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Key features of perfect competition

In economics, a market is defined as the system, where exchange of goods and services with money takes place. There are buyers and sellers and they exchange things against money between themselves. The markets are classified into two broad categories, namely perfect and imperfect competition. Under imperfect competition, there are more classification, namely monopoly, oligopoly, monopolistic competition, etc. (Baumol & Blinder, 2015). This essay focuses on the comparison between perfect competition and monopoly, and addresses if the monopoly outcome is better than that of perfect competition.

Perfect competition is a hypothetical structure of market, where the outcomes are most efficient for consumers, producers and the society. The key features of the perfect competition are: there are many buyers and many sellers; all the sellers are price takers and they do not have control on the market price; the producers sell identical products, hence the products are perfect substitutes; the buyers have perfect knowledge about the market; and there is no barrier to entry in the market, that is, firms have freedom to enter and exit from the market. This type of market is also called the pure competition. There is also prefect mobility of factors and no transaction cost. Buyers are rational since they have perfect information regarding the market. There is lack of economies of scale. The profit maximization production occurs when marginal cost (MC) equals marginal revenue (MR) (Moulin, 2014).

Monopoly is one type of the markets under imperfect competition. Monopoly occurs when there is a single supplier in the market. For legislative purpose, the definition of monopoly says that when a firm has the controls of 25% or more of a market, then monopoly exists in that market. Hence, the key features of a monopoly are: single seller, total control on market price, price making firm, economies of scale and existence of supernormal profit (Nicholson & Snyder, 2014) 

Monopolies can arise due to various reasons. Those are as follows:

When a firm has the exclusive rights for a scare resource, then it has a monopoly power over the resource. For example, Microsoft has monopoly power over Windows operating system.

Sometimes the government of a country grants monopoly status to a particular firm. For example, in many countries, the governments have granted the railways or the postal services the monopoly status.

The producers might have patents or copyrights over any intellectual property or service, and that gives them exclusive ownership or rights to use or sell that property or service.

Key features of monopoly

Sometimes a monopoly can be created from the merger of two or more organizations. This action reduces competition in the market and gives a larger market share to the firms (Hall & Lieberman, 2012).

The two types of market are very different from each other. In perfect competition, there may be profit or loss in the short run, but in long run, there is no profit. On the other hand, there is always profit in monopoly. In perfect competition, price is always equal to marginal cost and average revenue, while for monopoly, price is always more than marginal cost (Varian, 2014).

                                                Figure 1: Short run equilibrium and profit under perfect competition

                                                                                          (Source: Author)

The above figure depicts the short run equilibrium and profit of a firm under perfect competition. In this type of market, price always equals marginal revenue and average revenue, i.e. P = AR = MR. In the short run, when the price is greater than marginal cost, supernormal profit exists, shown by the area PLMN. Here equilibrium occurs at point L, where MC = MR.

Figure 2: Long run equilibrium and zero profit under perfect competition

(Source: Author)

Figure 2 depicts the long run equilibrium under perfect competition. In the long run also, P = AR = MR. However, equilibrium occurs at E*, where marginal cost (MC) equals average cost (AC)  and MC curve cuts the AC curve at its lowest point from below. If there is supernormal profit in the short run, new firms would enter the market, supply increases, price falls and the supernormal profits gets absorbed. Thus, there is no profit for the firms in the long run. Hence, at equilibrium, P = AR = MR = AC = MC.

 

Figure 3: Equilibrium and profit under monopoly

(Source: Author)

The above figure illustrates the equilibrium and profit of monopoly. Since the monopolist is a price maker, it would set the price higher than the market price. The equilibrium occurs at E, where MC = MR, however, the monopolist would set the price at P, which corresponds to the AR curve at A. AR is higher than MR. The equilibrium quantity is Q. Thus, the profit of the monopolist is shown by the area PABG.

Differences between perfect competition and monopoly

Under monopoly, there is deadweight loss, which does not occur in perfect competition (Huang, 2013).

Figure 4: Loss of welfare under monopoly

(Source: Author)

The above figure compares the welfare loss under perfect competition and monopoly. There is no welfare loss under perfect competition, while under monopoly, the area ABL denotes consumer surplus and BCL denotes producer surplus. The total area ABC denotes the social welfare loss. G denotes the socially optimum price under monopoly and Q1 is the efficient output. However, the firm produces Q2 and charges price PM, thereby earning profit of PMACG. Q2 is lower than Q1 and PM is higher than G.  Thus, there is deadweight loss due to higher price and lower output (Riley, 2012).

Efficiency refers to the optimum allocation of resources and production at lowest possible cost. There are two types of efficiency. Those are as follows:

Productive efficiency: when the firm produces at the best possible combination of resources, that is, when the production of one good cannot be increased without reducing the production of the other.

Allocative efficiency: when the output corresponds to the equality between MR and MC, i.e., P = MC, allocative efficiency is achieved (Morrison, 2012). 

Perfect competition displays economic efficiency for the following reasons. Figure 2 can be referred to in this context.

Productive efficiency: since in the long run, output is supplied at the lowest average cost, hence, firms with higher average cost cannot sustain in the industry as the market price is pushed down. Thus, productive efficiency is achieved under perfect competition.

Allocative efficiency: in perfect competition, price equals to marginal cost both in short run and long run. At this equilibrium price, both the consumer and producer surplus are maximum. Hence, there is no welfare loss for the society. Thus, allocative efficiency is achieved in perfect competition.

Dynamic efficiency: as the products are homogeneous under perfect competition, there is little scope for improvement and innovation, because if the products are differentiated, then there would be competitive advantage in the market and could generate monopoly power. Thus, dynamic efficiency is not achieved in perfect competition (Yang & Ng, 2015).

Under monopoly, the price of the products is always higher than the marginal cost, i.e.    P > MC. Hence, there is inequality between price and marginal cost, leading to productive inefficiency.

Moreover, price does not equal to marginal revenue under monopoly. The demand curve is negative for a monopolist as the price charged is higher than marginal revenue, i.e. P > MR. Thus, there is allocative inefficiency. In this context, figure 3 can be referred.

At the same time, there is social welfare loss under monopoly (refer to figure 4). Thus, monopoly is inefficient compared to perfect competition (Kirzner, 2015). 

Conclusion

Hence, it can be concluded from the above discussion that, monopoly does not lead to a better outcome than perfect competition. There is productive and allocative inefficiency along with loss of social welfare under monopoly.

References:

Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Cengage Learning.

Hall, R. E., & Lieberman, M. (2012). Microeconomics: Principles and applications. Cengage Learning.

Huang, A. Y. J. (2013). The Use of Cost Functions for the Teaching of Natural Monopoly in Intermediate Microeconomics. Advances in Economics and Business, 1(1), 22-27.

Kirzner, I. M. (2015). Competition and entrepreneurship. University of Chicago press.

Morrison, C. J. (2012). A microeconomic approach to the measurement of economic performance: Productivity growth, capacity utilization, and related performance indicators. Springer Science & Business Media.

Moulin, H. (2014). Cooperative microeconomics: a game-theoretic introduction. Princeton University Press.

Nicholson, W., & Snyder, C. M. (2014). Intermediate microeconomics and its application. Cengage Learning.

Riley, G. (2012). Monopoly and Economic Welfare. Retrieved 6 June 2017, from https://www.tutor2u.net/economics/blog/unit-3-micro-monopoly-and-economic-welfare

Varian, H. R. (2014). Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.

Yang, X., & Ng, Y. K. (2015). Specialization and economic organization: A new classical microeconomic framework (Vol. 215). Elsevier.

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