Micro - Theory of the Firm Flashcards
1
Q
What does the short run refer to in economics?
A
Short run – where one factor of production (e.g. capital) is fixed while other factors of production may be variable.
- If a firm wants to increase output in the short run it can only do so by increasing the units of variable factors (i.e. working hours) and not fixed variables (i.e. capital - the number of machines).
- Diminishing marginal returns and marginal costs may start to increase quickly —> more and more workers –> inefficient.
Note - The short run will vary between industries.
2
Q
What does the long run refer to in economics?
A
Long run – where all factors of production of a firm are variable. Planning takes place in the long run.
A firm can decide to increase any factor of production i.e. the number of factories etc.
3
Q
When do planning and production take place in terms of the short/long term?
A
All production takes place in the short term
All planning takes place in the long term
4
Q
What is total product (TP)?
A
Total product is the total output that a firm produces, using its fixed and variable factors in a given time period.
5
Q
What is average product (AP)?
A
Average product (AP) is the output that is produced, on average, by each unit of the variable factor.
AP = TP/V
TP - Total output
V - Number of units of the variable factor employed
6
Q
What is Marginal product (MP)
A
Marginal product is the extra output that is produced by using an extra unit of the variable factor.
MP = ΔTP/ ΔV
ΔTP - Change in total output
ΔV - Change in the number of units of variable factor employed.
Useful when examining the extra units of output produced by adding one more unit of the variable factor (i.e. Labour)
7
Q
Definition of diminishing marginal returns?
A
Diminishing marginal returns
As extra units of a variable factor are added to a given quantity of a fixed factor, the output from each additional unit of the variable factor will eventually diminish.
I.E. —> When trying to paint a room, adding more painters will increase the rate of painting but up to a certain point. Eventually, there are too many painters (variable factors) and they get in each other’s way.
8
Q
Definition of diminishing average returns?
A
Diminishing Average Returns
As extra units of a variable factor are added to a given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish.
I.E. —> When trying to paint a room, adding more painters will increase the rate of painting but up to a certain point. Eventually, there are too many painters (variable factors) and they get in each other’s way.
9
Q
What is economic cost?
A
The economic cost of producing a good is the opportunity cost of the firm’s production.
Opportunity cost –> next best alternative given up
In this case, it is the opportunity cost of the factors of production that have been used to produce the good/service.
10
Q
What are the factors that influence the economic cost of production?
A
- Factors that are purchased from others and not already owned by the firm. (Explicit cost)
Opportunity cost –> price that is paid for factor and the alternative that could have been bought.
I.e. Hiring a worker for $1000 –> cost = $1000 and other things that the money could have been spent on.
- Factors that are already owned by the firm (Implicit cost)
Even though a firm owns these factors, they still have to take into account the opportunity cost of using it.
11
Q
What are explicit costs?
A
Explicit costs are any costs to a firm that involve the direct payment of money.
12
Q
What is implicit cost?
A
Implicit cost –> the earnings that a firm could have had if it had employed it factors in another way or if it had hired out or sold them to another firm.
Examples
- The owner of a firm may be able to earn $100, 000 per year in her next best alternative job –> Lawyer
- Rent of a building –> $15 000 –> opportunity cost of using the building is the rent that is foregone and things that could be purchase with that money.
13
Q
How can total cost be measured?
A
Total cost is the complete costs of producing output.
Three measures are used.
14
Q
What is the definition of the total fixed cost?
A
Total fixed cost (TFC) is the total cost of the fixed assets that a firm uses in a given time period.
TFC is considered constant as the fixed assets/variables are fixed by definition.
TFC = Number of fixed assets x Cost of each asset
I.e. Machines –> they will be there regardless.
15
Q
What is the definition of the total variable cost?
A
TVC is the total cost of the variable assets that a firm uses in a given period of time.
TVC increases as a firm uses more units of the variable factor.
TVC = Number of variable factors x cost of each
I.e. Employment of workers.
16
Q
What is the definition of total cost?
A
TC is the sum of the total fixed cost and the total variable cost.
TC = TFC + TVC
17
Q
What is the definition of the average fixed cost?
A
Average fixed cost is the fixed cost per unit of output.
AFC = TFC/q
TFC - total fixed cost
q - Units of output.
Note - As TFC is consider constant –> AFC will always fall as the units of output increase.
18
Q
What is the definition for the average variable cost?
A
AVC –> the variable cost per unit of output.
Equation –> AVC = TVC/q
TVC –> Total variable cost
q –> level of output
Normal trend in AVC –> intially decreases as there are more units for the variable factors (i.e. labour) but eventually due to the law of diminishing average returns –> it increases.
19
Q
What is the definition for Average total cost?
A
ATC –> the total cost per unit of output.
ATC = AFC + AVC
ATC = TC/q
TC –> total cost
q —> Units of output
Same trend as AVC –> intial fall but eventually due to the law of diminishing average returns AVC increases.
20
Q
What is the definition of marginal cost?
A
MC is the increase in total cost of producing an extra unit of output.
Equation –> MC = ΔTC/ΔQ
ΔTC –> change in total cost
ΔQ –> change in output
MC tends to fall as output increase and then eventually rises due to the law of diminishing marginal returns.
21
Q
What is the relationship between the Marginal cost curve and the AVC/ATC cost curve?
A
The Marginal cost curve cuts the AVC and ATC curves at their lowest points.
22
Q
What is the relationship between the Short Run Average cost curves and the Long Run Average cost curve?
A
In theory, the LRAC is a U shape as it is made up of an infinite number of short-run average cost curves (tangent to the LRAC curve)
This diagram shows us that if demand were to increase the firm could…
- Increase the variable factors
- But they also know that in the long term they could increase all factors (including fixed) of production which is cheaper.
Hence, they can plan ahead.
23
Q
Definition of increasing returns on scale?
A
Increasing returns on scale —> This is when long-run unit costs are falling as output increases.
Basically –> a given percentage increase in all factors of production will lead to a greater percentage increase in output –> reducing long-run average cost.
This refers to the downward sloping section of the LRAC curve.
24
Q
Definition for constant returns on scale?
A
Constant returns on scale —> This is when long-run unit costs are constant as output increases.
Basically –> a given percentage increase in all factors of production will lead to the same percentage increase in output –> no change in long-run average cost.
This refers to the section of the LRAC curve where the gradient in 0 (minimum).
25
Definition of decreasing returns on scale?
Decreasing returns on scale ---\> This is when long-run unit costs are rising as output increases.
Basically --\> a given percentage increase in all factors of production will lead to a smaller percentage increase in output --\> increasing long-run average cost.
This refers to the upward sloping section of the LRAC curve.
26
What two factors influence whether the long-run cost may increase or decrease as output increase?
1. **Economies of scale** --\> occur when increasing output leads to lower long-run average costs.
Leads to a firm experiencing increasing returns to scale.
2. **Diseconomies of scale** --\> occur when increasing output leads to a higher long-run average cost
Leads to a firm experiencing decreasing returns to scale
27
What are the different economies of scale that might benefit a firm?
1. **Specialisation** --\> large-scale operations workers can do specific tasks --\> With little training --\> very proficient in their task --\> greater efficiency.
2. **Division of Labour** --\> Breaking down the production process into small activities --\> workers can perform repeatedly and efficiently.
3. **Bulk Buying** ---\> Firms increase in scale --\> they often negotiate discounts with suppliers ---\> reduces the cost of inputs --\> reduces the cost of production.
4. **Financial economies** --\> Large firms can raise financial capital more cheaply --\> bank charge lower interest rates as large firms are less risky.
5. **Transport economies** ---\> Bulk orders may be charged less for delivery + firm might invest in their own transport --\> reduces cost
6. **Technical** --\> some production processes require high fixed costs --\> Hence, using the factory to full capacity --\> drive average costs down.
7. **Promotional economies** --\> Cost for promotion is not directly proportional to the cost of output --\> more you produce --\> cost of promotion per unit falls
28
What are the different diseconomies of scale that might negatively impact firms?
1. **Control and communication problems** --\> Firm grows larger --\> manager will find it difficult to control and coordinate activities --\> lead to inefficiency --\> increase in cost per unit of output. Same applies to communication.
2. **Alienation and loss of identity** --\> Firm grows larger --\> individuals feel 'smaller' --\> they believe that their actions don't matter as much + lose a sense of belonging/loyalty --\> decrease in hard work/productivity --\> increase costs.
29
What is the difference between internal and external economies?
When considering economies and diseconomies of scale it is important to consider internal and external economies.
**Internal** ---\> refers to the impact of economies/diseconomies towards individual firms.
**External** ---\> refers to the impact of the size of a whole industry increasing on individual firms.
30
Example of external economies and diseconomies of scale?
**Economies of scale** --\> growth of industry in an area ---\> results in local Uni's/colleges setting up courses relating to that specific industry ---\> Firms will have labour available --\> reduces cost.
**Diseconomies of scale** --\> Rapid growth ---\> more competition ---\> firms can't acquire raw materials/capital/labour ---\> this forces up prices of the prices and thus unit cost.
31
Summary of Short and Long-run average cost curves?
- Short-run average cost curve is U shaped due to the law of diminishing returns.
- Long-run are U shaped, in theory, because of the existence of economies and diseconomies of scale.
- In reality --\> there is no evidence to support U-Shaped Long run curve ---\> diseconomies don't outweigh economies of scale.
Actual output Long run curve may be draw as follows:
32
What is the definition of revenue?
Revenue is the income that a firm receives from selling its products, goods and services over a certain period of time.
33
Definition of total revenue?
Total revenue is the total amount of money that a firm receives from selling a certain amount of good or service in a given time period.
TR = p x q
p --\> price of good/service
q --\> quantity of the good/service
34
Definition of average revenue?
AR is the revenue that a firm receives per unit of it sales.
Equation --\> AR = (TR)/q = (p x q)/q = P
As we can see AR = Price as quantity (q) cancels out.
35
What is the definition of marginal revenue?
MR is the extra revenue that a firm gains when it sells one more unit of a product in a given time period.
Mr = ΔTR/Δq
36
How is revenue affected when the price does not change with the output (Perfectly elastic demand curve)?
Theory ---\> When the demand curve is completely elastic then we assume that the firm sells all its products at the same price.
Hence...
Price = Average revenue = Marginal revenue = Demand
All these variables are all the same.
Hence, **revenue increase at a constant rate as output increases.**
37
How is revenue affected with a normal downward sloping demand curve?
Important to remember --\> In order to increase output (demand) --\> price has to decrease. (Law of demand)
This is given that the firm controls price.
1. Since **AR** = Price ---\> as output falls --\> AR will fall ---\> Average revenue downward sloping.
2. **MR** also decreases as output falls BUT at a quicker rate (twice as steep) --\> It is below AR as in order to sell more one more unit --\> price has to decrease.
3. **TR** normally rises at first but eventually will start to fall as output increases --\> extra revenue from dropping price/selling more is outweighed by the loss of revenue from the units that could be sold at a higher price.
38
What are the relationships between the price elasticity of demand and revenue?
1. Demand is inelastic ---\> increase in price ---\> increase revenue.
2. Demand is elastic ---\> increase in price --\> decrease in revenue.
3. If PED = 1 --\> price shouldn't be changed as revenue is already maximised (This is when MR = 0)
Hence, PED = 1 when MR = 0.
39
How does one calculate Total Profit?
Total profit = Total revenue - Economic cost (Explicit and implicit costs)
40
How does one define Abnormal profits, normal profits and a loss?
Abnormal profit --\> This is when total revenue is greater than total cost.
Normal profit --\> This is when total revenue is equal to total cost.
A loss --\> This is when total revenue is less than total cost.
41
What is the shut-down price?
The shutdown price is the price at which a firm will decide to stop producing. This happens when the firm can no longer cover its variable costs of production (AVC\>AR)
If the price does not cover the average variable cost, then the firm will shut-down in the short run.
There are two situation firms can find themselves in:
1. A firm may close down temporarily --\> they only have to pay the fixed cost but no variable cost.
2. The firm can continue producing --\> but only if they can cover the variable cost.
**However... In both cases in the long run they have change their factors of production so that they can make a normal profit.**
42
What is the break-even price?
Break-even price --\> the price at which a firm is able to make normal profits in the long run.
Means that they cover all their costs including the opportunity cost.
This happens at the point --\> Price (P) = Average total cost (ATC).
43
What is the profit-maximising level of output?
Economists assume that the main aim of a firm is to maximise profits.
Whenever MR\>MC, then firms should increase output.
Hence...
If a firm wishes to maximise its profits, it should produce at the level of output where Marginal cost (MC) cuts Marginal revenue (from below).
**MC = MR**
44
When one has found the profit-maximising level of output, how can you find the price?
To find the price, we look at what consumers are willing to pay for at this quantity. This is shown by the demand curve. It is found by going up from q (profit-maximising level) up to the demand curve and then across to the y-axis.
The same idea applies when you find the cost with the AC curve.
45
Where does the MC curve cut the AC curve?
**The MC curve cuts the AC curve at the lowest point!**
46
Apart from profit maximisation, what other objectives are there for a firm?
1. **Revenue maximisation** --\> Producing at the level where MR = 0. Entrepreneurs often measure success by the revenue they make ---\> revenue maximise!
2. **Growth maximisation** --\> companies may want to achieve growth in the short term in order to gain a larger market share and then dominate the market in the LR.
3. **Satisficing** --\> people don't always aim to profit maximise as they would rather achieve a satisfactory level and pursue other goals.
4. **Corporate Social Responsibility** --\> Business includes public interest in its decisions.
47
Benefits/disadvantages of having Corporate Social Responsibility as a goal?
**Advantages**
1. Attracting and keeping a better workforce
2. Building reputation
3. Building brand loyalty (ethical business)
4. If they tackle social/environmental issues --\> less government intervention in firm activities.
**Disadvantages**
1. Firms distracting consumers from the main product. Especially prevalent for cigarettes/alcohol.
48
What are the different types of market structure?
1. Monopoly
2. Duopoly
3. Oligopoly
4. Monopolistic Competition
5. Perfect competition
49
How to define perfect competition?
Perfect competition is a market structure in which industries are made up of a large number of firms that are price takers and they all offer homogenous products. There are no barriers to entry/exit and there is perfect information.
50
What are the assumptions made when examining perfect competition?
1. The industry ---\> **very large number of firms.**
2. **Price-Takers** --\> Each firm is small relative to the industry --\> firms have no noticeable impact on the supply of the entire industry --\> they can't change price ---\> Industry determines price.
3. **Homogeneous products** --\> Firms have exactly identical products --\> you can't differentiate products from one firm and another.
4. **No Barriers to entry or exit** --\> Firms are free to enter and exit the industry.
5. **Perfect Information** --\> All producers are aware of market price, costs and workings of the market. All consumers are aware of market price, quality and availability.
51
Explain the diagram of perfect competition?
Normal profits
As the industry decides the price --\> we need 2 diagrams.
1. Industry diagram --\> Normal supply and demand
2. The firm diagram --\> With the following curves:
- Perfectly elastic demand curve at the equilibrium price level of the industry diagram (Label - D = AR = MR)
- MC curve (J - shape) --\> Profit maximised when MC = MR ---\> Firm produces at this level (q)
- AC cost curve (U-Shape) ---\> MC cuts AC at the lowest point --\> local minimum.
52
Show how a firm in perfect competition can make an abnormal profit in the short run.
Short-run abnormal profits --\> This means that the firm is more than covering their total cost including opportunity cost.
The firm is selling at the industry price, P, and profit maximising by producing the quantity 'q' which is where MC=MR.
Average cost is less than average revenue --\> this creates abnormal profit --\> shown by the shaded area.
53
Show how a firm in perfect competition can make a loss in the short term.
Short run loss --\> This means that the firm is not covering their total cost.
On the diagram, the firm is selling at the industry price, P, and producing at the profit maximising level of q.
However, their Average cost is greater than their Average revenue so the firm is making a loss --\> shown by shaded region.
54
Can firms in perfect competition make a loss/abnormal profits in the long run?
No!!! Only possible in the short run.
Firms can only make a normal profit in the long run because if there are any loses/abnormal profits --\> the industry will adjust with firms entering and leaving the industry until a normal profit is reached.
Once the Long run equilibrium has been reached --\> there is no incentive for firms to enter or leave --\> equilibrium will persist until ...
1. Change in industry demand
2. Change in the cost of production
55
What happens to a firm in perfect competition if it is making an abnormal profit (transition short run to long run)?
As there is perfect information and No barriers to entry --\> firms outside the industry will realise that firms are making abnormal profits and thus enter the market.
Consequently, as more firms enter --\> industry supply shifts outwards ---\> this decreases price ---\> firms are price-takers ---\> they must accept change.
This process continues until firms make a normal profit (Average revenue = Average cost) --\> long-run equilibrium.
Note --\> industry supply has increased Q --\> Q1 .
56
What happens to a firm in perfect competition if it is making a loss (transition short run to long run)?
As firms are making a loss ---\> over time firms in the industry will leave --\> eventually the decrease is in the number of firms will result in an inward shift of the supply curve.
The process will continue until normal profits are made ---\> Long-run equilibrium.
The outcome for the industry --\> Lower levels of production.
57
Definition of productive efficiency?
Productive efficiency ---\> producing goods and services with the optimal combination of inputs to produce maximum output for the minimum cost.
Productive efficiency takes place when...
MC = AC
58
Definition of allocative efficiency?
Allocative efficiency = this is defined as the best allocation of resources from society’s point of view.
Allocative efficiency takes place when...
**MC = AR**
Important for economics because if a firm produces at an allocatively efficient level of output --\> we reach "Pareto Optimality" --\> impossible to make one person better off without making someone worse off.
59
Do firms in a perfectly competitive market produce at a productive and allocative efficient level in the short run?
They will **not** be producing at the productive level if they are making abnormal profits or loses.
1. **Abnormal profits diagram** ---\> Firm producing at profit maximising the level of output (MC=MR) and allocatively efficient level (MC=AR) at the level 'q'
But they are not producing at the productively efficient level of where MC=AC --\> q1 .
2. **Loss diagram** ---\> Firm producing at profit maximising the level of output (MC=MR) and allocatively efficient level (MC=AR) at the level 'q'
But they are not producing at the productively efficient level of where MC=AC --\> q1 .
60
Do firms in a perfectly competitive market produce at a productive and allocative efficient level in the long run?
In the long run, firms will always make normal profits ---\> in this scenario firms will produce at a productively and allocatively efficient level.
61
How can we define a monopoly?
In theory, a monopoly is a type of market structure where there is only **one firm producing** the product, so the **firm is considered the industry**. There are **high barriers to entry** which prevents new firms from entering and the firm is considered to be price-makers.
62
What are factors that may act as barriers for new firms entering into a market with a monopoly?
1. **Economies of Scale** - If a monopoly is large then they will experience economies of scale which is something new firms will lack when entering --\> new firm won't be able to compete.
2. **Natural Monopoly** - This is when there are only enough economies of scale available to support one firm --\> if a new firmed entered --\> Both firms would make a loss (examples --\> Utilities --\> Water, electricity, gas)
3. **Legal barriers** - Legal right to be the only producer in the market --\> i.e. Patents/copyrights/trademarks --\> examples of intellectual property rights. --\> i.e. Governments allow one firm to produce --\> nationalised industry.
4. **Brand loyalty** - If it is too strong then... It can put off a new firm from entering as they won't be able to compete.
5. **Anti-competitive behaviour** - Adopting restrictive practices to stop competition --\> i.e. Price war --\> lower price to a loss-making level --\> sustain losses for longer than competition --\> force firms out.
63
Explain the monopoly diagram.
As the monopolist is the industry --\> the monopolist's demand curve is the industry's demand curve.
**Demand curve** (D=AR) --\> downward sloping --\> Monopolist can decide either price **OR** level of output --\> not both
**Marginal revenue** (MR) curve below demand curve --\> roughly half.
**Marginal cost** (MC) curve ---\> J-shape curve upwards
**Profit Maximizing when MC = MR**
**Average cost curve** (AC) --\> U shape --\> cut by MC curve at the local minimum.
64
Are monopolists able to make abnormal profits in the long run? If yes --\> explain the diagram.
The monopolist can make abnormal profits in SR
If they have effective barriers to entry --\> no new firms enter --\> no competition that can take away profits ---\> This situation monopolist can make abnormal profits in the long run.
On diagram --\> At profit maximising level 'q' --\> the firm is making an abnormal profit (AR\>AC) shown by the area shaded in red.
65
Explain what would happen if a monopoly were to make losses?
If AC\>AR then the monopoly would be making a loss.
In the short run they could...
1. Temporarily close down
2. Continue producing for the time being
However, they would have to adjust their factors of production to ensure that normal profits are made in the long term.
If not? Then the firm will have to shut-down.
**Diagram** ---\> AC \> AR --\> Loss --\> Area shaded in red.
66
Can monopolies choose for revenue maximization?
Yes, monopolies can choose to revenue maximize instead of profit maximising.
This would correspond to producing at the level where **MR = 0.**
They might do this if they want to push competitors out of the market.
67
Are monopolies productively and allocatively efficient?
Unlike perfect competition --\> Monopolists produce at a level of output that is neither productively or allocatively efficient.
They do not produce at the...
Allocative efficient level of MC = AR
Productive efficient level of MC = AC
68
What are the advantages of monopolies in comparison with perfect competition?
Include possible evaluation points/balance.
1. Monopolies achieve large economies of scale --\> pushes down marginal cost curve ---\> higher output at a lower price.
Balance --\> Too Large? diseconomies of scale
2. High levels of abnormal profit --\> investment into research and development --\> long run --\> Better products/more choice/lower prices for consumers.
Balance --\> Will they invest into R&D --\> Lack incentive --\> no competition --\> However there still might be Global competition.
69
What are the disadvantages of monopolies in comparison to perfect competition?
1. If significant economies of scale do not exist --\> monopoly may restrict output and charge higher prices than the perfect competition.
2. High profits --\> unfair? ---\> unequal distribution of income.
3. Productively inefficient
4. Allocatively inefficient
5. Inefficiency --\> less incentive to cut costs because it doesn’t face competition from other firms.
6. Lack of choice --\> only one producer
6. Diseconomies of scale --\> If the firm becomes too large.
70
What is monopolistic competition?
Monopolistic competition is a market structure where...
1. The industry is made up of a fairly large number of firms
2. Small firms relative to the size of the industry --\> Action of one firm has minimal impact on competitors.
3. Firms assume that they act independently of each other.
4. Firms produce slightly differentiated products.
5. Low barriers to entry or exit.
71
Difference between monopolistic competition and perfect competition?
The only difference is that in monopolistic competition --\> products are differentiated.
They may be differentiated by...
- Colour, appearance, packaging, design, quality of service, skill levels and many other methods.
72
How does product differentiation impact consumers in monopolistic competition?
Differentiated products --\> brand loyalty
Consumers will be loyal and continue buying even if the price goes up a little.
Brand loyalty --\> producers have some element of independence when deciding price --\> Hence, to an extent they can be viewed as 'price-makers'.
73
What are the possible short-run profit and loss situations in monopolistic competition?
Firms in a monopolistic competition can make profits and losses in the short run.
Same diagram as a monopoly.
74
In the long run, what happens in monopolistic competition?
Due to the freedom of entry and exit --\> firms will always tend towards the long run equilibrium where firms are making a normal profit.
1. **Short run profit** --\> Firms are attracted to market and enter --\> possible as there are no barriers to entry --\> new firms take away demand from original firms --\> demand curve shifts inwards (decrease).
2. **Short run loss** --\> firms will leave the market --\> increases demand for other firms in the industry --\> outward shift of demand curve.
Both cases --\> industry will settle at long-run equilibrium (normal profits) ---\> no incentive for firms to enter or leave.
75
Do firms in a monopolistic competition produce at a producte/allocative efficient level?
**Short run profit/loss** --\> Firm produces at profit maximising level as **opposed** to productively efficient level or the allocatively efficient level.
**Long run** --\> Firm is producing at the profit-maximizing level of output and not productively/allocatively efficient level.
76
Comparison between monopolistic competition and perfect competition?
1. Perfect competition is productively/allocatively efficient in the long run but monopolistic competition is not.
Balance --\> inefficiency is not due to restriction in output and price increase like monopoly but rather due to consumers desire for variety.
Are consumers really worse off (allocatively inefficient)?
2. Instead of homogenous product in P.C --\> Monopolistic competition provides variety/choice.
77
How to define an oligopoly?
This is a type of market structure where a few firms dominate an industry. Hence, a large proportion of the industry's output is shared by just a small number of firms.
78
What are the assumptions/characteristics of an Oligopoly?
1. High barriers to entry (can vary)
2. Interdependence between firms --\> small number of firms dominating the industry --\> firms need to examine the actions of competitors
3. Price rigidity --\> Price don't fluctuate as much.
4. Consumers tend to have Brand loyalty.
79
What is a collusive oligopoly?
This is when firms in an oligopolistic market collude (work together) to charge the same prices for their products, in effect acting as a monopoly. So the firms end up dividing abnormal monopoly profits.
Oligopolies do this because...
- They want to coordinate prices --\> No Price War
- Limit competition --\> control market
- Reduce Uncertainties
80
What are the two types of collusion?
1. **Formal collusion** (also known as a cartel)--\> takes place when firms openly agree on the price that they will al charge.
Example: OPEC --\> production of petroleum
Note --\> This results in higher prices/less output for consumers ---\> Generally banned by governments
2. **Tacit Collusion** ---\> When firms in an oligopoly chare the same prices without formal collusion. This is illegal if firms secretively agree on prices/output behind closed doors.
81
What is game theory?
Economists use game theory in order to explain the behaviour of firms in a non-collusive oligopoly.
Game theory considers the optimum strategy that a firm could undertake in the light of different possible decisions by rival firms.
82
In game theory, what are the two main strategies?
1. **Maximin Strategy** --\> This involves maximizing minimum profit ---\> basically the ‘best of the worse' outcomes.
2. **Maximax** ---\> This involves making the maximum profit available --\> basically the outcome with the greatest benefit.
83
Evaluation points when using Game theory?
Advantage
1. Useful as it helps firms predict the outcomes of any set of decisions.
Disadvantage
1. Predictions --\> are they accurate? --\> More firms in the industry --\> more difficult it is to estimate combinations of decisions and outcomes.
**Conclusion** --\> Most accurate when there are only a few firms and a small number of options and the outcomes can be accurately predicted.
84
Explain the oligopoly diagram (kinked demand curve)
The kinked demand curve supports the idea of price rigidity.
The reason why the demand curve is kinked is because...
**1.** If a firm raised their price above the market price --\> other firms won't follow --\> Higher price less attractive for consumers --\> elastic demand curve --\> change in demand proportionally larger than a change in price.
Most likely result in a decrease in trade, sales and profit.
**2.** If a firm lowered the price ---\> other firms will most likely follow....
Price war --\> firms undercut each other --\> decrease price but don't gain any market share/increase in sales --\> fall in revenue --\> Represented by an inelastic curve as --\> change is the price is proportionally greater than the change in quantity
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What are examples of non-price competition used by oligopolies?
As changing price is undesirable, oligopolies employ non-price competition strategies to in order to increase the demand for their products.
Examples include:
1. Advertising/marketing --\> develop brand loyalty
2. Brand name
3. Packaging
4. Special features
5. Sales promotion
6. Personal selling
7. Special distribution features --\> free delivery
Etc...
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Definition of Sunk costs?
Sunk Costs --\> Costs that have already been incurred and cannot be recovered.
I.e. If rail track have been set up for trains and the firm decides to leave the market --\> they won't be able to recover the cost of the rail track
Monopoly and Oligopoly --\> High Sunk costs.
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What are some possible obstacles that oligopolies might face during collusion?
1. The possibility of cheating --\> Price war
2. Harder to come to an agreement when there are many firms in the market.
3. Hard to set prices as different firms might have different demand curves with varying elasticities.
4. Manufacturing costs between firms are different
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What is price-leadership?
Sometimes in an oligopoly market structure...
You will have one dominant firm in the industry that sets a price and also initiates any price changes.
Hence, remaining firms are price-takers --\> accepting the price set by the dominant firm.
**Obstacles**
- Firms attracted to high profits/market share --\> enter the market. To prevent this, firms keep profits low to discourage others.
- Price leadership may be illegal or legal --\> Tacit Collusion?
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What does 'Limit pricing' refer to in an oligopoly?
This refers to a situation when firms agree informally to set a price that is lower than the profit maximising price.
This discourages other firms from entering the market and allows firms to make a larger profit in the long run.
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What does 'sticky prices' refer to in an oligopoly?
Prices in an oligopolistic industry tend to be inflexible or 'sticky' once a price has settled.
After which, the price is stable for a long period of time.
This is because firms want to prevent the potential damage from price wars.
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What are price wars? Do they actually happen?
When suppliers undercut each other price in an attempt to achieve higher market share.
Even though it is undesirable (as shown by the kinked demand curve), it may still happen because....
1. Firms are seeking to gain short-term profits and win some extra market share.
2. Firms want to push competition from the market.
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What are the disadvantages of collusion?
1. High prices for consumers --\> decline in consumer surplus --\> allocative inefficiency.
2. New firms can be discouraged from entering the market.
3. Easy profits from collusion --\> drive down incentive to innovate and increase productivity.
4. Market suffers from the disadvantages of a monopoly (higher prices) but none of the advantages (i.e. economies of scale).
5. Illegal --\> fined --\> Significant?
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Why would oligopolies want to collude?
1. No price war
2. Set higher prices --\> increased revenue
3. Less costs --\> i.e. less spending on non-price competition (advertising)
4. Acts as a barrier to entry --\> limit competition
5. More profit
6. Reduce uncertainties
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What is price discrimination?
Price discrimination exists when a producer sells the exact same product to different consumers at different prices.
I.E.
Child Flight ticket --\> $500
Adult Flight ticket --\> $700
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What are the three conditions that are necessary for price discrimination?
Without these conditions --\> Price discrimination is not possible!!!
1. The producer must have some price-setting ability --\> More price-setting ability a producer has --\> the easier it is for price discrimination to take place.
Common in Monopoly/Oligopoly
Not possible in Perfect competition.
2. Consumers must have different price elasticities of demand for the product. If they do not, they will not be prepared to pay different prices
3. Producer must be able to separate the consumer so that they are not able to buy the product and sell it to another consumer.
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How can a producer separate consumers?
1. **Time** --\> Demand for particular products change with time. I.e. Train tickets --\> Rush hours and non-rush hours.
2. **Age** --\> Charge different prices based on age.
3. **Gender** --\> Different prices for males and females
4. **Income** --\> Higher prices for individuals with a high income.
5. **Geographical distance** --\> Firms sell products at different prices within different regions --\> possible if the cost of transport is greater than the difference in price.
6. **Types of Consumer** --\> Different users encounter different prices (i.e. Industrial use and domestic users of electricity).
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What is the first level of price discrimination?
First-degree price discrimination, alternatively known as perfect price discrimination, occurs when a firm charges a different price for every unit consumed.
Basically, each consumer pays exactly what he/she is prepared to pay.
Imagine a market/bazar where traders are selling products at the highest possible price.
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What is the second level of price discrimination?
Second level of price discrimination --\> firm charges different prices to consumers depending on how much they purchase.
I.e Quantity discounts for bulk purchases.
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What is the third level of price discrimination?
Third-degree price discrimination means charging a different price to different consumer groups.
For example, rail and tube travellers can be subdivided into commuter and casual travellers, and cinema goers can be subdivided into adults and children
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Advantages for firms of price discrimination?
Advantages for Firms:
1. Enables producers to gain a higher level of revenue. This is because consumer surplus eroded.
2. Allows firms to produce more --\> more likely to benefit from economies of scale.
3. Allow firms to drive out competitors from the more elastic market. Basically, using profits from the inelastic market segment (group) to lower prices for the elastic segment --\> allows firms to undercut
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Advantages for consumers of price discrimination?
1. Allow consumers to purchase a product that they would not have been able to afford if other consumers were not paying the higher price --\> Richer people basically 'subsidizing the poor'
2. Likewise, price discrimination allows some people to purchase products for a lower price. University tuition --\> domestic and foreign in UK.
3. Price discrimination increases total output --\> product is available to more consumers.
4. Price discrimination --\> economies of scale --\> lower consumer prices for all.
5. Price discrimination --\> reducing market failure --\> enables wider consumption of merit goods
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Disadvantages for consumers of price discrimination?
1. Some consumers will pay more relative to the price in a single, non-discriminated market.
Hence, consumers in a captive sub-market are being unduly exploited due to their inelasticity.
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What is imperfect competition?
Monopolists --\> push up prices in order to maximize profits --\> fail to allocate at socially efficient level.
A monopolist produces at the level of MC = MR which is not the socially optimum level (Q)
Results in a loss of consumer and producer surplus --\> community surplus is not maximised --\> market failure.
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How can market failure caused by imperfect competition be reduced?
1. Legal measures to make markets more competitive --\> laws that prevent mergers or takeovers that give a firm more than a certain percentage of the market.
2. Set up regulatory bodies to investigate markets ---\> prevent monopoly power abuse.
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How to can the government control monopoly power?
1. **Price controls** --\> I.e. In the UK --\> Office of Fair Trading (OFT), has developed a system of price ‘capping' for natural monopolies like gas and water.
2. **Preventing mergers** --\> Prevent a firm from obtaining a certain amount of the market share.
3. **Nationalisation** --\> The state can take control of the monopoly.
4. **Trade liberalization** --\> Increase competition --\> monopolies own less of the market.
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Difference between Monopolistic competition and a monopoly in terms of the PED.
The demand curve for the monopolistic competition is more elastic than the demand curve for a monopoly.
This is due to a large number of substitutes in a monopolistic competition market structure.
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What is dynamic efficiency?
Dynamic efficiency occurs over time and is strongly linked to the **pace of innovation** within a market and **improvements** in both the **range of choice** for consumers and also the **quality** of products.
Basically --\> Supernormal profits being reinvested into research and development/improving production efficiency.
Condition --\> Supernormal profits need to be made
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Diagram for price discrimination?
