profits. (Remember that normal profits are included in the cost functions as an
opportunity cost for the entrepreneur.) If the price falls below CB, the firm will
lose money, i.e. will earn less than normal profits. So long as the price is
above CC, the firm is recovering all the variable cost and a little more to offset
the fixed cost that it would have lost if the firm would have shutdown. At a
price of CC, the firm is recovering all its variable cost and losing its fixed cost
(which it would have done anyway if it had closed down.). Therefore, so long
as the firm can recover all its variable costs at a price of CC, it may as well
operate in the short run. Point C, at a price of CC and output of QC is called
247
12.2.1 Profit Maximization in the Short Run
the shutdown point. It will always be at the point where the MC intersects the
AVC (the minimum of the AVC).
In the long run all costs are variable, therefore the shut down point in the
long run is the minimum of the LRAC where MC= LRAC.
There may be other reasons for operating a production facility. In some
cases individuals may operate at less than normal profits because the get non-
monetary benefits from being in a particular line of work or being “their own
boss.” A government may encourage firms that produce particular products to
operate for reasons of national defense or national pride. In these cases public
policy may be used to subsidize the firms that would find it necessary to shut
down in a free market economy.
12.2.2 PROFITS IN LONG RUN PURE COMPETITION
I n the long run, producers are able to alter their scale of plant. The LRAC
or envelope curve was constructed from a series of short run periods with
different plant sizes. In the long run the firm is essentially able to select the
scale of plant (or a specific set short run production and cost functions
associated with a specific fixed (in the short run) input). The is essentially the
meaning of “relative ease of exit and entry from the market.
Another crucial aspect of long run pure competition is that the demand
faced by the firm is perfectly elastic at the market price. The AR and MR
functions coincide with the firm’s demand function. Because the firm’s demand
function is perfectly elastic, they cannot raise their price above the market
price. If they do, their sales will fall to 0. There is no reason to lower their
price below the market price because they can sell all they want to a the
market price. The firms in pure competition have no “market power. ” Market
power, in microeconomics, refers to the ability of an agent to raise the price
248
12.2.2 Profits in Long Run Pure Competition
and not have their sales fall to 0. A quick review of price elasticity suggests
that market power is influenced by a firm’s demand function. Purely
competitive firms are price takers. These firms have no incentive to advertise.
The largest producer in a purely competitive market can sell all they can
produce or none at all and the market price will be unaltered.
249
12.2.2 Profits in Long Run Pure Competition
LRMC
S
SRAC3
rice, $
SM
M*
rice, $
SRAC1
SRAC*
P
P
A
EM
SRAC2 B
D
P
f
EM
PEM
P*
ARf=MRf
P*
C
D*, AR*, MR*
DM
QEM
Qx(1027)
QA
QC QB
Qx/ut
Panel A.VII.6
Panel B.VII.6
(Market)
(Firm)
Figure VII.6
In Figure VII.6 The market demand an supply functions (in Panel A) are initially DM and SM.
Given thess demand and supply functions, the market equilibrium is at point EM resulting in an
equilibrium price (PEM) and quantity (QEM). When the market price is PEM, the firm reacts to
that price (The firm is a price taker.). If the firm’s objective is to maximize profits, it will
operate at the point where MR = MC. This equality of MR and MC occurs at point at Point B in
panel B. Note that the short run MC will lie to the right of the LRMC at this point, so short run
output would be greater. The firm will select plant size SRAC2 since it will minimize the cost
per unit at that output level (QB). This SRAC2 is not the most efficient size plant (SRAC*). The
AR is greater than the AC at this point. The firm can earn “economic profits” under these
conditions. Remember “normal profits” are included in the cost functions.
Since entry is relatively free, other entrepreneurs will desire to capture some of these economic
profits and enter the industry. The supply function will increase (shift to the right) causing the
equilibrium price to fall from PEM to P*. The equilibrium quantity in the market rises but there
are more firms. The firm represented in Panel B must adjust to the lower market price, P*.The
new demand and revenue functions faced by the firm is D*, AR* and MR*.MR* = MC at point
C. The firm reduces output to QC and adjusts plant size to SRAC*.
The firm now is operating where:
•
the plant that has allows the lowest cost per unit (most efficient size plant),
•
they operate that plant at the level of output that has the lowest cost per unit,
•
they earn a normal profit,
•
They are maximizing their profits given circumstances (They have no incentive to
change output or plant size, they are in equilibrium.),
•
The price is equal to the MC (This is the condition to optimize the welfare of the
individuals in society given the income distribution.)
250
12.2.2 Profits in Long Run Pure Competition
The process of long run equilibrium in pure competition can be shown in
Figure VII.6. You may remember part of Figure VII.6 as Figure VII.3. Both the
market and an individual firm’s demand and cost (supply) functions are
shown.
In Figure VII.6, it is apparent that a market price below P* would result in
the firm’s AC exceeding the AR at all levels. If this were the case firms would
earn less than normal profits and would have an incentive to leave the market.
As firms leave the market, the market supply decreases (shifts to the left) and
the market price would rise.
There are two important features in pure competition. First each firm is a
price taker and has no market power. The demand function faced by the firm
is perfectly elastic at the equilibrium price established in the market. This is
because the output of the purely competitive firms is homogeneous and there
are a large number of sellers, none of whom can influence the market price.
Secondly, entry and exit from the market is relatively free. Above normal
profits attract new producer/seller that increases the market supply driving the
market price down. If profits are below normal, firms exit the market. This
reduces the market supply and drives the price up.
Long run equilibrium in a purely competitive market is established when
the D (AR and MR) is just tangent to the long run average cost function
(LRAC). This will be at the minimum of the LRAC where its slope is 0 (the
demand function faced by the firm has a slope of 0). Firm earn normal profits
at this point and there is no incentive to enter or leave the market. There is no
incentive to alter plant size or change the output level.
At the point of long run equilibrium in Figure VII.6 at point C, the following
conditions will exist:
251
12.2.2 Profits in Long Run Pure Competition
•
AR = AC: Firms earn a normal profit. There is no incentive for firms to enter or
leave the market.
•
LRMC = LRAC: the firm is operating with the plant size that results in the
lowest cost per unit, i.e. the fewest resources per unit of output are used.
•
MR =LRMC: the firm has no incentive to alter output or plant size.
•
P = MR =MC: the price reflects the marginal value of the good to the buyers and
the marginal cost to the producer/seller.
Long run equilibrium in pure competition results in an optimal allocation of
resources. The price reflects the marginal benefits of the buyers and the
marginal cost of production. The user of the last unit of the good places a
value (the price they are willing and able to pay) on the good equal to the cost
of producing that unit of the good. Units of the good between 0 and the
equilibrium quantity have a greater value than the cost of production.
The purely competitive model provides a benchmark or criteria to evaluate
the performance of a market: MB = P = MC. The marginal benefit (MB) to the
buyer is suggested by the price they are willing and able to pay. The MB to the
seller is the marginal revenue (MR) they earn. The marginal cost (MC) reflects
the opportunity cost to society.
252
13 Firms With “Market Power”
13 FIRMS WITH “MARKET POWER”
P ure competition results in an optimal allocation or resources given the
objective of an economic system to allocate resources to their highest valued
uses or to allocate relative scarce resource to maximize the satisfaction of
(unlimited) wants in a cultural context. Pure competition is the ideal that is be
benchmark to evaluate the performance markets. The economic theory of
monopolistic competitive markets, oligopoly and monopoly is used to suggest
the nature of problems that may exist when firms or agents have market
power and are able to distort prices away from the purely competitive
optimum.
The existence of market power is tied to the demand conditions the firm
faces. If their product is (or can be differentiated), consumers may have a
preference for one firm’s output relative to others. A negatively sloped
demand function (less than perfectly elastic) allows the firm to raise its price
and not have its sales fall to zero. In pure competition, the firms may all try to
influence market demand (eat Colorado Beef, Eat Black Angus Beef, Drink
Florida orange juice, etc) but individual producers do not advertise their own
product (Eat Rancher Jones’s Beef). Many agricultural markets are close to
pure competition. In many cases some producers try to differentiate their
products. Organic produce is one example.
In pure competition, the firms’ outputs are homogeneous. If the firm has is
no opportunity to differentiate their product they have no incentive to
advertise and to try to influence the demand for their product. If a product can
be differentiated by altering the characteristics of the good or simply by
convincing the consumers that the product is different, the firm achieves
market power. Market power is the ability to have some control over the price
253
13 Firms With “Market Power”
of the good offered for sale. Advertising can be used to differentiate a product
or increase the demand for a product. The crucial factor is the demand for the
firm’s output must be negatively sloped: the firm becomes a “price maker.”
The extent to which a firm is a price maker (i.e. has market power) is partially
determined by the price elasticity of demand in the relevant price range. Note
that when the seller selects a price (price maker) the demand function
determines the quantity that will be purchased.
The conditions of entry or barriers to entry (BTE) are also important
determinants of market power. If there are significant BTE, a firm or firms
may be able to sustain above normal profits over time because other firms are
prevented from entry to capture the above normal profits.
Monopoly is the market structure that is usually associated with the
greatest market power. The monopolist produces a good with no close
substitutes (increased probability the demand is relatively inelastic) and there
are barriers to entry. Firms in monopolistic competition or imperfectly
competitive markets are more likely to have limited market power because
there are many firms with differentiated products (there are substitutes) and
there is relative ease of entry and exit into the market.
254
13.1 Monopoly
13.1 MONOPOLY
A monopoly is a market characterized by a single seller of a good with no
close substitutes and barriers to entry. Monopolies rarely occur in a pure form.
There are almost always substitutes or methods of possible entry into a
market. When the term “monopoly” is used it is usually referring to a degree
of monopoly or market power. In many cases the existence of a monopoly
results in regulation or the enforcement of antitrust laws that attempt to
introduce competition to reduce market power.
The definition of monopoly requires a judgment about the phrase “no close
substitutes” and what “barriers to entry” mean. I might be the only producer
of mink lined, titanium trash cans. This is not relevant as a monopoly since
there are many good substitutes: plastic or steel containers or even brown
paper bags will serve as trash containers. There are substitutes for the
electricity (KWH) produced by a public utility. It is possible to purchase a
portable generator powered by an internal combustion engine or use candles
for use in your home. However, neither of these can be regarded as a close
substitute. The concept of cross elasticity of demand can be used to identify
whether two goods are substitutes on not.
%Δ Q
( Cross price elasticity of demand ) E
≡
X
XY
%Δ PY
[ a change in the quantity of good X, caused by a change in the price of good Y ]
Barriers to entry are another important characteristic of monopoly.
Complete barriers to entry (BTE) make it impossible for competing firms to
inter a market. However, in n most cases, BTE are not complete but are
relative. Firms’ entry into a market can be restricted by a variety of factors.
BTE’s can be due to:
255
13.1 Monopoly
•
The ownership of a key resource or location maybe important. ALCOA’s monopoly in
aluminum was at first due to a patent on a low cost process to reduce bauxite into
aluminum. After the patent expired, their ownership of bauxite reserves allowed them
to maintain their monopoly position. In earlier times there may have been only one
location on a river where a dam could be built to power a gristmill. A movie theatre
gains monopoly power over its sale of popcorn by prohibiting customers from bringing
their own food into the theatre.
•
Information or knowledge not available to others. (Industrial secrets). Knowledge
about a process may kept secret (rather than using a patent since patent information is
publicly available).
•
Legal barriers such as license, franchise, patent, copyright, etc. ALCOA’s monopoly
began when the government gave them a patent on a low cost method of reducing
bauxite to aluminum. Other methods of making aluminum are possible but cannot
compete with the method pioneered and patented by ALCOA. A State park might
license a firm to provide prepared foods within the boundary of the park. This would
confer market power on the firm unless their price was regulated. A city that licenses a
taxi company gives them market power. They may license several taxi companies so
that there is some competition and or they may regulate the services and rates. Public
utilities often have a license to operate in a specific area. In return for this monopoly
power, they are subject to regulation. In fact, the British colonies that became the
United States and Canada were the result or grants from the British government.
Hudson Bay Company and the East India Companies were firms that were granted
rights to operate in specific areas.
•
Natural monopoly caused by economies of scale usually associated with a cost
structure with a high fixed cost relative to variable costs. A natural monopoly is the
result of significant economies of scale due to a high fixed cost. As the output
increases the LRAC falls. If the market demand intersects the LRAC as it falls (or at its
minimum), a natural monopoly exists.
256
13.1.1 Profit Maximization In a Monopoly
C, TR )T($
RM
TC
TRM
MT
TCM
CM
TR
QMQT
Q/ut
Figure VIII.1
13.1.1 PROFIT MAXIMIZATION IN A MONOPOLY
S ince a monopoly is characterized by a single seller, the market demand
and the demand faced by the firm are the same. The demand will tend to be
negatively Figure VIII.1 represents profit maximization by a firm in a
monopoly market.
The TR function increases up to an output level of QT then it declines.
Remember that any negatively sloped demand function is elastic at high prices
(top half of demand where price increases reduce TR) and inelastic at low
prices (bottom half of demand where price increases increase TR). The TC
increases at a decreasing rate, passes an inflection point and then increases at
257
13.1.1 Profit Maximization In a Monopoly
an increasing rate. Maximum profits is occurs at the output level where TR
>TR by the greatest vertical distance. This occurs at output QM. Profits are
reflected by the vertical distance, CMRM, or TRM-TCM. At point CM the slope of
the TC (MC) is the same as the slope of the TR at point RM (MR). The
maximum TR occurs at point MT at output level QT. If the firm increases output
from QM to QT profits will decrease because the costs of the additional units
(QT-QM) is greater than the additional revenue produced by those units of
output.
Unit cost and revenue functions can also be used to show the output and
price decisions of a monopolist. In Figure VIII.2 the demand, AR, MR, MC and
AC cost functions are shown.
In Figure VIII.2, revenue and cost functions
MC
for a monopolist are shown. The demand
rice
and AR are negatively sloped, so the MR
P
falls at twice the rate and intersects the Q-
axis half way between the origin and AR
(or demand) intercept.
AC
The firm will maximize profits where MC =
P
H
H
MR (at point Z) producing QH output.
Buyers are willing and able to pay a price of
P
th
H for the QH unit produced (they would
J
be willing to pay more for units from 0 to
CJ
C
F
Q
F
H, but don’t if there is no price
C
C
C
discrimination
Z
The cost per unit is CF, so profits are area
CFFHPH or (PH-CF)QH. Profits are above
AR
normal but BTE prevent others from
entering the market to capture the above
MR
D
normal profits.
0
QH QC
QJ
Q/ut
Figure VIII.2
Figure VIII.2 represents a monopolist. In the long run the monopolist
might adjust the scale of plant, but BTE prevents other firms from entering
and driving profits to normal. Monopoly or market power is suggested by two
258
13.1.1 Profit Maximization In a Monopoly
things. First, the price is greater than the marginal cost (P>MC). Secondly,
above normal profits will persist over time.
13.1.2 IMPERFECT COMPETITION AND MONOPOLISTIC COMPETITION
D uring 1933 Edward H. Chamberlin [1899-1967] and Joan Robinson
[1903-1983] independently published similar theories on “monopolistic” and
“imperfect” competition. The terms “monopolistic competition” and “imperfect
competition” originally were basically the same even though there were subtle
differences. Currently, the use of “imperfect competition” is more generic, it
refers to all market structures that lie between pure competition and
monopoly. In this usage monopolistically competitive and oligopolistic markets
are considered imperfect.
Monopolistically competitive markets are characterized by:
•
a large number of sellers, no one of which can influence the market,
•
differentiated products,
•
relative free entry and exit from the market.
Relaxing the characteristic of outputs from homogeneous to “differentiated
products” was the basic change from the purely competitive market model.
The differentiation of output results in the demand faced by each seller being
less than perfectly elastic. Since there are “many sellers,” many substitutes for
each seller’s output is implied. This suggests that the demand faced by a firm
in a monopolistically competitive market is likely more elastic than in a
monopoly. The elasticity obviously depends on the preferences and behavior
of the buyers. The negative slope of a firm’s demand function in imperfect
competition results in a different result than in pure competition.
259
13.1.2 Imperfect Competition and Monopolistic Competition
The conditions of entry and exit to and from a monopolistically competitive
market are similar to the purely competiti