Module 13 CFA level 1

economic profit equal to

(P* - ATC*) × Q*.

oligopoly

(few firms that compete in a variety of ways) The most important characteristic of an oligopoly market is that there are only a few firms competing. In such a market, each firm must consider the actions and responses of other firms in setting price and business strategy. We say that such firms are interdependent. While products are typically good substitutes for each other, they may be either quite similar or differentiated through features, branding, marketing, and quality. Barriers to entry are high, often because economies of scale in production or marketing lead to very large firms. Demand can be more or less elastic than for firms in monopolistic competition. The automobile market is dominated by a few very large firms and can be characterized as an oligopoly. The product and pricing decisions of Toyota certainly affect those of Ford and vice versa.

monopolistic competition

(many sellers and differentiated products) differs from perfect competition in that products are not identical. Each firm differentiates its product(s) from those of other firms through some combination of differences in product quality, product features, and marketing. The demand curve faced by each firm is downward sloping; while demand is elastic, it is not perfectly elastic. Prices are not identical because of perceived differences among competing products, and barriers to entry are low. The market for toothpaste is a good example of monopolistic competition. Firms differentiate their products through features and marketing with claims of more attractiveness, whiter teeth, fresher breath, and even of actually cleaning your teeth and preventing decay. If the price of your personal favorite increases, you are not likely to immediately switch to another brand as under perfect competition. Some customers would switch in response to a 10% increase in price and some would not. This is why firm demand is downward sloping.

We can analyze where an industry falls along this spectrum by examining the following five factors:

1. Number of firms and their relative sizes. 2. Degree to which firms differentiate their products. 3. Bargaining power of firms with respect to pricing. 4. Barriers to entry into or exit from the industry. 5.Degree to which firms compete on factors other than price.

calculate marginal revenue for a firm that faces a downward-sloping demand curve and sells all units for the same price

MR = P( 1 - 1/Ep)

Which of the following describes the regulatory practice of setting prices at a level where the monopoly firm's average total cost curve intersects the demand curve?

Average cost pricing. Under average cost pricing, regulators attempt to force monopolies to reduce prices to where a firm's average total cost curve intersects the market demand curve. This will increase output and decrease price, increase allocative efficiency, and ensure zero economic profit. (Study Session 4, Module 13.4, LOS 13.b)

prisoner's dilemma

Confess/confess is the Nash equilibrium since neither prisoner can unilaterally reduce his sentence by changing to silence. Another way to view this outcome is that no matter what the other prisoner chooses to do, the best sentence for a prisoner comes from confessing.

One way to calculate marginal revenue for a firm that faces a downward-sloping demand curve and sells all units for the same price is

MR = P ( 1- 1/Ep) Therefore, we can also express the single-price profit-maximizing output as that output for which MC =MR = P ( 1- 1/Ep)

dominant firm model.

In this model, there is a single firm that has a significantly large market share because of its greater scale and lower cost structure—the dominant firm (DF). In such a model, the market price is essentially determined by the dominant firm, and the other competitive firms (CF) take this market price as given.

Consider a firm in an oligopoly market that believes the demand curve for its product is more elastic above a certain price than below this price. This belief fits most closely to which of the following models?

Kinked demand model. The kinked demand model assumes that each firm in a market believes that at some price, demand is more elastic for a price increase than for a price decrease. (LOS 13.b)

the single-price profit-maximizing output as that output for which

MC = P ( 1 - 1/Ep)

To maximize profit, monopolists will expand output until

Marginal revenue (MR) equals marginal cost (MC). Due to high entry barriers, monopolist profits do not attract new market entrants. Therefore, long-run positive economic profits can exist. Do monopolists charge the highest possible price? The answer is no, because monopolists want to maximize profits, not price.

Firm Output Under Monopolistic and Perfect Competition

Note that with monopolistic competition, price is greater than marginal cost (i.e., producers can realize a markup), average total cost is not at a minimum for the quantity produced (suggesting excess capacity, or an inefficient scale of production), and the price is slightly higher than under perfect competition. The point to consider here, however, is that perfect competition is characterized by no product differentiation

kinked demand curve model

Oligopoly model in which each firm faces a demand curve kinked at the currently prevailing price: at higher prices demand is very elastic, whereas at lower prices it is inelastic.

In which market structure(s) can a firm's supply function be described as its marginal cost curve above its average variable cost curve?

Perfect competition only.

Cournot model

The model considers an oligopoly with only two firms competing (i.e., a duopoly), and both have identical and constant marginal costs of production. Each firm knows the quantity supplied by the other firm in the previous period and assumes that is what it will supply in the next period. By subtracting this quantity from the (linear) market demand curve, the firm can construct a demand curve and marginal revenue curve for its own production and determine the profit maximizing quantity (given constant competitor sales).

13.2 Monopolistic Competition

The price/output decision for monopolistic competition is illustrated in Short-Run and Long-Run Output Under Monopolistic Competition . Panel (a) of Short-Run and Long-Run Output Under Monopolistic Competition illustrates the short-run price/output characteristics of monopolistic competition for a single firm. As indicated, firms in monopolistic competition maximize economic profits by producing where marginal revenue (MR) equals marginal cost (MC), and by charging the price for that quantity from the demand curve, D. Here the firm earns positive economic profits because price, P*, exceeds average total cost, ATC*. Due to low barriers to entry, competitors will enter the market in pursuit of these economic profits.

natural monopoly.

When the average cost of production for a single firm is falling throughout the relevant range of consumer demand, we say that the industry is a natural monopoly.

An oligopolistic industry has:

a great deal of interdependence among firms.

In a perfectly competitive market all the firms produce

a homogenous product

N-firm concentration ratio

a measure of the market share of the largest n firms in an industryWhich of the following statements most accurately describes a significant difference between a monopoly firm and a perfectly competitive firm? A perfectly competitive firm:

The short-run supply curve for a price taker firm is the portion of the marginal cost (MC) curve:

above the average variable cost (AVC) curve. The short-run supply curve for a firm is its MC curve above the AVC curve. Price takers will produce where price (P) equals MC. At prices below the AVC curve the firm will not be able to remain in operation. Above the ATC curve the firm is making economic profits and will continue to expand production along the MC curve. (Study Session 4, Module 13.1, LOS 13.c)

Herfindahl-Hirschman Index (HHI)

an index of market concentration found by summing the square of percentage shares of firms in the market The HHI is calculated as the sum of the squares of the market shares of the largest firms in the market. The following example illustrates this difference between the two measures and their calculation.

Marginal cost pricing (also referred to as efficient regulation)

forces the monopolist to reduce price to the point where the firm's MC curve intersects the market demand curve. This increases output and reduces price, but causes the monopolist to incur a loss because price is below ATC, as illustrated in Natural Monopoly—Average Cost and Marginal Cost Pricing. Such a solution requires a government subsidy in order to provide the firm with a normal profit and prevent it from leaving the market entirely.

In the long-run, a firm operating under perfect competition will:

generate zero economic profit.

A profit maximizing firm will expand output as long as marginal revenue is:

greater than marginal cost. A purely competitive firm will tend to expand its output so long as the market price (marginal revenue) is greater than marginal cost. In the short term and long term, profit is maximized when P = MC. (Study Session 4, Module 13.1, LOS 13.b)

Short-Run and Long-Run Output Under Monopolistic Competition

illustrates long-run equilibrium for a representative firm after new firms have entered the market. As indicated, the entry of new firms shifts the demand curve faced by each individual firm down to the point where price equals average total cost (P* = ATC*), such that economic profit is zero. At this point, there is no longer an incentive for new firms to enter the market, and long-run equilibrium is established. The firm in monopolistic competition continues to produce at the quantity where MR = MC but no longer earns positive economic profits.

perfect competition

in which many firms produce identical products, and competition forces them all to sell at the market price. refers to a market in which many firms produce identical products, barriers to entry into the market are very low, and firms compete for sales only on the basis of price. Firms face perfectly elastic (horizontal) demand curves at the price determined in the market because no firm is large enough to affect the market price. The market for wheat in a region is a good approximation of such a market. Overall market supply and demand determine the price of wheat.

Average cost pricing

is the most common form of regulation. This would result in a price of PAC and an output of QAC as illustrated in Natural Monopoly—Average Cost and Marginal Cost Pricing. It forces monopolists to reduce price to where the firm's ATC intersects the market demand curve. This will: -Increase output and decrease price. -Increase social welfare (allocative efficiency). -Ensure the monopolist a normal profit because price = ATC.

Price discrimination

is the practice of charging different consumers different prices for the same product or service. Examples are different prices for airline tickets based on whether a Saturday-night stay is involved (separates business travelers and leisure travelers) and different prices for movie tickets based on age. The motivation for a monopolist is to capture more consumer surplus as economic profit than is possible by charging a single price. For price discrimination to work, the seller must: - Face a downward-sloping demand curve. - Have at least two identifiable groups of customers with different price elasticities of demand for the product. - Be able to prevent the customers paying the lower price from reselling the product to the customers paying the higher price.

Monopolistic competition has

low barriers to entry

A purely competitive firm will tend to expand its output so long as:

market price is greater than marginal cost. A purely competitive firm will tend to expand its output so long as the market price is greater than MC. In the short run and long run, profit is maximized when P = MC. (LOS 13.d)

A market characterized by low barriers to entry, good substitutes, limited pricing power, and marketing of product features is best characterized as:

monopolistic competition.

In a purely competitive market, economic losses indicate that:

price is below average total costs.

Compared to a perfectly competitive industry, in an industry characterized by monopolistic competition:

price is likely to be higher and quantity is likely to be lower.

When a firm operates under conditions of pure competition, marginal revenue always equals:

price.

Nash equilibrium

reached when the choices of all firms are such that there is no other choice that makes any firm better off (increases profits or decreases losses). The Nash equilibrium results when each nation pursues the strategy that is best, given the strategy that is pursued by the other nation.

A natural monopoly

refers to a situation where the average cost of production is falling over the relevant range of consumer demand. In this case, having two (or more) producers would result in a significantly higher cost of production and be detrimental to consumers. Examples of natural monopolies include the electric power and distribution business and other public utilities. When privately owned companies are granted such monopoly power, the price they charge is often regulated by government as well.

Two pricing strategies that are possible for a monopoly firm are

single-price and price discrimination

Which of the following statements most accurately describes a significant difference between a monopoly firm and a perfectly competitive firm? A perfectly competitive firm:

takes price as given; a monopolistic firm must search for the best price.

When a regulatory agency requires a monopolist to use average cost pricing, the intent is to price the product where:

the ATC curve intersects the demand curve.

The demand for products from monopolistic competitors is relatively elastic due to:

the availability of many close substitutes.

A monopolist will expand production until MR = MC and charge a PRICE determined by:

the demand curve.

monopoly

where only one firm is producing the product. A monopoly market is characterized by a single seller of a product with no close substitutes. This fact alone means that the firm faces a downward-sloping demand curve (the market demand curve) and has the power to choose the price at which it sells its product. High barriers to entry protect a monopoly producer from competition. One source of monopoly power is the protection offered by copyrights and patents. Another possible source of monopoly power is control over a resource specifically needed to produce the product. Most frequently, monopoly power is supported by government.