There are few places on Earth

that are not touched by the continual changes of market

organization (Cleaver, 2004).The examination of different types of market is an important aspect

of economic analysis because it helps the society to decide whether one form of market structure
is better than another; this has implications for government policy(Gillespie, 2011).A market
structure is defined as the organizational characteristics that affect the nature of competition
and pricing in a market (Bannock et al., 2003: 244). Those features are interrelated because the
absence of barriers to entry affects the numbers and the size distributions of buyers and sellers,
which, in turn, reflect the extent of monopoly (Bannock et al., 2003). The purpose of this essay is
to explain why the level of profits differs between market structures. First, it explains normal and
abnormal profits. Then, it examines the benchmark models of perfectly competitive market and
monopoly market. Finally, a judgement with a supported analysis will be given.
The profit is defined as the residual return to the entrepreneur (Bannock et al., 2003: 312). In
traditional economic theory, profit is the surplus remaining after the full opportunity costs of all
the factors of production have been met (Bannock et al., 2003: 312). However, according to
Mankiw (2012: 238) profit equals total revenue minus all the opportunity costs both explicit
and implicit. Two forms of profit are distinguished in economics. Normal profit, is the minimum
level of profit which can influence a producer to remain in business (Stanlake et al., 2000).
Arnold (2013 :188) defines it as the zero economic profit where earning revenue equals total
costs. On the other hand, abnormal profit or supernormal profit is the profit in excess to normal
profit. Therefore, it occurs when the revenue is greater than the costs (Gillespie, 2001).
Perfect competition is an idealized version of market structure that provides a foundation for
understanding how markets work. The perfect competition model, has five key characteristics.
There are numerous buyers and sellers, none of whom has any influence on the market price
(Stanlake et al., 2000); there is freedom of entry and exit in the market, which means firms enter
and leave the market as profit levels change; both buyers and sellers have perfect knowledge of
market prices (Anderton 2008); all products are the same with no possibility of brand loyalty or
product differentiation (Stanlake et al, 2000). Finally, all producers are price takers; they must
sell at the price decided by the market (Gillespie, 2009).

The firm in a perfect competition is a price taker.

(a) The industry

(b) The firm

S

Price

Price

0
Q1

P = MR

Quantity
(millions of units)

Quantity
(hundred
of units)

Source: Based on Gillespie (2011: 199)

The diagram (a) above shows the downward sloping demand curve for the industry. Diagram (b)
shows the perfectly elastic demand curve for the firm. The market price is determined by the
forces of supply and demand as shown in (a) (Gillespie 2011); the firm must then sell at this
price (b) hence P=D=AR=MR for the firm.
Monopoly stands at the opposite end of the competitive spectrum. There are two definitions
assigned to it. In economic definition a pure monopoly occurs when there is a sole supplier
(Gillespie, 2011). For example, Bank of England is the only supplier of banknotes in England
and Wales. The government definition is a firm with at least 25% market share (Stanlake et al.,
2000: 413). Reference is also made to natural monopoly; an industry in which technical factors
preclude the efficient existence of more than one producer, therefore, one firm produces and
transmits all of the commodity in that industry (Bannock et al., 2003: 273).
An economic monopoly has the power to determine either: the price of the product or the
quantity supplied. In other words, is a price-maker. It cannot determine both because is faced by
the downward sloping market demand curve which cannot be controlled (Taylor, 2007: 308).
The monopolist power to earn supernormal profits depends upon two closely related features: the

availability of close substitutes and the power to restrict the entry of new firms (Stanlake et al.,
2000: 413). Notably, in order to have an economic monopoly there must be a low cross elasticity
of demand between the monopolists product and other products (Landsburg, 2011).
One similarity between monopoly and perfect competition is that in both types of market
structure firms are assumed to be profit maximisers (Jain and Khanna, 2010). According to
Anderton (2008) this occurs when firms produce at the highest output where MR=MC. Must be
remembered that MC rises due to the principle of diminishing returns.
In perfect competition MC curve shows the quantity that must be supplied by a firm in order to
profit-maximize granted that firms are price takers (Gillespie, 2011).In the diagram below is
illustrated how a profit-maximizing firm under perfect competition does not produce if the price
cannot cover AVC(Gillespie, 2009).Sloman et al.(2012) states that the firms short-run supply
curve is therefore the MC curve above AVC which below is between P0 and P1.Correspondingly,
the long-run supply curve is the MC curve above AC, hence in the long run a firm will only
supply if it makes a normal profit (Gillespie, 2011).
The decision to produce in the short run and long run.

Price

MC=S
AC

AVC
Break-even point P1

Shutdown point

P0

Source: Based on Gillespie (2009: 40)

Quantity

Another similarity is the presence of abnormal profits in both market structures (Gillespie, 2011).
Short-run equilibrium of an industry and a firm under perfect competition.
(c) Industry

(d) Firm
S

Price

AC
MC

D = AR

AR

Pe

ACC

= MR

Quantity
(millions)

Qe
Q(thousands)

Source: Based on Sloman et al.(2012: 175)

In the diagram (d) from above can be observed that if the average cost curve is beneath average
revenue, the firm in perfect competition earns abnormal profit which is the vertical difference
between average revenue and average cost at Qe.
The differences between competition and monopoly are mainly a direct consequence of the
presence of barriers to entry and exit in monopoly (Baumol and Blinder, 2012). According to
Stanlake et al. (2000: 387) the situation depicted in the diagram (d) is temporary. Profits such as
those shown in figure (d)would be competed away in long-run by free entry in a perfectly
competitive market because an abnormal profit would attract new firms into the business, total
supply would increase and, as a result P e would fall to P1. This situation is illustrated below in
the diagrams (e) and (f) where firms are moving in long-run equilibrium because of the firms
entering the market.

The adjustement process from short-run to long-run equilibrium in perfectly competitive market.
(e) Industry

(f) Firm

Pe

D = AR

P1

P1

AC

MC

S1 Cost/revenue

Price

= MR

Quantity

Quantity

Source: Based on Stanlake et al.(2000: 387).

By the same token, firms in perfect competition may experience losses in the short-run because
of the absence of barriers to exit. (Tragakes, 2012). This is illustrated below:P2<AC; this leads to
the exit of firms; the fall in supply causes P2 to rise until P1=AC.

Short-run losses; firms leave the industry.

Industry
S1

MC

Price
S2

P1

P1

P2

P2

O
Q1

AC

Firm

Q2

Source: Based on McEachern (2009: 189)

Q2

Q1

To clarify, the situation of monopoly is presented below. Unlike in a perfectly competitive

industry, the diagram (g) illustrates how a monopolist can earn supernormal profits in the longrun because of the existence of barriers to entry such as government regulations and patents
(Gillespie, 2011). The triangle EFG is a welfare loss area produced by the allocatively inefficient
monopolist with market power which seeks to maximize profits by limiting output at Q2 while
charging prices above the competitive level (Taylor, 2007: 314). By doing this the firm is also
productively inefficient. If it was to produce at Q3 where output level is most efficient the firms
profits would fall because MR<MC on those additional Q3-Q2 units (Gillespie, 2011). In
addition, the diagram (h) shows a monopoly minimizing losses when AC>MR because of the
barriers to exit such as suck costs and long term contracts (Stanlake et al., 2000: 415-31).

The price and output outcome in a monopoly.

MC

C/R

MC

(h)

(g)
C/R

AC

AC
C
P

P2
C

F
G

AR

0
Q2

Q3 AQ

AR

Qutput
MR

MR

Qutput

Source: Based on Stanlake et al.(2000: 430-1).

There is also more empirical evidence that monopolies tend to be productively inefficient .Xinefficiency or organisational slack push up the AC curve due to complacency and respectively
overstaffing (Stanlake et al., 2000:433). Another reason for higher costs is due to rent-seeking
behaviour (Arnold, 2011:240). However, the shape of AC can be modified through innovation in
monopoly whereas in perfect competition is almost impossible because of the absence of
economies of scale and long-run abnormal profits (Stanlake et al., 2000:429-33).

There is also the argument of natural monopoly in favour of EOS. It is more productively
efficient for there to be one dominant provider of a national infrastructure such as British
Telecom, which builds and maintains the UK telecommunications network for the broadband
industry (Tutor2u.net, 2014). The key point is that a natural monopoly is characterized by
increasing returns to scale at all levels of output(McGuigan et al., 2010).

Natural Monopoly.
Costs

P1
AR

C1

LRAC
Q1

MR

Output

Source: Based on (Tutor2u.net, 2014)

In the diagram (i) above the profit-maximizing price is P1 at an output of Q1. Price is well above
the marginal cost of supply and high supernormal profits are made but output is high too and
there is still a sizeable amount of consumer surplus because of the internal economies of scale
that have brought down the unit cost for all consumers (Tutor2u.net, 2014).
Profit-maximising monopolists practice price discrimination in order to remove the allocative
inefficiency of a single-price monopoly (Arnold, 2011). This is defined as the practice of selling
the same commodity to different buyers at different prices (Bannock et al., 2003:304). If there is
a different price elasticity of demand and the monopolist is able able to segment the market and

prevent arbitrage between segments discrimination among buyers or third degree price
discrimination can be practiced (Arnold, 2011).For example:
Third-Degree Price Discrimination (j)

Price

Price

MC

PA
PC

0
QA

DC

MRC
MRA
QC Q3 AQ
Q3QA+QC
AQ

MRA

MR

DA

Qutput

QA

QC

MR

Qutput

Source: Based on (Landsburg, 2011:338)

Diagram (j) above, Benjamin Barker sells haircuts, MR= MRA+ MRC, the firm produces at
QA+QC where MC=MR; high price in the inelastic segment and a low price in the elastic segment
according demand curves in the second panel. As result welfare loss is reduced or eliminated
(Landsburg, 2011). However price discrimination may be used to increases monopoly power or
to discourage potential rivals which can be seen as a barrier to entry (Stanlake et al. 2000). The
situations from above are impossible in perfectly competitive market because of its feautres.
To summarize, the markets share similarities such as goal of the firms, rule for maximizing and
the ability to earn economic profits in short run.On the other hand there are differences in
number of firms, marginal revenue, price, economic profits or entry in long-run and finally, the
ability to price discriminate or welfare-maximize level of output. A conclusion can drawn that
perfect competition wins over monopoly in terms of being productively and allocatively
efficient, and also X-efficient. However, monopoly can be justified by dynamic considerations,
particularly through its ability to reduce prices over time as a result of benefiting from economies
of scale and innovation in new products and methods of production. By restricting output and

raising prices, monopolies transfer consumer surplus to producer surplus, and also trigger a net
welfare loss (Allan, 2014).

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