Pure Competition and Monopoly (Comparison)

When comparing any two models we are looking at the following aspects:

1. Goals of the firm

2. Assumptions of models regarding.

(a) Product

(b) Number of sellers (and buyers)

(c) Entry conditions

(e) Degree of knowledge

3. Implications of assumptions for the behaviour of the firm

(a) Shape of demand

(b) Atomistic behaviour or interdependence

(c) Policy variables of the firm and main decisions

4. Comparison of basic magnitudes at equilibrium (long-run)

(a) Price (and price elasticity of demand)

(b) Output

(c) Profit

(d) Capacity utilization (economies of scale)

5. Predictions of the models

(a) Shift in market demand

(b) Shift in costs

(c) Imposition of a tax

Comparing perfect competition and monopoly in the light of the above method­ological scheme we derive the following conclusions:

Goals of the firm:

In both models the firm has a single goal, that of profit maximization. Indeed the whole concept of rational behaviour is defined in terms of profit maximization: the firm is rational when its behaviour aims at the maximization of profit. In both models the owner of the firm is also the manager-entrepreneur. There is no separation of ownership and management in these traditional models.

Assumptions:

The product is homogeneous in pure competition. In monopoly the product may or may not be homogeneous. The main feature of monopoly is that the total supply of the product is concentrated in a single firm. In pure competition there is a large number of sellers, so that each one cannot affect the market price by changing his supply. In monopoly there is a single seller in the market. In pure competition entry (and exit) is free in the sense that there are no barriers to entry. However, in the short run entry is not easy entry is a long-run phenomenon. In monopoly entry is blockaded by definition.

In both models the cost conditions are such as to give rise to U-shaped cost curves both in the short run and in the long run. The plant is planned to produce a single level of output with minimum cost. There is no flexibility (reserve capacity) in the plant. In the short run the U-shape is due to the inevitable results of the law of eventually diminishing returns of the variable factors (or law of variable proportions). In the long run all factors are variable, but eventually the efficiency of management declines and this causes the LAC curve to turn upwards beyond a certain (optimal) scale of output.

Perfect knowledge is assumed in both market structures. Uncertainty is dealt with (in the neoclassical versions of pure competition) by assuming that the firm knows the results of any action up to a probability distribution. Having this knowledge, the firm has a certain time horizon and aims at the maximization of the present value of its future stream of net profits.

Obtaining information about the present or the future requires some expense. Information or search activity is decided on marginalistic rules, by equating the MC of information to its MR.

Behavioural rules of the firm:

Given the assumptions of large numbers and homogeneous product, the demand curve in pure competition is perfectly elastic, showing that the firm is a price-taker. In monopoly the demand of the firm is also the demand of the industry and hence is negatively sloping.

The only decision (and policy variable) of the firm in pure competition is the deter­mination of its output. There is no room for selling activities, since the firm can sell any amount of output it can produce. Some economists argue that there is no incentive for research and development for the firm in the purely competitive market, since the firm can sell whatever it wishes without such activities.

Others argue that the urge for technological research is strong in pure competition, since the firm can increase its profits only by decreasing its costs, something that can be achieved only with research and development in new methods of production. Such arguments are not conclusive, and empirical evidence can hardly be expected to support or refute them, since pure competition does not exist in most economic activities.

The monopolist can determine either his output or his price, but not both, since once one of these policy variables is decided, the other is simultaneously determined. The monopolist may change the style of his product and/or indulge in research and develop­ment activities, especially if there is danger of development of close substitutes in other industries.

Under these conditions the monopolist may also undertake heavy advertising and other selling activities. Thus the monopolist has more policy variables at his disposal (product, price, research and development, advertising, etc.). Whether he will make use of these instruments and to what extent, is a matter highly debated in theory and in practice. In general the use of such instruments as product differentiation, advertising, R 8c D expenditures, depends on the threat of potential competition from new similar products, or on social and governmental pressures.

In both markets the firm acts atomistically, that is, it takes the decisions which will maximize its profit, ignoring the reactions of other firms (in the same or other industries).

In both markets the decisions are taken by applying the marginalistic rule

MC = MR

Both models are basically static. Although a distinction is made between the short run and the long run, it is assumed that the long run consists of identical time periods, which are independent: the decisions taken in one period do not affect the profits in other periods. Thus short-run profit maximization leads to long-run profit maximization.

Comparison of long-run market equilibrium:

Given the cost conditions, in monopoly the level of output will generally be lower and the price higher as compared with pure competition. This is due to the fact that in pure competition the firm produces at optimum cost (minimum point on the LAC curve) and earns just normal profit, while the monopolist usually earns abnormal profits even in the long run. Under such conditions price will be higher in monopoly and output lower, as compared with pure competition.

The market elasticity of demand in equilibrium may assume any value in a purely competitive market. In monopoly the price elasticity must be greater than unity in equilibrium, because if |e| < 1 the monopolist can increase his revenue by increasing his price.

The firm in pure competition produces at optimum cost in long-run equilibrium, that is, at the minimum point of the LAC curve there are neither unexhausted econ­omies of scale nor diseconomies of large-scale production. In monopoly there is no certainty that the monopolist will produce at minimum long-run costs. He may never reach the lowest point of the LAC, or he may overshoot it, depending on the market size.

The supply of a purely competitive firm is uniquely determined it is its MC curve above its intersection with the variable costs of the firm.

In monopoly the supply function is not uniquely determined: the same quantity may be offered at different prices, or the same price may be charged for different quan­tities, depending on the demand in the market (and given the monopolist’s cost structure). Thus the monopolist’s MC curve is not its supply curve. In pure competition there are no abnormal profits in the long run. In monopoly abnormal profits are usually earned both in the short run and in the long run.

Comparison of predictions:

Shift in market demand:

In pure competition an increase in market demand will lead to an increase in price and in output in the short run. In the long run the output will be larger, but price may return to its initial level (constant-cost industry), remain above the original level (increasing-cost industry), or fall below the original level (decreasing-cost industry). In monopoly we do not distinguish between SR and LR. A shift of the demand above the original level will result in an increase in output, which may be sold at the same, a higher or a lower price, depending on the extent of the shift in the demand and the change in its elasticity.

A shift in costs:

An increase in fixed costs in pure competition will not change the firm’s output in the short run since MC is not affected. In the long run firms will close down if they do not cover their higher total average costs. The monopolist will not change his output in the short run or in the long run. Only if the increase in fixed costs wipes out the abnormal profits and reduces the normal profit of the monopolist, will he go out of business.

With an increase in variable costs the MC is shifted upwards, output is reduced and price increases in both market structures. However, the changes in output and price will be more accentuated in pure competition, ceteris paribus.

Imposition of a tax:

The imposition of a lump-tax in pure competition will not lead to a change in output and price in the short run. However, the shift in the TFC will put firms out of business (if they were earning just normal profits in the pre-tax situation), so that market output will decline and price will rise in the long run.

In monopoly a lump-tax will not affect the market equilibrium in the short run or in the long run, so long as the monopolist continues to earn some abnormal profits. The effects of a profits tax are the same (in both markets) as in the case of the imposition of the lump-tax.

In pure competition a specific sales tax will be passed partly on to the consumer so long as the supply curve has a positive slope. The higher the elasticity of supply the more of the tax burden will be shifted to the consumer. If the supply is perfectly elastic, ΔP = tax and the whole tax is passed to the consumer. In monopoly the monopolist will bear some of the tax burden even if his MC is parallel to the output axis.