Principles of Economics 2 nd edition by Fred

Chapter 11 Price & Output in Monopoly, Monopolistic Competition, & Perfect Competition 3/6/2021 ©

Price and output in monopoly Recall monopoly, single firm, no close substitutes, barriers to entry 3

In monopoly, firm is a price maker 4

What is a Price Maker? A firm that has the ability to choose among combinations of price and output, attempting to find the profit maximizing combination 5

How does a Monopoly determine Price & Output to maximize profits? MR = MC

Why are profits maximized MR = MC? MR > MC (keep producing) MR <

What does the Demand Curve look like for a Monopoly? It is the same as the market demand curve 8

Demand curve in Monopoly, same as the market demand P D Q 9 9

What is Marginal Revenue? MR = TR Q © 1999 South-Western College Publishing 10

Recall that in perfect competition, MR = P, but this is not the case in monopoly. The firm cannot sell any amount at the same price, but must lower price in order to sell more 11

What is TR at the 3 rd unit? Price Q $50 $40 $30 $20 $10 2 3 4 5 6 $120 12 12

What is MR at the 3 rd unit? Price Q $50 $40 $30 $20 $10 2 3 4 5 6 $20 13 13

What is MR at the 5 th unit? Price Q $50 $40 $30 $20 $10 2 3 4 5 6 -$20 14 14

Why is MR < P for all but the first unit of output for a Monopoly? To sell additional units the firm not only has to lower price on the last unit, but on all previous units © 1999 South-Western College Publishing 15

MR < P for all but the first unit of output P Demand Marginal Revenue Q 16 16

Profit maximization in monopoly Put in the marginal cost curve, best output is where MR=MC, best price for that output is found by going up to the demand curve 17

Best price and output for monopoly $ MC P MR Q 18 D Q 18

Short run profit possibilities As always in the short run, can make positive profits, losses, or zero economic profits-to show profit, must add in the average total cost curve. 19

Monopoly: Positive Profit $ P ATC P MC Profit ATC MR Q 20 D Q 20

Monopoly: Loss Case ATC $ MC Loss P P MR Q 21 D Q 21

Monopoly: Zero Profits Case ATC $ ATC MC P P MR Q 22 D Q 22

When will a firm continue to operate even when making a loss? When its losses are less than its fixed costs: in other words, as long as Price exceeds AVC, can stay in business in the short run 23

When will a firm shut down when making a loss? When its losses are

How does Monopoly compare to Perfect Competition ? • Higher prices & less output under monopoly • Long run profits possible in monopoly due to barriers to entry © 1999 South-Western College Publishing 25

Move from monopoly to monopolistic competition Recall the characteristics of monopolistic competition: many firms, producing similar yet differentiated products, relatively free entry 26

What does the graphic model look like for Monopolistic Competition compared to Monopoly? It looks very similar because both face a downward sloping demand curve—possibly more elastic in monopolistic competition due to more close substitutes. 27

Why are demand curves downward sloping in Monopolistic Competition? Because a firm can distinguish itself from competitors and therefore has some control over price © 1999 South-Western College Publishing 28

What happens to the demand curve with more competition? The demand curve for an

P More Elastic More Inelastic D 2 D 1 © 1999 South-Western College Publishing

What is Normal Profit? The minimum profit a business owner will accept to continue operating the business ( same as zero economic profit) 31

What is Economic Profit? Money made above and beyond a normal profit © 1999

In Monopolistic Competition, can Economic Profit be made in the short run? Yes! Positive or negative economic profit can be made in the short run 33

Why is Normal Profit the long run equilibrium in Monopolistic Competition? Because when positive economic profit is made, firms will enter the industry eliminating the economic profit 34

In monopolistic competition, what happens as more firms enter in search of profits? The

Now move from monopolistic competition to perfect competition Recall the characteristics of perfect competition: many firms, each a tiny share of the market, producing identical products, free entry and perfect information 36

Why does a Perfectly Competitive firm face a horizontal demand curve? Because it can sell all it brings to market at the market price, therefore P always equals MR © 1999 South-Western College Publishing 37

Why is a firm that is a part of a Perfectly Competitive Market a price taker? Because if the firm charges higher than the market price it will not sell one unit © 1999 South-Western College Publishing 38

Why is this so? Because consumers will buy the same thing at a lower

The Market and the firm in Perfect Competition P D S P P=MR The Market Individual firm 40 40

Profits are maximized where P MR = MC MR 1=P 1 MR 2=P 2 MC MR 1=MC MR 2=MC Q Q 2 Q 1 41 41

Why is a firm’s MC curve above its AVC curve its Supply Curve? Because

Why don’t we include the MC curve below its AVC curve as a part

What is the Market’s Supply Curve? It is the aggregation of the long-run MC

In Perfect Competition, can Economic Profit be made in the short run? Yes! Positive or negative economic profit can be made in the short run 45

Why is a Normal Profit (zero economic profits) made in the long run? Because

Zero Profits in Perfect Competition MC ATC P P = MR P = ATC Q 1 47 47

What happens when a firm makes more than a Normal Profit? More firms enter

Right Shift in Supply S 1 P 2 S 2 D Q 1 Q

What happens when a firm makes less than a Normal Profit? Some firms leave

Left Shift in Supply S 2 P 1 S 1 D Q 2 Q

The Long Run adjustments in Perfect Competition P D D 1 S S 1 MC P ATC P 1 P=MR P Q The Market Q 1 Individual firm 52 52

Explanation of long run adjustments 1. Start at price P, typical firm making zero profits 2. Suppose demand increases to D 1 3. Price rises to P 1 4. Typical firm making positive profits 5. What happens in the long run? 6. Assuming perfect information and free entry, new firms enter the market 7. Supply shifts right until profits eliminated 8. Price comes down—but how far depends on whether costs are affected 53

Long Run, continued 1. Constant cost industry: no change in costs as new firms enter the market, price returns to P, original price 2. Increasing cost industry: all firms experience rising costs as new firms enter the market, final price will be higher than original price P 3. Decreasing cost industry: all firms experience lower costs as new firms enter the market, final price will be lower than original price 54

Zero Profits in Perfect Competition MC ATC P P = MR P = ATC Q 1 55 55

Whats so “perfect” about Perfect Competition? ØNote that Q 1 output is the output which minimizes ATC, sometimes called the technically efficient output level ØAlso, at Q 1, P = MC , price equals marginal cost, sometimes called the allocative or social efficiency condition 56

According to Joseph Schumpeter why are monopolies more innovative than perfect competition? Because of its deeper financial pockets, can afford more for research and development 57

Are big firms necessarily more innovative? Not necessarily: some small firms are very innovativethis is still a controversial area in economics. 58

• Why are profits maximized where MR = MC? • Why is MR < P for all but the first unit of output for a Monopoly? • What does the Demand Curve look for a Monopoly? • When will a firm continue to operate even when making a loss? 59

• What is Normal Profit? • What is Economic Profit? • Why do firms tend to make a Normal Profit when others enter the market? • Why does a Perfectly Competitive firm face a horizontal demand curve? • Why is a firm’s MC curve above its AVC curve its Supply Curve? 60