7: The theory of the firm II: Market structures Flashcards
Define market structure:
What are the four market structures?
Market structure describes the characteristics of market organisation that influence the behaviour of firms within an industry.
The four types are monopoly, oligopoly, monopolistic competition and perfect competition.
What assumptions is the model of perfect competition based on:
- There is a large number of firms.
- All firms produce identical or homogenous products.
- There is free entry and exit.
- There is complete information.
- There is perfect resource mobility (they can transfer easily from one firm to another).
- They are price takers (they have no influence over the market price).
Examples of perfectly competitive markets?
Although in real life no market is perfectly competitive, some markets are best described as such, such as agricultural products and the foreign exchange market.
Show the demand curve for a product in a market under perfect competition:
What is the PED?
The demand curve is horizontal, fixed at the price at which all goods are bought and sold. This is normal profit.
PED is unit elastic, PED = infinity.
Why is the price fixed in perfect competition?
If one firm increases prices, the consumers will easily find cheaper substitutes. It cannot lower the price however since this is normal profit, and the firm would be at a loss if it did so.
Explain, using a diagram, why a perfectly competitive firm’s average revenue and marginal revenue curves are the same:
No matter how much output a perfectly competitive firm sells, D = P = MR = AR.
Why is the number of firms in the industry in the short run fixed?
In order to leave an industry a firm must be able to vary all of its inputs. This cannot be done in the short run so the number of firms in the industry in the short run is fixed.
When a firm wants to maximise its profit in the short run what can it do?
Since it is a price taker, it can only make a choice on how much quantity of input it should produce.
Short run profit maximisation based on the marginal revenue and marginal cost rule:
- Compare MR and MC. Where MR = MC is Qπmax.
- Compare AR and ATC.
Because Profit/Q = TR/Q - TC/Q
So, profit/Q = AR - ATC or P - ATC.
If you look at P and ATC on the diagram, you can find Profit/Q. - Profit/Q * Q.
How can you show total PROFIT using a diagram in the short run under perfect competition p172:
P on y, Q on x.
Draw P = MR = AR = D as horizontal line.
Draw MC, curved then exponential.
Draw a U shaped ATC with the minimum point BELOW P level. Draw AVC below that, the gap between them decreases.
Find where MC = MR, this should be above ATC and AVC. Draw a vertical line down to Q.
Find where this vertical line meets ATC, draw a horizontal line across to P. This rectangle is total profit.
Explained: MC = MR is Qπmax. The difference between MC and ATC = profit/Q. By drawing a horizontal line from this point (at Q) to price, you are multiplying by Q.
How can you show break-even price using a diagram in the short run under perfect competition p172:
P on y, Q on x. Draw P = MR = AR = D as horizontal line. Draw MC, curved then exponential. Draw a U shaped ATC whose minimum point intersects with the intersection of MC and MR. Draw a vertical line down from this intersection to Q. Draw minimum of AVC below P and ATC. P = MR = AR = D = break-even price
How can you show TOTAL LOSS using a diagram in the short run under perfect competition p172:
P on y, Q on x.
Draw P = MR = AR = D as horizontal line, relatively low.
Draw minimum of ATC above P line and minimum of AVC below P line.
Draw vertical line down from MR = MC, this is Q. Draw vertical line up from MR = MC to ATC. From here draw horizontal line across to P. Label this area total loss.
How can you show shut down price using a diagram in the short run under perfect competition p172:
P on y, Q on x.
Draw P = MR = AR = D as horizontal line, relatively low.
Draw an MC curve starting lower than P and ending high.
Draw minimum of ATC above P line and AVC minimum intersecting with P line.
Draw vertical line down from MR = MC, this is Q. Draw vertical line up from MR = MC to ATC. From here draw horizontal line across to P. Label this area total loss.
P = MR = AR = D = shut down price.
How can you show a loss making firm that will not produce using a diagram in the short run p172:
P on y, Q on x.
Draw P = MR = AR = D as horizontal line, low.
Draw minimums of ATC and AVC above the P line.
Where MR = MC. Draw a vertical line down to Q and a vertical line up to ATC.
Why would a firm in the short run keep producing when it is making a loss?
Because of the fixed costs. The average fixed cost is shown on the diagram by the difference in ATC and AVC. If the loss is greater than this difference, the firm is losing money and should shut down. If the loss is less than this, the firm should keep producing as if it shuts down it will pay the AFC and lose even more.
Summarise the numerical decisions in perfect competition in the short run:
- When P > ATC the firm makes economic profit.
- When P = minimum ATC, the firm breaks even.
- When ATC > P > AVC the firm is making a loss but should continue producing because its loss is smaller than its fixed cost.
- When p = minimum AVC this is the firms short-run shut-down price.
- When ATC > AVC > P, the firm should shut down.
You can show all this information on the same graph.
Where is the short run supply curve?
The portion of its marginal cost curve that lies above the point of minimum AVC.
Why in the long run do perfectly competitive firms make normal profit?
If perfectly competitive firms are making profits in the long run, other firms will join as there is free entry and exit. They shift supply to the right, which decreases price to the break even price. If too many firms are in the market and they are making losses due to competition, some will leave, shifting supply to the left and increasing the price meaning the rest make economic profit once again.
Show that in the long run firms make normal profit using a diagram:
P on y, Q on x.
MC curve.
D = MR horizontal line. Where MC = MR, draw a vertical line down to Q. Also here is the minimum of the SRATC curve and LRATC curve.
Can you make loss in the long run?
How does this fit with the short run?
No, you have no fixed inputs and entry and exit is free so you just leave. In the long run, a loss making firm shuts down and exits the market as soon as price falls below minimum ATC.
In the short run, if you are making a loss less than the fixed cost you will continue to produce but given that you are making a loss as soon as your fixed input is no longer fixed, for example if your rent contract runs out, you will shut down, hence you will be in the long run.
Explain using diagrams why perfectly competitive firms make normal profit in the long run:
Show a) the firm and b) the industry
With the firm show two alternatives, P1 and P2. P1 is above ATC and P2 is at ATC. Label Q1 and Q2.
With the industry show P1 and P2 as the intersection of D and S, label S1 and S2.
Explain that in the long run entry and exit is easy. New firms enter at P1, attracted by the prospect of profit. This shifts supply to the right, decreasing the price until it reaches P2.
Add a P3 below ATC to show that if firms making a loss some leave and shift supply to left to normal profit.
What factors in the long run could cause disturbance to the long run equilibrium?
- Changes in demand - shift the demand curve. The price would change and for a short period firms would be making profit or loss until more join the industry and again all make normal profit.
- Changes in technology - improvements in technology will cause the cost curve to fall for the firm so now firms making supernormal profits as the price remains. However, firms enter and cause normal profits again by shifting the supply curve.
When does a firm reach allocative efficiency?
When P = MC because MB = P.
What is productive efficiency?
Productive efficiency is achieved when production takes place at the lowest possible cost, i.e. production occurs at the minimum ATC.
Is the long run equilibrium under perfect competition efficient?
Yes, there is both allocative efficiency and productive efficiency as P=MC and production is at the minimum ATC. This can be shown on the graph.
Perfect competition is the only market structure in which this occurs.
