2.theoryoffirm

Copyright K. Bucknall © June, 2004 1

2. The Theory of the Firm: market conditions Covers perfect competition, imperfect (or monopolistic) competition, and monopoly. These are increasingly less competitive in that order. Oligopoly is considered as something of a special case. The Arrow of Competition:

Monopoly

Monopolistic competition

PerfectCompetition

Oligopoly

All firm diagrams start the same way!

0

Price, Costs

AC MC

Output

All equilibrium positions are where marginal cost = marginal revenue! Why? Logic! If profit maximising, a firm continues an action until it costs more to do than it brings in as revenue.

• The cost at the margin (the addition to total cost from the last unit produced) increases as production rises (MC).

• The revenue from the last unit sold = the marginal revenue (MR). • Logic tells us that the firm continues producing and watching MC rise until it

equals what the firm receives from the marginal unit sold (MR). • Therefore when MC = MR it is the best the firm can do, so it stops there i.e., it

is in equilibrium. We use the MC curve to trace what happens if a firm changes its output level, for that reason.


PERFECT COMPETITION (right hand end) Perfect competition is defined as: • many small buyers and sellers (firms) each too small to affect the price - firms are

"price-takers". • homogeneous product [identical]. • free entry and exit i.e. allowed and costs nothing. • perfect knowledge. - if take out perfect knowledge & leave first 3 assumptions, get "PURE COMPETITION' = less than perfect, but still very competitive. Perfect competitors are price takers! The price is set in the industry, by the total supply and demand curves, and the firm must accept it – because the industry is made up of lots and lots of small identical firms, none can affect price. The price is set in the whole industry by the demand of the consumers cutting the industrial supply curve. Get this from adding up all the MC curves of each little individual firm in the industry. All these MC curves added up ARE the industry supply curve when in perfect competition! The individual firm:

AC

Output

MC

0

Price, Costs

P

Q


How industry sets the price:

And the small individual firms are price takers. If demand for the product increases in the industry, it causes an increase in price and firms move up the MC curve. Q. Why the MC curve? (A. as said above). The price is set for the firm – it can sell any more produce at the same price – so the marginal revenue is always = price in perfect competition. How an increase in demand in the industry affects the perfectly competitive firms: We first change the price in the whole industry as demand has increased then trace this over to see what it would like for an individual firm:

0 Quantity(in mills) 0 O1 O2 Output

0

S

0 QQ0Q1

P P

firm 1

quantity in millions

pricePrice, Costs

quantity in hundreds quantity in hundreds

Price, Costsfirm 2

AC ACMC MC

P1

industrysets price

D


Average variable costs must be covered always, but not necessarily average total costs – these do not have to be covered in the short run. ABOVE equilibrium point where MR = AC = MR, firm makes more than its normal profit. Normal profit is built into the AC curve – without it the firm goes bust! Firms can earn above normal profit in the short term only. But above normal profit immediately attracts other firms in – perfect knowledge means they know about it! And free entry and exit means they race in! And this bids away the profits back to the MC = MR = AC position of equil. So in long term, no above normal profits are possible. BELOW AC = MC = MR all firms lose money, and some firms go out of business until the fall in output causes price to increase back to equil. position. If look at Average Variable Costs, can see firm can stay in business in short term if covering these – and not earning anything towards Average Fixed Costs. The AFCs must be covered in the long term. So can stay in business in short run only if below AC but above AVC. [This is a common multiple choice question].

Advantages Of Perfect Competition 1. Resources are allocated in the most efficient way to meet market D and consumer satisfaction - market mechanism works better. 2. It is the cheapest way of using the factors of production - and at lowest part of AC curve. 3. No cost of advertising selling, marketing, promotions - a form of waste to society as a whole, though beneficial for individual firms.

ATC

Output

MC

0

Price, Costs

AVC


4. Rapid change is possible to meet new consumer demands - v. flexible. 5.Producers’ interests are same as consumers interests. 6. Freedom to chose exists. 7. Avoids all wastes of monopoly. 8. Stops the emergence of a few rich and powerful people - there are a lot of firms, all small. Disadvantage Of Perfect Or Pure Comp 1. It produces what is demand UNDER THE GIVEN Y DISTRIBUTION - a few rich people with pets might eat well, while masses starve. 2. spillovers and externalities can exist - costs caused to others, e.g. disposal of nuclear waste or toxic chemicals by dumping in streams. 3. No economies of scale possible - all are small firms. 4. Perfect comp can have limited choice of range of goods; monopolistic comp may have wider range - e.g. in motorcars – lots of models. 5. Little or no R&D - because no funds for it - no surplus profits in the LR - all whittled away! R&D is possible under monopoly etc. because make monopoly profits. MONOPOLY – THE LEAST COMPETITIVE MARKET SITUATION (left hand end) WHAT IS A MONOPOLY Definition: Technically a sole supplier i.e., e one firm in industry. But are degrees of monopoly - if one firm supplies 80%, it is close to a monopoly and will usually act like one. Types Of Monopoly 1. economies of scale i.e. one firm grows large, costs less than others, so sells more, and grows to become sole firm. This is so-called natural monopoly = result of economies of scale often.


2. law - govt may restrict to one nationalised firm e.g. British Steel tried it decades ago - or a trade union monopoly over supply of 1 kind of labour - BMA for instance. 3. agreement between firms, so that all act together as one monopolist - often illegal but happens. 4. exclusive ownership of unique resource : e.g. one source of supply of raw material e.g. all known supply of iron ore in Oz once in hands of BHP - or de Beers diamond mining once virtually all, still a lot, of diamond supply. 5. copyrights, patents and licences are particular forms of this. Marginal revenue and monopoly Marginal revenue is the additional total revenue from the last item sold.

• A perfectly competitive firm can sell as much as it wants at an unchanged price i.e., its MR curve is equal to price – if sell one more for 50P, it adds 50P to TR.

• A monopolist is the industry so faces a normal downward sloping demand curve.

• So if wants to sell more must lower the price. • And sell all its products at that lower price. • So the price of marginal product is NOT the MR – total revenue increases by

less than this sale, because lose a bit of price on all earlier products can sell. E.g., table AS INCREASE QUANTITY

MUST LOWER PRICE

TOTAL REVENUE (PxQ)

MARGINAL REVENUE

1 7 7 7 2 6 12 5 3 5 15 3 4 4 16 1 5 3 15 - 1 6 2 12 - 3 7 1 7 - 5

Note that MR is less than price for all Q demanded. Monopoly equilibrium Where MC = MR, as usual – locate that point first.


Seeing monopoly profits in a diagram Profits = total revenue minus total cost. Total revenue = price x quantity. Total cost = average cost x quantity. Total revenue = 0 P A Q. Total costs = 0 AC B Q. So profit is difference between these two areas i.e., = P A B AC.

Output

MC

0

Price, Costs

ACP

Q

DMR


Problems with monopoly, what is wrong with monopoly or "welfare effects of monopoly" 1. Limits output and keeps price high. 2. Redistributes Y from all consumers to one firm or person [equity issue]. 3. Monopolist may develop political and social power over others - reduces democracy efficiency and equity. Political danger of a few very rich and powerful people (Marx calls them “monopoly capitalists” misuse their position and exploit people). 4. May behave badly in an anti-social way - e.g. force out potential rival firm by selling at give-away prices well below cost, then put price back up again when forced out competitor. May or may not be legal -depends on each country and its legislation but always reprehensible. 5. ** Lack of competition tends to promote inefficiency, rests on laurels, no need to try hard, lacks dynamism. This Is Probably The Main Criticism – said Austin Robinson - lazy managers and owners results. - means technical progress is slow, leading to slow growth of country and lower standard of living than could have.

Output

MC

0

Price, Costs

ACP

Q

DMR

AC

A

B


6. Resources are misallocated - too many to monopolist and not used fully = a waste for society. Price mechanism prevented from working. 7. Reduces consumer choice. 8. Monopolist ignores small market demands as cannot be bothered to meet them - Henry Ford “Any colour as long as its black”. 9. Long run effect is slow growth, low standard of living, higher unemployment (because employ fewer) higher prices (though not rising); slightly poorer balance of payments, less equal Y distribution and poor resource allocation Benefits of monopoly – few really. 1. CAN use monopoly profits for R&D leading to product improvement, faster growth, lower costs etc. - Schumpeter's argument on innovation - that big firms only ones to be able to afford labs, research staff etc. - but research shows many breakthroughs come from small firms e.g. Apple began computers in garage. 2. May reap economies of scale e.g. Post office, telephone lines, electricity supply, gas supply, railways, which means lower costs. 3. State monopoly may be safer - if private monopoly cuts corners and reduces necessary maintenance in areas like railway or air traffic control. IMPERFECT COMPETITION OR MONOPOLISTIC COMPETITION (The bit in the middle!) What is monopolistic competition? Defined as: • Many buyers and sellers of that type of good (= competition). • Free entry and exit (= competition). • But each with own brand of the good (= a monopoly on the brand name). • So each faces a downward sloping demand curve for its branded product (= a

monopoly on the brand name).


Elements of both monopoly and competition. Equilibrium condition Still is where MC = MR

COSTS,PRICE

OUTPUT

AC

MC

D

IMPERFECTCOMPETITION(MONOPOLISTIC COMPETITION)

0

P1

O1 Why is equilibrium tangential? Because of assumptions of strong competition. If the firm improves the product, e.g. colours it fashionably, the demand for the product increases, this allows a price increase and hence higher profits for the firm. See firm gets monopoly profits – but SHORT TERM ONLY!! The higher profits and visible higher price draw the attention of the competitors who can compete by colouring their product also! The demand for the original product then falls back. How far does it fall back? Until the monopoly profits are eroded to zero when competitors stop coming in! So in long run no monopoly profits - always tangential!! NOTE Price = AC but is above MC! (Multiple choice Qs might ask!)


Problems with Monopolistic Competition • Wastes of time and effort - worry about competitors actions. • Waste of resources underused = not at bottom of AC curve - could produce more

and more cheaply but cannot do it i.e., excess capacity exists. • May be too much differentiation - pretend product is “better” but merely different! • Advertising wastes. • Free gifts, 2-for-1, competitions to get trip to Barrier Reef resort etc. • Instead of better or cheaper products. Benefits of Monopolistic Competition • Is very competitive – firms watch competitors very closely. • Competition drives firms along - competition is strong for quality, design, price. • Free entry and exit keeps competition up. • Variety is great - more choice - greater consumer satisfaction. On balance, there is a lot of monopolistic competition about and some argue it is the mainspring that drives the economy forward by producing new goods, better goods or at least different ones.

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