Intermediate Microeconomic Theory: ECON 251:21 Perfect Competition

Firm and Industry Supply under Perfect Competition We have examined how we can think about a firms profit maximizing decision through its choice of inputs both in the long and short run. Just as in the consumer theory we can think of those choices as being derived from either utility maximization, or expenditure minimization, so to can we think of a firms choice as being derived from either revenue maximization or cost minimization. Both methods must yield the same supply decision. That is the choice of inputs gives the firms demand for inputs. This in turn defines the supply decision of the firm, since as its demand for input varies, it ultimately changes the level of production it engages in. To see this, let output produced be K such as in the short run. As the labor choice changes so to does the output. Yet at the same time labor choice L as we have found is dependent on the wage rate based on the firms labor demand in the short run. We can think of this as firms being given a level of output, and they having to choose the most optimal level of production. The next question then is how do firms decide how to produce in the first place? You would recall that in your Introduction to Economics classes, that that choice is made based on a firms profit maximization choice as well. Specifically, the firm chooses profit based on maximizing, =PQ-C(Q) This would yield you the standard condition within the perfect competitive framework, that price must equate with marginal cost of production, i.e. P=MC(Q). And as you will recall, the solution to that condition gives you the firms supply curve, which is that segment of the marginal cost (MC) curve above the average cost (AC) curve. Diagrammatically, Q = F (L, K ) = L
1 2 1 2

Price ,$

MC ATC

Firms Supply

Quantity

Intermediate Microeconomic Theory: ECON 251:21 Perfect Competition

You should know, or have asked yourself the question why we only consider the segment of the MC above the AC or ATC line. The principal argument is that when price is equal to marginal cost is occurs below the AC curve, we get the case of the firm making negative profits, which hence implies the firms should not and would not produce, and simply exit the market. This would have been what you learned in your first economics course, but it pertains to the long run when all inputs are variable, and there is no differentiation between fixed and variable cost. However, to be even more precise, we have to examine when it is better for the firm to exit the market, so as to determine the correct supply curve in the short run as well. Recall that a firm has two types of cost in the short run, fixed and variable cost. In the short run, the former is not variable, and can thus be considered a constant. The question now is when should the firm shutdown? Consider when the profit of the firm is lower than the fixed cost, when FC > PQ VC (Q ) FC . At such a price, and production choice, the firm cannot even recoup its fixed cost, which means it will shutdown. Rearranging the inequality, we obtain VC (Q ) > PQ VC (Q ) = AVC (Q ) > P = MC (Q ) Q AVC (Q ) > MC (Q ) Which gives the condition that when the firm faces a higher average variable cost than marginal cost, it will shutdown. Put another way, the relevant segment in the short run for the firms supply is that portion of marginal cost MC(Q) above the AVC(Q). To obtain the industrys supply (long and short run), as you would and should recall is just through horizontal summation of the individual firms supply curves. The principal assumptions that underlie the perfect competitive outcome is that this market structure has 1. Large number of firms (maybe infinite), 2. the size of the industry, in terms of the number of firms is that there is no barriers to entry, 3. all firms produces the same good with the same cost structure. There is essentially no way we can discern one firm from the other, which means when one firm shutdown, all should shutdown. No one can outdo the other say because of a lower cost structure, then by being able to undercut the other. However, should there be an exogenous increase in demand we should see an increase in the number of firms through entry by new firms. And if instead the demand falls, we can imagine a fall in the number of firms, but not necessarily everyone would leave. We can think about this case when the number of firms falling through some random process. The crux of the matter is that the market size dictates that there can be only a smaller number of firms, unless at the same time, firms are able to reduce their cost. The close of this segment, we now note the relationship between profits, and producer surplus. Profit is the revenue in excess of all cost (both fixed and variable cost) by definition, while producer/firm surplus is the portion of revenue above the variable cost.

Intermediate Microeconomic Theory: ECON 251:21 Perfect Competition

This measure is derived from the above idea that supply is the portion of MC that is above the AVC, and not just the AC. Recall from your demand and supply framework, that producer surplus is the segment between the price line, and the supply curve. This means diagrammatically,

Price ,$

MC ATC AVC
Firms Supply

Producer Surplus

Quantity

And lastly, the differential between the long and short run supply as derived from the marginal cost differs in slope, with the latter being steeper than the other. The reason being in the long run, with all factor inputs being variable, the elasticity of supply is higher, consequently the long run supply is gentler. How about the industrys long and short run supply? Essentially, the shape of the supply takes on that of the firms since the industry supply is obtained through horizontal summation of the firms supply. Recall also that another key characteristic of perfect competition is that it has a large number of firms. Recall from your earlier classes that as the number of firms increases, and you keep performing horizontal summation, the slope of the industry supply falls. Well, on the limit, when there is a large number of firms, the slope of the industry supply would tend to zero, i.e. a flat horizontal line. This is why in your first year, whenever we talk about perfect competition, we simply draw a flat P=MC line, and have the demand determine the level of production for the industry, and consequently the firms.

Intermediate Microeconomic Theory: ECON 251:21 Monopoly

Monopoly We have completed the study of a competitive firms behavior where the firm operates within a market structure with a lot of other similar firms, producing and selling the same product. This assumption prevents any of the competitors from attaining any form of market power. In fact, in the long run, none of the firms would be able to earn any positive profit. We will now examine the other extreme where the firm operates within a market where it is totally unique, and where no other firm sells a product that directly competes with it, i.e. a monopoly. Principally, the manner in which a firm chooses between its optimal technology, or mode of production is as we have examined earlier, using the isoprofit line for the short run analysis, and the isoquant and isocost curves in the long run. This then allows us to focus on the key differential between a perfectly competitive firm, and that of a monopoly, their equilibrium choice of optimal level of output. As we noted above, because the perfectly competitive firm is a price taker, its optimal choice is to produce up to the point where its price of output is equal to the cost of producing its output. What is the choice for a monopoly then? Let us assume a simple and general representation, and let R be the monopolys revenue function, and C be its cost function, both dependent on the quantity of output it chooses; = R(Q ) C (Q ) R(Q ) C (Q ) = MR(Q ) MC (Q ) = 0 Q Q MR(Q ) = MC (Q ) Which gives the marginal revenue equal to marginal cost condition you had learned before in your first year. More specifically, we can write the revenue function as the product of price and output, noting that the price that the monopoly chooses is dependent on its level of output it chooses, since it is a price setter.
= (P (Q ) Q ) C (Q ) P (Q ) C (Q ) = MR (Q ) MC (Q ) = 0 Q + P (Q ) Q Q

P (Q ) Q C (Q ) 1 C (Q ) P (Q ) Q P (Q ) + 1 Q = P (Q ) (Q ) + 1 Q = 0 1 1 C (Q ) P (Q ) (Q ) + 1 = P (Q )1 (Q ) = Q C (Q ) Q P (Q ) = 1 1 (Q )

Intermediate Microeconomic Theory: ECON 251:21 Monopoly

Let us examine the denominator of the final equality condition we derive from above, 1 1 . First note that the monopoly would never choose to operate where the (Q ) elasticity of demand is less than 1, i.e. where the demand is inelastic, since when elasticity is less than 1, the term above is less than 1, which turn would mean the monopoly charges a price of less than 0, which is not possible. Secondly, since the monopoly produces at the point where the demand is elastic, i.e. greater than one, the bracketed term is less than 1, and consequently implies charges a price that is greater than the marginal cost, and we call this the markup of monopoly above the perfectly 1 competitive outcome, . When we have a constant elasticity of demand 1 1 (Q )

(examine your earlier work in the first three chapters where we did have an example of a 1 constant elasticity demand), this markup is just , which means the price is 1 1 always set at a constant markup above the marginal cost. We will now examine how we should depict the diagrams for a monopoly. Let us examine a simple example when the monopolys demand is a straight line as like our earlier discussions. P(Q ) = a bQ P(Q )Q = aQ bQ 2 MR(Q ) = a 2bQ Comparing the inverse demand, the first equation, and the last equation, which gives the marginal revenue line, note that both are straight lines, with the sole exception that the

Intermediate Microeconomic Theory: ECON 251:21 Monopoly

latter has a slope that is twice as steep as the inverse demand. Diagrammatically,
P Intercept of a

Slope of -b Slope of -2b

MR, P=a-2bQ

Demand, P=a-bQ Q

Adopting the usual shape of MC and AC, and combining the above diagram we get;
P

MC

P* ATC Profit Markup

MR, P=a-2bQ Q*

Demand, AR=P=a-bQ, Q

Intermediate Microeconomic Theory: ECON 251:21 Monopoly

We next ask ourselves, is the perfectly competitive output more efficient in its choice, than say the monopolistic choice. For that we refer to the following diagram,
P

MC

P* A P
PC

B C D

MR, P=a-2bQ Q* QPC

Demand, AR=P=a-bQ, Q

1. Because of market power, the monopolist captures the portion of consumer surplus, A, that would have accrued to consumers under perfect competition. 2. Because of the fact that a monopolists MR is less than price, they chooses to produce less than the competitive level, and hence creates deadweight loss, B+C. This is commonly noted as welfare loss, since society would have benefited from this had production been increased to the competitive level. 3. Because of their choice, resources that could have been used to produce more goods are diverted to other uses in the form of D. This is not a loss to the society in general, unless the resources diverted are used for evil, and goods produced by the monopolist potentially benefits human kind! But none of these arguments relate to efficiency. In examining efficiency, we are asking ourselves whether by changing the level of output, would that choice make everyone better of, or at least one person better of without making another worse off, be it in pecuniary or non-pecuniary ways (when we think about utility, it measure is nonpecuniary). Lets begin at the monopoly output choice, suppose the monopoly chooses to raise that output by an additional unit, based on the above diagram, since the willingness of the consumer to pay, which gives the price the monopoly would receive from the additional sale is greater than the marginal cost, the monopoly benefits, and yet at the same time, the consumer who otherwise wouldnt have gotten the good would benefit from consuming the good. This means that everyone is better or at least as well off. This then means that the monopoly choice is inefficient. Based on the above argument, if by raising production by an additional unit, everyone is better off, why doesnt it do it. The principal reason is that in selling the additional unit at a lower price based on the demand (reflecting the consumers willingness to pay), all its

Intermediate Microeconomic Theory: ECON 251:21 Monopoly

other clients would also be eligible for that price. That is the monopoly has to contend with the inframarginal effects! It would seem based on the above analysis, Monopolies are by necessity a bad and should then be subject to regulation, forcing them to either breakup into smaller separate entities such as in the case of AT&T, and Microsoft, or by forcing them to produce at the level of P=MC. The latter however does not always work. Consider the example below of a natural monopoly, which arises due to large fixed cost of operation, and small marginal costs;
P

MC

ATC

P* PC

MR, P=a-2bQ Q*

Demand, AR=P=a-bQ, Q

Based on the above scenario, by forcing the natural monopoly to operate at the point where MC and demand intersect would be about its demise since the firm would be making a lost. In such a scenario, what governments has done is through one of the following, 1. Regulation to produce at point where demand equals to ATC, thereby having the firm just breaks even. The idea is for the natural monopoly to just breakeven. 2. Have the Natural Monopoly be operated by the Government, which would attain the P=MC level through direct subsidy. Is this really efficient? Is the point where P=MC really efficient, when say the effective supply, segment of MC above AVC is above the demand. That is the demand is in fact to inelastic! Put another way, what if the supply and demand never intersect?!
What causes Monopolies? The formation of monopolies is dependent on the idea of Minimum Efficient Scale (MES), the level of output that minimizes average cost, relative to demand. Consider two extreme examples below, the first should result in a competitive market, and in the latter, a monopoly may result.

Intermediate Microeconomic Theory: ECON 251:21 Monopoly P

ATC P*

Demand MES Q

ATC P*

Demand MES Q

Under the latter scenario, and assuming there is no way to enlarge the market, it becomes a candidate for regulation. However, even regulation entails cost through governmental oversight. If these costs are more substantial then the deadweight loss induced by the monopoly, the market might best be left to operate on its own, unless there are other national agenda that needs to be fulfilled through the provision of the good. Another reason for the formation of monopolies is through Cartel formation which is the formation of a pseudo monopoly through collusion between firms to raise prices above the competitive level. This practice is illegal, but because it is often not overt, its 9

Intermediate Microeconomic Theory: ECON 251:21 Monopoly

detection is not possible, and evidence is not verifiable, i.e. without hard evidence, it is difficult to incriminate the culprits. Examples: De Beers, and OPEC.
Monopoly Behavior We have thus far considered Monopoly behavior in a single market. However, the reach of these large firms are typically quite wide in terms of geographic range of its market, and the size of its product range. What kind of behavior can they engage in to capture the highest level of profit? We will now consider these possibilities.

We have rationalized that monopolies do not wish to sell at the competitive price level because of its inframarginal concerns. However, if the monopolist could sell different units of output at different prices then it would sell up to the point where P=MC. We call this practice Price Discrimination. First Degree Price Discrimination means the monopolist sells different unit at different prices, and this could differ for every individual. This is sometimes referred to as Perfect Price Discrimination. In this scenario, the Monopolist captures the entire consumer surplus (Area A) since it charges each an every consumer its willingness to pay.

P MC

Surplus Captured

Demand

Second Degree Price Discrimination mans that the monopolist sells different units of output for different prices, but every individual who buys the same amount of the goods pays the same price. An example of this is bulk discounts, and the price schedule of public utilities. To see how this works, consider two types of individuals with two different demand, and the monopolist know the demand function, hence it can potentially as in First Degree Price Discrimination obtain the full surplus. The problem however is that the monopolist does not know who has which demand, and hence has to rely on self selection, i.e. trickery to induce the consumer to reveal her own type of demand. Lets assume that the monopoly does not have any cost to speak of, so that we can isolate the

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Intermediate Microeconomic Theory: ECON 251:21 Monopoly

crux of the argument. And let demand for type 1 consumer be uniformly greater than type 2, that is type 1 has a higher willingness to pay, such as below.

Type 1 Consumer

Type 2 Consumer

C Quantity

Q2

Q1

Ideally, the monopolist if he knew the consumers type would charge type 1 consumers a price of A+B+C for quantity Q1, and type 2 consumers a price of A for Q2. However, consumer 1 knows that by pretending to be type 1, and buying Q2 at A, she gains B in surplus, which is greater than 0 should she reveal her true type. Note that with this strategy, the monopolist gains 2A in profit. The question now is how to induce the type 1 consumer to reveal herself. Of course the monopolist could charge type 1 consumer A+C, and thereby induce type 1 consume Q1. This gives a profit of 2A+C. But it is possible to raise profit to the monopolist by reducing output to type 1 consumer. Here is how it can work.
P

F D G Q3 Q2 Q1 Quantity H

The monopolist could sell instead now Q3 to type 2 consumers at D, but Q1 to type 1 consumers at D+G+F+H. At this price, type 2 consumers would consume Q3 at the said 11

Intermediate Microeconomic Theory: ECON 251:21 Monopoly

price of D. Following our consumer theory assumption that if the consumer can consume more it would consume more, we have the type 1 consumer revealing herself by consuming Q1 and paying D+G+F+H, but gaining E in surplus, which is lower than B of before, while the monopolists profit is 2D+F+H>2A. In fact, the monopolist using this rationale would continue squeezing for additional profit until it just equal the additional cost of profit lost from type 2 consumers, that is until 2G=F.
P

F D G Q3 Q2 Q1 Quantity H

This type second degree price discrimination however typically is on the quality dimension, but the crux of the argument is that you need at least two types of consumers, of whose demand you know are different, and of what form, and magnitude. The final type of price discrimination is Third Degree Price Discrimination where the monopolist sells output to different people for different prices, but every individual who buys the same amount of the goods pays the same price. Here the monopolist knows the demand of the different groups (markets) of consumers but cannot fully extract the full surplus buy selling different units at different price. In this case, the problem of the monopolist is to maximize profit by choosing two quantities, max Q1 ,Q2 = max Q1 ,Q2 (P(Q1 ) Q1 ) + (P(Q2 ) Q2 ) C (Q1 + Q2 )

This then gives two equilibrium conditions

C (Q1 + Q2 ) 1 P (Q1 ) = MC 1 (Q ) = MR1 = Q 1 C (Q1 + Q2 ) 1 = MR2 = 1 P (Q 2 ) = MC Q (Q2 )

This means that as usual, the monopolist would charge up to the point where the individual marginal revenue for each market is equal to its marginal cost. It also has an interesting point, suppose the market 1 has a higher elasticity of demand. Then the markup term for market 1 is smaller, and consequently the price charged to them for the output is smaller than that of the less elastic market which is a very intuitive outcome.

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