Analyse and comment upon the pricing and output decisions of the firm and the industry in perfect competition and monopoly
Q. Analyse and comment upon the pricing and output decisions of the firm and the industry in perfect competition and monopoly.
A. Perfect competition is a market structure which is characterised by many buyers and sellers. As such, no single buyer or seller can affect the market price taker. In perfect competition, all firms sell identical or homogenous product. There is also perfect mobility of resources, free entry and exit of firms and perfect knowledge.
As the individual firm can only contribute a small fraction in the total output of the industry, its actions cannot affect price. Therefore, the demand curve of an individual firm is perfectly elastic. It is a horizontal straight line at the prevailing market price over the range of output that the firm can produce.
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Assuming the factor prices remain constant and firms in the competitive industry simultaneously expand or contract output, the industry’s supply curve is the horizontal summation of the supply curves of all the producers. Since the firm’s supply curve is MC curve, the industry supply curve is the aggregate marginal cost curve, as shown below.
Equilibrium in the market is reached at the point where the demand curve intersects the supply curve. Thus, as shown in the diagram above, equilibrium price is OP, and output is OQ1. In the short run, firms in the perfect competitive industry may enjoy normal, subnormal, or supernormal profits. However, those firms which previously enjoyed supernormal profits will be able to reap only normal profits in the long run due the entrance of new firms which were attracted to the industry. To survive the competition posed by new firms can survive in the long run only if it is producing at optimum size or at the lower point of the average cost curve. At this equilibrium point the firm is producing the least cost output at the most efficient plant size. Thus, the firm is technologically efficient. Since the price equals marginal cost in perfect competition, this market structure is also allocatively efficient.
A monopoly is a market structure in which a single firm or a combination of firms collectively as one firm, supplying al the output in the market. Since the firm supplies all the market output, it can influence either price or the level of output but not at the same time.
The monopolist is faced with a downward sloping average revenue(AR) curve and hence his marginal revenue(MR) curve will also slope downwards and lie below the AR curve.
The monopolies will maximise profit by producing up to the point where marginal cost equals marginal revenue.
The firm produces 0Q and sells at price 0P and makes supernormal profits at PEFD. In a monopolistic situation, there are barriers to entry to keep out new competition. These come in the form of patents, government legislation, huge capital outlay and poor initial returns. Thus, the monopoly can make supernormal profits in the long run. Discrimination is also practised by the monopolist to cream off some of the consumer surplus. Thus, it would appear that monopoly leads to a higher price and lower output than a competitive market.
However, in reality, the monopoly would take advantage of any economies of scale available. This gives rise to the following situation:
As a result of the economies of scale, marginal cost drops from MC1 to MC2. This leads to a rise in output to 0Q2, as compared to 0Q1, under perfect competition. Price also falls to 0P2 compared with the price under perfect competition of 0P1. Thus, it is possible to have a lower price and larger output under monopoly than under perfect competition, if economies of scale do exist.