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Perfect competition II. Monopolistic competition by kvw36946

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									 Perfect competition II.
Monopolistic competition

  Ing. Michaela Krčílková
Review of last lecture

 Golden rule of profit maximization: MR=MC
    Valid for all firms no matter on market structure

 Perfect competition
    Large number of buyers and sellers
    Homogenous product                          Firms are price takers
    Free entry and exit

    Perfectly competitive firm faces to horizontal demand => decision
    of individual firm cannot influence market price

    Along horizontal demand: MR=P=AR

    Profit maximizing condition in perfect competition can be written
    as: MC=P
Short run decision – graphical analysis

   We will combine revenue and costs with demand to
   determine profit maximizing output decisions

   In the short run, capital is fixed and firm must choose
   levels of variable inputs to maximize profits

   We can look at the graph of MR, MC, ATC and AVC to
   determine profits

   The point where MR = MC = P, the profit maximizing output
   is chosen
 Perfect competition – choosing output: Short run

                                                          Lost Profit
  50                          Lost Profit                 for q2>q*
                              for q1<q*

  40      B                                 A                AR=MR=P
  30                                                 AVC
                                                               q1 : MR = 40, MC = 25
                                                                     MR > MC
                                                               q2: MR = 40, MC = 55
                                                                     MC > MR
  10                                                           q*: MR = 40, MC = 40
                                                                     MC = MR

      0       1   2   3   4   5   6    7    8   9    10      11
                                       q1 q* q2
    Profit is
                  Profit in short run
 between total
 revenue and
  total cost =
       this                                                          MC
represents the
    area of            50
Total revenue          40 D                                                     AR=MR=P
is price                                                       C
multiplied by
quantity = this
                       30 E                                     F         AVC
represents the
area of
ABCD                   20
Total cost can
be calculated
as ATC                 10
multiplied by
quantity = this
                               A                               B
represents the             0       1   2   3   4   5   6   7   8     9    10    11
area of                                                         q*                Output
                 Loss in short run
Profit =TR-TC
 Here the cost
is higher than
  revenue i.e.
   firm loses                                                      MC
     => this        CZK
represents the
     area of          50
Total revenue         40
is P*q                                                                  ATC
=> this                                                   F
                      30 E                                              AVC
represents the
                              D                           C                   AR=MR=P
area of
ABCD                  20
Total cost can
be calculated
as ATC*q              10
=> this
represents the                A                           B
area of                   0       1   2   3   4   5   6   7    8   9    10    11
                                                          q*                    Output
         Supply curve of perfectly competitive firm

                                                                  S        MC
                                                                      q1          P1
                                                                  q2              P2

                                                              q3                  P3
The firm chooses the                                                        ATC P4
  output level where                                         q4
    P = MR = MC,                                                            AVC
 as long as P > AVC.

 => Supply curve is
  MC above AVC           20


                             0   1   2   3   4   5   6   7    8        9    10    11
Producer surplus for a firm

   At q* MC = MR.         CZK
  Between 0 and q*,             Producer    MC   AVC
 MR > MC for all units.         Surplus

       Producer                                    P
      surplus is
      area above
       MC to the

   Producer surplus is
   sum of differences
     between market
   price and marginal                      q*      Output
    cost over all units
Producer surplus for a market

 Adding up surplus for all   CZK
 producers in the market
    given total market                                 S
    producer surplus

       Producer                    Producer
      surplus for                  Surplus
       market is
      area above              P*
      supply and
      market price                                    D

                                              q*   Output
 Output choice in long run

   In short run a firm chooses
       output where P = MC
              => qSR                       MC
In the long run, a firm can alter
all its inputs, including the size    P*
  of the plant => this changes
curves of marginal and average
  cost (MC=>LMC, AC=>LAC)

In the long run, a firm adjusts its
size and will produce where long
 run marginal cost equals price

 Given firm gains positive profit          qSR         qLR   Output
     in long run (P > LAC)
           Output choice in long run

CZK                                                                             S1
                     MC                          P
                                     LMC                                                 S2



                    qSR           qLR   Output                    q*       q*

Positive economic profit encourage new               The process continue untill positive
        firms to enter the market                          economic profit exists

                                                 Long run equilibrium arises when price is
Entry of new firms causes shift of market           equal to minimum average cost =>
   supply to the right and fall in price                        P = minAC
Long-run equilibrium

 All firms maximizes profit
     Condition of equality of marginal revenue and cost is fulfilled
     MR = MC and P = MC

 No firm has incentive to enter or exit industry
    P=min LAC

 Output is produced at the lowest possible cost (min AC)
     => Perfect competition is PRODUCTIVE EFFICIENT

 The most preferred output is produced (D=S and P=MC)
     => Perfect competition is ALLOCATIVE EFFICIENT
Imperfect competition

 Imperfect competition arises because some of the assumptions
 of perfect competition are broken

    Monopolistic competition


Monopolistic competition - assumptions

 Large number of buyers and sellers – same as in perfect

 Free entry and exit – same as in perfect competition

 Heterogeneous product – in perfect competition product is
Resources of product differentiation


 Accompanying services

 Quality differentials

 Product image
Monopoly power

 Product differentiation causes that consumers prefer good of
 one firm to goods of other firms

 Each firm has its own consumers and faces to the downward sloping
 demand curve

 Firm can sell more products only if lower the price

 Decision of firm about the product influences the price => monopoly

 Amount of monopoly power depends on degree of product
Profit maximization in monopolistic competition

 The main objective of firms under the monopolistic competition is
 maximization of profit

 Golden rule of profit maximization is: MR=MC

 In monopolistic competition firm faces to downward sloping demand,
 from that follows:

    Total revenue curve is non-linear

    Average revenue curve is equal to demand curve (P=AR)

    Marginal revenue does not equal to price = then marginal revenue
    curve differs from demand curve (MR<P=AR)
      Monopolistic competition

                                       Firm faces downward sloping
                                                  P = 100 − q

                                       Total revenue is then non-linear

                                        TR = P * q = (100 − q)q = 100q - q 2

                                       Average revenue is equal to the price
                                       – and then average revenue curve is
                                       equal to the demand curve

                                            TR 100q − q 2
                                       AR =    =          = 100 − q ⇒ AR = P
                                             q    q

                                       Marginal revenue does not equal to
                       MRSR            the price – then the marginal revenue
                                       curve is not demand curve

                                         dTR d(100q − q 2 )
                                    MR =     =              = 100 − 2q ⇒ MR ≠ P
                                          dq     dq
      Monopolistic competition – short run

CZK                                A firm will produce output
                   MC              where MR=MC (indicated by
                                   red point)
                                   Consumers are willing to
                                   purchase given amount of
 AC                                product for price PSR (derived
                                   from demand curve, indicated
                            DSR    by yellow point)

                                   The price is above the
                     MRSR          average cost then the firm
                                   gains profit (Indicated by
           QSR          Quantity   yellow rectangle)
      Monopolistic competition – long run

CZK                                 In long run firm can change its
                  LMC               size => Long-run decision is then
                                    related to the long run curves
                        LAC         (LMC, LAC)

                                    Positive profit encourage new
                                    firms to enter the industry
                                    Some consumers are enticed by
                            SR      new firms => demand curve and
                                    curve of marginal product move
                           DSR      down

                      SR            This process continue until
                                    economic profit exists
          QLR       MRLR Quantity
                                    In LR economic profit is zero
Monopolistic competition – conclusion

Firm under the monopolistic competition determines the output
according to condition MR=MC

The price is determined by demand curve. The price does not
equal to the marginal cost =>monopolistic competition is then
allocative inefficient

In short run firms can gain positive economic profit

In long run due to the entrance of new firms economic profit is
zero => in long run P=AC

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