ED0101 Introduction to Economics Topic 5 Learner's Guide PDF

Introduction ============ In topic 4, we learnt that profits are maximized where its marginal cost equals its marginal revenue: *MC = MR.* But we want to more than this by asking such questions;  What determines the amount of profit that a firm will make? Will its profits be large or just enough f...

Introduction ============ In topic 4, we learnt that profits are maximized where its marginal cost equals its marginal revenue: *MC = MR.* But we want to more than this by asking such questions;  What determines the amount of profit that a firm will make? Will its profits be large or just enough for it to survive? Will the price charged to the consumer be high or low? And more generally, will the consumer benefit from the decisions a firm make? To answer these questions, it depends on the amount of competition that a firm face. A firm in a highly competitive environment will behave quote differently from a firm facing little or no competition. In particular, a firm facing competition from many other firms will be forced to keep its prices down be efficient as possible, simply to survive.  When firms face little or no competition like water and electrical authority, they have considerable power over prices and consumers may end up paying more.  So, in this topic, the students will look at two different types of markets:   - - Learning Objectives =================== At the end of this topic, the learner should be able to: - Define each of the economic markets. ** ** - Explain why a perfectly competitive firm cannot affect the market price. ** ** - Explain how a competitive market's output changes when price changes. ** ** - Explain why firms sometimes shut down temporarily and lay off workers. ** ** - Explain why perfect competition is good for consumers. ** ** - Explain how the monopolist sets price and output levels. ** ** - Explain the theory of contestable markets. ** ** Contents ======== 1. Market Structure and Perfect Competition 2. Monopoly 3. Oligopoly Study Resources =============== Suggested Study Time Tutorials  2 hours  ------------------------------------ ---------- Online Learning  4 Hours  *(6 hours per week for 13 weeks)*  Required Resources [[https://sites.bu.edu/manove-ec101/files/2019/04/UMinnMicroeconomics.pdf]](https://sites.bu.edu/manove-ec101/files/2019/04/UMinnMicroeconomics.pdf)  Textbooks Sloman, J., Norris, K. and Garrett, D., 2013. *Principles of economics*. Pearson Higher Education AU. 1 Market Structure and Perfect Competition ========================================== Market structure refers to the way that various industries are classified and differentiated in accordance with their degree and nature of competition for products and services. It consists of four types: perfect competition, oligopolistic markets, monopolistic markets, and monopolistic competition.  A diagram of different types of firms Description automatically generated    **Normal and super normal profit**  [Normal profit] is included as a cost of production  - - - - **Perfect Competition:**  **Definition**: Perfect competition describes a market structure where competition is at its greatest possible level. To make it clearer, a market which exhibits the following characteristics in its structure is said to show perfect competition:  1. Large number of buyers and sellers  2. Homogenous product is produced by every firm  3. Free entry and exit of firms  4. Zero advertising cost  5. Consumers have perfect knowledge about the market and are well aware of any changes in the market. Consumers indulge in rational decision making.  6. All the factors of production, viz. labor, capital, etc, have perfect mobility in the market and are not hindered by any market factors or market forces.  7. No government intervention  8. No transportation costs  9. Each firm earns normal profits and no firms can earn super-normal profits.  10. Every firm is a price taker. It takes the price as decided by the forces of demand and supply. No firm can influence the price of the product.  **Description:** *Ideally, perfect competition is a hypothetical situation which cannot possibly exist in a market. However, perfect competition is used as a base to compare with other forms of market structure.*  **Short and long-run equilibrium **  To maximize profit in perfect competition, a firm must set its production output such that marginal revenue (the income earned by selling one additional unit of a good) is equal to marginal cost (the cost of producing one additional unit of a good). However, maximizing profit does not necessarily mean that economic profit will be earned. That depends on whether or not total revenues are greater or less than total costs. That, in turn, depends on whether the price set by the market for a unit of product is greater or less than the average cost per unit of producing that product incurred by the firm.  The equivalency of these two ways of conceptualizing and calculating profit and loss can be stated in the following way:   Using these equations, when the price per unit is greater than the average cost per unit, the result is a positive number, meaning that the firm is earning profit from selling its goods or services. Conversely, when the price per unit is less than the average cost per unit, the result is a negative number. This means that the firm is operating at a loss, even though it has maximized the amount of possible profit through setting its output levels at the point where marginal revenue is equal to marginal cost.  A diagram of a economic profit Description automatically generated   **Loss minimization and the shut-down rule**  - - - - -    **A firm's Long-run equilibrium under Perfect Competition**  Long-term is the period in which the firm can vary all of its inputs. There are no fixed costs and therefore, the AFC or Average Fixed Cost curve vanishes. Also, the Average Cost (AC) curve represents the Average Total Cost (ATC) curve. Further, since the firm can vary all its inputs, it can close own and leave the industry.  We know that in the long-run, the AC curve which is formed by its short-run AC curves is also U-shaped. This means that up to a certain limit, the firm experiences increasing returns and the AC curve slopes downwards.  A phase of constant returns follows in which the AC curve neither rises nor falls. Subsequently, diminishing returns to scale phase starts in which the AC curve slopes upwards.  - - - A screen shot of a graph Description automatically generated   The figure above describes the determination of long-run equilibrium under perfect competition. As you can see, the output is measured along the X-axis and the costs along the Y-axis. Also, the firm is a price-taker.  Further, its AR curve runs parallel to the X-axis and the MR curve coincides with it.  ***In order to determine the equilibrium of the firm, we will consider three alternative prices that the firm receives from the industry:***  **Price \#1:** The price in the market is below the optimum cost of the firm (OP~0~). From this cost, we get a corresponding average revenue of AR~0~ and Marginal Revenue of MR~0~. As you can see in the figure, MR~0~ cuts the LMC curve at two points -- E and E~0~.  However, none of these points is the long-run equilibrium of the firm. At point 'E', the LMC curve cuts the MR~0~ curve from above while at point E~0~, it cuts the curve from below. But, since AR~0~ \< LAC, the firm incurs losses.  **Price \#2:** The price of the firm's product is more than the optimum cost or the least possible average cost of the firm. In such cases, the firm is not in a state of stable equilibrium. If this price is OP~2~ with the average revenue curve AR~2~ and the marginal revenue curve MR~2~, then we can see that  - - This means that the firm is enjoying super-normal profits. However, this attracts new firms to the industry which increases the supply and the price falls until no firm can earn super-normal profits.  **Price \#3:** The price of the firm's product is equal to its optimum cost of production. If this price is OP~1~ with the average revenue curve AR~1~ and the marginal revenue curve MR~1~, then we can see that  - - Therefore, the firm neither incurs a loss nor earn a super-normal profit. Therefore, there is no incentive for the existing firms to leave the market or new ones to join it. Also, the corresponding equilibrium output is OM~1~. Hence, we can note that in long-run equilibrium, the firm produces an optimum output at the lowest possible average cost. Therefore, the firm operates under constant returns to scale. Also, we have  **MC = AC**  **MC = MR**  **AC = AR**  **Therefore, we have AC = AR = MC = MR.**  2 Monopoly ========== **Definition:** A market structure characterized by a single seller, selling a unique product in the market. In a monopoly market, the seller faces no competition, as he is the sole seller of goods with no close substitute.  **Description:** In a monopoly market, factors like government license, ownership of resources, copyright and patent and high starting cost make an entity a single seller of goods. All these factors restrict the entry of other sellers in the market. Monopolies also possess some information that is not known to other sellers.  While single-firm monopolies are rare, except for those subject to public regulation, it is useful to examine the monopolist's market conduct and performance to establish a standard at the pole opposite that of perfect competition. As the sole supplier of a distinctive product, the monopolistic company can set any selling price, provided it accepts the sales that correspond to that price. Market demand is generally inversely related to price, and the monopolist presumably will set a price that produces the greatest profits, given the relationship of production costs to output. By restricting output, the firm can raise its selling price significantly---an option not open to sellers in atomistic industries.  The monopolist will generally charge prices well in excess of production costs and [**[reap]**](https://www.britannica.com/dictionary/reap) profits well above a normal interest return on investment. His output will be substantially smaller, and his price higher, than if he had to meet established market prices as in perfect competition. The monopolist may or may not produce at minimal average cost, depending on his cost-output relationship; if he does not, there are no market pressures to force him to do so.  If the monopolist is subject to no threat of entry by a competitor, he will presumably set a selling price that maximizes profits for the industry he monopolizes. If he faces only impeded entry, he may elect to charge a price sufficiently low to discourage entry but above a competitive price---if this will maximize his long-run profits.  **Equilibrium of the Industry under Perfect Competition**  In economic terms, an industry consists of many independent firms. Each firm has a number of factories, farms or mines, as required. Each such firm in industry produces a homogeneous product. Equilibrium of the industry happens when the total output of the industry is equal to the total demand. In such a scenario, the prevailing price of a commodity is its equilibrium price.  We know that under competitive conditions, the interaction of demand and supply determines the equilibrium price as shown below:    ***In Fig. 1*** above, OP is the equilibrium price. Further, OQ is the equilibrium quantity sold at that price. Now, the equilibrium price is the price at which both the demand and supply are equal. In other words, no buyer, who wanted to buy at that price, goes dissatisfied and no seller, who wanted to sell his goods at that price, goes dissatisfied either.  Note that with the demand remaining the same, if the price is higher or lower than OP, then the market is not in equilibrium. Also, if goods are lesser or higher than the demand, the equilibrium is not attained.   **Equilibrium of the Firm under Perfect Competition**  A firm is in equilibrium when it maximizes its profits. Hence, the output that offers maximum profit to a firm is the equilibrium output. When a firm is in equilibrium, there is no reason to increase or decrease the output.  In a competitive market, firms are price-takers. The reason being the presence of a large number of firms who produce homogeneous products. Therefore, firms cannot influence the price in their individual capacities. They have to follow the price determined by the industry.   The following figure shows a firm's demand curve under perfect competition:  A diagram of a market Description automatically generated  ***From Fig. 2*** above, you can see that the industry price, OP, is fixed throughout the interaction of demand and supply of the industry. Firms have to accept this price. Hence, they are price-takers and not price-makers. Hence, they cannot increase or decrease the price OP.  Therefore, the line P acts as a demand curve for such firms. Hence, in perfect competition, the demand curve of an individual firm is a horizontal line at the level of the industry-set market price. Firms have to choose the level of output that yields maximum profit.  **Conditions for the equilibrium of a firm**  **To attain an equilibrium position, a firm must satisfy the following two conditions:**  They must ensure that the *[Marginal Revenue]* is EQUAL to the *[Marginal Cost]* **(MR = MC).**  If **MR \> MC,** the firm has an incentive to expand its production and sell additional units.  If **MR \< MC,** the firm must reduce the output since additional units add more cost than revenue.  The firm gets ***Maximum Profits*** only when **MR = MC.**  The MC curve must have a positive slope and cut the MR curve from below.    ***In Fig. 3*** above, DD is the demand curve and SS is the supply curve. They equilibrate at point E and set the market price as OP. Under perfect competition, firms adopt OP as the industry price and consider the P-line as the demand curve or AR -- average revenue curve (perfectly elastic at P).  Since all units are equally priced, the MR curve is a horizontal line and is equal to the AR line. Observe that the curve MC cuts the MR curve at two points -- T and R. At point T, the MC curve cuts the MR curve from above whereas at point R it cuts the MR curve from below. Therefore, according to the conditions of equilibrium of a firm, point R is the point of equilibrium and OQ2 is the equilibrium level of output.  **Price and Output Determination under Monopoly**  A firm under monopoly faces a downward sloping demand curve or average revenue cum. Further, in monopoly, since average revenue falls as more units of output are sold, the marginal revenue is less than the average revenue. In other words, under monopoly the MR curve lies below the AR curve.  The equilibrium level in monopoly is that level of output in which marginal revenue equals marginal cost. The producer will continue producer as long as marginal revenue exceeds the marginal cost. At the point where **MR** is equal to **MC** the profit will be [Maximum] and beyond this point the [producer] will [stop producing].  A diagram of a business diagram Description automatically generated  It can be seen from the diagram that up till OM output, marginal revenue is greater than marginal cost, but beyond OM the marginal revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium at output OM where marginal revenue is equal to marginal cost and the profits are the greatest.  The corresponding price in the diagram is MP or OP. It can be seen from the diagram at output OM, while MP' is the average revenue, ML is the average cost, therefore, P'L is the profit per unit. Now the total profit is equal to P'L (profit per unit) multiply by OM (total output). In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop producing.  In the long run, the monopolist can change the size of plant in response to a change in demand. In the long run, he will make adjustment in the amount of the factors, fixed and variable, so that MR equals not only to short run MC but also long run MC.  **Pricing and Output Decisions -- Long Run Equilibrium:**  In the long run the monopolist has the time to expand his plant, or to use his existing plant at any level that will maximize his profit. Since the monopolist does not face the threat of entry of new firms, it is not necessary for him to reach an optimal scale.  A monopolist will not stay in business if he makes losses in the long run. He will most probably continue to make supernormal profits even in the long run, given that entry is barred. However, the size of his plant and the degree of utilization of any given plant size depend entirely on the market demand. He may reach the optimal scale or remain at sub-optimal scale or surpass the optimal scale depends on the market conditions. ***Figure 4.11*** portrays the situation in which the market size is such that does not allow the monopolist to reach the optimal scale.   **COMPARISON OF PRICE DETERMINATION UNDER PERFECT COMPETITION AND MONOPOLY:**  The key points of comparison of price determination under Perfect Competition and Monopoly is as below:     **Perfect Competition**  **Monopoly**  ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------------------------------------------------------------- **(i)** The demand curve or average revenue curve is perfectly elastic and is a horizontal straight line.  **(i)** The demand curve or average revenue curve is relatively elastic and a downward sloping from left to right.  **(ii)** The firm is in equilibrium at the level of output where MC is equal to MR. Since in perfect competition MR is equal to AR or price, therefore, when MC is equal to MR, it is also equal to AR or price at the equilibrium position, i.e., MC=MR=AR (Price)  **(ii)** The firm is in equilibrium at the level of output where MC is equal to MR.  **(iii)** In equilibrium position, the price charged by the firm equals to MC.  **(iii) **In equilibrium position, the price charged by the firm is above MC.  **(iv)** The firm is in long-run equilibrium at the minimum point of the long-run AC curve.  **(iv) **The firm is in long-run equilibrium at the point where AC curve is still declining and has not reached the minimum point.  **(v)** The firm is in equilibrium at the level of output at which MC curve is rising, and is cutting MR curve from below.  **(v)** The firm is in equilibrium at the level of output at which MR curve is sloping downwards, and MC curve is cutting it from below or above. ***(See figure 1)***  **(vi)** In the long run, the firm is earning normal profit. There may be super normal profit in the short run but they will be swept away in the long run, as new firms entered into the industry.  **(vi)** The firm can earn abnormal or supernormal profit even in the long run, as there is no competitor in the industry.  **(vi)** In the long run, the firm is earning normal profit. There may be super normal profit in the short run but they will be swept away in the long run, as new firms entered into the industry.  **(vii)** Price is set higher and output smaller by the monopolist. ***(See Figure 2)***    **Monopolistic Competition**  Monopolistic competition is a market structure defined by free entry and exit, like competition, and differentiated products, like monopoly. Differentiated products provide each firm with some market power. Advertising and marketing of each individual product provide uniqueness that causes the demand curve of each good to be downward sloping. Free entry indicates that each firm competes with other firms and profits are equal to zero on long run equilibrium. If a monopolistically competitive firm is earning positive economic profits, entry will occur until economic profits are equal to zero.  **Monopolistic Competition in the Short and Long Runs**  The demand curve of a monopolistically competitive firm is downward sloping, indicating that the firm has a degree of market power. Market power derives from product differentiation, since each firm produces a different product. Each good has many close substitutes, so market power is limited: if the price is increased too much, consumers will shift to competitors' products.    **Monopolistic Competition in the Short Run and Long Run**  Short and long run equilibria for the monopolistically competitive firm are shown in Figure. The demand curve facing the firm is downward sloping, but relatively elastic due to the availability of close substitutes. The short run equilibrium appears in the left-hand panel and is nearly identical to the monopoly graph. The only difference is that for a monopolistically competitive firm, the demand is relatively elastic, or flat. Otherwise, the short run profit-maximizing solution is the same as a monopoly. The firm sets marginal revenue equal to marginal cost, produces output level q∗SRqSR∗ and charges price PSRPSR. The profit level is shown by the shaded rectangle π~π~.  The long run equilibrium is shown in the right-hand panel. Entry of other firms occurs until profits are equal to zero; total revenues are equal to total costs. Thus, the demand curve is tangent to the average cost curve at the optimal long run quantity, q∗LRqLR∗. The long run profit-maximizing quantity is found where marginal revenue equals marginal cost, which also occurs at q∗LRqLR∗ 3 Oligopoly =========== Oligopoly means few sellers. In an oligopolistic market, each seller supplies a large portion of all the products sold in the marketplace. In addition, because the cost of starting a business in an oligopolistic industry is usually high, the number of firms entering it is low.  Companies in oligopolistic industries include such large-scale enterprises as automobile companies and airlines. As large firms supplying a sizable portion of a market, these companies have some control over the   A black background with blue letters Description automatically generatedprices they charge. But there's a catch: because products are fairly similar, when one company lowers prices, others are often forced to follow suit to remain competitive. You see this practice all the time in the airline industry: When American Airlines announces a fare decrease, Continental, United Airlines, and others do likewise. When one automaker offers a special deal, its competitors usually come up with similar promotions.  References ========== Sloman, J., Norris, K. and Garrett, D., 2013. *Principles of economics*. Pearson Higher Education AU.