Perfect Competition
Perfect
competition assumes that consumers are rational utility maximizers, know their
own tastes and preferences, and have perfect information on prices and other
characteristics of goods and services; and that firms are rational profit
maximizers, produce homogeneous, identical goods within each industry, face no
restriction moving into or out of an industry, and have perfect information on
the opportunity cost of all resources. Both consumers and firms are price takers;
there are such a large number of both that their individual actions have a
negligible effect on the price and quantity exchanged in the market.
Each
individual firm under perfect competition faces a perfectly elastic demand
curve: Each firm can sell all the output it can produce at the going price, but
it cannot sell any output at higher than the going price and has no incentive
to sell any output at lower than the going price. This means AR=MR=Price. The
firm cannot control price, so it controls quantity and chooses to produce the
quantity that maximizes profit, which is the quantity where MC=MR (=AR=Price).
If, at this quantity, the price is higher than the average total cost, then
excess profit exists and resources will move into the industry, shifting the
supply curve to the right and reducing price and profits. Resources will
continue to move into the industry until ATC=MC (=MR=AR=Price). If below normal
profit exists, then resources will move out of the industry, shifting the
supply curve to the left and increasing price and profits. Resources will
continue to move out of the industry until ATC=MC.
Economic
efficiency requires that the ratio MU/MC be equal for all goods. Under perfect
competition, utility maximizing consumer behavior will ensure that MU/P is
equal for all goods, and the behavior of profit maximizing firms will ensure
that P=MC for all goods. Therefore, MU/MC will be equal for all goods, and
economic efficiency will be achieved.
Monopoly
A monopolist
is a producer who supplies the complete market for a good or service. Barriers
to entry prevent new firms from entering the market. Barriers to entry could be
patents, legal protections, or financial disincentives such as economies of
scale.
Since a
monopolist is the sole provider, the firm’s marginal cost curve (which is the
firm’s supply curve) becomes the industry supply curve. There is also no
difference between the market and individual demand curves for a monopolist,
since there is only one firm.
The
monopolist faces a downward sloping demand curve, which is the same as its
average revenue curve. When average revenue is decreasing, marginal revenue
must by definition be less than average revenue. The monopolist follows the
same profit maximization rule as anyone else: Produce until MR=MC. But since AR
(the demand curve) is greater than MC at this quantity, the monopolist earns
above normal profits. This is a short run equilibrium position. However, there
are no new firms to enter the profit and drive down the above normal profit in
the long run. The only change in the long run is that the monopolist will
adjust plant size so that LRMC=MR. But the monopolist will only act to increase
profit, so the above normal profit is the same or higher in the long run.
Economic
efficiency, which requires that the ratio of MU/MC be equal for all goods, will
not exist when monopoly conditions exist. The ratio of MU/P will still be equal
for all goods because of utility maximizing consumer behavior. However, the
monopolist sets P=AR and MR=MC where AR>MR, hence P>MC. The ratio MU/MC
for the monopolistic good will be higher than for other goods.
Despite this
economic inefficiency, it may be in society’s best interest to have only one
producer of a good or service when economies of scale exist. Economies of scale
exist where average costs decline as plant size and output increases. Under
these conditions, one firm can produce a given output for less cost than would
be incurred if many small firms attempted to produce the same total output.
Under these conditions, in the absence of government intervention, there will
be a tendency for monopoly to arise. The largest firm in the industry has a
cost advantage over all smaller firms and can charge a lower price that drives
all competitors out of the market. The alternative is for firms to get together
and act like a monopoly, splitting the profits between them—an illegal activity
in many countries.
Many
competitive firms, each operating a small plant at a high average cost, may
cost society more resources to produce the same output as a monopolist, even
including the monopolist’s above normal profit.
Imperfect Competition / Monopolistic
Competition
An
imperfectly competitive industry consists of large numbers of firms each facing
a downward sloping demand curve for its goods or services. Firms have a degree
of control over price, possibly because there are real or imagined differences
between their products and those of competitors, due to elements of local
monopoly like the corner grocery store being more convenient to consumers who
live nearby, or perhaps for other reasons. The more these factors exist, the
more inelastic the firm’s demand curve will be. In the case of a corner store,
if they increase prices they will certainly lose some business, but some people
will continue to pay the higher price because of the time and inconvenience
involved in going “into town.”
Since each
firm faces a downward sloping demand curve, average revenue and marginal
revenue will diverge, as they do under a monopoly, but by much less. Again as
with a monopoly, firms will expand or contract output so that MC=MR. But since
the demand curve (AR) is greater than MR, above normal profits will be earned.
This will provide an incentive for new firms to move into the industry. Assuming
factor prices remain constant, the demand curve of existing firms will shift to
the left until, in long run equilibrium, the firm’s demand curve is tangential
to its average cost curve (AR < ATC for all points except one where AR=ATC,
which also happens to be the quantity where MR=MC). Normal profit is thus
earned.
However, the
point where AR=ATC is not the point of minimum ATC. A monopolistic competitor
in long-term equilibrium produces at a quantity where ATC is higher than
minimum, or in other words where spare capacity exists. At the same time, price
is higher than MC, so economic inefficiency results. If the firm were to
produce at minimum ATC, at which point price would equal MC since MC intersects
ATC at the minimum point, ATC would be higher than AR and the firm would incur
a loss. There is therefore no incentive for firms to produce beyond the point
where AR=ATC (and MR=MC).
The
implication of imperfect competition is that spare capacity exists and this
produces economic inefficiency, even though above normal profits are not being
earned. This inefficiency must be set against the product differentiation which
such firms provide society.
Oligopoly
An oligopoly
is an industry where a small number of firms produce the bulk of the industry’s
output. Each firm competes with the others in an interdependent manner; every
firm’s sales depends not only on the price it charges, but also on the prices
charged by its competitors. Because there are few firms and because there are
real or imagined differences between them, the demand curve faced by each firm
is downward sloping. However, many of the goods and services produced by
oligopolists are essentially homogeneous. Barriers to entry in oligopolies are
largely the same as for monopolies: Economies of scale, patents, or the sheer
size and complexity of the firms involved.
Unlike
perfect competition, when an oligopolist changes their price, the other
producers are likely to react. If one firm raises its price, most of its
customers will switch to other firms (assuming they do not raise prices to
match). So above the going price, the demand curve is highly elastic. If one
firm lowers its price, the other firms will lower theirs to match, so the quantity sold will not change much. So below the going price, the demand curve
is relatively inelastic. This results in a “kinked” demand curve. Since the
demand curve (=average revenue curve) is downward sloping, the marginal revenue
curve is also downward sloping and below the demand curve. At the point where the
kink appears in the demand curve, the marginal revenue curve is vertical over
some price range. As a result, there is a range of marginal costs over which
the profit maximizing price is the same.
The long
term profit maximizing strategy for an oligopolist is not simple because it
depends on what the competitors will do. This is what has led to the compexity
of airline pricing. The easiest solution is for the oligopolists to to form a
cartel, establish the industry-wide profit maximizing price, and earn monopoly
profits. Fortunately this is illegal. What oligopolists can do legally is to
implicitly elect one firm as the “price leader” and have all other firms match
any price changes. This is legal so long as the firms act only on publically
available data and do not collude.