Module 7 - Organisation of Industries Flashcards
Definition of Perfect Competition:
- All firms in this market produce an identical good – no real or perceived difference in the good
- Resource owners have information on the opportunity cost of their resources
- Each firm in a perfect market faces a perfectly elastic demand curve – at the equilibrium price he can sell as much as he can produce, but only at the equilibrium price
- If above normal profits are made, then resources flow into the industry until no resources can earn a higher return by flowing between industries, when this happens each firm is in long run equilibrium
- Above normal profits (new firms entering) causes the supply curve to shift to the right. This causes the price to decrease and quantity supplied to increase
- Since the firm is a price taker and the demand curves are elastic, the effect is to reduce the demand curve
- Resources stop moving into the industry when Price = Average Cost, this occurs for a firm at the very bottom of its LRAC curve, when P=LRMC=min LRAC
In the world of perfect competition
I. firms set prices in the short run to maximise profit or minimise loss
II. firms set prices in the long run to maximise sales
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is D. Perfectly competitive firms are price takers in both the short run and long run. They can sell all they can produce at the going market price and would therefore never charge a lower price. They can sell nothing at a price higher than the equilibrium price. Thus I and II are both wrong.
In response to above normal profit/returns firms move into an industry. Which of the following reflects this movement?
A. The demand and supply curves shift to the right, price decreases
B. The supply curve shifts to the right, price decreases, consumers move down the demand curve
C. MU/price for the good in question decreases; total utility increases
D. Existing firms increase output, shifting the supply curve to the right.
The correct answer is B. Firms moving into an industry cause the supply curve to shift to the right but do not affect the position of the demand curve. Thus A is wrong. The shift to the right of the supply curve will cause price to decrease and consequently MU/price to increase. Thus C is wrong. The price decrease will cause existing firms to decrease output as they move down their supply (marginal cost) curves. Thus D is wrong. The new supply curve will intersect the existing demand curve at a lower equilibrium price; consumers will move along the demand curve.
By regulating the price of a monopoly good so that its equal to the MC…
- more of the monopolists good and less of the competitive are produced.
- Society’s utility will be increased by shifting resources from compeitive firms to the monopoly and economic efficiency will prevail because marginal equivalency conditions (P=MC) will be satisfied
Name the type of product for each firm:
- Perfect competition: Homogeneous
- Monopolistic/ imperfect competition: Differentiated
- Oligopoly: Homogeneous
- Monopoly: Unique
Name the number of firms for each organisation:
- Perfect competition: Very Large
- Monopolistic/ imperfect competition: Large
- Oligopoly: Small
- Monopoly: One
Definition of principal-agent problem:
the principal (the govt) gives the agent (the monopoly firm) the ability to set prices at a level which covers cost and gives normal profit, there is no incentive for the agent to minimize costs and so the firm will not be economically efficient
Imperfect Competition
Explain why each imperfectly competitive firm has spare capacity?
- not operating at the minimum point on its ATC
- each firm would not be economically efficient for the same reason as monopoly – P is not equal to MC
Common features of perfectly and imperfectly competitive firms are
I. in the long run in equilibrium both produce at the minimum points on their long run average cost curves
II. facing downward sloping demand curves in the short run
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is D. Imperfectly competitive firms have some control over prices, i.e. can raise price without losing all customers because they face downward sloping demand curves. Perfectly competitive firms have no control over price – they face horizontal demand curves. Thus II is wrong. Because imperfectly competitive firms face downward sloping demand curves, in equilibrium, the demand curve will be tangent to the ATC but not at its minimum point. This I is incorrect.
A firm’s stated objective was ‘to motivate employees for results’. Which of the following is best suited for solving the implicit principal/agent problem? Paying each employee
A. for hours worked
B. the same wage as every other
C. for his/her contribution to output
D. the average product of labour in the firm
The correct answer is C. In options A, B and D there is no incentive for each employee to give of his/her best because pay is not related to output. Only in option C is there a correlation between reward and productivity, i.e. only there will each employee (agent) be motivated to do what the firm owner (principal) wishes.
An imperfectly competitive firm discovers that at its present level of output average total cost, which is at a minimum, is $16.50 and its average revenue is $18. Marginal revenue is $12. To maximise profit what should the firm do?
A. Leave price and output unchanged.
B. Increase price and leave output unchanged.
C. Increase price and decrease output.
D. Decrease price and decrease output.
The correct answer is C. The marginal cost curve intersects the average variable cost curve at its minimum point, i.e. at the current output level, and at a price of $16.50. However, at this output level, marginal revenue is only $12. Thus, marginal cost exceeds marginal revenue, and to maximise profit the firm must contract its output. However, at a lower output level the market clearing price must be higher on a downward-sloping demand curve.
A monopolist is a producer that…
….supplies the complete market for a good or service – they are price makers rather than takers
Given that marginal revenue is less than average revenue under monopoly (either in the short run or in the long run), the profit-maximising monopolist will…
…produce an output level where price is greater than marginal cost.
When an unregulated profit maximizing monopolist is the supplier in a market, economic efficiency…
… will not prevail as marginal equivalency will not be met
- To achieve economic efficiency, prices must be equated with marginal cost of the good in question
- In some cases replacing a monopoly with competitive firms can achieve economic efficiency
The marginal equivalency conditions for economic efficiency specify that the ratios of marginal utility to marginal cost,
MU
MC
must be equal for all goods and service. This will be achieved when the ratios of
MU
P
are equal and when P = MC for all goods and
services. Under monopoly, however…
- Price is greater than marginal cost
- Thus the marginal equivalency conditions cannot be met, since marginal cost cannot be substituted for price in the equivalency equation
- The ratio of
MU
MC
for the monopo- list’s product will be greater than the ratio of
MU
MC
for competitively produced goods since, for each good produced under monopolistic conditions, P > MC.
* Conse-quently it would be possible to increase society’s utility by reallocating resources so that more of the monopolist’s good and fewer of other goods were produced
With economies of scale in place, regulation to equate price with MC…
… is necessary to achieve economic efficiency
When monopoly exists in an economy, economic efficiency will…
…not prevail
In a long run monopoly situation, the firm may make above normal profits…
P>ATC and P>LRAC
Suppose a fully employed economy had only two industries, one being monopolistic and the other being competitive. Assuming that there are no economies of large-scale production, what would be the result of government action to break up the monopoly into many competitive firms? There would be
A. an increase in output for the monopolised industry and a decrease in output for the competitive industry.
B. a decrease in output for the monopolised industry and an increase in output for the industry.
C. an increase in output for both industries.
D. a decrease in output for both industries.
The correct answer is A. The existence of the monopoly in one of the two industries implies that, in that industry, price is higher than marginal cost. If that industry were to become competitive, then price would be bid down and output would be increased in the long run since the existence of excess profits would result in new firms entering the industry. As the output of the previously monopolised industry expanded, resources would be bid away from the competitive industry, which would result in lower output in that industry.
Give example of each firm:
- Perfect competition: Many agricultural
products - Monopolistic/ imperfect competition: Restaurants, clothing stores
- Oligopoly: Cars, chemicals, oil
- Monopoly: Public utilities
Name the control over price for each firm:
- Perfect competition: None
- Monopolistic/ imperfect competition: Some
- Oligopoly: Substantial
- Monopoly: Complete
In the case that the regulation price is less than ATC and LRAC…
…a subsidy will have to be put in place to avoid resources leaving the industry
When a firm in imperfect competition is in long-run equilibrium…
- the price of its product will be greater than marginal cost
- economic inefficiency results
because the ratios of marginal utility to marginal cost in different industries will not
be equal - The achievement of economic efficiency would require that price be set
equal to marginal cost by imperfectly competitive firms, but since this would result
in a non-profit-maximising output, given rational firm behaviour, it will not occur - a firm in imperfect competition produces an output level above the minimum point on the average total cost curve
In the world of perfect competition it is assumed that
I. on the demand side consumers, with perfect knowledge, are utility maximisers
II. on the supply side firms, with perfect information, face no restrictions on movement in to and out of any industry.
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
The correct answer is C. This is a definitional question; all of the characteristics mentioned in I and II are true.
Draw short run profit maximisation for a monopolist
The most important sources of economies of scale are
- Specialization of Labor
- Lower per unit costs associated with large capital equipment
- Bulk buying of raw material
Assume the jumps were completely automated so that variable costs were zero what price per jump would result in a maximum profit and why?
A. $2.00 because demand is price elastic
B. $4.00 because marginal revenue is zero when output = 40
C. $6.00 because demand is price inelastic
D. The answer cannot be determined from the diagram
The correct answer is B. Profit maximising output occurs where MR = MC. The marginal revenue curve can be drawn; it is twice as steep as the D (AR) curve and intersects the horizontal axis at an output of 40. MC = 0. Thus the profit maximising output is 40 since MR = MC at that output. The corresponding profit maximising price, i.e. the price which clears the market is given by the demand curve at output 40, i.e. at a price of $4.00 per jump.
At which price would a monopolist whose cost and revenue curves are those pictured in Figure 7.17 maximise profit?
A. B.
B. C.
C. D.
D. E.
The correct answer is D. A monopolist’s profit-maximising output is determined by the intersection of the MR and MC curve. This occurs in Figure 7.17 at the output level F. The corresponding profit-maximising price, given by the demand (average revenue) curve, is E.
At which operating level would a monopolist maximise profit (minimise loss)? At the output where
A. marginal cost equalled average cost.
B. marginal cost equalled marginal revenue.
C. marginal cost equalled price.
D. average cost equalled price.
The correct answer is B. It will always pay a monopolist to add to output as long as each additional unit produced adds more to total revenue than it does to total cost, i.e. as long as marginal revenue exceeds marginal cost. Profit will be maximised at the level where marginal revenue equals marginal cost.
If the leisure company wishes to maximise daily revenue what price should it charge and how many jumps will it sell?
A. $2.00 and 80 jumps
B. $4.00 and 40 jumps
C. $6.00 and 30 jumps
D. The answer cannot be determined from the diagram
The correct answer is B. Total revenue equals price × quantity. The largest total revenue possible given demand curve D occurs when the price = $4.00 and quantity of jumps equals 40; total revenue = $160.
What is the largest output the monopolist in Figure 7.17 could produce without suffering losses?
A. G.
B. H.
C. I.
D. J.
The correct answer is D. As long as average revenue exceeds average total cost, the monopolist will make a profit (above-normal returns). Those two curves intersect in Figure 7.17 at output point J, beyond which the monopolist will incur losses.
Which of the following is correct? In the long run, in monopolistic competition, high profits on the part of one firm
A. will lead to high profits for others, as they imitate the successful firm’s meth-ods.
B. will drive other firms out of the industry, and lead to pure monopoly.
C. will lead to new entry, and tend to drive profits down to normal.
D. will continue indefinitely, since the profitable firm will erect barriers to entry.
The correct answer is C. In monopolistic competition, above-normal profits will attract new firms into the industry, causing the demand curve facing the original firm to shift to the left. This process will continue until only normal profits remain, and this will prevent above-normal profits being earned by successful imitators and will prevent monopoly arising. Monopolistically competitive firms, by definition, cannot erect barriers to entry.
Explain why an ‘enforced’ competitive industry would not only have higher per unit costs but could also yield a lower total output than the monopoly.
- Consider Figure 7.9 and suppose that a government legislates that no firm can produce more than 0q1
- All firms will produce 0q1 at minimum cost for that level of output, having plant size ATC1.
- Industry output would be 0Q1; aggregate demand would equal aggregate supply; and the industry would be in short-run equilibrium
- Each firm would be operating at the minimum point of its ATC1
- the ‘competitive’ price would be Pc and each firm would be in short-run equilibrium, i.e. MC = MR = Pc.
- The monopolist, on the other hand, would produce output 0QM (> 0Q1), i.e. the output where MR = MC4 and charge the profit-maximising price of PM (
- Because PM > MC, the marginal equivalency condition will not hold and we shall have an inefficient allocation of resources.
- Despite this fact, society is obviously better off under the monopolistic situation compared with the enforced competitive situation.
- Thus society wants the monopoly
with the economies of scale
If the average total cost (ATC) of operating the jump were constant at all levels of output and equalled $4.00 what would be the profit maximising output and price?
A. 60 and $2.00
B. 40 and $4.00
C. 20 and $6.00
D. The answer cannot be determined from the diagram and data
The correct answer is C. Given a constant ATC of $4.00, marginal cost must equal $4.00 at all levels of output. Profit maximisation occurs when MR = MC. The MR curve intersects the MC ($4.00) curve at an output level of 20, the corresponding market clearing price being $6.00.
If the demand curve were to shift to the left and average variable costs were to stabilise at $4.00 per jump for all levels of output what would be the profit maximising price?
A. $5.00
B. $6.00
C. $7.00
D. The answer cannot be determined from the diagram and information given
The correct answer is D. Since it is unknown where the new demand curve will be, the marginal revenue curve cannot be derived nor, as a consequence, the profit maximising price and quantity if indeed there remains a profitable output.
The monopolist’s average revenue curve
A. is the line labelled MR.
B. is the line labelled D. C. is the line labelled MC.
D. does not appear on the Figure.
The correct answer is B. By definition a monopolist’s demand curve is his average revenue curve; it tells what quantities can be sold at different prices.
Draw avgerage and marginal curve under monopoly…
