Business Economics - Monopolies

SESSION 5 AND 6

Profit Max for a Price Taker

• the firm can sell as much as it wants at the prevailing market price P1 and MR = P1 at any chosen output level. The firm’s own demand curve is effectively horizontal (perfectly elastic) at the prevailing market price  
• AR = P = MR  
• Since MR = P, profits are maximised at P=MC  

Price and Marginal Revenue for a Price Setter

• MR

   

• If the firm has to cut price to sell an extra units, the extra revenue gained from the sale of another unit is offset by the loss of revenue from selling all units at a lower price  
• TR = PQ P = a − bQ
• TR = aQ − bQ 2
• the firm has to cut price to sell more. It faces a downward-sloping demand curve and MR is less than P at any output level. For example, to sell q1 the firm sets price at P1 and MR at q1 is MR1 < P1. Similarly, at q2 MR is MR22
• Profit maximisation occurs at the quantity where MR = MC  
• But price must be greater than MC  
• In both the short run and the long run, producer surplus is the area under the horizontal price line and above the marginal cost of production.

Market Structures

• The structure of a market is typically defined in terms of the features that determine the degree of competition:  

• The number of firms in the industry  
• The nature of the product produced  
• The degree to which the firm can influence price  
• The extent of barriers to entry  

Session 6 

Perfect Competition

• This is the case of perfect competition.....

• Large number of buyers and sellers in the market  
• Each producer supplies a very small proportion of total industry output  
• Products are homogenous (identical)  
• No Barriers to Entry or Exit for the Industry  
• Consumers and producers have perfect knowledge about the market  
• Firms are price takers  

The Firm’s Short-Run Decision to Shut Down

• A firm will cease production in the short-run if the market price falls below the shut down price, which is equal to minimum average variable cost (AVC)  -The firm shuts down if the revenue it gets from producing is less than the variable cost of production  Shut down if TR i.e. Shut down if P < AVC  

• P > AVC the firm should produce in the short-run, because it can make at least some contribution to fixed costs  

The Competitive Firm’s Supply Curve

• The portion of the marginal cost (MC) curve that lies above average variable cost (AVC) is the competitive firm’s short-run supply curve
• But remember the firm will only remain in production in the long run if it can cover ATC

• This means that the firm will supply units in the long run only if P is high enough to cover ATC. The portion of the marginal cost (MC) curve that lies above the minimum point of average total cost (ATC) curve can be thought of as the competitive firm’s long-run supply curve

• Short-run: The minimum supply price is the minimum of AVC
• The market price is set by the interaction of market supply and market demand

Perfect Competition: Production in the Long-Run

• If the firm thinks it will operate at a loss in the long run it will exit the industry (because the return on capital employed is lower than it is in alternative activities involving similar risk)
• If above-normal profits can be earned there is an incentive for new firms to enter the industry (because the return on capital employed is higher than it is in alternative activities involving similar risk)
• P > ATC implies entry                         P < ATC implies exit

• THE INDUSTRY

• Above-normal profits attract new firms into the industry and supply expands, causing price to fall

• THE FIRM 

• The market price falls and above-normal profits decline. The firm earns just normal profits

The Exit Process

• THE INDUSTRY

• Losses induce some firms to leave the industry and market supply contracts, causing price to rise.

• THE FIRM

• The representative firm incurs losses at the market price P1.. The firm breaks even when price rises to P1 

Long Run Equilibrium

• THE INDUSTRY: long-run equilibrium prevails when firms earn just normal profits and there is no incentive for entry or exit
• THE FIRM: long-run equilibrium prevails when the market price is just sufficient to cover minimum ATC and the representative firm earns normal profits

Normal Profits and Above-Normal Profits

• Normal profits are the minimum profits to keep a firm in the industry  
• Normal profits are included as a component of total costs  
• Above-Normal Supernormal profits are in excess of normal profits  
• Above-Normal Profits are also called economic profits  
• A perfectly competitive firm/industry can earn above-normal profits in the short-run but not in the long-run  

Monopoly

• A pure monopoly is a market structure in which there is a single seller of a product  
• There are no close substitutes  
• There are significant barriers to entry  
• A less stringent view is that monopoly power exists when one firm dominates the market  
• Firms may be investigated for examples of monopoly power when market share exceeds a specified percentage, typically 25%  

Origins of Monopoly

• The size of the market
• Lower costs for an established firm  
• Ownership of raw materials or exclusive knowledge of production techniques  
• Patent rights for a product or production process
• Government licensing
• Strategic pricing
• Brand loyalty

Short Run Costs for the Monopolist

• In the short run, costs follow the usual pattern, with MC rising as output expands.

Marginal Revenue for the Monopolist

• MR is positive for price reductions in the elastic region. MR is zero around the unit elastic region. MR is actually negative for price reductions in the inelastic region

Profit Maximization for a Monopolist

• The firms maximizes profits at q1 where MC=MR
• The extent to which the firm can continue to earn above- normal profits depends on whether it can retain its market power

Price Discrimination