Firms in Competitive Markets

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 The Zero-Profit Condition
 Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
 Zero economic profit occurs when P = ATC.
 Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
 Recall that MC intersects ATC at minimum ATC.
 Hence, in the long run, P = minimum ATC.

FIRMS IN COMPETITIVE MARKETS 1

 The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
FIRMS IN COMPETITIVE MARKETS 2
 SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
FIRMS IN COMPETITIVE MARKETS 3
 CONCLUSION: The Efficiency of a
Competitive Market
 Profit-maximization: MC = MR
 Perfect competition: P = MR
 So, in the competitive equilibrium:
P = MC
 Recall, MC is cost of producing the
marginal unit.
P is value to buyers of the marginal unit.
 So, the competitive equilibrium is
efficient, maximizes total surplus.
4
FIRMS IN COMPETITIVE MARKETS
 Monopoly

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws

MONOPOLY 8
 Why Monopolies Arise
3. Natural monopoly: a single firm can produce
the entire market Q at lower cost than could
several firms.
Example: 1000 homes
need electricity Cost Electricity
ATC slopes
ATC is lower if downward due
one firm services to huge FC and
all 1000 homes $80 small MC
than if two firms $50 ATC
each service
Q
500 homes. 500 1000
MONOPOLY 9
Understanding the Monopolist’s MR
 Increasing Q has two effects on revenue:
 Output effect: higher output raises revenue
 Price effect: lower price reduces revenue
 To sell a larger Q, the monopolist must reduce
the price on all the units it sells.
 Hence, MR < P
 MR could even be negative if the price effect
exceeds the output effect (e.g., when Common
Grounds increases Q from 5 to 6).

MONOPOLY 10
 Profit-Maximization
 Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR =
MC.
 Once the monopolist identifies this quantity,
it sets the highest price consumers are willing
to pay for that quantity.
 It finds this price from the D curve.

MONOPOLY 11
 Profit-Maximization

Costs and
1. The profit- Revenue MC
maximizing Q
is where P
MR = MC.
2. Find P from
the demand D
curve at this Q. MR

Q Quantity

Profit-maximizing output
MONOPOLY 12
 The Monopolist’s Profit

Costs and
Revenue MC

As with a P
ATC
competitive firm, ATC
the monopolist’s
profit (π) equals D
(P – ATC) x Q MR

Q Quantity

MONOPOLY 13
A Monopoly Does Not Have an S Curve
A competitive firm
 takes P as given
 has a supply curve that shows how its Q depends
on P.
A monopoly firm
 is a “price-maker,” not a “price-taker”
 Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.
So there is no “supply curve” for monopoly (with S being
the interaction of Q and P or the firm’s Q reponse to each
change in P). MONOPOLY 14
 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QC loss MC
P = MC
total surplus is P
maximized P = MC
MC
Monopoly eq’m:
quantity = QM D
P > MC MR
deadweight loss
QM QC Quantity

MONOPOLY 15
 Price Discrimination
 Discrimination: treating people differently based
on some characteristic, e.g. race or gender.
 Price discrimination: selling the same good
at different prices to different buyers.
 The characteristic used in price discrimination
is willingness to pay (WTP):
 A firm can increase profit by charging a higher
price to buyers with higher WTP.

MONOPOLY 16
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist Consumer
charges the same Price
surplus
price (PM) to all
Deadweight
buyers. PM loss
A deadweight loss
results. MC
Monopoly
profit D
MR

QM Quantity

MONOPOLY 17
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the Price
competitive quantity, Monopoly
profit
but charges each
buyer his or her WTP.
This is called perfect
MC
price discrimination.
D
The monopolist
captures all consumer MR
surplus as profit.
Quantity
But there’s no Q
deadweight loss.
18
MONOPOLY
Monopolistic Competition

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 Comparing Perfect & Monop. Competition
Perfect Monopolistic
competition competition

number of sellers many many

free entry/exit yes yes

long-run econ. profits zero zero

the products firms sell identical differentiated

firm has market power? none, price-taker yes

downward-
D curve facing firm horizontal
sloping

MONOPOLISTIC COMPETITION 20
Comparing Monopoly & Monop. Competition
Monopolistic
Monopoly
competition
number of sellers one many

free entry/exit no yes

long-run econ. profits positive zero

firm has market power? yes yes

downward-
downward-
D curve facing firm sloping
sloping
(market demand)
close substitutes none many
MONOPOLISTIC COMPETITION 21
Characteristics of Different Market Organizations
Industry Characteristics
monopolistic competition A common form of
industry (market) structure characterized by a large
number of firms, no barriers to entry, and product
differentiation.
TABLE. Percentage of Value of Shipments Accounted for by the Largest Firms in
Selected Industries, 2002

Industry Designation Four Largest Eight Largest Twenty Number of

Firms Firms Largest Firms
Firms
Travel trailers and campers 38 45 58 733
Games, toys 39 48 63 732
Wood office furniture 34 43 56 546
Book printing 33 54 68 560
Curtains and draperies 17 25 38 1,778
Fresh or frozen seafood 14 24 48 529
Women’s dresses 18 23 48 528
Miscellaneous plastic products 6 10 18 6,775
 A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve. Price
profit MC
At each Q, MR < P. ATC
P
To maximize profit,
ATC
firm produces Q D
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

MONOPOLISTIC COMPETITION 24
 A Monopolistically Competitive Firm
With Losses in the Short Run
For this firm,
P < ATC
Price
at the output where MC
MR = MC.
losses ATC
The best this firm
ATC
can do is to
minimize its losses. P

D
MR
Q Quantity

MONOPOLISTIC COMPETITION 25
 A Monopolistically Competitive Firm
in Equilibrium
For this firm,
P = ATC
Price
at the output where MC
MR = MC.
Long-run econ ATC
ATC
profit=0.
P
No more incentive
to move but P does D
not coincide with MR
the min. ATC. Q Quantity

MONOPOLISTIC COMPETITION 26
 Oligopoly

© 2009 South-Western, a part of Cengage Learning, all rights reserved

 Oligopoly
 Oligopoly: a market structure in which only a
few sellers offer similar or identical products.
 Strategic behavior in oligopoly:
A firm’s decisions about P or Q can affect other
firms and cause them to react. The firm will
consider these reactions when making decisions.
 Game theory: the study of how people behave
in strategic situations.

OLIGOPOLY 28
 Assumptions
 Few firms, many buyers
 Each firm holds a substantial portion of total market output
that action of one firm cannot be ignored by its competitors
 The fewness of sellers introduces interactions or
interdependencies into the price-output decision of each firm

 Either a homogenous or differentiated products

 ex. automobile, telecommunications
 Limited entry (conditioned by technology or cost)
 To reach an economically operational output level in
automobile or telecom industry requires considerable initial
investment

OLIGOPOLY 29
 Measuring Market Concentration
 Concentration ratio: the percentage of the
market’s total output supplied by its four largest
firms.
 The higher the concentration ratio,
the less competition.
 This session focuses on oligopoly,
a market structure with high concentration ratios.

OLIGOPOLY 30
Concentration Ratios in Selected U.S. Industries
Industry Concentration ratio
Video game consoles 100%
Tennis balls 100%
Credit cards 99%
Batteries 94%
Soft drinks 93%
Web search engines 92%
Breakfast cereal 92%
Cigarettes 89%
Greeting cards 88%
Beer 85%
Cell phone service 82%
Autos 79%
EXAMPLE: Cell Phone Duopoly in Sagada
P Q  Sagada has 140 residents
P0 140
 The “good”:
5 130
cell phone service with unlimited
10 120 anytime minutes and free phone
15 110
20 100
 Sagada’s demand schedule
25 90  Two firms: SMART, Globe
30 80 (duopoly: an oligopoly with two firms)
35 70  Each firm’s costs: FC = P0, MC = P10
40 60
45 50
OLIGOPOLY 32
EXAMPLE: Cell Phone Duopoly in Sagada
P Q Revenue Cost Profit Competitive
P0 140 P0 P1,400 –1,400 outcome:
5 130 650 1,300 –650
P = MC = P10
Q = 120
10 120 1,200 1,200 0
Profit = P0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350
Monopoly
30 80 2,400 800 1,600 outcome:
35 70 2,450 700 1,750 P = P40
40 60 2,400 600 1,800 Q = 60
45 50 2,250 500 1,750 Profit = P1,800
OLIGOPOLY 33
EXAMPLE: Cell Phone Duopoly in Sagada
 One possible duopoly outcome: collusion
 Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
 SMART and Globe could agree to each produce
half of the monopoly output:
 For each firm: Q = 30, P = P40, profits = P900
 Cartel: a group of firms acting in unison,
e.g., SMART and Globe in the outcome with
collusion

OLIGOPOLY 34
ACTIVE LEARNING 1
Collusion vs. self-interest
P Q Duopoly outcome with collusion:
P0 140 Each firm agrees to produce Q = 30,
5 130 earns profit = P900.
10 120 If SMART reneges on the agreement and
15 110 produces Q = 40, what happens to the
20 100 market price? SMART’s profits?
25 90 Is it in SMART’s interest to renege on the
30 80 agreement?
35 70 If both firms renege and produce Q = 40,
40 60 determine each firm’s profits.
45 50 35
ACTIVE LEARNING 1
Answers
P Q If both firms stick to agreement,
each firm’s profit = P900
P0 140
5 130 If SMART reneges on agreement and
produces Q = 40:
10 120
Market quantity = 70, P = P35
15 110
SMART’s profit = 40 x (P35 – 10) = P1000
20 100
SMART’s profits are higher if it reneges.
25 90
30 80 Globe will conclude the same, so
both firms renege, each produces Q = 40:
35 70
Market quantity = 80, P = P30
40 60
Each firm’s profit = 40 x (P30 – 10) = P800
45 50 36
 Collusion vs. Self-Interest
 Both firms would be better off if both stick to the
cartel agreement.
 But each firm has incentive to renege on the
agreement.
 Lesson:
It is difficult for oligopoly firms to form cartels and
honor their agreements.

OLIGOPOLY 37
ACTIVE LEARNING 2
The oligopoly equilibrium
P Q If each firm produces Q = 40,
P0 140 market quantity = 80
5 130 P = P30
10 120
each firm’s profit = P800
15 110 Is it in SMART’s interest to increase its
20 100 output further, to Q = 50?
25 90 Is it in Globe’s interest to increase its
30 80 output to Q = 50?
35 70
40 60
45 50 38
ACTIVE LEARNING 2
Answers
P Q If each firm produces Q = 40,
P0 140 then each firm’s profit = P800.
5 130 If SMART increases output to Q = 50:
10 120 Market quantity = 90, P = P25
15 110 SMART’s profit = 50 x (P25 – 10) = P750
20 100 SMART’s profits are higher at Q = 40
25 90 than at Q = 50.
30 80
The same is true for Globe.
35 70
40 60
45 50 39
 The Equilibrium for an Oligopoly
 Nash equilibrium: a situation in which
economic participants interacting with one another
each choose their best strategy given the
strategies that all the others have chosen
 Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.
 Given that Globe produces Q = 40,
SMART’s best move is to produce Q = 40.
 Given that SMART produces Q = 40,
Globe’s best move is to produce Q = 40.

OLIGOPOLY 40
 A Comparison of Market Outcomes
When firms in an oligopoly individually choose
production to maximize profit,
 oligopoly Q is greater than monopoly Q
but smaller than competitive Q.
 oligopoly P is greater than competitive P
but less than monopoly P.

OLIGOPOLY 41
 The Output & Price Effects
 Increasing output has two effects on a firm’s profits:
 Output effect:
If P > MC, selling more output raises profits.
 Price effect:
Raising production increases market quantity,
which reduces market price and reduces profit on
all units sold.
 If output effect > price effect,
the firm increases production.
 If price effect > output effect,
the firm reduces production.
OLIGOPOLY 42
 The Size of the Oligopoly
 As the number of firms in the market increases,
 the price effect becomes smaller
 the oligopoly looks more and more like a
competitive market
 P approaches MC
 the market quantity approaches the socially
efficient quantity

Another benefit of international trade:

Trade increases the number of firms competing,
increases Q, brings P closer to marginal cost

OLIGOPOLY 43
 Game Theory
 Game theory helps us understand oligopoly and
other situations where “players” interact and
behave strategically.
 Dominant strategy: a strategy that is best
for a player in a game regardless of the
strategies chosen by the other players
 Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial

OLIGOPOLY 44
 Prisoners’ Dilemma Example
 The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
 The police question each in separate rooms,
offer each the following deal:
 If you confess and implicate your partner,
you go free.
 If you do not confess but your partner implicates
you, you get 20 years in prison.
 If you both confess, each gets 8 years in prison.

OLIGOPOLY 45
 Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnie’s decision
both confess
Confess Remain silent
Bonnie gets Bonnie gets
8 years 20 years
Confess
Clyde Clyde
Clyde’s gets 8 years goes free
decision Bonnie goes Bonnie gets
Remain free 1 year
silent Clyde Clyde
gets 20 years gets 1 year

OLIGOPOLY 46
 Prisoners’ Dilemma Example
 Outcome: Bonnie and Clyde both confess,
each gets 8 years in prison.
 Both would have been better off if both remained
silent.
 But even if Bonnie and Clyde had agreed before
being caught to remain silent, the logic of self-
interest takes over and leads them to confess.

OLIGOPOLY 47
 Oligopolies as a Prisoners’ Dilemma
 When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.
 Our earlier example:
 SMART and Globe are duopolists in Sagada.
 The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
 Here is the “payoff matrix” for this example…

OLIGOPOLY 48
SMART & Globe in the Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
SMART
Q = 30 Q = 40
SMART’s SMART’s
profit = P900 profit = P1000
Q = 30
Globe’s profit Globe’s profit
= P900 = P750
Globe
SMART’s profit SMART’s
= P750 profit = P800
Q = 40
Globe’s profit Globe’s profit
= P1000 = P800

OLIGOPOLY 49
Another Example: Negative Campaign Ads
Each candidate’s
dominant strategy: R’s decision
run attack ads.
Do not run attack Run attack ads
ads (cooperate) (defect)

Do not run no votes lost R gains 1000

attack ads or gained votes
(cooperate) no votes D loses
lost or gained 3000 votes
D’s decision
R loses 3000 R loses
Run votes 2000 votes
attack ads D gains D loses
(defect) 1000 votes 2000 votes

OLIGOPOLY 50
Game Theory

FIGURE 14.5 Payoff Matrixes for Left/Right–Top/Bottom Strategies

In the original game (a), C does not have a dominant strategy. If D plays left, C plays top; if D plays right, C
plays bottom. D, on the other hand, does have a dominant strategy: D will play right regardless of what C
does. If C believes that D is rational, C will predict that D will play right. If C concludes that D will play right,
C will play bottom. The result is a Nash equilibrium because each player is doing the best that it can given
what the other is doing.
In the new game (b), C had better be very sure that D will play right because if D plays left and C plays
bottom, C is in big trouble, losing $10,000. C will probably play top to minimize the potential loss if the
probability of D’s choosing left is at all significant.

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