much as the entrepreneur can earn elsewhere.

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Price and Output in Price and Output in Perfect CompetitionPerfect Competition

• There is no product differentiation in a perfectly competitive market.

• Firms in perfect competition are typically modest in size.

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EXHIBIT 8A THE COMPETITIVE FIRM’S COST STRUCTURE

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EXHIBIT 8B THE COMPETITIVE FIRM’S COST STRUCTURE

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Exhibit 8: The Exhibit 8: The Competitive Firm’s Competitive Firm’s

Cost StructureCost StructureHow does ATC change as the firm changes output from 4.5 to 6.0 in Exhibit 8?

• At an output of 4.5, the firm achieves its minimum ATC of $47.

• ATC increases to $55 when the firm increases output to 6.0.

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Price-taker

A firm that views market price as a given and considers any activity on its own part as having no influence on that price.

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For firms in perfect competition, price always equals marginal revenue (P=MR).

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EXHIBIT 9A DEMAND AND SUPPLY FOR ICE IN A PERFECTLY COMPETITIVE MARKET

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EXHIBIT 9B DEMAND AND SUPPLY FOR ICE IN A PERFECTLY COMPETITIVE MARKET

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Exhibit 9: Demand and Exhibit 9: Demand and Supply for Ice in a Perfectly Supply for Ice in a Perfectly

Competitive MarketCompetitive Market

1. What is the equilibrium price and quantity demanded in panel a of Exhibit 9?

• The equilibrium price is $78 and the quantity demanded is 440.

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2. Why is the firm’s demand curve horizontal?

• The firm is a price-taker. The firm must charge the equilibrium price regardless of the quantity it produces.

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3. Should a firm in perfect competition increase its price in order to generate more profit?

• No. If the firm increases its price by even a penny, then the firm will not be able to sell any product.

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Short-Run Equilibrium Short-Run Equilibrium Price and Output for the Price and Output for the

Firm in Perfect CompetitionFirm in Perfect Competition

• Economic profit will attract new producers to a market.

• As new producers enter the market, the supply curve shifts to the right, forcing the equilibrium price to fall.

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Short-Run Equilibrium Short-Run Equilibrium Price and Output for the Price and Output for the

Firm in Perfect CompetitionFirm in Perfect Competition

• Each producer must adjust its output to maximize profit at the new equilibrium price.

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EXHIBIT 10A THE PERFECTLY COMPETITIVE FIRM IN THE SHORT RUN

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EXHIBIT 10B THE PERFECTLY COMPETITIVE FIRM IN THE SHORT RUN

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Exhibit 10: The Perfectly Exhibit 10: The Perfectly Competitive Firm in the Competitive Firm in the

Short-RunShort-Run1. How does a price-taker know what output maximizes profit?

• The price-taker uses the MR=MC rule. Since MR is always equal to price, the firm must determine the output where MC is equal to price.

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Exhibit 10: The Perfectly Exhibit 10: The Perfectly Competitive Firm in the Competitive Firm in the

Short-RunShort-Run2. What is the economic profit received by the firm in Exhibit 10?• Economic profit =$(78-51)*5.5=$148.50.

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EXHIBIT 11 EFFECTS OF A SHIFT IN MARKET SUPPLY

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Exhibit 11: Effects of a Exhibit 11: Effects of a Shift in Market SupplyShift in Market Supply

1. How does the equilibrium price change as the supply curve shifts from S1 to S2 to S3 in Exhibit 11?

• The short-run equilibrium price changes from $78 at S1 to $60 at S2 and to $47 at S3.

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Exhibit 11: Effects of a Exhibit 11: Effects of a Shift in Market SupplyShift in Market Supply

2. How does the change in price affect the economic profit of firms?

• With each decrease in price, economic profit decreases. At an output of 4.5 tons, price equals ATC. Economic profit is zero.

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Long-Run Equilibrium Price Long-Run Equilibrium Price and Output for the Firm in and Output for the Firm in

Perfect CompetitionPerfect Competition

The long-run equilibrium position of firms in perfect competition is identified by P=MR=MC=ATC.

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EXHIBIT 12 THE MARKET AND FIRM IN LONG-RUN EQUILIBRIUM

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Exhibit 12: The Market Exhibit 12: The Market and Firm in Long-Run and Firm in Long-Run

EquilibriumEquilibrium At what point along the ATC curve does the firm in perfect competition end up producing in the long run?

• The firm produces at the lowest point on its ATC curve.

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EXHIBIT 13 ANATOMY OF THE FIRM’S LONG-RUN SUPPLY CURVE

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Exhibit 13: Anatomy of Exhibit 13: Anatomy of the Firm’s Long-Run the Firm’s Long-Run

Supply CurveSupply Curve Where does the supply curve begin for the firm in Exhibit 13?

• The supply curve begins at the point where MC=ATC on its marginal cost curve.

• Any point on the supply curve below that point will result in loss to the firm.

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Long-Run Equilibrium Long-Run Equilibrium Price and Output for the Price and Output for the

Firm in Perfect Firm in Perfect CompetitionCompetition

The market supply curve is the aggregation of the long-run MC curves of the firms in the market.

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EXHIBIT 14 ANATOMY OF THE MARKET SUPPLY CURVE

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Exhibit 14: Anatomy of Exhibit 14: Anatomy of the Market Supply Curvethe Market Supply Curve

When P=$100, what is the total market supply?

• At P=$100, 150 firms are willing to supply 6 tons each.

• Market supply = 150 firms * 6 tons = 900 tons.

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EXHIBIT 15 THE INNOVATOR FIRM IN PERFECT COMPETITION

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Exhibit 15: The Innovator Exhibit 15: The Innovator Firm in Perfect Firm in Perfect CompetitionCompetition

Complete this sentence: Innovation results in _____ economic profit in the long-run.

i. Higher.

ii. The same.

iii.Lower.

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ii. The same.

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ii. The same.

Economic profit may initially rise, but it will return to zero in the long-run.

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EXHIBIT 16 CONSTANT AND INCREASING RETURNS TO SCALE

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Exhibit 16: Constant and Exhibit 16: Constant and Increasing Returns to Increasing Returns to

ScaleScale How does ATC change between panel a and panel b in Exhibit 16?

• In panel a, constant returns to scale, the minimum ATC is the same for small and large firms.

• In panel b, increasing returns to scale, ATC falls as firm size and output increase.

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The Schumpeter The Schumpeter HypothesisHypothesis

• According to economist Joseph Schumpeter, bigness can be an advantage for an innovating firm.

• The economies of scale and low average costs of production available to big firms may allow them to charge prices that are actually lower than those charged by small, competitive firms.

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• Monopoly profits permit these firms to experiment with new technologies that ultimately lead to more efficient production.

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• Other economists, such as Alfred Marshall, disagree.

• They contend that the large number of small firms that undertake innovation will lead to the greatest efficiency in production over time.

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EXHIBIT 17 PRICE AND PRODUCTION IN MONOPOLY AND PERFECT COMPETITION: SCHUMPETER’S VIEW

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Exhibit 17: Price and Exhibit 17: Price and Production in Monopoly and Production in Monopoly and

Perfect Competition: Perfect Competition: Schumpeter’s View Schumpeter’s View

1. What is price and quantity for the competitive firm in panel a?

• Price is $25.

• With 200 firms in the market, quantity supplied to the market is 4,000.

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Exhibit 17: Price and Exhibit 17: Price and Production in Monopoly and Production in Monopoly and

Perfect Competition: Perfect Competition: Schumpeter’s View Schumpeter’s View

2. How does the competitive firm’s price and quantity compare to the monopoly in panel b?• The monopoly’s price is $20 -- $5 less than the competitive firm’s price.

• The monopoly’s output quantity is 10,000 -- 6,000 greater than the competitive firm’s output.

c hapter 11 price and output in monopoly, monopolistic competition, and perfect competition © 2002...

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