Perfectly Competitive Market and Monopoly Market Structure

Theory of Product Pricing
Market Structure and
Product Pricing
By
Khemraj Subedi
Associate Professor
M.Phil in Economics
PhD Scholar in Economics

●Concept of Market Structure
●Perfect Competition Market
●Monopoly market
●Social Cost of Monopoly
Outline

Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Market Structure by degree of competition

Key words of the unit.
● Firms : Firm is a business unit, enterprises that buys and hires,
produces resources and sells goods and services.
● Industry: Industry is group of such productive firms, enterprises
or organizations that produce or supply homogeneous goods,
services.
● Revenue: The total income received from a given source.
● Cost: An amount that has to be paid or given up in order to get
something human wants satisfying goods and services as output.
● Output: Production; quantity produced, created, or completed.

Perfectly competitive market
●Perfectly competitive market is a market
where large numbers sellers (firms) and
buyers interact together to buy and sell
homogeneous products at a price determined
by industry(market).
●Generally there is no barriers to entry and
exit of firms and market remains free from
government intervention.

Characteristics/ Features
Perfectly Competitive Market
● Large number of buyers and sellers
● Homogeneous Product
● Firms as price taker
● Rational behavior of sellers and buyers
● No barriers to entry and exit of firms
● Perfect information
● No government control in business decision
● Perfect factor mobility
● Well defined property right,
● No transportation cost

Price determination in perfect
Competition/ Market Equilibrium
● The price of the product under perfect competition, is
influenced by both buyers (demand side) and
sellers(supply side)and equilibrium price is determined by
the interaction of demand and supply forces.
● According to Marshall, demand and supply are like two
blades of a pair of scissors. Just as cutting of cloth is not
possible with the use of one blade, the equilibrium price of
a commodity cannot be determined, either by the forces of
demand or by supply alone. Both together determine the
price.

Interaction between market force Demand and Supply

Price determination in perfect
Competition/ Market Equilibrium

Meaning of Equilibrium

Price and Output Determination in
short run/ Short run equilibrium
● In the short-run, there the following
assumptions:
● The price of the product is given and the firm can
sell any quantity at that price.
● The size of the plant of the firm is constant.
● The firm faces given short-run cost curves.
● There operate many firms in the market.

The Competitive Firm
● Short-Run Equilibrium for the Perfectly
Competitive Firm:
♦ Profit-max Q is where MR = MC.
♦ D (or AR curve) is horizontal. So D is the MR curve or
MR = P.
■If a firm ↑Q by 1 unit, it still receives the same P.
♦ At an optimum Q: MR = P = MC → P = MC.

We know that the necessary and sufficient
conditions for the equilibrium of a firm are:
(i)Necessary condition:
MC = MR (Marginal Cost equals to marginal revenue)
(ii) Sufficient condition:
MC curve cuts the MR curve from below
● In other words, the MC curve must intersect the MR curve from
below and after the intersection lie above the MR curve. In simpler
terms, the firm must keep adding to its output as long as MR>MC.
● This is because additional output adds more revenue than costs
and increases its profits. Further, if MC=MR, but the firm finds
that by adding to its output, MC becomes smaller than MR, then it
must keep increasing its output.

Equilibrium of firms in Perfect Competition

Firm A Equilibrium with abnormal Profit=AR>AC
Firm B Equilibrium with normal Profit = AR=AC
Firm C Equilibrium with abnormal loss = AR<AC

Firm A Equilibrium with abnormal
Profit=AR>AC

Firm B Equilibrium with
normal Profit AR=AC

Firm C Equilibrium with
abnormal loss = AR<AC

Long-run Equilibrium in Perfect Competition
A perfectly competitive market is in its long-run equilibrium ONLY when the typical
firm is breaking even.
• Equilibrium is defined as “a state of balance”
• If any profits or losses are being earned, a PC market is out of balance, and firms will
enter or exit the market until equilibrium is restored.

● The Zero-Profit Condition in long-run
● Long-run equilibrium: The process of entry or
exit is complete – remaining firms earn zero
economic profit.
● Zero economic profit occurs when P = ATC.
● Since firms produce where P = MR = MC, the
zero-profit condition is P = MC = ATC.
● Recall that MC intersects ATC at minimum ATC.
● Hence, in the long run, P = minimum ATC.

TABLE 1. Revenues, Costs, and
Profits of a Competitive Firm
Quantity
(1,000's
of bushels)
Total
Revenue
($1,000's)
Marginal
Revenue
($1,000's)
Total Cost
($1,000's)
Marginal
Cost
($1,000's)
Total
Profit
($1,000's)
0 0 ------ 0 ------ 0
10 80 80 85 85 -5
20 160 80 150 65 10
30 240 80 180 30 60
40 320 80 230 50 90
50 400 80 300 70 100
60 480 80 450 150 30
70 560 80 700 250 -140

● Firms can't endure a loss forever.
● Sunk costs = costs that cannot be escaped in SR.
♦ E.g., restaurant owner has signed a one-year lease on
a building.
● If firm shuts down → TR = 0 and TVC = 0, but
TFC (or sunk costs) remain. Sometimes it is
better to remain in operation until the sunk costs
expire.
Shutdown and Break-Even
Analysis

● 2 rules that govern the shutdown decision:
1. If TR > TC → firm earns positive profits and should
remain open in SR and LR.
2. Firm should operate in SR if TR > TVC, but should
plan to close in LR if TR < TC.
● Proof:
♦ Loss if the firm stays open = TC - TR
♦ Loss if the firm shuts down = TFC = TC - TVC
● So stay open in SR if: TC - TR < TC - TVC
or TR > TVC.
Shutdown and Break-Even
Analysis

Shutdown and Break-Even Analysis

Monopoly Market
●The word monopoly has been derived from
the combination of two words i.e., ‘Mono’
and ‘Poly’. Mono refers to a single and poly
to seller.
●In this way, monopoly refers to a market
situation in which there is only one seller of
a commodity.

Monopoly cont…
● There are no close substitutes for the commodity it
produces and there are barriers to entry. The single
producer may be in the form of individual owner or a
single partnership or a joint stock company. In other
words, under monopoly there is no difference between
firm and industry.
● Monopolist has full control over the supply of
commodity. Having control over the supply of the
commodity he possesses the market power to set the
price. Thus, as a single seller, monopolist may be a king
without a crown. If there is to be monopoly, the cross
elasticity of demand between the product of the
monopolist and the product of any other seller must be
very small.

Characteristics/ Features of Monopoly

Equilibrium a Firm in
Monopoly

Equilibrium of Monopoly Firm under
TR and TC approach

Monopolist reaches at equilibrium when there is maximum
difference between TR and TC. In the following figure, this
maximum difference is maximum as BC when monopolist
produces given level of output.

Equilibrium in Monopoly
● The conditions for Equilibrium in Monopoly are
the same as those under perfect competition. They
are:
(i)Necessary condition :The marginal cost (MC) is
equal to the marginal revenue (MR) i.e. MC=MR
and
(ii) Sufficient Condition: The MC curve cuts the
MR curve from below. i.e. slope of MC > slope of
MR

A Firm’s Short-Run Equilibrium in Monopoly
● Like in perfect competition, there are three
possibilities for a firm’s Equilibrium in Monopoly.
These are:
● The firm earns normal profits: If the average cost =
the average revenue(i.e. AC=AR).
● It earns super-normal profits: If the average cost <
the average revenue (i.e. AC<AR).
● It incurs losses: If the average cost > the average
revenue (i.e. AC > AR).

Normal Profits : A firm earns normal profits when the
average cost of production is equal to the average revenue
for the corresponding output.

Super-normal Profits: A firm earns super-normal profits when the
average cost of production is less than the average revenue for the
corresponding output (i. e. AC<AR).

Abnormal Loss :A firm earns losses when the average
cost of production is higher than the average revenue
(AC > AR) for the corresponding output.

Summary of Short-run Equilibrium in Monopoly
● In the short-run, a monopolist firm cannot vary all
its factors of production as its cost curves are
similar to a firm operating in perfect competition.
● Also, in the short-run, a monopolist might incur
losses but will shut down only if the losses exceed
its fixed costs.
● Further, if the demand for his product is high, then
the monopolist can also make super-normal
profits.

Long-run Equilibrium a Firm in Monopoly
●In the long-run, a monopolist can vary all the
inputs.
●Therefore, to determine the equilibrium of the
firm, we need only two cost curves – the AC
and the MC.
● Further, since the monopolist exits the
market if he is operating at a loss, the demand
curve must be tangent to the AC curve or lie
to the right and intersect it twice.

cont…
● In the long run the monopolist has the time to expand his
plant, or to use his existing plant at any level which will
maximize his profit.
● With entry blocked, however, it is not necessary for the
monopolist to reach an optimal scale (that is, to build up
his plant until he reaches the minimum point of the
LAC).
● Neither is there any guarantee that he will use his
existing plant at optimum capacity.
● What is certain is that the monopolist will not stay in
business if he makes losses in the long run.

Social Cost of Monopoly
Understanding Social Cost
● Definition of social cost – Social cost is the total cost to
society. It includes private costs plus any external costs.
Social Cost of Driving a car for 10 Km
● Costs of paying for petrol (private cost)
● Costs of increased congestion (external cost)
● Pollution and worse air quality (external cost)
Now, the social cost includes all the above. (Petrol +
congestion + pollution)

Example of social cost – smoking
● If you smoke, the private cost is £6 for a packet of 20
cigarettes.
● But, there are also external costs to society. They are:
● Air pollution and risks of passive smoking,
● Litter from discarded cigarette butts,
● Health costs to society,
The social costs of smoking include the total of all private
and external costs.

Example of social cost of building airport
Private costs of airport
●Cost of constructing an airport.
●Cost of paying workers to run airport
External costs of airport
●Noise and air pollution to those living
nearby.
●Risk of an accident to those living nearby.
●Loss of landscape.

Social Cost of Monopoly
●Monopoly power results in higher prices and
lower quantities.
●However, does monopoly power make
consumers and producers in the aggregate
better or worse off?
●We can compare producer and consumer
surplus when in a competitive market and in
a monopolistic market.

Social cost of Monopoly
● Perfectly competitive firm will produce where MC
= D  PC and QC
● Monopoly produces where MR = MC, getting
their price from the demand curve  PM and QM
● There is a loss in consumer surplus when going
from perfect competition to monopoly
● A deadweight loss is also created with monopoly

B
A
Lost Consumer Surplus Because of the
higher price,
consumers lose
A+B and producer
gains A-C.
C
Deadweight Loss from
Monopoly Power
Quantity
AR=D
MR
MC
QC
PC
Pm
Qm
$/Q
Deadweight
Loss

Compare Monopoly to Competitive
Industry
300
$10
AC
AC
Quantity
PriceperUnit
8
150
D (= AR = P = MU)
D
MC
MC
MR
B
P
M
C
Monopoly Q = 150 →
MR = MC (pt M).
Comp. Q = 300 → P
= AC (pt B).
Monopolist produces
less Q and charges a
higher P.

Monopoly Leads to an Inefficient
Resource Allocation
● Competitive industries produce what society wants at
min possible cost.
● Efficiency in resource allocation requires that MU =
MC. This occurs under competition because industry
produces where D (or MU) = MC.
● Yet, monopolist produces smaller Q where MU > MC.
So consumers are willing to pay more for an add. unit
than it would cost to produce it.
● Resources are allocated inefficiently under monopoly,
because too few resources are used to produce the good.

Perfectly Competitive Market and Monopoly Market Structure

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