Perfect competition and demand curve Essay Example for Free

Perfect competition and demand curve Essay COMPARE(SIMILAR) similarity. The cost functions are the same. [16] Both monopolies and perfectly competitive companies minimize cost and maximize profit. The shutdown decisions are the same. Both are assumed to have perfectly competitive factors markets. compare monopoly and perfect competition is the four characteristics of perfect competition: (1) large number of relatively small firms, (2) identical product, (3) freedom of entry and exit, and (4) perfect knowledge. * Number of Firms: Perfect competition is an industry comprised of a large number of small firms, each of which is a price taker with no market control. Monopoly is an industry comprised of a single firm, which is a price maker with total market control. Phil the zucchini grower is one of gadzillions of zucchini growers. Feet-First Pharmaceutical is the only firm that sells Amblathan-Plus, a drug that cures the deadly (but hypothetical) foot ailment known as amblathanitis. * Available Substitutes: Every firm in a perfectly competitive industry produces exactly the same product as every other firm. An infinite number of perfect substitutes are available. A monopoly firm produces a unique product that has no close substitutes and is unlike any other product. Gadzillions of firms grow zucchinis, each of which is a perfect substitute for the zucchinis grown by Phil the zucchini grower. There are no substitutes for Amblathan-Plus. Feet-First Pharmaceutical is the only supplier. * Resource Mobility: Perfectly competitive firms have complete freedom to enter the industry or exit the industry. There are no barriers. A monopoly firm often achieves monopoly status because the entry of potential competitors is prevented. Anyone can grow zucchinis. All they need is a plot of land and a few seeds. Feet-First Pharmaceutical holds the patents on Amblathan-Plus. No other firm can enter the market. * Information: Each firm in a perfectly competitive industry possesses the same information about prices and production techniques as every other firm. A monopoly firm, in contrast, often has information unknown to others. Everyone knows how to grow zucchinis (or can easily find out how). Feet-First Pharmaceutical has a secret formula used in the production of Amblathan-Plus. This information is not available to anyone else. The consequence of these differences include: * First, the demand curve for a perfectly competitive firm is perfectly elastic and the demand curve for a monopoly firm is THE market demand, which is negatively-sloped according to the law of demand. A perfectly competitive firm is thus a price taker and a monopoly is a price maker. Phil must sell his zucchinis at the going market price. It he does not like the price, then he does not sell zucchinis. Feet-First Pharmaceutical can adjust the price of Amblathan-Plus, either higher or lower, and so doing it can control the quantity sold. * Second, the monopoly firm charges a higher price and produces less output than would be achieved with a perfectly competitive market. In particular, the monopoly price is not equal to marginal cost, which means a monopoly does not efficiently allocate resources. Although Feet-First Pharmaceutical charges several dollars per ounce of Amblathan-Plus, the cost of producing each ounce is substantially less. Phil, in contrast, just about breaks even on each zucchini sold. * Third, while an economic profit is NOT guaranteed for any firm, a monopoly is more likely to receive economic profit than a perfectly competitive firm. In fact, a perfectly competitive firm IS guaranteed to earn nothing but a normal profit in the long run. The same cannot be said for monopoly. The price of zucchinis is so close to the cost of production, Phil never earns much profit. If the price is relatively high, other zucchini producers quickly flood the market, eliminating any profit. In contrast, Feet-First Pharmaceutical has been able to maintain a price above production cost for several years, with a handsome profit perpetually paid to the company shareholders year after year. * Fourth, the positively-sloped marginal cost curve for each perfectly competitive firm is its supply curve. This ensures that the supply curve for a perfectly competitive market is also positively sloped. The marginal cost curve for a monopoly is NOT, repeat NOT, the firms supply curve. There is NO positively-sloped supply curve for a market controlled by a monopoly. A monopoly might produce a larger quantity if the price is higher, in accordance with the law of supply, or it might not. If the price of zucchinis rises, then Phil can afford to grow more. If the price falls, then he is forced to grow less. Marginal cost dictates what Phil can produce and supply. Feet-First Pharmaceutical, in comparison, often sells a larger quantity of Amblathan-Plus as the price falls, because they face decreasing average cost with larger scale production. * The single seller, of course, is a direct contrast to perfect competition, which has a large number of sellers. In fact, perfect competition could be renamed multipoly or manypoly, to contrast it with monopoly. The most important aspect of being a single seller is that the monopoly seller IS the market. The market demand for a good IS the demand for the output produced by the monopoly. This makes monopoly a price maker, rather than a price taker. * A hypothetical example that can be used to illustrate the features of a monopoly is Feet-First Pharmaceutical. This firm owns the patent to Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis. As the only producer of Amblathan-Plus, Feet-First Pharmaceutical is a monopoly with extensive market control. The market demand for Amblathan-Plus is THE demand for Amblathan-Plus sold by Feet-First Pharmaceutical. * Unique Product * To be the only seller of a product, however, a monopoly must have a unique product. Phil the zucchini grower is the only producer of Phils zucchinis. The problem for Phil, however, is that gadzillions of other firms sell zucchinis that are indistinguishable from those sold by Phil. * Amblathan-Plus, in contrast, is a unique product. There are no close substitutes. Feet-First Pharmaceutical holds the exclusive patent on Amblathan-Plus. No other firm has the legal authority to produced Amblathan-Plus. And even if they had the legal authority, the secret formula for producing Amblathan-Plus is sealed away in an airtight vault deep inside the fortified Feet-First Pharmaceutical headquarters. * Of course, other medications exist that might alleviate some of the symptoms of amblathanitis. One ointment temporarily reduces the swelling. Another powder relieves the redness. But nothing else exists to cure amblathanitis completely. A few highly imperfect substitutes exists. But there are no close substitutes for Amblathan-Plus. Feet-First Pharmaceutical has a monopoly because it is the ONLY seller of a UNIQUE product. * Barriers to Entry and Exit * A monopoly is generally assured of being the ONLY firm in a market because of assorted barriers to entry. Some of the key barriers to entry are: (1) government license or franchise, (2) resource ownership, (3) patents and copyrights, (4) high start-up cost, and (5) decreasing average total cost. * Feet-First Pharmaceutical has a few these barriers working in its favor. It has, for example, an exclusive patent on Amblathan-Plus. The government has decreed that Feet-First Pharmaceutical, and only Feet-First Pharmaceutical, has the legal authority to produce and sell Amblathan-Plus. * Moreover, the secret ingredient used to produce Amblathan-Plus is obtained from a rare, genetically enhanced, eucalyptus tree grown only on a Brazilian plantation owned by Feet-First Pharmaceutical. Even if another firm knew how to produce Amblathan and had the legal authority to do so, they would lack access to this essential ingredient. * A monopoly might also face barriers to exiting a market. If government deems that the product provided by the monopoly is essential for well-being of the public, then the monopoly might be prevented from leaving the market. Feet-First Pharmaceutical, for example, cannot simply cease the production of Amblathan-Plus. It is essential to the health and welfare of the public. * This barrier to exit is most often applied to public utilities, such as electricity companies, natural gas distribution companies, local telephone companies, and garbage collection companies. These are often deemed essential services that cannot be discontinued without permission from a government regulation authority. * Specialized Information * Monopoly is commonly characterized by control of information or production technology not available to others. This specialized information often comes in the form of legally-established patents, copyrights, or trademarks. While these create legal barriers to entry they also indicate that information is not perfectly shared by all. The ATT telephone monopoly of the late 1800s and early 1900s was largely due to the telephone patent. Pharmaceutical companies, like the hypothetical Feet-First Pharmaceutical, regularly monopolize the market for a specific drug by virtue of a patent. * In addition, a monopoly firm might know something or have a piece of information that is not available to others. This something may or may not be patented or copyrighted. It could be a secret recipe or formula. Perhaps it is a unique method of production. * One example of specialized information is the special, secret formula for producing Amblathan-Plus that is sealed away in an airtight vault deep inside the fortified Feet-First Pharmaceutical headquarters. No one else has this information. CONTRAST Arguably, perfect competition has the advantage of promoting consumer sovereignty, in the sense that the goods and services produced are those that consumers have voted for when spending the pounds in their pockets. When consumer sovereignty exists, the ‘consumer is king’. (However, the extent to which consumer choice exists in a perfectly competitive world would be extremely limited. All the firms in a particular market would sell identical goods at an identical price, namely the ruling market price. ) Firms and industries that produce goods other than those for which consumers are prepared to pay, do not survive in perfect competition. By contrast, a monopoly may enjoy producer sovereignty. The goods and services available for consumers to buy are determined by the monopolist rather than by consumer preferences expressed in the market place. Even if producer sovereignty is not exercised on a ‘take-it-or-leave-it basis’ by a monopoly, the monopolist may still possess sufficient market power to manipulate consumer wants through such marketing devices as persuasive advertising. In these situations, the ‘producer is king In contrast to perfect competition — and once again assuming an absence of economies of scale — monopoly equilibrium is both productively and allocatively inefficient. Figure 6. 6 shows that at the profit-maximising level of output Q1, the monopolist’s average costs are above the minimum level and that P MC. Thus, compared to perfect competition, a monopoly produces too low an output which it sells at too high a price. The absence of competitive pressures, which in perfect competition serve to eliminate supernormal profit, mean that a monopoly is also likely to be X-inefficient, incurring average costs at a point such as X which is above the average cost curve. A monopoly may be able to survive, perfectly happily and enjoying an ‘easy life’, incurring unnecessary production costs and making satisfactory rather than maximum profits. This is because barriers to entry protect monopolies. As a result, the absence or weakness of competitive forces means there is no mechanism in monopoly to eliminate organisational slack. 62 Marginal revenue and price In a perfectly competitive market price equals marginal revenue. In a monopolistic market marginal revenue is less than price. [17] * Product differentiation: There is zero product differentiation in a perfectly competitive market. Every product is perfectly homogeneous and a perfect substitute for any other. With a monopoly, there is great to absolute product differentiation in the sense that there is no available substitute for a monopolized good. The monopolist is the sole supplier of the good in question. [18] A customer either buys from the monopolizing entity on its terms or does without. * Number of competitors: PC markets are populated by an infinite number of buyers and sellers. Monopoly involves a single seller. [18] * Barriers to Entry Barriers to entry are factors and circumstances that prevent entry into market by would-be competitors and limit new companies from operating and expanding within the market. PC markets have free entry and exit. There are no barriers to entry, exit or competition. Monopolies have relatively high barriers to entry. The barriers must be strong enough to prevent or discourage any potential competitor from entering the market. * Elasticity of Demand The price elasticity of demand is the percentage change of demand caused by a one percent change of relative price. A successful monopoly would have a relatively inelastic demand curve. A low coefficient of elasticity is indicative of effective barriers to entry. A PC company has a perfectly elastic demand curve. The coefficient of elasticity for a perfectly competitive demand curve is infinite. * Excess Profits- Excess or positive profits are profit more than the normal expected return on investment. A PC company can make excess profits in the short term but excess profits attract competitors which can enter the market freely and decrease prices, eventually reducing excess profits to zero. [19] A monopoly can preserve excess profits because barriers to entry prevent competitors from entering the market. [20] * Profit Maximization A PC company maximizes profits by producing such that price equals marginal costs. A monopoly maximises profits by producing where marginal revenue equals marginal costs. [21] The rules are not equivalent. The demand curve for a PC company is perfectly elastic flat. The demand curve is identical to the average revenue curve and the price line. Since the average revenue curve is constant the marginal revenue curve is also constant and equals the demand curve, Average revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D = AR = MR = P. * P-Max quantity, price and profit If a monopolist obtains control of a formerly perfectly competitive industry, the monopolist would increase prices, reduce production, and realise positive economic profits. [22] * Supply Curve in a perfectly competitive market there is a well defined supply function with a one to one relationship between price and quantity supplied. [23] In a monopolistic market no such supply relationship exists. A monopolist cannot trace a short term supply curve because for a given price there is not a unique quantity supplied. As Pindyck and Rubenfeld note a change in demand can lead to changes in prices with no change in output, changes in output with no change in price or both. [24] Monopolies produce where marginal revenue equals marginal costs. For a specific demand curve the supply curve would be the price/quantity combination at the point where marginal revenue equals marginal cost. If the demand curve shifted the marginal revenue curve would shift as well and a new equilibrium and supply point would be established. The locus of these points would not be a supply curve in any conventional sense. [25][26] The most significant distinction between a PC company and a monopoly is that the monopoly has a downward-sloping demand curve rather than the perceived perfectly elastic curve of the PC company. [27] Practically all the variations above mentioned relate to this fact. If there is a downward-sloping demand curve then by necessity there is a distinct marginal revenue curve. The implications of this fact are best made manifest with a linear demand curve. Assume that the inverse demand curve is of the form x = a by. Then the total revenue curve is TR = ay by2 and the marginal revenue curve is thus MR = a 2by. From this several things are evident. First the marginal revenue curve has the same y intercept as the inverse demand curve. Second the slope of the marginal revenue curve is twice that of the inverse demand curve. Third the x intercept of the marginal revenue curve is half that of the inverse demand curve. What is not quite so evident is that the marginal revenue curve is below the inverse demand curve at all points. [27] Since all companies maximise profits by equating MR and MC it must be the case that at the profit maximizing quantity MR and MC are less than price which further implies that a monopoly produces less quantity at a higher price than if the market were perfectly competitive. The fact that a monopoly has a downward-sloping demand curve means that the relationship between total revenue and output for a monopoly is much different than that of competitive companies. [28] Total revenue equals price times quantity. A competitive company has a perfectly elastic demand curve meaning that total revenue is proportional to output. [29] Thus the total revenue curve for a competitive company is a ray with a slope equal to the market price. [29] A competitive company can sell all the output it desires at the market price. For a monopoly to increase sales it must reduce price. Thus the total revenue curve for a monopoly is a parabola that begins at the origin and reaches a maximum value then continuously decreases until total revenue is again zero. [30] Total revenue has its maximum value when the slope of the total revenue function is zero. The slope of the total revenue function is marginal revenue. So the revenue maximizing quantity and price occur when MR = 0. For example assume that the monopoly’s demand function is P = 50 2Q. The total revenue function would be TR = 50Q 2Q2 and marginal revenue would be 50 4Q. Setting marginal revenue equal to zero we have 1. 50 4Q = 0 2. -4Q = -50 3. Q = 12. 5 So the revenue maximizing quantity for the monopoly is 12. 5 units and the revenue maximizing price is 25. A company with a monopoly does not experience price pressure from competitors, although it may experience pricing pressure from potential competition. If a company increases prices too much, then others may enter the market if they are able to provide the same good, or a substitute, at a lesser price. [31] The idea that monopolies in markets with easy entry need not be regulated against is known as the revolution in monopoly theory. [32] A monopolist can extract only one premium,[clarification needed] and getting into complementary markets does not pay. That is, the total profits a monopolist could earn if it sought to leverage its monopoly in one market by monopolizing a complementary market are equal to the extra profits it could earn anyway by charging more for the monopoly product itself. However, the one monopoly profit theorem is not true if customers in the monopoly good are stranded or poorly informed, or if the tied good has high fixed costs. A pure monopoly has the same economic rationality of perfectly competitive companies, i.e. to optimise a profit function given some constraints. By the assumptions of increasing marginal costs, exogenous inputs prices, and control concentrated on a single agent or entrepreneur, the optimal decision is to equate the marginal cost and marginal revenue of production. Nonetheless, a pure monopoly can -unlike a competitive company- alter the market price for its own convenience: a decrease of production results in a higher price. In the economics jargon, it is said that pure monopolies have a downward-sloping demand. An important consequence of such behaviour is worth noticing: typically a monopoly selects a higher price and lesser quantity of output than a price-taking company; again, less is available at a higher price. [33] Sources of monopoly power Monopolies derive their market power from barriers to entry – circumstances that prevent or greatly impede a potential competitors ability to compete in a market. There are three major types of barriers to entry; economic, legal and deliberate. [6] * Economic barriers: Economic barriers include economies of scale, capital requirements, cost advantages and technological superiority. [7] Economies of scale: Monopolies are characterised by decreasing costs for a relatively large range of production. [8] Decreasing costs coupled with large initial costs give monopolies an advantage over would-be competitors. Monopolies are often in a position to reduce prices below a new entrants operating costs and thereby prevent them from continuing to compete. [8] Furthermore, the size of the industry relative to the minimum efficient scale may limit the number of companies that can effectively compete within the industry. If for example the industry is large enough to support one company of minimum efficient scale then other companies entering the industry will operate at a size that is less than MES, meaning that these companies cannot produce at an average cost that is competitive with the dominant company. Finally, if long-term average cost is constantly decreasing, the least cost method to provide a good or service is by a single company. [9] Capital requirements: Production processes that require large investments of capital, or large research and development costs or substantial sunk costs limit the number of companies in an industry. [10] Large fixed costs also make it difficult for a small company to enter an industry and expand. [11] Technological superiority: A monopoly may be better able to acquire, integrate and use the best possible technology in producing its goods while entrants do not have the size or finances to use the best available technology. [8] One large company can sometimes produce goods cheaper than several small companies. [12] No substitute goods: A monopoly sells a good for which there is no close substitute. The absence of substitutes makes the demand for the good relatively inelastic enabling monopolies to extract positive profits. Control of natural resources: A prime source of monopoly power is the control of resources that are critical to the production of a final good. Network externalities: The use of a product by a person can affect the value of that product to other people. This is the network effect. There is a direct relationship between the proportion of people using a product and the demand for that product. In other words the more people who are using a product the greater the probability of any individual starting to use the product. This effect accounts for fads and fashion trends. [13] It also can play a crucial role in the development or acquisition of market power. The most famous current example is the market dominance of the Microsoft operating system in personal computers. * Legal barriers: Legal rights can provide opportunity to monopolise the market of a good. Intellectual property rights, including patents and copyrights, give a monopolist exclusive control of the production and selling of certain goods. Property rights may give a company exclusive control of the materials necessary to produce a good. * Deliberate actions: A company wanting to monopolise a market may engage in various types of deliberate action to exclude competitors or eliminate competition. Such actions include collusion, lobbying governmental authorities, and force (see anti-competitive practices). In addition to barriers to entry and competition, barriers to exit may be a source of market power. Barriers to exit are market conditions that make it difficult or expensive for a company to end its involvement with a market. Great liquidation costs are a primary barrier for exiting. [14] Market exit and shutdown are separate events. The decision whether to shut down or operate is not affected by exit barriers. A company will shut down if price falls below minimum average variable costs. Monopoly versus competitive markets While monopoly and perfect competition mark the extremes of market structures[15] there is some similarity. The cost functions are the same. [16] Both monopolies and perfectly competitive companies minimize cost and maximize profit. The shutdown decisions are the same. Both are assumed to have perfectly competitive factors markets. There are distinctions, some of the more important of which are as follows: * Marginal revenue and price In a perfectly competitive market price equals marginal revenue. In a monopolistic market marginal revenue is less than price. [17] * Product differentiation: There is zero product differentiation in a perfectly competitive market. Every product is perfectly homogeneous and a perfect substitute for any other. With a monopoly, there is great to absolute product differentiation in the sense that there is no available substitute for a monopolized good. The monopolist is the sole supplier of the good in question. [18] A customer either buys from the monopolizing entity on its terms or does without. * Number of competitors: PC markets are populated by an infinite number of buyers and sellers. Monopoly involves a single seller. [18] * Barriers to Entry Barriers to entry are factors and circumstances that prevent entry into market by would-be competitors and limit new companies from operating and expanding within the market. PC markets have free entry and exit. There are no barriers to entry, exit or competition. Monopolies have relatively high barriers to entry. The barriers must be strong enough to prevent or discourage any potential competitor from entering the market. * Elasticity of Demand The price elasticity of demand is the percentage change of demand caused by a one percent change of relative price. A successful monopoly would have a relatively inelastic demand curve. A low coefficient of elasticity is indicative of effective barriers to entry. A PC company has a perfectly elastic demand curve. The coefficient of elasticity for a perfectly competitive demand curve is infinite. * Excess Profits- Excess or positive profits are profit more than the normal expected return on investment. A PC company can make excess profits in the short term but excess profits attract competitors which can enter the market freely and decrease prices, eventually reducing excess profits to zero. [19] A monopoly can preserve excess profits because barriers to entry prevent competitors from entering the market. [20] * Profit Maximization A PC company maximizes profits by producing such that price equals marginal costs. A monopoly maximises profits by producing where marginal revenue equals marginal costs. [21] The rules are not equivalent. The demand curve for a PC company is perfectly elastic flat. The demand curve is identical to the average revenue curve and the price line. Since the average revenue curve is constant the marginal revenue curve is also constant and equals the demand curve, Average revenue is the same as price (AR = TR/Q = P x Q/Q = P). Thus the price line is also identical to the demand curve. In sum, D = AR = MR = P. * P-Max quantity, price and profit If a monopolist obtains control of a formerly perfectly competitive industry, the monopolist would increase prices, reduce production, and realise positive economic profits. [22] * Supply Curve in a perfectly competitive market there is a well defined supply function with a one to one relationship between price and quantity supplied. [23] In a monopolistic market no such supply relationship exists. A monopolist cannot trace a short term supply curve because for a given price there is not a unique quantity supplied. As Pindyck and Rubenfeld note a change in demand can lead to changes in prices with no change in output, changes in output with no change in price or both. [24] Monopolies produce where marginal revenue equals marginal costs. For a specific demand curve the supply curve would be the price/quantity combination at the point where marginal revenue equals marginal cost. If the demand curve shifted the marginal revenue curve would shift as well and a new equilibrium and supply point would be established. The locus of these points would not be a supply curve in any conventional sense. [25][26] The most significant distinction between a PC company and a monopoly is that the monopoly has a downward-sloping demand curve rather than the perceived perfectly elastic curve of the PC company. [27] Practically all the variations above mentioned relate to this fact. If there is a downward-sloping demand curve then by necessity there is a distinct marginal revenue curve. The implications of this fact are best made manifest with a linear demand curve. Assume that the inverse demand curve is of the form x = a by. Then the total revenue curve is TR = ay by2 and the marginal revenue curve is thus MR = a 2by. From this several things are evident. First the marginal revenue curve has the same y intercept as the inverse demand curve. Second the slope of the marginal revenue curve is twice that of the inverse demand curve. Third the x intercept of the marginal revenue curve is half that of the inverse demand curve. What is not quite so evident is that the marginal revenue curve is below the inverse demand curve at all points. [27] Since all companies maximise profits by equating MR and MC it must be the case that at the profit maximizing quantity MR and MC are less than price which further implies that a monopoly produces less quantity at a higher price than if the market were perfectly competitive. The fact that a monopoly has a downward-sloping demand curve means that the relationship between total revenue and output for a monopoly is much different than that of competitive companies. [28] Total revenue equals price times quantity. A competitive company has a perfectly elastic demand curve meaning that total revenue is proportional to output. [29] Thus the total revenue curve for a competitive company is a ray with a slope equal to the market price. [29] A competitive company can sell all the output it desires at the market price. For a monopoly to increase sales it must reduce price. Thus the total revenue curve for a monopoly is a parabola that begins at the origin and reaches a maximum value then continuously decreases until total revenue is again zero. [30] Total revenue has its maximum value when the slope of the total revenue function is zero. The slope of the total revenue function is marginal revenue. So the revenue maximizing quantity and price occur when MR = 0. For example assume that the monopoly’s demand function is P = 50 2Q. The total revenue function would be TR = 50Q 2Q2 and marginal revenue would be 50 4Q. Setting marginal revenue equal to zero we have 1. 50 4Q = 0 2. -4Q = -50 3. Q = 12. 5 So the revenue maximizing quantity for the monopoly is 12. 5 units and the revenue maximizing price is 25. A company with a monopoly does not experience price pressure from competitors, although it may experience pricing pressure from potential competition. If a company increases prices too much, then others may enter the market if they are able to provide the same good, or a substitute, at a lesser price. [31] The idea that monopolies in markets with easy entry need not be regulated against is known as the revolution in monopoly theory. [32] A monopolist can extract only one premium,[clarification needed] and getting into complementary markets does not pay. That is, the total profits a monopolist could earn if it sought to leverage its monopoly in one market by monopolizing a complementary market are equal to the extra profits it could earn anyway by charging more for the monopoly product itself. However, the one monopoly profit theorem is not true if customers in the monopoly good are stranded or poorly informed, or if the tied good has high fixed costs. A pure monopoly has the same economic rationality of perfectly competitive companies, i. e. to optimise a profit function given some constraints. By the assumptions of increasing marginal costs, exogenous inputs prices, and control concentrated on a single agent or entrepreneur, the optimal decision is to equate the marginal cost and marginal revenue of production.