Comparison of the models of perfect competition and monopoly under special consideration of innovation

Chosen questions:

2 a) Compare and contrast the models of perfect competition and monopoly. (50%)
2 b) “Monopoly profits are essential for higher innovation rates and future economic growth.” Evaluate this statement. (50%)

2 a)

Perfect competition and monopoly represent benchmark cases describing the two extremes of market models.^[1] The first consists of many buyers and sellers, whose decisions do not affect the market price (Mankiw 2004, Dornbusch et al. 1987). Therefore, firms under perfect competition are price takers. The price results of the supply (S) and demand (D) equilibrium as shown in figure 1 (Sloman and Sutcliff 2001).

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Figure 1: Industry equilibrium and demand curve of a firm in perfect competition.

Following: Begg and Ward 2004, Mankiw 2004

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In addition to the already mentioned low market power of the producers, perfect competition has the following characteristics: The industry provides a standardised, homogeneous product, therewith customers do not have buying preferences. Also, customers have perfect knowledge of market conditions and there are no restrictions on market entry or exit of firms (Begg and Ward 2004).

In a monopoly, there is only one seller, but many buyers (Pindyck and Rubinfeld 1995). Also, there are high market entry barriers, e.g. distinctive technological advantage or legal protection (Stanlake 1983, Sloman and Sutcliff 2001).^[2] Monopolists set prices and are therefore price makers (Dornbusch et al. 1991).

To compare and contrast both models, economists analyse which price, output and profit will apply in each case. Therefore, the respective cost and revenue curves have to be investigated. The Average Total Cost (ATC) and Marginal Cost (MC) curves of a company are assumed to be U-shaped, because an increasing output eventually leads to a unit costs rise due to the law of diminishing returns. This means there is a point, where the cost of producing a unit will exceed the market price for this unit. It is evident that a firm will expand its output as long as the revenue it receives from an additional output, i.e. the Marginal Revenue (MR), exceeds the costs of producing it (Begg and Ward 2004, Mankiw 2004, Dornbusch et al. 1987).

When analysing perfect competition, a distinction between the short and the long run has to be made. In the short run, no new firms enter the industry (Mankiw 2004, Sloman and Sutcliff 2001). As described before, profit maximization is reached when the marginal costs equal the marginal revenue (MR=MC). If the Average Total Costs (ATC) at this point are lower than the Average Revenue (AR) a firm will earn supernormal profits (Figure 2, Dobson et al. 1995).

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Figure 2: Short-run equilibrium under perfect competition.

Following: Begg and Ward 2004, Mankiw 2004

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Figure 3: Long-run equilibrium under perfect competition

As the achieved supernormal profits will attract new market entrants, this situation will not persist in the long run. Moreover, the market price will decrease gradually with increasing supply and the available supernormal profits will decrease. This leads to a long-run equilibrium where all firms earn normal profits – which are already included in ATC in economic terms. Firms produce productively, i.e. at minimum costs, and allocatively, i.e. with MC equalling MR, efficient (Begg and Ward 2004, Mankiw 2004, Stanlake 1983).^[3]

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^[1] The other possible market models lying in-between the mentioned extremes, e.g. oligopolistic market structures, will not be observed in this assignment because of the given task. It should be noted that in praxis the two extremes are not very likely to occur, but for a theoretical examination they are good examples.

^[2] One special form of monopolies are natural monopolies, where economies of scale lead to a situation where only one firm is cost competitive in the market (Begg and Ward 2004, Mankiw 2004).

^[3] This development is the same, if the ATC are higher than the AR. Then, the firm suffers losses and will leave the market on the long run, also leading to a long-run equilibrium in which the companies gain normal profits. In addition to that, there are also several other reasons that influence the market equilibrium, but which should not be analysed in this assignment in more detail (Begg and Ward 2004).