Flashcards in Week 6 - competition monopoly Deck (26)
4 market structures
3. Monopolistic competition
4. Perfect competition
characteristics of a perfectly competitive market
A perfectly competitive market has the following characteristics:
–There are many buyers and sellers in the market.
–The goods offered by the various sellers are largely the same; homogenous.
–Firms can freely enter or exit the market; no barriers to ent
What is a perfectly competitive market
As a result of these characteristics, the perfectly competitive market has the following outcomes:
–The actions of any single buyer or seller in the market have a negligible impact on the market price.
–Each buyer and seller takes the market price as given • Price takers.
• Market is efficient: P = MC, no deadweight loss
profit = zero
In perfect competition firms will maximize profits, driven by rational self interest – by meeting marginal revenue (market price) and minimize costs (through enhacniing efficiency, lower cost of producing the good) Average total costs at the lowest point – perfect competition forces to that point when a good is cheapest
Maximize profits at 0
*look at diagrams page 330*
Define a price taker
A buyer or seller who takes the price ad given by the market conditions (cannot control the price)
define average revenue
total revenue divided by the quantity sold
define marginal revenue
is the change in total revenue from an additional unit sold.
MR =ΔTR/ ΔQ
• For competitive firms, marginal revenue equals the price of the
Define a monopoly
A firm that is the sole seller of a product without close substitutes
characteristics of a monpoly
it is the sole seller of its product.
–its product does not have close substitutes.
• While a competitive firm is a price taker, a monopoly firm is a price maker.
The fundamental cause of monopoly is barriers to entry.
Why monopolies arise – are caused by barriers to entry where firms:
1. Own a key resource that is a rare cause of monopoly
2. Has exclusive production right from government
3. Has production costs much lower than many smaller producers = natural monopoly
define a natural monopoly
A monopoly may arise because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms (not actually a market failure) Benefit from economies of scale lower costs with more they produce
Monopoly price setting
Monopoly sole producer faces a downward-sloping demand curve is a price maker reduces price to increase sales.
When a monopoly increases the amount it sells this action has 2 affects on total revenue (P X Q):
1. The output affect = More output is sold, so Q is higher, which tends to increase total revenue
2. The price effect = the price falls, so P is lower, which tends to decrease total revenue.
Because a competitive firm can sell all it wants at the Market price there is no price effect, when it increases production by one unit, it receives the market price for the unit, and it does not receive any less for the amount it was already selling – That is because a competitive firm is a price taker and it’s marginal revenue equals the price of it’s good sold. In contrast when a monopoly increases production by one unit, it must reduce it’s price it charges for every unit it sells and this cut in price reduces revenue on the units it was already selling, as a result monopoly’s marginal revenue is less than it’s price
A monopoly maximizes profit by producing the quantity at MR = MC.
–It uses the demand curve to find the price that will induce consumers to buy that quantity. Thus the monopolist’s profit maximizing quantity of output is determined by the intersection of marginal revenue curve and the marginal cost curve
Explain monopoly and welfare
from a consumer’s position the fact that a monopoly charges a price above marginal cost makes monopoly undesirable.
– Cost of resources to make one more unit is less than the value of that unit to society.
• However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.
• The monopoly deadweight loss is similar to a tax deadweight loss.
• The difference between the two cases is that: –the government gets the revenue from a tax, –whereas a private firm gets the monopoly profit
Dixon and Creedy, estimated that the monopoly deadweight loss in Australia is about 1 per cent of total production.
They concluded that monopolies have a greater impact on lower‐ income households.
• Abuse of monopoly power has a social cost and it also tends to increase social inequality.
how does a monopoly create a dead-weight loss
Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than it’s cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the vale of the good to consumers) and the marginal cost curve (which reflects the cost of the monopoly to the producer.
define price discrimination
The business practice of selling the same good at different prices to consumers (even though the production costs for different consumers remains the same)
Price discrimination is not possible in a competitive market since there are many firms all selling a good at the market price.
– In order to price discriminate, the firm must have some market power!
What is perfect price discrimination?
Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.
Two important effects of price discrimination:
1. it can increase the monopolist’s profits
2. it can reduce deadweight loss
different types of price discrimination
First degree price discrimination – Charge different price for each unit
Second degree price discrimination – Discounts for bulk purchases
Third degree price discrimination – Segmenting market by elasticity.
Problem 1: What are the characteristics of a competitive market? Which of the following drinks do you think is best described by these characteristics? Why aren’t the others?
a) Tap water
b) Bottled mineral water
A competitive market is one in which:
(1) there are many buyers and many sellers in the market;
(2) the goods offered by the various sellers are largely the same; and
(3) usually firms can freely enter or exit the market.
Of these goods, bottled mineral water is probably the closest to a competitive market. Tap water is a natural monopoly because there is usually only one seller (the price is much lower because the market is highly regulated). Cola and beer aren't perfectly competitive because every brand is slightly different. Note: The same argument holds for mineral water. In practice large price variations are a good indicator of imperfect competition.
Draw a diagram that illustrates a monopolist that makes a profit in the long run. Make sure you label your diagram fully, indicating the price the monopolist will charge, the equilibrium quantity, the monopolist’s profit, the consumers’ surplus, and the deadweight loss. Explain these areas.
This is a standard diagram of a monopoly with long-run profits. Monopolists maximise profit by equating MC to MR. This means producing Qm and charging the monopoly price (Pm). Monopoly profit is area A. Consumer surplus is the triangle B. There is a deadweight loss of area C.
Useful to review and discuss each of these areas again: (1) deadweight loss; (2) consumer surplus; (3) economic profit. Why does deadweight loss occur? Why do profits arise? Why does consumer surplus arise?
If the monopolist’s marginal cost increases, what will happen to the monopolist’s price, the monopolist’s quantity, the monopolist’s profit, the consumers’ surplus, and the deadweight loss? Illustrate your answer with a diagram, and explain fully.
Use standard monopoly diagram but now introduce a shift in the MC curve (upwards – each unit costs more to produce). When marginal cost increases, from MC0 to MC1, the monopolist will still maximise profits by equating MC1 to MR. With increased MC, the monopolist will now produce less, from Q0 to Q1, charge a higher price, from P0 to P1, and earns smaller economic profit.
see week seven lecture answers for pic*
“In the long run the monopolist profits can never be zero.” Is this statement true? Explain why or why not
Incorrect. While we normally think of monopolists as earning profits in the long-run, it is possible that they may break even. They may even make a loss; in this case a privately owned monopolist would have to be subsidised by the state or the monopolist is government owned and taxpayers cover the losses.
What is the link between elasticity of demand and market power?
In general, the less elastic is the demand for the firm’s product, the more market power the firm has. If elasticity is infinite, then the firm is a price taker.
Also, elasticity affects the discrepancy between marginal revenue and price. When demand is highly elastic, monopoly prices are not that much higher than under perfect competition.
A government regulator can reduce deadweight loss by requiring the monopolist to: (1) charge a price equal to marginal cost or (2) to set price equal to average
Seminar 7 Solutions 2017
i. Illustrate what happens to the monopolist’s profits with marginal cost pricing?
ii. Illustrate what happens to the monopolist’s profits with average cost pricing?
MC pricing means that the monopolist produces qmc units of output, which is the level of output that the perfect competitive industry would produce; increase in output from qm. As a result, the monopolist incurs a loss (see graph above) and would need to be subsidized by the state.
Note that the figure relates to a natural monopoly with a declining ATC curve.
AC pricing means that the natural monopolist is required to produce qac, this is where AC and AR intersect. This is also known as fair return pricing
How can a monopolist be induced to adopt marginal cost pricing?
The government regulator may subsidize the monopolist for any losses incurred as a result of marginal cost pricing. Another strategy is to nationalise the monopolist, that it is, the government takes over ownership of the monopolist and the losses are then born by the taxpayer.
What are some of the pitfalls involved with these pricing strategies? (subsidies to monopolist producers)
A major problem with subsidising a monopolist to produce more is that they have an incentive to misrepresent their costs and hence seek a larger subsidy. For example, in the figure below the real ATC may be AC1. But the monopolist may claim that it is ATC2 (or higher) and hence that a larger subsidy is necessary. Regulators then need to verify actual costs.
An alternative approach is for government ownership of a natural monopoly. The government is then responsible for running a corporation. This leads to all sort of challenges.