The Theory of the Firm Flashcards
Define normal profit
the situation where a firm makes sufficient revenue to cover its total costs and remain competitive within an industry
Define abnormal profit
any profit above normal profit
What is the point of productive efficiency?
MC = AC
Define productive efficiency
producing goods and services with the optimal combination of inputs to produce maximum output for the minimum cost
What is the point of allocative efficiency?
MC = AR
Explain why the point MC = AR is allocatively efficient
as the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the marginal cost of the scarce factor resources used up in production
When does allocative efficiency occur?
when there is an optimal distribution of goods and services, taking into account consumer’s preferences
Define consumer surplus
the difference between what consumers were willing to pay, and what they actually pay
Define producer surplus
the difference between what producers are willing and able to supply a good for and the price they actually receive
When does dynamic efficiency occur?
in the long-run
What is dynamic efficiency linked to?
the pace of innovation and investment, leads to the improvements in the performance and quality of the product
What is needed for dynamic efficiency to occur?
supernormal/abnormal profits
What is X-inefficiency?
where a lack of effective/real competition in a market or industry means that average costs are higher than they would be with competition
Give 4 characteristics of a monopoly
- 25%+ of market share
- price makers
- profit maximising
- abnormal profits
- high barriers to entry
Give 4 characteristics of a oligopoly
- few firms control majority of the market share
- high barriers to entry and exit
- sticky or rigid prices
- firms are interdependent
- non-price competition
- some product differentiation
Give 4 characteristics of monopolistic competition
- large number of small buyers and sellers
- few and low barriers to entry
- good knowledge/information
- goods are non-homogenous / goods are slightly differentiated
Give 4 characteristics of perfect competition
- large number of small buyers and seller (theoretically infinite)
- no barriers to entry
- perfect knowledge/information
- goods are homogenous
- price takers
- no abnormal profits made in the long-run
Give 3 characteristics of a contestable market
- no barriers to entry or exit
- there are no sunk costs
- perfect information and access to all existing technologies
- there is a POTENTIAL for competition
Explain why a firm in perfect competition cannot make abnormal profits in the long-run
- due to no barriers to entry, any abnormal profits will attract new entrants into the industry
- this increases the market’s supply, reducing the price until all abnormal have been competed away
Explain why a firm in perfect competition will not make a loss in the long-run
due to no barriers to exit, if firms are making a loss, some will choose to leave the market
- this will decrease supply, pushing up price until no losses are being made
What profit is made in the long-run in perfect competition?
normal profit
What efficiencies does a perfect competition firm operate at in the long-run?
- productively efficient
- allocatively efficient
Perfect competition will only result in allocative efficiency if…
… there are no externalities (positive or negative) in the market
What is the profit maximising point?
MR = MC
What is the point of normal profit?
AR = AC
At what point will a monopoly operate at?
at the point of profit maximisation, where MR = MC
How could a monopoly be deemed as disadvantageous to the consumer?
- operating below the point of allocative efficiency
- thus there is a deadweight loss to society
How could a monopoly be deemed as advantageous to the consumer?
- make supernormal profit, so can be dynamically efficient
- this could be used for investment, innovation, research and development, which could reduce costs in the long-run
- this could then be passed onto the consumer in terms of lower prices
Give 3 determinants of monopoly power
- high barriers to entry
- low number of competitors
- advertising and product differentiation
Give 2 types of barriers to entry
- legal barriers
- absolute cost barriers
- relative cost barriers
Give 2 types of legal barriers to entry
- licences
- patents
Explain what is meant by absolute cost barriers
the large amount of capital required to set up a firm in some markets
Explain what is meant by relative cost barriers
- AC of new firms is higher than AC of incumbent firms
- incumbent firms enjoy economies of scale and the benefits of R + D
Explain how high barriers to entry is a cause of monopoly power
- decreases the number of potential competitors
- means that one firm can dominate the market
When does a natural monopoly occur?
occurs when the benefits of economies of scale in an industry are so large that it is uneconomic for more than one firm to supply in that industry
Explain how high relative cost barriers is a cause of monopoly power
- AC of new firms would be higher than the incumbent monopoly
- because the monopoly has dynamic efficiency, economies of scale, R + D, etc
- discourages new firms from entering the monopoly, reducing competition, causing/increasing the monopoly power
Explain what happens if a firm is making abnormal profit in a monopolistic competition market
- low barriers to entry allow new competitors to enter the market
- this has the effect of reducing the % of overall market share each individual firm enjoys, and make the demand for each product more PED elastic (due to an increased number of substitutes)
- this shifts the AR and MR curves downward, competing away abnormal profits away
For a firm is monopolistic competition, when can abnormal profits be made?
in the short-run
Give 2 reasons why firms in monopolistic competition are not forced to be productively or allocatively efficient
- differentiated products
- lack of rigorous competition
Compare the PEDs for a monolpoly and a firm in monopolistic competition
PED is more elastic for the firm in monopolistic competition
Compare the PEDs for a firm in perfect competition, and a firm in monopolistic competition
PED is more elastic for the firm in perfect competition
Explain how monopolistic competition can improve consumer choice of products
- low barriers to entry mean that there is intense competition between firms
- provides an incentive to compete for market share and profit
- leading to more choice of product for consumers
Explain why the increased product choice for consumers, as a result of monopolistic competition may not always be beneficial
consumers have bounded rationality and may not make optimal decisions of there is a bewildering choice
Referring to MC and price, give a potential benefit of monopolistic competition
in monopolistic competition, prices are kept closer to marginal cost, leading to improved allocative efficiency
Explain why monopolistic competition may not be beneficial to the firms, in terms of productive efficiency
- although competition keeps prices low, the saturation of products may lead to firms not exploiting economies of scale
- this leads to a loss of productive efficiency
Why are firms in an oligopoly able to make long-run abnormal profit?
due to high barriers to entry
Why are firms in an oligopoly likely to be dynamically efficient?
as they face stiff competition
How do firms in an oligopoly prefer to compete?
using non-price competition
Give 2 examples of non-price competition
- advertising
- marketing campaigns
- loyalty programs
As firms in an oligopoly choose not to compete on price, what does this result in?
sticky/rigid prices
Why is there an incentive for firms in an oligopoly to collude and fix prices? (2 reasons)
- it would maximise their joint profits
- it would increase their producer surplus
What law would it break if firms in an oligopoly decided to collude?
EU competition law
If firms in an oligopoly do collude, what market structure would they effectively be operating as?
a monopoly
What would the 2 main costs to consumers from firms in an oligopoly colluding?
- higher prices
- lost consumer surplus
What is meant by a non-collusive oligopoly?
where firms in the market act independently when setting prices
What is meant by a collusive oligopoly?
where firms collude to fix prices or overall market supply
Why doesn’t it make sense for a firm in an oligopoly to raise its price?
if it raises its price, other firms will not follow, so you lose a lot of quantity demanded
Why doesn’t it make sense for a firm in an oligopoly to lower its price?
if it lowers its price, other firms will follow, so the quantity demanded wouldn’t massively increase
Is a competitive oligopoly good for consumers and/or firms?
- good for consumers
- bad for firms
Is a collusive oligopoly good for consumers and/or firms?
- good for firms
- bad for consumers
Why is the number of firms that exist in a contestable market irrelevant?
due to the constant threat of new competition
Why are the costs facing a new firm similar to, if not the same as, an incumbent firm, in a contestable market?
due to perfect information and access of/to all existing technologies
What profit will a firm in a contestable market make in the long-run?
normal profit
Why does a firm in a contestable market operate at AC = AR in the long-run?
to deter the threat of “hit and run” entrants in to the market
How could governments use the theory associated with contestable markets when producing market-based solutions to market failures?
- increasing the contestability in a monopoly industry
- such as by deregulation and/or privatisation
- this is principally done through reducing/removing barriers to entry and exit
Give 3 pros of making a market more contestable
- more allocative efficiency
- more productive efficiency
- more x-efficiency
- job creation
Give 2 cons of making a market more contestable
- lack of dynamic efficiency
- may lead to cost cutting in dangerous areas
Give 3 ways that technology has increased contestability
- has lowered barriers to entry and/or exit
- has increased the pool of potential entrants
- has improved the information available
Define price discrimination
the action of selling the same product at different prices to different buyers, in order to maximise sales and profits
Give 3 factors that firms may price discriminate because of
- age
- gender
- country
- region
- time of day
Give the four conditions that are necessary for price discrimination
- different markets must have different PEDs
- the firm must have price-making power
- the markets must be able to be separated by time, place etc and be kept separate so that no cross-selling can occur
- the cost of separating the markets must not be greater than the potential gain from price discriminating
What is meant by first degree price discrimination?
where a firm with price making power charges each individual consumer the maximum price they are willing to pay, turning all consumer surplus to producer surplus
What is meant by third degree price discrimination?
where the market is split in two according to their different elasticities of demand, different markets will then face different prices in order to maximise profits from the two markets
Who first coined the term “creative destruction”?
Joseph Schumpeter
What did Schumpeter say that innovation enables entrepreneurs to do?
enables entrepreneurs to compete with existing firms in an industry, eroding their profits and market share, and eventually becoming more powerful than them
Give a real life example of “creative destruction”
- the music industry
- cassettes overtook vinyl in the 80s
- compact discs overtook cassettes in the 90s
- electronic downloads overtook compact discs in the 00s
Define creative destruction
- the process of how capitalism leads to a constantly changing structure of the economy
- old firms and industries, which are no longer profitable and/or efficient, close down enabling resources to be moved into more productive processes
Give 2 benefits of creative destruction
- the threat of going out of business is an incentive for firms to move with the changing market and keep costs low
- although there are short-term job losses, new jobs are also created through economic change
Give 2 costs of creative destruction
- some jobs are lost when new market models are introduced, may lead to structural unemployment
- the firm or industry may provide external benefits which impact on social efficiency
Give an example of where a firm or industry provided external benefits, but was shut down / not invested in to allocate resources elsewhere
- the rail industry in the 60s, resources were taken away from rail and put into road travel
- however, nowadays rail closures are now regretted as it can help reduce road congestion, pollution, etc
