Profit Maximisation Point

The profit maximisation point is MR=MC. Below are the diagrams for the profit maximisation point for both monopoly and perfect competition markets. The profit maximisation point is the quantity and price level that the firm will produce at to ensure the most benefit. Before point X, MR is greater that MC thus profits will rise and rise. After point X, MC is greater than MR, thus firms do not see it profitable to produce after that point because they lose money.


For a monopolist, firms charge a price level higher than profit maximisation because it maximises producer surplus and consumers are still willing to purchase at that price level (See notes here). The quantity produced remains at Q1. For a firm in perfect competition, the level of output produced is at X and the price charged to consumers is P1, making the firm productively and allocatively efficient. For more notes, see here.

For more notes on perfect competition and monopoly markets, see here and here, respectively.

Monopoly

·     A few firms dominating the market. Actual monopolies (only one firm in the market) are very rare.

Monopoly Equilibrium

The profit maximisation point is Q1 and P1, where MR=MC. The equilibrium quantity is Q1, however the equilibrium price is not P1. Instead the firm charges P3 since P3 is the maximum price the monopolist firm can charge while succeeding at selling quantity Q1.

Therefore the total revenue gained by the firm is rectangular area P3XQ1O. The total costs the firm incurs is the rectangular area P2YQ1O. The supernormal profits that the monopoly firm makes is P3XQ1O - P2YQ1O (total revenue minus total costs), which equals P3XYP2. This profit is the monopoly profit that the firm makes.

The monopoly IS the industry and therefore there is no separate market demand and supply diagram (like with perfect competition, see here and here). They get combined and put together because the market is the monopoly. AR is downward sloping because if they set a large price, following the law of demand, the number of units they will sell will fall and vice versa.

This diagram is the long run equilibrium and the short run equilibrium. Barriers of entry prevent new firms entering the market, thus monopoly profits are sustained in the long run as well. Firms want to be monopolies because monopoly firms sustain supernormal profits in the long run.

Efficiency

For a monopolistic market, the firm is…

·     NOT allocatively efficient. The firm does not produce above quantity Q1. Price does NOT equal MC.

·     Not productively efficient because it is not producing at its cost minimising point (the lowest point on the AC curve).

Benefits of a monopoly:

·     Market can benefit from economies of scale due to lower ACs.

·     Supernormal profits can be used for R&D.

This model, like perfect competition, can be used to compare real life markets with.

Perfect Competition Long Run Equillibrium

Long run equilibrium

Because supernormal profits can be made in the short run, new firms enter the market.

When new firms enter the market, market supply increases from MS1 to MS2 which drives the price down from P1 to P2. There is a new equilibrium of price P2 and quantity Q2. For the individual firm in the market (diagram on the right), the firm now charges price P2 leading to MR and AR moving down to P2 as well. Point Y is the profit maximisation point (MR2=MC), therefore the firm will sell at quantity Q2 and total revenue gained is the rectangular area P2YQ2O. Because AC=MC, the rectangular for the firm’s total costs is P2YQ2O as well. This means that supernormal profits are not being made, only normal profits are being made. Costs per unit are equal to revenue per unit and so the firm is unable to make supernormal profits in the long run. Price = Long run ACs as well.

Furthermore, the firm is producing fewer units of output. Because there are no supernormal profits being made by firms within the market, there is no incentive for firms to enter or exit the market and the market is said to be at rest.

Efficiency

In the LR in a perfectly competitive market, there is….

·       Productive efficiency because the firm is producing at AC’s lowest point (Q2). The firm is producing at its cost minimising point. Resources are used efficiently.

·       Allocative efficiency because firms are allocating the same amount of extra cost (MC) to customers as customers are allocating extra revenue to firms (P). Therefore P=MC, so it is allocatively efficient.

A perfectly competitive market is the only type of market structure where it is possible to be both allocatively and productively efficient.

This model of a perfectly competitive market is a theoretical extreme and is used to judge how closely real world industries approximate to this even if they are not truly competitive. This model, although unrealistic, holds the strong argument that resources are allocated efficiently and firms make beneficial exchanges which enable it to be efficient. The model provides a benchmark in which imperfectly competitive markets can be compared and contrasted.

Great Perfect Competition Video

Okay, so here's a really good video on Perfect competition.

The first diagram drawn shows abnormal/supernormal profits.
Second diagram drawn shows normal profits.
Third diagram shows subnormal profits.