MARKET STRUCTURES AND PROFIT MAXIMIZATION Key Note Speech

MARKET STRUCTURES AND PROFIT MAXIMIZATION

• Key Note Speech- 10 (3: 00 Hrs)

CONTENTS OF THIS UNIT 4. 1. Competitive Market 4. 1. 1. Characteristics/ Behavioral Assumptions 4. 1. 2. Derivation of the individual firm's demand curve 4. 1. 3. Total, Average and Marginal Revenue 4. 1. 4. Profit Maximization in a Perfectly Competitive Market • The Total Revenue- Total cost Approach • The Marginal Approach 4. 2. Overview of Theories of Imperfect Competition 4. 2. 1. Monopoly 4. 2. 2. Oligopoly 4. 2. 3. Monopolistic Competition 4. 2. 4. Profit Maximization in an Imperfectly Competitive Market

Market Structure • The opportunity for profit may be limited by the structure of the industry. • Market structure is the number and relative size of firms in an industry. • Perfect competition is market in which no buyer or seller has market power. - Monopoly is a firm that produces the entire market supply of a particular good or service.

Market Structure Imperfect competition Perfect Monopolistic Oligopoly competition Duopoly Monopoly

Basic Difference Between Perfect and Imperfect Market Structure • Their basic difference lies on the fact that firms have a market power in the latter case than the former. But it doesn’t mean that there is no competition in the latter. 1. Firms have market power when the following conditions exist. a. Firms can influence price in attempts to increase profits. b. The existence of profits does not attract new firms into the industry. 2. The following conditions are required for market power. a. A few firms control the product. b. There are limitations on the entry of new firms.

Perfectly Competitive Market • It is a market structure with the following characteristics – Many sellers and buyers in the market – Homogeneous products – Independent behavior – Perfect information – Free entry and exit – Perfectly elastic demand curve /Individual firms are price takers

Price Takers • A perfectly competitive firm has no market power and has no ability to alter the market price of the goods it produces. – Market Power - The ability to alter the market price of a good or service. • The output of a perfectly competitive firm is so small relative to the market supply so that it has no significant effect on the total quantity or price in the market.

Market Demand Curves vs. Firm Demand Curves • It is important to distinguish between the market demand curve and the demand curve confronting a particular firm. • While the actions of a single competitive firm are negligible, the unified actions of many such firms are not. • The market demand curve for a product is always downward-sloping. - The demand curve confronting a perfectly competitive firm is horizontal (perfectly elastic demand curve).

Market Demand Curves vs. Firm Demand Curves The market (Industry) Demand facing a single firm PRICE Market supply pe Equilibriu m price pe Demand facing single firm Market demand Quantity

The Production Decision • A competitive firm has only one decision to make: how much to produce. • The production decision is the selection of the short-run rate of output (with existing plant and equipment).

Output and Revenues • In searching for the most desirable rate of output, the distinction between total revenue and total profit must be kept in mind. – Total revenue - The price of the good multiplied by the quantity sold in a given time period. Total revenue = price X quantity

Output and Revenues • The total revenue curve of a perfectly competitive firm is an upward-sloping straight line, with a slope equal to pe.

Total Revenue Total revenue Total Revenue $96 88 80 72 64 56 48 40 32 24 16 8 0 pe= $8 1 2 3 4 5 6 7 8 9 101112 Quantity

Output and Costs • To maximize profits a firm must consider how increased production will affect costs as well as revenues. • Producers are saddled with certain costs in the short-run. • Short-run - The period in which the quantity (and quality) of some inputs cannot be changed.

Output and Costs • Fixed costs are incurred even if no output is produced. • Fixed costs - Costs of production that do not change when the rate of output is altered, e. g. , the cost of basic plant and equipment. • Once a firm starts producing output, it incurs variable costs as well. • Variable costs - Costs of production that change when the rate of output is altered, e. g. labor and material costs. • The primary objective of the producer is to find that one particular rate of output that maximizes profits.

Profit Maximizing Rules • • The total approach- compares the total revenue (TR) with total cost (STC) The marginal approach- compares marginal revenue (MR) with marginal cost (MC)

Revenues Or Costs (dollars period) Total Profit Total cost its f o r Pr s es s s Lo f h g Output (units period) Total revenue

The Gap Between Revenue and Cost must be the Highest for Profit Maximization such as at q* as per the Total Approach Costs (TC) Revenues (TR) Costs, Revenue (a) 0 (b) Output per week Profits 0 q 1 q* q 2 Profits Output per week 19

Profit-Maximizing Rule • The best single rule for maximizing shortrun profits is straightforward: • Never produce a unit of output that costs more than it brings in.

Key Note Speech- 11 (1: 00 Hrs)

Marginal Revenue = Price • The contribution to total revenue of an additional unit of output is called marginal revenue. • Marginal revenue (MR) is the change in total revenue that results from a one-unit increase in the quantity sold. • For perfectly competitive firms, price equals marginal revenue.

Marginal Revenue = Price

Marginal Cost • A firm’s goal is not to maximize revenues, but to maximize profits. • Marginal revenue is compared to marginal costs to determine the best level of output. • What an additional unit of output brings in is its marginal revenue (MR). -What it costs to produce is its marginal cost (MC).

Marginal Cost

Profit-Maximizing Rate of Output • According to the profit-maximization rule a firm should produce at that rate of output where marginal revenue equals marginal cost.

Profit-Maximizing Rate of Output • If marginal cost exceeds price, total profits decline if the additional output is produced. If marginal cost is less than price, total profits increase if the additional output is produced. n Profits are maximized at the rate of output where price equals marginal cost. n

Short-Run Profit-Maximization Rules for Competitive Firm Price > MC increase output Price = MC maintain output and maximize profit Price < MC decrease output

Profit-Maximizing Rate of Output $18 Marginal cost Price or Cost (per bushel) 16 14 12 10 p = MC MRB Price (= MR) Profits increasing 8 Profit-maximizing rate of output 6 4 Profits decreasing MCB 2 0 1 2 3 4 5 Quantity (bushels per day) 6 7

Adding Up Profits • Profits can be computed in two ways. • Total profit is the difference between total revenue and total cost. Total profit = total revenue – total cost

Adding Up Profits • Total profit is average profit times the number sold. Profit per unit = price – ATC Total profit = profit per unit X quantity Total profit = (p – ATC) X q

Adding Up Profits • The profit-maximizing producer never seeks to maximize per-unit profits. n What counts is total profits, not the amount of profit per unit.

Price and average cost Total revenue and total cost $90 80 70 60 50 40 30 20 10 0 Total revenue Maximum total profit Total cost 1 2 3 4 5 Rate of Output 6 7 $18 Average 16 total cost 14 Total Profit 12 10 8 6 4 Marginal cost 2 Price or Cost (per unit) Revenue or Cost (dollars per day) Alternative Views of Total Profit 0 1 Price Profit per unit Cost per unit 2 3 4 5 Rate of Output 6 7

The Shutdown Decision • The short-run profit maximization rule does not guarantee any profits. • Fixed costs must be paid even if all output ceases. • A firm should shut down only if the losses from continuing production exceed fixed costs.

Price vs. AVC • Where price exceeds average variable cost but not average total cost, the profit maximizing rule minimizes losses. • When price does not cover average variable costs at any rate of output, production should cease. • The shutdown point is that rate of output where price equals minimum AVC.

The firm will opt for Q > 0 providing

The Shutdown Point Profit 18 16 Price or Cost 14 Loss MC ATC X 12 Price (=M R) MC ATC AVC 10 Shutdown MC AVC Price Y 8 AVC 6 Price 4 shutdown point 2 0 1 2 3 4 5 6 7 8 Quantity

Numerical Example( See page 89) Given : market price 250 Total Cost = 6000+400 q 2+Q 3 Should the firm produce at this price.

The Firm’s Short-Run Supply Curve • The firm’s short-run supply curve is the relationship between price and quantity supplied by a firm in the short-run. • For a price-taking firm, this is the positively sloped portion of the short-run marginal cost curve. • For all possible prices, the marginal cost curve shows how much output the firm should supply.

Price Short-Run Supply Curve $18 16 14 12 10 8 6 4 2 0 X Shutdown point Y Marginal cost curve 1 2 3 = Short-run supply curve for competitive firm 4 Quantity Supplied 5 6 7

Long run Equilibrium of the firm and industry • • All factors are variable New firms can enter the industry Firms can leave the industry Thus, the firm will not incur losses in the long • Long run(LR) equilibrium conditions: 1. Price(AR)= LMC= MR 2. Price= Average cost

Cont… • Hence, in the LR the firm will be in equilibrium if price =AR=LMC=LAC=MRm • The firm is making normal profit • See fig 2. 7 in your module. • Equilibrium of the industry is when quantity demanded equal with quantity at the minimum point of LAC.

• Key Note Speech- 12 (1: 50 Hrs)

Theories of Imperfect Competition • It includes • monopoly, monopolistic competition and oligopoly

Monopoly • Introduction • A monopoly is a single seller of a product with no close substitutes. • This part examines how a market controlled by a single producer behaves. – What are the basic characteristics of such a market? – What price will a monopolist charge? – How much will the monopolist produce?

Monopoly • is a market, which has the following characteristics/ behavioral assumptions. – Single seller – Firm and industry – Market power – Unique products – Price Discrimination – Blocked entry

Monopolies derive their market power from barriers to entry including • Economic barriers – Economies of scale – Capital requirements – Control of Natural Resources • Legal barriers – patents, copyrights • Artificial barriers/ Deliberate Actions – Through hiding information and technologies, controlling strategic resources, collusion, lobbying governmental authorities, and even may use force • Technological barriers • – Natural Monopoly – Technological superiority Franchise and licenses- A franchise is a contract that gives a single firm the right to sell its goods within an exclusive market. A license is a government-issued right to operate a business.

Market Power • Market power is the ability to alter the market price of a good or service. • Firms with market power confront downward-sloping demand curves. • Competitive firms face a horizontal demand curve.

Firm vs. Industry Demand Price The competitive firm $13 Demand facing competitive firm The industry $13 Market demand 0 Quantity

Monopoly • The demand curve facing the monopoly firm is identical to the market demand curve for the product. • Monopoly is a firm that produces the entire market supply of a particular good or service.

Price and Marginal Revenue • A monopoly faces a different profit maximizing situation than competitive firms. – Profit-maximization rule – Produce at that rate of output where MR = MC. • Unlike competitive firms, marginal revenue for a monopolist is not equal to price.

Price and Marginal Revenue • Marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

Price and Marginal Revenue • So long as the demand curve is downward -sloping, MR will always be less than price. n The MR curve lies below the demand (price) curve at every point but the first.

Price and Marginal Revenue

Price and Marginal Revenue $14 A B Price (per basket) 12 C D b 10 E c 8 F G Demand (= price) d 6 e 4 f 2 Marginal revenue g 0 1 2 3 4 5 6 7 Quantity (baskets per hour) 8 9 10

Mathematical relation • Mathematical relation of MR, AR and P is shown on page 99 of your module.

Profit Maximization • We need to find the intersection of marginal cost and marginal revenue. • This will give us the profit-maximizing rate of output. • Only one price is compatible with the profit -maximizing rate of output.

Price or Cost (per basket) Profit Maximization $14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 Average total cost D Profits d Demand Marginal cost 1 2 Marginal revenue 3 4 5 6 7 Quantity (baskets per hour) 8 9

The Monopoly Price • The intersection of the marginal revenue and marginal cost curves establishes the profit-maximization rate of output. • The demand curve tells us how much consumers are willing to pay for that output.

Initial Conditions in the Monopolized Market W C Price (per computer) 1000 800 B 400 200 0 Marginal cost 200 400 1000 Average total cost M 600 1200 Price (per computer) $1200 Monopoly outcome Competitive outcome Demand curve facing single plant Marginal revenue of single plant 800 1200 Quantity (computers per month) 1600 800 600 Competitive market supply A X Market demand 400 200 0 24, 000 Quantity (computers per month)

Monopoly Profits • Total profit equals average profit per unit times the number of units produced. Profit per unit = price – average total cost Profit per unit = p – ATC Total profits = profit per unit X quantity Total profits = (p – ATC) X q

Monopoly Profits • A monopoly receives larger profits than a comparable competitive industry by reducing the quantity supplied and pushing prices up.

Monopoly Profits $1200 Marginal cost W C 1000 Price 800 Profit Average total cost M 600 K Demand curve B 400 200 0 Marginal revenue 200 400 600 800 1000 Quantity 1200 1400

Long run(LR) Equilibrium of Monopoly • The magnitude of the LR profits of a monopoly depends up on the cost conditions and the demand curve • See fig 6. 4 page 103. • Equilibrium level of out put(LMC=MR) may not have the lowest LR : AC.

Monopolist supply • The suply curve for a perfectly competitive firm was the marginal cost curve. • But in monopoly these is no supply curve. • This unique relationship of price and quantity supplied does not exist. • There is no uniqe relationship between price and quantity.

Cont…. • The reason is the same output can be sold at infinite number of different price or the same price may be charged for various quantities supplied depending on the price elasticity of demand. • See panal A and B on page 104

Multi plant monopolist • Assumptions for simplicity • The firm has two plants • The firm is aware of its AR and MR curves • Thus , in order to produce the profit maximization level of out put, the monopoly firm will operate each plant in such a manner that MC in each plant equals to the common MR. • See numerical examples on page 106.

Other concepts of monopoly • Price discrimination • Social cost of monopoly

Monopolistic Competition (M. C. ) • Introduction • In monopolistic competition, many companies compete in an open market to sell products which are similar, but not identical. • Key questions answered in this part include: – What are the unique features of monopolistic competition? – How are the market outcomes affected by this market structure?

M. C. is a market structure, which has the following basic characteristics • Large number of sellers • Product differentiation-Features that make one product appear different from competing products in the same market. • Independent behavior- The relative independence of monopolist competitors means that they don’t have to worry about retaliatory responses to every price or output change. • Freedom of entry & exit • None Price Competition- such as advertising the difference in their products or by supplying other services attached to the sale of the product. • Non-price competition is a way to attract customers through style, service, or location, but not a lower price.

Ctd. • A distinguishing structural characteristic of monopolistic competition is that there are “many” firms in the industry. • Monopolistic competition is a market in which many firms produce similar goods or services but each maintains some independent control of its own price. • “Many” is somewhere between the “few” of oligopolies or the “hordes” that characterize perfect competition. • Each producer in monopolistic competition is large enough to have some market power. • A monopolistically competitive firm confronts a downward -sloping demand curve for its output.

Ctd. • Each firm has a distinct identity – a brand image. • Consumers perceive its output to be somewhat different than others in the industry. • By differentiating their products, monopolistic competitors establish brand loyalty. • Brand loyalty gives producers greater control over the price of their products.

Ctd. • By differentiating their products, monopolistic competitors establish brand loyalty. • Brand loyalty gives producers greater control over the price of their products. • Each firm only has a monopoly on its brand image. • It still competes with other firms offering close substitutes.

• Brand loyalty makes the demand curve facing the firm less price-elastic. • Brand loyalty implies that consumers shun substitute goods even when they are cheaper. • Each monopolistically competitive firm will establish some consumer loyalty • A symptom of brand loyalty is the price differences between computers which are essentially the same.

Short-Run Price and Output • The monopolistically competitive firm’s production decision is similar to that of a monopolist. – Production decision - The selection of the short-run rate of output (with existing plant and equipment). • As always, the profit-maximizing rate of output is achieved by producing the quantity where MR = MC.

Entry and Exit • With low barriers to entry, new firms will enter the market if there is economic profit. – Economic profit – The difference between total revenues and total economic costs.

Equilibrium in Monopolistic Competition Price or Cost (dollars per unit) The short run pa ca MC F ATC Demand K MR 0 qa Quantity (units period)

Price and Output in Monopolistic Competition The Firm’s Short-Run Output and Price Decision A firm that has decided the quality of its product and its marketing program produces the profit-maximizing quantity at which its marginal revenue equals its marginal cost (MR = MC). Price is set at the highest price the firm can charge for the profit-maximizing quantity. The price is determined from the demand curve for the firm’s product.

Equilibrium in Monopolistic Competition Figure 13. 2 shows a shortrun equilibrium for a firm in monopolistic competition. It operates much like a single-price monopoly.

Price and Output in Monopolistic Competition The firm produces the quantity at which marginal revenue equals marginal cost and sells that quantity for the highest possible price. It makes an economic profit (as in this example) when P > ATC.

Price and Output in Monopolistic Competition Figure 13. 4 shows a firm in monopolistic competition in long-run equilibrium. If firms incur an economic loss, firms exit to achieve the long-run equilibrium.

Price and Output in Monopolistic Competition and Perfect Competition Two key differences between monopolistic competition and perfect competition are: § Excess capacity § Markup A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. A firm’s markup is the amount by which its price exceeds its marginal cost.

Price and Output in Monopolistic Competition Excess Capacity Firms in monopolistic competition operate with excess capacity in long-run equilibrium. The downward-sloping demand curve for their products drives this result.

Price and Output in Monopolistic Competition Markup Firms in monopolistic competition operate with positive mark up. Again, the downwardsloping demand curve for their products drives this result.

Price and Output in Monopolistic Competition In contrast, firms in perfect competition have no excess capacity and no markup. The perfectly elastic demand curve for their products drives this result.

Price and Output in Monopolistic Competition Is Monopolistic Competition Efficient Because in monopolistic competition P > MC, marginal benefit exceeds marginal cost. So monopolistic competition seems to be inefficient. But the markup of price above marginal cost arises from product differentiation. People value variety but variety is costly. Monopolistic competition brings the profitable and possibly efficient amount of variety to market.

Oligopoly • Oligopoly is a market in which a few firms produce all or most of the market supply of a particular good or service. • Oligopoly describes a market dominated by a few large, profitable firms. Collusion • Collusion is an agreement among members of an oligopoly to set prices and production levels. Price- fixing is an agreement among firms to sell at the same or similar prices. Cartels • A cartel is an association by producers established to coordinate prices and production.

Oligopoly • is a market structure, which has the following basic characteristics – Few Large Firms – Market power – Identical or Differentiate Products – Interdependence – Barriers to Entry

Profit Maximizing Output & Price • A firm in an Oligopoly market maximizes profit like a firm in all other market structures at MR=MC and MC is rising. • Profit-maximization rule – Produce at that rate of output where marginal revenue equals marginal cost. •

Price or Cost (dollars per unit) Maximizing Oligopoly Profits marginal cost Profitmaximizing price average cost Market demand Profits Average cost at profitmaximizing output J marginal revenue Profit-maximizing output 0 Quantity (units period)

Characteristics of Market Structures

Characteristics of Market Structures

Determinants of Market Power • The determinants of market power include: – Number of producers. – Size of each firm. – Barriers to entry. – Availability of substitute goods.

Determinants of Market Power • The numbers and size of firms determine the extent that firms can withstand pressures and threats to change prices or product flows. • The barriers to entry determine to what extent the market is a contestable market. • Contestable market – An imperfectly competitive industry subject to potential entry if prices or profits increase. • The availability of substitute goods weakens any firm’s market power.

Thank you.