Chapter 7 Flashcards
It is traditional to divide industries in categories according to the degree of competition that exists between the firms within the industry.
There are four of such categories:
Perfect competition
Monopoly
Monopolistic competition
Oligopoly
Perfect competition
a market structure where there are many firms, none of which is large; where there is freedom of entry into the industry; here all firms produce identical products; and where all firms are price takers.
Monopoly
a market structure where there is only one firm in the industry. (Note that this is the economic definition of a pure monopoly. In UK competition law, the part that applies to the abuse of monopoly power covers firms that are in a position of ‘market dominance’. Such firms have a larger share, but not necessarily a 100% share of the market.)
Monopolistic competition
a market structure where, as with perfect competition, there are many firms and freedom of entry into the industry, but where each firm produces a differentiated product and thus has some control over its price.
Oligopoly
a market structure where there are few enough firms to enable barriers to be erected against the entry of new firms.
To distinguish more precisely between these four categories, the following must be considered:
How freely can firms enter the industry. Is entry free or restricted? If it is restricted, just how great are the barriers to the entry of new firms?
The nature of the product. Do all firms produce an. Identical product, or do firms produce their own particular brand or model or variety?
The firm’s degree of control over price. Is the firm a price taker or can it choose its price, and if so, how will changing its price affect its profits? (how elastic is it?)
Imperfect competition
the collective name for monopolistic competition and oligopoly. The vast majority of firms in the real world operate under imperfect competition.
Four assumptions of perfect competition:
Firms are price takers. There are so many firms in the industry that each one produces a small proportion of total industry supply, and therefore has no power to affect the price of the product. Horizontal demand curve at the market price.
There is complete freedom of entry into the industry for new firms. (applies in the long-run)
All firms produce an identical product (the product is homogeneous). There is no branding and advertising).
Producers and consumers have perfect knowledge of the market. Producers: prices, costs and market opportunities. Consumers: price, quality and availability.
Advantages of perfect competition
Keeping prices down to marginal cost
Preventing firms from making supernormal profit in the long-run.
Short-run
number of firms is fixed.
Long-run
the level of profits affects entry and exit from the industry. The rate of profit determines whether a firm stays in the industry or leaves. Rate of profit = the level of profit (TII) as a proportion of the level of capital (K) employed: r= TII/K. often measured by using ROCE in the real world. ROCE = TII is measured as profit before tax and interest payment, r is referred to as the Return Of Capital Employed.
The short-run equilibrium of the firm
Price. The price is determined in the industry by the intersection of demand and supply. Demand curve is horizontal. Can produce at market price but nothing at a price above Pe.
Output. The firm will maximize profit where marginal cost equals marginal revenue (MR = MC), at an output of Qe. Marginal revenue equals price.
Profit. If the average cost curve dips below the average revenue curve the firm will earn supernormal profit. Supernormal profit per unit at Qe is the vertical difference between AR and AC at Qe.
The firms short-run supply curve
The supply curve and the MC curve will follow the same line. So, under perfect condition, the firm’s supply curve is entirely dependent on costs of production. This demonstrates why the firm’s supply curve is upward sloping.
The short-run industry supply-curve
This shows the total quantity supplied by all the firms already in the industry at each possible price. It does not include the output produced by any new entrants as this would only apply in the long-run. Add up how much each individual firm wants to supply at that price = industry supply.
Industry supply curve = add up short-run supply curves of all the firms already in the industry.
The long-run equilibrium of the firm
In the long-run if typical firms are making supernormal profits, new firms will be attracted into the industry. The effect of entry of new firms and/or the expansion of existing firms to increase industry supply.
Since the LRAC is tangential to all possible short-run AC curves, the full long-run equilibrium is where LRAC = AC = MC = MR = AR.
The firm’s long-run supply curve
The firm can adjust all of its inputs. This means that all of its costs are now variable and hence the long-run average cost curve is the same as long-run average variable cost curve. Therefore, the firm’s long-run supply curve is the portion of its long-run marginal cost curve above the point where it is cut by the average cost curve.
The long-run industry supply curve
It can be derived by analyzing the impact of an increase in demand on a market that is initially in long-run equilibrium.
See page 196.
In the long-run, this supernormal profit will act as a signal to entrepreneurs and new firms will enter the market. The arrival of new entrants will cause the short-run market supply curve to shift to the right, putting downward pressure on the market price.
Benefits of perfect competition:
Price equals marginal cost. Given that price equals marginal utility, marginal utility will equal marginal cost. This is argued to be an optimal position.
Long-run equilibrium is at the bottom of the firm’ long-run AC curve. That is, for any given technology, the firm, in the long-run, will produce at the least-cost output.
Perfect competition is a case of ‘survival of the fittest’. Inefficient firms will be driven out of business, since they will not be able to make even normal profits. This encourages firms to be as efficient as possible.
The combination of production being at minimum average cost and the firm making only normal profit keeps prices at a minimum.
If consumer tastes changes, the resulting price change will lead firms to respond. An increased consumer demand will result in extra supply with only a short-run increase in profit.
Possible disadvantages of perfect competition
Limitations
There is no guarantee that the goods produced will be distributed to the members to the society in the fairest proportions.
There may be considerable inequality in income.
Production of certain goods may lead to various undesirable side effects (pollution)
Perfect competition may be less desirable than other market structures such as monopoly
Even though firms under perfect competition may seem to have an incentive to develop new technology, the long-run normal profits they make may not be sufficient to fund the necessary research and development. Also, with complete information available if they did develop new more efficient methods of production, their rivals would merely copy them.
Perfectly competitive industries produce undifferentiated products. This lack of variety might be seen as a disadvantage to the consumer. Under monopolistic competition and oligopoly there is often intense competition over the quality and design of the product. This can lead to innovation and improvements that would not exist under perfect competition.
Barriers exist for a number of reasons:
- Economies of scale. If an industry experiences substantial economy of scale, it may have lower long-run average costs of production when one firm supplies the entire output of the industry.
- natural monopoly
Absolute cost advantages
Switching costs for consumers
Product differentiation and brand loyalty.
More favorable or complete control over access to customers.
Legal protection. (patents, copyright, licensing and tariffs)
Mergers and takeovers
Aggressive tactics (start a price war, mount massive advertising campaigns, attractive after-sales service, introduce new brands to compete with new entrants, etc.)
Intimidation.
Natural monopoly
a situation where long-run average costs would be lower if an industry were under monopoly than if it were shared between two or more competitors.
A natural monopoly is most likely to occur if the market is relatively small and/or the industry has relatively low marginal costs.
Imperfect competition
the collective name for monopolistic competition and oligopoly. The vast majority of firms in the real world operate under imperfect competition.
Constant-cost industry
an industry where average costs stay constant as the size of the industry expands. It has a horizontal long-run industry supply curve
Decreasing-cost industry
an industry where average costs decrease as the size of the industry expands. It has a downward-sloping long-run industry supply curve.
Absolute cost advantages (ACC will be below that of any potential entrants at all levels of output) What might give a monopolist such a cost advantage?
More favorable access or control over key inputs. In some markets the monopolist might be able to obtain access to important factor inputs on more favorable terms for a certain period of time.
Superior technology. The monopolists may have access to superior technology that is difficult for rival firms either to copy or to imitate.
More efficient production methods. Through years of experience of running the business an established monopoly might have learnt the most efficient way of organizing the production of its goods or service. Much of this knowledge is tacit.
Economies of scope. A firm that produces a range of products is also likely to experience a lower average cost of production.
Switching costs
the costs to a consumer of switching to an alternative supplier.
Examples:
Searching costs. The more time and effort it takes to compare the higher will be the switching costs.
Contractual costs.
Learning costs. The switching costs increase as the knowledge becomes more specific to the brans/product supplied by a particular firm.
Product uncertainty costs.
Compatibility costs
Network externality or network economies
the benefits a consumer obtains from consuming a good/service increase with the number of other people who use the same good/service.
When a good or service has significant network externalities it makes it difficult for a new entrant.
Limit pricing
where a monopolist charges a price below the short-run profit-maximizing level in order to deter new entrants.
Disadvantages of a monopoly
Higher price and lower output than under perfect competition (short run).
Higher price and lower output than under perfect competition (long run). Keep long run prices down (perfect competition). Barriers to entry allow profits to remain supernormal in the long run. The monopolist is not forced to operate at the bottom of the AC curve. Thus, long-run prices will tend to be higher and hence output lower (monopoly).
Possibility of higher cost curves due to lack of competition. A monopolist does not have to use the most efficient techniques. It has less incentive to be efficient. On the other hand, it can lowers it costs by using and developing more efficient techniques, it can gain extra supernormal profits which will not be competed away.
Unequal distribution of income. The high profits of monopolists may be considered as unfair. The scale of this problem obviously depends on the size of the monopoly and he degree of its power.
Advantages of a monopoly
Economies of scale due to larger plant, centralized administration and the avoidance of unnecessary duplication.
Possibility of lower cost curves due to more research and development and more investment.
Competition for corporate control = the competition for the control of companies through takeovers.
Innovation and new products.
price discriminate
to charge different prices either to all customers or to different groups of customers.
The theory of contestable markets
argues that what is crucial in determining price and output is not whether an industry is actually a monopoly or competitive, but whether there is the real threat of competition.
Perfectly contestable market
a market where there is free and costless entry and exit and the monopolist cannot immediately respond to entry.
Hit and run
a strategy whereby a firm is willing to enter a market and make short-run profits and then leave again when the existing firm(s) cut prices. Costless exit makes hit-and-run behavior more likely.
