Market structure 1: Perfect CompetitionThe perfectly competitive firm is a price taker: it cannotinfluence the price that is paid for its product.This arises due to consumers’ indifference between the products ofcompeting firms =⇒ for example, buy from store with lowest price.Consumers’ indifference arises from:• Product homogeneity• Consumers have perfe ct in formation• No transaction s cost• Many firmsPC firm faces horizontal demand curve at market price pPC firm’s profit maximization problem• maxqπ(p) = pq − C(q)• First-order condition: p = C′(q) = M C(q)• Second-order condi t i on : C′′(q) > 0, satisfied if MC(q) is anincreasing function• If p ↑, production rises along MC(q) curve: MC(q) is the“supply curve” of the firm.PC firm’s shutdown decisions• A firm produces only when its profits from producing exceedthe costs it would avoid by not producin g• In short-run: avoidabl e costs do not inclu de sunk costs. Shutdown when revenues fall short of avoidable costs⇐⇒ pq < Avoidable costs(q).Consider two cases:1. All fixed costs are sun k . Avoidab l e costs = V C(q): shu tdown once p < AV C(q) (< AC(q)).2. Proportion α of fixed costs not sunk. Avoidable costs =V C(q) + αF : shut down once p < AV C(q) +αFq• In long-run: avoidable costs in clude sunk cost. Shut downwhen pq < C(q) =⇒ p < AC(q)• Short-run supply curve? Long-run supp l y curve? Graph.The perfectly-competitive industry: Short runIn the short run:• Number of firms fixed• Industry sup ply curve: sum of individual firms’ short-runsupply curves. Zero supply at price s below shutdown point.Graph.• Industry de mand curve: downward sloping. Graph.• Price determined by intersection of industry demand an dsupply curves. Graph.• In short-run equ i l i b riu m: positive profits for each firm as longas p > AC(q).The perfectly competitive industry: Long-run• Number of firms can vary• Free e ntry and ex it:Any short-run profits soaked up by new firms in long-run =⇒Price is driven down to the minimum of the AC curve• Long-run industry supply curve: horizontal at minimu m of theaverage cost curveLR supply curve may be upward-sloping if min AC is rising inmarket demand Q (due, for example, to resource scarcity)Desirability of PC outcomep = MC(q) = minqAC(q )• Production at p = MC(q): firm produces an additional unitonly if it can cover the prod uction costs. Producer surplus ismaximized.• Value placed on marginal unit of the good p exactly equals thecost of producing that marginal unit (consumptionefficiency). Consumer surplus is maximized.• Production at minimum average cost: no better alternative useof resources is possible (production efficiency). In otherwords, each firm operating at minimum efficient scale.Barriers to EntryNice outcome in perfect competitive world depend s crucially onfree-entry assumption. Fixed costs of entry are present in manymarkets: are they a barrier to entry??• Fixed costs borne equally by all firms: accommodated by freeentry assumptionExample: salt factory, advertising?• Fixed costs which affect entrant firms di sproportionately:barriers to entryExample: First mover advantage .C1(q) = F + V C(q), C2(q) = 2F + V C(q)Microsoft: computer operating systems?Next focus on extreme case where entry ruled out: monopolyMarket structure 2: Monopoly• Industry has one firm, who faces downward-sloping industrydemand curve• Market power: ability of a firm to d i ctate market prices in anindustry. Depends on the slope of the res i dual demand curve.• Market power is “opposit e” of price -takin g be haviorMonopoly and profit maximizationTwo equivalent formu l ati on s1. Monopolist chooses quantity to maximize profits• maxqp(q)q − C(q) = Revenue(q) − C(q)• Graph. Quantity can be in creased only if pric e i s lower.Tradeoff between increased demand versus revenue lost onconsumers who woul d h ave bought even under the higherprice• FOC: R′(q)) = p(q) + p′(q)q = C′(q) ↔ M R(q) = MC(q).Graph.2. Monopolist chooses price to maximize profits• maxppq(p) − C(q(p)), where q(p) is demand curve.• FOC: q(p) + pq′(p) = C′(q(p))q′(p)• At optimal price p∗, Inverse Elasticity Property holds:(p∗− MC(q(p∗))) = −q(p∗)q′(p∗)orp∗− mc (q(p∗))p∗= −1ǫ(p∗),where ǫ(p∗) is q′(p∗)p∗q(p∗).• Across monopolistic markets, should observe negativerelationship between price and demand elasticity• If ǫ → +∞: p = M C(q)• Example: q(p) = 10 − q• What if −1 < ǫ(p∗) < 0? Implies p∗< 0 so monopolist willnever produce at this point. (See handout).How monopolies ariseCrucial aspect of monopoly : price-setting ability (relativelyinelastic demand curve)• Product differentiati on• Supe rior production technology• Government-granted monopoliesIs monopoly good or bad?• Negative aspec t s of monopoly– At monopoly solution, p > M C. Graph. Deadweight lossfrom1. consumer surplus (consumers whose valuations liebetween p(qM) and p(qP C) do not buy the product2. producer surplus (uni t s with marginal cost betweenMC(qM) and MC(qP C) are not produced .– This deadwei ght loss i s greater the more inelastic(“steeper”) demand is.• Positive aspects of monopoly– Demsetz critiqu e: monopolist is the firm with lowest-costtechnology. Monopolist “deserves” its market leadership.– Schumpeter: monopoly profits provide an incent i ve forinnovation and technological ch ange (“process of creativedestruction”)– Natural monopoly: ind ustry characterized by increasing returnsto scale.• Government antitrust poli cy: balance these aspects• Checks on a monopolist’s market powe r: th reat of entry keepsprice around average costSummary1. Perfect competition• Individual firm take s pric es as give n in making outputdecisions• Shutdown d ecisions: long run v s. short run• Industry equilibrium: in long-run p = MC(q) = minqAC(q)2. Monopoly• Firm has power to set both quantity an d p rice• Tradeoff between higher demand but lower per-unit price s• MR(q∗) = MC(q∗); inve rse -el asti city pricing prope rtyNext, consider intermediate case of an industry with several