Business Flashcards
What is a perfectly competitive market
Many firms each with insignificant market share.
No single firm can affect market price.
Firms have equal access to resources, and hence identical U-shaped cost curves.
No entry/exit barriers to the market.
Consumers have perfect information about the market.
Products are homogenous (or at least appear so to consumers, i.e. no branding/advertising).
The outcome of perfect competition is that market price equals the minimum average cost, which equals the marginal cost. P = min AC = MC
Under perfect competition there are zero normal profits in the long run; if there are short run profits, new firms will enter the market freely.
Useful as a benchmark for comparison with other models, but not approached in reality, apart from e-commerce, currency markets, stock exchange, agriculture
What is a monopoly?
Firm that is the only supplier of a product, and the only potential supplier in the future.
There must be impossible barriers to market access, and no potential product substitutes.
Access barriers can be maintained through statutory, strategic (patents, aggressive pricing,
advertising), or structural means.
Disadvantages of monopolies
Monopolies take the market demand curve as their own demand curve, and can control their output and price.
Monopolies can earn supernormal profits, but the consumer is paying above the price of the resources used to make the product.
Lack of competition leads to a lack of innovation and reduced efficiency.
Monopoly market equilibrium has a higher price and lower consumption than a perfectly
competitive market.
There is a deadweight loss (reduction in surpluses) compared to a perfectly competitive
market – see profit maximisation.
Consumers’ needs and wants are not being satisfied as the product is being under-
consumed.
Advantages of monopolies
Monopolies can potentially exploit economies of scale.
Larger resources allow more R&D, which is not needlessly duplicated by other companies (e.g. aerospace, pharma), so innovation may be faster.
This allows monopolies to compete more effectively in international markets.
Profit maximisation in monopolies and perfectly competitive markets
Ignoring economies of scale
Under normal conditions, monopoly market equilibrium has a higher price and lower consumption than a perfectly competitive market.
Monopolies take the market demand curve as their own demand curve, and can control their output and price.
Consumer surplus is the difference between the value of the good, and the amount paid for it. Producer surplus is the different between the revenue and the cost to produce it. Under a monopoly, the net surplus (and hence economic utility) is reduced. The reduction is the deadweight welfare loss.
Including economies of scale
Economies of scale allow the MC curve to be reduced compared to a perfectly competitive market.
This may mean that profit maximisation occurs at a lower price and greater output (e.g. natural utilities companies).
What is profit maximisation?
Profits maximised when the next unit produced and sold adds as much to total revenue as it does to total cost.
Hence marginal revenue (MR) = marginal cost (MC).
If MR > MC, increasing production increases profits.
If MC > MR, decreasing production increases profits.
Why would firms avoid profit maximisation?
Can’t quantify MR and MC as firms have imperfect info about the market.
May seek to maximise revenue rather than profits (e.g. sales based incentives for managers).
Different groups in firms have different priorities (employees, managers, shareholders,
customers). Rather than profit maximising, aim for a minimum level of satisfaction across all groups. This is known as ‘satisficing’ – satisfy and suffice.
Cost curves
AFC due to factors of production which do not change with output (e.g. premises rent).
AVC due to factors of production which do change with output (e.g. labour costs).
MC is the difference in cost if one more product is made. Due to diminishing returns,
marginal cost will start to increase above a certain output.
MC will intersect the AC curve at its minimum; any extra products made will then cost more
than the average cost, thus increasing the AC curve.
AC=AVC+AFC
Contestable markets
Single or small number of firms in market.
Barriers to entry and exit are low.
Consumers have perfect information.
No sunk (irrecoverable) costs.
Hence one firm can dominate market, but market equilibrium is the same as a perfectly competitive market P = MC.
Definition of an oligopoly
Market dominated by several large firms (e.g. supermarkets).
Each firm has a high level of market concentration.
Large entry barriers exist.
Markets tend towards oligopolies in the long run.
Periodic price wars, but also intensive non-price related competition.
Oligopoly models - Sweezy *same as the kinked demand curve*
Oligopoly models - Bertrand
Firms produce identical products with identical marginal costs.
Consumers are rational, have perfect information, no transaction costs.
Some barriers to market entry, few firms present.
Firms set price (constant production) to maximise profits – unique equilibrium is P = MC,
same as perfectly competitive market.
Oligopoly models - Cournot
Firms produce identical products with identical marginal costs.
Consumers are rational, have perfect information, no transaction costs.
Some barriers to market entry, few firms present.
Firms set production (constant price) to maximise profits – unique equilibrium is MR < P < MC, between monopoly and perfectly competitive market.
Nash equilibrium and game theory
The Prisoner’s dilemma can also be applied to collusion in oligopolies; cooperation allows net benefit to be maximised.
Without collusion, the dominant strategy for each firm leads to the Nash equilibrium, minimising potential losses.
Collusion in oligopolies - Reasons for collusion.
Collusion (overt or tacit) between oligopoly firms maximises industry-wide profits, compared to non-cooperation.
Horizontal collusion is between firms in the same industry; vertical collusion is between manufacturers and retailers (e.g. franchises).
