2.2 the firm and market structures

Question 1

Economists’ Four Types of Structure

Answer 1

Perfect Competition

Monopolistic Competition

oligopoly

monopoly

Question 2

Perfect Competition

Answer 2

Markets with perfect competition have homogeneous (i.e., identical) products with no producer large enough to influence the price

Profits are driven to the minimum required to raise capital

Question 3

Monopolistic Competition

Answer 3

This type of market also has a large number of firms, but the products are differentiated

Soft drinks and cosmetics fall into this category.

Question 4

oligopoly

Answer 4

The oligopoly market structure has only a few firms supplying the market. Retaliatory strategies must be considered when changing prices or production levels

The airline industry is an oligopoly.

Question 5

Monopoly

Answer 5

This is the least competitive market structure. There is a single seller and no substitutes for the product. The seller has much control over the prices, but often regulated by governments

Local utility companies often fall into this category.

Question 6

Factors that Determine Market Structure

Answer 6

Numbe of Sellers

Degree of Product Differentiation

Barriers to Entry

Pricing Power of Firm

Non-Price Competition

Question 7

Perfectly competitive markets will lead to which type of demand curves

Answer 7

horizontal demand schedules

At a given price, the quantity demanded is infinite.

For example, a farmer can sell all his corn at the market price but none at a higher price

Question 8

Vertical demand schedules

Answer 8

exist when a fixed quantity is demanded, regardless of the price.

For example, a diabetic consumer that relies on insulin will not consume less if the price goes up.

This is a case of perfect price inelasticity

Question 9

Consumer surplus

Answer 9

the value placed on the units purchased less the amount paid.

It represents the “bargain” earned by consumers that pay less than they would be willing to pay

Question 10

a marginal value curve

Answer 10

The negatively sloped demand curve can be considered a marginal value curve because it shows the highest price a consumer would be willing to pay for each additional unit

Question 11

Supply Analysis in Perfectly Competitive Markets

Answer 11

The supply functions for individual firms have positive slopes.

This means when the price per unit increases, the firms will supply a greater quantity of the product

Question 12

Optimal Price and Output in Perfectly Competitive Markets

Answer 12

The market supply and demand functions can be set equal to each other to find the equilibrium price and quantity

The demand curve faced by each firm in a perfectly competitive market is horizontal, even if the whole market demand curve is downward sloping

Question 13

Factors Affecting Long-Run Equilibrium in Perfectly Competitive Markets

Answer 13

In the long run, as more firms enter into a perfectly competitive market, the industry supply curve will shift to the right (more quantities are produced with the same price) and a perfectly competitive firm will operate with zero economic profit

The equilibrium price will equal the marginal cost, which will also equal the minimum average cost

Question 14

Demand Analysis in Monopolistically Competitive Markets

Answer 14

The demand curve for each firm will have a negative slope – lowering the price will increase the quantity demanded.

Demand is more elastic at higher prices

Question 15

The profit-maximization point in the short run in Monopolistically Competitive Markets

Answer 15

where marginal revenue equals marginal cost

Question 16

Supply Analysis in Monopolistically Competitive Markets

Answer 16

In monopolistic competition, the supply function is not well-defined. The price charged is based on the market demand schedule. The firm must calculate the optimal quantity to supply at various prices

Question 17

Factors Affecting Long-Run Equilibrium in Monopolistically Competitive Markets

Answer 17

Economic profit will attract competition.

In the long run, economic profit will fall to zero in monopolistically competitive markets.

However, the equilibrium quantity will be less than it would be in a market with perfect competition

Question 18

three pricing strategies in non-colluding oligopoly markets

Answer 18

Pricing Interdependence

Cournot Assumption

Game Theory/Nash Equilibrium

Question 19

Pricing Interdependence

Answer 19

This situation exists in any market with price wars.

–> A common example is airlines that serve the same cities

It is common to assume competitors will match price reductions and ignore price increases. This means market share will increase when competitors increase their prices but stay about the same when price drops are matched

Question 20

the effect of pricing Interdependence on elasticity

Answer 20

the elasticity is greater for price increases than decreases.

Question 21

Cournot Assumption

Answer 21

each firm determines its profit-maximizing production level assuming all the other firms will not change their output.

In the long run, the equilibrium output and price are stable

Question 22

The equilibrium price under the Cournot assumption

Answer 22

will be between the equilibrium prices of the monopoly and competitive market.

As the number of firms increases, the Cournot equilibrium price will move closer to the competitive market equilibrium price

Question 23

Game Theory/Nash Equilibrium

Answer 23

the pricing strategy is set when no firm has an incentive to change.

Each firm does the best it can given the reaction of its rivals

This approach assumes each firm is acting in their own best interest without price collusion. The resulting market equilibrium may not maximize the total profits for all firms.

Question 24

cartels

Answer 24

Open collusive agreements

Question 25

Collusion is more likely to be successful under the following conditions

Answer 25

1. There are just a few firms or one of the firms is dominant.

–> Firms should not all have similar market shares. Otherwise, the competitive forces would overshadow the benefits of collusion.

2. Products are homogeneous.
3. Firms have similar cost structures.
4. Order sizes are small and deliveries are frequent.
5. There is a threat of severe retaliation from competitors for breaking a collusive agreement.
6. Collusion among incumbent firms is likely to be a barrier to new entrants

Question 26

The Stackelberg model

Answer 26

another potential strategy based on game theory.

This theory assumes moves are made sequentially, whereas Cournot assumes they are made simultaneously.

Under the Stackelberg model, the leader firm has a distinct advantage

Question 27

Supply Analysis in Oligopoly Markets

Answer 27

The optimal output for a firm in an oligopoly market is dependent on the demand conditions and the competitor’s strategies

Question 28

when is profit maximized in an Oligopoly?

Answer 28

Profit is still maximized when marginal revenue equals marginal cost

Question 29

The dominant (or leader) firm in an Oligopoly

Answer 29

generally is the price maker

Typically, the dominant firm has a lower cost structure, which makes it unlikely other firms will start a price war

The dominant firm will set the price where its marginal cost equals its marginal revenue

The total market demand curve will have a steeper slope than for the leader because the leading firm will capture a larger percentage of the total market at lower prices

Question 30

Optimal Price and Output in Oligopoly Markets

Answer 30

Optimal Price and Output in Oligopoly Markets

Question 31

Factors Affecting Long-Run Equilibrium in Oligopoly Markets

Answer 31

Over time, the market share of the dominant firm typically declines as other firms become more efficient

Pricing wars should be avoided because they only lead to temporary market share gains

To maintain their dominant positions, oligopolistic firms must innovate.

Question 32

Supply Analysis in Monopoly Markets

Answer 32

The profit is maximized when marginal revenue equals marginal cost

Question 33

Demand Analysis in Monopoly Markets

Answer 33

The monopolist’s demand schedule is the aggregate demand for the product. It has a typical negative slope.

The marginal revenue has a steeper slope, and it is twice as much if the demand schedule is linear

Question 34

how to find the the marginal revenue and marginal cost in a Monopoly market?

Answer 34

Both the marginal revenue and marginal cost can be calculated by taking the derivative of the total revenue and total cost function

The optimal output and price can be calculated by setting the marginal revenue equal to the marginal cost

Question 35

first-degree price discrimination

Answer 35

the monopolist charges a price to take the entire consumer surplus

A different price is charged to each client depending on the highest price they are willing to pay for a product

Question 36

second-degree price discrimination

Answer 36

the monopolist allows consumers to select various options of quantity or quality.

Consumers that value the product more are charged more.

Question 37

Third-degree price discrimination

Answer 37

segregates consumers by demographic or other traits

Question 38

Factors Affecting Long-Run Equilibrium in Monopoly Markets

Answer 38

An unregulated monopoly structure can maintain its position over the long run by using substantial barriers to entry

Governments tasked with regulating monopolies have a number of long-run solutions

Question 39

Government solutions against Monopoly barriers to entry

Answer 39

1. Set price equal to marginal cost: Subsidies will be required if the marginal cost is less than the long-run average cost (LRAC).
2. Nationalization: Government ownership often hinders the monopoly’s ability to impose politically unpopular price increases.
3. Authorized monopolies: If the price is set to equal LRAC, investors will earn a normal profit for their level of risk. However, it can be difficult for regulators to determine a realistic LRAC.
4. Franchising monopolies through a competitive bidding process: Examples include retail stores at airports and rail stations.

Question 40

The concentration ratio

Answer 40

the sum of the market shares of the N largest firms

The result will be a number between 0 and 1.

However, a high concentration ratio does not necessarily imply market power. Just the threat of new entrants could force a firm to act in a competitive manner.

Also, the ratio is not affected by the mergers of the top players in the market

Question 41

The Herfindahl-Hirschman index (HHI)

Answer 41

attempts to fix some of the issues with the concentration ratio

The HHI is the sum of the squared market shares of the
largest firms

The HHI still does not take into account the possibility of new entrants