Lecture 4(a) Lecture 4(a) Competition and Competition and

MonopolyMonopoly

Why Bother?

The first part of this course looked at the motivation and calculation of individual consumers and producers. Now we need to examine how these groups interact in a marketplace.

The actual models are so unrealistic as to border on the absurd, but they provide a kind of a benchmark against which we can judge markets in the real world.

What Would a Perfectly What Would a Perfectly Competitive Market Look Competitive Market Look

Like?Like? Many Buyers and Sellers, of more or less the Many Buyers and Sellers, of more or less the

same size.same size. No Walmarts or Dept. of DefenseNo Walmarts or Dept. of Defense

Homogenous ProductHomogenous Product Meaning the output of one firm is indistinguishable Meaning the output of one firm is indistinguishable

from that of another (i.e., a commodity)from that of another (i.e., a commodity) Perfect Information (about prices and costs)Perfect Information (about prices and costs) No Entry Barriers (we’ll have to think more No Entry Barriers (we’ll have to think more

carefully about exactly what this means later). carefully about exactly what this means later).

Firm Demand is Perfectly Firm Demand is Perfectly Elastic (that is, firms are Elastic (that is, firms are

price takers)price takers)Market Demand

P

Q

Firm Demand

All This Really Means Is All This Really Means Is That MR=PThat MR=P

This makes perfect sense: the firm This makes perfect sense: the firm doesn’t have to cut price in order to doesn’t have to cut price in order to sell more. Thus, every added unit sell more. Thus, every added unit sold increases revenue by the price sold increases revenue by the price of the good.of the good.

Of course if you like calculus:Of course if you like calculus:

R = Pq and so R = Pq and so

MR = dR/dq = PMR = dR/dq = P

The Next Step is Describe What an The Next Step is Describe What an Equilibrium Will Look Like in a Equilibrium Will Look Like in a

Competitive MarketCompetitive Market An “equilibrium” is defined in economics (and An “equilibrium” is defined in economics (and

most other sciences) as a state of the world in most other sciences) as a state of the world in which none of the relevant variables will have a which none of the relevant variables will have a tendency to change. tendency to change.

In analyzing markets it is useful to distinguish In analyzing markets it is useful to distinguish between “short run” equilibrium and “long run” between “short run” equilibrium and “long run” equilibrium.equilibrium. The short run describes a period of time that is too The short run describes a period of time that is too

short for new firms to enter the market or for existing short for new firms to enter the market or for existing firms to make significant adjustments to their firms to make significant adjustments to their productive capacity. (Think about how that fits in with productive capacity. (Think about how that fits in with the discussion of fixed costs and time from the the discussion of fixed costs and time from the previous lecture.)previous lecture.)

The long run refers to a time period sufficiently long The long run refers to a time period sufficiently long to permit new entry (or exit) and maybe capacity to permit new entry (or exit) and maybe capacity adjustment.adjustment.

Short Run Equilibrium Part I: How Much Short Run Equilibrium Part I: How Much Does a Typical Firm Produce?Does a Typical Firm Produce?

(Obvious Answer: The q such that MC=MR=P(Obvious Answer: The q such that MC=MR=P

Firm Demand

P

MC

q

Short Run Equilibrium Part II: Short Run Short Run Equilibrium Part II: Short Run SupplySupply

MC

Po

Firm Demand

qo

Market Supply With N Firms

Nqoq1

P1

Nq1

The “supply curve” is

really just a reflection of MC

Short Run Equilibrium Part III: Putting It All Short Run Equilibrium Part III: Putting It All TogetherTogether

MC

Po

Firm Demand

qo

Market Supply With N Firms

Nqo

Supply

Demand

Think About Why This is

Equilibrium

Short Run Equilibrium IV: Short Run Equilibrium IV: Summing UpSumming Up

A Short Run Equilibrium is A Short Run Equilibrium is Characterized byCharacterized by

P=MR=MCP=MR=MC ““Market Clearing Prices” (i.e., Market Clearing Prices” (i.e.,

Quantity Demanded = Quantity Quantity Demanded = Quantity SuppliedSupplied

Long Run Equilibrium I: Long Run Equilibrium I: What Does it MeanWhat Does it Mean

Since the defining characteristic of Since the defining characteristic of the “short run” was the assumption the “short run” was the assumption of no entry, the “long run” will be of no entry, the “long run” will be defined as the period of time long defined as the period of time long enough for firms to enter (or change enough for firms to enter (or change scale).scale).

This means we need to ask about This means we need to ask about profits.profits.

This Can’t Happen in the Long RunThis Can’t Happen in the Long Run

MC

Po

Firm Demand

qo

Market Supply With N Firms

Nqo

Supply

Demand

AC Positive

Profits

So What Would Happen in the Long Run With So What Would Happen in the Long Run With Positive Profits?Positive Profits?

MC

Po

Firm Demand

qo

Market Supply With N Firms

Nqo

Supply

Demand

AC Positive

Profits

Entry and

Lower Price

What Would Happen in the Long Run If There What Would Happen in the Long Run If There Were Negative Profits?Were Negative Profits?

MC

Po

Firm Demand

qo

Market Supply With N Firms

Nqo

Supply

Demand

AC

Exit and Higher Price

Loss

The Long Run EquilibriumThe Long Run Equilibrium

MC

Po

Firm Demand

qo

Market Supply With N Firms

Nqo

Supply

Demand

AC

No (economic) profit or loss

Long Run Equilibrium: Long Run Equilibrium: Summing UpSumming Up

A Short Run Equilibrium is A Short Run Equilibrium is Characterized byCharacterized by

P=MR=MCP=MR=MC ““Market Clearing Prices” (i.e., Market Clearing Prices” (i.e.,

Quantity Demanded = Quantity Quantity Demanded = Quantity Supplied)Supplied)

No (economic) profits or loss No (economic) profits or loss (P=AC(P=ACminmin))

Issue: Can You Make Issue: Can You Make Money (i.e., earn positive Money (i.e., earn positive

economic profits) In a economic profits) In a Competitive MarketCompetitive Market

The model says no but….The model says no but….

A note on “stability” and A note on “stability” and competitive equilibriumcompetitive equilibrium

An equilibrium may exist but not be An equilibrium may exist but not be “stable”“stable”

Think about the “cattle cycle” or Think about the “cattle cycle” or “bubbles”. “bubbles”.

Applying the Model: SR Applying the Model: SR Equilibrium and the Burden Equilibrium and the Burden

of a Taxof a Tax Consider a “per unit” tax on some Consider a “per unit” tax on some

good (like the tax on a pack of good (like the tax on a pack of cigarettes).cigarettes).

Does it matter whether the tax is Does it matter whether the tax is imposed on the buyer or seller?imposed on the buyer or seller?

Suppose the Producer Must Suppose the Producer Must Pay $5 TaxPay $5 Tax

Supply (no tax)

Demand

Pno tax

Supply (tax)

Tax shifts the Supply by $5

Ptax

Ptax

Pnet

Suppose the Consumer Suppose the Consumer Must Pay $5 TaxMust Pay $5 Tax

Supply

Demand (no tax)

Pno

tax

Tax shifts the demand by $5

Ptax

Ptax

Pnet

Demand (tax)