MICRO ECONOMICS

PERFECT COMPETITION OR PURE COMPETITION

Definition and Characteristics of Pure Competition
Pure competition is a term that describes a market that has a broad range of competitors who are selling
the same products. It is often referred to as perfect competition. Here are some characteristics that define a pure
competition.
In an ideal purely competitive market, the products being sold would be identical, which removes the
option of one seller offering something different or better than another seller.
Because there are so many competitors in the market offering the same product at the same price, one
competitor doesn’t have an edge over the others. Essentially, all the sellers are equal.
New companies can easily enter the market.
The price of products is determined solely by what consumers are willing to pay.
Definition and Characteristics of Perfect Competition
 Perfect competition is a market structure in which the following five criteria are met.
 All firms sell an identical product
 All firms are price takers – they cannot control the market price of their product
 All firms have a relatively small market share
 Buyers have complete information about the product being sold and the prices charged by each firm
 The industry is characterized by freedom of entry and exit
 Perfect competition is sometimes referred to as “pure competition”.
Key characteristics of perfect competition
 A large number of small firms
 Identical products sold by all firms
 Perfect resource mobility or the freedom of entry into and exit out of the industry
 Perfect knowledge of prices and technology
Advantages of Perfect Competition
 Optimal allocation of resources
 Competition encourages efficiency
 Consumers charged at a lower price
 Responsive to consumer wishes: Change in demand, leads extra supply
Disadvantages of Perfect Competition
 Insufficient profits for investment
 Lack of competition over product design and specification
 Unequal distribution of goods and income
 Externalities e.g pollution
PERFECT COMPETITION DEMAND
In a perfectly competitive market the market demand curve is a downward sloping line, reflecting the
fact that as the price of ordinary good increases, the quantity demanded of those good decreases. Price is
determined by the intersection of market demand and market supply; individual firms do not have any influence
on the market price in perfect competition. Once the market price has been determined by market supply and
demand forces, individual firms become price takers. Individual firms are forced to charge the equilibrium price
of the market or consumers will purchase the product from the numerous other firms in the market charging a
lower price. The demand curve for an individual firm is thus equal to the equilibrium price of the market.

The demand curve for a firm in a perfectly

competitive market varies significantly from that of
the entire market. The market demand curve slopes
downward, while the perfectly competitive firm's
demand curve is a horizontal line equal to the
equilibrium price of the entire market. The
horizontal demand curve indicates that the elasticity
of demand for the good is perfectly elastic. This means that if any individual firm charged a price slightly above
market price, it would not sell any products.
A strategy often used to increase market share is to offer a firm's product at a lower price than the
competitors. In a perfectly competitive market, firms cannot decrease their product price without making a
negative profit. Instead, assuming that the firm is a profit-maximizer, it will sell its goods at the market price.
A perfectly competitive industry is comprised of a large number of relatively small firms that sell
identical products. Each perfectly competitive firm is so small relative to the size of the market that it has no
market control, it has no ability to control the price. In other words, it can sell any quantity of output it wants at
the going market price. This translates into a horizontal or perfectly elastic demand curve. It also translates in
equality between price, average revenue, and marginal revenue.
PERFECT COMPETITION MARGINAL REVENUE
Marginal revenue is the extra revenue generated when a perfectly competitive firm sells one more unit
of output. It plays a key role in the profit-maximizing decision of a perfectly competitive firm relative to
marginal cost. A perfectly competitive firm maximizes profit by equating marginal revenue, the extra revenue
generated from production, with marginal cost, the extra cost of production. If these two marginal are not equal,
then profit can be increased by producing more or less output.
The relation between marginal revenue and the quantity of output
produced depends on market structure. For a perfectly competitive firm,
marginal revenue is equal to price and average revenue, all three of which
are constant. For a monopoly, monopolistically competitive, or oligopoly
firm, marginal revenue is less than average revenue and price, all three of
which decrease with larger quantities of output. The constant or
decreasing nature of marginal revenue is a prime indication of the market
of a firm.
Marginal revenue can be represented in a table or as a curve. For a
perfectly competitive firm, the marginal revenue curve is a horizontal, or
perfectly, line. For a monopoly, oligopoly, or monopolistically
competitive firm, the marginal revenue curve is negatively sloped. The
marginal revenue received by a firm is the change in total revenue divided by the change in quantity, often
expressed as this simple equation:
change in total revenue
marginal revenue =
change quantity

EFFICIENCY IN PERFECTLY COMPETITIVE MARKETS

When profit-maximizing firms in perfectly competitive markets combine with utility-maximizing
consumers, something remarkable happens: the resulting quantities of outputs of goods and services
demonstrate both productive and allocative efficiency.
Productive efficiency means producing without waste, so that the choice is on the production possibility
frontier. In the long run in a perfectly competitive market, because of the process of entry and exit, the price in
the market is equal to the minimum of the long-run average cost curve. In other words, goods are being
produced and sold at the lowest possible average cost.
The productive efficiency of perfect competition can be observed in the long run equilibrium point of all
firms in the industry, which is at the minimum of average total cost. This means that all firms are forced to cut
their costs and utilize the best available technology in order to have their minimum average total cost no higher
than that of all the other firms in the industry. There is also no under or over utilized capacity.
Productive efficiency occurs when the equilibrium output is supplied at minimum average cost.
This is attained in the long run for a competitive market.
Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven
down by the forces of competition.
ALLOCATIVE EFFICIENCY means that
among the points on the production possibility
frontier, the point that is chosen is socially
preferred—at least in a particular and specific sense.
In a perfectly competitive market, price will be equal
to the marginal cost of production. Think about the
price that is paid for a good as a measure of the social
benefit received for that good; after all, willingness to
pay conveys what the good is worth to a buyer. Then
think about the marginal cost of producing the good
as representing not just the cost for the firm, but more
broadly as the social cost of producing that good.
When perfectly competitive firms follow the rule that profits are maximized by producing at the quantity where
price is equal to marginal cost, they are thus ensuring that the social benefits received from producing a good
are in line with the social costs of production.
To explore what is meant by allocative efficiency, it is useful to walk through an example. Begin by
assuming that the market for wholesale flowers is perfectly competitive, and so P = MC. Now, consider what it
would mean if firms in that market produced a lesser quantity of flowers. At a lesser quantity, marginal costs
will not yet have increased as much, so that price will exceed marginal cost; that is, P > MC. In that situation,
the benefit to society as a whole of producing additional goods, as measured by the willingness of consumers to
pay for marginal units of a good, would be higher than the cost of the inputs of labor and physical capital
needed to produce the marginal good. In other words, the gains to society as a whole from producing additional
marginal units will be greater than the costs.
Conversely, consider what it would mean if, compared to the level of output at the allocatively efficient
choice when P = MC, firms produced a greater quantity of flowers. At a greater quantity, marginal costs of
production will have increased so that P < MC. In that case, the marginal costs of producing additional flowers
is greater than the benefit to society as measured by what people are willing to pay. For society as a whole,
since the costs are outstripping the benefits, it will make sense to produce a lower quantity of such goods.
When perfectly competitive firms maximize their
profits by producing the quantity where P = MC, they
also assure that the benefits to consumers of what they
are buying, as measured by the price they are willing to
pay, is equal to the costs to society of producing the
marginal units, as measured by the marginal costs the
firm must pay—and thus that allocative efficiency holds.
The statements that a perfectly competitive
market in the long run will feature both productive and
allocative efficiency do need to be taken with a few
grains of salt. Remember, economists are using the
concept of “efficiency” in a particular and specific sense,
not as a synonym for “desirable in every way.” For one
thing, consumers’ ability to pay reflects the income distribution in a particular society. Thus, a homeless person
may have no ability to pay for housing because they have insufficient income.
Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as
monopoly, monopolistic competition, and oligopoly, which are more frequently observed in the real world than
perfect competition, firms will not always produce at the minimum of average cost, nor will they always set
price equal to marginal cost. Thus, these other competitive situations will not produce productive and allocative
efficiency.
The allocative efficiency in perfect competition comes from the fact that the quantity produced by each
firm is just that for which the price paid by society is equal to the cost of additional resources (marginal cost).
More could not possibly be obtained for a lower price. The resources are also the most efficiently allocated
among industries since firms will bid for these resources up to the price consumers want to pay for them.
PERFECT COMPETITION SHORTCOMINGS
In spite of its beneficial economic effect, perfect competition
Loss minimization - If a firm fails fails to provide any correction for income distribution inequity,
to derive a profit, it may generate any public goods since there is not profit, stimulate
nevertheless seek, in the short run, technological progress because of lack of profits, offer diversity in
to produce at that level of sales
products since these are standardized.
where the
difference between its cost and its
PERFECT COMPETITION PROFIT MAXIMIZATION & LOSS
revenue, i.e., its loss, MINIMIZATION
is minimum. In perfectly (and imperfectly) competitive markets, is it
appropriate to assume profit maximization on the part of firms? At the
outset we should recognize that any profit realized by a business
belongs to the business owner(s). For the millions of small businesses
with only one owner-manager, decisions concerning what products to carry, whom to employ, what price to
charge, and so on, will be heavily influenced by the way the owner’s profit is affected. Owners of such
businesses may well have goals such as early retirement or expensive educations for their children. These goals,
however, are not inconsistent with the assumption of profit maximization. Since money is a means to many
ends, early retirement or college educations can more easily be afforded when the owner makes more money. A
possible problem with assuming profit maximization is that the owner-manager cannot have detailed knowledge
of the cost and revenue associated with each action that could be taken to maximize profit. Economic theory,
however, does not require that firms actually know or think in terms of marginal cost and revenue, only that
they behave as if they did.
Firms may come close enough to maximizing profit by trial and error, emulation of successful firms,
following rules of thumb, or blind luck for the assumption to be a fruitful one. When we move from the small,
owner-managed firm to the large, modern corporation, another potential criticism of the profit maximization
assumption arises. A characteristic of most large corporations is that the stockholder-owners themselves do not
make the day-to-day decisions about price, employment, advertising, and so on. Instead, salaried personnel of
the corporation—managers—make these decisions. And so there is a separation of ownership and control in the
corporation; managers control the firm, but stockholders own it. It is safe to assume that stockholders wish to
make as much money on their investment as possible, but it is virtually impossible for them to constantly
monitor their managers’ actions. Therefore, managers will have some discretion, and some of their decisions
may conflict with the stockholder-owners’ profit-maximizing goals.
While managers may have some discretion to deviate from the profit-maximizing goals of firms’
shareholder-owners, several factors limit the exercise of such discretion. For example, stockholder-owners often
link business managers’ compensation to profits, sometimes paying them in part with shares of stock or stock
options, in order to give an incentive to pursue profits more actively. In addition, the profitability managers
achieve in a given enterprise will affect their job prospects
with others. And, finally, if managers do not make as large a
Profit maximization the assumption that
profit as possible, stock prices, which tend to reflect firms select an output level so as to
profitability (especially projected profitability), will be maximize profit.
lower than need be. Undervalued stock creates an A firm must seek to sell a volume of
incentive for outsiders, or “raiders,” to buy up a output where its total
controlling interest in the firm and replace the inefficient revenue exceeds its total cost by the
management team. A firm that neglects profit largest amount possible;
opportunities too often leaves itself open to such a that is, its profit is the maximum.
takeover bid, a fairly common occurrence in the corporate
world.
MAXIMUM PROFIT GRAPH
Since maximum profit is the excess of total revenue over total cost, it is shown graphically as the area by
which the total revenue rectangle exceeds the total cost rectangle. The height of total revenue rectangle is the
price received by the firm, and the width is the optimum quantity (where MR=MC). The height of total cost
rectangle is average total cost (on ATC curve), and the width is the optimum quantity.
SHORT RUN SUPPLY CURVE
The short run supply curve of firms in perfect competition is the upsloping portion of the marginal cost
curve (above the average variable cost intersection). Indeed, a firm determines its optimum volume of sales by
taking the intersection of marginal revenue and marginal cost. The marginal revenue is also the price it receives.
Thus supplier's price-quantity combinations are given by the marginal cost upsloping portion.
LONG RUN PERFECT COMPETITION EQUILIBRIUM
The long run equilibrium for firms in perfect competition is where demand (and marginal revenue which
is identical to it) is tangent to the minimum of average total cost (where marginal cost also intersects average
total cost). At that point, there is no profit or loss for the firm. (Note that there is no pure or economic profit, but
normal profit must still be covered).

Graph G-MIC4.2
A perfectly competitive firm is presumed to produce the
quantity of output that minimizes economic losses, if price is
greater than average variable cost but less than average total
cost. This is one of three short-run production alternatives facing
a firm. The other two are profit maximization (if price exceeds
average total cost) and shutdown (if price is less than average
variable cost).
A perfectly competitive firm guided by the pursuit of
profit is inclined to produce the quantity of output that equates
marginal revenue and marginal cost in the short run, even if it is
incurring an economic loss. The key to this loss minimization
production decision is a comparison of the loss incurred from
producing with the loss incurred from not producing. If price
exceeds average variable cost, then the firm incurs a smaller loss
by producing than by not producing.
ONE OF THREE ALTERNATIVES Production Alternatives
Loss minimization is one of three short-run production
alternatives facing a perfectly competitive firm. All three are Price and Cost Result
displayed in the table to the right. The other two are profit
maximization and shutdown. P > ATC Profit Maximization
With profit maximization, price exceeds average total cost ATC > P >
at the quantity that equates marginal revenue and marginal cost. AVC Loss Minimization
In this case, the firm generates an economic profit.
With shutdown, price is less than average variable cost at P < AVC Shutdown
the quantity that equates marginal revenue and marginal cost. In
this case, the firm incurs a smaller loss by producing no output and incurring a loss equal to total fixed cost.
PERFECT COMPETITION, SHORT-RUN SUPPLY CURVE:
A perfectly competitive firm's supply curve is that portion of its marginal cost curve that lies above the
minimum of the average variable cost curve. A perfectly competitive firm maximizes profit by producing the
quantity of output that equates price and marginal cost. As such, the firm moves along its positively-sloped
marginal cost curve in response to changing prices.
A perfectly competitive firm maximizes profit by producing the quantity of output that equates marginal
revenue and marginal cost. In that price equals marginal revenue for a perfectly competitive firm, price is also
equal to marginal cost. In other words, the firm produces by moving up and down along its marginal cost curve.
The marginal cost curve is thus the perfectly competitive firm's supply curve.
Because the marginal cost curve is positively sloped due to the law of diminishing marginal returns, so too is
the firm's supply curve. And because all firms in a perfectly competitive industry have positively-sloped
marginal cost curves, the market supply curve for the entire industry is also positively sloped. This offers a
prime explanation for the law of supply.
INSIGHT INTO SUPPLY
The analysis of the short-run production decisions for a perfectly competitive firm has direct
implications for the market supply curve and the law of supply. The primary conclusion is that a perfectly
competitive firm's short-run supply curve is that segment of its marginal cost curve that lies above the average
variable cost curve.
A perfectly competitive firm produces the quantity of output that equates marginal revenue, which is
equal to price, and marginal cost, as long as price exceeds average variable cost.
Consider three key points:
A profit-maximizing firm produces the quantity of output that equates marginal revenue and marginal
cost (MR = MC).
A perfectly competitive firm is characterized by the equality between price and marginal revenue (P =
MR).
The law of diminishing marginal returns gives the marginal cost curve a positive slope.
Combining all three points means that a profit-maximizing perfectly competitive firm produces the quantity of
output that equates price and marginal cost (P = MC).
An increase in the price, moves the profit-maximizing quantity to a higher point on the positively-sloped
marginal cost curve, and a larger production quantity.
A decrease in the price, moves the profit-maximizing quantity to a lower point on the positively-sloped
marginal cost curve, and a smaller production quantity.
Working a Graph

LONG RUN SUPPLY CURVE

In the long‐run, firms can vary all of their input factors. The ability to vary the amount of input factors in
the long‐run allows for the possibility that new firms will enter the market and that some existing firms will
exit the market. Recall that in a perfectly competitive market, there are no barriers to the entry and exit of firms.
New firms will be tempted to enter the market if some of the existing firms in the market are earning positive
economic profits. Alternatively, existing firms may choose to leave the market if they are earning losses. For
these reasons, the number of firms in a perfectly competitive market is unlikely to remain unchanged in the
long‐run. In zero economic profit, the entry and exit of firms, which is possible in the long‐run, will eventually
cause each firm's economic profits to fall to zero. Hence, in the long‐run each firm earns normal profits. If
some firms are earning positive economic profits in the short‐run, in the long‐run new firms will enter the
market and the increased competition will reduce all firms' economic profits to zero. Firms that are earning
negative economic profits (losses) in the short‐run will have to either make some changes in their fixed factors
of production in the long‐run or choose to leave the market in the long‐run. A perfectly competitive market
achieves long‐run equilibrium when all firms are earning zero economic profits and when the number of firms
in the market is not changing.
FIRM’S LONG RUN EQUILIBRIUM: AVERAGE REVENUE=AVERAGE TOTAL COST
IN LONG RUN EQUILIBRIUM, PERFECT COMPETITION FIRMS ARE PERFECTLY EFFICIENT:
ALLOCATIVE EFFICIENCY - A situation in
which the limited resources of the firm are allocated
in accordance with the wishes of the consumer.
Price is equal to marginal cost

PRODUCTIVE (TECHNICAL) EFFICIENCY

Occurs when economy is operating at its production
possibilities frontier. This takes place when
production of goods is achieved at the lower cost
possible.
Marginal Cost is equal to Average Total Cost

PERFECT COMPETITION FIRM’S LONG

RUN SUPPLY CURVE
FOR THE PRODUCT INCREASE
Market demand shift to right, causing the market price to rise.
As price increases, existing firms begin earning economic
profit
Additional firms are drawn to enter the industry, increasing
market supply and driving market price back down to the long
run equilibrium

DEMAND FOR
PRODUCT DECREASES
Market demand shift to left, causing the market price to decrease As price decreases, existing firms begin losing
money Over time, as cost commitments end, the least efficient firms exits the industry, decreasing market
supply and driving market price up to the long run equilibrium.
MARGINAL REVENUE MARGINAL COST
MARGINAL REVENUE, PERFECT COMPETITION
The change in total revenue resulting from a change in quantity of output sold. Marginal revenue
indicates how much extra revenue a perfectly competitive firm receives for selling an extra unit of output.
Because a perfectly competitive firm is a price taker and faces a horizontal demand curve, its marginal
revenue curve is also horizontal and coincides with its average revenue
(and demand) curve. A perfectly competitive firm maximizes profit by producing the quantity of output found
at the intersection of the marginal revenue curve and the marginal cost curve.
Marginal revenue is the extra revenue generated when a perfectly competitive firm sells one more unit
of output. It plays a key role in the profit-maximizing decision of a perfectly competitive firm relative to
marginal cost. A perfectly competitive firm maximizes profit by equating marginal revenue, the extra revenue
generated from production. If these two are not equal, then profit can be increased by producing more or less
output.
The relation between marginal revenue and the quantity of output produced depends on market
structure. For a perfectly competitive firm, marginal revenue is equal to price and average revenue, all three of
which are constant.
Marginal revenue can be represented in a table or as a curve. For a perfectly competitive firm, the
marginal revenue curve is a horizontal or perfectly elastic.
Marginal revenue received by a firm is the change in total revenue divided by the change in quantity,
often expressed as this simple equation:
Marginal revenue = ∆𝑻𝑹/∆𝑸
MARGINAL REVENUE CURVE, PERFECT COMPETITION
A curve that graphically represents the relation between the marginal revenue received by a perfectly
competitive firm for selling its output and the quantity of output sold.
REVENUE OF A COMPETITIVE FIRM
For competitive firm, the price it receives does not depend on the quantity it chooses to sell. Marginal
Revenue equals the price of its output.
For example, if the price is P280, then the total revenue of selling 10 units is P2,800 and the total
revenue of selling 11 units is P3,080. Marginal revenue, ∆TR/∆𝑄= (3,080-2800)/(11-10)= P280.
MARGINAL COST, PERFECT COMPETITION
The increase in cost that companies a unit increase in output; the partial derivative of the cost function
with respect to output. Additional cost associated with producing one more unit of output.
THE MARGINAL COST CURVE AND THE FIRMS SUPPLY DECISION
When marginal revenue (price)>marginal cost, the firm increases profits by producing one more unit.
When marginal revenue (price)<marginal cost, the firm increases profis producing one less unit.
A competitive firm can only be maximizing profits when price = marginal cost.
Because the firm’s marginal cost curve determines how much the firm is willing to supply at any price,
it is competitive firm’s supply curve.
One qualification: instead of choosing the optimal production, the firm might want to shut down and
produce zero.
MARGINAL REVENUE MARGINAL COST RULE
Marginal revenue equals marginal cost rule is applicable to loss maximization as well as profit
maximization. However, if marginal revenue intersects marginal cost below average variable cost, it means that
revenues are not sufficient to cover the fixed costs and the firm should close down.
Marginal revenue means the addition made to the total revenue by producing and selling an additional
output unit and marginal cost means the addition made to the total cost by producing an additional unit of
output. Now a firm will go on expanding this level of output so long and extra unit of output adds more to
revenue than to cost, since it will be profitable to do so. The firm will not produce an additional unit of the
product which adds more to cost than to revenue because to produce that unit will means losses. In other words,
it will pay the firm to go on producing additional unit of output so long as the marginal revenue exceeds
marginal cost. The firm will be increasing its total profits by increasing its output to the level at which marginal
revenue just equals marginal cost. It will not be profitable for the firm to produce a unit of output of which
marginal cost is greater than the marginal revenue.
The firm will be making maximum profit by expanding output to the level where marginal revenue is
equal to marginal cost. If it goes beyond the point of equality between marginal revenue and marginal cost, it
will be incurring losses on the extra units of output and therefor will be reducing its total profit. Thus the firm
will be in equilibrium position when it is producing the amount of output at which marginal revenue equals
marginal cost.
MR = MC = Market Price
QUIZ
1. Because the perfectly competitive firm is a price-taker, it’s demand curve is
a) Upward sloping c) Horizontal
b) Downward sloping d) Vertical
2. In order to maximize profit, the firm should produce where
a) Marginal Revenue = Price c) Marginal Cost = Average Variable
b) Marginal Cost = Marginal Cost
Revenue d) Price = Average Variable Cost
3. At long run equilibrium for the perfectly competitive firm, the marginal cost is equal to
all of the following except
a) Average total cost c) Price
b) Average Variable Cost d) Marginal Revenue
4. If a firm incurs losses, it should continue to produce as long as the price covers the
a) Average variable cost c) Average total cost
b) Average fixed cost d) Marginal Cost
5. If a perfectly competitive firm is initially in long run equilibrium and the firm’s variable
cost increases, all of the following occur in the short run except
a) The firm’s average total cost will c) The firm’s average fixed cost will
increase increase
b) The firm’s marginal cost will d) The firm’s output will decrease
increase
6. In a perfectly competitive industry in which firms are achieving short-run economic
profit,
a) Firms will enter the industry c) Industry output will decrease
b) Firms will increase the product price d) Firms will exit the industry
7. Productive efficiency occurs when the firm produces at the lowest cost per product. This
occurs at the minimum Average total cost, where
a) Marginal Cost = Price d) Marginal Revenue = Average total
b) Marginal Revenue = Price cost
c) Marginal Cost = Average total cost
8. Allocative efficiency is attained when
a) Marginal Cost = Price c) Marginal Cost = Average total cost
b) Marginal Revenue = Price
 d) Marginal Revenue = Average total cost
9. Is a term that describes a market that has a broad range of competitors who are selling
identical products and can easily enter and exit the industry.
a) Monopolistic Competition c) Perfect Competition
b) Imperfect Competition d) Monopoly
10 – 11 Give 2 key characteristics of a perfectly competitive firm (Any of the following answers)
A large number of small firms Perfect resource mobility or the freedom of
Identical products sold by all firms entry into and exit out of the industry
Perfect knowledge of prices and technology
12 – 13 Give 2 advantages of a perfectly competitive firm (Any of the following answers)
Optimal allocation of resources Responsive to consumer wishes: Change in
Competition encourages efficiency demand, leads extra supply
Consumers charged at a lower price
14 – 15 Give 2 disadvantages of a perfectly competitive firm (Any of the following answers)
Insufficient profits for investment Unequal distribution of goods and income
Lack of competition over product design and Externalities
specification

MONOPOLY
-(from Greek mónos ("alone" or "single") and pōleîn ("to sell") exists when a specific
person or enterprise is the only supplier of a particular commodity (this contrasts with
a monopsony which relates to a single entity's control of a market to purchase a good or service,
and with oligopoly which consists of a few entities dominating an industry).
ORIGIN
The term "monopoly" first appears in Aristotle's Politics. Aristotle describes Thales of
Miletus's cornering of the market in olive presses as a monopoly.
TERMS USED
Monopolize refers to the process by which a company gains the ability to raise prices and
exclude competitors. In economics, a monopoly is a single seller. In law, a monopoly is a
business entity that has significant market power, that is, the power to charge overly high
prices. Although monopolies may be big businesses, size is not a characteristic of a monopoly. A
small business may still have the power to raise prices in a small industry or market.
Monopolies are thus characterized by a lack of economic competition to produce
the good or service, a lack of viable substitute goods, and the possibility of a high monopoly
price well above the firm's marginal cost that leads to a high monopoly profit.
Market power is the ability to increase the product's price above marginal cost without
losing all customers. Although a monopoly's market power is great it is still limited by the
demand side of the market. A monopoly has a negatively sloped demand curve, not a perfectly
inelastic curve. Consequently, any price increase will result in the loss of some customers.
Government-granted monopoly or legal monopoly is sanctioned by the state, often to
provide an incentive to invest in a risky venture or enrich a domestic interest
group. Patents, copyrights, and trademarks are sometimes used as examples of government-
granted monopolies. The government may also reserve the venture for itself, thus forming
a government monopoly.
Characteristics of a MONOPOLY:
 Profit Maximizer: Maximizes profits.
 Price Maker: Decides the price of the good or product to be sold, but does so by
determining the quantity in order to demand the price desired by the firm.
 High Barriers: Other sellers are unable to enter the market of the monopoly.
 Single seller: In a monopoly, there is one seller of the good that produces all the
output.] Therefore, the whole market is being served by a single company, and for
practical purposes, the company is the same as the industry.
 Price Discrimination: A monopolist can change the price and quality of the product. He
or she sells higher quantities, charging a lower price for the product, in a very elastic
market and sells lower quantities, charging a higher price, in a less elastic market.
The characteristics of a monopoly market:
 Sellers are price makers – as there is only one seller in the market, it can influence the
market price by its own production decisions. If the market demand curve is downward
sloping then the monopoly firm faces the same demand curve, the price falls as the
amount of output sold rises. So the firm can increase the market price by selling less.
 Buyers are price takers – each buyer is sufficiently small in relation to the overall
market that they can’t influence the market price by the amount they consume.
 Sellers do not engage in strategic behaviour – when a firm makes its own output
decisions, it does not take into consideration the response of other firms – because there
aren’t any.
 No new firms can enter the market – the monopoly firm faces no threat of entry from
potential rivals. When you have a market that has only one firm producing, but the firm is
producing at a lower price than you would expect it to, this could suggest that it is fearful
of rivals entering and so is trying to deter entry through keeping the price down.
Sometimes you will have a situation where there appears to be only one firm in the
market, but it is not really a monopoly – the threat of entry will erode its market power.
In order for these four characteristics to be present, you will usually need to have:
 A large number of buyers but only one seller – so that the first two assumptions hold
 Goods that are not substitutable – if a firm produces goods that consumers can easily
switch away from in favour of alternative goods in a different market, then it doesn’t
have monopoly power because it is effectively competing with the firms in that other
market.
 Buyers must have full information – buyers have to be aware of the price and the
characteristics of the monopolist’s product in order to make decisions of whether to buy it
at the asking price
 Effective barriers to entry – these could be legal (requiring a licence to enter) or
because of control of key inputs, you can easily have a monopoly railway company
because if it controls the rail network, nobody is likely to build a new railway to compete.
FORMATION OF MONOPOLIES
Monopolies can form for a variety of reasons, including the following:
If a firm has exclusive ownership of a scarce resource, such as Microsoft owning
the Windows operating system brand, it has monopoly power over this resource and is the only
firm that can exploit it.
Governments may grant a firm monopoly status, such as with the Post Office, which was
given monopoly status by Oliver Cromwell in 1654. The Royal Mail Group finally lost its
monopoly status in 2006, when the market was opened up to competition.
Producers may have patents over designs, or copyright over ideas, characters, images,
sounds or names, giving them exclusive rights to sell a good or service, such as a song writer
having a monopoly over their own material.
A monopoly could be created following the merger of two or more firms. Given that this
will reduce competition, such mergers are subject to close regulation and may be prevented if the
two firms gain a combined market share of 25% or more.
Sources of monopoly power
Monopolies derive their market power from barriers to entry – circumstances that prevent
or greatly impede a potential competitor's ability to compete in a market. There are three major
types of barriers to entry: economic, legal and deliberate.
Economic barriers - Economic barriers include economies of scale, capital requirements, cost
advantages and technological superiority.
 Economies of scale - Monopolies are characterized by decreasing costs for a relatively
large range of production. Decreasing costs coupled with large initial costs give
monopolies an advantage over would-be competitors. Monopolies are often in a position
to reduce prices below a new entrant's operating costs and thereby prevent them from
continuing to compete. Furthermore, the size of the industry relative to the minimum
efficient scale may limit the number of companies that can effectively compete within the
industry. If for example the industry is large enough to support one company of minimum
efficient scale then other companies entering the industry will operate at a size that is less
than MES, meaning that these companies cannot produce at an average cost that is
competitive with the dominant company. Finally, if long-term average cost is constantly
decreasing, the least cost method to provide a good or service is by a single company.
 Capital requirements - Production processes that require large investments of capital, or
large research and development costs or substantial sunk costs limit the number of
companies in an industry. Large fixed costs also make it difficult for a small company to
enter an industry and expand.
 Technological superiority - A monopoly may be better able to acquire, integrate and use
the best possible technology in producing its goods while entrants do not have the size or
finances to use the best available technology. One large company can sometimes produce
goods cheaper than several small companies.
No substitute goods - A monopoly sells a good for which there is no close substitute. The
absence of substitutes makes the demand for the good relatively inelastic enabling monopolies to
extract positive profits.
Control of natural resources - A prime source of monopoly power is the control of resources
that are critical to the production of a final good.
Network externalities - The use of a product by a person can affect the value of that product to
other people. This is the network effect. There is a direct relationship between the proportion of
people using a product and the demand for that product. In other words, the more people who are
using a product the greater the probability of any individual starting to use the product. This
effect accounts for fads, fashion trends, social networks etc. It also can play a crucial role in the
development or acquisition of market power. The most famous current example is the market
dominance of the Microsoft office suite and operating system in personal computers.
Network externalities - The use of a product by a person can affect the value of that product to
other people. This is the network effect. There is a direct relationship between the proportion of
people using a product and the demand for that product. In other words, the more people who are
using a product the greater the probability of any individual starting to use the product. This
effect accounts for fads, fashion trends, social networks etc. It also can play a crucial role in the
development or acquisition of market power. The most famous current example is the market
dominance of the Microsoft office suite and operating system in personal computers.
Legal barriers - Legal rights can provide opportunity to monopolise the market of a good.
Intellectual property rights, including patents and copyrights, give a monopolist exclusive control
of the production and selling of certain goods. Property rights may give a company exclusive
control of the materials necessary to produce a good.
Deliberate actions - A company wanting to monopolise a market may engage in various types
of deliberate action to exclude competitors or eliminate competition. Such actions include
collusion, lobbying governmental authorities, and force
In addition to barriers to entry and competition, barriers to exit may be a source of market
power. Barriers to exit are market conditions that make it difficult or expensive for a company to
end its involvement with a market. Great liquidation costs are a primary barrier for
exiting. Market exit and shutdown are separate events. The decision whether to shut down or
operate is not affected by exit barriers. A company will shut down if price falls below minimum
average variable costs.
MONOPOLY VERSUS COMPETITIVE MARKETS
While monopoly and perfect competition mark the extremes of market structures there is
some similarity. The cost functions are the same. Both monopolies and perfectly competitive
(PC) companies minimize cost and maximize profit. The shutdown decisions are the same. Both
are assumed to have perfectly competitive factors markets. There are distinctions, some of the
more important of which are as follows:
1. Marginal revenue and price - In a perfectly competitive market, price equals marginal
cost. In a monopolistic market, however, price is set above marginal cost.
2. Product differentiation - There is zero product differentiation in a perfectly competitive
market. Every product is perfectly homogeneous and a perfect substitute for any other.
With a monopoly, there is great to absolute product differentiation in the sense that there
is no available substitute for a monopolized good. The monopolist is the sole supplier of
the good in question. A customer either buys from the monopolizing entity on its terms or
does without.
3. Numbers of competitors - PC markets are populated by an infinite number of buyers
and sellers. Monopoly involves a single seller.
4. Barriers to Entry - Barriers to entry are factors and circumstances that prevent entry into
market by would-be competitors and limit new companies from operating and expanding
within the market. PC markets have free entry and exit. There are no barriers to entry, or
exit competition. Monopolies have relatively high barriers to entry. The barriers must be
 strong enough to prevent or discourage any potential competitor from entering the
market.
5. Elasticity of Demand - The price elasticity of demand is the percentage change of
demand caused by a one percent change of relative price. A successful monopoly would
have a relatively inelastic demand curve. A low coefficient of elasticity is indicative of
effective barriers to entry. A PC company has a perfectly elastic demand curve. The
coefficient of elasticity for a perfectly competitive demand curve is infinite.
6. Excess Profits - Excess or positive profits are profit more than the normal expected
return on investment. A PC company can make excess profits in the short term but excess
profits attract competitors, which can enter the market freely and decrease prices,
eventually reducing excess profits to zero. A monopoly can preserve excess profits
because barriers to entry prevent competitors from entering the market.
7. Profit Maximization - A monopoly is presumed to produce the quantity of output that
maximizes economic profit--the difference between total revenue and total cost. This
production decision can be analyzed directly with economic profit, by identifying the
greatest difference between total revenue and total cost, or by the equality between
marginal revenue and marginal cost.
The profit-maximizing level of output is a production level that achieves the greatest level of
economic profit given existing market conditions and production cost. For a monopoly, this
entails adjusting the price and corresponding production level to achieve the desired match
between total revenue and total cost.
The monopolist's profit maximizing level of output is found by equating its marginal revenue
with its marginal cost, which is the same profit maximizing condition that a perfectly
competitive firm uses to determine its equilibrium level of output. Indeed, the condition that
marginal revenue equal marginal cost is used to determine the profit maximizing level of output
of every firm, regardless of the market structure in which the firm is operating.
The profit-maximizing condition of a monopolistic firm is:
MR = MC
If MR > MC, the monopoly can increase profit by increasing output
If MR < MC, the monopoly can increase profit by decreasing its output
TR-TC= PROFIT
PROFIT MAXIMIZATION: GRAPHS
Profit Curve Total Curves Marginal Curves

MARGINAL REVENUE AND DEMAND ELASTICITY

The relation between the price elasticity of demand
and the marginal revenue curve indicates that a monopoly is
only able to maximize profit by producing a quantity of
output that falls in the elastic range of the demand curve. A monopoly cannot maximize profit in
the inelastic range of demand because this involves negative marginal revenue, and by virtue of
the profit-maximizing equality between marginal revenue and marginal cost, it requires negative
marginal cost, which is just not a realistic possibility.
The connection between marginal revenue and elasticity works like this:
 If the demand is elastic, then marginal revenue is positive.
 If the demand is inelastic, then marginal revenue is negative.
 If demand is unit elastic, then marginal revenue is zero.
P-Max quantity, price and profit - If a monopolist obtains control of a formerly perfectly
competitive industry, the monopolist would increase prices, reduce production, and realise
positive economic profits.
Supply Curve - in a perfectly competitive market there is a well-defined supply function with a
one to one relationship between price and quantity supplied. In a monopolistic market no such
supply relationship exists. A monopolist cannot trace a short term supply curve because for a
given price there is not a unique quantity supplied. As Pindyck and Rubenfeld note, a change in
demand "can lead to changes in prices with no change in output, changes in output with no
change in price or both". Monopolies produce where marginal revenue equals marginal costs.
For a specific demand curve the supply "curve" would be the price/quantity combination at the
point where marginal revenue equals marginal cost. If the demand curve shifted the marginal
revenue curve would shift as well and a new equilibrium and supply "point" would be
established. The locus of these points would not be a supply curve in any conventional sense.
THE INVERSE ELASTICITY RULE
A monopoly chooses that price that maximizes the difference between total revenue and
total cost. The basic markup rule can be expressed as (P − MC)/P = 1/PED. The markup rules
indicate that the ratio between profit margin and the price is inversely proportional to the price
elasticity of demand. The implication of the rule is that the more elastic the demand for the
product the less pricing power the monopoly has.
MARKET POWER
Market power is the ability to increase the product's price above marginal cost without
losing all customers. Perfectly competition (PC) companies have zero market power when it
comes to setting prices. All companies of a PC market are price takers. The price is set by the
interaction of demand and supply at the market or aggregate level. Individual companies simply
take the price determined by the market and produce that quantity of output that maximizes the
company's profits. If a PC Company attempted to increase prices above the market level all its
customers would abandon the company and purchase at the market price from other companies.
A monopoly has considerable although not unlimited market power. A monopoly has the power
to set prices or quantities although not both. A monopoly is a price maker. The monopoly is the
market and prices are set by the monopolist based on his circumstances and not the interaction of
demand and supply. The two primary factors determining monopoly market power are the
company's demand curve and its cost structure.
Market power is the ability to affect the terms and conditions of exchange so that the
price of a product is set by a single company (price is not imposed by the market as in perfect
competition). Although a monopoly's market power is great it is still limited by the demand side
of the market. A monopoly has a negatively sloped demand curve, not a perfectly inelastic curve.
Consequently, any price increase will result in the loss of some customers.
PRICE DISCRIMINATION
 Price discrimination is a technique used by sellers to extract the maximum price possible
from buyers, which has the obvious and direct implications of increasing the revenue
and profit received by the seller. This is accomplished by transferring consumer surplus from
buyers to sellers.
Three Conditions
To be a successful price discriminator a seller must satisfy three things: (1) to have market
control and be a price maker, (2) to identify two or more groups that are willing to pay different
prices, and (3) to keep the buyers in one group from reselling the good to another group. In this
way, a seller is able to charge each group what they, and they alone, are willing to pay.
1. Market Control: First and foremost, a seller must be able to control the price. Monopoly
is quite adept at price discrimination because it is a price maker, it can set the price of the
good. Oligopoly and monopolistic competition can undertake price discrimination to the
extent that they are able to control the price. Perfect competition, with no market control,
does not do well in the price discrimination arena.
2. Different Buyers: The second condition is that a seller must be able to identify different
groups of buyers, and each group must have a different price elasticity of demand. The
different price elasticity means that buyers are willing and able to pay different prices for
the same good. If buyers have the same elasticity and are willing to pay the same price,
then price discrimination is pointless. The price charged to each group is the same in this
case.
3. Segmented Buyers: Lastly, price discrimination requires that each group of buyers be
segmented and sealed into distinct markets. Segmentation means that the buyers in one
market cannot resell the good to the buyers in another market. Price discriminate is not
effective if trade among groups is possible. Those buyers charged a higher price cannot
purchase the good from those paying the lower price instead of from the seller.
Three Degrees
Price discrimination can take one of three forms (or degrees):
 First-Degree Price Discrimination: Also termed perfect price discrimination, this form
exists when a seller is able to sell each quantity of a good for the highest possible price
that buyers are willing and able to pay. In other words, ALL consumer surplus is
transferred from buyers to the seller.
 Second-Degree Price Discrimination: Also termed block pricing, this form occurs when
a seller charges different prices for different quantities of a good. Such discrimination is
possible because the different quantities are purchased by different types of buyers with
different demand elasticities. Block pricing of electricity, in which electricity prices
depend on the amount used, is the most common example. The key is that regular
households tend to use very little electricity compared to retail stores, which uses less
compared to large manufacturing firms.
 Third-Degree Price Discrimination: This is the most common of price discrimination.
It occurs when the seller is able to separate buyers based on an easily identifiable
characteristic, such as age, location, gender, and ethnic group. Senior citizen discounts
are a common example. Higher gasoline prices near highways versus inside cities are
another.
EXAMPLES:
Youngsters Demand and Price Oldsters Demand and Price

KEY CHARACTERISTICS OF MONOPOLY

Monopolies can maintain super-normal profits in the long run. As with all firms, profits
are maximized when MC = MR. In general, the level of profit depends upon the degree
of competition in the market, which for a pure monopoly is zero. At profit maximization, MC =
MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal profits
are possible (area PABC).
With no close substitutes, the monopolist can derive super-normal profits, area PABC.
A monopolist with no substitutes would
be able to derive the greatest monopoly power.
HIGHER PRICES
The traditional view of monopoly
stresses the costs to society associated with
higher prices. Because of the lack of
competition, the monopolist can charge a higher
price (P1) than in a more competitive market (at
P).
The area of economic welfare under
perfect competition is E, F, B. The loss of
consumer surplus if the market is taken over by
a monopoly is P P1 A B. The new area of
producer surplus, at the higher price P1, is E, P1,
A, C. Thus, the overall (net) loss of economic
welfare is area A B C.
The area of deadweight loss for a monopolist can
also be shown in a more simple form, comparing perfect
competition with monopoly.
ALTERNATIVE DIAGRAM
The following diagram assumes that average cost
is constant, and equal to marginal cost (ATC =
MC).Under perfect competition, equilibrium price and output is at P and Q. If the market is
controlled by a single firm, equilibrium for the firm is where MC = MR, at P1 and Q1. Under
perfect competition, the area representing economic welfare is P, F and A, but under monopoly
the area of welfare is P, F, C, B. Therefore, the deadweight loss is the area B, C, A.
THE DEADWEIGHT LOSS OF MONOPOLY
In economics, a deadweight loss (also known as
excess burden or allocative inefficiency) is a loss of
economic efficiency that can occur when equilibrium for a
good or service is not achieved or is not achievable.
NATURAL MONOPOLY
A natural monopoly is an organization that
experiences increasing returns to scale over the relevant
range of output and relatively high fixed costs. A natural
monopoly occurs where the average cost of production
"declines throughout the relevant range of product
demand". The relevant range of product demand is where
the average cost curve is below the demand
curve.[64] When this situation occurs, it is always cheaper for one large company to supply the
market than multiple smaller companies; in fact, absent government intervention in such
markets, will naturally evolve into a monopoly. An early market entrant that takes advantage of
the cost structure and can expand rapidly can exclude smaller companies from entering and can
drive or buy out other companies. A natural monopoly suffers from the same inefficiencies as
any other monopoly. Left to its own devices, a profit-seeking natural monopoly will produce
where marginal revenue equals marginal costs. Regulation of natural monopolies is problematic.
Fragmenting such monopolies is by definition inefficient. The most frequently used methods
dealing with natural monopolies are government regulations and public ownership. Government
regulation generally consists of regulatory commissions charged with the principal duty of
setting prices.
To reduce prices and increase output, regulators often use average cost pricing. By
average cost pricing, the price and quantity are determined by the intersection of the average cost
curve and the demand curve. This pricing scheme eliminates any positive economic profits since
price equals average cost. Average-cost pricing is not perfect. Regulators must estimate average
costs. Companies have a reduced incentive to lower costs. Regulation of this type has not been
limited to natural monopolies. Average-cost pricing does also have some disadvantages. By
setting price equal to the intersection of the demand curve and the average total cost curve, the
firm's output is allocatively inefficient as the price exceeds the marginal cost (which is the output
quantity for a perfectly competitive and allocatively efficient market).
GOVERNMENT-GRANTED MONOPOLY
A government-granted monopoly (also called a "de jure monopoly") is a form of coercive
monopoly by which a government grants exclusive privilege to a private individual or company
to be the sole provider of a commodity; potential competitors are excluded from the market
by law, regulation, or other mechanisms of government enforcement.
MONOPOLIST SHUTDOWN RULE
A monopolist should shut down when price is less than average variable cost for every
output level – in other words where the demand curve is entirely below the average variable cost
curve. Under these circumstances at the profit maximum level of output (MR = MC) average
revenue would be less than average variable costs and the monopolists would be better off
shutting down in the short term.
BREAKING UP MONOPOLIES
In a free market, monopolies can be ended at any time by new competition, breakaway
businesses, or consumers seeking alternatives. In a highly regulated market environment a
government will often regulate the monopoly, convert it into a publicly owned monopoly
environment, or forcibly fragment it (see antitrust law and trust busting). Public utilities, often
being naturally efficient with only one operator and therefore less susceptible to efficient
breakup, are often strongly regulated or publicly owned. American Telephone &
Telegraph (AT&T) and Standard Oil are debatable examples of the breakup of a private
monopoly by government: When AT&T, a monopoly previously protected by force of law, was
broken up into various components in 1984, MCI, Sprint, and other companies were able to
compete effectively in the long distance phone market.
The existence of a very high market share does not always mean consumers are paying
excessive prices since the threat of new entrants to the market can restrain a high-market-share
company's price increases. Competition law does not make merely having a monopoly illegal,
but rather abusing the power a monopoly may confer, for instance through exclusionary practices
(i.e. pricing high just because you are the only one around.) It may also be noted that it is illegal
to try to obtain a monopoly, by practices of buying out the competition, or equal practices. If one
occurs naturally, such as a competitor going out of business, or lack of competition, it is not
illegal until such time as the monopoly holder abuses the power.
First it is necessary to determine whether a company is dominant, or whether it behaves
"to an appreciable extent independently of its competitors, customers and ultimately of its
consumer". As with collusive conduct, market shares are determined with reference to the
particular market in which the company and product in question is sold. The Herfindahl-
Hirschman Index (HHI) is sometimes used to assess how competitive an industry is. In the US,
the merger guidelines state that a post-merger HHI below 1000 is viewed as unconcentrated
while HHIs above that will provoke further review.
By European Union law, very large market shares raise a presumption that a company is
dominant, which may be rebuttable. If a company has a dominant position, then there is "a
special responsibility not to allow its conduct to impair competition on the common market". The
lowest yet market share of a company considered "dominant" in the EU was 39.7%.
Certain categories of abusive conduct are usually prohibited by a country's legislation. The main
recognized categories are:
 Limiting supply  Tying (commerce) and product
 Predatory pricing bundling
 Price discrimination
 Refusal to deal and exclusive dealing
Despite wide agreement that the above constitute abusive practices, there is some debate
about whether there needs to be a causal connection between the dominant position of a
company and its actual abusive conduct. Furthermore, there has been some consideration of what
happens when a company merely attempts to abuse its dominant position.
EXAMPLES OF MONOPOLIES
Microsoft has been the defendant in multiple anti-trust suits on strategy embrace, extend
and extinguish. They settled anti-trust litigation in the U.S. in 2001. In 2004 Microsoft was fined
493 million euros by the European Commission which was upheld for the most part by the Court
of First Instance of the European Communities in 2007. The fine was US$1.35 billion in 2008 for
noncompliance with the 2004 rule.
MPAA (Motion Picture Association of America) has a monopoly over film ratings in the U.S.
Joint Commission is an organization that accredits more than 20,000 health care organizations
and programs in the United States. The Commission has a monopoly over determining whether a
U.S. hospital can participate in the publicly funded Medicare and Medicaid healthcare programs.
Monsanto has been sued by competitors for anti-trust and monopolistic practices. They have
between 70% and 100% of the commercial GMO seed market in a small number of crops.
AAFES has a monopoly on retail sales at overseas U.S. military installations.
State stores in certain United States states, e.g. for liquor.
The Registered Dietitian union seeks monopoly over nutrition services through state-level
licensing schemes.
The State retail alcohol monopolies of Norway (Vinmonopolet), Sweden (Systembolaget),
Finland (Alko), Iceland (Vínbúð), Ontario (LCBO), Quebéc (SAQ), British Columbia (Liquor
Distribution Branch), among others.
Google is widely considered a monopoly for search engines in Europe and North America,
where "to google" has even become a word used in everyday language.
EXAMPLE OF MONOPOLY
Since 1903, Meralco has powered the growth of the
Philippines and its people. As the premier electric service
distributor, it is an inseparable partner for progress.
Meralco’s service area, equivalent to only about 3% of the
country’s total land area, produces almost 46% of the gross
domestic product (GDP), 33% from Metro Manila alone.
The franchise area is home to 24.7 million people, roughly a
quarter of the entire Philippine population of 92 million.
In fulfilling its mandate of distributing electricity to homes and establishments within its
franchise, Meralco, through its business, fulfills a social responsibility.
Through the years, the demand for electricity is rising, especially now with the advent
of technology where almost everything needs electric power
With this in mind, the following factors will be taken into consideration in the conduct of an
industry analysis:
 Barriers to entry  Demographic influences
 Industry level of concentration  Government and regulatory
 Impact of industry capacity influences
 Market share stability  Social influences
 Industry life cycle  Technological influences
 Price competition
Furthermore, an industry analysis will be also conducted based on Porter’s Five Forces:
 Threat of new entrants  Bargaining power of suppliers
 Threat of substitute products  Rivalry among existing firms
 Bargaining power of customers

MONOPOLISTIC COMPETITION
The model of monopolistic competition describes a common market structure in which
firms have many competitors, but each one sells a slightly different product. Monopolistic
competition as a market structure was first identified in the 1930s by American economist
Edward Chamberlin, and English economist Joan Robinson.
Monopolistic competition is a market structure characterized by a large number of
relatively small firms. While the goods produced by the firms in the industry are similar, slight
differences often exist. As such, firms operating in monopolistic competition are extremely
competitive but each has a small degree of market control.
Monopolistic Competition is a form of imperfect completion. It can be found in many
real world markets raging from clusters of sandwich bars, other fast food shops and coffee stores
in a busy town centre to pizza delivery businesses in a city or hairdressers in a local area.
Monopolistic competition is something of a hybrid between perfect
competition and monopoly. Comparable to perfect competition, monopolistic competition
contains a large number of extremely competitive firms. However, comparable to monopoly,
each firm has market control and faces a negatively-sloped demand curve.
EXAMPLES OF MONOPOLISTIC COMPETITION
The first one is of course the example of clothing. Even if we take any specific item of
clothing, such as a simple shirt, then we will see that there are several producers and almost the
entire world population as consumers. The goods produced, though not congruent, tend to have
similarities in them.
Among all the examples of monopolistic competition, this one is also universally applicable.
Simply put, all the restaurants that serve burgers, or for that matter, any kind of food. There is
similarity but no congruence.
Another prominent and classic example, is stationery manufacturers. They produce the
same thing, but there is no congruence.
A very nice example for monopolistic competition is farmers. Farmers produce crops for
the entire world population, but again, they have different characteristics by virtue of things like
size and quality.

CHARACTERISTICS OF MONOPOLISTIC COMPETITION

 Product differentiation - Monopolistic Competition firms sell products that have real or
perceived non-price differences. However, the differences are not so great as to eliminate
other goods as substitutes. The goods perform the same basic functions but have
differences in qualities such as type, style, quality, reputation, appearance, and location
that tend to distinguish them from each other.
 Many firms - There are many firms in each monopolistic competition product group and
many firms on the side lines prepared to enter the market. A product group is a
"collection of similar products". The fact that there are "many firms" gives each
monopolistic competition firm the freedom to set prices without engaging in strategic
decision making regarding the prices of other firms and each firm's actions have a
negligible impact on the market.
 No entry and exit cost in the long run - In the long run there are no entry and exit costs.
There are numerous firms waiting to enter the market, each with their own "unique"
product or in pursuit of positive profits. Any firm unable to cover its costs can leave the
market without incurring liquidation costs. This assumption implies that there are low
start up costs, no sunk costs and no exit costs.
 Independent decision making - Each monopolistic competition firm independently sets
the terms of exchange for its product. The firm gives no consideration to what effect its
 decision may have on competitors. The theory is that any action will have such a
negligible effect on the overall market demand that a monopolistic competition firm can
act without fear of prompting heightened competition. In other words, each firm feels
free to set prices as if it were a monopoly rather than an oligopoly.
 Same degree of market power - Monopolistic competition firms have some degree of
market power. Market power means that the firm has control over the terms and
conditions of exchange. A monopolistic competition firm can raise its prices without
losing all its customers. The firm can also lower prices without triggering a potentially
ruinous price war with competitors. The source of a monopolistic competition firm's
market power is not barriers to entry since they are low. Rather, a monopolistic
competition firm has market power because it has relatively few competitors, those
competitors do not engage in strategic decision making and the firms sell differentiated
product. Market power also means that a monopolistic competition firm faces a
downward sloping demand curve. The demand curve is highly elastic although not "flat".
 Buyers and Sellers do not have perfect information (Imperfect Information) - No
sellers or buyers have complete market information, like market demand or market
supply.
PRODUCT DIFFERENTIATION
1. Physical product differentiation, where firms use size, design, colour, shape,
performance, and features to make their products different. For example, consumer
electronics can easily be physically differentiated.
2. Marketing differentiation, where firms try to differentiate their product by distinctive
packaging and other promotional techniques. For example, breakfast cereals can easily be
differentiated through packaging.
3. Human capital differentiation, where the firm creates differences through the skill of its
employees, the level of training received, distinctive uniforms, and so on.
4. Differentiation through distribution, including distribution via mail order or through
internet shopping, such as Amazon.com, which differentiates itself from traditional
bookstores by selling online.

DEMAND AND REVENUE

Monopolistically competitive firm faces
Demand Curve,
a relatively elastic, but not perfectly elastic, demand
curve, such as the one displayed in the graph to the right. Monopolistic Competition
Each firm in a monopolistically competitive market can
sell a wide range of output within a relatively narrow
range of prices.
Demand is relatively elastic in monopolistic
competition because each firm faces competition from a
large number of very, very close substitutes. However,
demand is not perfectly elastic (as in perfect competition)
because the output of each firm is slightly different from that of other firms. Monopolistically
competitive goods are close substitutes, but not perfect substitutes.
In the graph, the monopolistically competitive firm can sell up to 10 units of output
within the range of ₱5.50 to ₱6.50. Should the price go higher than ₱6.50, the quantity demanded
drops to zero.
A monopolistically competitive firm is a price maker, with some degree of control over price.
Once again, unlike perfect competition, a monopolistically competitive firm has the ability to
raise or lower the price a little, not much, but a little. And like monopoly, the price received by a
monopolistically competitive firm (which is also the firm's average revenue) is greater than
its marginal revenue.
In the exhibit to the right, the marginal revenue curve (MR) lies below the demand/average
revenue curve (D = AR). While marginal revenue is less than price, because demand is relatively
elastic, the difference tends to be relatively small. For example, 5 units of output correspond to a
₱5 price. The marginal revenue for the fifth unit is ₱4.80, less than price, but not by much.
SHORT RUN PRODUCTION
The analysis of short-run production by a
monopolistically competitive firm provides insight into
market supply. The key assumption is that a
monopolistically competitive firm, like any other firm, is
motivated by profit maximization. The firm chooses to
produce the quantity of output that generates the highest
possible level of profit, given price, market demand, cost
conditions, production technology, etc.
The short-run production decision for monopolistic
competition can be illustrated using the graph. The first
graph indicates the two sides of the profit decision--revenue
and cost. The slightly curved green line is total revenue.
Because price depends on quantity, the total revenue curve is
not a straight line. The curved red line is total cost. The
difference between total revenue and total cost is profit,
which is illustrated in the second graph as the brown line.
A firm maximizes profit by selecting the quantity of
output that generates the greatest gap between the total
revenue line and the total cost line in the first graph, or at the
peak of the profit curve in the second graph. In this example, the profit maximizing output
quantity is 6. Any other level of production generates less profit.
LONG RUN PRODUCTION
In the long run, with all inputs variable, a monopolistically competitive industry
reaches equilibrium at an output that generates economies of scale or increasing returns to scale.
At this level of output, the negatively-sloped demand curve is tangent to the negatively-sloped
segment of the long run-
average cost curve,
This is achieved through a two-
fold adjustment process.
Long R
The first of the folds is
entry and exit of firms into and
out of the industry. This ensures that firms earn zero economic profit and that price is equal to
average cost.
The second of the folds is the pursuit of profit maximization by each firm in the industry.
This ensures that firms produce the quantity of output that equates marginal revenue with short-
run and long-run marginal cost.
Because a monopolistically competitive firm has some market control and faces a negatively-
sloped demand curve, the end result of this long-run adjustment is two equilibrium conditions:
MR = MC = LRMC
P = AR = ATC = LRAC
With marginal revenue equal to marginal cost, each firm is maximizing profit and has no
reason to adjust the quantity of output or factory size. With price equal to average cost, each firm
in the industry is earning only a normal profit. Economic profit is zero and there are no economic
losses, meaning no firm is inclined to enter or exit the industry.
These conditions are satisfied separately. However, because price is not equal to marginal
revenue, the two equations are not equal (unlike perfect competition). This further means that
monopolistic competition does NOT achieve long-run equilibrium at the minimum efficient
scale of production.

ADVANTAGES OF MONOPOLISTIC COMPETITION

1. The Promotion of Competition (lack of Barriers to Entry)
In such a market, one of its primary aspects is that there a lack of barriers to entry ( factors
that cause difficulty for a new firm to enter the market e.g. intellectual property rights,
advertising, large start-up costs etc.), hence making it relatively easy for firms to enter
(and exit) the market. This therefore ensures (at least in the long run) no 'single firm' will
find themselves with monopoly power (and with that -- the ability to exploit consumers),
due to new entering firms to the market.
2. Differentiation Brings Greater Consumer Choice and Variety
One of the main positives to come out of a monopolistically competitive market is that in
order to be a competitive firm within such a market place, a firm's primary goal is to
differentiate itself from others in order to gain greater custom than its rival competitors --
essentially appealing to consumer sovereignty (where consumers determine the goods to
be produced within a market). With this, is the provision of greater choice and variety of
products and services for consumers to purchase from -- they have a wider range of
consumer choice as opposed to just a single choice (either just one product -- monopoly --
or all the products are generic and homogenous -- perfectly competitive).
3. Product and Service Quality - Development
Another potential merit of monopolistic competition, is that of incentives for firms to
improve product quality in order to gain (temporary) economic profit -- which in some
aspects relates to the above point on some levels. "Monopolistically competitive industries
are in a constant state of flux -- they are always trying to edging on ways to make profit,
whether that be by lowering the cost of production or by improving on their product. The
process of 'creative destruction' -- the drive to ensure short term gain.

4. Consumers Become More Knowledgeable of Products

A positive externality from monopolistic competition and the intense advertising and
marketing that accompanies it, is that due to firms trying to differentiate their products --
consumers become more informed and aware of their options regarding such products and
services. They can gain an understanding of the unique features and aspects that certain
products have compared to that of others. Hence, with this comes further competition, as
firms can recognize what consumers are wanting to a better degree.
DISADVANTAGES OF MONOPOLISTIC COMPETITION
1. They Can be Wasteful -- Liable of Excess Capacity
A negative factor of firms that are in monopolistic competition is that they don't produce
enough output to efficiently lower the average cost and benefit from economies of scale.
As if they were to do this they are reducing their 'economic profits', as a result of the
marginal revenue being less than that of the marginal cost. Moreover, the funding and
expense that goes into packaging, marketing and advertising can deemed extremely
wasteful on some levels.
2. Allocatively Inefficient
Compared with perfect competition, it can be shown that such firms that there is an
element of allocation efficiency as the price is above that of the marginal cost curve -- less
so in the long run, due to more competition. As the demand curve is one which is
downward sloping this then implies the price has to be greater than the marginal cost for a
monopolistically competitive firm. Hence it is allocatively inefficient as not enough of the
product gets produced for society to benefit -- they want more, however this would force
the company to lose money.
3. Higher Prices
Another drawback of a monopolistic competition, is that as a result of firms having 'some
market power', they can extenuate a mark-up on the marginal cost of revenue. Compared
to a perfectly competitive firm, who have their price equal to their marginal cost. Causing
a deadweight loss in society as described above. This would be difficult for a
governmental authority to regulate for two reasons: i) there are m any firms and ii) they
would be making a loss -- hence eventually forcing such firms out of business.
4. Advertising
Although, as stated earlier, advertising and marketing can be beneficial to consumers on
some levels such as providing information to customers and from this an increase in
competition, it can also have negative impacts on consumer sovereignty. It is argued to
manipulate and distort what consumers’ desire, as well as obviously reducing competition
as consumers become captivated over the perception of differentiation.
MONOPOLISTIC COMPETITION AND MONOPOLY
The following are the points of similarities between the two market situations:
1) Both in monopoly and monopolistic competition the point of equilibrium is at the equality of
MC and MR and the MC curve cuts the MR curve from below.
2) In both, the demand curve (AR) slopes downward to the right and the corresponding marginal
revenue curve is below it.
3) In both situations the equilibrium point is below the price line (AR).
4) In both, there is excess capacity. In other words, the demand curve (AR) is not tangent to the
long-run average costs curve at its minimum point.
5) In both market situations, the producer is a price-maker. He can raise or lower the price.
There are, however, more dissimilarities than similarities in monopoly and monopolistic
competition which are as under:
1) There is only one producer of a product under monopoly while there are a number of produc-
ers under monopolistic competition.
2) There is no difference between firm and industry under monopoly. The monopoly firm is the
industry. On the contrary, there are many firms in monopolistic competition and the industry is
called a group.
3) Only a single product is produced under monopoly and there is no product differentiation.
Under monopolistic competition every producer produces differentiated products. Products are
similar but not identical. They are close substitutes rather than perfect substitutes. They differ
from one another in design, colour, flavour, packing etc. As a result, there is product
differentiation.
4) There are no selling costs in monopoly because the monopolist has no competitor. However,
when the monopoly firm is established, the monopolist may spend some money on advertisement
to acquaint the consumers about his product. But he will spend on advertisement only once. On
the other hand, due to large number of firms and existence of competition among them,
expenditure on selling costs is essential under monopolistic competition.
5) The monopolist can charge different prices from different customers for the same product and
can adopt the policy of price discrimination. But price discrimination is not possible under
monopolistic competition due to the presence of ‘competitive’ element in it.
6) There being no close substitutes of the product under monopoly, the demand for his product is
less elastic. Therefore, the demand curve of the monopolist is steep. On the contrary, products
are close substitutes under monopolistic competition. As a result, the demand for the product of
every firm is more elastic and its demand curve is flat.
7) The inference can be drawn from the above analysis that the monopoly price is higher than the
price under monopolistic competition. Moreover, the monopolist has more freedom in fixing the
price for his product than the monopolistic competitor.
8) Firms can enter and leave the ‘group’ under monopolistic competition in the long run because
the element of competition is present in this market situation. Since the monopolist has full
control either over the price or the supply, no firm can enter the monopoly industry.
9) There being no fear of entry of new firms in monopoly, the monopolist earns super-normal
profits even in the long run; whereas firms earn only normal profits in the long run under
monopolistic competition because the firms can enter and leave the ‘group’.
MONOPOLISTIC COMPETITION AND OLIGOPOLY
DEGREE OF PRICE CONTROL
Monopolistic Competition: A firm under monopolistic competition has partial control over the
price, i.e. each firm is neither a price-taker nor a price-maker. An individual firm is able to
influence the price by creating a differentiated image of its product through heavy selling costs.
Oligopoly: A firm under oligopoly follows the policy of price rigidity. Although, the firm can
influence the prices, but it prefers to stick to its prices so as to avoid a price war.
NATURE OF DEMAND CURVE
Monopolistic Competition: The firm under monopolistic competition also faces a downward
sloping demand curve as more quantity can be sold only at a lower price. However, the demand
curve is more elastic in comparison to demand curve under monopoly because of presence of
close substitutes.
Oligopoly: The demand curve for an oligopoly firm is indeterminate, i.e. it cannot be drawn
accurately as exact behavior pattern of a producer cannot be ascertained with certainty.
Influence on activities on other firms
Monopolistic Competition: There are large numbers of firms and behavior of each firm has less
impact on activities of other firms.
Oligopoly: There are few firms and behavior of each firm has significant impact on activities of
other firms.

SOCIALLY UNDESIRABLE ASPECTS COMPARED TO PERFECT COMPETITION

Selling costs: Products under monopolistic competition are spending huge amounts on
advertising and publicity. Much of this expenditure is wasteful from the social point of view. The
producer can reduce the price of the product instead of spending on publicity.
Excess Capacity: Under Imperfect competition, the installed capacity of every firm is large, but
not fully utilized. Total output is, therefore, less than the output which is socially desirable. Since
production capacity is not fully utilized, the resources lie idle. Therefore, the production under
monopolistic competition is below the full capacity level.
Unemployment: Idle capacity under monopolistic competition expenditure leads to
unemployment. In particular, unemployment of workers leads to poverty and misery in the
society. If idle capacity is fully used, the problem of unemployment can be solved to some
extent.
Cross Transport: Under monopolistic competition expenditure is incurred on cross
transportation. If the goods are sold locally, wasteful expenditure on cross transport could be
avoided.
Lack of Specialization: Under monopolistic competition, there is little scope for specialization
or standardization. Product differentiation practiced under this competition leads to wasteful
expenditure. It is argued that instead of producing too many similar products, only a few
standardized products may be produced. This would ensure better allocation of resources and
would promote economic welfare of the society.
Inefficiency: Under perfect competition, an inefficient firm is thrown out of the industry. But
under monopolistic competition inefficient firms continue to survive.
QUIZ ANSWERS KEY
TRUE or FALSE. Write M if the statement is true and C if it is f.
C 1. Monopolistic Competition is a form of perfect competition. (Imperfect Competition)
M 2. Monopolistic Competition describes a common market structure in which firms have
many competitors, but each one sells a slightly different product.
M 3. No sellers or buyers have complete market information, like market demand or market
supply.
C 4. Demand is perfectly elastic in monopolistic competition because each firm faces
competition from a large number of very, very close substitute. (Relatively elastic/highly elastic)
M 5. A firm maximizes profit by selecting the quantity of output that generates the greatest
gap between the total revenue line and the cost line or at the peak of the profit curve.
M 6. The key assumption is that a monopolistically competitive firm, like any other firm, is
motivated by profit maximization.
C 7. Competition is comparable to Monopoly that contains a large number of extremely
competitive firms. (Perfect competition)
 C 8. American economist Joan Robinson and English economist Edward Chamberlin are
the “Founding Father of the Theory of Monopolistic Competition. (American Edward
Chamberlin: English Joan Robinson)
C 9. Monopolistic Competitive firm is a price-taker. (Price-maker)
C 10. Monopolistic Competitive firm faces a horizontal demand curve. (Downward
sloping)
II. Enumeration.
Characteristics of Monopolistic Competition
 Product differentiation  Same degree of market
 Many firms  Buyers and Sellers do not have perfect
 No entry and exit cost in the long run information (Imperfect Information)
 Independent decision making
Advantages of Monopolistic Competition
 They Can be Wasteful -- Liable of Excess  Higher Prices
Capacity  Advertising
 Allocatively Inefficient
Disadvantages of Monopolistic Competition
 The Promotion of Competition (lack of  Product and Service Quality -
Barriers to Entry) Development
 Differentiation Brings Greater Consumer  Consumers Become More Knowledgeable
Choice and Variety of Products
OLIGOPOLY
An oligopoly is a market structure in which a few firms dominate that produce
homogenous or differentiated products.
An oligopoly market might have dozens or hundreds of individual firms but most of them
are unimportant in the industry perhaps only 2-20 firms dominate the industry.
Oligopolies may be identified using:
Concentration ratios which measure the proportion of total market share controlled by a
given number of firms. When there is a high concentration ratio in an industry, economists tend
to identify the industry as an oligopoly. (We will provide hypothetical figures to further explain
this during the report)
Oligopolists have to make critical strategic decisions such as:
Whether to compete with rivals, or collude with them.
Whether to raise or lower price, or keep price constant.
Whether to be the first firm to implement a new strategy, or whether to wait and see what rivals
do.
Characteristic of Oligopoly
 Few sellers  Difficult Entry
 Homogenous product  Barriers to entry
Oligopolies maintain their position of dominance in a market might because it is too costly or
difficult for potential rivals to enter the market because of these barriers.
1. Economies of large scale production. If a market has significant economies of scale that
have already been exploited by the incumbents, new entrants are deterred.
2. Ownership or control of a key scarce resource. Owning scarce resources that other firms
would like to use creates a considerable barrier to entry, such as an airline controlling
access to an airport.
 3. High set-up costs. High set-up costs deter initial market entry, because they increase
break-even output, and delay the possibility of making profits.
4. High R&D costs. Spending money on Research and Development (R & D) is often a
signal to potential entrants that the firm has large financial reserves. In order to compete,
new entrants will have to match, or exceed, this level of spending in order to compete in
the future.
5. Predatory pricing. Predatory pricing occurs when a firm deliberately tries to push prices
low enough to force rivals out of the market.

6. Limit pricing. The incumbent firm sets a low price, and a high output, so that entrants
cannot make a profit at that price.
7. Superior knowledge. An incumbent may, over time, have built up a superior level of
knowledge of the market, its customers, and its production costs. This superior
knowledge can deter entrants into the market.
8. Predatory acquisition. Predatory acquisition involves taking-over a potential rival by
purchasing sufficient shares to gain a controlling interest, or by a complete buy-out.
9. Advertising. The more that is spent by incumbent firms the greater the deterrent to new
entrants.
10. A strong brand. Brand creates loyalty, ‘locks in’ existing customers, and deters entry.
11. Loyalty schemes. It helps oligopolists retain customer loyalty and deter entrants who
need to gain market share.
THE ADVANTAGES OF OLIGOPOLIES
 Oligopolies may adopt a highly competitive strategy, in which case they can generate
similar benefits to more competitive market structures, such as lower prices
 Oligopolists may be dynamically efficient in terms of innovation and new product and
process development. The super-normal profits they generate may be used to innovate, in
which case the consumer may gain.
 Price stability may bring advantages to consumers and the macro-economy because it
helps consumers plan ahead and stabilizes their expenditure, which may help stabilize the
trade cycle.
THE DISADVANTAGES OF OLIGOPOLIES
 High concentration reduces consumer choice.
 Cartel-like behavior reduces competition and can lead to higher prices and reduced
output.
 Firms can be prevented from entering a market because of deliberate barriers to entry.
 There is a potential loss of economic welfare.
 Oligopolists may be allocatively and productively inefficient.
TYPES OF OLIGOPOLY:
1. Pure or Perfect Oligopoly: If the firms produce homogeneous products, then it is called pure
or perfect oligopoly. Though, it is rare to find pure oligopoly situation, yet, cement, steel,
aluminum and chemicals producing industries approach pure oligopoly.
2. Imperfect or Differentiated Oligopoly: If the firms produce differentiated products, then it is
called differentiated or imperfect oligopoly. For example, passenger cars, cigarettes or soft
drinks. The goods produced by different firms have their own distinguishing characteristics, yet
all of them are close substitutes of each other.
3. Collusive Oligopoly: If the firms cooperate with each other in determining price or output or
both, it is called collusive oligopoly or cooperative oligopoly.
4. Non-collusive Oligopoly: If firms in an oligopoly market compete with each other, it is called
a non-collusive or non-cooperative oligopoly.
COLLUSIVE OLIGOPOLIES
Another key feature of oligopolistic markets is that firms may attempt to collude, rather
than compete. It is a common practice among oligopolist, it is a secret agreement among them to
have a common price and to manipulate their output for their own interest.
TYPES OF COLLUSION
1. Overt. It occurs when there is no attempt to hide agreements, such as the when firms
form trade associations like the Association of Petrol Retailers.
(These are illegal collusions)
 Price fixing is an agreement to increase, fix or maintain the price
 Market Division is agreement in which competitors divide the market among themselves.
 Bid Rigging

GRAPH FOR OVERT COLLUSION (As you can see firms can have moving up demand
curve)
2. Covert. Occurs when firms try to hide the
results of their collusion, usually to avoid
detection by regulators, such as when fixing
prices.
3. Tacit. Arises when firms act together,
called acting in concert, but where there is no
formal or even informal agreement.
4. Price Leadership it is a collusion in which
firms in the industry follows the price changes
made by a firm recognized “price leader”

What if there is no collusion?

There will be a competition and the demand curve of a firm will be “kinked”
Two Unique Aspect of Oligopoly Competition.
In oligopoly industries competition happens in ways that are unique to these industries TWO
UNIQUE ASPECTS ARE:
1. Mutual Interdependence
This exist when the action of one
firm has a major impact on the
other firm in the industry
(Further explanation and
example will be on our report)
2. Repeated Interaction
When the oligopolist within the industry have been competing with one another for a long period
of time like pepsi and coke have been competed with in the same market for decades. (Further
explanation and example will be on our report)