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Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
Chapter 8-market-structure (1)
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Chapter 8-market-structure (1)

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  • 1. Written by: Edmund Quek CHAPTER 8 MARKET STRUCTURE LECTURE OUTLINE 1 INTRODUCTION 2 PERFECT COMPETITION 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 Characteristics of perfect competition Revenue curves and schedules under perfect competition Profit-maximising rule Short-run equilibrium of a perfectly competitive market Long-run equilibrium of a perfectly competitive market Short-run shut-down rule Long-run shut-down rule Derivation of the short-run supply curve of a firm under perfect competition Perfect competition and the public interest 3 MONOPOLY 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 Characteristics of monopoly Barriers to entry Revenue curves of a monopoly Short-run equilibrium of a monopolistic market Long-run equilibrium of a monopolistic market Short-run shut-down rule Long-run shut-down rule A monopoly does not have a supply curve Monopoly and the public interest Natural monopoly 4 MONOPOLISTIC COMPETITION 4.1 4.2 4.3 4.4 4.5 Characteristics of monopolistic competition Revenue curves of a monopolistically competitive firm Short-run equilibrium of a monopolistically competitive market Long-run equilibrium of a monopolistically competitive market Monopolistic competition and the public interest © 2011 Economics Cafe All rights reserved. Page 1
  • 2. Written by: Edmund Quek 5 OLIGOPOLY 5.1 5.2 5.3 5.4 Characteristics of oligopoly Collusive versus competitive (non-collusive) behaviour Non-price competition Oligopoly and the public interest References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics © 2011 Economics Cafe All rights reserved. Page 2
  • 3. Written by: Edmund Quek 1 INTRODUCTION Economists are interested to study the behaviour of firms such as whether they will charge a high or low price, whether they will make a large or small amount of profit, whether they will produce efficiently, etc. The answers to these questions will depend on the number of firms in the market, the nature of their products, the availability of knowledge and the presence or absence of barriers to entry. For instance, a firm in a highly competitive environment will behave quite differently from a firm facing little or no competition. In particular, a firm that faces competition from many firms is likely to charge a low price, make a small amount of profit and produce efficiently. The converse is also true. The structure of a market is the characteristics of the market such as the number of firms in the market, the nature of their product, the availability of knowledge and the presence or absence of barriers to entry that affect the behaviour and profitability of the firms in the market. This chapter gives an exposition of the four types of market structure: perfect competition, monopoly, monopolistic competition and oligopoly. 2 PERFECT COMPETITION (PC) 2.1 Characteristics of perfect competition A very large number of small firms (small market share) In a PC market, there are a very large number of small firms. Therefore, each firm in a PC market has a small market share. Homogeneous products In a PC market, the firms sell homogenous products that are perfect substitutes for one another. Homogenous products are identical products. Perfect knowledge In a PC market, firms and consumers are fully aware of the production technology, price, quality and availability of the product. PC firms are price-takers Due to its small market share, product homogeneity and perfect knowledge, a PC firm is a price-taker in the sense that it is unable to influence the market price by changing its output level. Therefore, a PC firm can only sell its output at the market price that is determined by the market forces of demand and supply. In other words, a PC firm faces a perfectly elastic demand curve at the market price. At the market price, the quantity demanded of the good produced by a PC firm is infinite. Therefore, in principle, a PC firm can sell all the output that it produces at the market price. © 2011 Economics Cafe All rights reserved. Page 3
  • 4. Written by: Edmund Quek No barriers to entry There are no barriers to entry in a PC market. The absence of barriers to entry in a PC market allows a PC firm to make only normal profit (TR  TC) in the long run. Note: Perfect competition does not exist. It is only a benchmark. The word 'perfect' in “perfect competition” does not mean 'the best' or 'the most desirable'. Rather, when it is used with the word 'competition', perfect means “of the highest degree”. 2.2 Revenue curves and schedules under perfect competition The market demand curve is downward-sloping (refer to the notes on “Demand and Supply”). A PC firm's demand curve is horizontal (perfectly elastic) at the market price (refer to section 2.1). The revenue schedules of a perfectly competitive firm Price 3 3 3 3 Quantity 10 11 12 13 TR 30 33 36 39 AR 3 3 3 3 MR --3 3 3 Total revenue (TR)  Price (P) × Quantity (Q) Average revenue (AR)  TR/Q  P Marginal revenue (MR)  ΔTR/ΔQ Market © 2011 Economics Cafe All rights reserved. Representative firm Page 4
  • 5. Written by: Edmund Quek In the above left-hand diagram, the market price (P0) is determined by the market demand (D) and the market supply (S). In the above right-hand diagram, the PC firm faces a perfectly elastic demand curve at P0. At P0, the quantity demanded of the good produced by the PC firm is infinite. Therefore, in principle, a PC firm can sell all the output that it produces at the market price. TR curve of a PC firm The representative firm's demand curve is horizontal at the market price of $3. The representative firm's demand curve is also its AR and MR curves. Since the demand curve is perfectly elastic, the TR curve is an upward-sloping straight line drawn from the origin. 2.3 Profit-maximising rule Profit is the excess of TR over TC. Profit is maximised at the output level where MR is equal to MC. © 2011 Economics Cafe All rights reserved. Page 5
  • 6. Written by: Edmund Quek In the above diagram, profit is maximised at Q0 where MR is equal to MC. If output increases from Q0, both TR and TC will rise. However, at an output level higher than Q0, such as Q1, MC is higher than MR. Therefore, the increase in TC will be greater than the increase in TR and hence the increase in output will lead to a decrease in profit. If output decreases from Q0, both TR and TC will fall. However, at an output level lower than Q0, such as Q2, MR is higher than MC. Therefore, the decrease in TR will be greater than the decrease in TC and hence the decrease in output will lead to a decrease in profit. Since profit cannot be increased by changing output from Q0, it must be maximised at Q0. Further, MR is equal to MC at two output levels, Q0’ and Q0. At Q0’, where MC is falling, profit is NOT maximised. Between Q0’ and Q0, MR is higher than MC. If output increases from Q0’ to Q0, a profit will be made on each unit of output and this means that the profit at Q0 is higher than the profit at Q0’. Therefore, the profit of a PC firm is maximised at the output level where MR is equal to MC, assuming MC is rising. © 2011 Economics Cafe All rights reserved. Page 6
  • 7. Written by: Edmund Quek In the above diagram, the vertical distance between the TR and the TC curves is the largest at Q0. The slope of the TR curve at this output level (MR) is equal to the slope of the TC curve (MC). Therefore, Q0 in the TR/TC diagram is the same as Q0 in the MR/MC diagram. The profit-maximising rule can also be proven mathematically. Profit  Total Revenue – Total Cost (Q)  TR(Q) – TC(Q) By the first-order condition, d/dQ  0 dTR/dQ – dTC/dQ  0 MR – MC  0 MR  MC 2.4 Short-run equilibrium of a perfectly competitive market A PC firm is in short-run equilibrium when it is producing the profit-maximising output level. A PC market is in short-run equilibrium when all the firms in the market are in short-run equilibrium. However, this does not necessarily mean that the firms in the market are making positive economic profit. Indeed, the firms in a PC market in short-run equilibrium can make one of three types of profit: supernormal profit (positive economic profit), subnormal profit (negative economic profit or economic loss) and normal profit (zero economic profit). Supernormal profit (TR  TC or AR  AC) In the above diagram, at Q0 where MR is equal to MC, AR is greater than AC. Therefore, the firm is making supernormal profit represented by the shaded area. © 2011 Economics Cafe All rights reserved. Page 7
  • 8. Written by: Edmund Quek Subnormal profit (TR  TC or AR  AC) In the above diagram, at Q0 where MR is equal to MC, AR is less than AC. Therefore, the firm is making subnormal profit represented by the shaded area. Normal profit (TR  TC or AR  AC) In the above diagram, at Q0 where MR is equal to MC, AR is equal to AC. Therefore, the firm is making normal profit. © 2011 Economics Cafe All rights reserved. Page 8
  • 9. Written by: Edmund Quek 2.5 Long-run equilibrium of a perfectly competitive market A PC market is in long-run equilibrium when the firms that wish to leave the market and the potential firms that wish to enter the market have done so. In other words, a PC market is in long-run equilibrium when the number of firms in the market is constant. In PC market, this occurs when all the firms make normal profit. If the firms in a PC market are making supernormal profit, potential firms will enter the market in the long run due to the absence of barriers to entry. The market supply will increase which will lead to a fall in the market price. Potential firms will stop entering the market when the firms in the market make only normal profit. Market Representative firm In the above diagram, supernormal profit represented by the shaded area attracts potential firms into the market in the long run, resulting in the market supply curve (S) shifting to the right from S0 to S1. With the entry firms, the market price (P) falls from P0 to P1. At P1, since the firms in the market make only normal profit, the incentive for potential firms to enter the market disappears. If the firms in a PC market are making subnormal profit, they will leave the market when their fixed factor inputs need replacing. Those that cannot cover their total variable cost will leave the market immediately. The market supply will decrease which will lead to a rise in the market price. The exit of firms will stop when the firms in the market start making normal profit. © 2011 Economics Cafe All rights reserved. Page 9
  • 10. Written by: Edmund Quek Market Representative firm In the above diagram, subnormal profit represented by the shaded area induces the firms to leave the market, resulting in the market supply curve (S) shifting to the left from S0 to S1. With the exit of firms, the market price (P) rises from P0 to P1. At P1, since the firms in the market make normal profit, the incentive for the firms to leave the market disappears. 2.6 Short-run shut-down rule If a firm is making supernormal profit (TR  TC), it should continue production. If it is making subnormal profit (TR  TC), at first thought, it may seem that it should shut down production. However, this is not true in the short run. In the short run, a firm should continue production so long as its TR can at least cover its TVC (TR ≥ TVC). This is because fixed costs will be incurred whether the firm continues or shuts down production in the short run. Consider the following cases. Case 1: TR  TVC or AR  AVC If TR is less than TVC, the firm will make a loss equal to its TFC if it shuts down production. However, if it continues production, the excess of its TVC over its TR will add to its loss, in which case, it will make a loss greater than its TFC. Therefore, the firm should shut down production. However, it will still stay in the market. Case 2: TR  TVC or AR  AVC If TR is greater than TVC, the firm will make a loss equal to its TFC if it shuts down production. However, if it continues production, the excess of its TR over its TVC will offset a portion of its TFC, in which case, it will make a loss less than its TFC. Therefore, the firm should continue production. However, it will still stay in the market. © 2011 Economics Cafe All rights reserved. Page 10
  • 11. Written by: Edmund Quek Case 3: TR  TVC or AR  AVC If TR is equal to TVC, the firm will make the same amount of loss whether it continues or shuts down production. However, in this instance, the firm should continue production because in doing so, it may be able to make supernormal profit in the future if market conditions improve. In the event that market conditions deteriorate, the firm can shut down production without being worse off than if it shuts down production now. 2.7 Long-run shut-down rule In the long run, all costs are variable. Therefore, if a firm is making subnormal profit (TR  TC), it should shut down production and leave the market. In other words, in the long run, a firm should continue production only if its TR is greater than or equal to its TC (TR ≥ TC). 2.8 Derivation of the short-run supply curve of a firm under perfect competition The supply curve shows the quantity supplied at each price. In other words, given the price of a good, the quantity supplied is determined entirely by the supply curve. The portion of the MC curve above the AVC curve of a PC firm is the supply curve. In the above diagram, given the market price of the good (P0) that is determined by the market forces of demand and supply, the quantity supplied (Q0) is determined entirely by the MC. Intuitively, given the price of a good, the quantity supplied is determined by the marginal revenue and the marginal cost. However, in the case of a PC firm, price is equal to marginal revenue. Therefore, given the price of the good produced by a PC firm, the quantity supplied is determined entirely by the MC curve. Further, at a price lower than its AVC, the firm will shut down production to avoid making a loss greater than its TFC. Therefore, the supply curve of a PC firm is the portion of the MC curve above the AVC curve. © 2011 Economics Cafe All rights reserved. Page 11
  • 12. Written by: Edmund Quek 2.9 Perfect competition and the public interest Advantages Due to intense competition in the market, PC firms are not lax in cost control. In other words, they are not overstaffed, they do not lack the incentive to use the most efficient production technology, etc. Therefore, PC firms are x-efficient and hence productively efficient. A firm is allocatively efficient when it cannot change its output level and hence the allocation of resources in the economy in a way that will increase the total benefit for consumers and this occurs when it charges a price equal to its marginal cost, assuming no externalities. PC firms are allocatively efficient because they charge a price equal to their marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that they place on the amount of other goods that could have been produced using the same resources. Therefore, PC firms cannot change their output level to increase the total benefit for consumers and hence are allocatively efficient. The price charged by the firms in a PC market is lower than the price that would be charged by the firm in the same market operating under monopoly, assuming the cost structure of a monopoly is the same as that of a PC industry. In the above diagram, the PC price (PPC) is lower than the monopoly price (PM) and the PC output level (QPC) is higher than the monopoly output level (QM). The distribution of income in an economy that abounds with PC markets will be more equal than one that abounds with monopolistic markets because although PC firms can make only normal profit in the long run, a monopoly can make supernormal profit in the long run. © 2011 Economics Cafe All rights reserved. Page 12
  • 13. Written by: Edmund Quek Since PC firms produce the output levels which correspond to the lowest points on their AC curves, we say that they are producing at optimum capacity. Disadvantages A monopoly reaps more economies of scale than a PC industry and if this results in its MC curve being substantially lower than the horizontal summation of the MC curves of the firms in the same market operating under PC, it will produce a higher output level and charge a lower price. In the above diagram, due to substantial economies of scale, the monopoly price (PMC) is lower than the PC price (PPC). Due to lack of ability and willingness, PC firms do not engage in research and development. Due to perfect knowledge, any innovation, whether process or product, can easily and quickly be copied by other firms. Further, research and development very often requires huge expenditure outlays which PC firms are unable to finance and this is because they are small and they make only normal profit in the long run. PC firms produce homogeneous products which offer consumers no variety of choices. 3 MONOPOLY 3.1 Characteristics of monopoly A single large firm In a monopolistic market, there is a single large firm (known as the monopoly or the monopolist). Therefore, the output level of a monopoly is the market output level. Unique product A monopoly sells a unique product that has no close substitutes. © 2011 Economics Cafe All rights reserved. Page 13
  • 14. Written by: Edmund Quek A monopoly is a price-setter Due to lack of competition in the market, a monopoly is a price-setter in the sense that it is able to set its price by setting its output level. In other words, a monopoly faces a downward-sloping demand curve. Barriers to entry There are barriers to entry in a monopolistic market. The presence of barriers to entry in a monopolistic market allows a monopoly to make supernormal profit (TR  TC) in the long run. Note: In reality, a monopoly is not defined as a single large firm in a market that sells a unique product that has no close substitutes. For instance, in the UK, a monopoly is defined as a firm that has 25% or more of the share of the market. 3.2 Barriers to entry Definition A barrier to entry is an obstacle that is faced by potential firms which restricts them from entering and competing with the firm or firms in a market. Barriers to entry are the sources of monopoly power. Very substantial economies of scale A monopoly may emerge naturally because it can reap very substantial economies of scale and this occurs when the economies of scale are so substantial that the market can accommodate only one firm. In other words, a single firm can meet the market demand at an average cost which allows it to make supernormal profit. However, with two or more firms, all will make subnormal profit. With each firm catering to less than the market demand, there is simply no price that would allow the firms to cover cost. © 2011 Economics Cafe All rights reserved. Page 14
  • 15. Written by: Edmund Quek In the above diagram, the monopoly which faces the demand curve (D1) can make at least normal profit by producing anywhere within the output range from QMIN to QMAX. With two firms in the market, each firm faces the demand curve (D2), which lies entirely below the LRAC curve. Neither firm can make at least normal profit regardless of the output level. A monopoly that occurs due to this reason is known as a natural monopoly (which will be discussed in greater detail later). Financial barriers Some businesses require high start-up costs which not many firms are able to finance. Legal barriers A firm may have obtained its monopoly position through the acquisition of a patent or copyright. A patent is granted to an inventor to allow him the exclusive right to produce the product or use the production process that is patented. In the latter, potential firms cannot enter the market as they do not have access to the technology. The aim of awarding patents is to promote research and development. A copyright, similar to a patent, is granted on plays, textbooks, novels, songs, computer software, and the like. Today, patents and copyrights are commonly referred to as intellectual properties. Control of key factor inputs If a firm controls the supply of some key factor inputs, it can deny access to these factor inputs to potential rivals. Control of wholesale and retail outlets If a firm controls the outlets through which the product can be sold, it can prevent potential rivals from gaining access to consumers. © 2011 Economics Cafe All rights reserved. Page 15
  • 16. Written by: Edmund Quek 3.3 Revenue curves of a monopoly AR, MR and TR curves of a monopoly 3.4 Short-run equilibrium of a monopolistic market A monopoly is in short-run equilibrium when it is producing the profit-maximising output level. A monopolistic market is in short-run equilibrium when the monopoly is in short-run equilibrium, since it is the only firm in the market. However, this does not necessarily mean that the monopoly is making positive economic profit. Indeed, a monopoly in short-run equilibrium can make one of three types of profit: supernormal profit (positive economic profit), subnormal profit (negative economic profit or economic loss) and normal profit (zero economic profit). © 2011 Economics Cafe All rights reserved. Page 16
  • 17. Written by: Edmund Quek Supernormal profit (TR  TC or AR  AC) In the above diagram, at Q0 where MR is equal to MC, AR is greater than AC. Therefore, the firm is making supernormal profit represented by the shaded area. Subnormal profit (TR  TC or AR  AC) In the above diagram, at Q0 where MR is greater than MC, AR is less than AC. Therefore, the firm is making subnormal profit represented by the shaded area. © 2011 Economics Cafe All rights reserved. Page 17
  • 18. Written by: Edmund Quek Normal profit (TR  TC or AR  AC) In the above diagram, at Q0 where MR is equal to MC, AR is equal to AC. Therefore, the firm is making normal profit. 3.5 Long-run equilibrium of a monopolistic market Provided that a monopoly can sustain the barriers to entry, the short-run equilibrium will also be the long-run equilibrium. If a monopoly cannot reverse a subnormal-profit equilibrium in the long run, it will cease production and leave the market. In other words, in the long run, a monopoly can make supernormal or normal profit. Note that the former is impossible for the firms in PC market in the long run. 3.6 Short-run shut-down rule Refer to section 2.6. 3.7 Long-run shut-down rule Refer to section 2.7. 3.8 A monopoly does not have a supply curve Although the portion of the MC curve above the AVC curve of a PC firm is the supply curve, this is not true of a monopoly. © 2011 Economics Cafe All rights reserved. Page 18
  • 19. Written by: Edmund Quek In the above diagram, given the profit-maximising price of the good (P0) that corresponds to the output level where marginal revenue (MR) is equal to marginal cost (MC), the quantity supplied will be Q0’ if the MR curve is MR’. However, given the same price of the good (P0), the quantity supplied will be Q0” if the MR curve is MR”. Therefore, given the price of the good produced by a monopoly, not only is the quantity supplied determined by the MC curve, but it is also affected by the MR curve. Since the quantity of the good supplied by a monopoly is not determined entirely by the MC curve, the MC curve of a monopoly is not the supply curve. Indeed, given the price of the good produced by a monopoly, there is no single curve that entirely determines the quantity supplied. Therefore, a monopoly does not have a supply curve. 3.9 Monopoly and the public interest Advantages A monopoly reaps more economies of scale than a PC and MC industry and if this results in its MC curve being substantially lower than the horizontal summation of the MC curves of the firms in the same market operating under PC or MC, it will produce a higher output level and charge a lower price. Since a monopoly is large and it can make supernormal profit in the long run, it has the ability to engage in research and development. Successful product innovations will lead to greater product variety and successful process innovations will lead to a lower average cost of production and hence a lower price. The ability of a monopoly to practise price discrimination may be beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise would not be reached or to produce a good that otherwise would not be produced. Further, if the increase in profit from price discrimination is ploughed back into research and development, more benefits to consumers will be created. © 2011 Economics Cafe All rights reserved. Page 19
  • 20. Written by: Edmund Quek Disadvantages Due to lack of competition in the market, a monopoly may be lax in cost control. In other words, it may be overstaffed, it may lack the incentive to use the most efficient production technology, etc. Therefore, a monopoly may be x-inefficient and hence productively inefficient. However, if a monopoly faces potential competition, it may be x-efficient and hence productively efficient to prevent potential firms from entering the market. Even in the absence of potential competition, the sheer aim of making more profit may drive a monopoly to be x-efficient and hence productively efficient. A monopoly is allocatively inefficient because it charges a price higher than its marginal cost. When the price of a good is higher than the marginal cost, the marginal benefit that consumers place on the last unit of the good is greater than the forgone marginal benefit that they place on the amount of other goods that could have been produced using the same resources. Therefore, if a monopoly increases its output level, the total benefit for consumers will increase and hence is allocatively inefficient. In the above diagram, the deadweight loss, which is the loss of surplus due to market failure or government intervention, is represented by the shaded area. The price charged by the firm in a monopolistic market is higher than the price that would be charged by the firms in the same market operating under perfect competition or monopolistic competition, assuming the cost structure of a monopoly is the same as that of a PC industry and a MC industry. The distribution of income in an economy that abounds with monopolistic markets will be less equal than one that abounds with PC markets because although PC firms can make only normal profit in the long run, a monopoly can make supernormal profit in the long run. © 2011 Economics Cafe All rights reserved. Page 20
  • 21. Written by: Edmund Quek A monopoly does not produce the output level which corresponds to the lowest point on its AC curve, unless by chance. In other words, a monopoly is not producing at optimum capacity. Due to its big size, a monopoly may be able to exert pressure on the government to pass laws that may hurt other sectors of the economy. The ability of a monopoly to practise price discrimination may lead to a fall in the consumer surplus, which will be a welfare loss for consumers. 3.10 Natural monopoly A natural monopoly is a monopoly that emerges when the market can accommodate only one firm. An example is a public utility firm. A natural monopoly has two distinctive characteristics. First, it can reap very substantial economies of scale and hence its LRAC curve is falling over the entire range of market demand. In other words, its minimum efficient scale is high relative to the market demand. Second, it incurs very high start-up costs and hence its AC curve is falling over the entire range of the market demand. In the above diagram, the monopoly which faces the demand curve (D1) can make at least normal profit by producing anywhere within the output range from QMIN to QMAX. With two firms in the market, each firm faces the demand curve (D2), which lies entirely below the LRAC curve. Neither firm can make at least normal profit regardless of the output level. A monopoly that occurs due to this reason is known as a natural monopoly. © 2011 Economics Cafe All rights reserved. Page 21
  • 22. Written by: Edmund Quek In the above diagram, the profit-maximising output level (QM) where marginal revenue (MR) is equal to marginal cost (MC) is much lower than the allocatively efficient output level (QA) where price (P) is equal to marginal cost (MC). Therefore, if a natural monopoly increases its output level, the total benefit for consumers will increase significantly and hence is very allocatively inefficient. The government can pass a regulation that requires the monopoly to charge a price equal to its marginal cost to achieve allocative efficiency, assuming no externalities and the monopoly, and this is commonly known as marginal cost pricing. In the above diagram, the output level under marginal cost pricing (QMC) is equal to QA. However, in an attempt to make more supernormal profit, the monopoly may provide false information about its revenue and cost structures to the government. If this happens, the © 2011 Economics Cafe All rights reserved. Page 22
  • 23. Written by: Edmund Quek use of marginal cost pricing in a monopolistic market will not achieve allocative efficiency. Further, under such a pricing regulation, the monopoly will make a loss represented by the shaded area, because PMC is lower than AC at QMC. Therefore, the government has to give the monopoly a lump-sum subsidy to allow it to cover its loss. However, if the government is unwilling or unable to give the monopoly a lump-sum subsidy, marginal cost pricing will not be feasible. In the event that marginal cost pricing is unfeasible since it may cause the monopoly to make a loss, the government can pass a regulation that requires the monopoly to charge a price equal to its average cost to reduce allocative inefficiency and this is commonly known as average cost pricing. In the above diagram, the output level under average cost pricing (QAC) is closer to QA than QM is. However, the use of average cost pricing in a monopolistic market will not achieve allocative efficiency. The government can give a subsidy to the monopoly to induce it to increase output to achieve allocative efficiency. In the above diagram, a per-unit subsidy leads to a fall in the AC and the MC curves. If the new AC and the new MC curves are AC’ and MC’, the new profit-maximising output level (QM’) will be equal to QA. However, in an attempt to make more supernormal profit, the monopoly may provide false information about its revenue and cost structures to the government. If this happens, the use of subsidy in a monopolistic market will not achieve allocative efficiency. Further, since the subsidy will be financed by taxpayers and will increase the profit of the monopoly, the government is likely to refrain from using it to avoid hurting its popularity rating. © 2011 Economics Cafe All rights reserved. Page 23
  • 24. Written by: Edmund Quek The government can nationalize the market to produce the good itself to achieve allocative efficiency. If it seeks to maximise welfare, allocative efficiency will be achieved. However, advocates of privatisation argue that since a state-owned monopoly does not need to consider factors such as profitability and survival and does not face potential competition, it is more likely to be x-inefficient and hence productively inefficient than a private monopoly. 4 Monopolistic competition (MC) 4.1 Characteristics of monopolistic competition A large number of small firms In a MC market, there are a large number of small firms. Differentiated products In a MC market, the firms sell differentiated products that are close substitutes for one another. Differentiated products are products that are sufficiently similar to be distinguished as a group from other products. An example is restaurant foods. MC firms are price-setters Due to product differentiation, a MC firm is a price-setter in the sense that it is able to set its price by setting its output level. In other words, a MC firm faces a downward-sloping demand curve. However, due to the large number of substitutes in the market, the demand for the good produced by a MC firm is more price elastic than the demand for the good produced by a monopoly. No barriers to entry There are no barriers to entry in a MC market. The absence of barriers to entry in a MC market allows a MC firm to make only normal profit (TR  TC) in the long run. Note: Since MC firms sell differentiated products, there is no market demand and market supply in a MC market. 4.2 Revenue curves of a monopolistically competitive firm Refer to section 3.3. 4.3 Short-run equilibrium of a monopolistically competitive market Refer to section 3.4. © 2011 Economics Cafe All rights reserved. Page 24
  • 25. Written by: Edmund Quek 4.4 Long-run equilibrium of a monopolistically competitive market A MC market is in long-run equilibrium when the firms that wish to leave the market and the potential firms that wish to enter the market have done so. In other words, a MC market is in long-run equilibrium when the number of firms in the market is constant. In a MC market, this occurs when all the firms make normal profit. If the firms in a MC market are making supernormal profit, potential firms will enter the market in the long run due to the absence of barriers to entry. As the number of firms in the market increases, each firm will have a smaller market share. In other words, the demand curve that each firm faces will shift to the left which will lead to a fall in its profit. Potential firms will stop entering the market when the firms in the market make only normal profit. If the firms in a MC market are making subnormal profit, they will leave the market when their fixed factor inputs need replacing. Those that cannot cover their total variable cost will leave the market immediately. As the number of firms in the market decreases, each firm will have a larger market share. In other words, the demand curve that each firm faces will shift to the right which will lead to a fall in its loss. The exit of firms will stop when the firms in the market start making normal profit. 4.5 Monopolistic competition and the public interest Advantages Due to intense competition in the market, MC firms are not lax in cost control. In other words, they are not overstaffed, they do not lack the incentive to use the most efficient production technology, etc. Therefore, MC firms are x-efficient and hence productively efficient. Due to intense competition and the absence of barriers to entry in a MC market, the price charged by the firms in a MC market is lower than the price that would be charged by the firm in the same market operating under monopoly, assuming the cost structure of a monopoly is the same as that of a MC industry. The distribution of income in an economy that abounds with MC markets will be more equal than one that abounds with monopolistic markets because although MC firms can make only normal profit in the long run, a monopoly can make supernormal profit in the long run. MC firms produce differentiated products which offer consumers a great variety of choices. Disadvantages MC firms are allocatively inefficient because they charge a price higher than their marginal cost. When the price of a good is higher than the marginal cost, the marginal benefit that consumers place on the last unit of the good is greater than the marginal benefit that they © 2011 Economics Cafe All rights reserved. Page 25
  • 26. Written by: Edmund Quek place on the amount of other goods that could have been produced using the same resources. Therefore, if MC firms increase their output level, the total benefit for consumers will increase and hence are allocatively inefficient. However, the problem of allocative inefficiency in a MC market is less severe than that in a monopolistic market because the price elasticity of demand for the good produced by a MC firm is higher than that for the good produced by a monopoly. A monopoly reaps more economies of scale than a MC industry and if this results in its MC curve being substantially lower than the horizontal summation of the MC curves of the firms in the same market operating under MC, it will produce a higher output level and charge a lower price. The price charged by the firms in a MC market is higher than the price that would be charged by the firms in the same market operating under PC. In the above diagram, the PC price (PPC) is lower than the MC price (PMC). Due to lack of ability and willingness, MC firms do not engage in research and development. Due to the absence of barriers to entry, any innovation, whether process or product, can easily and quickly be copied by other firms. Further, research and development very often requires huge expenditure outlays which MC firms are unable to finance and this is partly because they small and partly because they make only normal profit in the long run. Since MC firms do not produce the output levels which correspond to the lowest points on their AC curves, we say that they are producing with excess capacity (or producing under capacity). Due to intense price and non-price competition, MC firms may spend excessively on advertising. © 2011 Economics Cafe All rights reserved. Page 26
  • 27. Written by: Edmund Quek 5 Oligopoly 5.1 Characteristics of oligopoly A small number of large firms In an oligopolistic market, there are a small number of large firms. Hence, the output level of each firm in an oligopolistic market is large relative to the market output level. Homogeneous or differentiated products Although the firms in some oligopolistic markets sell homogeneous products (e.g. cement and steel), the firms in most oligopolistic markets sell differentiated products (e.g. cars and electrical appliances). Oligopolists are price-setters Due to its large market share, an oligopolist is a price-setter in the sense that it is able to set its price by setting its output level. In other words, an oligopolist faces a downward-sloping demand curve. Barriers to entry There are barriers to entry in an oligopolistic market, although they are often lower than the barriers to entry in a monopolistic market. The presence of barriers to entry in an oligopolistic market allows an oligopolist to make supernormal profit (TR  TC) in the long run. Strategic interdependence (also known as mutual interdependence) Due to the small number of large firms in an oligopolistic market, the actions of one firm affect, and are affected by the actions of its rivals. Therefore, if a firm in an oligopolistic market changes the price or the specification of its product, the sales of its rivals will be affected. The rivals will then respond by changing the price and the specifications of their product, which will affect the sales of the first firm. Therefore, no firm in an oligopolistic market can ignore the actions and the reactions of the other firms in the market. Note: Oligopoly is the dominant market structure for the production of goods. However, for the provision of services, monopolistic competition is more prevalent. 5.2 Collusive versus competitive (non-collusive) behaviour On the one hand, the interdependence of oligopolists gives them the incentive to collude because they will be better off if they to jointly maximise profit. On the other hand, they are tempted to compete with each other to gain a bigger market share. Therefore, oligopolists may either collude or compete. Collusive behaviour © 2011 Economics Cafe All rights reserved. Page 27
  • 28. Written by: Edmund Quek If oligopolists collude, there will be price stability. Oligopolists can collude by banding together to agree on a common price higher than the price that they currently charge and this is commonly known as cartelisation. To avoid a surplus of the goods, they must also agree on a set of output quotas and the most likely method is for them to divide the market among themselves according to their current market shares. There are certain factors that favour cartelisation. Cartelisation is more likely in a market where there are only a few firms, the firms produce homogeneous products, the firms have the same cost structure and there are high barriers to entry and therefore there is little fear of disruption by potential firms. In reality, cartelisation is illegal in many parts of the world due to competition policy (known as anti-trust laws in the US), where any attempt to distort competition is prohibited. Despite that, oligopolists can collude covertly and this is commonly known as tacit collusion. Tacit collusion usually takes the form of price leadership where the followers keep to the price set by the leader. The price leader may be the firm with the largest market share (known as the dominant firm price leadership) or the firm which is believed to have the most information about market conditions (known as the barometric firm price leadership). Competitive (Non-collusive) behaviour At first thought, if oligopolists do not collude, price war will be inevitable. However, price stability has been found to be an empirical regularity in most oligopolistic markets, even in those where the firms do not collude. This phenomenon can be explained by the theory of the kinked demand curve which is based on two asymmetrical assumptions. First, if a firm in an oligopolistic market increases its price, its rivals will not follow suit because by keeping their price the same, they can attract customers from the firm. Accordingly, if a firm in an oligopolistic market increases its price, its quantity demanded will decrease by a larger percentage as customers will switch from the firm to the rivals which will lead to a fall in revenue for the firm. Second, if a firm in an oligopolistic market reduces its price, its rivals will follow suit to prevent losing customers to the firm. Accordingly, if a firm in an oligopolistic market reduces its price, its quantity demanded will increase by a smaller percentage as customers will not switch from the rivals to the firm, which will lead to a fall in revenue for the firm. Therefore, oligopolists do not have the incentive to change their price, assuming no substantial changes in the cost of production. The theory of the kinked demand curve can be illustrated with a diagram. A firm in an oligopolistic market faces a demand curve that is kinked at the current equilibrium, and the kink on the demand curve leads to the gap on the MR curve. © 2011 Economics Cafe All rights reserved. Page 28
  • 29. Written by: Edmund Quek Kinked demand curve In the above diagram, since the current price and the current output level are P0 and Q0, the MC curve must be cutting the MR curve at the gap. A small change in the cost of production will lead to a shift in the MC curve but so long as the new MC curve lies between MC’ and MC”, the price will remain unchanged and this explains price stability in oligopolistic markets where the firms do not collude. However, if there is a large change in the cost of production, the new MC curve will shift out of the range between MC’ and MC” which will lead to a change in the price and the output level. In this case, the firms may plunge into a price war before they reach a new equilibrium. The new demand curve will be kinked at the new equilibrium. One limitation of the theory is that it does not explain how the price is set in the first place. Further, price stability could be due to other factors. For example, oligopolists may not want to change price too frequently to prevent upsetting customers. 5.3 Non-price competition Firms engage in non-price competition through product development and product promotion. Product development will improve the quality and the features of the good and product promotion will increase the awareness and the appeal. Successful product development and product promotion will not only lead to an increase in the demand for the good, but they will also make the demand less price elastic as consumers will perceive the good to be more different from its substitutes. In other words, successful product development and product promotion will shift the demand curve of the good to the right and make it steeper. © 2011 Economics Cafe All rights reserved. Page 29
  • 30. Written by: Edmund Quek 5.4 Oligopoly and the public interest If oligopolists collude, they will effectively be acting like a monopoly. In this instance, the advantages and disadvantages to society experienced under monopoly will also be experienced under oligopoly. However, oligopoly may be more disadvantageous than monopoly in two respects. First, an oligopolist is likely to be smaller than a monopoly. Therefore, it may reap less economies and hence charge a higher price. Second, an oligopolist is more likely to engage in excessive advertising than a monopoly. Therefore, it is likely to produce at a higher average cost and hence charge a higher price. If oligopolists compete, oligopoly may be more advantageous than a monopoly in two respects. First, unlike a monopoly may not be x-efficient and hence productively efficient due to competition in the market, an oligopolist is x-efficient and hence productively efficient. Second, unlike a monopoly which may not have the incentive to engage in research and development due to lack of competition in the market, an oligopolist has the incentive to engage in research and development due to competition in the market. Successful product innovations will lead to greater product variety and successful process innovations will lead to a lower average cost of production and hence a lower price. © 2011 Economics Cafe All rights reserved. Page 30

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