2.2 Perfect competition and Monopoly Flashcards
What are we going to look at today?
We are going to look at what makes firms what they are ( Perfectly comepetitive, monopoly and cartel), it will depend heavily on the production technology of the firm, so you cant take a perfectly competitive firm and mwarf it into a monopoly.
What is a cartel?
Multiple firms colluding as if they were a monopoly ( a single price setter) trying to maxmise industry profits
What is the profit function, then divide by q? Where does the cost function come from ?
This is the cost function that comes from last week ( minimum cost to achieve output q. so its not any cost function.
When wiill a firm make profit, loss and breakeven?
P < AC the firm makes losses
P > AC the firm makes profit
P = AC the firm break even
Whether a firm is profitable or not relies heavily on price in relation to AC.
what is the cost of production when you produce 0 c(r,w,0)? and is this always the case ?
the cost of production if firm produce 0, your cost will be 0 and you make 0 profits, although this isn’t necessarliy the case, as you might have Fixed costs in the short run
If producing nothing = 0 profit when will a firm shut down?
You would do something if its better than 0. ( but in the short run a firm could sustain losses)
What is the output condition?
If you are going to produce how much should you produce.
Does MR = MC always imply profit maximisation?
No we need to check for the SOC to confirm its a maximum.
What is price taking, what market structure does this apply too and what does it not mean?
Perfect competition implies firms are price taking (no market power)
• A firm is a price taker if nothing it can do affects the prices it gets for its
output (or pays for its inputs)
• …but price-taking does not mean prices do not change ( firms entering and exiting the market affecting price
When is price taking plausible?
Price taking is plausible if the firm has a small market share
• Many small producers producing a homogeneous good
• Everyone can observe prices
Lets look at profit maximising with DRS? first of all draw cost function, and remind me again why its DRS? why have we chosen DRS for perfectly competitive market?
1) its decreasing returns to scale as AC is rising, hence its less efficient to be big
2) Your more likely to have small producers
If we are a price taker we can draw a horizontal line to show price in the market = P = MR, where will firm produce, AND WILL FIRM SHUT DOWN ?
They will produce at where mc=mr, to profit maxmise, the firm will not shut down as P>AC. ( you always check if MR=MC, then check if price > AC). Firm makes profits
Will a firm ever shut down here? What is the supply curve? When we are at q* is the shutdown rule satisfied?
No because every price that could ever be quoted the MC is above AC. Hence the supply curve is the whole MC.
We are going to look at profit maxmisaition with U shaped AC and horizontal price? Draw it and show that the output and shutdown condition holds, where is profit minimising? Also draw minAC, ( is it worth to produce below it?
So here there are 2 places where MC = MR ( so you have to check second order condition to see whats the maximum
Output condition is only satisfied at q2
Shutdown condition satisfied at p>ac at q2 not q1.
If price is above minimum of AC curve,the firm will not shut down
Where would be the lower bound of price that would allow this firm to survive?
DOES FIRMS MAKE PROFITS
What is the supply curve of a price taking firm with U shaped AC?
Any supply below minimum of average cost is 0
The supply curve is the
upward sloping part of Mc
curve where MC ≥ AC
Price taking: profit maximisation and supply with CRS, draw this ie MC = AC? what is profit function?
as c(q) is a constant its just {p-MC}q
What does it mean if P< MC = AC? What does it mean if P = MC = AC What does it mean if P> MC = AC? With a firm with CRS can you pin down firm size? What is the supply curve of firm?
if P< MC = AC? the firm makes losses at all q > 0 so produces 0
if P = MC = AC there will be no single optimal quantity to produce, firms are equally happy producing 10, 20 ro 100, 0 profit is made anyway, so your indifferent in producing or not producing ( Hence you cant pin down firm size with CRS)
If p>Mc = Ac there is no optimal q so you’d be willing to produce infintie amounts as you will be making profit for every next unit, you don’t want to stop
Draw a price taking firm with IRS( HINT AC IS FALLING FOR EVERY LEVEL OF Q AND AC>MC?
Where would a price taking firm produce?
Firms want to produce an indinteley large amount because the more you produce the bigger the gap between price and MC, profit margin getting bigger and bigger. Thus there is no maximum profit ( MC = MR ) is not maximum profit
Does it make sense that a price taker with IOS wants to produce as much as possible ?
No it doesn’t you cannot have IRS and be small, as the firm has incenetive to be as big as possible ( where PC is small firms) , you can be a price taker if you have U shaped Upward sloping AC or constant but not IRS
So if the technology is IRS, we know for definite what?
If it has IRS and therefore EOS, we know for sure will not be a perfectly competitive market, its either monopoly or oligiopoly.
Now lets look at Perfect competition properly now we looked at characteristics with relations with the shutdown and output condidition.
So in a Perfectly competitive market Many homegeouns firms producing with the same technology ( they could have different technology but we want to keep it simple, as all firms would have different cost function and optimal q)
We will assume U shaped AC
We will assume input prices do not vary with size of industry ( WHAT DOES THIS MEAN)
What is industry output and what is firm output, what is market price?
How do we work out the number of firms?
1) this is because say a firm is competiting for workers and one industry got very large, this would drive up wages, changing cost function which we don’t want, so factor prices are constant.
2) Industry output = Q and firm output = q and market price is where market supply = demand ( you are a price taker but that prices comes from supply and demand in the market)
3) the number of firms = N= Q/q
What are we going to assume in the short run for Perfectly competitive firms?
Number of firms is fixed (no entry or exit)
• Each firm supplies a profit maximizing level of output q, given input and
output prices, where p = mc; may make profits or losses
What are we going to assume in the Long run ( entry and exit equilibrium) for Perfectly competitive firms? What is the equilibrium number of firms in the industry?
• Firms can enter (if profitable in the SR) or exit (if losses in the SR) the market
The equilibrium number of firms in the industry is at a level where
1. no firms in the market make losses: p ≥ AC for firms in the market
2. no firm outside the market could enter and make profits: p ≤ AC for firms
not in the market ( if they enter supply increases, hence price falls below AC)
3. market clearing: industry demand = industry supply
Question: since every firm is identical and everyone making losses, wouldn’t industry shut down, if firms come into the market and p is less than AC?
As firms exit and demand is constant there is less supply in the market, hence this pushes up price. So they might be making losses atm but as firms leave the market the price goes up and they survive.
In secondary school for a Perfectly competitive firm we draw the long run equilibrium, with Firm and industry diagram, so draw that, how do we know its LR equilibrium? How can i deduce number of firms?
The firm is happy to stay in market as P = minAC, so they are breaking even, they are not thrilled but have to stay, in the long run no one is making profits.
Lets look at perfectly competitive firm in the short run. Lets say in the SR something happens and demand rises ( watermelon happens, what are the steps here?What happens to profit of firms and industry
Prises rise, hence demand in industry shifts to the right, hence supply for individual firms rises reading of the firm diagram. Supply increases because profits are positive, we can see from the vertical distance between AC and and q2.
It also increases industry profit as well as indivdual profit, as each firm is producing more
How do we know we are not in a long run equilibrium? What has happened to number of firms? Show the long run equilibrium on diagram?
Because of profit i will except there to be entry, so the SRS curve will shift, price will come back down and we will go back to p1. So Q3 is final output in industry , individual quantity falls back to q1.
The number of firms has increased because Q3/q1 > N1 ( supply of industry gone up).
So for a monopoly we will analyse demand as linear What is function we use ( HINT ( use alpha and beta, what does the function tell you? ) then give give inverse demand function, why do we want inverse demand btw?
What does price have to be above ?
Because we want price on the vertical axis.
alpha tells us how much you would sell if prices were 0. ( if you have a linear demand curve, you must have a linear inverse demand curve, so if price = alpha, no one would buy the product, so price has to be above alpha
What is your revenue function as a function of q and what is marginal revenue?
why do we factor in the demand? What is the relationship between MR AND TR?
I control price but the number of people buy is up to consumers, so i have to factor that in.
MR is twice as steep as total revenue
Now lets look at costs for monopoly lets assume CRS so MC = AC = c, so what is total cost?
What is the profit now, if we want to maxmise profit, what do we do need to find out?
TC = cQ
You find FOC set = 0 and SOC to confirm its a maximum
Now what is the profit maximising Q
We rearrange this to find Q
Now we have profit maxmising q how can we find profit maximising price and Profit?
Sub Q into the inverse demand function then find price, for profit sub it into the Profit function and profit.
Interpret this? What would the profit function if costs were cQ - 5 ( fixed costs)
For Q = alpha is the intercept of demand curve so the higher demand you get the more you can produce, the higher the MC less it sales because some of MC is passed onto consumer as higher prices. B is about elasticity.
Price depends on cost parameter and demand, the more people demand the higher the price you can charge, the bigger the cost of production the more you can pass onto consumer, which is half.
Profit = its the square of output. Profit would be the profit formula - 5
Show on diagram monopoly with Constant returns to scale with demand function, MR ( both linear), where is the profit and Deadweight loss?
Supply = equal demand at Z ( mc is the supply curve)
Now we want to study the link between profit maxmimisation, markups and elasticity, What is the equation that links MR, price of good and elasticity?
What is own PED when you are a price taker ?
It is infinitely elastic because if you charge just a little bit over the market price, you lose all your customers to so epsolm here would tend to infinity. So marginal revenue is simply price.
If you are not a price takeer and demand was not infinitely elastic does MR = P, >P or
MR is always below price, how much depends on the elasticity e.g. if elasticity was 3 MR would be 2/3’s of price.
SO we have already established this so what about monopoly?
WHY does epsom have to be greater than >1, because MC is always positive and price has to be posititive so its impossible for 1/epsolm to be bigger than one.
What is the formula for Markup and what does it equal?
NOW lets say | E | = 5 and MC = 8, what is the price and what is the markup?
Now lets say | E | = 3 and MC = £8 what is the price and what is the markup?
What is the link/implication?
Price = 10 and markup = p/mc = 25% Price = 12.50 and markup= p/mc =50%
Firms charges higher price the less elastic demand is, hence greater markup.
So realistically monopoly is likely to have some increasing returns to scale, as they are big, lets say, these monopolist HAVE TO PAY FIXED COSTS in researching for a new vaccine, so what is the cost function and what is average fixed costs? Why cant this be a firm as a price taker?
Average costing is declining with more and more output.
This firm cannot be a price taker because there is an incentive here to be as large as possible.
Now draw just MC and AC with increasing returns to scale ( HINT think about the derartive of total cost and what must be higher mc or ac?
Now what is the profit function, profit maximising q, p and profit with increasing returns to scale with a F? when will a firm shut down?
So nothing changes here except profit
We are going to show to cases where the profit is > FC and where the fixed is greater than profit. Firstly show IRTS monopoly diagram when F < profit ? How do we know from the graph that this condition is satisfied?
Price > Ac hence profits are positive hence we know F < profit function. So how P relates to AC tells us about profits.
Firstly show IRTS monopoly diagram when F > profit ? How do we know from the graph that this condition is satisfied? If new entrants entered with the same technology could they make a profit ?
Still the same MR, Mc and demand function, so monopolies maxmise at mc=mr, we read of price line. But at optimising Q, price is below output, hence a loss making thing to do. Hence shutdown.
No they couldn’t make a profit
Whats another way to see this,? How does this explain why rare diseases doesn’t usually have cures?
The fixed costs are way too high relative to size of market. So the market for example vaccines, demand is sky high, and has huge fixed costs, so demand would be way high in the north west, hence can be profitable. THATS WHY FOR RARE CONDITIONS, THERE ISNT A CURE, AS FIXED COSTS ARE SO HIGH BUT NOT ENOUGH DEMAND BECAUSE ITS RARE)
Assume that all the firms in the cartel have the same technology and bare same F costs and variable costs, what is the cost function of individual firm and total industry cost, use qi to denote individual q of firm.
If we assume the inverse demand is p = a - bQ, what is the industries profit function? What do you notice in this industry?
The fixed costs are being paid numerous of times so its not as efficient as a monopoly.
Cartels would like to maximise industry profit function, so what is profit maximising q and p and Profit. Compare this to Monopoly profits. ( HINT: You would find FOC and SOC( confirm max) then rearrange FOC to find Q extra but do we have to do it ? )
By rearranging cartel profit, what are the conditions we can say? ( HINT YOU WANT TO FIND THE NUMBER OF FIRMS BELOW WHICH THE CARTEL CAN STILL MAKE PROFIT) When will a cartel make positive profits?
How do you calculate average variable cost?
PROBLEM SET ( Question 1)
(ii) Take price 𝑝 as given and find the level of 𝑞 that maximizes profit 𝑝𝑞 − 𝑐(𝑞).
How much does each farm supply as a function of 𝑞? Sketch the supply curve in
your diagram if a farm has to pay the fixed cost of 8 even when 𝑞 = 0. Express
profits as a function of 𝑝.
Now assume if a farm produces 0 it does not have to pay the fixed cost, so
𝑐(0) = 0. What is the lowest price at which a farm would be willing to produce a
positive quantity of avocados? Sketch the farm’s supply curve in this scenario.
PROBLEM SET QUESTION 4
PROBLEM SET QUESTION 5
PROBLEM SET 6 QUESTION
Discuss how the avocado industry would be affected in the short- and long-run
by a fall in fixed cost for all farms? What if instead there were two types of farm,
some with high fixed cost and some with low fixed cost?
