Theory of the Firm Flashcards
What are the key characteristics of Perfect Competition?
- Many buyers and sellers
- Homogenous products
- No barriers to entering the market
- Each consumer is able to buy and each producer is able to sell as much as they wish at the ruling price
- Consumers and sellers have perfect information
Define productive + dynamic + allocative efficiency
Productive: The level of output at which costs of production are minimized
Dynamic: Occurs in the long run. Leads to the development of new products & more efficient processes that improve productive efficiency
Allocative: Where it is impossible to improve economic welfare by reallocating resources eg P=MC
What are the business objectives + explain?
Profit maximization: MC=MR
Revenue maximization: MR=0
Sales maximization: producing largest output possible so normal profits are achieved, AR=AC
Satisficing behaviour: involves the shareholders of a business setting minimum acceptable levels of achievement in terms of revenue & profitability
Explain Perfect Competition in the short run
- Market price is set by the interaction of market supply & demand
- Each individual firm is a price taker
- Ruling market price becomes AR & MR curve
- AR=MR at every level of output
- We assume that firm is profit mazimizing where MC=MR
Explain Perfect Competition in the long run
- If most firms are making supernormal profits in the short run, it encourages the entry of new firms into the market
- This will cause an outwards shift in market supply, forcing down ruling market price
- Will keep reducing until eventually price=long run average cost
- Every firm in market now making normal profit where price (AR)=average cost
- Ceteris paribus, there is no further incentive for movement of firms in & out of the industry & a long run equilibrium has been established where price=average cost at a profit maximizing output where MC=MR
What are the assumptions regarding Monopolistic Competition?
- Many producers & consumers, industry concentration ratio is low
- Non-price competition (Consumers are aware of non-price differences i.e. slight product differentiation )
- Producers are price makers, they have SOME control over price. PED is higher than would be under monopoly (XED is high)
- Barriers to entry & exit are low
Explain Monopolistic Competition in the long run
- In short run, profits can be at any level
- No barriers to entry
- So presence of supernormal profits acts as a signal
- Short run supernormal profits attract new producers with new products & so normal profits are made in the long run where AR=AC
- As new firms enter the market the demand curve for existing firms shift left as consumers opt for new alternatives
- The demand curve continues to move left until it is tangential to the AC curve
- At this point firm is profit maximizing because MC=MR but is only making normal profit because AR=AC
What are they key characteristics of an Oligopoly?
- Few dominant firms
- Non-price competition
- Interdependence
- Barriers to entry
What are the 5 key concepts regarding Oligopolies?
1- CARTEL: association of business or countries that collude to influence production levels & thus the market place
2- COLLUSION: takes place when rival companies cooperate for their mutual benefit
3- KINKED DEMAND CURVE: Assumes that a business faces a dual demand curve for its product based on the likely reactions of other firms
4- INTERDEPENDANCE: when the decisions made by a business cannot be taken in isolation, it must consider likely reactions of rival firms
5- PRICE LEADERSHIP: when one firm has a dominant position & firms with lower market shares follow the price changes of the leader
Explain the Kinked Demand Curve
- Rivals are assumed not to follow price increase by one firm, so the acting firm will lose market share, therefore demand will lose market share, therefore demand will be relatively elastic & a rise in price will lead to less revenue
- Firms are assumed to be likely to match a price fall by one firm to avoid a loss in market share. If this happens demand will be more inelastic & a fall in price will also lead to a fall in total revenue
- One of the key predictions of the model is that prices will be “sticky” even where there is a change in marginal cost of supply
Evaluation of Oligopoly?
- Barriers to entry can prevent new ideas from being developed.
- Can promote inequality, take advantage of consumers + smaller competitors
- Encourages high levels of expenditure on non-price competition
- Inefficient in terms of productive & allocative efficiency
What is the concentration ratio?
The concentration ratio is the total market share of the leading firms in an industry; these firm’s output as a percentage of total output
What is predatory pricing?
Temporarily lowering a good’s price below average cost, creating an artificial barrier to entry
What is a Price Maker?
A firm with monopoly power; the ability to set prices
What is a price taker?
A firm that passively accepts the market price, set by forces beyond the firm’s control