MICRO ECONOMICS

Motivation: Why did Forever 21 shut down?
Microeconomics December 1, 2019 1 / 92

Motivation: Does monopoly in water supply improve
quality of water?

Chapter 6: Market Structures
December 1, 2019

Content
1 Introduction to market structures
2 Perfectly competitive market
3 Monopoly market
4 Imperfectly competitive market
Monopolistic competition
Oligopoly

Introduction to market structures
Definition of market
Market is a group of buyers and sellers of a particular good or service
Classification of market structures
Number of firms
Types of goods (Identical, similar or differentiated)
Barriers to Entry (and Exit)
Control over price (price setter, price maker, and price taker)

Market types

Perfectly competitive market
1 What is perfect competition?
2 Characteristics of a perfectly competitive market
3 Demand and marginal revenue for a competitive firm
4 Choosing output in the short run
5 The competitive firm’s and market’s short-run supply curve
6 Choosing output in the long run
7 The industry’s long-run equilibrium and supply curve

What is perfect competition (competitive market) ?
Perfectly competitive market
A market with many buyers and sellers trading identical products so that
each buyer and seller is a price taker
Characteristics of the market
There are many buyers and many sellers in the market.
The goods offered by the various sellers are largely the same.
Firms can freely enter or exit the market.

(a) Demand curve facing the firm
(b) Market demand curve

(a) Demand curve facing the firm
(b) Market demand curve
In (a) the demand curve facing the firm is perfectly elastic.
In (b) the market demand curve is downward sloping.
A perfectly competitive firm supplies only a small portion of the total
output of all the firms in an industry
→ the firm takes the market price of the product as given, choosing its
output on the assumption that the price will be unaffected by the output
choice.

Profit maximization (Theory of profit - chapter 5)
Profit = Total Revenue - Total Cost
π(Q) = TR(Q) − TC(Q) (1)
π(Q) is maximized at the point at which an additional increment to
output leaves profit unchanged: ∆π/∆Q = π0(Q) = 0
∆π
∆Q
= ∆TR/∆Q
| {z }
MR
− ∆TC/∆Q
| {z }
MC
= 0 (2)
Profit is maximized when MR - MC = 0, so that MR = MC

Profit maximization: AB = Max(profit) at q*

Marginal revenue curve = Demand curve (at firm-level)
The demand curve D facing an individual firm in a perfectly
competitive market is both its average revenue curve and its marginal
revenue curve.
Additional revenue = price (P = MR)
→ Along this demand curve, marginal revenue, average revenue, and price
are all equal.
To maximize profit, the competitive firm follows:
MC = MR = P

Choosing output in the short run
How much output should a firm produce over the short run, when its
plant size is fixed (capital = constant, labour is changeable)?
A firm can use information about revenue and cost to make a
profit-maximizing output decision.

Choosing output in the short run at q* (P=MC)

Choosing output in the short run at q* (P=MC)
The profit of the firm is measured by the rectangle ABCD
Any change in output, whether lower at q1 or higher at q2, will lead to
lower profit.
Output Rule:
If a firm is producing any output, it should produce at the level at which
marginal revenue equals marginal cost.

Shut down if P < AVCmin

Breakeven point: P = ATCmin. Shut down if P <
AVCmin.
Sunkcost: Let bygones be bygones
Sunk cost a cost that has already been committed and cannot be
recovered.
The firm cannot recover its FC by temporarily stopping production. That
is, regardless of the quantity of output supplied (even if it is zero), the
firm still has to pay FC.
The FC are sunk in the short run, and the firm can ignore them when
deciding how much to produce. The firm’s short-run supply curve is the
part of the MC curve that lies above AVC, and the size of the FC does not
matter for this supply decision.

The competitive firm’s and market’s short-run supply curve
A supply curve for a firm tells us how much output it will produce at
every possible price
Competitive firms will increase output to the point: P = MC
Competitive firms will shut down if P < AVCmin.
→ The firm’s supply curve is the portion of the MC curve for which MC >
AVC.

The competitive firm’s and market’s short-run supply curve

Choosing output in the long run
In the short run:
One or more of the firm’s inputs are fixed. This may limit the flexibility of
the firm to adapt its production process to new technological
developments, or to increase or decrease its scale of operation as economic
conditions change.
In the long run:
A firm can alter all its inputs, including plant size. It can decide to shut
down (i.e., to exit the industry) or to begin producing a product for the
first time (i.e., to enter an industry).

In the short-run:
Profit is the area ABCD
In the long-run:
The firm maximizes its profit by choosing the output at which price equals
long-run marginal cost LMC.
The firm increases its profit from ABCD to EFGD by increasing its output
in the long run.

The industry’s long-run equilibrium and supply curve
Economic profit
π = TR − (wL + rK)
| {z }
=TC
(3)
Where: π is profit, TR is total revenue, w is wage, L is labour, r is rent, K
is capital (machines)

The industry’s long-run equilibrium and supply curve
Zero economic profit
A firm is earning a normal return on its investment—i.e., it is doing as well
as it could by investing its money elsewhere.
Entry and exit
In a market with entry and exit, a firm enters when it can earn a positive
longrun profit and exits when it faces the prospect of a long-run loss.

A long-run competitive equilibrium occurs when three
conditions hold:
1. All firms in the industry are maximizing profit.
2. No firm has an incentive either to enter or exit the industry because all
firms are earning zero economic profit.
3. The price of the product is such that the quantity supplied by the
industry is equal to the quantity demanded by consumers.

A long-run competitive equilibrium

A long-run competitive equilibrium
In (a) we see that firms earn positive profits because long-run average cost
reaches a minimum of $30 (at q2).
Positive profit encourages entry of new firms and causes a shift to the
right in the supply curve to S2, as shown in (b).
The long-run equilibrium occurs at a price of $30, as shown in (a), where
each firm earns zero profit and there is no incentive to enter or exit the
industry.

The Industry’s Long-Run Supply Curve
Constant-cost industry Industry whose long-run supply curve is
horizontal.
Increasing-cost industry Industry whose long-run supply curve is upward
sloping.
Decreasing-cost industry Industry whose long-run supply curve is
downward sloping.

Constant-cost industry

Constant-cost industry
The long-run supply curve for a constant-cost industry is, a horizontal line
at a price that is equal to the long-run minimum average cost of
production.
At any higher price, there would be positive profit, increased entry,
increased short-run supply, and thus downward pressure on price.
Remember that in a constant-cost industry, input prices do not change
when conditions change in the output market.
Constant-cost industries can have horizontal long-run average cost curves.

Increasing-cost industry

Increasing-cost industry
In an increasing-cost industry, the long-run industry supply curve is
upward sloping. The industry produces more output, but only at the
higher price needed to compensate for the increase in input costs.
The term “increasing cost” refers to the upward shift in the firms’ long-run
average cost curves, not to the positive slope of the cost curve itself.

Decreasing-cost industry
The industry supply curve can be downward sloping. In this case, the
unexpected increase in demand causes industry output to expand as
before. But as the industry grows larger, it can take advantage of its size
to obtain some of its inputs more cheaply.
For example: a larger industry may allow for an improved transportation
system or for a better, less expensive financial network. In this case, firms’
average cost curves shift downward (even if they do not enjoy economies
of scale), and the market price of the product falls. The lower market price
and lower average cost of production induce a new longrun equilibrium
with more firms, more output, and a lower price. Therefore, in a
decreasing-cost industry, the long-run supply curve for the industry is
downward sloping.

Producer and consumer surplus
Consumer surplus
is the area above the market price and up to the demand curve; this is the
total benefit or value that consumers receive beyond what they pay for the
good.
Producer surplus
is the area above the supply curve up to the market price; this is the
benefit that lower-cost producers enjoy by selling at the market price.

Consumer A would pay $10 for a good whose market price is $5 and
therefore enjoys a benefit of $5. Consumer B enjoys a benefit of $2, and
Consumer C, who values the good at exactly the market price, enjoys no
benefit. Consumer surplus, which measures the total benefit to all
consumers, is the yellow-shaded area between the demand curve and the
market price.
Producer surplus measures the total profits of producers, plus rents to
factor inputs. It is the green-shaded area between the supply curve and the
market price.
Together, consumer and producer surplus measure the welfare benefit of a
competitive market.

Deadweight loss: Net loss of total (consumer plus
producer) surplus

Deadweight loss: Net loss of total (consumer plus
producer) surplus
The change in consumer surplus is A − B and the change in producer
surplus is - A − C. The total change in surplus is:
(A − B) + (−A − C) = −B − C (4)
A deadweight loss is given by the two triangles B and C.

Exercise 1
Suppose there is a perfectly competitive industry with a market demand
curve that can be expressed as: P = 100 –(1/10)Q where P is the market
price and Q is the market quantity. Furthermore, suppose that all the
firms in this industry are identical and that a representative firm’s total
cost is: TC = 100 + 5q + q2 where q is the quantity produced by this
representative firm. The representative firm’s marginal cost is:MC = 5 +
2q.
a. What is the average total cost for the representative firm?
b. In the long run, how many units will this firm produce and what price
will it sell each unit for in this market?
c. What is the total market Qm produced in this market in the long run?

Monopoly market
1 What is monopoly?
2 Sources of monopoly power
3 Demand and marginal revenue for a monopolist?
4 Monopolist’s output decision (price, quantity and profit)
5 Is there any supply curve for a monopolist?
6 Measuring market power
7 Price discrimination

What is monopoly and market power?
A monopoly
is a market that has only one seller but many buyers.
Market power
is an ability of a seller or buyer to affect the price of a good.

Why does Monopoly arise?
The fundamental cause of monopoly is barriers to entry
Monopoly resources: A key resource required for production is owned
by a single firm (E.g: Diamond company). In practice monopolies
rarely arise for this reason.
Government regulation: The government gives a single firm the
exclusive right to produce some good or service. monopoly a firm
that is the sole seller of a product without close substitutes. E.g:
patent and copyright laws.
The production process: A single firm can produce output at a lower
cost than can a larger number of producers. Natural monopoly a
monopoly that arises because a single firm can supply a good or
service to an entire market at a smaller cost than could two or more
firms.

Natural monopoly
The distribution of water:
To provide water to residents of a town, a firm must build a network of
pipes throughout the town. If two or more firms were to compete in the
provision of this service, each firm would have to pay the fixed cost of
building a network. Thus, the average total cost of water is lowest if a
single firm serves the entire market.

A natural monopoly : Water suppliers

A natural monopoly arises when there are economies of
scale over the relevant range of output (ATC decreases)

Demand and marginal revenue for a monopolist
Relationship among total, average, and marginal revenue
Consider a firm facing the following demand curve D (b>0):
P = a − bQ (7)
TR = Q.P = aQ − bQ2
(8)
AR = TR/Q = a − bQ (9)
Marginal revenue (MR) : The first derivative of TR subject to Q
MR = TR0
(Q) = a − 2bQ (10)

Demand and marginal revenue for a monopolist

Price, quantity and profit of monopolies

Recall: Q* maximizes profit
π(Q) is maximized at the point at which an additional increment to
output leaves profit unchanged: ∆π/∆Q = π0(Q) = 0
∆π
∆Q
= ∆TR/∆Q
| {z }
MR
− ∆TC/∆Q
| {z }
MC
= 0 (11)
→ the profit-maximizing condition is: MR - MC = 0, or MR = MC.

Q* maximizes profit
is the output level at which MR = MC.
If the firm produces a smaller output Q1:
then it sacrifices some profit because the extra revenue that could be
earned from producing and selling the units between Q1 and Q* exceeds
the cost of producing them.
Similarly, expanding output from Q* to Q2 would reduce profit because
the additional cost would exceed the additional revenue.

Pricing in monopoly
MR =
∆TR
∆Q
=
∆(PQ)
∆Q
(12)
1 Producing 1 extra unit and selling it at price P yields revenue = P.
2 But because the firm faces a downward-sloping demand curve,
producing and selling this extra unit also results in a small drop in
price ∆P/∆Q which reduces the revenue from all units sold (i.e., a
change in revenue Q ∗ h∆P/∆Qi).
3 Thus:
MR = P + Q
∆P
∆Q
= P + Ph
P
Q
ih
∆P
∆Q
i (13)

Pricing in Monopoly
MR = P + P h
P
Q
ih
∆P
∆Q
i
| {z }
1/Ed
(14)
MR = P + P
1
Ed
= MC (15)
P − MC
P
= −
1
Ed
(16)

Pricing in Monopoly
Rule of pricing in Monopoly
From Equation 16:
P =
MC
1 +
1
Ed
(17)
For example, if the elasticity of demand is 4 and marginal cost is $9 per
unit, price should be $9/(1 − 1/4) = $9/.75 = $12 per unit.

Supply curve of monopolies

Supply curve of monopolies
Shifting the demand curve shows that a monopolistic market has no
supply curve, because there is no one-to-one relationship between price
and quantity produced.
In (a), the demand curve D1 shifts to new demand curve D2. But the new
marginal revenue curve MR2 intersects marginal cost at the same point as
the old marginal revenue curve MR1. The profit-maximizing output
therefore remains the same, although price falls from P1 to P2.
In (b), the new marginal revenue curve MR2 intersects marginal cost at a
higher output level Q2. But because demand is now more elastic, price
remains the same.

Market power: Sources of monopoly power
Monopoly power
is the ability to set price above marginal cost and that the amount by
which price exceeds marginal cost depends inversely on the elasticity of
demand facing the firm.
The less elastic the demand curve is, the more monopoly power a firm has.
The ultimate determinant of monopoly power is therefore the firm’s
elasticity of demand.

Measuring monopoly power
Lerner Index of Monopoly Power
Measure of monopoly power calculated as excess of price over marginal
cost as a fraction of price.
This index of monopoly power can also be expressed in terms of the
elasticity of demand facing the firm (See Equation 16):
L = (P − MC)/P = −1/Ed (18)
The Lerner index always has a value between zero and one. For a perfectly
competitive firm, P = MC, so that L = 0. The larger is L, the greater is
the degree of monopoly power.

Price markup
The markup (P − MC)/P is equal to minus the inverse of the elasticity of
demand facing the firm (Ed ).
Ed is the elasticity of demand for the firm, not the elasticity of market
demand.
(The next slide) If the firm’s demand is elastic, as in (a), the markup is
small and the firm has little monopoly power. The opposite is true if
demand is relatively inelastic, as in (b).

Price markup

Source of Monopoly power
Recall in Equation 18: the less elastic its demand curve, the more
monopoly power a firm has.
Three factors determine a firm’s elasticity of demand:
1 The elasticity of market demand. Because the firm’s own demand will
be at least as elastic as market demand, the elasticity of market
demand limits the potential for monopoly power.
2 The number of firms in the market. If there are many firms, it is
unlikely that any one firm will be able to affect price significantly.
3 The interaction among firms. Even if only two or three firms are in
the market, each firm will be unable to profitably raise price very
much if the rivalry among them is aggressive, with each firm trying to
capture as much of the market as it can.

Price discrimination
Price discrimination: the business practice of selling the same good at
different prices to different customers
Perfect price discrimination: a situation in which the monopolist knows
exactly each customer’s willingness to pay and can charge each customer a
different price.
Imperfect price discrimination: In reality, price discrimination is not
perfect. Customers do not walk into stores with signs displaying their
willingness to pay. Instead, firms price discriminate by dividing customers
into groups: young versus old, weekday versus weekend buyers, peak
versus off-peak customers, Vietnamese versus foreigners, etc.

Price discrimination: Electricity rate by EVN

Figure (a) shows a monopolist that charges the same price to all
customers. Total surplus in this market equals the sum of profit (producer
surplus) and consumer surplus.
Figure (b) shows a monopolist that can perfectly price discriminate.
Because consumer surplus equals zero, total surplus now equals the firm’s
profit.
Comparing these two figures: perfect price discrimination raises profit,
raises total surplus, and lowers consumer surplus.

Inefficiency of Monopoly

Public Policy toward Monopolies
Policy makers in the government can respond to the problem of
monopoly in one of four ways:
By trying to make monopolized industries more competitive.
By regulating the behavior of the monopolies.
By turning some private monopolies into public enterprises.
By doing nothing at all.

Da River plant apologises for Hanoi water crisis

Discussion (To be cont. in Chapter 8)
Sector’s public goods provision: necessary but needs supervision
Update: November, 05/2019 - 08:35 (Vietnamnews.vn/econommy) by Vo
Tri Thanh
Despite knowing that oil waste had been dumped at the source, the
supplier – Vinaconex Water Supply Joint Stock Company (Viwasupco) –
continued to pump water into family homes. At a press conference, the
company’s CEO even said: “Viwasupco was the biggest victim in this
case.”
The case has raised questions about who is responsible for checking water
quality and ensuring it is safe for use, and whether the participation of the
private sector in delivering public goods is as necessary and efficient as
expected.

Shinkansen Japanese High-speed rail

Shinkansen Japanese High-speed rail (Loss JPY 36,7K
Billions in 1987)

Swiss Federal Railway: SBB, CFF, and FFS

Comparison between Perfect Competition and Monopoly

Four types of markets

Imperfect competitive markets
1 Monopolistic competition: a market structure in which many firms
sell products that are similar but not identical
2 Oligopoly: a market structure in which only a few sellers offer similar
or identical products

Monopolistic competition: Car industry

Monopolistic competition
1 Many sellers: There are many firms competing for the same group of
customers.
2 Product differentiation: Each firm produces a product that is at least
slightly different from those of other firms. Thus, rather than being a
price taker, each firm faces a downward-sloping demand curve.
3 Free entry and exit: Firms can enter or exit the market without
restriction. Thus, the number of firms in the market adjusts until
economic profits are driven to zero.
4 It is a hybrid of monopoly and competition.

Monopolistic competition: in short-run
In panel (a), price exceeds average total cost, so the firm makes a profit.
In panel (b), price is below average total cost. In this case, the firm is
unable to make a positive profit, so the best the firm can do is to minimize
its losses.

Monopolistic competition: in long-run

A Monopolistic Competitor in the Long Run
In a monopolistically competitive market, if firms are making profit, new
firms enter, and the demand curves for the incumbent firms shift to the
left.
Similarly, if firms are making losses, old firms exit, and the demand curves
of the remaining firms shift to the right. Because of these shifts in
demand, a monopolistically competitive firm eventually finds itself in the
longrun equilibrium shown here.
In this long-run equilibrium: P = ATC and the firm earns zero profit.

Monopolistic Competition and Perfect Competition in
Long Run

Monopolistic Competition and Perfect Competition in
Long Run
Two differences:
1 The perfectly competitive firm produces at the efficient scale, where
average total cost is minimized. By contrast, the monopolistically
competitive firm produces at less than the efficient scale.
2 Price equals marginal cost under perfect competition, but price is
above marginal cost under monopolistic competition.

Exercise 1
Consider a monopolistically competitive market with N firms. Each firm’s
business opportunities are described by the following equations: Demand:
Q = 100/N – P
Marginal Revenue: MR
Total Cost: TC = 50 + Q2
Marginal Cost: MC = 2Q
a. How does N, the number of firms in the market, affect each firm’s
demand curve? Why? b. How many units does each firm produce? (The
answers to this and the next two questions depend on N.) c. What price
does each firm charge?

Exercise 2
For each of the following characteristics, say whether it describes a
monopoly firm, a monopolistically competitive firm, both, or neither.
1 Faces a downward-sloping demand curve
2 Has marginal revenue less than price
3 Faces the entry of new firms selling similar products
4 Earns economic profit in the long run
5 Equates marginal revenue and marginal cost
6 Produces the socially efficient quantity of output

Oligopoly
Oligopoly:
A market structure in which only a few sellers offer similar or identical
products
Strategy
Because oligopolistic markets have only a small number of firms, each firm
must act strategically. Each firm knows that its profit depends not only on
how much it produces but also on how much the other firms produce. In
making its production decision, each firm in an oligopoly should consider
how its decision might affect the production decisions of all the other firms.
Game theory
the study of how people behave in strategic situations.

Competition, Monopolies, and Cartels
Collusion
An agreement among firms in a market about quantities to produce or
prices to charge.
Cartel
A group of firms acting in unison.
Example: OPEC. What is OPEC? Please try to look in youtube.
Website of OPEC: https://www.opec.org/opecw eb/en/

The Equilibrium for an Oligopoly
Nash equilibrium:
a situation in which economic actors interacting with one another each
choose their best strategy given the strategies that all the other actors
have chosen
Oligopoly chooses product to maximize profit
it produces a quantity of output greater than the level produced by
monopoly and less than the level produced by competition. The oligopoly
price is less than the monopoly price but greater than the competitive
price (which equals marginal cost).

How the Size of an Oligopoly Affects the Market Outcome
As the number of sellers in an oligopoly grows larger, an oligopolistic
market looks more and more like a competitive market. The price
approaches marginal cost, and the quantity produced approaches the
socially efficient level.

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