Theme 6D: Firms and decisions

Define perfect competition + characteristics

• (Def.): A market structure where there are many firms; freedom of entry and exit into the industry; where all firms produce an identical (homogeneous) product; and where there is perfect knowledge of the good and its market by both consumers and producers and all firms are price takers

1. Many small firms -> small market share 

• No dominant firm whose output is sufficiently large to be able to influence the market price -> firm is a price taker 

2. Homogeneous product -> perfect substitutes 

3. Perfect information 

Describe consumers and producers in PC

Consumers	Producers
Have perfect information on prices  -> buy lower price are available -> price uniformity  Have perfect knowledge of the types and quality of products available in the market -> persuasive advertising to differentiate products will not work	Have perfect knowledge of factor prices and the latest technology -> productively efficient method of production to minimise costs Aware of the type of profits made by every producer in the industry -> new firms will enter when firms are making supernormal profits

Define MC + characteristics

• (Def.): A market structure where there are many firms and ease of entry and exit in the industry, but each firm produces a differentiated product and thus has some control over its price

1. Large number of small firms 

• Limited control over price 

• No mutual interdependence and each firm determines its price-output policy without considering the possible reactions of the other firms

• Firms are competitors NOT rivals 

Define oligopoly + characteristics

• (Def.): There are a few dominant firms which control the major share of the market and there are barriers that prevent the entry of new firms. These firms are mutually interdependent and are rivals

• A duopoly is a special case of oligopoly where there are 2 sellers

1. Few dominant firms 

• The number of sellers is considered ‘few’ if each seller takes the actions and reactions of their rivals’ strategies into account when making their own production and marketing decisions = mutual interdependence / rival consciousness -> rivals 

• There may be hundreds of firms in the oligopolistic industry but with a few dominating or controlling the industry

2. Homogeneous products = Homo good -> must minimize costs -> must have high internal EOS -> high BOE -> few large firms = perfect oligopoly (Eg. electricity) 

3. Differentiated products = high BOE -> few large firms -> high ability to protect intellectual property -> heavily differentiated = imperfect oligopoly (Eg. different brands, grades of cars) 

Describe oligopoly sticky prices

• When a firm raises price, its consumers are likely to switch to the rival's offerings -> rivals are unlikely to match the rise in price -> large incentive to switch to substitutes.

• Hence, demand for their goods will be price-elastic, causing the increase in price to result in a more than proportionate fall in quantity demanded

• This will cause a decrease in total revenue and profits

• On the other hand, when a firm decreases price, its rival's customers are likely to switch to the firm lowering price -> rivals match the decrease in price -> low incentive to switch to substitutes

• Hence, the demand for their goods will be price-inelastic -> decrease in total revenue and profits

• Since changes in price will lead to the firm to experience a fall in revenue, firms are unlikely to compete in terms of price and will instead compete through non-price strategies (Competitive Oligopoly) or engage in collusive behaviour (Collusive Oligopoly) 

Define monopoly and describe it

• (Def.): A market structure where a single firm controls most/all the market share of the good or service

• SG: > 60% market share = dominant = monopoly 

• UK and EU:  > 50% market share

1. Single seller 

• World monopolies – Microsoft

• Domestic monopolies - Postal service, utilities

• Localised monopolies – Bookshop in VJC

Profit-maximising output explanation + graph

• Start of essays: Assuming that firms are rational, self-interested and insatiable, they will usually have a profit-maximising objective 

• This occurs at the level of output where the difference between TR and TC is the maximum

• A rational firm who seeks to achieve maximum total profit will adjust its output to the point where the additional revenue from producing an additional unit of output (MR) = the additional cost it incurs from producing an additional unit of output (MC)

• When MR>MC (at Q1), an additional unit of output produced adds more to the firm’s TR than to its TC, causing the firm's total profit to rise

• This implies that the firm’s current output level does not yield the highest level of total profit yet

• When MR<MC (at Q2), reducing a unit of output reduces TC more than TR, causing the firms’ total profit to rise

• When MC=MR (at Qe), there is no way the firm can increase its profit level by either increasing or decreasing its output further

• At output level Qe, the firm is in equilibrium

• A firm with market power will fully exploit its market power by charging PM for each unit sold since this is the highest price that consumers are willing and able to pay

Describe monopoly decisions

1. 1 dominant firm + unique G&S -> market power = price setters -> produce @ MR = MC = Q1 -> charge P1 where Q1 cuts AR -> earn supernormal profit of… 

2. High BOE -> new entrants cannot enter to steal profits -> make supernormal profits in LR -> pricing and output decisions remain the same in the LR

Describe oligopoly decisions

• (same as monopoly) 

1. However, for oligopolies that sell homogeneous products, once firms have set prices, they are unlikely to change them and prices are sticky 

• This is because firms operate through mutual interdependence with a high degree rival-consciousness as they sell similar products -> firms avoid price competition due to expected reactions of other firms 

• Supernormal profits in SR and LR

Describe PC decisions

1. Many small firms + homogeneous G&S -> no market power = price takers -> follow market P (DD=SS) -> produce @ MC = MR = Q1 and P1 -> earn SR supernormal profit of… 

2. 0 BOE + perfect information -> new entrants can enter to steal profits -> increase supply of good -> surplus and downward pressure and price falls -> individual firms face lower demand -> fall in supernormal profit if AC/MC remains unchanged 

3. If firms continue earning supernormal profits -> more firms will enter and erode excess profits -> only make normal profits in LR 

4. No more incentive for new firms to enter -> firms produce at new profit-maximizing output Q2 where MC = MR2 -> normal profits of P2 = C2

Describe MC decisions

1. Supernormal profits in SR 

2. New firms enter -> fall in individual demand for goods sold by each firm from AR1 to AR2 and MR1 to MR2 with AR/MR becoming more price elastic (less steep graph) due to increased number of substitutes available 

3. Firm will produce at new profit maximising output Q2 where MR2 = MC and charge new highest possible price of P2 -> normal profit