Micro Econ - Market power

Normal profit

Minimum amount of profit that a firm must recieve to keep the buisness running (as opposed to shutting down) AC=AR

Abnormal profit (attracts new firms, as supply up, price down - normal profit)

MC is less than MR, leads to profit not being maximised bc additional revenue increasing at faster rate than additional cost of producing that additional unit.

Losses (causes firms to exit, supply down, price up - normal profit)

MC larger than MR, leads to profit not being maximised because additional costs will be higher (increasing at a faster rate) than the additional revenue.

Profit maximisation

MR=MC

Perfect competition characteristics (E.g apples)

• Large number of sellers

• Firms sell homogeneous product

• No barriers to entry

Additional characteristics PC

• Makes normal profit in long run

• Perfectly elastic demand

• Price takers at market price, bc no ability to change price thus no market power

- When firms can no longer pay workers=shut down

- Unable to cover variable costs in SR=shut down

- Covering variable cost but not all costs in SR=shut down in LR

Evaluation of Perf. Comp.

Observations:

• Consumer tastes - reflected by market demand and thus prices & Q will reflect these changes

• Inefficient firms to close down - inefficient firms will be unable to have revenues to cover all their costs and forced to shut down.

Advantages:

• Allocative effeciency - in LR will achieve optimal amount of resources, where P=MC

• Low prices for consumers - Bc firms cant make abnormal profit (bc of compeition = low price) in LR = comp. keeping prices low for consumers.

Limitations/disadvantages:

• Unrealistic assumptions - there are strict & unrealistic assumptions that are rare in real world

• No economies of scale for small firms - no specialisation of labour

• No incentive for innovation - bc only making NP in LR, so lacking funds for R&D

• No product vareity = No choice for consumers

Monopoly (form of imperfect competition) characteristics (e.g Oil)

• Single seller in industry

• Sells unique product with no close substitutions

• High entry barriers

Additional characteristics Monopoly

• Ability to make price, due to 1&2 above

• Ability to make price creates allocative inefficiency

• Profit maximising = underallocation of resources

• Demand is downwards sloping

• MR goes to negatives

The barriers to entry:

• Economies of scale - larger firms have advantage of lower costs of FoPs — thus charge lower price for the good

- Small firms = unable to cover costs w/ low prices

- New firms = not willing to risk large start up costs

• Branding — unique product leads to customer loyalty — makes harder for firms to enter the market

• Legal barriers

• Control of essential resources - limits other firms from entering

• Aggressive tactics - can cut price to take over new entrant

Legal barriers:

• Patents

• Licenses

• Copy right

• Trade protections

If firms cant compete w/ the monopolist…

Abnormal profit can be made

Natural monopoly

Firm w/ economies of scale so large that its possible for a single firm to supply the market w/ a lower average cost then 2 or more firms

Evaluation Monopoly

Potential/advantages:

• Can take advantages of economies of scale — leads to lower price for consumers & less waste of resources

• Abnormal profit — leads to more R&D — more innovation & unique products

Criticism/disadvantages:

• Produces at price above P=MC — allocative inefficiency & market failure

• Lack of competition — lead to less efficiency, higher costs & less innocation / R&D

— Lower consumer surplus - price is up Q is down (DWL arises)

- redistribution of Y from consumer & towards monopolist

Monopolistic competition characteristics (E.g restaurants)

• Large number of firms

• No entry barriers

• Product differentiation - helps make SR profit

- if unable to differentiate, reliance more on changing price

Additional characteristics Monopolistic

• Some price making ability

• Bc more competition — more elastic demand than monopolist

• Engages in price & non price competition

• NP, AP or losses - bc low entry barriers

- firms close bc cannot make NP due to high AC

Allocative inefficiency in monopolistic competitor…

Gives choice to consumers (good) until too many choice (bad) — leads to higher advertising costs = higher costs for consumers

Evaluation Monopolistic

Advantages/potential:

• Product vareity=allows for choice for consumers

• Some degree of competition=some incentive to innovate

• NP in LR

Disadvantages/limitations:

• Allocative inefficiency - price is higher than P=MC

— leads to heavy spending on advertising & branding (as consumers have too much choice) in non price competition - may be an opportunity cost.

Oligopoly (avoids competition) characteristics (E.g OPEC)

• Small number of large firms

• High entry barriers

• Interdependence - large firms decisions have effects on others — firms to be keenly aware of what rivals are doing

Collusion

When firms agree to work together to limit competition, raise prices, & increase profits

Cartels

When firms try to restrict competition to maximise profits. E.g OPEC

Interdependence implications:

• Strategic behaviour - making decisions based on how it thinks other firms will make decisions

• Conflicting incentives:

- Incentive to collude - agreement to fix prices or lower Q

— limits competition, allows firms to profit maximise

- Incentive to compete or cheat in an agreement - firms can change prices to gain profit & market share

Game theory

Mathematical technique to analyse the behaviour of decision makers who are dependent on one another

Prisoners dilemma

Illustration of conflict between the pursuit of self interest & collective interest

Payoff matrix helps understand:

• Interdependence

• Strategic behavour

• Face conflicting incentives

• Engage in price wars - makes firms worse off by lowering profits

• Try to avoid price wars - bc firms will be worse off

Non price oligopolist contributes by:

• Developing their products

• Advertising

• branding

• Better customer services

Important bc:

Non collusive oligopoly

Oligopolistic firms that do not collude in any way to change output or prices

Concentration ratio

Provides an indication of the percentage of output produced by the largest firms in the industry

Firms are considered oligopoly if…

4 largest firms control 40% of industry

Concentration ratio limits:

• Dont refelct competition abroad

• Dont tell us about firms importance in global market

• Dont account competition amongst substitue goods

• Dont distinguish between different sizes of firms within the concentration

Evaluation Oligopoly

Benefits/advantages:

• Economies of scale

• Product development and innovation bc of abnormal profit

• Technological innovation

Limitations/disadvantages:

• Welfare loss & AE

• Higher prices & lower consumption

- Loss of consumer surplus bc P is larger than MC, Y for consumers negativley distributed

• Highe rproduction costs bc lack of price competition (they face less pressure to operate at the lowest possible cost)

• Possibly less innovative

Costs of production

Include money payments to buy resources plus anything else given up by a firm for the use of resources

Explicit costs

Costs for firms for using resources that they dont own

Implicit costs

Costs for firms for using resources which they already own

Economic costs

The sum of both explicit and implicit costs

Short run

Time period where one FOP (capital) s fixed

Long run

Time period which all FOPs can be changed

Economies of scale

Decreases in average cost over the long run as firms increase their factors of production

Diseconomies of scale

Increases in average costs over the long run as firms increase their factors of production