topic 6,7,8: firms and decision Flashcards
minimum efficient scale
Q* is minimum scale of production that firms must expand so as to reap all IEOS and achieve lowest LRAC
LRAC for substantial IEOS
industries with high BOE
- significant EOS to be reaped, MES is large relative to industry demand
- as firms increase output (Q1 to QMES) there is significant cost savings
- LRAC falls over large range of output
IEOS
unit cost reductions that accrue to a firm as a result of expanding scale of production.
- when firms initially expand scale of production, they first exp increasing returns to scale and falling LRAC due to IEOS.
- shift along LRAC
sources of IEOS 1. technical economies
a. specialisation and division of labour
- as firms expand, there is greater scope for labour to be deployed to diff job scopes across production process
- workers can specialise on specific area of work and become more proficient
- increase their productivity as they are able to produce more units of output per man hour -> COP fall, movement down along LRAC
b. factor indivisibility
- certain machinery cater to large production scale (utilise more fully)
c. law of increased dimensions
- when cost to produce container increases, there is MTP increase in volume that can be stored, leading to fall is storage cost per unit
sources of IEOS 2. managerial economies
- as firms expands, managers can be assigned to look after specific processers, become specialist, more productive
sources of IEOS
FMMRT financial economies marketing economies managerial economies risk-bearing economies technical economies
sources of IEOS 3. marketing economies
- larger firms tend to buy raw materials and components in bulk
- significant buyer can dictate requirements in relation to specifications and quality, will be able to enjoy cost advantages
sources of IEOS 4. financial economies
larger firms associated with greater credibility and lower risk of loan defaults
- more avenues to raise funds, receive loans at lower i/r
- better credit ratings and collateral available for pledging
- unit interest cost reduced
sources of IEOS 5. risk-bearing economies
large firm have financial ability and capacity to produce more diverse range of products
- fall in DD for particular product can be compensated by sales of other products
IDOS - internal diseconomies of scale
decreasing returns to scale and increasing unit costs that accrue to a firm as a result of the firm over expanding its scale of production
sources of IDOS 1. overspecialisation
as firm expand output with increased specialisation, workers become disengaged due to monotony of repetitive work
- management that do not involve workers in firm decisions/engage them, feel undervalued
care less of value, productivity falls, asssume constant wages, increase COP
sources of IDOS 2. managerial economies
managers become more specialised in their area of work, more diff to coordinate across diff departments
- firms unable to swiftly respond to changes in mkt condition and miss out on new challenges and opt.
- diff to monitor quality of work of subordinates
- excessively large and complex, communication channels more challenging.
- works have diff understanding of company direction
- increase monitoring costs and fall in productivity, increase COP
sources of IDOS - administrative economies
complex administrative and approval procedures delay effective action
- unable to respond swiftly to changes to mkt conditions, limit intended benefits that could have been reaped
- increased admin cost, fall in productivity, COP increase
sources of IDOS
OMA
external economies of scale - EEOS
unit cost reductions which accrue to a firm as a result of industry expanding
- shift of entire LRAC curve (downwards)
source of EEOS - 1. economies of concentration
- related firms concentrate themselves in a specific geographical location as they form a cluster and develop a reputation for selling specific goods, each firm attract more customers, cut down on marketing/ advertising costs
- firms that are related through linked processes enjoy reduced transport costs when they situate near one another
- if concentration of firms increases importance to economy and govt increases support in terms of transport and communications infrastructure, this cuts down on transportation and communication costs
- pool of labour within area grows, easier for firms to have access to ready pool of labour and for labour to transit from one firm to another, recruitment costs reduced
sources of EEOS - 2. economies of information
as industry grows and mkt becomes saturated, collaborate to reap breakthrough innovation
- minimise wastage of resources, reduce R&D costs
sources of EEOS - 3. economies of disintegration
expansion of industry, firms may divide processes and sub-contract out certain production process where other firms can produce at lower average cost
- concentrate on core business
sources of EEOS
IDC
economies of information
economies of disintegration
economies of concentration
sources of EDOS
- strain on infrastructure
- firms within geographical area will likely lead to constraints on infrastructure
- more time spent transporting goods and workers
higher transportation costs, higher AC - strain on resources
- demand for same pool of resources increase
- to increase output, compete and offer higher wages to attract works
- higher labour costs, higher COP
reasons for small firms
revenue reasons
- DD for personalised reasons
- convenience to consumers
- complement large firms - supply component parts/ supporting services
- more adaptable and responsive to changing mkt conditions - lower stocks, can adapt to changing consumer tastes and pref, w/o incurring too much operating cost and unsold stocks. lesser communication and admin layers
cost reasons
1. limited IEOS (small MES)
in some industries, MES at low level of output and LRAS may rise quickly if firms continue to expand output
2. unwilling to take risk
- larger firm involves larger capital and investment risk.
- may be decentralised in terms of production process and management, lead to quality control issues if management too far from core business
price-taking firms DD curve
DD=AR=MR is horizontal
- MC (tick) cuts middle of AC curve (U-shaped)
- regardless of output, all firms charge same price. homogenous products, increasing price will lead to loss of customers, lowering price means all firms eventually settle with fall in price (perfect knowledge)
price setting firms DD curve
AR=DD downward sloping, MR half of axis
- MC (tick) cuts middle of AC curve (U-shaped)
long run shut-down condition
firm is making subnormal profits (P
short run shut-down condition
- firm able to cover at least variable costs (P≥AVC)
can still cover part of fixed costs (which it still need to bear in full anyway if it stops production)
minimise loss
firms incur less subnormal profits (draw graph) - rectangle below ATC and horizontal DD curve instead of all fixed costs
profit maximising output Qm
MC=MR
characteristics of perfect competition
- many buyers and seller
- identical products
- perfect knowledge
- freedom of entry into and exit from industry - sunk costs involved are low, all FOP perfectly mobile
types of market structures
perfect comp
monopolistic comp
oligopoly
monopoly
long-run equilibrium of PC firm
no BTE -> firms cna only make normal profits
a) supernormal -> normal (entry of new firms)
firms enticed to join industry, supply curve of PC industry shifts right
- exerts downward pressure on price (DD curve of PC curve shift downward, in line with mkt eqm price)
-profits will be competed away until all firms in industry are just covering total costs
- long-run eqm reached when firms making normal profits C1=P1
b) subnormal -> normal
- eqm price falls until remaining firms can cover total cost.
non-pricing strategies of PC firm
none
- will not differentiate products - can sell all output at mkt price, any additional expense unprofitable
- will not innovate - other firms have perfect knowledge, can only earn normal profits in LR
impact of PC - allocative efficient
price taker, MR=AR=DD
profit-maximising output is MC=MR and that occurs when P=MC
no DWL, societal welfare maximised
impact of PC - productive efficient
output is produced with the last cost combination of inputs
- firms perspective: lowest average cost of producing any output is attained
- society perspective: producing on minimum efficient scale
productive efficient as it cannot afford to produce at higher cost as compared to rivals. earn normal profits in LR, producing at min. point of LRAC (draw graph)
impact of PC - dynamic inefficient
improvement in efficiency achieved through product or process innovation
- perfect knowledge & normal profit - no incentive/funds to engage in R&D
impact of PC - equity
equitable:
- large number of sellers -> essential goods more affordable to lower-income households
- can only make normal profits, will not make profits at expense of consumers and other firms
but unable to carry out R&D which lower COP
impact of PC - consumer surplus
max CS
impact of PC - consumer welfare (X)
choice, quality, variety
homogenous products, unable to cater to varying pref
impact of PC - producer profit
can only make normal profits :(
characteristics of monopoly
- single producer of good
- good has no close substitute
- imperfect knowledge
- existence of high barriers of entry
monopoly - natural barriers to entry
NGL
1. geographical endowment
- control entire supply of natural resource
- crops req special geographical conditions
2. limited market size
- population too small to support more than one firm
3. network economies
product/service req network of users to function, giving first mover advantage to existing firms whose networks have alr been established
monopoly - artificial BOE
BSBSPF
- legal barriers to entry
- intellectual property rights - illegal for others to copy invention - strategic barriers to entry
- incumbent firm enact predatory pricing - strong brand loyalty
- advertise increases start up costs, deterring entry - controlling supply chains
- inputs/distribution and retailing - product proliferation
- harder for firms to find a niche, average cost of advertising higher - financial barriers
- certain production processes req large start up costs and R&D costs, more likely for producer to supply entire mkt and enjoy lower AC due to opt to reap IEOS
- deter potential entrants with insufficient capital funds
- firms which req large start up costs may be large in size, more credible to banks, enjoy lower i/r.
pricing strategies of monopoly
a. limit pricing - deter entry of potential competitors
charge price below new entrant’s average cost, esp if mkt is contestable, make less profits. (new entrant unable make at least normal profits)
b. predatory pricing (to drive out competitors)
- price good below its own average cost (make sub-normal profits temporarily)
price discrimination
- seller has some degree of monopoly power
- mkts can be segregated
- mkts have diff price elasticities of demand - no difference in production cost
- products are perfect substitution
PED<1: high price, result in LTP fall in qty demanded, total revenue increases
[ED>1: lower price, result in MTP increase in qty demanded, total revenue increases
non-pricing strategies of monopoly
product differentiation - reduce PED and XED
innovation - has supernormal profits
monopoly - allocative inefficient
at profit maximising output Qm, eqm price is more than MC (P>MC). However, allocative efficient output is achieved at Qs where P=MC. Hence, there is underproduction QsQm and underallocation of resources. The gain in benefit to society if production increases Qs is QmBAQs while cost is QmCAQs, DWL ABC.
BUT: may be more efficient for monopolist to supply entire mkt
if monopolist enjoys significant EOS, industry output may be produced at lower AC. if monopolisits pass on cost savings to consumers, consumers may enjoy lower prices. MC curve will be lower(downwards), produce at higher output level at lower price than perfect comp
benefits and costs of PD
- increase productive capacity
- increased production enjoys EOS, average costs lower - increased consumer welfare
- lower COP translate to lower prices and greater CS
- lower income group able to afford lower-priced good
costs of PD: 1. greater loss of consumer welfare - firm able to capture more consumer surplus 2. worsened inequity - increase in mkt power btn producers
monopoly - productive inefficient
likely to be X-inefficient as it has no incentive to reduce costs to lowest level due to absence of competitive pressures. produce output at higher cost, no rival to compete away supernormal profits
society perspective:
operating with excess capacity and not producing at Qmes
monopoly - dynamic efficiency
well protected from any entrant by high BTE, no incentive to improve on product/ production process
BUT to increase profits/ lower COP
monopoly - equity
inequitable
consumer have access to limited qty of good at higher price as compared to PC mkt
lack of substitutes - dd for good produced tend to be price inelastic. to profit-maximise, monopoly will set high prices
make supernormal profits at expense of consumer welfare. essential goods unaffordable for low-income consumer
btn producers- engage in pricing strategies
consumer welfare; CS
supernormal profits- has ability to conduct R&D, downward shift of MC and AC, leading to lower prices
consumer welfare; consumer choice
quality of good may improve
but no alt provider of good
producer profits
able to earn supernormal profits in LR
impacts
allocative, productive, dynamic efficiency equity consumer surplus consumer welfare - choice and variety producer profits
contestable mkt
firms forced to keep excess profits to minimum
hit and run competition from potential entrants- incumbent firms unable to raise prices
contestable mkt: dominated by only a few sellers, threat of entry by potential entrants force sellers to behave competitively; extent to which potential firms can enter mkt
VS
competitive mkt: actual comp., many firms in the mkt
factors affecting contestability
- ease of entry and exit
- low sunk costs
cost that firm cannot recover when leaving mkt. production that requires specialised capital assets that cannot be transferred to alternative uses (occupational immobility)/ location (geographical immobility) - ability to have access to same resources as incumbent firms
- able to produce product at costs comparable/ lower than incumbent firms
implications of contestable mkt
- firms may practice limit pricing to deter potential entrant -> result in lower prices, reduce allocative inefficiency, increase CS
- firms may innovate to improve quality (improve consumer welfare) + improve production process (lower COP, increase productive efficiency)
- lower price -> increase equity
BUT
- does not take into account retaliatory responses -> build up real/perceived barriers (advertising, strong brand loyalty)
natural monopoly
a single firm can supply the entire mkt demand at a lower average cost then two or more firms operating at lower output levels
- MES occurs at high level of output relative to mkt size such that only one firm can operate at efficiency scale to reap all available EOS and provide output req to satisfy total mkt DD
- tend to occur in industries where firms req. significant infrastructure
D1:
average cost keeps falling due to significant EOS, monopolist can earn supernormal profits at any output btn pt A and C (AR>AC)
D2:
2 firms in industry each supply 1/2 of industry output face dd curve 2, no price to cover costs, subnormal profits
characteristics of monopolistic competitive firm
- many firms in mkt w/o any dominant firm
- differentiated products
- imperfect knowledge
- freedom of entry and exit (low BTE)
monopolistic competitive firm - long-run eqm of profits
normal profits in LR
- supernormal profits incentivizes new firms to enter, firm DD fall due to comp. (DD and MR curve shift left)
- DD is more price elastic due to more substitutes (gentler slope_
monopolistically competitive firm - price/non-price strategies
- set low prices to raise TR (since dd is price elastic), MTP increase in qty dd
- in LR can gain more mkt power to increase P - price discrimination
non-price:
- product differentiation
- small scale incremental improvements (due to normal profits in LR)
- to increase DD
- DD becomes more price inelastic, good perceived to be of better quality, reduce degree of substitutability
impacts of MPC mkt - AE, PE, DE
- allocative inefficient. at Qmpc, price is higher than marginal cost, society values good more than it takes firm to product it
- more production of good desired by society
- underallocation and underproduction of resources -> DWL - productive efficiency
- productive efficient from firm POV (producing on LRAC across output levels)
- high degree of comp., competitive pricing, least cost method of production
but productive inefficient from society pov (operating with excess capacity and not producing at MES) - dynamic inefficient
- normal profits, limited ability to innovate
impacts of MPC mkt - profits, CS, welfare, equity
- producer profits
- normal profits in LR - equity
- normal profits in LR - relatively equitable when comparing welfare distribution btn firms and consumers, profits among all firms - consumer welfare: consumer choice (quality and variety)
- extensive product differentiation, enjoy incremental product improvements - consumer welfare: consumer surplus
- lower than PC but higher than oligopoly and monopoly
- lower price, higher output
characteristics of oligopolistic firm
- few large dominant firms which are mutually interdependent
- small number of firms who has large majority of mkt share
- actions of one firm significantly affect rivals, oligopolistic firm make decisions carefully in anticipation of what rivals could do - differentiated products
- imperfect knowledge
- no freedom of entry and exit (high BTE)
collusive oligopoly -cartel theory (explicit collusion)
- formal and explicit collusion whereby oligopolistic firms cooperate to increase overall profits by restricting total output for all members
- individual firms assigned pre-agreed quota to produce and common price to sell
- supernormal profits can be shared among members of cartel
- w/o cartel arrangement, rival firms engage in aggressive comp will incur high costs but limited benefits
demand more price inelastic due to availability of few substitutes.
but cartels often illegal as govt concerned abt how such anti-comp move will exploit consumers, force them to buy good at higher P with access to lower output levels + firms have tendency to deviate from cartel agreed price (can lead to MTP increase in qty DD)
price leadership theory (implicit collusion)
price leader will decide on price, other firms simply match price w/o any obv means of comm.
- price leader has lowest cop from tech know-how/EOS, has ability to retaliate if firm set lower prices
kinked demand curve theory
why competitive oligopolies might exhibit price rigidity
1. rival firms match each other price reductions but not each other price increases
prices above existing mkt price; firms face relatively price elastic dd curve
- firms will be gaining sales lost by first firm, so they have no reason to match price increase
- goods are similar, consumers switch to cheaper alt.
price below existing mkt price; firm has relatively price inelastic dd curve
- rivals will lose sales to firm firm, match price cut to retain mkt share.
- all firms suffer from lower profit level, have to sell same output at lower profit level
hence, rational competitive oligopolistic firms will not increase/decrease price.
-> price will not change as long as shift in MC curve are confined to gap btn 2 portions of MR curve
oligopoly - price/non-price strategies
- limit/ predatory pricing
- avoidance of price wars (price rigidity)
- price discrimination
- based on diff PED values
non-price strategies (tend to use)
- product differentiation
- differentiated services
- advertising
- product and process innovations
- for reduce PED and XED value
- more cost efficient - mergers and acquisitions
revenue: tap on customer base
cost: access to more resources, prevent need to sink in huge research cost, enjoy EOS
oligopoly - impacts
- producers profit
- supernormal profits in LR due to high BTE - allocative inefficient
- productive efficiency
firm POV: productive efficient as it is producing on LRAC across all output levels
- firms enjoy supernormal profits in LR, firms may be complacent and incur unnecessary costs (X-inefficient)
society POV: not productive efficient - dynamic efficiency
- long-run supernormal profits
- oligopolistic firms have willingness and ability to engage in large scale innovation - equity
less equitable, lack of substitutes (dd price inelastic)m to profit maximise: set high P - consumer welfare:CS
- more mkt power to increase prices and restrict output - consumer choice (variety and quality)
- extensive choice
