Lesson 7 - Theory of the firm: Monopoly

Question 1

what are the benefits of perfect competition?

Answer 1

• firms only make normal profits in the long run
• firms are allocatively efficient
• firms are productively efficient
• firms will be dynamically efficient to innovate and earn short run supernormal profits

Question 2

what are the problems with perfect competition?

Answer 2

• lack of choice (products are not differentiated)
• firms lack economies of scale, so they have higher costs, and therefore higher prices
• can only make normal profits in the long run, so they may lack the funds to invest into R&D

Question 3

what is an oligopoly?

Answer 3

when a few firms dominate and have market power

Question 4

what is a pure monopoly?

Answer 4

when one firm dominates 100% of the market, and there are total barriers to entry

Question 5

why are markets usually dominated by a small number of large firms?

Answer 5

• profit incentive encourages firms to grow and gain a competitive advantage
• they can use these profits to buy other firms and enjoy external growth (horizontal/vertical integration)

Question 6

why is there no distinction between the long and short run in a pure monopoly?

Answer 6

there are total barriers, so supernormal profits can be enjoyed in both the short and long run

Question 7

what is the effect of economies of scale in monopolistic markets?

Answer 7

• lower long run average costs
• can offer customers lower prices (if they chose to do so)

Question 8

What is the theory of monopoly?

Answer 8

• based on the assumption that there are total barriers to entry, and monopolies have 100% market power
• no way for there to be competition, supernormal profits can be made both in the long run and short run
• monopolies can therefore set prices or the quantity that they sell

Question 9

What are the issues with monopolies?

Answer 9

• not always productively efficient, since they can still make supernormal profits without costs being as low as possible
• no competition, so no incentive to produce
• restricted choice
• can choose to restrict supply and increase prices

Question 10

What are the benefits of monopolies?

Answer 10

• can enjoy economies of scale which lowers average costs, and can be reflected through lower prices
• SN profits can be reinvested into R&D, which can lead to the innovation of new products (dynamic efficiency)