Chapter 7

Calculating economic profit or loss

(P-ATC) x Output

Explaining each box in the payoff matrix

(think of Z as $) in box 3: USL with a low-price strategy makes 70 million Zs, and IST with a high-price strategy makes 10 million Zs. The reason why the low-price fi rm makes much higher profits is that by charging a low price it captures a large portion of sales from its rival. in box 1: Firms decide to collude and both move to the high price strategy in box 4 Dilemma: IST realises that if it sticks to its agreement it will continue to earn 40million along with USL. The realise that by breaking the agreement and going to the low price strategy they can earn 70mill while USL earns only 10. IST would be better off in the initial condition of 20 mill each. IST has to try 'outguess' USL. it is likely to cut its price to beat USL to the higher profits, but since USL is thinking along exactly the same lines, they are both likely to adopt the low-price strategy, in which case they will end up in box 1 where they both have low prices and low profits. This is the Nash equilibrium, in which both firms become worse off.

Advantages and disadvantages of advertising: The following arguments suggest that advertising can increase efficiency:

- Advertising provides consumers with information about alternative products; it makes it easier for consumers to search for the product that is best suited to their needs, and therefore reduces time and effort wasted on searching for alternative products. - Advertising by rival firms increases competition between them, and therefore contributes to decreasing their monopoly power. - Advertising facilitates introduction of new products by providing information to consumers; in this way, competition (non-price) increases between firms. - By facilitating the introduction of new products, advertising can help lower barriers to entry of new firms into an industry. - By facilitating the introduction of new products, advertising can also provide firms with an extra incentive to engage in research and development for the development of new products.

Evaluating perfect competition -Insights provided by the model

- Allocative efficiency - Productive efficiency -Low prices for consumers -Competition leads to the closing down of inefficient producers. -The market responds to consumer tastes -The market responds to changes in technology or resource prices.

Evaluating perfect competition -Insights provided by the model - w explanation

- Allocative efficiency - Perfect competition leads to the best or 'optimal' allocation of resources based on the mix of goods and services that consumers mostly want, achieved through P = MC in long-run equilibrium. - Productive efficiency -Perfect competition also leads to production at the lowest possible cost, avoiding waste in the use of resources, achieved through production at minimum ATC. -Low prices for consumers - production is at lowest cost, no economic profits in the long run therefore low price. -Competition leads to the closing down of inefficient producers - Inefficient firms produce at higher than necessary costs. They make a loss and therefore exist the industry in the long run. -The market responds to consumer tastes - this shifts demand and changes price. This causes short run profits/losses. In the long run price adjusts. -The market responds to changes in technology or resource prices - Cost curves will shift up or down, leading to profit/loss and more firms entering/leaving. This results in price adjustment in the long run.

Changes demand

- Changes in demand cause movement to a new long run equilibrium -Things such as changes in taste -When demand increases, price rises, profits rise, more people are attracted to the industry raising supply, bringing profit back to normal profit

Allocating efficiency

- Competitive markets achieve allocative efficiency because the equilibrium is at MC=MB where social surplus is at a max. there is equality between what consumers are prepared to pay to get one more unit and what it costs to produce it. Allocative efficiency occurs when firms produce the particular combination of goods and services that consumers mostly prefer. The condition is the following: Allocative efficiency is achieved when P = MC. -This holds when there are no externalities, which also means that at this point MSB=MSC

Advantages and disadvantages of advertising: The following arguments suggest that advertising can lower efficiency

- Huge sums spent on advertising by large oligopolistic firms can create barriers to the entry of new firms that cannot match such expenditures. -Advertising increases costs of production and means higher prices for consumers. - Successful advertising increases a firm's monopoly power. -Consumers may become confused and misled about product quality, and may pay higher prices for inferior products. -Advertising may create needs that consumers would not otherwise have, resulting in a waste of resources as consumers buy goods and services they would not have wanted if they were not influenced by advertising.

Profit maximisation in the long run

- In the long run, all the firm's resources are variable; therefore, the number of firms in the industry is no longer unchanging. -Firms can enter or leave and grow or shrink their business

Non-collusive oligopoly: the kinked demand curve

- In the real world, prices of oligopolistic industries tend to be rigid or 'sticky' (dont change much over time) -in situations when prices do change, they tend to change together for all the firms in an industry -Price rigidities also happen in non-collusive oligopoly, where oligopolistic firms do not agree, whether formally or informally, to fix prices or collaborate in some way. -Kinked demand curve explains price rigidities of oligopolistic firms that do not collude -Instead of agreeing on how to fix prices, their pricing behaviour is strategic, and is strongly influenced by their expectations of how rival firms will react if they undertake a price change. -Corresponding to the kinked demand curve is a broken marginal revenue curve; - -The break in MR occurs exactly at the point of the kink in the demand curve, and is a reflection of the abrupt drop in marginal revenue at the point where the demand curve suddenly bends.

Conflicting incentives

- Incentive to collude - . By colluding to limit competition, they reduce uncertainties resulting from not knowing how rivals will behave, and maximise profits for the industry as a whole. -Incentive to compete - at the same time, each firm faces an incentive to compete with its rivals in the hope that it will capture a portion of its rivals' market shares and profits, thereby increasing profits at the expense of other firms.

Conditions for price discrimination - The price-discriminating firm must have some market power/ability to control price

- Means it must face a downward-sloping demand curve. -Price discrimination can therefore occur in all market structures except perfect competition. -e.g natural monopoly electricity companies often charge lower prices at night than during the day for consumption of electricity -e.g. oligopolistic as a rule charge higher fares during peak travel seasons such as during summer months -e.g. monopolistic firms like cinemas charge kids different amounts and may have discounts on certain days -Perfectly competitive firm would lose customers if they had price discrimination ( sold at a price different to the price determined in the market). Would have no reason to lower price sometimes since it can sell the same amount at the higher price

advertising

- Oligopolies engage heavily in advertising as part of non-price competition. -The only other market structure where advertising figures prominently is monopolistic competition, where firms also engage in non-price competition. -Firms in perfect competition obviously do not advertise, as they produce a homogeneous product, whereas in monopoly there is no need for advertising as the monopolist is the sole producer. Economists disagree on the efficiency aspects of advertising. Some of the points contradict each other. It is possible that different circumstances give rise to different (positive or negative) results.

Why a monopoly may be desirable: Possibility of greater effi ciency and lower prices due to technological innovations

- R&D leads to technological innovations -they may adopt production processes and new technologies that can make them more efficient (i.e. able to produce at a lower cost) -Some of these lower costs could be passed to consumers in the form of lower prices.

Explaining oligopolistic behaviour by use of game theory: Prisoners dilemma

- Shows how two rational decision makers, who use strategic behaviour to maximise profits by trying to guess the rival's behaviour, may end up being collectively worse off. -The final position that results from the game is called a Nash equilibrium. Suppose there are two oligopolistic firms in the space travel industry: Intergalactic Space Travel (IST) and Universal Space Line (USL). Each fi rm must decide on a pricing strategy, i.e. what price to charge consumers for its space travel services, and can choose either a high-price or a low-price strategy. Each firm is interested in making its own profit as large as possible, but its profit will depend on the particular combination of pricing strategies that the two firms choose. this figure, a 'payoff matrix' shows four possible combinations of pricing strategies and their corresponding profit outcomes (called 'payoffs') for the two firms

Shutting down in the short run and the long run: the shut-down price

- Shutting down in the short run is different to the long run - In the short run firms continue to produce as long as the price is above AVC, even though it may be making a loss. It stops producing when price is below minimum AVC -In the long run the firm stops producing as soon as price is below ATC

Conditions for price discrimination

- The price-discriminating firm must have some market power/ability to control price - Means it it must face a downward-sloping demand curve. Price discrimination can therefore occur in all market structures except perfect competition. e.g natural monopoly electricity companies often charge lower prices at night than during the day for consumption of electricity -Separation of consumers into groups to avoid the possibility of resale -Different price elasticities of demand

Monopolistic competition: Assumptions of the model

- There is a large number of firms - each firm has a small share of the market and acts independently from others -There are no barriers to entry and exit. -There is product differentiation - biggest diff to perfect comp. differences such as physical, quality, location, service (e.g. home delivery, warranty), product image (may have celebs advertise)

Concentration ratio

- an indication of the percentage of output produced by the largest firms in an industry. -e.g. we could say that the 3-firm concentration ratio of industry X is 78%, which means that the three largest firms of industry X produce 78% of the industry's total output; or the 4-firm concentration ratio of industry Y is 45%, which means that the four largest firms in industry Y produce 45% of the industry's total output - used to provide an indication of the degree of competition in an industry. They suggest that the higher the concentration ratio, the lower the degree of competition. - In general, an industry is considered to be oligopolistic if the four largest firms control 40% of output.

Oligopoly - Why is non price competition very in oligopoly

- considerable financial resources (due to large profits) that they can devote to both R&D and advertising and branding. Whereas monopolistically competitive firms also engage in non-price competition, their resources for these purposes are generally not as large. - The development of new products provides firms with a competitive edge; they increase their monopoly power, demand for the firm's product becomes less elastic, and successful products give rise to opportunities for substantially increased sales and profits. -Product differentiation can increase a firm's profit without risk of retaliation. Takes time and resources for rival firms to develop new competitive products. Cannot be quickly matched like price cuts.

Legislation to reduce monopoly power-Difficulties of legislation to protect competition

- difficulties in interpreting the legislation, what behaviour is allowed and not?. Different views on what actions involve anti-competitive behaviour. -The laws themselves may be vague, allowing much room for different interpretations. -Some countries enforce laws more strictly than others, depending on their priorities or their political and ideologicalviews. -Not all govs accept that government intervention in the market (strict enforcement of competition policies) is necessary to protect consumers against monopolistic practices and to achieve allocative efficiency. Some disagree because over long periods of time, the market and competitive forces on their own accomplish these functions. -There is no 'right' or 'wrong' answer to this issue, as it depends on normative ideas about the economy -Difficult to know if firms are colluding and come up w evidence

Strategic behaviour

- plans of action that take into account rivals' possible courses of action -think in terms of chess- you make a move thinking about the move the opponent is able to make as a consequence of your move -Guess the reactions of their competitors when making their decisions

Calculating short-run shut-down and break-even prices

- short-run shut-down price =AR= MR = min AVC -break-even price = AR= MR = min ATC

Legislation to reduce monopoly power-Legislation in the case of mergers

-A merger is an agreement between two or more firms to join together and become a single firm. -Mergers occur for various reasons such as: such as an interest in capturing economies of scale , or an interest in firm growth , or interest in acquiring monopoly power -Mergers are an issue in competition policy because they may allow firms to gain too much monopoly power when they become bigger -Legislation usually involves limits on the size of the combined firms. Difficulties with merger policies include: -questions and uncertainties about what firms should and should not be allowed to merge, -issues of interpreting the legislation -Ideological differences among different governments on the desirability or not of a high degree of monopoly power (as in the case of competition policies).

Third-degree price discrimination 3 - profit-maximisation

-Assume there are two consumer groups (or two markets) for product X, distinguished from each other on the basis of differing PEDs. Part (a) shows the consumer group of market 1 to have a relatively inelastic demand (low PED), while part (b) shows the consumer group of market 2 to have a relatively elastic demand (high PED). The two marginal revenue curves are added horizontally, leading the total market marginal revenue curve in part (c), which also shows the firm's marginal cost curve To maximise profit, MR=MC, thus finding the profit-maximising level of output Q3. Output Q3 must now be divided between the two markets. The firm does this by equating its MC of the total market with the MR of each individual market: MC = MR = MR1 = MR2. This determines output level Q1 in market 1, sold at price P1 (given by the demand curve D1), and output level Q2 in market 2, sold at price P2 (given by the demand curve D2). (Note that Q1 + Q2 = Q3.) Figure 7.26 shows that the firm will charge: -a higher price (P1) for the consumer group with relatively inelastic demand -a lower price (P2) for the consumer group with relatively elastic demand. Third-degree price discrimination results in higher revenues and profits for fi rms.9 If profits did not increase, firms would not practise price discrimination

Open/formal collusion: cartels

-Cartel - a formal agreement between firms in an industry to take actions to limit competition in order to increase profits it therefore involves formal collusion (or open collusion). The agreement may involve: - Limiting/fixing the quantity each firm produces. Results in increasing the price - Fixing price -Restricting nonprice competition (e.g. advertising) -dividing the market according to geographical or other factors - agreeing to set up barriers to entry objective: to limit competition, increase the monopoly power of the firms, and increase profits.

Changes in technology or resource prices

-Causes a fall in resource prices and improved technology for production -These changes lower the firms cost curves leading to supernormal profit -More suppliers are attracted to the industry bringing it back to normal profit -Industry output increases and the final price is lower -Fall in price is equal to the fall in minimum ATC

Collusive oligopoly

-Collusion in oligopoly refers to an agreement between firms to limit competition, increase monopoly power and increase profits. illegal in most countries, because it works to limit competition. -Most commonly involve price fixing agreements -May be done formally, a cartel, or informally, such as price leadership.

Third-degree price discrimination 1

-Common type of discriminations, based on the principle that different consumer groups have different price elasticities of demand for a product. -Also known as 'discrimination among consumer groups' -Lower prices for people with high PED, higher price to those with low PED examples: -cinemas, museums charge lower rates to children -airlines charge higher prices for business travellers than for leisure travellers and cheaper if tickets are bought in advance -Restaurants may have discounts on specific days -hotels are cheaper in some seasons -phone rates cheaper on weekends -hairdressers and drycleaners may charge higher prices for women -bars may offer lower prices for a short period immediately after working hours -bars may offer lower prices for a short period immediately after working hours

Conditions for price discrimination - Separation of consumers into groups to avoid the possibility of resale

-Consumers must be separated from each other on the basis of some characteristic, such as time, geography, age, gender, technology, income or other factors. -Firms differentiate their prices on the basis of these characteristics. -e.g. cinemas and hotels often charge lower prices to older people and children (consumer separation by age); telephone companies sometimes offer lower rates for evening or weekend calls (consumer separation by time) -The price-discriminating fi rm must ensure that it is not possible (or is hard and costly) for any consumer to buy at the low price and resell at the higher price. -In some cases, resale is impossible due to the nature of the product, especially where services are involved, such as in the case of medical services, legal services and education

There are two factors at work making for a natural monopoly:

-Costs and market demand D, intersects the LRATC curve, LRATC curve is still declining meaning that economies of scale have not yet been fully exhausted and the minimum efficient scale occurs at a higher level of output. Minimum efficient scale - lowest level of output at which lowest average total costs are achieved. As output increases, average costs fall, and keep on falling even beyond the point where the entire market demand for the product is satisfied. This means it is extremely difficult for new firms to enter because monopoly firm is able to satisfy all the demand at the lowest price.

Barriers to entry: Branding

-Creation of a unique image by a firm. -Works through advertising campaigns that attempt to influence consumer tastes in favour of the product and establish consumer loyalty -If successful, can convince consumers of the products superiority, making them unwilling to switch to substitutes even if they may be qualitatively similar. -May work as an entry barrier making it difficult for new firms to enter the industry. -NOTE: branding need not lead to a monopoly but it is a method used by firms in monopolistic and oligopolistic competition. -Limits new competitors entering the market, e.g. cocacola, Nike, adidas

Concentration ratios have several weaknesses that limit their usefulness as a measure of the degree of competition:

-Does not consider firms from abroad who import. -Provide no indication of the importance of firms in the global market -do not account for competition from other industries, which may be important in the case of substitute goods, such as in the case of different metals. -do not distinguish between different possible sizes of the largest firms. For example, a three-firm concentration ratio of 90% could consist of three firms with 30% of the market each, or of three firms, one of which has 60% of the market and the other two have 15% each.

Explaining the kinked demand cruve

-Each firm perceives the demand curve it faces to be elastic for prices above P1 and inelastic for prices below P1. -If one firm raises its price above P1, the others will not follow; if it lowers its price below P1, the others will match the price decrease. In either case, the firm will be worse off. -Therefore, no firm takes the initiative to change its price, and they all remain 'stuck' at point Z for long periods of time.

Benefi ts of oligopoly

-Economies of scale can be achieved -Product development and technological innovations can be pursued due to the large economic (supernormal) profits - This benefit of oligopoly is more important than in the case of monopoly, since non-price competition forces firms to be innovative in order to increase their market share and profits. -Technological innovations that improve efficiency and lower costs of production may be passed to consumers in the form of lower prices Over and above the benefits of oligopoly that are similar to monopoly, oligopoly also offers the following advantage: • Product development leads to increased product variety, thus providing consumers with greater choice (monopoly does not offer product differentiation and variety).

3 important points illustrated by the kinked demand curve

-Firms that do not collude are forced to take into account the actions of their rivals in making pricing decisions (interdependence) Otherwise they risk lowering their revenues and profits, which in turn could lead to price instability. -Even though the firms do not collude, there is still price stability. Firms are reluctant to change their price because of the likely actions of their rivals, which could result in lower profits for the firm initiating price changes. -Firms do not compete with each other on the basis of price. They do not try to increase their sales by attracting customers through lower prices. A lower price not only invites price cuts by rivals, with resulting lower profits for all the firms, but also risks setting off a price war if some firms overreact with price cutting.

Explaining the kinked demand curve

-Imagine three firms, A, B, and C, each producing output Q1 and selling it at price P1; this price-quantity combination is point Z at the kink of the demand curve. why does the demand curve facing them have the kink? Firm A considers a price change, but before changing its price, it tries to predict how firms B and C will react. Firm A's reasoning is as follows: -If A raises price, what will • B and C do? They are unlikely to increase their price, because if they continue to sell at P1, many of my customers will leave me and start buying from B and C. Therefore, B's and C's market share will increase, and A will fall. I should therefore not increase my price. A demand curve is relatively elastic above P1, and A profits may fall (though not all customers will leave me because of differentiated product). -If A drop price, what will B and C do? They are likely to drop their price as well, because if they do not, A will capture a large portion of their sales, and will be better off at their expense. But if they drop their price, A will capture only a small part of their market shares. A's demand curve is relatively inelastic below P1, because for any price decrease A will have only a small increase in sales and revenues, and profits may fall. A should therefore not drop my price. -A should therefore not change my price, and should continue selling at P1.

Lack of competition in monopoly may lead to higher costs (X-inefficiency)

-In perfect comp there is constant pressure to produce at the lowest possible cost to survive -in monopoly the lack of competition can make the monopolist less concerned about keeping costs low. -Higher costs could arise due to: poor management a poorly motivated workforce lack of innovation lack of use of new technologies. This is known as X-inefficiency,defined as producing at a higher than necessary ATC. This is a separate issue from the lack of productive efficiency. Lack of productive efficiency means that while the firm does not produce at the point of minimum ATC, it does produce at some point on the ATC curve. X-inefficiency indicates that the firms' costs are higher than ATC, shown in Figure 7.17.

Obstacles to forming and maintaining cartels 1

-Incentive to cheat - firms may secretly offer lower price or other concessions to customers increasing their profits at the expense of the other firms. If cheating is discovered it puts the cartel in danger of collapse -Cost differences between firms-different firms have different costs. Output will not equate to every firms MC=MR profit maximising output. Difficult to agree where to set the price and how much each firms produces. -Firms face different demand curves -due to different market shares and product differentiation, making agreeing on common price difficult. -Number of firms - more firms, more difficult to agree on price and output allocation. -Possibility of a price war -possible outcome of one or more firms cheating on the cartel agreement. Other firms will retaliate and go lower and they will all be worse off

Another type of informal collusion

-Informal agreements -Firms agree to use a rule for co-ordinating prices such as limit pricing -limit pricing - firms informally agree to set a price that is lower than the profit-maximising price, thus earning less than the highest possible profits and so discouraging new firms from entering the industry. With limit pricing, firms may end up sacrificing some profit in order to avoid attracting new firms into the industry.

Profit maximisation by the monopolist: when do they continue producing?

-Just as in perfect competition, the loss-making monopolist continues to produce in the short run as long as its losses are smaller than its fixed costs (P > minimum AVC). -In the long run (when all resources are variable), the loss-making monopolist is likely to shut down or move its resources to another more profitable industry. -Distinction between long and short run is not as big in monopoly as in perfect competition. -In perfect competition, the distinction between the short and long runs is of crucial importance because as firms enter and exit an industry in the long run, economic (supernormal) profits and losses disappear, and firms are left with normal profits in their long-run equilibrium. This is not possible in monopoly, due to the presence of barriers to entry.

Legislation to reduce monopoly power

-Legislation to protect competition -Legislation in the case of mergers

The monopolist's revenue curve continued

-MR<D because unlike perfect comp when MR = P, the firm must lower price to sell more output. The lower price is charged not only for the last unit of output but all the previous units of output sold. Even the people who were willing to pay the higher price get to pay the lower price when the price is lowered Marginal revenue, or the extra revenue from selling an additional unit of output, is therefore equal to the amount of the price of the last unit sold minus what is lost by selling all the other units of output at the now lower price. (in basic words: everyone gets to pay the lower price, not just the additional people who demanded the good after the price fall)

Comparison of Monopolistic competition and monopoly 2

-Market power - Monopoly has more power because no substitutes -Allocative and productive efficiency - Both face downward-sloping demand curves, and therefore both have MR curves that lie below the demand curve. This means that at the profit-maximising level of output (found by MR = MC), P > MC for both (i.e. no allocative efficiency). Also, ATC is higher than minimum ATC at the point of production for both (i.e. no productive efficiency). -Competition and costs - More firms in monopolistic comp causes downward pressure on price, and inefficient producers leave. No price pressure for monopoly. -Economies of scale - much greater potential for monopoly -Research and development - monopoly can earn profit in the long run to fun R&D. Pressures of competition faced by monopolistically competitive firms may induce them to pursue R&D for product development in order to maintain/increase their sales.

Short-run profit maximisation based on the marginal revenue and marginal cost rule

-Market revenue vs marginal cost to determine profit maximising level of output: A firm that wants to maximise profit produces at where MR=MC -Average revenue and average total cost to determine amount of profit per unit: Comparing AR - AC = profit. Can also be calculated as shown in the photo.

Barriers to entry: Control of essential resources

-Monopolies can arise from ownership or control of an essential resource. e.g. South African diamond mining firm DeBeers mines roughly 50% of of the world's diamonds and purchases about 80% of diamonds sold on open markets. -Not the sole supplier but able to have significant control over the price due to large market share -another example - professional sports leagues create a local monopoly by signing long-term contracts with the best players and securing exclusive use of sports stadiums. -local monopoly - a single producer/supplier within a particular geographical area. -Local monopolies appear more commonly than national or international ones. For example, a local grocery store in a residential area located some distance from any other stores may be a local monopoly.

Criticisms of oligopoly

-Neither productive nor allocative efficiency is achieved. -Higher prices are charged and lower quantities of output are produced than under competitive conditions. -There may be higher production costs due to lack of price competition (X-inefficiency). -In addition, there is a further argument against oligopoly: • Whereas many countries have anti-monopoly legislation that protects against the abuse of monopoly power, the difficulties of detecting and proving collusion among oligopolistic firms means that such firms may actually behave like monopolies by colluding and yet may get away with it.

Comparison of Monopolistic competition and perfect competition

-Number of firms - Both structures are similar if they have a large number of firms -Free and entry and exit -both structures -Normal profit in the long run, supernormal profit or loss in the short run - both structures -Market power and the demand curve - perfect comp has no power, they take the market price. Perfectly elastic D curve. monopolistic competition have some power, hence the sloping D -Productive and allocative efficiency - perfectly competitive firm achieves both in the long run. monopolistically competitive firm achieves neither Production is not at minimum ATC, consumers pay more. MB>MC -Excess capacity - monopolistic competition produces a lower level of output than that where ATC is minimum, and therefore has excess capacity -Product variety-in perfect competition produce the identical product, under monopolistic competition firms go to great lengths to differentiate their products. -Economies of scale - Firms in perfect competition cannot achieve economies of scale because they are very small. Firms in monopolistic competition may have some small room for achieving economies of scale but only to a relatively small degree as these firms also tend to be relatively small.

Comparison of Monopolistic competition and monopoly 1

-Number of producers - monopoly is a single firm -Size of firms - in monopolistic comp, many small firms. Monopoly is one big firm. -Barriers to entry. Monopolistic competition is characterised by free entry and exit, whereas in monopoly there are high barriers to entry. -Normal and economic profits - monopoly can earn economic (supernormal) profits due to high barriers to entry that prevent new entrants from entering the industry. -Competition and prices - Free entry and exit under monopolistic competition drive economic profits down to zero in the long run, and allow prices to be lower for the consumer than is possible under monopoly, where barriers to entry allow the firm to maintain profits over the long run.

The role of non-price competition in oligopoly

-Oligopolistic firms go to great lengths to avoid price competition (unlike monopolistic comp). -Careful not to trigger a price war because this makes all firms worse of - lower price, lower profit. - A price war may even lead to prices lower than average costs, leading to losses for the firms. Firms in oligopoly are better off co-ordinating their pricing behaviour where they can, and when they do not collude they still avoid competitive price-cutting. -Usually engage in non-price competition, involving efforts by firms to increase market share by methods such as advertising and branding

What if P is not equal to MC? - allocative inefficiency

-P > MC, an additional unit of the good is worth more to consumers than its costs to produce. There is an underallocation of resources to its production, and consumers would be better off if more of it were produced. - If P < MC, an additional unit of the good costs more to produce than it is worth to consumers; there is an overallocation of resources to the good, and consumers would be better off if output were reduced.

Barriers to entry: Legal Barriers

-Patents - Rights given by the gov to a firm that has developed a new product. Gives them the right to be a sole producer for a specific period of time. For that period of time, that firm has a monopoly on the product. -Licences - granted by the gov for particular professions or industries. e.g license for medicine, architecture, law. These do not prevent monopoly, but limit competition -Copyrights - guarantee that an author (or an author's appointed person) has the sole rights to print, publish and sell copyrighted works -Public franchises - granted by the government to a firm which is to produce or supply a particular good or service. -Tariffs, quotas and other trade restrictions - limit the quantities of a good that can be imported into a country, thus reducing competition

Allocative inefficiency: loss of consumer and producer surplus

-Perfectly competitive industry achieves allocative efficiency shown by MB = MC and maximum social surplus, monopoly does not. -In perfect competition Consumer surplus (sect A) is greater the in monopoly (C). In monopoly part of A is converted into producer surplus due to the higher monopoly price. Another part was lost (Part E) as welfare loss because the Quantity supplied is lower than what is demanded at market equilibrium. -Area D is the surplus the producer has taken from the consumer due to the higher price. Producer surplus has also fallen by part F (welfare loss) due to the lower quantity being sold -E + F represents loss of social benefits (consumer and producer surplus) due to monopoly's higher price and lower quantity.

Why a monopoly may be desirable

-Product development and technological innovation -Possibility of greater effi ciency and lower prices due to technological innovations -Economies of scale

Obstacles to forming and maintaining cartels 2

-Recessions-during recession firms have a stronger incentive to lower prices and cheat on the agreement, endangering the survival of the cartel -Potential entry into the industry -If cartel is successful, it will make large economic profits, encouraging entry of new firms into the industry. New entrants, increased supply, lowered price and profit. The cartel's long-run survival therefore depends on high barriers to entry that block potential new entrants. -The industry lacks a dominant firm- A dominant is like a leader and helps form the agreement. e.g. in OPEC, the dominant member of the cartel is Saudi Arabia, which is also the largest producer of oil among all the members. The lack of a dominant firm makes agreement among the cartel members more difficult to reach.

Barriers to entry: Economies of scale

-Results in a downward sloping curve of a firms LRATC permitting lower average costs as the firm grows in size - Barrier to entry exists when economies of scale are extensive. LRATC declines over a very large range of output. - SRATC of a large firm (SRATC1) sits much lower than a small firm (SRATC2) -Large firm can lower costs, forcing smaller firms to sell at a price where they cant cover costs. This means new small firms cant enter the industry because they cannot compete with the large one. -Entering an industry on a large scale however would require huge start up costs.

Mutual interdependence has important implications for the behaviour of oligopolistic firms:

-Strategic behaviour -Conflicting incentives

This game illustrates many real-world aspects of oligopolistic firms

-Strategy interdependence - display strategic behaviour - actions based on what their rivals are likely to do -face conflicting incentives - incentive to collude and compete -become worse off as a result of price competition - price war -have a strong interest in avoiding price wars, because they realise that everyone will become worse off through price cutting - this creates a strong incentive for them to compete on the basis of factors other than price (non-price competition).

The demand curve facing the monopolist vs perfectly competitive firm continued

-The ability of a monopoly to adjust price is limited by the position of the market demand curve. -E.g. the monopoly can only choose a combination of price and quantity that is on the D curve. The cannot choose for example P2 and Q1. When they choose the price the quantity is automatically chosen

Third-degree price discrimination 2

-The condition that makes this kind of price discrimination profitable for a firm is that each consumer group must have a different PED -e.g. business travellers' demand for airline tickets is relatively inelastic (low PED), and therefore airline tickets are often more expensive if there is no stay-over on a Saturday night (on the assumption that business travellers are usually unwilling to stay overnight on a Saturday). -Children and elderly people have a more elastic demand (higher PED) for movies, transport etc. and are therefore charged a lower price -The firm's profit-maximising strategy in third-degree price discrimination is illustrated in Figure 7.26

Perfect competition is based on the following assumptions

-There is a large number of firms -All firms produce identical or homogenous products -There is free entry and exit. -There is perfect (complete) information. -There is perfect resource mobility. Some industries meet these assumptions more than others.

Monopoly: assumptions of the model

-There is a single seller or dominant firm in the market -The firm is assumed to be the entire industry. In the real world they just dominate a large part of the industry -There are no close substitutes - Consumers are unable to easily switch to consuming other firms good. -There are significant barriers to entry - The monopolist owes its dominance in the market and the absence of competitor firms partly to the inability of other firms to enter the industry.

Assumption of an oligopoly

-There is a small number of large firms. -There are high barriers to entry - same as monopoly due to things like economies of scale -Products produced by oligopolistic firms may be differentiated or homogeneous -There is mutual interdependence-decisions taken by one firm affect other firms in the industry. If any one firm changes its behaviour, this can have a major impact on the demand curve facing the other firms. Therefore, firms are keenly aware of the actions of their rivals.

Criticisms of the monopolistic competition model

-This model suggests that firms make decisions only on quantity of output and price because the MC=MR rule is used. It does not account for the fact that non-price competition may be part of the decision. -In the real world, entry into the industry may not be as free as the model suggests, and this is another factor leading to some monopoly power. -in view of product differentiation, it is not possible to derive an industry demand curve, as each product is different from the others. Therefore, we can only examine monopolistic competition at the level of the firm.

Evaluating perfect competition -Limitations of the model w explanation

-Unrealistic assumptions. -Limited possibilities to take advantage of economies of scale -In perfect competition the requirement that the firms are many and small prevents them from growing to a size large enough to take advantage of economies of scale. -Lack of product variety - homogenous products are a disadvantage for consumers who like variety -Waste of resources in the process of long-run adjustment -the model unrealistically assumes there are no costs of adjustment. When people continually enter and leave, resources are wasted - Limited ability to engage in research and development -The lack of economic profits in the long run does not offer firms the necessary funds to pursue research and development -Market failure-there are numerous real-world situations where resources are allocated inefficiently because of market failures

Evaluating perfect competition -Limitations of the model

-Unrealistic assumptions. -Limited possibilities to take advantage of economies of scale. -Lack of product variety. -Waste of resources in the process of long-run adjustment. - Limited ability to engage in research and development. -Market failure.

Price discrimination -The single-price firm versus the price discriminating firm

-firms often find that they can increase their profits by selling their product at different prices. -Price discrimination is the practice of charging a different price for the same product to different consumers when the price difference is not justified by differences in costs of production. (If price differences are due to differences in a firm's costs of production, then they do not qualify as 'price discrimination'.)

The monopolist's output and price elasticity of demand

-in the range of output where TR is increasing and MR is positive, the demand curve facing the firm (P = AR) is price elastic (PED > 1) -When TR is falling and MR is negative, PED<1 -When demand is elastic, price and total revenue change in opposite directions. E.g. as price falls from €12 to €6, TR rises -When demand is inelastic, price and total revenue change in the same direction e.g. after €6 where PED<1 (inelastic) -Total revenue is maximum, and MR = 0 where PED = 1. The monopolist will not produce any output in the inelastic portion of its demand curve (which is also its average revenue curve).

Profit maximisation by the monopolist: Profit maximisation based on the marginal revenue and cost approach

-same three-step approach used by the perfectly competitive firm 1) profit-maximising (or loss-minimising) level output using the MC = MR rule. 2)For that level of output, it determines profit per unit or loss per unit by using profit/Q=P −AT The diagrams show the standard ATC and MC curves as well as the monopolist demand and marginal revenue curves a) firm maximising profit: a line is drawn upward from where the MR=MC point = the D curve which is at the profit maximising level of output. b) firm minimising loss: a line is drawn upward from where the MR=MC point = the D curve which is at the loss minimising level of output.

Productive inefficiency, product differentiation and excess capacity (Monopolistic competition)

A firms capacity output is output at min ATC; the output level at which the firm's capacity is fully used In the diagram, the capacity output is Qc The difference between capacity output and profit-maximising output is called excess capacity; the amount of output that is lost when firms underuse their resources and produce an amount that does not minimise ATC If all firms produced at min ATC, the same total output could be produced by less firms and costs to society would be lower excess capacity results from product differentiation causing the the firm's downward-sloping demand curve. (Only if the demand curve were horizontal could it be tangent to the ATC curve at its minimum point, as in perfect competition.) Note that excess capacity is closely related to productive inefficiency: they are both the result of production at greater than minimum ATC. e.g. empty restaurant tables, empty hotel rooms Yet product differentiation leads to greater product variety. Because consumers enjoy product variety, it is often argued that monopolistic competition may not be as inefficient as appears at first sight, and that excess capacity may be the 'price' consumers pay for having greater product variety.

industry

A group of one or more fi rms producing identical or similar products is called an industry

monopoly

A market in which there are many buyers but only one seller. Complete control of a product or business by one person or group When there is a single firm producing a good or service for the entire market, it is called a pure monopoly. The firm is therefore the entire industry.

natural monopoly

A natural monopoly is a firm that has economies of scale so large that it is possible for the single firm alone to supply the entire market at a lower average cost than two or more firms. A natural monopoly is illustrated in Figure 7.13.

Why a monopoly may be desirable: Product development and technological innovation

A number of factors suggest that monopolies have good reasons to pursue innovation: -Economic profits allow them to finance R&D -Protection from competition due to high barriers to entry allows firms to enjoy the profits arising from their innovative activities (new inventions, new products, new technologies, etc.) - allows for patents to be awarded -Firms may use product development and technological innovation as a means of maintaining their economic profits over the long term, by creating barriers to entry for new potential rivals. e.g. by creating an innovative product that others can't produce

All firms produce identical or homogenous products

All products are identical no matter which firm produces them

Allocative and productive inefficiency

Allocative inefficiency: loss of consumer and producer surplus Allocative inefficiency: P > MC Productive inefficiency: production at higher than minimum ATC

Regulation of natural monopoly -average cost pricing pt 2

Although neither allocative nor productive efficiency are achieved through average cost pricing, this policy offers two very important advantages: (a) the monopolist makes normal profit (b) it is more efficient than the market solution. Disadvantages: If through regulation it is guaranteed a price equal to its average costs, it loses this incentive to produce at min cost and maximise profit. Even if average costs go up due to inefficiency, it will still receive a price covering its costs. The regulated monopoly may continue to survive as a monopoly, even though it may stop being a natural monopoly (if technological improvements change cost conditions). Continued regulation provides protection to the firm from new competitors that would have been able to produce more efficiently.

the loss-making firm that will not produce

As shown in the diagram, this firm has been forced to produce at a price that is below their AVC. If the price falls to this point, below the shut-down price, the firm should stop producing. If the firm were to keep producing, their loss would be between points c and d, which is greater than the AFC. They will be losing the AFC in addition to the AVC cost that is not covered by revenue. When price falls below the shut-down price, so that P < minimum AVC, the firm should shut down in the short run, and will make a loss equal to its fixed costs

Moving from short-run equilibrium to long-run equilibrium: Economic (supernormal) profit in the short run to normal profit in the long run

Assume that a perfectly competitive industry is in short-run equilibrium where each firm in the industry is earning economic (supernormal) profit Initial industry equilibrium in show in diagram b at 1. At this price, MC= MR at Q1 and as shown on diagram a, the firm earns supernormal profit. One the firm is in the long run, there is free entry and exit so more firms are attracted to the industry shifting supply to S2. This reduced price to break-even price and firms earn normal profit again.

oligopoly examples

Cable Television Services Entertainment Industries (Music and Film) Airline Industry Mass Media Pharmaceuticals Computer & Software Industry Cellular Phone Services Smart Phone and Computer Operating Systems Aluminum and Steel Oil and Gas Auto Industry

market structure

Characteristics of market organisation that influence the behaviour of firms within the industry. 4 economic market structures: -Perfect competition -Monopoly -Monopolistic competition -Oligopoly

The firms revenue curves

Consider a perfectly competitive firm who sells at $10 and is unable to change the market determined price. No matter how much output the perfectly competitive firm sells, P = MR = AR and these are constant at the level of the horizontal demand curve. This follows from the fact that price is constant regardless of the level of output sold.

Conditions for price discrimination - Different price elasticities of demand

Consumers must have different price elasticities of demand (PEDs) for the good. This is because consumers with a relatively low PED will be willing to pay a higher price for a good than consumers with a relatively lower PED. This will become clearer in the discussion that follows.

The demand curve (average revenue curve) facing the firm

Diagram a shows the equilibrium of demand and supply of the entire industry. This sets the price for all firms to sell at Pe. Demand seems to firms as it is shown in diagram 2. Demand seems perfectly elastic. Firms are forced to sell at Pe because if they sell above that price they will selling nothing, and if they sell below that price they gain nothing, but they do lose something. This is because demand is perfectly elastic at this price. There is no limit to how much is demanded at this price. The demand curve for a good facing the perfectly competitive firm is perfectly elastic (horizontal) at the price determined in the market for that good. This means the firm is a price-taker, as it accepts the price determined in the market.

Monopoly market outcomes and efficiency - Higher price and lower output by the monopolist compared to the industry in perfect competition

Diagrams show the long run situation of a perfectly competitive industry vs a monopoly -Price is higher and quantity of output produced lower in monopoly. -For the monopoly MR lies below D, where as perfectly competitive firm MR = D

Tacit/informal collusion: price leadership and other approaches

Difficulties involved in making and maintaining cartels, such as their illegality can result in informal collusion. -Tacit collusion (or informal collusion)- cooperation that is implicit or understood between the co-operating firms, without a formal agreement. -objectives - co-ordinate prices, avoid competitive price-cutting, limit competition, reduce uncertainties and increase profits. Also attempts to bypass the obstacles created by the illegality of formal collusion (cartels).

Barriers to entry:

Economies of scale Branding Legal Barriers Control of essential resources Aggressive tactics

Why a monopoly may be desirable: Economies of scale

Economies of scale lead to falling average costs over a large range of output and firm scale. When a monopoly can achieve substantial economies of scale, it is even possible that its lower costs will permit price and output levels that approach those of a perfectly competitive industry. Perfectly competitive firms are then too small to achieve economies of scale, shown in the diagram. Consumers gain from economies of scale because lower costs of production mean lower prices, and increased quantity of output. Society as a whole also gains because lower costs of production mean increased efficiency in the use of resources. A perfectly competitive firm, due to its very small size, cannot capture economies of scale.

Natural monopoly examples

Examples of natural monopolies include water, gas and electricity distribution, cable television, fire protection and postal services.

Allocative inefficiency: P > MC

Figure 7.16 shows the long-run equilibrium position of the firm in perfect competition and monopoly. -The condition for allocative efficiency is given by P = MC at the profit-maximising level of output. -P > MC is the same as MB > MC (since P = MB), therefore monopoly does not achieve allocative efficiency, but perfect competition does In monopoly the underallocation of resources to the good is indicated also by P > MC at the profit maximising level of output.

Key objective of a cartel

Firms can gain monopoly power and increased profits. However, cartels are illegal in most countries, as they restrict competition and are therefore against consumers' and society's best interests.

The monopolist's revenue curve

For a perfectly elastic firm (a price taker), demand is perfectly elastic because price is constant for all output. When a firm faces a downward-sloping demand curve, price is no longer constant for all output: more output can only be sold at a lower price. -As price falls, quantity rises. TR (QxP) rises until output of 6-7 units, then falls. -Marginal revenue falls continuously. MR=0 when TR=Maximum. MR become g=negative when TR falls -AR = P -The AR and P curves represent the demand curve facing the firm.

Elements of competition and monopoly

Has elements of both competition and monopoly Like perfect comp because there are many firms in the industry and there is freedom of entry and exit. like monopoly because of product differentiation Each firm in an industry is a 'mini monopoly' in the specific version of the good that it produces. For example, Adidas is a monopoly in Adidas® shoes, NIKE is a monopoly in NIKE® shoes Downward sloping curve for their good, however it is relatively elastic because these shoe brands are substitutes for eachother. more elastic than in monopoly, but less elastic.

Homogeneous products

Homogeneous products are fewer; examples include oil, steel, aluminium, copper, cement

Barriers to entry: Aggressive tactics

If a monopolist is confronted with the possibility of a new entrant into the industry, it can create entry barriers: cutting its price advertising aggressively threatening a takeover of the potential entrant other behaviour that can dissuade a new firm from entering the market.

Profit maximisation for price-takers in the short run

Important to note that in the short run since at least one input for the good is fixed, it means that the amount of firms producing that good in the short run is fixed. (To enter or leave the industry the firm must be able to vary all inputs) How does a firm maximise its profit in the short run? Since it is a price-taker the firm cannot influence price. This means it can only adjust profit by changing its output

The roles of price and non-price competition

In general, the more differentiated the product is from its substitutes: -the more successful the advertising and branding as methods of convincing consumers about the superiority of a product - the less elastic will be the demand curve facing the firm -the greater the monopoly power (the ability to control price) -the larger the firm's potential to increase short-run economic profits. Monopolistically competitive firms compete with each other on the basis of both price and nonprice competition. Some firms may be more successful by raising sales through price competition, while others may be more successful by raising sales through non-price competition

Why is the demand curve in monopolistic competition in between monopoly and perfect comp

In perfect competition, if a fi rm raises its price, it loses all its sales to its competitors. In monopoly, if a firm raises its price, it loses some but not all sales, as it is the sole producer of the good and consumers have no alternative product they can buy . In monopolistic competition, if a firm raises its price, it will lose more sales than the monopolist, because consumers now do have substitutes they can switch to; but it will lose fewer sales than the perfectly competitive firm because of product differentiation - the available substitutes are not perfect substitutes, as they are in perfect competition.

Profit maximisation in the long run : Normal profit

In the long-run equilibrium of the perfectly competitive market structure, all firms earn zero economic profits (they earn normal profit). If firms are making economic profit, in a way they are getting free money. This means lots of people may be attracted to the industry. This will increase supply, lowering price until the profit goes back to 0. Profit could go below 0, but since it is easy for firms to leave, they will. In the long run, earning supernormal profit or making a loss causes firms to enter or exit the industry. This means short run profits and losses will tend toward zero. Price returns back to Pe which equals the firms short and long run ATC where each firm earns normal profit. Each firm produces Qf and the whole industry produces Qi

Normal profit in the long run - monopolistic competition diagram

In the short run, there may be profit and loss but this causes firms to enter or leave the market, returning firms to normal profit. (When D is tangent to ATC) MR = MC, P = ATC economic profit is zero and each fi rm is earning normal profit.

Efficiency in monopolistic competition: Allocative and productive inefficiency

In this diagram, neither allocative or productive efficiency is reached. - Allocative efficiency- P = MC - Productive efficiency - production takes place at minimum ATC Comparing price with marginal cost along the vertical line at the equilibrium level of output, Qe, we can see that price is higher than MC, indicating that there is an underallocation of resources to the production of the good: society would have liked to have more units of the good produced. Also, production occurs at greater than minimum average total cost, and therefore average cost is higher than what is optimal from society's point of view

There is a large number of firms

Large number means that each firms output is small in relation to the size of the market. Also means that firms act independently of each other and their actions do not impact each other.

MC = P

MC = opportunity cost of the resources used to produce one extra unit of the good.

Loss minimisation in the short run

Market price falls below minimum ATC and the firm does not earn enough revenue to cover all costs. The firm is making negative profit. This is the point where MC=MR therefore, Q3 is the firm's loss-minimising output. ATC - P3, (or the diff between c and d) represents the loss per unit output. Should the firm keep running? We have to remember that the firm is in the short run. If the firm stops producing, they will have no variable costs or revenue. They will however have fixed costs that still need to be paid off such as interest payments on loans, insurance payments and rental payments. These must still be paid; if the firm stops producing at this point their loss is equal to their fixed costs.

disadvantages of monopoly - Efficiency

Monopolies fail to achieve allocative efficiency shown by P>MC. There is a welfare loss because price is high and quantity output is lower than desired by consumers. MB > MC, consumers want more than is provided. - Under allocation of resources to the good. Fails to achieve productive efficiency. Production takes place above min ATC Finally, the absence of competition faced by the monopolist may lead to X-inefficiency (Lack of competition in monopoly may lead to higher costs)

Monopoly vs perfect competition

Monopoly lies at the opposite extreme of market structures to perfect competition. Monopoly has: -No comp from other firms -Substantial market power

Legislation and regulation to reduce monopoly power: an evaluation

Monopoly may have some advantages but it is agreed that it has more disadvantages. Most countries do not encourage monopolies. If there are natural monopolies, these are usually owned or regulated by the government, so that they will not be permitted to engage in behaviour that goes against society's interests.

Legislation to reduce monopoly power-Legislation to protect competition

Most countries have laws that try to promote competition by preventing collusion between oligopolistic firms in order to: -restrict competition between them -to prevent anti-competitive behaviour by a single firm that dominates a market. The objective of the legislation: to prevent monopolistic behaviour, thus promoting allocative efficiency A well-known example of a single firm accused of anti-competitive behaviour is Microsoft, found guilty of restricting consumer choice and preventing competitor firms from selling operating systems, thus maintaining its operating systems monopoly. Firms that are found guilty of anticompetitive behaviour are usually asked to pay fines (as in the case of Microsoft), or may be broken up into smaller firms.

Why would a firm continue running if they are earning negative profit?

Need to sell to make some money to cover the cost of fixed inputs. Because this is only in the short run when costs are fixed, in the long run they may be able to earn normal or supernormal profit.

Efficiency and perfect competition in the short run

Neither the profit-making nor the loss making firm achieves productive efficiency in the short run, because ATC is higher than minimum ATC at the level of output where they produce. Only if the firm is in diagram b earning normal profit will it be productively efficient. This is because short run equilibrium is equal to long run equilibrium. In the short run, the perfectly competitive firm achieves allocative efficiency but is unlikely to achieve productive efficiency.

What makes perfect competition demand curve flat?

No close substitutes therefore inelastic

Non price competition

Non-price competition - when firms use methods other than price reductions to attract customers from rivals. The most common forms of non-price competition are product differentiation (such as physical and quality differences, packaging, services provision, location, etc.), advertising and branding (creating brand names for products). Monopolistically competitive firms engage heavily in product differentiation through R&D in product development, advertising and branding Allows them to increase monopoly power and raise price without a great risk of losing consumers

There is free entry and exit

Nothing is stopping firms from entering or leaving. If firms are making economic profit, in a way they are getting free money. This means lots of people may be attracted to the industry. This will increase supply, lowering price until the profit goes back to 0. Profit could go below 0, but since it is easy for firms to leave, they will.

Explaining the appearance of short-run profits and losses

Once an industry and its firms find themselves in a position of long-run equilibrium, they will remain there indefinitely until something from outside the system causes a disturbance. If a disturbance occurs, firms find themselves in situations making economic profits or losses, as portrayed in Figure 7.6 (a) and (c). What factors could cause disturbances? -Changes demand -Changes in technology or resource prices

zero economic profit (normal profit) in the short run and the break-even price

P1 falls to P2. Applying MC=MR, profit maximisation level is at Q2. At this point P=ATC and therefore there is zero economic profit. When there is zero economic profit, price = minimum ATC. this is called the break even point. Revenue = Explicit + implicit costs Making a normal profit

loss in the short run and the short-run shut-down price

P= AVC is called shutdown price. If the firm keeps producing, they are only earning revenue to cover variable costs, and the loss is unchanged. Loss per unit is still equal to AFC The price P = minimum AVC is the fi rm's shut-down price in the short run. At this price, the firm's total loss is equal to its total fixed cost.

Efficiency and perfect competition in the long run

Part a shows the firm is earning normal profit. This means that in the long run the perfectly competitive firm achieves both allocative and productive efficiency. At the profit-maximising level of output, Qe, P = MC, and ATC is minimum. Part b illustrates how the firms efficiency corresponds to the efficiency at the level of the industry. Pe = MC = MB and consumer and producer surplus is at a max

Advantages and disadvantages of monopoly compared with perfect competition - R&D

Perfect competition: No incentive for R&D. No economic profits in long-run equilibrium to finance R&D. They sell homogeneous products and therefore are not interested in product development that would differentiate their products . They are unable to create barriers to entry as they are too small and so have no incentive to engage in R&D. Monopolies: have economic profits they can maintain over the long run, and this gives them the financial resources they need to pursue R&D. They also have incentives to engage in new product development and innovations because of patent protection that maintains their monopoly power. Possibilities that new innovations may create barriers to entry that will contribute to the maintenance of their monopoly power. However, the opposite may also occur. High barriers to entry, shielding monopolies from competition, could make them less likely to innovate than smaller firms, which are constantly under pressure to innovate in order to maintain or increase their share of sales in the market.

Examples of patents

Pharmaceutical products, polaroid and instant cameras, intel and microprocessor chips used by IBM computers

Advantages of perfect competition - Efficiency

Possibility that innovations in the area of new technology development may lower their costs of production leading to increased efficiencies. Perfectly competitive firms achieve both allocative and productive effi ciency in long-run equilibrium (and allocative effi ciency in short-run equilibrium). they are less likely to display X-ineffi ciency because they are under continuous pressure to lower their costs due to the presence of many competitor firms.

Allocative inefficiency: loss of consumer and producer surplus , Part 2

Presence of welfare loss means that MB and MC are no longer equal. At the point of monopoly production, Qm, MB>MC signalling that there is an under allocation of resources to the good

Advantages and disadvantages of monopoly compared with perfect competition

Price and output - monopolist produces a smaller quantity of output and sells it at a higher price than a perfectly competitive industry. Efficiency - explained in next flashcards Research and development (R&D) - explained in next flashcards Economies of scale - Perfectly competitive firms are unable to achieve this because they are too small. Monopolies can take advantage of economies of scale, and may use these to create a barrier to entry of new firms (by lowering their costs, thus their prices)

Price competition

Price competition - when a firm lowers its price to attract customers away from rival firms, thus increasing sales at the expense of other firms.

Why do MC and MR determine profit maximising level?

Q1 is the profit maximising point because MC have not exceeded MR. This is the greatest output level where MC does not exceeded MR

Why a monopoly may be desirable: Economies of scale diagram

Qm and Pm are the output and price of the standard monopolist, and Qpc and Ppc are the output and price of the perfectly competitive industry. Suppose the monopolist succeeds in achieving significant economies of scale, so its costs fall, and its MC curve shifts downward to MCes. MCes = monopolist's MR curve determines the profit-maximising level of output, Qpc, which is identical to that of the perfectly competitive industry. Monopolist sells output Qpc at price Ppc, which is the price of the perfectly competitive industry. Note that if the MCes curve were even lower, then the monopolist would produce a larger quantity of output and sell it at a lower price than the perfectly competitive industry.

Supernormal profit

Revenue - (Explicit + implicit costs)>0 If firms are making economic profit, in a way they are getting free money. This means lots of people may be attracted to the industry. This will increase supply, lowering price until the profit goes back to 0. Profit could go below 0, but since it is easy for firms to leave, they will. Therefore supernormal profit may not last long.

The demand curve facing the monopolist vs perfectly competitive firm

Since the pure monopolist is the entire industry, the demand curve it faces is the downward-sloping industry or market demand curve Perfectly competitive firm faces perfectly elastic demand at the price level determined in the market the perfectly competitive firm is a price-taker with zero market power monopolist is a price-maker with a significant degree of market power. All firms other that are not perfectly competitive have a downward sloping demand curve, and varying degrees of price changing ability. Monopolistic firm has the greatest ability.

Open/formal collusion: cartels - diagram

Suppose the firms of an industry decide to form a cartel by fixing price, we have this diagram. This is the exact same as how the monopolist maximises profit. D and MR are for the entire industry. The MC curve is the sum of all the MC curves of all the firms in the cartel. Profit maximising output of the cartel is found by MR=MC. How do they decide which firm produces how much? One way this can be done is to agree on what share of the market each firm will have based on historical market shares. Another way is that firms may agree to compete with each other for market shares using non-price competition (product differentiation and advertising).

Calculating the revenue-maximising level of output

TR is at a max when MR=0 Therefore revenue maximising output is 7

Revenue maximisation by the monopolist: Comparing revenue-maximisation with profit maximisation

TR is at a max when MR=0 This shows that the Revenue maximiser produces a greater output at a lower price than the profit maximiser who produces where MR=MC. (Pr and Qr are revenue maximiser values and the other ones are profit maximising values)

Normal profit in the long run - monopolistic competition

The assumption of free entry and exit of firms in the industry is very important in determining the long-run equilibrium of the firm (just as in perfect competition).

Cartel example

The best-known example of a cartel is OPEC (Organization of the Petroleum Exporting Countries), composed of a group of 13 oil-producing countries. OPEC periodically tries to raise the world price of oil by cutting back on its total output. Each member country is assigned an output level (quota) that it is permitted to produce. The restricted quantity of oil results in a higher price.

Productive inefficiency: production at higher than minimum ATC

The condition for productive efficiency is that production takes place at minimum ATC Therefore perfect comp firm is efficient but monopoly is not. At Qm, the monopolist's average total costs (ATC) are higher than minimum ATC; therefore, there is productive inefficiency

Natural monopoly: falling average costs

The falling average costs over a very large range of output often occur because of very large capital costs (such as laying pipes for water distribution, or laying cables for electricity distribution, or putting a satellite into orbit). A natural monopoly may stop being natural if new technologies allow other firms to produce at the lower price. This means that the firm is no longer a natural monopoly because they have to compete with new low cost firms.

Regulation of natural monopoly

The gov can step in to regulate a monopoly by: -Marginal cost pricing -Average cost pricing If there is a natural monopoly, it is not in society's interests to break it up into smaller firms, as this would result in higher average costs and would be inefficient. Therefore, governments usually regulate natural monopolies, to ensure more socially desirable price and quantity outcomes. the diagram shows a natural monopoly. The demand curve intersects the ATC curve before ATC reaches its minimum, indicating that economies of scale have not been full exhausted. MC=MR at Qm where price is Pm

Economic loss in the short run to normal profit in the long run

The market decides on equilibrium Price P1 and loss minimising quantity is where MC=MR which is at Q1. In the short run firms are unable to leave the industry but in the long run they can. Once firms leave the industry, supply falls, price rises until firms losses = 0 (where P= minimum ATC)

Monopoly and olligopoly - changing the

The term monopoly power, which refers to the ability of a firm to set prices, applies not only to monopoly, but also to oligopoly. Oligopolistic firms sometimes act together (or 'collude'), usually illegally, to acquire greater monopoly power. If this works, then together they can work as a monopoly. Legislation to reduce monopoly power applies not only to monopolies but also to fi rms that try to behave like monopolies.

what is better about monopolistic competition (than monopoly)

There is incentive to improve the product, where as monopoly has no incentive because no competition product variety

Short-run equilibrium under perfect competition

These short-run firm equilibrium positions for the firm and for the market hold and will continue to hold, ceteris paribus. The reason is that firms in the short run cannot change their fixed resources, and so if nothing else changes (market demand, resource prices, the technology of production, etc.), the firms will continue to produce at the equilibriums in the previous card, earning super normal, normal profit or making a loss

There is perfect (complete) information

This ensures that no firm has access to information not available to others that would allow it to produce at a lower cost compared to its competitors. Also, it ensures that all consumers are aware of the market-determined price, and would therefore not be willing to pay a higher price for the product

The break even price in the long run

This is the same in the short and long run This point is where P = minimum ATC =

There is perfect resource mobility

This means that they can easily and without any cost be transferred from one firm to another, or from one industry to another.

P=MR=AR

This result holds only for firms operating under perfect competition, because these are the only firms that have no control over price and are forced to sell all their output at the single price determined in the market. This is shown in diagram a where TR increases at a constant rate Diagram b shows that Since price is constant at €10, P = MR = AR, and they all coincide with the horizontal demand curve

Regulation of natural monopoly -average cost pricing Pt 1

To avoid creating losses for the natural monopolist, governments can force the fi rm to charge a price equal to its average total costs (P = ATC). This is known as average cost pricing. Occurs where D intersects ATC at point e. Average cost pricing results in a higher price and lower quantity than marginal cost pricing, indicating that it is not as efficient as marginal cost pricing The result mayn't be fully efficient but it is far superior to the price-quantity combination achieved by the market for the unregulated monopoly. (compare Qm and Pm to Qac and Pac) AKA fair return pricing, because the monopolist is forced to earn normal profit. When the monopolist is forced to produce where P = ATC, it is not achieving productive efficiency (not at min ATC). This cannot happen in a natural monopoly, since the demand curve cuts ATC to the left of minimum ATC.

When the loss-making firm exits the market in the long run

We have just seen that the price P2 is again the break-even price, but note that P2 is also the shutdown price in the long run. In other words, in the long run, the break-even price and the shut-down price are the same. The reason is that in the long run, any loss-making firm facing a price lower than minimum ATC will shut down and leave the industry.

profit maximisation and economic profit in the short run

When a market price is P1, P1=MR1=AR1=D1 The intersection of MC and MR, where MC=MR determines profit maximisation level. Since P1>ATC, the firms profit per unit = P1-ATC. This is represented by the vertical distance between P1 and ATC which is equal to a minus b Total profit is shown by the shaded area When P > ATC at the level of output where MC = MR, the firm earns positive economic profit (supernormal profit).

Productive (technical) efficiency

When production is at minimum ATC, this means that resources are being used economically and are not being wasted.

Monopoly power arises whenever...

a firm faces a downward sloping demand curve Firms in all market structures except perfect competition face a downward sloping demand curve and therefore have varying degrees of monopoly power

Game theory

a mathematical technique analysing the behavior of decision-makers who are dependent on each other, and who use strategic behaviour as they try to anticipate the behaviour of their rivals. -Can illustrate the characteristics of mutual interdependence, strategic behaviour, and conflicting incentives

firm (or business)

an organisation that employs factors of production to produce and sell a good or service.

collusion

conspiracy; secret cooperation an agreement between firms to limit competition between them, usually by fixing price and therefore lowering quantity produced

Short-run equilibrium under perfect competition (diagrams)

each represent a short run equilibrium position for an individual firm in a perfectly competitive market structure Each firm equilibrium also corresponds to a market equilibrium of demand and supply.

Strategy interdependence

firms are mutually interdependent - what happens to the profits of one firm depends on the strategies adopted by other firms

Example of extra capacity in relation to ATC

for example on a plane the average total cost is total cost/ total output. Total output is the total amount of seats BEING USED Therefore, the more empty seats, the lower the denominator and the higher the ATC Why wouldn't the airline just lower the price to fill the capacity? People would think that they will continue to drop the price and then just wait to pay the lower price. For example no one buys kathmandu when its at full price

Implications of monopolistic competition:

if consumers can be convinced that the product they are purchasing (for example, Puma® shoes) is superior to the available substitutes such as Nike; This means puma has established a mini monopoly.

Differentiated products

pharmaceuticals, cars, aircraft, breakfast cereals, cigarettes, refrigerators and freezers, cameras, tyres, bicycles, motorcycles, soaps, detergents.

pi symbol is a symbol for

profit

Continuation of Loss minimisation in the short run

remember the firms objective is to make losses as small as possible. Since the revenue that the firm is making is enough to cover variable costs as well as a small portion of fixed costs, they can minimise their loos by continuing to produce. Therefore : it is better to produce rather than shut down, as long as the loss it makes by producing is less than its total fixed cost. c-d is still less than fixed costs which equals ATC - AVC When ATC > P > AVC at the level of output whereMC = MR, the firm is making a loss but should continue producing because its loss is smaller than its fixed cost. Graphically, this occurs when the demand curve lies below minimum ATC and above minimum AVC.

If firms are earning economic profit then...

revenue > (Implicit+explicit costs)

Profit maximisation: Economic (supernormal) profit or loss in the short run

short-run equilibrium position of the individual firm in monopolistic competition is identical to that of the monopolist. Only difference is demand curve is more elastic and flatter in monopolistic competition. In the short run, the firm can either make supernormal profit, normal profit or losses. The firm applies the MR = MC rule to find the profit maximising or loss-minimising level of output

economic profit is the same as

supernormal profit

Regulation of natural monopoly- Marginal cost pricing

the 'best' / optimal policy is to force the firm to produce at P=MC where they would achieve allocative efficiency This is called marginal cost pricing, where intersection of D or AR and MC gives rise to price Pmc and to quantity Qmc. Qmc is larger than quantity produced by an unregulated firm (Qm) and is sold at a lower price Pros: Marginal cost pricing forces an efficient allocation of resources, and quantity of the good produced increases to the socially desirable level. Cons: Leads to losses for the natural monopolist. Pmc lies below the ATC curve at the point of production, so price is too low to allow the firm to cover its average costs . As long as the demand curve cuts the ATC curve to the left of minimum ATC, as in a natural monopoly, it is not possible for the MC curve to cut the demand curve at a point above ATC. This means that marginal cost pricing will always lead to losses for the natural monopoly. (may only occur for natural monopolies) Although marginal cost pricing leads to an efficient solution, it is impractical, as the losses forced on the monopolist would make it go out of business (shut down) in the long run.

A natural monopoly is illustrated in Figure 7.13.

the market demand for a product is within the range of falling LRATC, this means that a single large firm can produce for the entire market at a lower average total cost than two or more smaller fi rms. When this occurs, the firm is called a natural monopoly.

Effects of price discrimination

the results of third-degree price discrimination are very complex and ambiguous, as they depend on a variety of factors, making it difficult to draw general conclusions. -Possibility of increased monopoly power. Firms can use price discrimination to charge high prices in one market and low prices in another market with the intention of driving out rival firms that may be unable to compete with the low price. -Total output may increase or decrease. If it increases, it does not reach the socially optimum level (allocative efficiency is not achieved). -If output increases, then under certain conditions allocative efficiency will also improve; if output falls, then allocative efficiency will worsen. -Different prices for different groups . Therefore, some consumer groups can benefit if a product that was previously not affordable now comes within their reach (for example, students, pensioners, leisure travellers who plan far ahead of time, mid-week restaurant goers, and many others). On the other hand, those groups who have to pay higher prices will clearly lose, and for some of them, the product will become unaffordable. -Consumer surplus increases for some groups and falls for others -What happens to overall consumer surplus depends on what happens to output. If output falls, consumer surplus falls; if output increases, consumer surplus may either increase or decrease, depending on the particular situation.

Price leadership - one type of informal collusion

where a dominant firm in the industry (may be the largest, or the one with lowest costs) sets a price and initiates any price changes. Remaining firms in the industry become price-takers, accepting the price that has been established by the leader. T he implicit agreement (as there is no formal agreement) binds the firms as far as price goes, but they are free to engage in non-price competition. - characteristic of price leadership arrangements - price changes tend to be infrequent, and are undertaken by the leader only when major demand or cost changes occur.

Obstacles to sustained price leadership are similar to the obstacles faced by cartels:

• Cost differences between firms, particularly where there is significant product differentiation, make it difficult for firms to follow a leader. • some firms may not follow the leader. The leader risks losing sales and market share if it initiates a price increase that is not followed. • Firms still face the incentive to cheat by lowering their price (below that of the leader) to capture market share and increase profits; a breakdown in price leadership can result in a price war among firms. • High industry profits can attract new firms that will cut into market shares and profits of established firms and endanger the price leadership arrangement. • Price leadership, depending on where and how it is practised, may or may not be legal.