H2 Market Structure Lecture Notes Part II Structure + Behaviour PDF

Firms and Decisions (H2 Economics/ 9570) Catholic Junior College H2 Economics (9570) THEME 2: MARKETS 2.2 Firms & Decisions (Part 2) 2.2.3(a) Firms’ Deci...

Firms and Decisions (H2 Economics/ 9570) Catholic Junior College H2 Economics (9570) THEME 2: MARKETS 2.2 Firms & Decisions (Part 2) 2.2.3(a) Firms’ Decisions and Strategies CONTENT INTRODUCTION 1. PERFECT COMPETITION 1.1 Characteristics of Perfect Competition 1.2 Demand Curve of a Perfectly Competitive Firm 1.3 Revenue Curves of a Perfectly Competitive Firm 1.4 Short Run Price and Output Decisions of Perfectly Competitive Firms 1.4.1 Short Run Supernormal Profit Equilibrium 1.4.2 Short Run Normal Profit Equilibrium 1.4.3 Short Run Subnormal Profit Equilibrium 1.4.3.1 Shut down condition of a Perfectly Competitive Firm in the Short Run 1.5 Long Run Price and Output Decisions of Perfectly Competitive Firms 1.5.1 Supernormal Profits – entry of firms 1.5.2 Subnormal Profits – exit of firms 1.6 Long Run Price and Output Decisions of Perfectly Competitive Industry 1.7 Competitive strategies of Perfectly Competitive Firms 2. MONOPOLY 2.1 Characteristics of Monopoly 2.2 Revenue Curves of a Monopoly 2.3 Short Run Price and Output Decisions of a Monopoly 2.4.1 Short Run Supernormal Profit Equilibrium 2.4.2 Short Run Normal Profit Equilibrium 2.4.3 Short Run Subnormal Profit Equilibrium 2.4.3.1 Shut down condition of a Monopoly in the Short Run 2.4 Long Run Price and Output Decisions of a Monopoly 2.5 Natural Monopoly 3. OLIGOPOLY 3.1 Characteristics of Oligopoly 3.2 Models of Oligopoly 3.2.1 Competitive Oligopoly: The kinked demand curve 3.2.2 Collusive Oligopoly: Cartel 3.2.3 Collusive Oligopoly: Price leadership 3.3 Short Run Price and Output Decisions of an Oligopoly 3.3.1 Short Run Supernormal Profit Equilibrium 3.3.2 Short Run Normal Profit Equilibrium 3.3.3 Short Run Subnormal Profit Equilibrium 3.3.3.1 Shut down condition of an Oligopoly in the Short Run 3.4 Long Run Price and Output Decisions of an Oligopoly © Catholic Junior College Economics Department 2024 1 Firms and Decisions (H2 Economics/ 9570) 4 MONOPOLISTIC COMPETITION 4.1 Characteristics of Monopolistic Competition 4.2 Revenue Curves of a Monopolistic Competitive firm 4.3 Short Run Price and Output Decisions of Monopolistic Competitive firms 4.3.1 Short Run Supernormal Profit Equilibrium 4.3.2 Short Run Normal Profit Equilibrium 4.3.3 Short Run Subnormal Profit Equilibrium 4.3.3.1 Shut down condition of a Monopolistic Competitive firm in the Short Run 4.4 Long Run Price and Output Decisions of Monopolistic Competitive firms 5 STRATEGIES OF FIRMS 5.1 Price Competition 5.1.1 Predatory Pricing 5.1.2 Penetration Pricing 5.1.3 Discount Pricing 5.1.4 Psychological Pricing 5.1.5 Price Discrimination 5.2 Non-price Competition 5.2.1 Product Differentiation through Product Innovation 5.2.2 Marketing Strategies 5.3 Cost Reduction Strategies 5.3.1 Process Innovation 5.4 Growth Strategies and Diversification 5.4.1 Impact on Merger on the profitability of firms 5.4.2 Diversification 6 TECHNOLOGICAL DISRUPTIONS © Catholic Junior College Economics Department 2024 2 Firms and Decisions (H2 Economics/ 9570) CONCEPT MAP Market Structure Monopolistic Competition Perfect Competition Imperfect Competition Oligopoly Monopoly Characteristics Behaviour Implications on Demand curve Price and Revenue Cost Horizontal (Price-taker) vs Shut down strategies strategies output Downward Sloping and Steep (Price Setter with low PED) Profit maximisation Pricing Non-pricing MC=MR strategies strategies Barriers to Number of Nature of Degree of entry firms product knowledge Level of Homogeneou profits High vs Low Large vs One s vs Perfect vs Differentiated Imperfect © Catholic Junior College Economics Department 2024 3 Firms and Decisions (H2 Economics/ 9570) Introduction: Types of Market Structure Based on the above characteristics, markets can be broadly classified into perfectly and imperfectly competitive markets: - Perfectly competitive markets refer to markets where free competition exists (Perfect Competition). - Imperfectly competitive markets refer to markets where there are restrictions to free competition (Monopolistic Competition, Oligopoly & Monopoly). The following table shows four market structures. Since they have different characteristics, their degree of competition and market power of firms that exist within the market greatly differs. Table 1: Features of Different Market Structures Market Structures Characteristics Decreasing degree of competition Perfect Imperfect Competition Competition (Presence of Market Power) (Absence of Monopolistic Oligopoly Monopoly market power) Competition Barriers to Low barriers to High barriers to Very high barriers No barriers to entry Entry entry entry to entry No. of Firms A few large firms Very large number Large number of One dominant (relative to dominate the of small firms small firms firm Market Size) market Nature of Homogeneous or Homogeneous Differentiated Unique Product Differentiated Degree of Perfect knowledge Imperfect knowledge Knowledge The above characteristics of a market structure affects the market power of a firm, that is, the extent to which a firm can set its own price. ▪ A perfectly competitive firm has no market power. Given that there are no barriers to entry with a very large number for firms in the industry, each firm constitutes an insignificant fraction of the market. Its homogeneous good also means that there are perfect substitutes offered by other firms. As such, a perfectly competitive firm has zero price-settling ability and becomes a price-taker. ▪ For markets with high barriers to entry which deter new firms entering, firms will enjoy a greater market power as there are fewer substitutes for consumers to turn to. ▪ Within an industry, if a firm can make its products more differentiated from others, its products become less substitutable. This will enhance the price-setting ability of a firm. For instance, a gourmet bakery (eg. Duke bakery) can set a relatively higher price for its bread due to product differentiation. It is important to look at the characteristics of the different types of market structure because they determine the level of competition, which in turn, affects a firm’s behaviour or conduct. This behaviour in turn affects the firm’s performance. In a nutshell, the entire topic of market structure is about how the four basic characteristics help us to predict firms’ behaviour and their performance (i.e. impact on consumers, producers and society): Characteristics (Structure) → Behaviour → Performance Note: Students must always start by explaining how the characteristics of firms affect their behaviour before explaining performance. © Catholic Junior College Economics Department 2024 4 Firms and Decisions (H2 Economics/ 9570) 1. Perfect Competition The model of perfect competition is built on strict assumptions that do not hold in the real world. As a result, we will only be able to find real life examples that approximate this model such as markets for agricultural produce. Nevertheless, perfect competition acts as a benchmark that can be used to compare with other market structures. 1.1 Characteristics of Perfect Competition 1.1.1 No Barriers to Entry – Freedom of Entry Definition: Barriers to entry refers to conditions that impede other potential firms from entering the industry, thereby limiting the competition for existing firms. In the perfectly competitive market, there are no barriers to entry for new firms, i.e. firms can easily enter and leave the markets. Since firms are driven by profits, potential entrants will be enticed to enter the industry if existing firms are making supernormal profits. As new firms enter the market, profits earned by each firm will drop until they are making normal profit. The ease of entry ensures a large number of firms operate in the industry at any point and that perfectly competitive firms can make only normal profits in the long run. [Note: The different types of barriers to entry will be covered in Section 2.2. under ‘Monopoly’.] 1.1.2 Large Number of Small Firms Due to the absence of barriers to entry, a very large number of small firms or sellers exist in the industry, and each firm produces an insignificant share of the total output in the market. Therefore, no single firm has the market power to influence the market price. As a result, each firm must accept the prevailing price in the market as determined by the interaction of the market demand and supply. Such firms are said to be price takers, and they have a perfectly price elastic demand curve [as seen in Fig. 1(ii)]. Perfectly competitive firms have no market power. Thus, it is impossible for them to influence the market price by changing its supply because its individual supply is insignificant in relation to the market supply. A perfectly competitive firm has: - No incentive to increase the price since there are numerous other firms selling perfect substitutes that consumers can buy from. This is also linked to the next characteristics: perfectly competitive firms sell homogenous products that are perfect substitutes; and - No incentive to lower its price because theoretically, a perfectly competitive firm can already sell as much output as it wants at the prevailing market price [refer to the horizontal demand curve of the perfectly competitive firm in Fig. 1(ii)]. Therefore, perfectly competitive firms [Fig. 1 (ii)] are price-takers that always charge the price determined by the market [Fig. 1(i)]. 1.1.3 Homogeneous Product All perfectly competitive firms produce homogeneous products, i.e. the product sold by one firm is identical to that by another firm. Thus, their products are perfect substitutes As a result, demand for each firm’s goods is also perfectly price elastic (horizontal demand curve). © Catholic Junior College Economics Department 2024 5 Firms and Decisions (H2 Economics/ 9570) Important: Explaining why Perfectly Competitive firms are price takers Perfectly competitive firms are price-takers with no market power because: - There are no barriers to entry and hence there are many small firms with insignificant market share; and - They sell homogenous products that are perfect substitutes. 1.1.4 Perfect Knowledge Both producers and consumers have perfect knowledge of the market. Producers have all the information about the costs of factors of production, technology, and production techniques available in the market. This implies that no firm has exclusive access to information that would allow it to produce at a lower cost compared to others. Consumers have all the information about the prevailing market prices, types, and quality of products available in the market and therefore would not be willing to pay a price higher than the market price for the product. Given the assumptions of the perfectly competitive market, it is not surprising that few markets in the real world come close in terms of their characteristics. One close example is the agricultural market, where there are typically tens of hundreds of farms supplying the homogenous agricultural produce, such as carrots in the market. Consumers are not likely able to differentiate the products produced by each firm, and there are many producers with insignificant market share. 1.2 Demand Curve of a Perfectly Competitive Firm Due to the large number of firms selling homogenous goods in the perfectly competitive market, the demand faced by firms are perfectly price elastic in theory, i.e. horizontal. This is a key feature of price-taking firms. Figure 1(i) below shows the market equilibrium in a perfectly competitive market. The equilibrium market price of $10 per unit is determined by the intersection of the market demand and supply curves in the perfectly competitive industry. Figure 1(ii) shows the equilibrium output and price for a perfectly competitive firm. As no single firm has the market power to influence the market price, each firm is a price-taker and must accept the prevailing equilibrium market price of $10 per unit. Whether it sells Q1 or Q2, it is faced with the same equilibrium price of P=$10 per unit. Price Cost/ Price/ Revenue MC S P=$10 D O Q O Q1 Q2 Quantity Fig. 1(i) Market Equilibrium of a Perfectly Fig. 1(ii) Demand Curve of a Competitive Industry Perfectly Competitive Firm Figure 1: The Perfectly Competitive Industry and Firm © Catholic Junior College Economics Department 2024 6 Firms and Decisions (H2 Economics/ 9570) If the firm were to charge a price higher than P=$10, consumers can simply buy from another firm, since the products sold by all firms are homogeneous or identical, and therefore are perfect substitutes for one another. As a result, any increase in price above P will cause the quantity demanded for that firm’s product to fall to zero. On the other hand, the firm can sell any level of output at the prevailing market price. Hence, there is no incentive for the firm to reduce price below P. As a result of firms being price takers, the demand faced by each individual firm is perfectly price elastic. Diagrammatically, the firms’ demand curves will be a horizontal line. Note: The shape of the firms’ demand curve is indicative of whether it is a price-taking or price- setting firm: - Price-taking firms, i.e. perfectly competitive firms, have horizontal demand curves; and - Price-setting firms, i.e. all other firms in other market structures, have downward-sloping demand curves. Students should be mindful that while individual perfectly competitive firms have horizontal demand curves, the market demand curve is still downward-sloping due to the Law of Demand. 1.3 Revenue Curves of a Perfectly Competitive Firm Total Revenue Perfectly competitive firms sell every unit of output at the same price. Total revenue can be obtained by multiplying price charged per unit with the output of the firm. TR = P × Q P: Price per unit Q: Output of firm Average Revenue Recall that average revenue is the amount of revenue per unit sold. AR = TR / Q AR is equivalent to the price per unit of the product, i.e. AR = (P x Q)/Q = P. Therefore, the AR curve of firms is simply its demand curve. Important: For all firms, DD = AR = P, i.e. the same curve is used to represent DD, AR and P of a firm in all market structures. Marginal Revenue Recall that marginal revenue (MR) is the change in total revenue (TR) as a result of an additional unit of output sold. MR = TR / Q Perfectly competitive firms sell every unit of output at the same price [refer to the horizontal demand curve of the PC firm in Fig 1(ii)]. Hence, the revenue derived from an additional © Catholic Junior College Economics Department 2024 7 Firms and Decisions (H2 Economics/ 9570) unit sold is the same as the revenue derived from each of the previous units sold. Therefore, MR = P. Diagrammatically, the MR curve of a perfectly competitive firm is simply its demand curve. Self-Assessment 1 Given that the market price of Good X in a perfectly competitive market is $10, fill in the table below to show the Price (P), Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR) of a firm in below. Qty sold P TR AR MR 1 $10 2 3 4 Hence, for the perfectly competitive firm, P = ____ = ____ Important: For perfectly competitive firms: - DD = AR = P = MR [Refer to the horizontal curve of the PC firm in Fig 1(ii)]. - This is a unique feature of price-taking firms. For price-setting firms, i.e. firms in all other market structures: - DD=AR=P > MR. (to be explained later in Section 2.3) 1.4 Profit Maximising Equilibrium (Under Perfect Competition) A firm is said to be in equilibrium if there is no incentive for it to move away from its price and/or output level, ceteris paribus. To analyse firms’ price and output decisions, we always need to make an assumption of the firms’ objective. Traditionally, we assume that firms’ objective is to maximise profit, the equilibrium occurs when the firm is producing at an output level where total profit is maximised (or total loss is minimised). A firm’s profit is maximised when it produces at an output where: MC = MR, when MC is rising This is the Marginalist Principle / Marginalist Approach. - Marginal Revenue (MR) is the addition to total revenue when one more unit of output is produced and sold. - Marginal Cost (MC) is the addition to total cost when one more unit of output is produced. The output level where MC = MR is known as the profit-maximising output level. Figure 1 illustrates the MC and MR curves of a perfectly competitive firm. The MR is simply the price that the firm is paid for every unit of product sold. As a perfectly competitive firm charges a uniform price regardless of output level, its MR curve is a horizontal line. Note: An imperfectly competitive firm is faced with a downward sloping MR curve – the difference in the MR curves between a perfectly and imperfectly competitive firm will be explained later in the topic. © Catholic Junior College Economics Department 2024 8 Firms and Decisions (H2 Economics/ 9570) Two conditions are necessary for profit-maximisation: i) MC=MR In order to maximise its profits, a firm should produce at an output level where the addition to total revenue from the sale of the last unit of output equals to the addition to total cost from producing that last unit. This occurs at 0Q2 and 0Qe in Figure 1. Price/Revenue/Cost ($) MC MR=D=AR=P 0 Q1 Q2 Q3 Qe Q4 Output Figure 1: MR and MC of a perfectly competitive firm ii) MC must be rising (MC cuts MR from below) With reference to Figure 1, at 0Q2: MR = MC, but MC is falling. In this case, the firm should still further increase its output in order to maximise profits. This is because additional output produced will add more to total revenue than it does to total costs, giving rise to profit for every additional unit produced. At output 0Q3: MR > MC, i.e. the addition to total revenue from the last unit of output exceeds the additional cost incurred to produce it. Thus, the firm can increase total profits if it expands output beyond 0Q3. At output 0Q4: MC > MR, i.e. means that it costs more to produce the last unit than the revenue the firm is getting for it. Thus, producing this last unit of output results in a fall in total profits. Hence, the firm should reduce its output below 0Q4. At output 0Qe: MC = MR and MC is rising. This is the firm’s equilibrium profit maximising output where there is no incentive for the firm to expand or reduce output. This is true for all firms, whether perfectly competitive or imperfectly competitive. Based on the assumption that firms seek to maximise profits, the equilibrium output of firms will change when there are changes in cost of production (i.e. MC) or revenue (AR) from sales, i.e. costs and demand conditions jointly determine the output level of a profit maximising firm. © Catholic Junior College Economics Department 2024 9 Firms and Decisions (H2 Economics/ 9570) 1.4.1 Short Run Supernormal Profit Equilibrium of a Perfectly Competitive Firm Since firms can easily enter and exit a perfectly competitive market, the number of firms vary. As a result, a PC firm can be making supernormal profits, normal profits or subnormal profits in the short run. Supernormal profit is earned when a firm’s Average Revenue > Average Cost (or TR > TC). In the short run, it is possible that the PC firm makes supernormal profit. As shown in Figure 3, the PC firm is producing at the profit maximising output (where MC=MR, and MC is rising) of Qe. At Qe, the Average Revenue is AR = P, whereas the Average Cost is AC= A. Since P > A, there is a positive economic profit or supernormal profit per unit of (P – A), or a total profit of (P – A) x Qe, represented by the shaded area APEB. Cost/Price/Revenue At Qe, AR > AC SRMC SRAC Total Revenue (TR) = P x Qe = Area 0PEQe Total Cost (TC) = AC x Qe P E = Area 0ABQe D=AR=MR=P A Supernormal Profit = TR-TC B = Area APEB (shaded) 0 Qe Output (shaded) Figure 3: Short Run Supernormal Profit Equilibrium of a PC Firm Note: The cost curves are labelled with a prefix “SR” to allude to the time period. SRMC simply refers to marginal cost (MC) curve in the short run. Similarly, LRMC refers to MC curve in the long run. 1.4.2 Short Run Normal Profit Equilibrium of a Perfectly Competitive Firm Normal profit is earned when Average Revenue = Average Cost (or TR = TC). In the short run, it is also possible that the PC firm makes only normal profit. As illustrated in Figure 4, the firm produces at the profit maximising output (where MC=MR and MC is rising) of Qe. At Qe, the Average Revenue is AR = P, the Average Cost is AC= P. Since AR = AC, there is zero economic profit or normal profit to be earned at Q e. © Catholic Junior College Economics Department 2024 10 Firms and Decisions (H2 Economics/ 9570) Cost/Price/Revenue At Qe, AR = AC SRMC SRAC Total Revenue (TR) = P x Qe = Area 0PEQe Total Cost (TC) = AC x Qe P D=AR=MR=P = Area 0PEQe E Normal Profit = TR-TC =0 0 Qe Output Figure 4: Short Run Normal Profit Equilibrium of a PC Firm Graphically, the Average Cost curve is tangential to the Average Revenue curve at point E. Note: Normal profit does not mean zero accounting profit, but zero economic profit. 1.4.3 Short Run Subnormal Profit Equilibrium of a Perfectly Competitive Firm Subnormal profit is earned when Average Revenue < Average Cost (or TR < TC). In the short run, it is also possible that the PC firm makes subnormal profit. As illustrated in Figure 5, the firm produces at the profit maximising output (where MC=MR and MC is rising) of Qe. At Qe, the Average Revenue is AR = P, the Average Cost is AC= A. Since P < A, there is negative economic profit or subnormal profit per unit of (A – P), or a total profit of (A – P) x Qe, represented by the shaded area PABE. Cost/Price/Revenue At Qe, AR < AC SRMC SRAC Total Revenue (TR) = P x Qe = Area 0PEQe B A Total Cost (TC) = AC x Qe P D=AR=MR=P = Area 0ABQe E Subnormal Profit = TC-TR or TRAVC (or TR>TVC), the total revenue covers its total variable costs and part of its total fixed costs. ▪ If it continues, losses equal to part of fixed costs only. ▪ If it shuts down, losses equal to all fixed costs. - Hence, the firm minimises losses by continuing production to gradually pay off the fixed costs. In other words, the firm incurs a smaller loss by being in operation instead of shutting down. Therefore, firms should continue production to minimise losses despite making subnormal profit. Case 2: If the average revenue (i.e. price of the product) does not cover at least the average variable costs of production in the short run, i.e. AR < AVC, the firm should stop production. That is, the firm shuts down to minimise losses. - Explanation: Since AR < AVC (or TR TC in the short run. © Catholic Junior College Economics Department 2024 21 Firms and Decisions (H2 Economics/ 9570) Cost/Price/Revenue At Qe, , AR > AC SRMC Total Revenue (TR) = P x Qe = Area ____ SRAC A Total Cost (TC) = AC x Qe P = Area ____ Supernormal Profit = TR > TC P1 B = Area ____ E MR AR=DD=P 0 Qe Output Figure 12 : Monopolist Earning Supernormal Profit As shown in Figure 12, the firm maximises its profits by producing at output Q e, where MC=MR and MC is rising. The corresponding price is given by the demand curve to be P, which is also the AR. The average cost at Qe is given by the SRAC curve to be P1. Since P > P1, there is supernormal profit per unit of (P – P1), or a total profit of (P – P1) x Qe, represented by the shaded area PABP1. 2.4.2 Short Run Normal Profit Equilibrium of Monopoly It is also possible for the monopolist to earn normal profit where AR = AC or TR = TC in the short run. As shown in Figure 13, the firm maximises its profits by producing at output Qe and charges a price of P, which is also the average revenue. The average cost at Qe is given by the SRAC curve to be P. © Catholic Junior College Economics Department 2024 22 Firms and Decisions (H2 Economics/ 9570) Since AR = AC, normal profit is made by the firm at Qe. Cost/Price/Revenue At Qe, , AR = AC SRMC Total Revenue (TR) = P x Qe SRAC = Area ____ A Total Cost (TC) = AC x Qe P = Area ____ Normal Profit = TR - TC = Area ____ E MR AR=DD=P 0 Qe Output Figure 13: Monopolist Earning Normal Profit 2.4.3 Short Run Subnormal Profit Equilibrium of Monopoly A monopolist will not always make profit, even though it is the price-setter. The price that the monopolist can charge depends on the market demand for the product. In any situation, when the cost of producing the output is too high such that the price cannot cover the average cost, losses are incurred. As shown in Figure 14, the firm maximises its profits by producing at output Qe and charges a price of P. The average cost at Qe is given by the SRAC curve to be C. For every unit that is produced, the monopolist incurs a loss of (C – P) and a total subnormal profit represented by the shaded area CBAP. © Catholic Junior College Economics Department 2024 23 Firms and Decisions (H2 Economics/ 9570) Cost/Price/Revenue At Qe, , AR < AC SRMC SRAC Total Revenue (TR) = P x Qe = Area ____ C B Total Cost (TC) = AC x Qe P = Area ____ A Supernormal Profit = TR < TC = Area ____ E MR AR=DD=P 0 Qe Output Figure 14: Monopolist earning Subnormal Profit Diagram Drawing Edition: Profit Diagrams of PC and Monopoly 2.4.3.1 Shut Down decision of a Monopoly in the Short Run Watch how these diagrams are drawn, step-by-step, and learn when to use this diagram in your exams! The decision to shut down is similar across firms in all market structures. Similar to the perfectly competitive firm, the monopolist will only continue production if its total revenue is able to cover at least all the total variable costs of production, also known as the shutdown condition. See Section 1.4.3.1 for more details on the shutdown condition. 2.4.3.1 Shut Down decision of a Monopoly in the Short Run The decision to shut down is similar across firms in all market structures. Similar to the perfectly competitive firm, the monopolist will only continue production if its total revenue is able to cover at least all the total variable costs of production, also known as the shutdown condition. See Section 1.4.3.1 for more details on the shutdown condition. 2.5 Long Run Price and Output Decisions of a Monopoly nlike perfect competition, the presence of strong barriers to entry in a monopoly prevents new firms from entering the market. The monopolist is therefore in the position where it is usually able to earn positive economic profit i.e. supernormal profits, even in the long run. Hence, if supernormal profits are earned in the short run by the monopolist, these profits can be sustained in the long run, assuming demand and cost conditions remain unchanged. © Catholic Junior College Economics Department 2024 24 Firms and Decisions (H2 Economics/ 9570) Self-Assessment 2: Illustrate the LR equilibrium of a monopoly. Figure 15: LR equilibrium of the monopoly The monopolist maximises profit in the long run by producing at output level, Qe where the LRMC = MR. Pe is the corresponding equilibrium price. At Qe, since AR (Pt ___) > AC (Pt ____ ) and TR (Area________) > TC ( ________) the monopolist makes supernormal profit in the long run as shown by the shaded area ____________. In the long run, a monopolist will remain in business only if it can at least make normal profits. If the monopolist is earning subnormal profit in the short run and finds that it is still unable to eliminate its losses even after changing the scale/strategies of the firm in the long run, it will exit from the industry. 2.6 Natural Monopoly Definition: A natural monopoly is defined as an industry where long run average costs fall throughout the range of market demand. Earlier we examined how extremely high fixed cost will give rise to natural monopolies as it is more cost effective for one single firm to serve the entire market. The figure below illustrates why this is so. The minimum efficient scale (MES) of operation of such industries is large relative to market demand. The diagram illustrating a natural monopoly, where the economies of scale are so large that the LRAC and MC curves are falling throughout the entire range of output, is shown in Figure 16. © Catholic Junior College Economics Department 2024 25 Firms and Decisions (H2 Economics/ 9570) Cost/Price/Revenue Pe B A D LRAC LRMC MR AR=DD=P 0 Qe Output Figure 16: Natural Monopoly The natural monopoly equilibrium output is at Qe where the monopolist’ profit is maximised. Correspondingly, the price to be charged at Qe, as given by the demand curve is Pe. A supernormal profit of area PeBDA is made. Natural monopolies usually occur in public utilities industries, such as water and electricity distribution, where fixed costs are extremely high due to the building of extensive distribution networks. Resources could be wasted on competition since it requires the duplication networks. Refer to the article: “Natural Monopoly – Is the idea still relevant?” at the end of this set of lecture notes for a discussion on the relevance of natural monopolies in today’s context. In Singapore, the Public Utilities Board (PUB) is the sole supplier of water service. Since 2001, PUB was reconstituted as Singapore’s national water authority to oversee the entire water loop. With regards to electricity, natural monopoly remains relevant ONLY to a particular stage of the production process. Electricity reaches consumers through three stages: power generation (the production of electricity in power plants), power transmission (the flow of electricity through cables) and power distribution (the link to homes and businesses). Since the retail electricity market has been liberalised to promote competition in 2000, there are more electricity retailers for households and firms to choose from. However, given that there is only one power grid in Singapore, the transmission of electricity by Singapore Power remains as a natural monopoly. This is because the network of electrical cables entails substantial technical economies of scale. As a result, it is economically not viable to have more than one grid to compete. © Catholic Junior College Economics Department 2024 26 Firms and Decisions (H2 Economics/ 9570) 3 Oligopoly An oligopoly refers to a market dominated by a few large firms, with high barriers to entry and highly imperfect information. Products may be differentiated or homogenous. The small number of firms dominating the industry possess significant market share and market power, causing oligopolistic firms to have high rival consciousness and be mutually interdependent. Note: There can be many firms in the oligopolistic market but a few large firms dominate the market. A duopoly is a special case of an oligopoly where there are only 2 firms in the market. For example there are currently only two public bus operators in Singapore: SMRT and SBS Transit. 3.1 Characteristics of Oligopoly 3.1.1 High barriers of entry Unlike firms under perfect competition, there are various barriers to the entry to new firms in the oligopolistic market structure. These are similar to those explained under monopoly. Recall that existence of barriers to entry implies that firms can earn supernormal profits in the long run. 3.1.2 A few large firms dominate the industry An oligopoly market is dominated by a few large firms. Terms like “Big 4”, “Big 6”, “Big 8” etc. are used in the context of an oligopoly market. For e.g. The “Big 4” accounting firms refer to Deloitte, Ernest & Young (EY), PricewaterhouseCoopers (PwC) and Klynveld Peat Marwick Goerdeler (KPMG). Collectively, they take up 80% of the accounting industry in the UK. Definition: The market concentration ratio measures the combined market share of the top 'n' firms in the industry. An oligopoly may have as few as three or four firms or as many as a dozen firms dominating or leading the industry. What is more important is the market concentration ratio, which is an indication of the top largest firms’ combined market share in the industry. 𝑂𝑢𝑡𝑝𝑢𝑡 𝑜𝑓 𝑛 𝑙𝑎𝑟𝑔𝑒𝑠𝑡 𝑓𝑖𝑟𝑚𝑠 𝑛 − 𝑓𝑖𝑟𝑚 𝑐𝑜𝑛𝑐𝑒𝑛𝑡𝑟𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 = 𝑋 100% 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑑𝑢𝑠𝑡𝑟𝑦 𝑜𝑢𝑡𝑝𝑢𝑡 If the top four firms have a combined output of 60%, then the 4-firm concentration ratio is 60%. In general, the higher the market concentration ratio, the greater the degree of rivalry that is likely to exist between these firms. Rivalry means that firms will take the reactions of other firms into their decision making process. So a market where the top four firms supply 80% of market is likely to exhibit more rivalry than a market where the top four firms supply only 60% An oligopoly has a high market concentration ratio. A common rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of total © Catholic Junior College Economics Department 2024 27 Firms and Decisions (H2 Economics/ 9570) market sales or production. Example of oligopolistic markets: Global Logistics Services – FedEx, DHL, UPS have a market concentration ratio of 84% Commercial aircraft manufacturers – Boeing, Airbus have a market concentration ratio of 66%. Note that there is no fixed way to calculate concentration ratios. It is possible to calculate concentration ratio of the top 4 firms or even top 8 firms. 3.1.3 Mutual Interdependence of Firms Because high BTE and the oligopolistic market being is dominated by a few large firms, the action of one or more of these firm tend to have a significant impact on the competitors. Therefore, when making business decisions, an oligopolist has to consider the possible reactions of its rivals. If a firm changes the price or specification of its product, for example, or the amount of its advertising, the sales of its rivals’ will be affected which prompt rivals to take mitigating actions. The rivals may then respond by changing their price, specification or advertising. Such behaviour is known as mutual interdependence or exhibiting high rival- consciousness. The mutual interdependence has implications on oligopolistic firms’ demand curve, which will be explained in Section 3.2.1. Note: The characteristics of ‘mutual interdependence’ and ‘high rival consciousness’ are unique features of oligopolistic firms and must be highlighted when explaining firms in such markets. 3.1.4 Differentiated or homogeneous product The products could be homogeneous or differentiated, depending on the markets: - For example, while the oil market is dominated by a few major oil producing countries such as Saudi Arabia, Russia, Iran and Iraq, crude oil from any of these countries is largely homogeneous. - On the other hand, the car markets are dominated by a few major car-makers such as General Motors, Toyota, Hyundai & Volkswagen, their cars are highly differentiated. Even though oligopolistic firms may sell homogenous products, they are still price-setting firms. This is because there are high barriers to entry in the market that allows existing firms © Catholic Junior College Economics Department 2024 28 Firms and Decisions (H2 Economics/ 9570) to secure high market share. With few substitutes available in the market, demand faced by each oligopolistic firm is less price elastic. Hence, an oligopolistic firm faces a downward sloping demand curve, where DD=AR=P > MR. 3.1.5 Imperfect Knowledge There is imperfect knowledge in an oligopolistic market. Buyers are not fully aware of differences in prices and qualities of the product that may prevail in the market. Potential competitors are also not fully aware of available technology, input prices and profits margins, etc. 3.2 Models of Oligopoly Competition or Collusion? We have established that oligopolistic firms exhibit mutual interdependence and high rival consciousness in their behaviour because the action of the dominant firms tend to have a significant impact on its competitors. Therefore, unique to oligopoly, firms in this market have to make a decision about whether to: Collude, i.e. cooperate with one another to achieve a win-win situation. If firms join together, they act as if they were a monopoly and hence can maximise joint profits; or Compete with their rivals to gain a bigger share of market profits for themselves, i.e. non- collusion. Important: Regardless of whether oligopolistic firms choose to collude or compete, the market will be characterized by price rigidity – a scenario where firms charge similar prices and tend not to change prices from time to time, oligopolistic firms tend to refrain from engaging in price competition. High BTE & Mutual interdependence & high Few large rival consciousness Compete or Collude firms dominate - action of a firm depends on other - creates price rigidity the market firms' reactions Hence, the following sections examine different models of oligopoly based on collusive or competitive behaviours: first the competitive oligopoly (kinked-demand curve model) and then the collusive oligopoly (cartel and price leadership model). 3.2.1 Competitive Oligopoly – The kinked demand curve The name follows from the feature of demand curve of firms in a competitive oligopoly model. It assumes that each firm in an oligopolistic market believes that rivals will match its price reduction but will not follow suit with its price increase. To illustrate, let us take the telecommunication industry in Singapore as an example. The industry is dominated by a few large firms, including Singtel, Starhub and M1. Assume the price of mobile plans in the market is P0. How would competitors react if Singtel raises its price? What happens if Singtel reduces its price? © Catholic Junior College Economics Department 2024 29 Firms and Decisions (H2 Economics/ 9570) The flowchart below shows the possible reaction of Singtel’s competitors to its action of raising price above P0 and reducing price below P0. If Singtel raises its price above P0 If SIngtel lowers its price below P0 Competitors do not follow so as to gain market share Competitors follow and lower prices to avoid loss of market share Customers switch to competitors' products Firm's market share mostly unchanged Demand is more price elastic at Demand is less price elastic at prices prices above P0 below P0 (represented by AE portion of demand (represented by EF portion of demand curve) curve) An increase in price by Singtel will A fall in price by Singtel will hence lead hence lead to a more than proportionate to a less than proportionate rise in fall in quantity demanded quantity demanded Revenue and profit decline Revenue and profit decline This mixed response of competitors will result in a demand curve for the firm that is ‘kinked’ at price = P0 as shown in Figure 17. Cost/Price/Revenue AE portion of the demand curve is more price MC1 elastic than the EF portion. A MR curve has a discontinuous section E MC0 P0 represented by the vertical gap ‘ab’ because a At prices above P0, MR curve corresponds to the more price elastic demand curve, b At prices below P0, the MR curve corresponds to the less price elastic demand curve. DD=AR=P If the MC curve lies anywhere between MC0 and MR F MC1 (between gap ab), the profit maximizing price Q0 Output and output will still be P0 and Q0. 0 Figure 17: The Kinked Demand Curve Model The kinked demand curve model explains the decision making behind the behaviour observed among competitive oligopolies. The firm tends not to change prices once it has been set, i.e. there is price rigidity. The kinked demand curve model helps to explain why charging the same price is in line with firms’ profit – maximizing interest in an oligopoly market structure, where there is mutual interdependence and high rival consciousness. It also explains how oligopoly prices are stable even without collusion among firms. Only if the oligopolist’s costs change significantly such that MC shifts out of the vertical gap ‘ab’ will the firm be forced to alter its output or price. As a result, oligopolistic firms do not compete based on prices but prefer to engage in non- price competition. © Catholic Junior College Economics Department 2024 30 Firms and Decisions (H2 Economics/ 9570) Should firms engage in price competition, there will be successive rounds of undercutting that will lead to a price war which is detrimental to all. We will explore more about price and non-price competition in Section 3.5. Diagram Drawing Edition: The Kinked Demand Curve Watch how this diagram is drawn, step-by-step, and learn when to use this diagram in your exams! Criticism of the kinked demand curve model The kinked demand curve is often seen as an incomplete model, with the following main criticisms: 1) Price stability may be due to other factors such as unwillingness to modify price lists frequently to avoid upsetting customers. 2) Though the kinked demand model can explain price stability, it cannot explain how the prevailing price, P0 or quantity Q0 was established initially. This is a serious limitation, as it does not help us understand how firms would set prices if demand were to change. 3) Real life oligopoly behaviour may not fully follow the kinked demand theory. There are situations when competitive oligopolistic firms have engaged in price competition (See Section 3.5). Despite its limitations, it is still a widely used model to explain mutual interdependence and the resulting price rigidity. 3.2.2 Collusive Oligopoly – Cartel As competition becomes intense, the incentive for oligopolies to collude becomes strong. Definition: Collusion is the agreement between firms to limit competition, usually by fixing prices, output, market share and even advertising. Firms collude to avoid competition. This helps to reduce uncertainty faced in the form of competitive price cutting or retaliatory advertising, which could potentially cause decline in total industry profits. They may enter formal agreement that lay out the market price they should charge, output of each firm etc. Firms in formal collusive agreement form a cartel. Essentially, a cartel acts like a monopoly as they aim to maximise collective profit. A cartel is an example of open collusion. One of the well-known cartels is the Organisation of Petroleum Exporting Countries (OPEC). Because open collusion is an anti-competitive business strategy, it is prohibited in most countries. Suppose the firms in a market establish a cartel, the cartel acts as if it were a monopoly operating many plants. Figure 18 illustrates the equilibrium output, price and profit of a cartel seeking to maximise profit. © Catholic Junior College Economics Department 2024 31 Firms and Decisions (H2 Economics/ 9570) Cost/Price/Revenue The cartel’s demand curve is the AR curve. The marginal cost curve is the horizontal sum of the individual marginal cost curves for all firms in the cartel. LRMC Profit is maximised at output Q0 where MC = MR, LRAC and the cartel’s price is P0. At Q0, the cartel P0 A makes supernormal profit represented by area P0ABF. F B The members will then decide how to allocate the total output of Q0 among them. Usually the level E of each member’s quotas is allocated according MR AR=DD=P to their current market share. 0 Qe Output Figure 18: P & Q decision of a cartel Note: In a cartel, all firms charge the same price (unless individual firms ‘cheat) but they may not be producing the same level of output. For example, Saudi Arabia, the de facto leader of OPEC, produces almost a quarter of the cartel output whereas Algeria produces only 1%. Main revenue and cost advantages to a firm when joining a cartel Relative certainty about the demand curve. No fear of price-cutting as there is no competition. If cartel purchases raw materials as a collective whole, a firm in the cartel can also enjoy commercial economies of scale such as bulk purchase discounts. Main revenue and cost disadvantages to a firm when joining a cartel Quota restriction may constrain firms from enjoying cost savings that could have been reaped through producing more, forgoing more profits. Strong incentive to cheat among cartel members greatly reduces success of a cartel o To successfully raise prices in a cartel, it will require overall output to be restricted. Cartel members must therefore adhere to their allocated quotas and not cheat in order to keep market output low. Decision-Making Framework: How will other members in a cartel react if a member cheats? A member of a cartel might be incentivised to cheat by producing more than its allocated quota. It will benefit the defective firm as its revenue and therefore profits earned increases. A member who decides to cheat may trigger fellow members to follow suit, causing the unintended consequence of a fall in market price (since there is an increase in market supply) and eventual collapse of the cartel. © Catholic Junior College Economics Department 2024 32 Firms and Decisions (H2 Economics/ 9570) In reality, it is hard to ensure success of a cartel. In 2001, the coffee bean cartel, the Association of Coffee Producing Countries, whose members’ produce 70% of the global supply, was disbanded. The failure of member countries to comply with the cartel's production levels was an important reason for its collapse. 3.2.3 Collusive Oligopoly – Price Leadership As shown so far, collusion drives up prices and producers’ profits at the expense of consumers. To protect consumers’ interest, many countries have anti-monopoly laws in place that render open collusion illegal. The Competition Commission of Singapore (CCS) seeks to promote efficient functioning of markets in Singapore by curbing anti-competitive activities. In USA and UK, anti-trust legislation forbids open collusive agreement among firms to fix prices or share markets (e.g. the Sherman Anti-Trust Act of 1890). Hence, firms may choose to collude tacitly1 by watching each other’s prices and keeping theirs similar. Doing so allows firms to avoid competition and yet stay within the law. Firms may also tacitly ‘agree’ to avoid price wars or aggressive advertising campaigns. One form of tacit collusion is where firms keep to the price that is set by an established leader. The price leader may be the largest firm, the firm with the lowest cost or the barometric firm (the first to realise that industry demand or costs have changed). The price leader sets the price or changes the price while the rest of the firms in the industry follow. The price leader would typically be producing at the profit-maximising output based on its MC and MR, i.e. acting like a monopoly itself. The other price-following firms would then adjust their output to match the price leader’s price. Formal agreements are not involved. If other firms recognise the barometric firm’s ability to detect changing market conditions quickly, they may follow any price change it initiates. This leads to stable prices or an orderly change in price instead of competitive price cutting. Note: In price leadership model, all firms charge the same price (based on the price leader’s profit- maximising price) but they may not be producing the same level of output. The price leader may not choose the price that maximises profits for the industry because it focuses on its own cost and revenue conditions. However, overall industry profits are likely to be higher than if firms chose to compete. 3.1 Short Run Price and Output Decisions of an Oligopoly Recall that a firm is said to be in equilibrium when it is producing at an output level where profits are maximised such that it has no incentive to deviate from this output level unless there is a change in revenue/cost conditions. As with firms in other market structures, the oligopolist will seek to maximise profit where MC = MR, and MC is rising. 1 Definition of ‘tacit’:” understood or implied without being stated. © Catholic Junior College Economics Department 2024 33 Firms and Decisions (H2 Economics/ 9570) 3.3.1 Short Run Supernormal Profit Equilibrium of an Oligopoly When illustrating the equilibrium of an oligopoly, we use the general model of firms in imperfect competition, i.e. the demand curve should be downward sloping straight line. Cost/Price/Revenue The firm maximises its profits by producing at output Q0, at which MC=MR. MC At Q0, , AR > AC AC A Total Revenue (TR) = P x Q0 P = Area____ Total Cost (TC) = AC x Q0 C B = Area ____ Supernormal Profit = TR >TC MR AR=DD = Area _____ 0 Q0 Output Figure 19: Supernormal Profits of Oligopoly 3.3.2 Short Run Normal Profit Equilibrium of an Oligopoly It is also possible for firms in oligopoly to earn normal profit if at Qe, AR = AC or TR = TC. Cost/Price/Revenue The firm maximises its profits by producing at output Q0, at which MC=MR. SRMC At Q0, , AR = AC SRAC Total Revenue (TR) = P x Q0 A = Area____ P Total Cost (TC) = AC x Q0 = Area ____ E Normal Profit = TR - TC =0 MR AR=DD 0 Qe Output Figure 20: Normal Profits of Oligopoly 1 Note: The general model here applies to oligopolists which are price leaders and cartels. It does not apply to individual firms within a cartel, oligopolists which are price followers and under the kinked demand curve theory. 3.3.3 Short Run Subnormal Profit Equilibrium of Oligopoly It is also possible for firms in oligopoly to earn subnormal profit if at Q e, AR < AC or TR < TC. © Catholic Junior College Economics Department 2024 34 Firms and Decisions (H2 Economics/ 9570) Cost/Price/Revenue The firm maximises its profits by producing at output Q0, at which MC=MR. AC At Q0, , AR < AC MC B Total Revenue (TR) = P x Q0 C = Area____ P A Total Cost (TC) = AC x Q0 = Area ____ Normal Profit = TR < TC E = Area ____ MR AR=DD 0 Qe Output Figure 21: Subnormal Profits of Oligopoly 3.3.3.1 Shut Down Condition of Oligopolistic Firms The decision to shut down is similar across firms in all market structures. An oligopolistic firm earning subnormal profits will only continue production if its total revenue is able to cover at least all the total variable costs of production, also known as the shutdown condition. See Section 1.4.3.1 for more details on the shutdown decision. 3.4 Long Run Price and Output Decisions of an Oligopoly Like in the case of a monopoly, the presence of strong barriers to entry impedes the entry of new firms. The oligopolist is therefore, in the position where it is usually able to earn positive economic profit i.e., supernormal profits, even in the long run, provided costs are low enough and demand high enough. Hence, if supernormal profits are earned in the short run by the oligopolist, these profits can be sustained in the long run, assuming demand and cost conditions remain unchanged. Therefore, Figure 19 (which you have drawn) above also illustrates the long run price and output equilibrium of an oligopoly. On the other hand, if the oligopolist is earning subnormal profit in the short run and finds that it is still unable to eliminate its losses even after changing the scale/strategies of the firm in the long run, it will exit from the industry. Hence, similar to perfectly competitive firms and monopolist, an oligopolist will remain in business only if it can at least make normal profits in the long run. 4 Monopolistic Competition Most real-world markets lie between the two extremes of perfect competition and monopoly. Monopolistic competition is a market structure that embodies elements of both monopoly and perfect competition. It is, however, considered as a model of imperfect competition. Monopolistic competition is characterised by many small firms competing with one another by selling slightly differentiated products. Because of its differentiated products, each firm has some degree of market power, i.e., each firm has some discretion as to what price to charge for its products. Examples of firms operating in monopolistic competition include neighbourhood bakeries, boutiques and hairdressing salons. © Catholic Junior College Economics Department 2024 35 Firms and Decisions (H2 Economics/ 9570) 4.1 Characteristics of Monopolistic Competition 4.1.1 Low barriers to entry Low barriers to entry mean that the costs of establishing oneself in the industry is low, making it easier for firms to enter the industry. If supernormal profits are earned by existing firms, then new firms will be attracted to and can easily enter the industry. 4.1.2 Large Number of Small Firms There are many small firms such that no single firm can dominate the industry, since each has an insignificant share of the market – an element similar to the perfect competition market structure. There is independence of firms where the decisions of one firm have insignificant effect on its competitors, as opposed to the oligopoly. This is reflected in the decision-making of firms – each firm determines its price-output decision without considering the possible reactions of rival firms. This is particularly true of small retail shops e.g. neighbourhood grocery stores, coffee shops, barber shops, dry cleaners and hawker food stalls. Note: Unlike oligopolistic firms that have high rival consciousness and mutual interdependence, monopolistic competitive firms are relatively independent. This is because each firm has a very small market share and has limited impact on rival firms. 4.1.3 Slightly Differentiated Product Product differentiation distinguishes monopolistic competition from perfect competition. Instead of producing a homogeneous product, each firm produces a product or provides a service that is different in some ways from others. Products are slightly differentiated in terms of packaging, quality, design, branding, after- sales services, location, and promotion. As a result of selling differentiated products in a market with some barriers to entry, each firm has some degree of control over its own prices, i.e., it is a price setter. This means that firms can raise the price of its product without losing all its customers to its competitors, as in the case of perfect competition. Hence, the monopolistic competitive firm faces a downward sloping demand curve, where DD=AR=P > MR. However, the demand is relatively price elastic as there are a large number of close substitutes produced by rival firms. This severely limits the “market power” of each monopolistic competitive firm. To maintain market power, the firms have to ensure that their products are clearly differentiated. 4.1.4 Imperfect Knowledge As is the case of imperfect competition market structures, there is imperfect knowledge in a monopolistic competition. Consumers are not aware of all the differences in prices that may prevail in the market. Potential competitors are also not fully aware of available technology, input prices, profits margins etc associated with the market. 4.2 Revenue Curves of a Firm under Monopolistic Competition As mentioned, a monopolistic competitive firm produces a product that is differentiated from that of its competitors’. It therefore has some control over the price to charge for its product. Each firm faces a downward sloping demand curve or average revenue (AR) curve which implies that to sell more units of a product, the firm has to lower its price. It follows that the © Catholic Junior College Economics Department 2024 36 Firms and Decisions (H2 Economics/ 9570) marginal revenue (MR) curve lies below the AR curve. This is in contrast to a perfectly competitive firm who faces a perfectly price elastic demand curve (a horizontal demand curve) where price is constant even if the firm varies its output. Hence, the AR and MR curves of a monopolistic competitive firm look similar to that of a monopoly, such that both face downward sloping AR and MR curves. However, the demand curve for a monopolistic competitive firm is likely to be relatively more price elastic compared to that of a monopoly because are many close substitutes for each monopolistic competitive firm’s product. 4.3 Short Run Price and Output Decisions of Monopolistic Competitive Firms Given the wide range of differentiated products in the industry, it is impossible to construct the industry demand and supply curves (and hence a single industry price) which reflects demand and supply of a homogenous product. Each firm has its own demand and cost curves which are different from that of other firms. Therefore, the equilibrium analysis in this market structure is restricted to a ‘typical’ or ‘representative’ firm. The type of profits made by firms will depend on the individual firm’s cost and demand conditions. 4.3.1 Short Run Supernormal Profit Equilibrium of Monopolistic Competitive Firms A monopolistic competitive firm can earn supernormal profits in the short run if its total revenue exceeds its total costs of production, as in the case where the firm markets a differentiated product that catches the fancies of consumers. With reference to Figure 22, the firm maximises its profit by producing at Qe, where MC=MR and MC is rising. At output Qe, AR>AC and TR>TC. Therefore, the firm earns supernormal profits equal of the shaded area PABC. Cost/Price/Revenue MC AC P A C B MR AR=DD=P 0 Qe Output Figure 22: Short Run Supernormal Profit Equilibrium of a Monopolistic Competitive Firm © Catholic Junior College Economics Department 2024 37 Firms and Decisions (H2 Economics/ 9570) 4.3.2 Short Run Normal Profit Equilibrium of Monopolistic Competitive Firms The firm can earn normal profits in the short run if its AR=AC (or TR=TC). With reference to Figure 23, the firm maximises its profit by producing at Qe, where MC=MR and MC is rising. At output Qe, AR=AC and TR=TC. Therefore, the firm earns normal profits or zero economic profits. Cost/Price/Revenue MC AC P A E MR AR=DD=P 0 Qe Output Figure 23: Short Run Normal Profit Equilibrium of a Monopolistic Competitive Firm 4.3.3 Short Run Subnormal Profit Equilibrium of Monopolistic Competitive Firms The firm may earn subnormal profits if its AC>AR (or TC>TR) as in the case where the firm experiences poor demand for its product. With reference to Figure 24, the firm profit maximise at Qe, where MC=MR and MC is rising. At output Qe, AR