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Perfect Competition and Monopoly - Essay Example

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(a) Explain why perfectly competitive firms cannot make supernormal profits in the long run but monopolies can. Perfect Competition & Monopoly The producers make and sell their products in the markets, places where buyers and sellers meet, to achieve the highest possible profit they can get…
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Perfect Competition and Monopoly
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Download file to see previous pages 1. The size of the firm relative to the market is small. Hence, it has no influence on price. The firm is a price taker. 2. The product is homogeneous meaning to the consumer the product of one seller is same as the product of other seller. 3. There is freedom of entry and exit for each firm. 4. There is free mobility of resources. 5. All the participants in the market have perfect knowledge, meaning that everyone is aware of his benefit, consumer knows prices, and producer knows cost and so on. If even one condition is not fulfilled, the market will not be perfect anymore, it will be imperfect. An extreme case of such imperfection is monopoly. Monopoly is that market in which there is only one seller (or a group of sellers acts as one - cartel) of a commodity that has no close substitute. The seller has complete control of the supply of the commodity and hence is the price maker. We shall now see where the equilibrium of the firm lies and also which conditions are necessary for it. Equilibrium of the firm We shall use the marginal revenue1 and marginal cost2 approach to study the equilibrium of the firm. There are two conditions to this equilibrium: 1. MR = MC 2. Slope of MR < Slope of MC. Price MC P T P MR=AR=P Quantity (output) 0 Z? Z As we can see in the above graph, there are two points where marginal revenue is equal to MC but at Z? if the quantity is increased, the firm is still earning profit. But after Z, the cost of per unit is more than its price. Hence Z is the equilibrium output. The equilibrium can be proved mathematically. Let Z be the output, TR the revenue and TC the cost. Profits are calculated as ? = TR – TC. To maximise the profits we need i.e. MR = MC, and i.e. Slope of MR < Slope of MC. Equilibrium in Perfect Competition and Monopoly in the Long Run As we are trying to see how both markets generate different profits in the long run, we shall assume that the market demand and costs do not change due to entry and exit of a firm from the industry. Also, to simplify the analysis constant average cost is assumed. These assumptions give us MC = AC and the supply curve for perfect competition is equal to both costs. The equilibrium in perfect competition will be at the point where demand is equal to supply as this is where the price3 will set. The output will be according to this level. At this level price will be equal to MC and AC. In general, we can state the equilibrium in perfect competition as P = AR = MR = MC = AC Where P = Price of the commodity AR = Average Revenue MR = Marginal Revenue MC = Marginal Cost AC = Average Cost4. In case of monopoly the equilibrium will take place where marginal revenue is equal to marginal cost and the marginal cost curve cuts marginal revenue from below but there is an additional clause here that states that the marginal revenue will be less than the price. We can see both the equilibriums – for perfect competition and monopoly, in the figure. Comparison of Profit between Perfect Competition & Monopoly The comparison can be seen in the figure above. In perfect competition the price is fixed. Only the output varies and therefore supply curve is horizontal. The equilibrium price for competitive firm is Pc, where MR=MC. But the output level is Qc where MC= AR, meaning supply is equal to demand. For monopoly, the equilibrium position is same, where MR=MC, but the output leve ...Download file to see next pages Read More
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