PERFECT COMPETITION AND MONOPOLY MARKET

Perfect competition and monopoly market structures



Perfect competition and monopoly market structures

Introduction

An idealized market structure with the following assumptions: (a) buyers and sellers have perfect knowledge of what is going on in the market place, (b) there are many buyers and sellers, (c) there is unrestricted entry into and out of the market, (d) the good in question is homogeneous (of the same quality), and (e) the seller of the product has limited or no control over the price (price taker) in the marketplace because of competition. The perfect competitor, therefore, faces an infinitely elastic demand curve, which is equal to his or her marginal revenue and average revenue (Brock, 2009).

Monopoly

A monopoly is the only producer of a good for which there are no close substitutes. This puts the monopolist in a unique position: It can raise its price without losing consumers to competitors charging a lower price. Thus, the monopolist is the industry and faces the downward-sloping market demand curve for its product. The monopolist can choose any point along that demand curve; it can set a high price and sell a relatively small quantity of output, or it can lower price and sell more output.

Very few—if any—industries in the real world are pure monopolies. Examples of industries that come close include public utilities such as the local distributor of electricity or natural gas, the cable company in most communities, and, in a small isolated town, the local grocery store or gas station. Nonetheless, this model highlights how a firm with market power chooses its output level and price and helps us understand the welfare consequences of this choice (Dixit, 2009).

Marginal Revenue

All firms, ranging from perfectly competitive firms to monopolies, maximize profits by producing the quantity of output for which marginal revenue equals marginal cost. Recall the definition of marginal revenue: the additional revenue a firm receives from selling one additional unit of output. Because a monopoly faces the market demand curve, the only way it can sell an additional unit of output is by lowering the price it charges on all units. Consequently, marginal revenue for a monopoly has two components: an output effect and a price effect. The monopoly gains revenue from the additional unit of output sold but loses revenue on all of the units previously sold at a higher price. Marginal revenue incorporates both the gain and the loss; Figure 12.1 shows this trade-off (Kwoka, 2009).

At price P 1, the monopoly sells Q 1 units of output, and total revenue is the area of the rectangle OP 1 AQ 1. To sell an additional unit of output, the monopoly has to reduce price to P 2, leading to total revenue of OP 2 B(Q 1 + 1). The monopoly gains rectangle Q 1 CB(Q 1 + 1) in total revenue; this area is equal to P 2. However, because of the lower price, the monopoly loses area P 1 AC P 2, which is the initial quantity sold times the change ...