Lecture Notes: Economic Profits and Market Structures

Introduction to Economic Profits

• Economic profits are competed away in a competitive market because:
  • New firms can enter freely.
  • Firms have the necessary information to compete.
• Key Prediction in Economics: Competition normalizes profits across industries, equalizing economic rewards for resources.

Firm Costs and Market Dynamics

• Marginal Cost (MC):
  • Represents the cost of producing an additional unit.
  • Familiar with flat lines and U-shaped curves.
• Average Cost (AC):
  • Tells the average cost per unit based on production volume.
  • Typically U-shaped due to fixed costs.

Perfect Competition

• Characteristics:
  • Firms have no market power and are price takers.
  • Market price sets marginal revenue (MR).
  • Firms maximize profits by producing where MC = MR.
• Economic Outcome:
  • Competition drives market price to where MC = AC.
  • Economic profits are competed away.

Monopoly

• Characteristics:
  • Barriers to entry prevent competition.
  • Monopolists are price makers with market power.
  • MR curve is derived from market demand.
• Profit Maximization:
  • Produce where MC = MR.
  • Set prices based on consumer willingness to pay.
  • Earns high economic profits until competition finds entry.

Impact of New Entrants in a Monopolistic Market

• Changes in Demand:
  • New firm entry splits demand.
  • Monopolist's demand becomes more elastic.
  • Profits shrink as competition increases.

Monopolistic Competition

• Characteristics:
  • Firms have differentiated products.
  • Low barriers to entry.
  • Examples include clothing and restaurants.
• Economic Outcome:
  • Firms make accounting profits but zero economic profits.
  • Price set above MC but competition equalizes price to AC.

Comparison: Perfect vs. Monopolistic Competition

• Perfect Competition:
  • Produces identical products.
  • Firms are price takers.
  • Zero economic profits in the long run.
  • Industry costs are minimized.
• Monopolistic Competition:
  • Produces differentiated products with some market power.
  • Price makers with price set above MC.
  • Long-term zero economic profits but not at minimum AC.
  • Trade-off inefficiency for product variety.

Industry Example: Music

• Characteristics:
  • Low barriers to entry.
  • Most musicians earn normal income.
  • High earners often have innovative approaches.
  • Successful models eventually see a decline in economic profits due to copying.

Conclusion

• Overall Market Dynamics:
  • Perfect competition minimizes resource use but lacks variety.
  • Monopolistic competition provides variety but at higher industry costs.
• Economic Implications:
  • Understanding market structures helps in predicting profit behavior and industry efficiency.