Theme 6F: Firms and Decisions

Explain where PC causes allocative efficienct

• Assuming the absence of externalities and the good is a private good -> guarantees AE 

• Market equilibrium = AE -> last unit produced is valued as much as any other good that could have been produced using those same resources

Explain whether imperfect competition causes allocative efficiency + graph

• Socially optimal level of output is where AR = MC where marginal value society places on extra unit of good = marginal cost of producing it 

• Firms has market power -> firm will produce at MR = MC with price at profit-maximising output -> price charged is higher than MCOP 

• However, from society’s point of view, for the units QM to Q*, P > MC, this means that the price (P) consumers are willing to pay for the marginal unit exceeds the additional cost (MC) incurred by society in producing it

• There is additional net benefit to society that can be obtained if more goods were produced 

• By producing at QM, there is presently an underproduction of this good from society’s viewpoint

• If units Q* - QM were produced,

  • Additional benefit accruing to society = area QMabQ*

  • Additional cost incurred by society = area QMcbQ*

  • Since the additional benefit > additional cost, there will be a net TSB of area abc (area QMabQ* - area QMcbQ*) if these units were produced 

• By restricting output to QM, the firm has caused welfare loss of area abc

Effect on consumers: 

• Underproduction will lead to artificial shortage -> upward pressure on price -> CS falls

Evaluate extent of allocative inefficiency caused by imperfect competition (in different market structures + extent depends on what)

1. Extent of AE in MonoC less than Mono or Oligo 

• Demand for a monopolistically competitive firm’s product is much more price elastic as there are many competing firms in the industry, making it less able to charge a high price

• Level of underproduction and deadweight loss very small

2. Extent of allocative inefficiency depends on nature of good monopoly sells 

• Necessity: deadweight loss extremely large as such goods have an inelastic PED -> granting the monopoly a high ability to charge extremely high prices by restricting quantity

• One such example is Pfizer which has a monopoly over the life-saving vaccine against COVID

• Luxury: deadweight loss smaller as such goods have elastic PED

Describe productive efficiency of imperfect competition (when it is desirable and not desirable)

Desirable	Not desirable
Firms will experience lower MC due to greater internal EOS -> price of good is lower since MC=MR at a higher output -> firms producing nearer to MES on LRAC curve -> more productively efficient	As firms have price-setting ability, they have the power to choose to produce at any point on LRAC curve  They will restrict output at MC=MR to charge higher prices -> overproduction -> productive inefficiency as firm does not produce good efficiently at closest possible cost -> waste of society’s resources

Draw graph of increase in PE for imperfect competition

2 types of graphs: 

Explain how monopolies can be X-inefficient

Monopoly firms with very high market power due to the lack of competition may be complacent and be ‘X-inefficient’ -> incurs unit costs above lowest possible unit cost for any given output level due to slack management as they already earn supernormal profits 

• Can apply for colluding oligopoly firms which eliminates price competition amongst the firms

Define DE, process and product innovation

• (Def.): Situation where firms are technologically progressive through investing in research and development for the purpose of process and product innovation

• Process innovation: improving the method of production to reduce unit cost of production

• Product innovation: improving the quality of the good or developing new products

Describe DE of perfect competition

1. No incentive 

• Any invention of new products or improved methods of production can easily be copied by other firms (free riders) (due to perfect information) 

• Lack of BOE will lead to the erosion of any supernormal profits made by innovative firms 

2. No ability 

• Firms earn only normal profits in the long run

• Do not have supernormal profits to plough back for expensive R&D

Describe dynamic efficiency of MonoC

• Firms engage in some innovation to differentiate their product -> increase D and reduce PED -> increase market power 

• Due to low BOE -> erosion of supernormal profits in the long run + the difficulty of obtaining loans to finance R&D -> firms do not have the incentive or ability to engage in radical innovation that require heavy financial investment

Describe DE of Mono

1. Innovate: have greater incentive and ability to engage in innovation due to the possibility of earning supernormal profits in LR -> lower MCOP -> price falls 

2. No innovate: already earning supernormal profits and will tend to be complacent and unwilling due to lack of competition and high BOE unless there is threat of entry of new firms 

• R&D also costly and not certain -> prefer using other strategies which will certainly increase profits 

Describe evaluation of mono innovating (contestability)

• The extent to which dynamic efficiency will manifest in monopolies depends on the contestability

• With high contestability, there is a high threat of new entrants entering to steal the supernormal profits made by the monopoly -> incentive to use their profits to engage in R&D to increase dynamic efficiency (This occur when there is low sunk costs = low risk)

• Only when there is threat of potential competitors emerging will the monopoly have the incentive to innovate and improve their process and products

Explain why oligo has more incentive than mono to innovate

1. Wary of price competition because of the high degree of rival consciousness -> price competition -> price war -> opt for non-price competition (compete in terms of quality by the introduction of improved or new products via product innovation to win over customers) 

2. The desire to start a price war or the desire to survive a price war should one break out may cause oligopolistic firms to engage in innovation to lower unit cost of production

Describe inequity caused by Oligo and Mono

• PC + MC: normal profits 

• Monopolists + oligopolists: Earn sustained LR supernormal profits worsen income distribution as such profits come at the expense of consumers who are paying the high monopoly prices, and the monopoly/oligopoly shareholders are probably already more affluent than their customers

  • Firms are charging a higher price than AC and are not charging at lowest possible for firms to remain in the market in the LR -> worsen income inequality -> inequitable

Define and describe contestability of a market (what it depends on)

• (Def.): Threat of potential competition that could arise from new firms trying to enter the market 

• Contestability of market depends on existing BOE and sunk costs (barrier to exit) 

• Sunk costs are irrecoverable costs incurred by firms

• Lower level of sunk costs -> easier for firms to exit market without incurring large sunk costs -> firms more willing to enter market -> market more contestable -> prevent dominant firms from abusing its market power (which makes them undesirable for society) 

State whethere market dominance + no contestability and no market dominancne + high contestability is desirable

	PE	DE	Overall stand
Market dominance + NO contestability	More likely to be complacent and operate at higher AC -> no PE  Unlikely to pass cost savings to consumers due to no threats of competition	Have ability to R&D but lack willingness -> no DE	Undesirable
Market dominance + HIGH contestability	(opposite)	Have both ability and willingness to conduct R&D	Desirable

Describe how mono can reduce AE + eval (extent of fall in price)

A monopolist who produces for the whole market may use a large plant that enables it to enjoy more internal EOS which are not open to the comparatively smaller firms in PC MCMonopoly curve is lower than the SSPC Industry The monopolist maximises profits at price = PM and output = QM, where MR = MC Consumers benefit from the lower price and higher output of a monopoly compared to that of a PC industry *Although the monopolist charges a lower price, it is still allocatively inefficient because given its MC, it is producing an output level at which P > MC -> underproduction of the good from society’s viewpoint Evaluation: initial capital outlay  Significant initial capital outlay that gives rise to extremely high scope for EOS, the cost savings will be large -> price will be much lower than they would otherwise be

Describe evaluation of mono innovating (nature of good)

• If the good is a basic commodity such as agriculture or extracted minerals, there would be less scope for gains in dynamic efficiency (may only be able to undergo process innovation).

• If the good is a technologically complex product such as smartphone and laptops, there would be more areas for product and process innovation -> greater scope for gains in dynamic efficiency