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what are the different market structures?
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
what are the characteristics of perfect competition?
- e.g. apples in a farmers market
- many buyers and sellers, no single player has significant influence over price so firms are price takers
- homogeneous products, all products are the same in quality and features
- no barriers to entry and exit, new entrants can easily join the market and existing firms can easily leave the market
- perfect information, everyone has complete knowledge about prices, product quality and market conditions
what are the characteristics of a monopoly?
- e.g. a single firm dominates the market for aspirin
- one single seller, the monopolist controls the entire supply of a good/service so firm is a price maker
- unique product, no close substitutes exist, giving the monopolist significant market power
- barriers to entry, high costs or legal restrictions prevent new firms from entering the market
- imperfect info, monopolist may have more info about the market than consumers, enabling them to set higher prices
where do most real world markets fall?
- most real world markets fall somewhere between the extremes of perfect competition and pure monopoly
so what are the key factors that can determine the level of competition?
- number of firms, more firms generally indicate stronger competition, while fewer firms may lead to oligopolies (a market dominated by a few large firms) or monopolistic competition (many firms selling differentiated products)
- product differentiation: unique features or branding can create market power, allowing firms to charge higher prices. in contrast, homogeneous products lead to intense price competition
- barriers to entry: factors like economies of scale, government regulations or patents can prevent new firms from entering, reducing competition
what are some real-life examples of different markets?
- mobile phone market: oligopolies like apple and samsung compete with differentiated products, creating some but not perfect competition
- cereal market: many brands with various features exist, but economies of scale may favour larger producers, creating imperfect competition
- local taxi service: limited licenses and high initial capital requirements create barriers to entry, potentially leading to a monopolistic market
what do we assume in traditional economic theory?
- in traditional economic theory, we always assume the objective of firms is to be profit maximising
why do we assume this profit maximising objective?
- reinvestment: if a business is making large profits, they can reinvest that profit back into the business in the form of new/upgraded capital, technology, R&D etc.
- dividends for shareholders: shareholders are the owners of the company, without their finance there wouldn't be a company, so we reward them with greater profits
- to allow for lower costs and lower prices for consumers: profit = total revenue - total costs, so a business might be keeping costs very low in order to keep profits high and therefore pass on these lower costs to consumers via lower prices
- reward for entrepreneurship: there needs to be reward for that risk taken
where does profit maximisation occur?
- where MC = MR
- any point to the right of this point cannot be maximising profit as costs are always higher than revenue
- at any point to the left, revenue is so much higher than cost, so why stop there when each extra unit is going to bring in more revenue than cost, so basically each extra unit will generate profit
- as long as MR is greater than MC, each extra unit will always generate profit
- so the logical place to stop would be where no more extra profit can be made, which is at MR = MC
why do many businesses not produce at this profit maximising point?
- they don't know where their MC = MR point is, lack of accurate information
- to avoid scrutiny, if a firm is making very large profits, competition authorities and regulators might look at them and think they might be doing something dodgy e.g. charging high prices or taking shortcuts with costs reducing quality an so regulators may come in and investigate. usually these outcomes are very anti the interests of businesses
- key stakeholders could be harmed e.g. in the pharmaceutical industry, operating at a profit maximising point may mean many life-saving drugs are unaffordable
- other objectives may be more appropriate
- e.g. Octupus energy chose to ditch profit in order to keep energy bills down for consumers, a potential £9m profit dropped for £150m investment to shield consumers from price increases
- or in 2022, Greggs was in the news this week for announcing a seasonal bonus to the majority of their 25,000 employees after a strong surge in sales aided by the launch of their vegan sausage roll, this is not profit max but ethical objectives
what may these other objectives be?
- profit satisficing
- revenue maximising
- sales maximising
- e.g. after covid-19, many biotechnoogy firms set out to discover a vaccine
- Moderna sold their vaccines for the highest price out of all the firms, so their objective was arguably to profit max
- however, Pfizer distributed their vaccines free of charge to the public which suggests they had purely ethical objectives to reduce the number of COVID related deaths
what is profit satisficing?
- making enough profit to satisfy the needs of as many key stakeholders as possible
- makes a firm aim for a specific level of profit rather than the absolute 'maximum'
- it involves shareholders setting minimum acceptable levels of profit
what issue does profit satisficing overcome?
- it overcomes a key issue of profit maximising
- which is that it may harm key stakeholders (anybody with an interest with the business's activities)
who are some key stakeholders and how might they lose out as a result of profit maximising?
- shareholders: they will be happy with profit max due to high dividends
- managers: might receive higher bonuses and incomes so they're unlikely to suffer
- consumers: excess prices may be charged
- workers and trade unions: not happy as wages may be very low as a result of cost cutting
- government: may not like it if excess prices are charged for consumers and wages are very low for workers
- environmental groups: if environment takes a hit due to these cost-cutting techniques e.g. pollution and resource degradation
what's the consequences of harming these stakeholders?
- consumers: suffer from a bad reputation
- workers: workers could strike
- government: investigate if they're not happy, and outcomes could be anti the business' interests
- environmental groups: can protest and attack on social media, in the modern world reputation is a big thing for businesses
- therefore, it might be a better idea to profit satisfice rather than maximise to keep these stakeholders happy
what does profit satisficing look like on a diagram?
- it's important to remember that when drawing the profit satisficing diagram, there is no unique price and output, it much depends on the minimum requirements set by shareholders
- at point P1Q1, maximum profit is being made
- at any point between that and P2Q2, profit is still being made
- past P2Q2, a loss starts to made as average cost is higher than average revenue
- therefore, profit satisficing could be at any point between the two, depending on where the target set by shareholders is
what is the principal agent problem?
- a situation where an agent is expected to act in the best interest of a principal
- but the agent has different incentives to the principal
- this leads to a conflict of interests
how is the divorce of ownership and control an example of a principal agent problem?
- the shareholders are likely to have a goal of profit maximisation
- however, they delegate the running of the firm to managers and workers
- for example publicly traded companies, when a company goes public and sells shares to the public, ownership is spread among many different shareholders but they don't have direct control over the company's operations, as day-to-day management is handled by the company's executives and board of directors
- or private equity firms acquire ownership stakes in companies, but typically do not get involved in the day-to-day management and often hire their own executives to run the company and make strategic decisions
- the owners employ managers on the expectation that they will do a good job and try to maximise profits of the firm
- however, the owner cannot have complete knowledge about the effort and actions of their managers
- the managers know this - if they do a 'good enough' job, then they will continue to be employed
- they may also have their own goals e.g. to be happy at work and create good relationships with employees instead fo being strict on lateness
- this behaviour will not necessarily be maximising profit
- this is another cause of profit satisficing behaviour
- e.g. Microsoft and Berkshire Hathaway, where business operations were handled by professional managers rather than the founding owners
what is the behavioural economics behind this profit satisficing behaviour?
- profit and bonuses are only one way in which people are motivated at work
- behavioural economics is aware that human behaviour means there are different non-financial factors, such as a sense of achievement, responsibility and being a part of the creative process
- therefore, yes managers may seek to do the best job they can - because they get more satisfaction from maximising profits
- but equally, they may be motivated by different goals such as forming a good relationship with employees, helping them to enjoy their work environment
how could we overcome the problem of profit satisficing due to divorce of ownership and control?
- share options: giving managers shares in the company, overcomes the principal-agent problem as managers and shareholder's objectives will be more aligned (seen at walmart where workers were given shares, even some checkout assistances and in John Lewis, profits are shared among employees
- however, this isn't always possible e.g. in healthcare and teaching performance depends on much more than profitability, and a very small share of profit may not be enough to overcome issues
- performance reviews: owners could implement more targets and reviews of performance, keeping managers motivated by feeling the importance of doing a good job to get a good reference and good reputation.
- creating a sense of responsibility: managers have a sense that their work is important, makes them more invested in the creative process and will try to do a good job out of professional pride
where does revenue maximising occur?
- when MR = 0
- so the next unit sold doesn't add at all to revenue
- Q1P1 shows the standard profit maximising level of output
- Q2P2 shows the revenue maximising level of output
why might a firm look to be revenue maximising?
- predatory pricing: revenue max price is lower than the profit max price, so predatory pricing can take place. this is when a firm will undercut its rival on purpose (sacrificing profit to do so) in order to drive out competitors from the market with their lower prices
- e.g. Amazon, especially during its growth phase 2000-2010, rather than focusing on short-term profit max, amazon prioritised increasing revenue by reinvesting in expansion
- they did this to gain a very large customer base even if it lowered profit margins in the SR
- however, predatory pricing is illegal as it's anti-competitive
- Aberdeen Newspaper was fined by the OFT for predatory pricing and trying to eliminate its main competitor. They were fined £1.3million.
where does sales maximisation occur?
- where AC = AR at break even point
- this is the most sales they can make without making a loss
why might a firm look to be sales maximising?
- economies of scale
- limit pricing: the price P2 represents the limit price, if you price at breakeven point where normal profit is being made, it takes away the incentive for new firms to enter the market thus limiting competition. different to predatory pricing as it's not trying to drive out competition, but instead prevent it
- flood the market: by making many sales you flood the market, and therefore many consumers become aware of your product, seeing your product everywhere, developing loyalty to it. then, down the line you can change your objective away from sales max to a profit max objective
- e.g. uber, in its early years, focused on expanding its user base by offering heavily discounted rides and incentives to drivers
- this aimed to attract as many new users as possible
what are some other less common objectives a firm might have?
- survival, a short-run objective if they are entering a very competitive market. if they believe in their product, they might want to enter the market but just survive in the short-run. in that period of time they want to spread their brand awareness and make sure consumers are aware of their product. if they're successful in just surviving that period of time, once they've developed some brand loyalty, they can start to change their objective more towards profit max
- public sector organisations: objective is to maximise society interests so they look to produce at where S=D because that is where allocative efficiency is in the market
- this is at the point P=MC as we know that demand is the AR curve and that is the price, and MC is the supply curve. so where S=D is where P=MC
- corporate social responsibility, achieving ethical objectives e.g. the body shop not testing on animals
what is economic efficiency?
- making the best use of our scarce resources among competing ends so that economic and social welfare is maximised over time
what is the difference between static and dynamic efficiency?
- static efficiency is allocative, productive and X-inefficiency
- these are all efficiencies that occur at one specific production point, hence they are static
- dynamic efficiency occurs over time
what are the four types of economic efficiency?
- allocative efficiency
- productive efficiency
- X-inefficiency
- social efficiency
- dynamic efficiency
what is allocative efficiency?
- where resources follow consumer demand (where supply=demand) so society surplus is maximized
- it's achieved when the value consumers place on a good (which is reflected in the price they are willing to pay) is equal to the cost of these resources used in production
- so resources are being allocated to the production of the goods/services that society most values
- this is achieved where P=MC
- as AR is also the same as price, its at the point P1Q1 on the diagram, where AR and MC cross
- this is because the price reflects what value consumers place on the last unit of the good is equal to the cost of producing that unit
- and therefore, resources have been allocated optimally
what is productive efficiency?
- productive efficiency is when a firm is producing at the lowest point of their AC curve and therefore minimizing their costs
- it's the maximization of output at the lowest possible average cost, hence fully exploiting economies of scale
- this implies:
- the least costly labour capital and land inputs are being used
- the best available technology is being utilized
- an efficient production process
- economies of scale have been fully exploited
- minimized wastage of resources in the production process
what is X-inefficiency?
- X-inefficiency occurs when a business uses more inputs than necessary for a given level of output
- it occurs when a firm lacks the incentive to control costs
- so average cost of production is higher than necessary
- any point that is not on the potential AC curve is X-inefficient
- the difference between the two points is the x-inefficiency
why would a business be x-inefficient?
- a business may allow for waste to creep in if:
- monopolies: they lack the competitive drive so complacency could creep in and x-inefficiency could creep in
- but depends on contestability of the market, if there's a large threat of competition to the monopoly, it has an incentive to reduce waste and operate efficiently to avoid being undercut by new entrants, keeping the monopoly from becoming complacent
- and, monopolies are profit-maximisers, so even if there isn't competition it doesn't make much sense to allow for this waste to creep in
- to reduce x-inefficiency is quite difficult and unpopular, could mean reducing wages or taking away staff perks
- and so if a firm lacks a competitive drive it might just be easier to let it continue
- public sector firms: they are not profit motivated, their objective is to maximize social welfare
- so this means x-inefficiency may creep in as they lack this profit drive
what is dynamic efficiency?
- dynamic efficiency is the re-investment of long-run supernormal profits back into the business
- dynamic efficiency can be boosted by:
- R&D spending and a faster pace of invention and innovation
- investment in human capital leading to gains in product quality
- rapidly developing technology
- transfer of knowledge and ideas across countries
- for a firm to be dynamically efficient, they must be making supernormal profits in the LR
what is the consumer analysis of allocative efficiency?
- it means that resources are following consumer demand, consumers are getting exactly what they want in exactly the quantity they want it
- consumers are getting low prices meaning there's a maximization of consumer surplus
- quantity in the market is high, so there's lots of choice for consumers
- high quality goods due to competition, as firms must stay ahead of their rivals
what is the producer analysis of allocative efficiency?
- increased revenue/profits, by meeting consumer demand effectively, producers can sell more of their goods and services (depends on effectiveness of firms meeting consumer demands by anticipating consumer preferences, might be difficult, especially in firms in a competitive market with low profit margins)
- reduces waste, producers can avoid wasting resources on goods that consumers don't want which reduces costs (depends on flexibility of production process, can they just divert production away from one good to another to reduce waste quickly? )
- fast fashion industries e.g. zara can quickly respond as they use short production cycles to keep up with the ever changing fast fashion industry
- compared to the cement industry which involves involves large-scale facilities designed for continuous, high-volume production
- but could be argued consumer tastes for cement are constant compared to fashion
- stay ahead of competitors, firms that achieve allocative efficiency can outperform competitors by offering what consumers want, and hence increasing market share
what is the consumer analysis of productive efficiency?
- IF this lowest possible cost is passed onto consumers, then it means lower prices for them
- so there's a higher consumer surplus
what is the producer analysis of productive efficiency?
- higher output and at lower average costs
- this means higher profits
- so firms are getting higher returns on their investments, which may encourage further production and investment
- if they do pass on these costs via lower prices to consumers then they can stay ahead of rivals and increase their market share in the SR
- however in the LR, if firms are cost-cutting in dangerous ways quality will decrease, and they'll be uncompetitive in the LR
what is the consumer analysis of dynamic efficiency?
- through reinvestment, we get innovative, brand new products. as firms develop better products, it offers consumers improved performance, features and convenience, improving consumer satisfaction
- lower prices over time, because of new technology and new production techniques coming in, which lowers average cost for the producer which can be passed onto consumers via lower prices
- also, overtime, if there are new innovative products, then new producers might enter the market and we see greater competition, driving prices down once again
- all of this increases consumer surplus
what is the producer analysis of dynamic efficiency?
- it allows for long run profit maximization: by continually looking to innovate and spending on R&D, you can stay ahead of rivals and keep profits by coming up with brand new products and keep up your price making ability
- lower costs over time, investment in tech and new production techniques can improve efficiency, lowering costs over time. this allows them to keep prices low and increase profits over time
- this allows them to retain/increase market share
- this also may be very important as a way to get ahead of competition, as a way to gain patents and copyrights in order to gain monopoly power
what is the consumer analysis of X-efficiency?
- lower prices, if costs are being minimized due to no waste, then consumers may get lower prices if those costs are passed onto consumers
- so a higher consumer surplus
what is the producer analysis of X-efficiency?
- lower costs due to no waste means higher profit
- they can pass on these lower prices to the consumer, tp increase or maintain market share and stay ahead of competitors
what are the characteristics of a perfectly competitive market?
- many buyers and sellers, causing very intense and extreme competition
- each firm sells homogeneous products, for that reason firms are price takers. they have no ability to set their own prices. if a firm enters the market, they have to charge the price that is being charged by all other firms in the market. if they try and raise their price, they will lose all demand. if they lower prices, they'll lose revenue and profit without gaining anything
- also, as there's many sellers, each firm's output is a small proportion of total market supply, so no one firm can have influence over price
- no barriers to entry and exit, any firm that wants to enter or exit the market can do so freely
- perfect information, consumers know everything about prices and quality in the market and producers know about prices, technology and costs in the market
- we assume firms are profit maximisers, so they produce where MC = MR
- best example is the agricultural industry
what is important about perfectly competitive markets selling homogeneous products?
- it means firms are price takers
- since the products are identical, consumers have no reason to prefer one firm's product over another
- if one firm tries to charge a higher price, consumers will simply buy from another firm at the lower market price
what is important about perfectly competitive markets having perfect information?
- it means firms are price takers
- consumers know the prices being charged by all firms, so they will always choose the lowest price available
- so if a firm tries to charge more, they lose all their customers to competitors selling at the lower market price
what is the LR equilibrium defined as in a perfectly competitive market?
- when normal profit is being made
- any excess profit outside of normal profit is a short-run equilibrium in perfect competition, not long-run
what does the SR equilibrium for perfect competition look like on a diagram?
- in a PC market, firms are price takers, so they get their price from the market where S=D which is at P1Q1 on the left market diagram
- firms are price takers so we're going to take that price at P1 across
- and that price is going to be the AR, MR and D curve
- in the SR, we need to show SNP
- to show this, AC will be below AR
- the firm is a profit maximiser, so they will be producing where MC = MR which is at quantity Q2
- this means average costs are at the point P2
- therefore, the box P1 to P2 times by Q2 is the SNP being made
why does AR = MR = D in a PC market and why is the curve a straight line?
- firms are price takers, each firm sells its product at the market price, determined by supply and demand
- individual firms cannot influence the price, so the price remains constant no matter how much the firm produces, so price is the same for any level of output
- average revenue is the same as price, so the AR curve will be constant
- MR is the additional revenue earned by selling one more unit output
- in PC, since the price is constant, the revenue from each extra unit is always the same and is always equal to the price, hence why MR = AR
what does the LR equilibrium for perfect competition look like on a diagram?
- this SNP being made in the short-run is going to attract new firms into the market
- and they can enter because there are no barriers to entry, and because there is perfect information of market conditions
- this causes an outward shift in supply as more firms enter the market, creating a new market equilibrium at P2Q2 with a lower market price
- as firms are price takers, this new price carries over to P2 on the firm's diagram
- hence creating a new AR=MR=D curve at the bottom of the AC curve
- as a firm is profit-maximising, they will produce where MR = MC and at this point AC=AR and so normal profit is being made in the LR
what does a diagram look like in the SR for a PC firm making a subnormal loss?
- the market price is at P1, which will continue over to the firms price as firms are price takers
- this carries over and so AR=MR=D is at P1
- now, a loss is being made, so AC will be above AR
- firms in a PC market are profit maximisers, so they'll produce at quantity where MR = MC
- at Q2, AC is at C2, so the subnormal loss is shown by the yellow triangle
what happens in the LR?
- in the LR, firms will be incentivised to leave the market as a loss is being made and they can do this as there are no barriers to exit, it's costless
- as they leave the market, supply is going to shift left, raising the equilibrium price to P2
- this new price carries over to the firm, so the new AR=MR=D curve is at price P2
- as firms are profit maximisers, they'll produce at where MR=MC
- and at this level of output, AR=MR and hence normal profit is being made
is perfect competition allocatively efficient?
- in the LR all firms operate at quantity Q2
- Q2P2 is at the lowest point of the AC curve
- at this point, price is equal to MC
- so allocative efficiency is being achieved
- as resources are perfectly following consumer demand
is perfect competition productively efficient?
- in the LR, firms operate at output Q2
- this is at the lowest point on the average cost curve
- this means full exploitation of economies of scale
- so productive efficiency has been achieved
is perfect competition X efficient?
- by operating at quantity Q2 in the LR, firms are operating ON the AC curve
- this minimizes waste and minimizes costs
- so it's X efficient
so is perfect competition statically efficient?
- perfect competition is productively, allocatively and X efficient, so it is statically efficient
- all of these have to be achieved due to the nature of such intense competition
- if firms deviate away from these efficiencies they won't survive in the market
is perfect competition dynamically efficient?
- in the LR, firms cannot make supernormal profit
- so firms can't be dynamically efficient as they don't have the profit in the LR to reinvest back into the company
- therefore consumers may not see brand new innovative products or technologies over time
- producers will not be able to lower costs through new technologies over time
- so the market doesn't progress forward due to a lack of innovation
what's a good evaluation point to the efficiencies of PC models?
- shoe leather costs are the costs of time invested into having to search for the best prices and deals in the market
- therefore, PC markets may not be 100% allocatively efficient
- this efficiency is about using resources in the most efficient way possible
- shoe leather costs represent wasted resources of people spending excessive time searching for better prices, as resources aren't used optimally
how is the internet making the perfect competition theory more realistic?
- perfect information: internet access enables competitor firms to access more info about their rivals e.g. prices and production methods
- consumers can also quickly compare prices and quality across producers, so they're closer to having full information
- lower barriers to entry: firms need to spend less money on R&D as the info is readily available meaning less sunk costs
- e.g. sellers can set up online stores with minimal capital using platforms like Etsy or Shopify, lowering the entry barriers and encouraging new entrants
- more buyers and sellers: small scale firms can sell globally, increasing number of participants in the market
how is the internet making the perfect competition theory less realistic and towards monopoly production?
- as technological breakthroughs may lead to new firms patenting inventions
- e.g. dyson has copyrights over its products, allowing it to dominate the hoover sector
- this increases statutory barriers (barriers due to law)
- also, the new invention may cause a change in consumer preference, eg if the new invention offers better & cheaper products than its rivals
- firm may further secure their monopoly position in a market by carrying out predatory pricing tactics- undercutting rivals further to reduce incentive for new firms to enter the market
- rivals may not be able to compete and monopoly power rises
what happens when losses are being made in the short-run in a perfectly competitive market?
- firms leave the market, shown by a leftward shift in the supply curve
- however, why do some firms leave and some stay?
- we can show this through the concept of the shutdown price
how can we figure out whether a firm should continue making a loss in the SR or shut down?
- by looking at their costs
should company A shut down?
- if company A were to shut down, there'd be no revenue coming in but they'd still have to cover their fixed costs of production
- so to shutdown, it would cost them £100,000
- if they were to continue, their revenue would be £80,000, but they'd have to pay variable and fixed costs, so their total costs would be £200,000
- therefore, they'd be making a greater loss continuing production rather than shutting down
- so company A should not continue producing in the short run as the loss would be greater than if they shut down
should company B shut down?
- if company B were to shut down, it would cost them their fixed costs which are £100,000
- if they were to continue, revenue would be £120,000 and total costs £220,000
- so it would also cost them £100,000 to continue
- so company B continuing in the short-run, despite making a loss, it doesn't matter as it's the same loss either way
should company C shut down?
- if company C were to shut down, it would cost them their fixed costs which are £100,000
- if they were to continue, revenue would be £150,000 and total costs £240,000
- so the loss if they continued would be £90,000
- by shutting down, their losses would be greater than if they continued, so they should continue producing in the short-run
- this is because in production, their revenue coming in covers the variable costs of production
- so the extra revenue on top of covering the variable costs can be used to rundown some of the fixed costs of production
- whereas if they shut down and there was no revenue coming in, the full fixed costs would have to be payed and there'd be no revenue to help cover it
what's a benefit to company C being able to continue production?
- even though they are making a loss in the SR, a benefit to company C of company A and B leaving is that in the market, the supply curve will shift to the left as firms that aren't able to cover their variable costs leave
- this pushes the market price up, and maybe company C, who is able to keep producing, will go back towards normal profits as their revenues increase
- or maybe even supernormal profit
- this is what companies who stay in the market and continue producing despite making losses are aiming for
therefore, what is the shutdown condition?
- shutdown condition is when firms should shut down
- this point is where AR=AVC
- at this point, firms should consider shutting down
- if AR is less than AVC, then firms should definitely shut down
- this is very different to the breakeven condition (AC=AR), as at the shutdown point, firms could still be making a loss
- e.g. during covid, many restaurants faced reduced revenue due to lockdowns
- for some, the income generated from limited takeaway and delivery sales was below their variable costs (like food, staff, and utility bills)
- these restaurants reached their shutdown price and chose to close temporarily or permanently because staying open would result in continued losses
what does a firm that shouldn't shut down look like on a diagram?
- firms are price takers, so the AR=MR=D curve will be perfectly elastic
- firm must be making enough revenue to cover average variable costs, so the AVC curve is below the AR=MR=D curve
- AC and MC curves go on as normal
- perfectly competitive firms will operate where MR=MC to make maximum profit which is at Q1P1
- at this point average costs are at C1 and revenue at P1, so the yellow rectangle shows the subnormal loss
- however, at Q1, average variable costs are at price P2 which is less than average revenue at P1
- so this firm should continue producing, waiting for firms to leave the market and prices to rise, meaning subnormal loss turns to normal/supernormal profit
what does a firm that should shut down look like on a diagram?
- average variable costs aren't being covered, so the AVC curve is above the AR=MR=D curve
- firm is a profit maximiser so output will be at Q1 where MR=MC
- at Q1, revenue is at P1 whereas average costs are at C1, so the loss is shown by the yellow triangle
- however, average variable cost is up at C2, whereas average revenue is lower at P1
- so average revenue is not covering average variable cost
- so the firm should shut down as the loss can't be sustained
what are some good evaluation points for shutdown price?
- in the real world, there are circumstances where firms will continue to produce even if average revenue is less than average variable costs
- e.g. if there is a temporary fall in demand, due to a recession, a firm may prefer to keep producing - so they don't lose long-term customers.
- if a firm sees average revenue is less than average variable costs, they may not respond by shutting down, but trying to cut costs or increase the prices.
- a firm may shut down even if the price is greater than average variable costs e.g. if the firm is pessimistic about the growth of this particular market and feel there is a high opportunity cost to staying in a declining industry
- in the real world, it may take time for a firm to realise they are making an operating loss
what are the characteristics of a monopoly market structure?
- legal definition is a firm with 25% market share
- one seller dominating the market (pure monopoly or legal monopoly)
- differentiated products, this means that naturally the monopolist is a price setter as it's the sole provider of a product with no close substitutes
- high barriers to entry/exit, this means SNP in the long-run as it prevents other firms entering the market and competing away competition
- imperfect information, further prevents firms entering the market
- we assume the firm is a profit maximiser, outputting where MR=MC
- google is the best example with 84% market share
what are the two types of sellers dominating the market in a monopoly?
- pure monopoly, a theoretical example, one firm with 100% market share, where one firm is the entire industry
- e.g. local water supply companies, where a single company has exclusive control over the water supply, often results in 100% market share as these utilities are typically regulated by the governemnt and cannot legally be duplicated by other companies
- monopoly power, more realistic, where a firm has the power and potential to act like a monopoly
- the legal definition of monopoly power is where one firm has more than 25% market share
what does monopoly look like on a diagram?
- due to this price setting power, the AR curve is downwards sloping
- firm is a profit maximiser, so they'll produce where MC=MR
- SNP is shown by the yellow triangle
are monopolies allocatively efficient?
- allocative efficiency occurs where P=MC at P2Q2
- quantity Q1 is not at this point in the market, the MC are much lower than the price being charged in the market, exploiting consumers in this sense with high prices, limited output and low consumer surplus
- the quantity Q1 is much lower than the allocatively efficient point Q2, as monopolies limit output to maximise profit
- there aren't enough firms to compete to drive down prices and increase output
- so, choice is low in the market and resources aren't following consumer demand
- there's also a risk that quality could be low due to the lack of competitive forces
are monopoly markets productively efficient?
- firms are not producing at the lowest point on their AC curve
- so they are not productively efficient
- they're voluntarily foregoing economies of scale by not producing at the minimum point on their AC curve
- this is because it has no direct competition, so it lacks the external pressure to minimise costs
- firms want to produce at the output where profit is maximised, even if this means AC is higher than it has to be
- this is another reason why prices tend to be higher in monopolistic markets
are monopoly markets X-efficient?
- in monopolistic markets, we can assume X-inefficiency
- we can't see it from the diagram, but we can assume it with basic logic
- X-inefficiency occurs when monopolists are producing beyond their AC curve, allowing for waste to creep in
- there are excess costs
- monopolies do this as they become complacent with a lack of competitive drive, which is why they get away with it and can charge higher prices for it
- also because it's very difficult to reduce waste and cut down costs to the absolute minimum
- if a firm doesn't need to do so (in this case as they can just charge higher prices instead), then they're not going to do so
are monopoly firms dynamically efficient?
- yes, because there are long-run supernormal profits
- no firms can enter the market due to high barriers to entry and imperfect info
- so this keeps other firms out of the market which allows these SNP to persist in the LR
- therefore, the firm can reinvest these profits back into the company in the form of new technology, innovative new products and R&D
- this is in the LR interests of consumers due to more choice and higher quality goods/services
- and also in the interest of the producer
- e.g. Tesla consistently invests in futuristic projects, including the development of humanoid robots like the Optimus. Musk envisions these robots handling "unsafe, repetitive or boring tasks," which could eventually lead to greater efficiency and cost savings.
what do we mean by a deadweight welfare loss?
- deadweight means not recovered
- and by welfare we mean the net society surplus, the sum of consumer and producer surplus
- in terms of monopolies, it means compared to competitive markets, monoploies are reducing the total sum of society surplus
what is the consumer surplus in competitive vs monopoly markets?
- in competitive markets, output is where supply=demand so where MC=AR, at PcQc
- therefore, consumer surplus is the entire area above the point where Pc is in the yellow triangle
- however, in monopoly markets, output is at MC=MR where profit is maximised, which is at PmQm
- therefore, consumer surplus is the entire area above where Pm is, in the orange triangle
what is the producer surplus in competitive vs monopoly markets?
- producer surplus is the area beneath the price line, but above the supply curve
- so for competitive firms at output MC=AR, it's the yellow area shaded
- and for monopoly firms, where MC=MR, this is the orange area
so what does society surplus look like for the two markets?
- therefore, it can be seen from the two that the difference between the two market's society surplus is the white triangle
- therefore, this is the deadweight welfare loss for a monopoly market
- what was once previously benefitting consumers and producers via economic welfare, is now lost due to restricted output and higher prices
- this is why monopolies are so bad for society, as they reduce the total level of society surplus
- we're not too concerned by the loss of producer surplus, as they are gaining huge profits in this market
- the main concern is the loss of consumer surplus, consumers being exploited drastically via high pricing
what is price discrimination?
- where a firm charges different prices to different consumers for an identical good/service with no differences in costs of production
what are the conditions necessary for a firm to price discriminate?
- firm must be a price setter, for this they need monopoly power. price discrimination involves setting different prices based on consumers, so they must have price setting power in order to do this
- information to separate the market, they must be able segment the market into different types of consumers with different PEDs
- have to be able to prevent resale of a good, stop consumers from buying where the price is higher and selling where the price is lower
how do firms get the info to segment markets?
- e.g. when we do shopping online, we create accounts so then they can track what we do and our information
- so that they can segment us into different markets based on our PED
what is 1st degree price discrimination?
- when a firm charges the exact price consumers are willing and able to pay
- they charge a different price to each consumer based on their individual willingness to pay for every unit of the good they consume
- therefore eroding all consumer surplus in the market as the firm captures each consumer's willingness to pay and turning it into monopoly profit
- an example of this is auctions e.g. ebay
what does 1st degree price discrimination look like on a diagram?
- in a supply and demand diagram, if the price was P1Q1, then the consumer surplus would be the triangle area above this
- however, under price discrimination, all of this consumer surplus would be turned into monopoly profit
what is 2nd degree price discrimination?
- there are many ways to look at second-degree price discrimination, one way is with excess capacity pricing
- this is when you have a firm with fixed capacity e.g. a train/airline company, cinema or hotel all with a fixed number of seats
- here, it makes no sense to leave any of that capacity unfilled
- because these companies have fixed costs they need to pay
- so, last minute, they lower their prices in order to fill that capacity and contribute towards their fixed costs
- e.g. airlines offering last-minute discounts on unsold tickets in order to fill seats which allows the airline to generate additional revenue from price-sensitive customers and help cover fixed costs associated with operating the flight
what do the cost curves look like when showing second degree price discrimination on a diagram?
- the MC curve will equal the AC curve
- this is because as output increases in the LR, the firm has no more gains from economies of scale, so the AC will remain the same at any level of output
- therefore, the cost of producing one more good (MC) will simply be the same as the AC
- in second degree price discrimination, the MC=AC curve will be straight and then go up at the end at Qcap
- this shows that beyond Qcap e.g. when all the seats have been used up, you can't produce anything more without having to purchase e.g. another cinema room/larger plane so the AC=MC curve spikes to reflect that additional cost
- before that, MC=AC is constant, because we can see e.g. with a plane, the extra cost incurred by supplying that seat to another passenger is constant, as it may simply be a meal or admin with ticketing process, the cost is always constant
- revenue curves look just as normal
what does 2nd degree price discrimination look like on a diagram?
- assuming this firm is a profit maximiser, they will be producing where MC=MR
- this gives us quantity Q1 and price P1
- we can see on the diagram that if they maximise profits by outputting at Q1, they'll be some excess capacity left
- and it makes no sense to leave that idle given the fixed costs that exist
- so a firm may lower their prices to make sure they can fill all of that capacity and thus bring in revenue to contribute towards their fixed costs
- the logical place to price would be where AR=MC at price P2, because at this price you can see all capacity is going to be filled
- and the revenue coming in can be used to contribute towards fixed costs
- by doing so, the consumers that buy last minute can gain consumer surplus shown by the orange triangle
what is 3rd degree price discrimination?
- when a firm is able to segment the market into different price elasticities of demand
- there'll be one group of consumers with price inelastic demand, and one group of consumers with price elastic demand
- a firm will recognise this e.g. based on income and age
- and charge different prices based on different groups
- e.g. for train travel, business commuters are price inelastic as they have to get to work at a certain time, whereas leisure travellers are more price elastic
what does the diagram look like for price discrimination?
- we assume MC=AC and that this is constant, for the same reasons as second degree price discrimination
- costs will be the same for each segment in the market, so we can take this across
- for our AR curves, in the price elastic segment it will be quite shallow and for the price inelastic it will be quite steep
- in both cases firms will be operating where MC=MR as they're profit maximisers so they will be outputting at P1Q1 and P2Q2 as shown
- we can see there are different prices charged in the market depending on PED
- where demand is more inelastic, price is higher
what can we see from this diagram?
- we can see that instead of charging one price overall in the market, by charging two prices, this frim is able to maximise their joint profits
- we can see if the inelastic price P2 was charged in the elastic segment, there'd be much lower demand at Q3
- so, by being able to charge different prices to different consumers based on different PEDs, the firm is able to maximise profit
what are the advantages of price discrimination?
- dynamic efficiency, price discrimination leads to higher profits which could have more reinvestment potential, this would benefit economic welfare in the LR
- total output may be higher which could lead to economies of scale, in the future these lower costs could mean lower prices to consumers (depends on subsequent actions taken by the firm, may be unlikely as they're monopolies)
- lower prices for some consumers, enabling them to access a market they previously may not have been able to and hence increasing utility. they may even be operating at a loss (show this by 2 different MC curves on a diagram) in the price elastic segment in order to charge lower prices funded by high profits in the price inelastic segment e.g. people can go away not during term time for a cheaper holiday and BT broadband offers low price deal for families on Universal Credit
- cross-subsidisation, when a firm uses the profits from one group of consumers to subsidise lower prices for another group or product. e.g. these extra profits in the price inelastic segment for trains, such as business travellers, may be used to offer student discounts on railway cards
what are the disadvantages of price discrimination?
- allocative inefficiency, charging prices way beyond marginal costs exploits consumers
- in a price discriminating market, the price each consumer pays isn't equal to the MC of production
- this means firms capture more consumer surplus (in first degree it's all, in second and third-degree it's some)
- it also reduces output below the allocatively efficient point
- because under third-degree price discrimination, higher prices are charged to less elastic groups, which reduces the quantity demanded by those groups
- inequalities, those on lower incomes could be charged more which would widen income inequality in society
what are the depends on points for this?
- governments may intervene to prevent excessive price discrimination when prices deviate too far from marginal costs, particularly in essential goods markets e.g. energy and transport
- such regulation can reduce allocative inefficiency and limit the firm's ability to price discriminate
- e.g. BA virgin scandal, regulatory bodies fined them hundreds of millions of pounds for behaving in an uncompetitive way and unfairly price discriminating
what are some depends on points for this?
- depends on the industry, industries like technology or pharmaceuticals, where innovation is crucial, are more likely to see price discrimination reinvested into new products or improvements
-however firms in mature industries e.g. utilities or transport may have less need for R&D, so less likely to see dynamic efficiency gains
- the extent to which consumers gain profits depends on the price making ability of the firm. if the firm has monopoly power, then its ability to price discriminate will be greater, because it has greater price setting power and consumers have fewer substitutes to choose from
- depends on the ability of firms to extract information from the market
- to price discriminate perfectly, the firm would need to be able to know the maximum willingness to pay of all the consumers in the market and then charge them an exclusive price relative to this
- in reality, this is an unreasonable assumption, so first degree price discrimination is unlikely to benefit producers much
- however third degree price discrimination is particularly effective for train companies, as they are very aware of the necessity people have when travelling during peak hours
- this is why peak train tickets are often 3 or 4x the value of off-peak tickets, and this benefits train companies greatly
why is cross-subsidisation a good thing?
- allows firms to offer lower prices to groups that might otherwise be excluded from the market due to high costs
- e.g. public transportation often use profits from higher-income customers to offer discounted services to low-income households
what is a barrier to entry?
any obstacle that prevents a new firm entering a market
what are the different types of barriers to entry?
- legal
- technical
- strategic
- brand loyalty
what are legal barriers to entry?
- patents, patents mean you have sole ownership over something you've created
- this makes it difficult for new firms to come in and compete
- licenses and permits, maybe firms need a license or permit to operate in that market, if all of those have been given out already then you can't enter e.g. the pharmaceutical industry
- also, if they're expensive to obtain then that'll be a major barrier to entry
- red tape, is excess bureaucracy and paperwork reduces incentive to enter the market
- excess standards, e.g. product and environmental standards, then it's very costly for the market to reach those standards
what are technical barriers to entry?
- industry specific barriers
- high start up costs
- high sunk costs, costs that can't be recovered when a firm leaves the market e.g. advertising and specialist machinery. advertising will already be payed for you can't recover it and specialist machinery can't be sold on as it's so specific to the business
- economies of scale, if firms have very high economies of scale in the market and very low average costs, then they can price lower which might scare off new firms who can't grow to such a size and get the same economies of scale straight away
- natural monopoly, where it makes sense for just one firm to operate in the market. if a new firm were to enter that market, they could be driven out very easily
what are strategic barriers to entry?
- where incumbent firms (firms in the market already) act in a very threatening way
- predatory pricing, pricing lower on purpose to drive out competition, sometimes even at a loss
- e.g. amazon in the book-selling market, started off by selling at significantly low prices, often at a loss, to deter competition
- this lower price could even be making a loss for that firm but they do it to drive out competitors
- limit pricing, firms price at their normal profit/ break even point to limit competition entering the market, taking away the incentive to enter the market
- heavy advertising
