Firms and Decisions Pt II Flashcards
What are the 4 characteristics that determine market structure?
- Number of sellers relative to market size
- Extent of barriers to entry
- Nature of product
- Knowledge of product/market
What are the characteristic of a perfectly competitive market?
Large number of buyers and sellers, fulfilled when each firm has no significant share of the market due to the absence of entry barriers.
No barriers to entry and exit.
Homogenous products, all products are perfect substitutes.
Perfect knowledge. Sellers know the prices and production costs of rivals, costs, available technology etc. Buyers know all the prices, quality and availability of products
Why are firms in a PC market price-takers?
Due to the large number of buyers and sellers, homogeneity of products, and perfect knowledge, PC firms have no control over prices but has to follow the market price determined by forces of demand and supply. It has to sell at the prevailing price as Qdd will fall to 0 should it increase its price, and it has no incentive to reduce its price.
When is a PC firm in equilibrium?
By the traditional theory of the firm, when it is producing at the level where total profit is maximised, where MR=MC and MC is rising.
Why must MR=MC for a PC firm to be in equilibrium?
In order to maximise profits, a firm should produce at the level where addition to the total revenue from the sale of the last unit of output equals to the addition to total cost in producing it, ie MC=MR.
Why should MC be rising when a PC firm is in equilibrium?
When MC is falling, additional output will add more to the total revenue than total cost, thus MC≠MR and it should still increase outputs to maximise profits.
What is the short run shut down condition?
Whether its total revenue can cover its variable costs. It should keep producing if total revenue is more than variable costs as the surplus generated can be used to offset part of its fixed costs. If revenue earned is less than variable costs, the firms should shut down so that its losses are limited to only the fixed costs instead of making losses on both fixed and variable costs.
What are the implications of a shut down in the short run?
It will still retain its capital assets but will not leave the industry or avoid paying for its fixed factors of production. If market conditions improve, a firm can resume production. If it does not, the firm cannot keep incurring losses indefinitely, so it will exit the market.
Why do PC firms only make a maximum of normal profits in the long run?
Firms that earn supernormal profits attract new firms to enter the market, causing Qss to increase at every price, increasing market supply, leading to a surplus and hence equilibrium price to fall. PC firms are price-takers and hence have to sell at this lower price. Supernormal profits get eroded.
Some firms that earn subnormal profits may exit the market since there are no exit barriers, number of firms thus decreases, quantity supplied decreases at every price and market supply falls. There is a shortage and market price increases. Losses made thus reduce and firms earn normal profits.
What is a monopoly?
A market structure whereby the firm is the only seller of a good or service that has no close substitutes, complete barriers to entry and exit and imperfect information.
What are the characteristics of a monopoly?
- Single producer
- Complete barriers to entry and exit
- Unique product
- Imperfect knowledge
What does a monopoly being a single producer result in?
The monopoly faces no competition, and able to exert control over how much it charges for its product and is a price setter. However, it is still constrained by market demand, meaning it can only change price or output.
What are the barriers to entry and exit in a monopoly?
- Artificial barriers to entry
- Natural barriers to entry
- Sunk costs
What are the two artificial barriers to entry?
- Strategic barriers
- Statutory barriers
What are strategic barriers to entry in a monopoly?
Any move by the incumbent firm to keep potential firms out of the market. Examples include intensive advertising, gaining control of supplies of essential raw materials, hostile takeover and acquisitions, research and development.
How does intensive advertising raise barriers to entry?
It boosts demand and persuades consumers that there are no substitutes, inducing customer loyalty, making it more difficult for them to break into the market. Demand is also less price elastic.
How does gaining control of supplies of essential raw materials raise barriers to entry?
New entrants find it difficult to access resources, thus production and potential for profits are limited. This deters them from entering the market.
How do hostile takeover and acquisitions raise barriers to entry?
When the dominant company buys up a rival firm, new firms are less able to compete with an even bigger firm, thus they are deterred from entering.
How does research and development raise barriers to entry?
By coming up new products, improving quality, increasing product range and lowering costs, new firms are less likely to be able to compete and thus are deterred from entering.
How do statutory barriers raise barriers to entry?
They prevent potential firms from entering by legal means, if potential firms are caught flouting, heavy penalty is given. This deters them from entering, keeping demand high and less price elastic.
What are statutory barriers?
Barriers to entry given by force of law.
How do natural barriers raise barriers to entry?
Capacity expansions lower unit cost of production, thus allowing the incumbent firm to be more cost effective and thus more price competitive. They can thus lower prices to retain consumers and make a credible threat to potential entrants.
What are natural barriers?
Barriers that arise from differences in production and costs between incumbent and potential firms.
How do sunk costs raise barriers to exit?
It increases risk of making huge losses if firms decide to leave the market because once these costs are committed, they cannot be recovered.