Topic 8: Market Power and Profit

Four short-run operating positions.

1. Zero economic profit (P=ATC)

2. Economic profit (P>ATC due to increase in D)

3. Quasi Loss (P<ATC due to decrease in D)

4. Shut down (P<AVC)

Economic profit will attract more firms - perfect compeititon barriers to entry and exit 

in PC there are 0 barriers to entry or exit/low barriers

• Increase number of firms in the market 

• decrease market share for existing firms 

• D curve shifts left and down 

• existing firms profit falls 

• reduces incentive for new firms to enter 

Perfect competition in the long run. stages 0-2

stage 0: start with normal zero economic profit

stage 1: incentive for new firms to enter

stage 2: low barriers to entry and exit means new firms can enter

Economic loss prompts exit.

firms can easily exit:

• Decreased number of firms in the market

• increase market share for existing firms

• existing firms D curve shifts right and up

• existing firms losses fall

what are perfectly competitive markets used for/what is their purpose

• They are a benchmark for what is ideal

• the closer we are to a perfectly competitive market, the closer we are to maximising welfare and allocative efficiency

Requirements for the monopoly model 

1. Many consumers but only one firm

2. individual firm has market to itself and has maximum market power 

3. Impenetrable barriers to entry and exit 

Monopolistic Competiton

• Similar to perfect comp

• many firms

• low barriers to entry and exit

• Firms sell similar but differentiable products

• Firms demand curve is downward sloping

Oligopoly

• Small number of large and dominant firms

• Interdependent: actions of one firm will affect other firms

• barriers to enrty

  • Brand loyalty e.g. apple

  • patents e.g. pharmaceuticals

  • large set up costs e.g. new airline

Profit maximisation (Topic 7, extending into Topic 8): a) (Topic 7) Why does profit maximisation imply that price equals marginal cost for a price-taking firm? [Note this question has been used in the final exam in the past] b) (Extending into Topic 8, if you’re ready) **Why does profit maximisation imply that price is above marginal cost for a firm with some degree of market power?

a. Profit maximisation occurs when MR=MC. In perfect competition P=MR=AR so MR=MC becomes P=MC. If P is greater than MC the firm can produce more and make a higher profit. If P is lower than MC the firm needs to reduce outputs, however if MC=P then profits are maximised.

b. A firm with market power is a monopolistic firm. A firm with market power has a downward sloping demand curve. Firms with market power produce less and charge a higher price than perfectly competitive firms.

2. *** Shape of MC (Topic 7): Why does the marginal cost curve at first fall and then rise as production increases? [Note this question has been used in the final exam in the past]

The marginal cost curve is U shaped because marginal productivity first rises (MC falls) and then declines (MC rises).

6. * Short and long-run costs: One of the very early successes of the Japanese manufacturing company Sony was a transistor radio small enough to fit into a shirt pocket (very rare in 1953, when it was developed). In 1955 they went to New York in search of a U.S. department store chain to carry the Sony radios. Sony offered to sell 5,000 radios to a department store chain at a price of $29.95 each. If the chain wanted more than 5,000 radios, the price would change. If a chain wanted 10,000 radios, the price per radio would be cheaper, but for an order of 30,000 radios the price would be higher than for 5,000 radios. An order of 100,000 radios would bring the price much higher again. How could this be so? Suppose that Sony became convinced that they would be able to sell more than 75,000 radios per year (assume they only supply to one chain store in the US, and gets only one order per year). What steps would they have taken?

For small increases in output (e.g. from 5000 to 10,000 radios), Sony can spread fixed costs over more units and gain economies of scale → lower cost per unit → lower price. But beyond a certain scale, (30,000 → 100,000), diseconomies of scales appear - management inefficiencies, coordination problems, overused machinery - so average cost rises meaning that price must rise. If Sony expects more than 75,000 per year they would expand size (factory), invest in capital and move to long run equilibrium so that the long run average cost is lowest for new output level.