Principle of Economics

Market Structure :
Perfect Competition &
Monopoly

Learning Objectives
At the end of the lecture class, students will be
able to:
1. Define the meaning of perfect market
2. Identify the characteristics of perfect
competition and monopoly
3. Illustrate the different type of profit
obtained by firms under two different market
4. Distinguished pro and cons between perfect
competition and monopoly market

Perfect Competition

The Degree of Competition

Type of
market

Perfect
competition

Number
of firms

Freedom of
entry

Nature of
product

Examples

Implications for
demand curve
faced by firm

Very
many

Unrestricted

Homogeneous
(undifferentiated)

Tomatoes,
carrots,

Horizontal:
firm is a price taker

e-Commerce

Monopolistic
competition

Many /
several

Unrestricted

Differentiated

Monopoly

Few

One

Restricted

Restricted or
completely
blocked

Downward sloping,
but relatively
elastic

or differentiated

Banks, motor
vehicle industry,
TV stations

Downward sloping.
Relatively inelastic
(shape depends on
reactions of rivals)

Unique

Australia Post,
state water
authorities

Downward sloping:
more inelastic than
oligopoly. Firm has
considerable
control over price

Undifferentiated
Oligopoly

(these are close to

perfectly
competitive)
Restaurants, hair
salons

Not every industry fits neatly into one of these categories; however, this is
a useful framework for thinking about industry structure and behavior.

WHAT IS A COMPETITIVE
MARKET?
1. A perfectly competitive market has the following
characteristics:
Firms can freely enter or exit the market.
Sell a standardized or homogeneous product
Firms are price takers.
Buyers and sellers are fully informed about the
price and availability of all resources and products.
There are many buyers and sellers in the market.
Absence of any type of intervention (government
or other external factors) toward buyers and
sellers decision.

2. As a result of its characteristics each buyer and seller

takes the market price as given.

WHAT IS A COMPETITIVE
MARKET?
When a firm is said to be at equilibrium in
the short run, there are 3 possible profit
levels:
1. Supernormal profits
2. Subnormal profits (Loss)
3. Normal profits (Break even)
Short run in Perfect Competition
Period during which there is too little time for new
firms to enter the industry
Maximize profit: MR = MC

Supernormal profits
where firms AR(P) > firms SRAC.
(a) Industry

(b) Firm
$

MC

Pe

AR

AC

AC

E
D = AR=MR
z

D
0

0
Q (millions)

Qe

Profit is the shaded rectangle

Q (thousands)

Subnormal profits (Loss)

where firms AR(P) < firms SRAC. However it is advisable
for firm to keep on producing as its AR(P) is still greater
than its SRAVC, otherwise, stop producing or leave the
industry.
(a) Industry

(b) Firm

$
MC

AC
P1

AR1

AC

z D1 = AR1= MR1

D
O

Q (millions)

Qe Q (thousands)

Loss is the shaded rectangle

Normal profits (Break even)

where firms AR(P) = firms AC. It is advisable at this
time, for firm to replace its capital since it has worn out
already.
(a) Industry

(b) Firm

$
MC

AC

AR1

P1

E
D1 = AR1= MR1

D
O

Q (millions)

Qe

Q (thousands)

Calculating TR, AR, MR

Fill in the empty spaces of the table.
Q

P (RM)

TR (RM)

AR (RM)

MR (RM)

10

n/a

10

10

10

10

10

10

10

10

20 MR = P
30

10

10

10

40

10

10

10

50

10

10

TR = P x Q

Notice that

TR
AR =
Q

MR =

TR
Q

Profit Maximization
Q

TR
(RM)

TC
(RM)

Profit
(RM)

MR
(RM)

MC
(RM)

Profit
(RM)

-5

10

10

20

15

10

30

23

10

40

33

10

50

45

10

12

-2

Profit = TR - TC

MC =

TC
Q

Profit= New Profit Old Profit

At any Q with MR > MC, increasing Q raises profit.

At any Q with MR < MC, reducing Q raises profit.

Deriving the short-run supply curve

(b) Firm

(a) Industry
P

AVC
MC = S

a
P1

P2
c

D1 = MR1
D2 = MR2
D3 = MR3

P3
D1
D2
D3
O

Q (millions)

Q1 Q2 Q3

Q (thousands)

The portion of the marginal-cost curve that lies

above average variable cost is the competitive
firms short-run supply curve.

Deriving the short-run supply curve

Short run supply curve will be its marginal cost curve ?

Supply curve

Marginal Cost

Q -------- P

Q -------- MC
MC = MR

P = MR

P = MC
Supply curve = Marginal Cost curve

The Competitive Firms Short Run

Supply Curve
Costs

If P > ATC, the firm

will continue to
produce at a profit.

Firms short-run
supply curve

MC

ATC
If P > AVC, firm
will continue to
produce in the
short run.

AVC

Firm
shuts
down if
P < AVC
0

Quantity

Copyright 2004 South-Western

Long-run Equilibrium under

Perfect Competition
Period which long enough for new firms to enter the industry
Supernormal profit --------- Normal profit

(a) Industry

(b) Firm

S1
Se
LRAC
P1

AR1

D1

PL

ARL

DL

D
O

Q (millions)

QL

Q (thousands)

all supernormal profits competed away

LRAC = AC = MC = MR = AR
$
(SR)MC

(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

Perfect Competition
Because a competitive firm is a price taker, its revenue
is proportional to the amount of output it produces.
The price of the good equals both the firms average
revenue and its marginal revenue.

To maximize profit, a firm chooses the quantity of

output such that marginal revenue equals marginal
cost.
This is also the quantity at which price equals marginal
cost.
Therefore, the firms marginal cost curve is its supply
curve.

Perfect Competition
In the short run, when a firm cannot recover its fixed
costs, the firm will choose to shut down temporarily if
the price of the good is less than average variable
cost.
In the long run, when the firm can recover both fixed
and variable costs, it will choose to exit if the price is
less than average total cost.

Perfect Competition
Is Perfect Competition good for consumers ?
P = MC
P > MC ------ Ought to produce more
P < MC ------ Ought to produce less

Price at minimum
Firm making only normal profits
Survival of the fittest
Inefficient firms will be driven out of business

Monopoly

Monopoly
Monopoly is a market with a single supplier of a good
or service that has no close substitutes and in which
natural and legal barriers to entry prevent competition.
Since monopoly by definition, supplies the entire
market, the demand for goods and services produced by a
monopolist is also a market demand (slope downward)
While a competitive firm is a price taker, a monopoly
firm is a price maker.
The government gives a single firm the exclusive right
to produce some good.

Barriers to Entry
Economies of Scale
- If cost go on falling significantly up to the output that
satisfies the whole market, the industry may not be
able to support more than one producer
Natural Monopoly
LRAC would be lower if an industry were under monopoly
than if it were shared between two or more competitors
Product differentiation and Brand loyalty
- Differentiate products where consumers associates
products with the brand
Lower costs for an established firm
- developed specialized production and marketing skills
- have efficient techniques or access to cheaper finance

Barriers to entry
Legal Protection Patent, Copyright, Licensing
- Through legislation whereby the rights of
producers have to be protected.

the

Control of marketing channels

- If the monopolist controls the distribution agents then
rival firms would have difficulty in trying to reach the
consumers, e.g. newspaper vendors, retailers, etc.
Cut throat competition
- The monopolist will undercut price so that the rival
firm will not be able to compete at all.
Control of marketing channels
- If the monopolist controls the distribution agents then
rival firms would have difficulty in trying to reach the
consumers, e.g. newspaper vendors, retailers, etc.

Barriers to entry

Legal prohibition
- In some countries, competition is not allowed and this
is set by the government through a certain set of
regulations.

Ownership of certain raw materials

- The monopolist may own all the deposits of some
mineral resources, or control all or part of the
country's or region's mineral deposits.

Monopolys Marginal Revenue

A Monopolys Marginal Revenue: Marginal revenue is always less than the price of
its good.
The demand curve is downward sloping.
When a monopoly drops the price to sell one more
unit, the revenue received from previously sold units
also decreases.

Price maker ------- Market Demand

Demand Curves for

Competitive and Monopoly Firms
(a) A Competitive Firms
Demand Curve

(b) A Monopolists
Demand Curve

Price

Price

Demand

Demand

Quantity of Output

Quantity of Output

Copyright 2004 South-Western

Example: Demand and MarginalRevenue Curves for a Monopoly

Price
$11
10
9
8
7
6
5
4
3
2
1
0
1
2
3
4

Demand
(average revenue)

Quantity of Water

Marginal
Revenue

Copyright 2004 South-Western

Profit Maximising under Monopoly

MC

Total profit

AC

Equilibrium price
and output MC =

AR

MR

It then uses the

demand curve to
find the price
that will induce
consumers to buy
that quantity.

AC

The monopolists
demand curve is
downward sloping
and MR below AR.

AR
MR

Qm

Example : Profit Maximization for a

Monopoly
Costs and

2. . . . and then the demand 1. The intersection of the

Revenue

curve shows the price

consistent with this quantity.
B
Monopoly
Pm
price

marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .

Average total cost

P*

Demand

Marginal
cost

Marginal revenue

Q1

QMAX

Q2

Quantity
Copyright 2004 South-Western

Monopoly versus Perfect

Competition: Which best serves
the public interest?

Monopoly vs. Perfect Competition:

Short & Long Run Price and Output
Disadvantages of monopoly:

High prices / low output: short run & long run

For a competitive firm, price equals marginal cost.

P = MR = MC

For a monopoly firm, price exceeds marginal cost.

P > MR = MC

Quantity produced by the monopoly will be less than

the competitive level of output

The monopoly price level will be higher than the price

under perfect competition.
PPC = MC
PM > MC

Equilibrium of Industry under Perfect Competition

and Monopoly: with the same MC curve
MC

Monopoly

A
P1
AR = D
C

MR m
Q

Q1

MC = (supply under
perfect competition)

P1
P2

B
C

Comparison with
Perfect competition

Q1

AR = D (= MRpc )

MR m
Q2

Monopoly versus Perfect Competition:

Long Run
Perfect Competition
1. Freedom of entry eliminate supernormal profit
2. Firm to produce at the bottom of their LRAC curve
3. Keep long run prices down

Monopoly
1. Barriers of entry allow profit remain supernormal
2. Firm is not force to produce at the bottom of their LRAC curve
3. Long run prices will tends to be higher and lower output

Monopoly versus Perfect Competition:

Cost
Perfect Competition
1. Require usage or develop the most efficient techniques:
Lower cost
Monopoly
1. Barriers of entry and still making profit even though do not use
efficient techniques: Higher cost

BUT
1. Able to achieve substantial economies of scale: Higher output at
Lower price
2. Use part of the supernormal profit for R&D
Still need to be efficient as subject to
competition of corporate control