Market failure and socially undesirable outcomes 3

Profit maximisation, perfect competition, monopolies

revenues definition

payments that firms receive when they sell the goods and services that they produce.

total revenue vs average revenue

• total revenue = PxQ → amount of money a firm gets when they sell a g/s

• average revenue = TR/Q = P → revenue per unit output sold

marginal revenue

• formula = change in TR/ change in quantity

• additional revenue from producing one more unit of output

average + marginal revenue for price taker firms

• AR=MR=P

• straight horizontal line → price is constant

price taker vs price maker

• price taker → cannot control the price → exists with perfect competition (price does not change with output)

• price maker → can set their own price → monopoly, oligopoly, monopolistic competition (price changes with output)

total revenue for price taker firms

• increases by the same amount

Average revenue + marginal revenue for price maker firms

• MR is twice as steep as AR

• MR is negative → firm is loosing revenue with each extra unit of output

• when MR = 0 TR is at maximum

Total revenue for price maker firms

• revenue is maximized at the local maximum (where MR=0)

PED and TR

• PED is rel. elastic → price increases → TR increases

• PED is rel. inelastic → price increases → TR decreases

costs of production definition

payments by firms to obtain and use factors of production in their production process

fixed vs variable costs definition

• fixed - costs that don’t change with output (short run)

• variable - costs that change with output

Total costs

• total amount of money spent on producing a certain quantity

• = fixed + variable costs

Average costs

• costs per unit output produced

• average fixed costs + average variable costs

Marginal cost 

• additional costs to produce an extra unit of output

• = change in total costs / change in quantity 

the relationship between average costs + marginal costs in the short run

• MC<AC → average cost is falling

• MC>AC → average cost is rising

• MC intersect AC at AC’s minimum

what is meant by short run vs long run

• short run - at least one factor of production is fixed

• long run - all factors of production are variable

total product vs marginal product 

• total - the total quantity of output produced by a firm

• marginal - the additional output that results from one additional variable input

relationship between marginal and total product

• when MP=0, TP is maximized 

• when MP is rising TP rises faster

• when MP is falling TP falls slower

relationship between marginal and average product

• MP>AP → AP increases

• MP<AP → AP decrease

law of diminishing marginal returns

as more and more units of a variable input are added to one or more fixed inputs the marginal product of the variable input at first increases, but then it reaches a point after which the marginal product of the variable input starts to decrease

relation of marginal costs to diminishing marginal returns

• marginal product increases → marginal cost decreases

• when marginal product is at maximum → marginal costs is at minimum

• when marginal product falls → marginal costs increase

marginal costs and the firms supply curve

• upward sloping part of MC curve = supply curve

• the firm can only produce more output if the price of the good increases to cover the extra cost of each extra unit produced

explicit vs implicit costs

• explicit -  direct, out-of-pocket payments that businesses actually make, e.g wages, rent, materials, and utility bills.

• implicit - opportunity costs - value of resources the firm already owns but could have used elsewhere (not used when calculating accounting profit)

profit formulas

• revenue - costs of production

• economic profit = total revenues - economic costs

• total revenue - sum of explicit costs - implicit costs

• (economic costs = implicit + explicit costs)

profit maximization

• producing a level of output where the difference between total revenue and total costs is the largest

• largest amount of profit

rewards for f.o.p

• land - rent

• labour - wages

• capital - interest

• enterprise - profit

• → the costs of a business

normal profit

• the minimum amount of revenue that the firm must receive in order to keep the business running

• TR=TC

• normal profit also = the opportunity cost of running the business instead of doing something else. 

abnormal/supernormal profit

• TR>TC

• more than normal profit is made

losses

• TR<TC

• less than normal profit is made

profit maximization - price takers

• AR>AC → abnormal profit

• AR=AC → normal profit

• MC=MR → profit maximization

minimizing loss - price takers

• when AR<AC

• MC=MR → minimize loss

profit maximization - price makers

• MR=MC

• as long as MR>MC the profit can be increased by producing more units until the last unit of output brings not more profit (MC=MR)

types of market structure

• perfect competition

• monopolies

• oligopoly

• monopolistic competition

• (monopolies, oligopoly, monopolistic competition → imperfect competition)

conditions for normal profit + profit maximization

• normal profits : AC=AR

• Profit maximisation : MC=MR

conditions for productive + allocative efficiency

• productive efficiency - AC=MC

• allocative efficiency= S=D/MC=AR

Assumptions for perfect competition

• large number of small firms + many small households/consumers

• no barriers to market entry/exit

• firms are price takers : AR=MR=P

• homogenous/identical products → perfect substitutes for each other

• perfect information about costs, revenues, etc.

examples of perfect competition

• there are no existing perfectly competitive markets but a few come close:

• agricultural markets (wheat,corn)

• online market places - eBay, Amazon

• Raw material markets

what happens in the market when businesses in perfect competition are making abnormal profit

• more businesses enter the market due to perfect information + no barriers to entry → lowers price

• This happens until the AR curve is a tangent to the AC curve

effect of more firms entering the market in perfect competition

• increase in supply → increase in competition as goods are perfect substitutes for each other → fall in price due to excess supply → expansion of demand

• each firm now has lower AR + MR → abnormal profit falls

perfect competition short run - allocative efficiency, normal profit, profit maximization, productive efficiency

• Yes:

• allocative efficiency

• profit maximisation

• No:

• normal profit

• productive efficiency

perfect competition long run - allocative efficiency, normal profit, profit maximization, productive efficiency

• all are present

• allocative efficiency

• normal profit

• profit maximisation

• productive efficiency

• → stable

benefits of perfect competition

• allocative efficiency

• low prices for consumers due to absence of abnormal profits

• closing down of inefficient producers due to competition

• market responds to consumer tastes - changes in consumer tastes → change in market demand + market price

limitations of perfect competition

• relies unrealistic assumptions that are rarely met in the real world

• no economies of scale - firms are too small

• lack of product variety - firms produce homogenous products but consumers prefer variety

• limited ability to engage in product development - lack of abnormal profit → cannot fund research + innovation

Monopoly definition

A market structure with a single supplier of a good or service and that has control over the market price. The firm sells a unique product and is protected by high barriers to entry

characteristics/assumptions of a monopoly

• single supplier = market supply

• price maker

• High barriers to entry + exit

• Differentiated goods and services without close substitutes.

Average revenue curve for monopolies

= market demand due to monopoly being the single supplier.

Why do barriers of entry + exit arise in monopolies

• economies of scale

• legal barriers

• control of essential resources

• natural monopoly

• Aggressive tactics

economies of scale - Monopolies

• = lower average costs of production in the long run resulting from being a large firm.

• occurs in the downward sloping part of a firms long run average revenue curve.

• Occurs due to :

• bulk buying

• specialisation of labour

• lower costs for marketing

• lower borrowing costs

legal barriers - Monopolies

• applies to all imperfect competition

• patent = temporary monopoly for an inventor

• Licences - granted by governments for a certain profession/industry

• copyrights = temporary monopoly for artistic output

• tariffs/quotas

• all limit competition and so create market power

aggressive tactics (limit pricing) - Monopolies

• monopolist sets a price with which any new market entry cannot compete with and therefore preventing entry to the market

• illegal

natural monopoly

• a situation where a single firm will be able to supply a greater amount of output at a lower price than if more than one firm were to compete

• due to high capital costs + high economies of scale enjoyed by monopolist.

Example of natural monopoly

• Bratislava water company (BVS)

• builds an expensive pipeline network. If multiple firms were to compete each firm would have to build its own pipelines leading to higher costs, inefficiencies and waste of resources.

how to know if a firm is a natural monopoly on a graph

market demand for a g/s intersects LRAC (long-run average costs) whilst it is falling.

how can natural monopolies stop being ‘natural’

if changing technologies create conditions which allow new competitor firms to enter the industry and begin production at a relatively low cost.

advantages of monopolies

• abnormal profit → funds for R&D→ can boost innovation

• economies of scale → lower costs of production (see graph in notes)

• Natural monopolies - can supply a greater amount + at lower price

disadvantages of monopolies

• limited choice for consumers due to lack of competition

• Higher prices for consumers (profit maximising monopolist)

• Allocatively inefficient → creates DWL

• Productively inefficient market outcome

• X inefficiency → average costs are not as low as AC curve due to lack of competition

Mylan (Epipens) monopoly

• Pharmaceutical monopoly (over 90% market share)

• ad : abnormal profits allow for R&D which helps improve epipens

• dis : increased the price by over 400% → low income earners struggle to afford Epipens

why are monopolies allocatively inefficient

• P>MC at profit-maximising level of output

• there is an underallocation of resources

market power definition

• the ability of a firm to charge a price greater than marginal costs (P>MC)

• can only occur when a firm experiences a downwards sloping demand curve (imperfect competition)

characteristics of an oligopoly

• small number of large firms

• high barriers to entry - all barriers as in monopoly + high start up costs (spend a lot on product differentiation + advertising)

• interdependence - decisions made by one firm greatly impact other firms in the industry

• products are differentiated

• imperfect information

• Quite strong market power (depends on concentration of market which can be found through concentration ratio)

affect of interdependence on oligopoly behaviour

• Strategic behaviour

• Conflicting incentives : incentive to cheat, incentive to collude

strategic behaviour oligopoly

Firms use analysis (like game theory) to predict competitor reactions, deciding whether to cooperate or compete.

conflicting incentives - oligopoly

• incentive to collude - fix price + reduce quantity → maximize profits for industry as a whole

• incentive to cheat - want to capture a portion of rivals’ market share + profits → increasing profits at the expense of other firms

Types of oligopoly

• collusive oligopoly : firms overcome uncertainty by charging the same price or splitting the market geographically → act like a monopolist.

• non-collusive oligopoly : businesses charge similar prices (competitive pricing) use non-price competition e.g design,durability,customer service

types of collusive oligopolies

• formal collusion (cartel) : firms openly agree on a price to charge consumers.

• tacit collusion : firms charge the same price without a formal agreement → price leadership (dominating firm decides the market price with other firms following). if price leadership is done to restrict competition = illegal.

advantages for firms in a cartel

• increase in market power → can influence price

• increased profits due to higher price

• elimination of competition → remove uncertainty

game theory definition

a mathematical technique analysing the behaviour of decision-makers that are dependent on each other and who use strategic behaviour to try and anticipate the behaviour of their rivals.

prisoner’s dilemma

2 rational decision makers that use strategic behaviour to maximize profits collectively end up being worse off. (at Nash equilibrium)

prisoner’s dilemma oligopoly

the incentive to cheat for each firm makes it most likely that both firms will cut prices leading to price competition and a failure of the collusive agreement

payoff matrix definition

shows all the possible combinations of outcomes of different decisions made by the players in game theory

price war definition

competitive price cutting by firms (usually oligopoly) as each one tries to capture market shares from rival firms → lower profits for both firms

why are cartels difficult to maintain

• incentive to cheat

• cost differences between firms - AC differences make it hard to agree on a price

• number of firms - a lot of firms → difficult to come to an agreement

• possibility of price war -

non-collusive oligopolies and competition

• avoid price competition due to wanting to avoid price wars

• compete with non-price factors such as advertising, branding, warranty, packaging,etc. → create high barriers to entry through strong product differentiation

why is non-price competition important to oligopolies

• oligopolies have large profits which they can use to fund things such as branding and R&D

• development of new products → increase in market power → demand for firms’ product becomes less price elastic → increased sales + profits

• product differentiation → increase in profit due to it taking time for rivals to develop new competitive products

oligopolies + stable prices

• fear of loosing sales revenue/market share if price rises

• fear of price war when cutting prices

• “price a” may remain profit maximising price even if marginal costs increase

concentration ratio

• a measure of how much an industry’s production is concentrated amongst the industry’s largest firms

• measures percentage of output produced by the largest firms in an industry

• used to indicate degree of competition/market power

• higher ratio = more market power = less competition

market concentration

• the degree to which a market is dominated by a small number of large firms controlling the market

• measured using concentration ratio

concentration ratio disadvantages

• do not reflect competition from abroad

• do not reflect competition from other industries that act as substitutes

• do not distinguish between sizes of largest firms

• no indication of importance in global market

Advantages of oligopolies

• economies of scale → lowers costs of production (only benefit consumers if producers lower price as a result)

• promotes product + process innovation → dynamic efficiency → falling long run costs of production

• advertising + other marketing activities create jobs + income

• advertising provides information to consumers + reduces search costs

Disadvantages of oligopolies

• allocative inefficiency + welfare loss

• higher prices + lower quantities compared to perfect competition

• loss in consumer surplus due to high price P>MC

• less efficient/higher production costs due to lack of competition

• too much product choice → consumers are overwhelmed + creates disutility

example of collusive oligopolies

• OPEC - Organisation of the Petroleum Exporting Countries

• price fixing + output restriction

• limited firms : OPEC nations

examples of non-collusive oligopoly markets

• smartphone market (apple vs samsung)

• softdrinks market

assumptions of monopolistic competition

• large number of firms + consumers

• low barriers to entry

• perfect knowledge

• differentiated products (real/imagined) → price setting power

• downward sloping demand curve that is relatively price elastic due to competition (more elastic than monopoly but less elastic than perfect competition)

how can product differentiation be achieved in monopolistic competition

• physical differences

• quality differences

• location

• services

• product image

price vs non-price competition

• price - firm lowers prices to attract customers from rival firms thus increasing sales at the expense of other firms. (occurs in monopolistic or perfect competition)

• non-price - firms use methods other than price reductions to attract customers from rival firms (occurs in oligopoly or monopolistic competition)

SR vs LR of firms in monopolistic competition

• abnormal profits attract new entries reducing AR/MR as demand is spread over more firms

• short run losses → firms leave the industry → AR/MR increases due to demand being spread over less firms

• both continue until AR=AC/AR is tangent to AC and all firms make normal profit.

market outcomes present in monopolistic competition

• profit maximisation - yes

• normal profit - yes

• productive efficiency - no

• allocative efficiency - no, P>MC/MB>MC → underallocation of resources

advantages of monopolistic competition

• differentiated products → choice + gain in customer utility + satisfies needs + wants better

• advertising provides information → reduces search costs

• marketing activities + advertising create jobs + income

• cheaper market entry → increases competition + the need to innovate in order for firms to stay competitive (dynamic efficiency)

disadvantages of monopolistic competition

• productively inefficient

• allocatively inefficient → DWL even in LR although less than in oligopoly

• higher prices compared to perfect competition due to promotional activities which raise average costs

• inability to generate economies of scale due to small size compared to oligopoly + monopoly

• firms often lack sufficient funds for R&D → product development is difficult