Part 2. The Firm and Market Structures

Question 1

Perfect competition

Answer 1

• A market in which many firms produce identical products.
• Barriers to entry are low.
• Firms compete for sales only on the basis of price.
• Firms face price elastic (horizontal) demand curves at market price, as not firm is large enough to affect price.

e.g. market supply and demand determine price of wheat.

Question 2

Monopolistic competition

Answer 2

• Differs from perfect competition in products that are not identical.
• Differentiated products between firms in product quality, features and marketing.
• Demand curve is downward sloping, where its highly elastic, but not perfectly elastic, as competing products perceived by consumers are close substitutes.
• Prices are not identical.
• Low barriers to entry.
• Large number of independent sellers, with each firm having a small market share and no significant power over price.
• Too many firms in industry for collusion (price fixing), based on average market price.

i.e. the market for toothpaste, if price of personal favourite increases, its not likely that you will immediately switch to other brand like under perfect competition, some may switch in response to 10% increase in price.

Question 3

Oligopoly

Answer 3

• Only few firms competing.
• Each firm considers actions and responses of other firms in setting price and business strategy - firms are interdependent.
• Products are good substitutes, but may differ/be similar through features, branding, marketing and quality.
• High barriers to entry, due to economies of scale and marketing lead to large firms.
  Demand less elastic than monopolistic competition.

i.e. automobile market - product and pricing of Toyota affected Ford.

Question 4

Monopoly

Answer 4

• A single seller of product with no close substitutes.
• Downward sloping demand curve for firm, and pricing power.
• High barriers to entry; protection offered by copyrights and patents, or control over resource specifically needed to produce the product.
• Profit max. involves a trade off between price and quantity sold of the firm sells at the same price to all buyers.
• price searchers
• imperfect information

Question 5

Natural monopoly

Answer 5

A situation where average cost of production is falling over the relevant range of consumer demand.

Having 2 or more producers will result in a significant higher cost of production and will be detrimental to consumers, meaning large economies of scale in industry present significant barriers and price they charge is often regulated by the government.

e. g. electric power, distribution business, other public utilities
- high fixed costs
- low marginal costs

Question 6

Networks effects/synergies

Answer 6

When market power makes it very difficult to compete with a company once it has reached a critical level of market penetration.

e. g. EBay gained a large share of the online auction market, that its information on buyers and sellers, and number of buyers who visit EBay precluded others from establishing competing business.
- Ebay had a negatively sloped demand curve, and good pricing power, but changes in technology and consumers tastes can reduce market power over time, e.g. Polaroid bankruptcy in 2001 due to the intro of digital photography.

Question 7

Marginal

Answer 7

The increase in total revenue from selling one more unit of a good or service.

Question 8

Economic profit

Answer 8

• The total revenue less the opportunity cost of production, which includes the cost of normal return to all factor of production including invested capital.
• Maximised at the quantity for which MR = MC, when TR exceeds TC.

Question 9

Economic loss

Answer 9

This occurs on any units for which marginal revenue is less than marginal cost.

i.e. any output above MR = MC

Question 10

Short run supply curve for firm

Answer 10

The MC line above the average variable cost curve, AVC.

Question 11

Short run market supply curve

Answer 11

The horizontal sum (add up the quantities from all firms at each price) of the MC curves for all firms in an given industry as firms will supply more units at higher prices, the SR market supply curve slopes upward to the right.

Question 12

Downsizing

Answer 12

A firms LR adjustment to shift industry demand, resulting in change in price to alter size of plant or leave the market entirely.

i.e. Ford and GM have decreased plant size to reduce economic losses.

Question 13

Permanent change in demand

Answer 13

This leads to the entry or exit of firms from an industry.

Question 14

Product innovation

Answer 14

• A necessary activity as firms in monopolistic competition pursue economic profits, firms that bring new and innovative products to the market are confronted with less elastic demand curves, thus increasing price and earn economic profit.
• Close substitutes and imitations will erode initial economic profit, so constant innovation makes product more desirable to some consumers.
• Cost of innovation must be weighed against extra revenue it produces, where its optimal innovation when MC of add. innovation = MR (marginal benefit) of add. innovation.

Question 15

Advertising expenses

Answer 15

• High for monopolistic firms, increasing ATC.
• Advert costs decrease as output increases, as more fixed advertising dollars are averaged over a larger quantity.
• If ads lead to enough increase in output, it can decrease firms ATC.

Question 15

Advertising expenses

Answer 15

• High for monopolistic firms, increasing ATC.
• Advert costs decrease as output increases, as more fixed advertising dollars are averaged over a larger quantity.
• If ads lead to enough increase in output, it can decrease firms ATC.

Question 16

Brand names

Answer 16

• Provide information with signals about quality of branded product.

Question 17

4 models of an oligopoly:

Answer 17

1. Kinked demand curve model
2. Cournot duopoly model
3. Nash equilibrium model (the prisoners dilemma)
4. Stackelberg dominant firm model

Question 18

Cournot model

Answer 18

• An early model of oligopoly pricing decisions.
• The 2 firms with identical MC each choose their preferred selling price based on price of the other firm chosen in previous model.
• The equilibrium of 2 firm oligopoly (duopoly), is for both firms to sell same amounts and quantities splitting the market equally at equilibrium price.
• The equilibrium price is less than price of a single monopolist would charge, but greater than under perfect competition.

Question 19

Stackelberg model

Answer 19

_ One firm is the leader and choses price first, and the other choses price based on leaders price.

• In equilibrium under these rules the leader charges higher price and receives greater proportion of firms total profits.
• Firms determine quantities simultaneously each period under Cournot assumptions, which change each period until they are equal.
• When each firm selects the same quantity, there is no longer additional profit to be gained by changing quantity, and there is a stable equilibrium.
• As more firms are added to model, the equilibrium market price falls to MC, which equilibrium price in limit as number of firms get larger.

Question 20

Nash equilibrium

Answer 20

When choice of all firms are such that there is no other choice that makes any firm better off (increases profits or decreases losses).

Question 21

Collusion

Answer 21

e.g. OPEC cartel

• Agreement to restrict oil production to increase the world price of oil.
• Members chose to cheat on agreement by producing more oil than agreed, thus not adhering took advantage of higher market price but failed to restrict output.
• Agreement broke down quickly.

Question 22

More successful collusive agreements to increase price in oligopoly market:

Answer 22

• there are fewer firms
• products are more similar
• cost structures are more similar
• purchases are relatively small and frequent
• retaliation by other firms for cheating is more certain and severe.
• there is less actual or potential competition from firms outside the cartel.

Question 23

Dominant firm model (oligopoly):

Answer 23

• There is a single firm that has significantly large market share due to greater scale and lower cost structure - the DF.
• The market price is determined by DF, other CF (competitive firms) take market price given.
• DF believes quantity supplied by other firms decreases at lower prices so Ddf, and MRdf firms will maximise profits at price, P*.
• Competitive firms maximise profits producing quantity for which MCcf = P*, at Qcf.

Question 24

2 pricing strategies for monopoly firm:

Answer 24

1. Single price

2. Price discrimination

Question 25

Price discrimination

Answer 25

The practice of charging different consumers different prices for the same product or service.

e.g. airline tickets based on night of stay, movie tickets dependent on age.

Aim is to capture more consumer surplus as economic profit than possible by charging a single price.

Question 26

For price discrimination to work, seller must:

Answer 26

• Face a downward sloping demand curve.
• Have at least 2 identifiable groups of customers with different price elasticities of demand for product.
• Prevent customers paying lower price from reselling the product to consumers paying higher price.

= result is increased profits for firm.

Question 27

Deadweight loss

Answer 27

The quantity produced by monopolist reduces the sum of consumer and producer surplus by this amount.

Question 28

Perfect price discrimination

Answer 28

The monopolist charges each customer the maximum they are willing to pay for each unit, meaning no deadweight loss, as would produced the same quantity as under perfect competition.

• There will be no consumer surplus, it would all be captured by the monopolist.

Question 29

Average cost pricing

Answer 29

Most common form of regulation.

• Result in price of Pac and output of Qac forces monopolists to reduce price where firms ATC intersects the market demand curve.

This will:

• increase output and decrease price
• increase social welfare (allocative efficiency)
• ensure monopolist a normal profit because price = ATC.

Question 30

Marginal cost pricing (efficient regulation)

Answer 30

This forces the monopolist to reduce price to a point where firms MC curve intersects the market demand curve.

• This increases output and reduces price, causing monopolist to incur loss as price below ATC.
• This requires a government subsidy to provide firm with normal profit and prevent market exit.

Question 31

Monopoly regulation (alt.)

Answer 31

• The government to sell monopoly to the highest bidder, such as the right to build gasoline station on tollway.
• The winning bidder will be an efficient supplier that bids amount equal to value of expected economic profit and sets price equal to LRAC.

Question 32

Pricing strategy under each market structure:

Answer 32

1. Perfect competition - proits max. quantity when producing at MC=MR=P.
2. Monopoly - profit max. when MC=MR, as demand is downward sloping, P > MR & MC.
3. Monopolistic competition - profit max. firm produces quantity where MC = MR, like monopoly downward sloping curve means P > MC & MR.
4. Oligopoly = a key characteristic is interdependence of firms pricing and output, so optimal pricing strategy is dependent on reactions of other firms to each firms actions.

Question 33

Pricing strategies of an oligopoly:

Answer 33

1. Kinked demand curve - assumes competitors will match price decrease but not price increase, producing at MC=MR, but MR is discontinuous (gap), so for many cost structures the optimal quantity is the same, given same kinked demand curve.
2. Collusion - All producers agree to share market to maximise total industry profits, produce at MC=MR, and charge price from industry demand curve at which qty is sold. Same overall price for profit max. monopoly, but oligopoly agrees to share total output among themselves and share economic profits.
3. Dominant firm - One firm with lowest cost structure, and large market share will max. profits producing at MC=MR, charging price related to quantity produced. Other firms take price given, and produce quantity which MC = P.
4. Game theory = The interdependence of oligopoly firms decisions, assuming how competitor will react to a price and output decision can determine optimal pricing strategy. Given models and assumptions of competitor reactions, the long run outcome is indeterminate, where price will be between monopoly price (successful collusion) and perfect comp. (P=MC, if competition rules out price above this level).

Question 34

Concentration measures

Answer 34

Rather than estimating elasticity of demand, this is used for a market or industry as an indicator of market power.

Question 35

N-firm concentration ratio

Answer 35

The sum or percentage market shares of the largest N firms in a market.

Limitation:

• May be relatively insensitive to mergers of 2 firms with large market shares, a solution being Herfindahl=Hirschman Index.
• but barriers to entry are not considered in either case, as high market share does not mean high pricing power if barriers to entry are low (potential competition) - thus existing firms must by highly elastic even though they have high market shares.

Question 36

Herfindahl-Hirschman Index (HHI)

Answer 36

This is calculated as the sum of the squares of the market shares of the largest firms in the market.