2.5. Market Power

Law of Diminishing Marginal Returns

As a firm increases its output, the marginal productivity of workers will eventually start to diminish, as the workers become constrained by the fixed amount of capital, causing marginal costs of production to start to increase.

Total Cost (TC)

Sum of all costs incurred by a firm in producing output.

Average Cost (AC)

Total cost per unit of output.

Formula to calculate AC

TC divided by Quantity of Output

Marginal Cost (MC)

The change in total costs that occurs when an additional unit of output is produced.

Formula to calculate MC

Change in TC divided by Change in Output

What is important about the intersection of AC and MC?

It is at the minimum point of AC (productive efficiency)

Total Revenue (TR)

Total amount of money earned by a firm from selling goods and services.

Average Revenue (AR)

Revenue earned by a firm per unit of output.

Marginal Revenue (MR)

Change in revenue earned by a firm when it produces one more unit of output.

Formula for AR

TR divided by Quantity of Output, which equals Price

Formula for MR

Change in TR divided by Change in Output

Revenue Maximisation occurs when...

...MR=0.

On the left hand side (top) of the demand curve, PED is...

...elastic.

In the middle of the demand curve, PED is...

...unit elastic.

On the right hand side (bottom) of the demand curve, PED is...

...inelastic.

Abnormal (Economic) Profit

Occurs when Total Revenue is greater than Total Economic Cost.

Normal Profit

Occurs when Total Revenue equals Total Economic Cost. There is just about enough revenue to keep the firm in the industry.

Loss

Occurs when Total Revenue is less than Total Economic Cost.

Profit Maximisation occurs when...

...MC=MR.

Growth Maximisation

A goal of the firm, whereby they aim to produce as much output as possible.

Satisficing

A goal of the firm, whereby rather than maximising profit, the firm aims to make just about enough profit to satisfy shareholders.

Corporate Social Responsibility

A goal of the firm, whereby the firm aims to make profit at the same time as considering the ethical implications of their actions.

Market Power (Monopoly Power)

The ability of a firm to set its own price by restricting output.

Perfect Competition

A large number of small firms, a homogenous product, free entry and exit, perfect information.

In perfect competition, how much market power do firms have?

Zero

In perfect competition, the D=AR curve faced by firms is...

...perfectly elastic (firms are price-takers).

Productive Efficiency occurs where...

...MC=ATC (ATC is at its lowest point)

Allocative Efficiency occurs where...

...MC=AR (social surplus is maximised).

In the long-run, perfectly competitive firms always make...

...normal profit.

Monopoly

A single, dominant firm, product has no close substitutes, high barriers to entry.

Barriers to Entry

Ways in which a firm may prevent others from entering an industry.

Natural Monopoly

An industry in which the significant economies of scale in the industry only allow it to support one firm.

Marginal Cost Pricing

A solution to the abuse of monopoly power, whereby the government forces a firm to charge a price equal to its marginal cost (MC=AR).

Average Cost Pricing

A solution to the abuse of monopoly power, whereby the government forces a firm to charge a price equal to its average cost (AR=AC).

Nationalisation

A solution to the abuse of monopoly power, whereby the government buys all firms in the industry and sells the product itself.

Monopolistic Competition

Large number of small firms, a differentiated product, free entry and exit.

Price Competition

Occurs when firms aim to increase their market share by lowering prices.

Non-Price Competition

Occurs when firms aim to increase their market share by differentiating their product to make it more appealing to certain consumer groups.

Oligopoly

A few dominant firms, mutual interdependence, a homogenous or differentiated product, high barriers to entry.

Mutual interdependence

Occurs when the actions of one firm affect all other firms in the market.

Collusion

Occurs when firms fix prices or restrict output together to maximise joint, rather than individual, profit.

Concentration Ratio

Measures the market share held by the largest few firms in the industry.

Formal Collusion

Occurs when firms formally agree to fix prices or restrict output to maximise joint profit.

Informal (Tacit) Collusion

Occurs when firms restrict output or fix prices to maximise joint profit with no formal agreement.

Price Leadership

A model of informal collusion whereby the biggest firm in the industry sets a price and initiates price changes, with all other firms effectively become price takers.

Cartel

A group of firms that formally collude.

Price Discrimination

Occurs when a firm charges different prices to different consumers for the same product, for any reason other than differences in the costs of production.