ECON1001 FINAL EXAM

What is Perfect Competition?

It is a particular type of selling environment where:
There are many, many small firms.
All firms produce the same product.
Entry and exit are easy.
Information for buyer and sell is considered symmetrical (i.e. each knows what they are getting [i.e. knowing the 'full deal of the transaction')

What does the demand curve look like for a single firm?

Because there are many rivals, easy entry, and all firms produce an identical product:
Then demand for an individual firm is extremely elastic.
The firm is a total price-taker. By itself, it cannot do anything to influence market price. It can only react to the overall industry demand.

What does the market demand curve look like?

The market demand is the sum of every consumer's demand; it is the standard-looking demand curve. (assume there are substitutes outside of this market)

What does the market supply curve look like?

Market supply comes from adding up the quantities that ALL firms would be willing and able to supply at each price. Remember, all firms are producing an identical product.

The firm makes a profit (above normal or positive economic profit). What then happens?

Other firms want to get in on the good deal. • As long as there is free entry, a firm can not continue to make ABOVE NORMAL profit.
Competition will ensure the firm produces at the lowest possible cost in the most efficient manner.

What is a Monopoly?

Consists of one producer (seller)
There's no entry.
'Pure' monopolies are rare and (usually) prohibited by anti-competitive legislation in many countries.
However, there are many real-world examples where a firm can have monopoly power for a period of time (e.g. by owning a patent, or being the single seller in a geographic area because of lack of competitors).
Examples of firms having almost monopoly power include Sydney Airport corporation; some toll road operators, etc.

Monopolies have extremely high barriers to entry

Barriers can be because of technological reasons (e.g. economies of scale), or legislation by governments, or geographic factors such as exclusive access to a resource

Profit Maximisation

We assume that firms are not only in business to make a profit BUT that they seek to maximise the level of profit they make (although sometimes firms do not always intentionally profit maximise in each short-run period but do inevitably attempt to profit maximise in the long-run).
If production of one more unit of output increases cost less than it increases revenue, then producing and selling that unit of output will increase profit.
Profit is maximised when the additional revenue (MR) from producing and selling an additional unit of output equals the additional cost (MC) of making or supplying that unit.

Graphical representation of profit maximisation for a price-maker firm

The profit maximising quantity is then identified where MC = MR.
Graphically, this particular quantity point of maximum profit is also where the distance between total revenue and total cost is greatest.
The profit maximising point can be at a slightly lower quantity than the cost minimisation point (that is where MC = ATC)

What is Monopolistic Competition?

Many producers (sellers)
Each with a differentiated product
Easy entry; each entry is made with a slightly differentiated product
Since there is easy entry, economic profit will be competed away
Other firms capture market share and drive down the profits of the existing, above-normal profit firm - until there is zero economic profit
Examples are numerous and feature in most retail areas (e.g. coffee shops, restaurants, hairdressers, clothing stores, sports stores, music stores, etc. )

Demand Curve

A monopolistically competitive firm, however, must reduce the price to sell more, so its marginal revenue curve will slope downwards and will be below its demand curve. Because the monopolistically competitive firm can change price it is called a 'price maker' or 'price searcher', meaning it can experiment with different prices to gauge customer responses. However because there is lots of competition its ability to be a price maker is much less than an oligopoly or monopoly firm that has huge market power.

Monopolistically competitive firm in the short-run

The monopolistically competitive firm maximises profit in the short-run.
Monopolistic competition: like a monopoly in the short-run but then the firm takes on characteristics of a competitive market in the long-run (still with the downward sloping demand curve)

Excess Capacity

Monopolistic competition results in firms producing below optimal capacity - with 'excess capacity'.
BUT Society may be prepared to trade off this loss of static efficiency for the variety and choice provided to consumers.
This is the economic justification for the welfare loss (i.e. less consumer surplus compared with perfect competition but now the consumer has lots of product variety and thus choice).

What happens when the monopolistically competitive firm advertises?

Increases a firms costs (assume advertising is a fixed costs)
Increases demand for the firms products
Note in the LR (long-run) price rises (so consumers are worse off [allegedly] in this model) and the firm is no better off than before advertising because it still only earns 'normal' economic profit).

What is Oligopolistic Competition?

Along with Monopolistic Competition, Oligopoly is the other most common type of market structure, especially in small to medium size economics such as Australia.
But Oligopoly is very different to Monopolistic Competition because Oligopoly is where a few big - and sometimes even gigantic - firms dominate a market.
Examples are everywhere: auto-manufacturers, major brewers, telecommunications [e.g. Telstra and Optus for services; Samsung, Sony or Apple for the hardware], airline travel companies [e.g. Virgin and Jetstar], aluminum, steel, soft drinks [e.g. Coke and Pepsi])
Products can be fairly homogenous (e.g. oil, steel) or highly differentiated (e.g. cars, mobile phones)
There is no single model of oligopoly because of the uncertainty of competitors responses. The profit maximisation model is a generalised description but much economic theory goes further than this to explain this market structure.

Pricing Strategies

Because oligopolies have considerable market power they usually have far more ability to set prices than monopolistic competitive firms.
Basic approach is to add the per unit variable costs such as raw material costs, energy, and importantly wage costs (which depend on worker productivity), and add up the per unit fixed costs (e.g. overhead costs such as research & development, rent, equipment, advertising, managerial salaries, etc.), and then mark-up (depending on degree of market power the firm has). Oligopolies usually have considerable scope to mark-up the prices of their products.

Game Theory to analyse strategic behaviour of firms

Both firm will advertise, even though they can improve their payoffs by mutually agreeing not to advertise (like the 'Prisoner's Dilemma if the prisoners mutually agreed to not confess) .
Advertising costs money so that is why profits for each firm are more than with no advertising, assuming the other also does not advertise (see box on bottom right hand corner). But assuming they are not colluding, the risk is if one firm does do not advertise then the rival will, so both will advertise.

Kinked demand curve model

Oligopoly model in which each firm faces a demand curve kinked at the current prevailing price.
At higher prices demand is very elastic, whereas at lower prices it is inelastic.
Each firm believes that if it raises its price above the current price P* (e.g. $40 in this example) , none of its competitors will follow suit, so it will lose most of its sales.
Each firm also believes that if it lowers price, everyone will follow suit, and its sales will increase only to the extent that market demand increases.

Strategy Concept Perspective

The traditional market structure explanation covered over the last several lectures suggests that the individual firm's ability to make above normal profit simply depends upon the market structure the firm happens to be in (e.g. oligopoly).
The strategy concept perspective, that we briefly overview here, is an improved theory of firm-performance compared with the traditional market structure approach. It emphasises that it is important what happens inside the firm (called Barriers to Imitation approach), not just the market structure the firm is in (simply just 'barriers to entry).

Resources and Capabilities

Resources: which are the tangible assets (e.g. machines, computers, buildings, people) and intangible assets (patents, trademarks, brand names).
Capabilities: Are the unique ways that firms put their resources together, making it hard for competitors to imitate.
These factors allow an individual firm to sustain its competitive advantage ( i.e. maintain above normal profits despite competition) and offer important insights into firm-management that traditional market structure analysis does not provide.
Therefore firms need to configure their resources and distinct capabilities in unique ways to create more value than competitors and to sustain this advantage.

Value Creation

Another way of looking at this is that the firm must continue to produce more value than its rivals.
Value (or total economic surplus) is consumer surplus plus producer surplus. Note the tension between the two as higher B might mean higher production costs (C) and thus higher price (P).
Consumers will demand at least the same consumer surplus from the firm's product as from its rivals. With superior value creation, the successful firm's products can offer greater consumer surplus than the rivals and thereby sustain an economic profit. This can be done either by increasing B (benefits) and / or lowering C (costs). But in reality achieving both is very challenging as there are tradeoffs between costs and quality.

Value Map Concept

Points on the indifference curve represent price-benefit (i.e. quality) tradeoff for different products by rival firms that offer the same consumer surplus.
The steepness of the indifference curve reflects the tradeoff between price and quality that the consumers are willing to make.

Why is a market economy generally considered efficient?

The market system is usually good for allocating a huge array of goods and services where the laws of S and D interact.
This 'invisible hand of the market' works because the seller is happy with her price, the buyer is satisfied with what he purchased from the seller.

Economists usually promote markets as good because...

Equilibrium in a competitive market results in the economically efficient level of output, where marginal benefit equals marginal cost.
Also, equilibrium in a competitive market results in the greatest amount of economic surplus, or total net benefit to society, from the production of a good or service.

Maintaining or enforcing competition

Competition regulations aim to make a monopolist / oligopolist (i.e. any firm with excess mkt power) more open to competition (in practice a lot of compromise). In Australia, the Australian Competition and Consumer Commission (ACCC) aims to ensure that trade practices foster competition. Governments try to make some markets 'contestable' (e.g. telecommunications). For many decades Australia only had one provider of telecommunications (Telecom) before deregulation. After deregulation in the 1990s Telecom became Telstra and had competitors such as Optus.
Contestable market: A market in which the potential for competition exists due to minimal entry and exit costs (e.g. entry as an Uber driver compared with the monopoly power of traditional cab companies).

Natural monopoly

A situation in which economies of scale are so large (i.e. the set up & production costs are so large) that it makes economic sense to have only one firm involved (e.g. transport infrastructure, electricity network, water and sewer delivery systems). Traditionally, this firm has had to be state (i.e. government) owned.
But since the 1990s in many countries 'natural monopolies' can be mix of public owned and private enterprise: e.g. telephone or electricity network [gov. owned 'poles and wires', private sector generators)

Externality

A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service (e.g. a negative externality is pollution; positive externality is vaccinations). Without government intervention (e.g. environmental laws), there would be too much of 'bad' (negative) externalities; too little of good (positive) externalities.

Asymmetric information

In many market interactions, there may be an asymmetry of information between individual consumers and producers.
Example of intervention to correct asymmetric information:
• Food and health regulations (in the absence of any regulations, restaurant diners would not know whether the restaurant's food handling was hygienic).
• Compulsory labelling nutritional information
• Consumer protection laws (e.g. legal recourse if you buy a 'dodgy' second hand from a car dealer)
• Information campaigns on the danger of particular goods and/or services

To provide public goods (and services)

Defined as a good or service that an additional consumer does not 'use up' or prevent another's use of it (non-rival), and / or, no one can be excluded from consuming the good or service (non-excludable) (e.g. 'merit goods' [e.g. public libraries, art galleries and museums]; street lights; public parks; national defence; police, etc. ). The private sector alone would not engage in producing such goods & services, as there is no profit incentive.
Merit good: A good that is beneficial to society irrespective of the preferences of consumers (e.g. museums and art galleries, opera, ABC).

Equity

Free markets often result in outcomes that are considered inequitable. The taxation system, social security benefits and government provision of free or cheap services, to some extent, promote equity. For instance, workers in cafés, restaurants and hotels,etc. have a right to receive the minimum wage.

Stabilisation (macroeconomic) policy

Management of the economy as a whole is a very important role for government including facilitating low unemployment, low inflation and strong economic growth. For example, RBA decisions for determining the cash rate.

What is Market Failure?

Market failure occurs when freely functioning markets operating without government intervention fail to deliver an efficient or optimal allocation of resources
The unregulated market becomes inefficient because prices fail to provide proper signals to consumers and producers
The economic and social welfare is not maximised, leading to loss of economic efficiency

Causes of Market Failure

Market dominance and abuse of market monopoly power
Incomplete or imperfect information (i.e asymmetrical information)
Existence of positive and negative externalities
Inadequate provision of public goods and services if left to the private sector alone.

Positive externality

Occurs when a production or consumption activity positively benefits others who are not directly involved with that activity and who do not pay for it (e.g. vaccinations; privately funded and public R&D with spin-off benefits [e.g. the CSIRO developed Wii FI in the 90s])

Negative externality

Occurs when a production or consumption activity imposes costs on others who are not directly involved with that activity and no compensation is paid (e.g. living next to a polluting factory; impact of different types of pollution on society).

Internalising Externalities

An externality is internalised if the persons or group that generated the externality incorporate into their own private or internal cost-benefit calculations the external benefits (in the case of a positive externality) or the external costs (in the case of a negative externality).

THREE ways to internalise extrenalities

Persuasion and using penalties
Taxes and subsidies
Assigning property rights

Persuasion and using penalties such as fines (command and control approach)

Many negative externalities arise partly because persons or groups do not consider other individuals (including future generations) when they decide to undertake an action.
Trying to persuade those who impose external costs on us to lessen these externalities (i.e. to consider future generations when undertaking an activity).
But persuasion often only has a limited effect. Therefore fines can be used if people do no obey. For example, the gov fines a factory for being over a certain pollution limit. But this method offers no incentive to reduce, only to stay below a certain limit. Also, having set limits on pollution will be easier for some producers than for others.

Taxes and Subsidies

A better way than simply asking people not to do something, or fining them when they do, is to use taxes and subsidies as corrective devices for a market failure.
A tax (e.g. pollution tax) adjusts for a negative externality; a subsidy (e.g. R&D funding grant from the gov. ) adjusts for a positive externality.

Assigning Property Rights

Air pollution and ocean pollution (i.e. big negative externalities) are the result of the air and oceans being unowned. Because no one owns them, many people feel free to emit wastes into them; if they were owned, negative externalities would likely decrease (as individuals we tend to look after something we own or feel responsibility towards).
Because the oceans or atmosphere cannot be owned by any individual, the next best solution is to assign permits or property rights to extract a resource and / or to pollute (e.g. fishing licenses and quotas; carbon permits).

Externalities and Efficiency

Economic efficiency is reduced as externalities lead to a divergence between:
private benefits and social benefits
private costs and social costs.

How externalities in production reduce economic efficiency

Negative externalities in production occur because a cost is imposed on others who are not directly associated with that activity, meaning:
The social cost of the production activity is greater than the private cost of production.
Production occurs at a level that is higher than the socially efficient level, and price is lower than the socially efficient price.
To correct this negative externality, the social cost of the externality (i.e. pollution) is included or internalised. This shifts the supply curve to the left (or upward).
It also corrects a deadweight loss occurs.

The effect of a positive production externality

Positive externalities in production occur when a production activity benefits others who are not directly associated with that activity and who do not pay for it (e.g. Wi Fi was developed initially by the CSIRO in the late 1980s for application to astronomical research; the commercial applications unbeknown at the time).
The social cost of the production activity is less than the private cost of production.
Without intervention, production occurs at a level that is lower than the socially efficient level, and price is higher than the socially efficient price.
A deadweight loss occurs.

What is a 'Cap and Trade' Pollution Permit System?

Under a cap and trade system, a 'cap' or ceiling is placed on how much pollution can be emitted; permits are allocated to polluters or auctioned off; a market for pollution permits emerges. Each permit gives the holder 'the right' to pollute up to a certain amount. These is then an incentive for those firms who can cut their pollution further to then sell (i.e. trade) their unused permits to another firm who cannot cut their pollution as easily.

Similarities and Differences between Emission Taxes and Tradable Pollution Permits

Both place a price on pollution because the producer must pay to pollute.
With emission taxes, firms pay a tax to the government; with tradable permits, firms pay each other, or they pay government at a permit auction.
One of the things government can't know with an emission tax is what the quantity demanded of pollution will be, given any specific tax.
But this problem does not exist under a system of tradable permits.

Why do public goods cause market failure?

This is a type of market failure because the market system will not provide many goods and services that are necessary and desirable as there is no profit to be made. Therefore we need government (or some form of state or philanthropic intervention) to provide what we call public goods.

What is a public good?

A good or service which an additional consumer does not 'use up' or prevent another's use of it, and no-one can be excluded from consuming the good or service. It is both non-rival and non-excludable (e.g. street light, lighthouse, national defence).

What is a private good?

A good or service that is both rival and excludable.

What is a mixed public good (also called quasi-public good)?

A good or service that is excludable but not rival (admission to a swimming pool, national park , art gallery etc.)

What is a common resource?

A good that is rival but not excludable (e.g. fisheries, forests, rivers especially before permits and licenses were in place to mitigate again over exploitation).

The demand for a public good

To determine the demand curve for a public good, we add the price each consumer is willing to pay for each quantity of a public good.
This differs from how the demand curve for a private good is determined, where we add the quantity of the good demanded at each price by each consumer.

The effect of a 'internalising' a negative production externality by using a pollution tax

Too much production of coal-fired electricity generation is produced at the market equilibrium QM. The marginal private cost and its equilibrium price when equated with mkt demand does not include the true social / environmental cost of this activity.
The externality is equal to the cost of the carbon dioxide emissions and is the vertical distance between the marginal private cost of electricity generation and the marginal social cost.
The imposition of a tax equal to the externality will equate marginal social cost and demand (MB) and will eliminate the externality.
The result of the tax is that an efficient level of electricity QE will be generated.