Theory of the Firm Flashcards
Imperfect competition is:
The most common situation in which markets fail to achieve efficiency (as in, market failure occurs).
A perfectly competitive market is:
Individual firms produce such a small proportion of the overall supply of the product that altering their own output has no influence over the market price of the product.
Firms in a perfectly competitive market are called:
Price-takers. Meaning, they find it impossible to charge a price higher than that of their competitors, nor can they successfully offer their output at a lower price since competition forces the price down to the producers’ lowest average cost.
The perfectly competitive market model also assumes that firms:
- Produce completely homogenous products
- Can enter or exit the market very easily
- Produce where MSB equals MSC, achieving allocative efficiency (assuming no externalities arise from the goods production or consumption).
- No shortages or surpluses, therefore, exist.
A monopoly is:
Market structure where one firm dominates the market for a good that has no substitutes and where significant barriers to entry exist.
The characteristics of a monopoly include:
- Single seller: Only one firm controls the market entirely and produces the good (‘pure monopoly’).
- No close substitutes: Product is something that has no substitutes.
- Price-maker: Firm has power to set price, as they are the sole seller of the product. This price-making power is limited to the demand of the product.
- Barriers to entry: Maintain their dominant position through significant barriers, allowing the firm to make abnormal profit.
How can monopolies maintain barriers to entry?
- Legal barriers, such as permits or licenses required by law (but held by a sole firm).
- Economies of scale (high fixed costs to enter market), patents, or copyrights.
- Control or ownership of key resources or other factors that prevent competition from entering the market.
The spectrum of competition determines several factors, such as:
- Level of efficiency
- Degree to which firm achieves socially optimal levels of output
- Price level of the goods being produced
- Amount of consumer surplus relative to producer surplus
- Profitability of the firms in the market
- Amount of deadweight loss (DWL) resulting from production
What is the general relationship between the level of competition in a market and efficiency?
“The more firms there are competing in a market, the closer the market will come to achieving allocative and productive efficiency. The less competitive a market, the more likely firms are to earn profits, but at the expense of consumer surplus and allocative efficiency.”
State a real-world example of a monopoly:
Dutch East India Company, during the 17th and 18th centuries. The company exerted nearly total control over the spice trade between Europe and Asia.
State a real-world example of perfect competition:
Agricultural commodities (such as cocoa and coffee).
What is the objective of firms?
The objective of most firms is to maximize their profits through the production and sale of their various goods and services in the product market.
In pursuit of said goal, firms must accomplish two objectives:
1) Reducing costs.
2) Increasing revenues until the difference between the two (the profit) is maximized.
Costs are:
“Those things that must be given up in order to have something else”. There are two types, explicit and implicit.
Explicit costs are:
The monetary payments that firms make to the owners of land, labor, and capital in the resource market (i.e. rent, wages, interest respectively).
Implicit costs are:
The earnings a firm could have had if it had employed its factors in another use or if they had hired out or sold out to another firm.
Revenue is:
The income earned from a firm’s sale of its goods and services to consumers in the product market.
Profit is:
The difference between total revenue (TR) earned in the product market and its total costs (TC) in the resource market:
* Economic profit = TR - TC
Total cost is:
The total cost of all the fixed and variable factors used to produce a certain output. It increases as output increases, as more variable resources must be employed.
* TC = TFC + TVC
