9. Decisions & Strategies Of Firms Flashcards
What is the profit maximization condition for firms?
Use diagrams to illustrate the different profit levels of a PC firm in the short run.
MR=MC
Using diagrams, illustrate different types of profits a monopolist can earn in the short run.
Explain the short run shut down condition.
In the short run, a firm will shut down and cease production if its price (AR) < AVC or TR < TVC.
Note that the firm must be facing subnormal profits in order for it to consider shutting down.
Using a diagram, explain what happens to a PC firm in the long run when existing firms in the industry makes supernormal profits. (Same line of thoughts apply to subnormal profits condition)
Since there is free entry and exit into the PC industry, firms outside the industry will be attracted to reallocate their resources to this industry so that they can enjoy the high profits. The entry of new firms will increase the market supply from S0 to S1. If demand remains unchanged and supply increases, the market equilibrium price will fall from P0 to P1 and this will erode away any supernormal profits earned by the firms. The increase in supply and fall in price will continue until all firms in the industry earn normal profits in the long run.
Using a diagram, explain what happens to a MC firm in the long run when existing firms in the industry makes subnormal profits. (Same line of thoughts apply for supernormal profits)
Define price discrimination.
Price discrimination is defined as the practice of charging different consumers different prices for the same product. The different prices must not be due to cost differences.
What is third degree price discrimination.
In third degree price discrimination, firms separate the market into two or more groups and charges different prices based on the PED of the consumers.
Draw a diagram to explain the outcome when a firm practices third degree of price discrimination.
Explain 3 conditions for price discrimination.
- Ability to set prices (market power)
- Ability to segment market
- Ability to stop resale
- provide a unique service
- issue product warranties tied to customer identity
- restricting the location that the good can be used
- having contractual clauses to forbid the resale of the product
- checking of identification
- restricting the time allowed to use the product
State the assumptions of the Kinked Demand Curve Theory. Using a diagram, explain how the Kinked Demand Curve Theory is used to illustrate price rigidity. What are the limitations of this theory.
Assumptions:
1. If a firm raises price, other firms will not follow
2. If a firm lowers price, other firms will match the price cut.
With reference to the diagram when the change in MC is small, price will not change. Firms tend to focus on non-price competition as means of reinforcing their market position and increasing their supernormal profits. Oligopolies will attempt to differentiate their products from their rivals by establishing real or perceived differences or by varying the conditions of sales.
Limitations
1. Fails to explain why demand curve is kinked at that particular point
2. The assumption that competing firms will follow price cuts but not price increase is overly simplistic.
Define what a perfectly contestable market is.
A perfectly contestable market is one into which entry is absolutely free, and exit is absolutely cost less.
Exit is absolutely cost less means there is no sunk cost. Entry is absolutely free means there is no cost that must be borne by a new entrant which the incumbent firms are not experiencing. Access to same level of technology and ease of entry.
Define sunk cost and give some examples. Explain the significance of sunk cost.
Sunk costs are costs that have already been incurred by the firms and cannot be recovered even if firms choose to exit the market.
Eg. R&D and marketing expenses, highly specific physical assets that might be resold at a substantial loss upon exit or not at all.
Sunk costs affect a firm’s decision to enter the industry because if the firm fail and exit then these costs will be wasted. Hence sunk cost represent a BTE.
Explain what is hit and run strategy and its significance.
If the monopolist insists on its level of supernormal profits, there is incentive for new firms to enter the market, increasing the supply and driving down price to a level where only normal profits are made. Since supernormal profits are exhausted and exit is absolutely cost less, the firm can leave the industry. This threat of competition may be sufficient to induce firms to price as competitively as possible. As such, the theory implies that given easy entry to and exit from the industry, monopolists or oligopolies will behave if they actually existed in perfect competition.
