Chapter 9 Flashcards
What does market structure refer to?
All the features of a market that affect the behaviour and performance of firms in that market, such as the number and size of sellers, the extent of knowledge about one another’s actions, the degree of freedom of entry, and the degree of product differentiation.
When do firms have market power?
When they can influence the price of their product.
When is a market competitive?
- A market is said to be competitive when its firms have little or no market power.
- The more market power the firms have, the less competitive is the market.
- The extreme form of competitive market structure occurs when each firm has zero market power.
- This extreme is called a perfectly competitive market
What is competitive behaviour?
Refers to the degree to which individual firms actively vie with one another for business.
Examples:
- MasterCard and Visa engage in competitive behaviour but their market is not competitive
- Two wheat farmers do not engage in competitive behaviour but they both exist in a very competitive market
What are the assumptions of perfect competition? [4]
- All firms sell a homogenous product
- Customers know the nature of the product being sold and the prices charged by each firm
- The level of each firm’s output at which its long-run average cost reaches a minimum is small relative to the industry’s total output
- The industry is characterized by freedom of entry and exit.
Compare firm and industry demand curves. [2]
- Although the firm faces a perfectly elastic demand, the firm cannot sell an infinite amount at the going price.
- The horizontal demand curve indicates, rather, that any realistic variations in the firm’s production will leave the price unchanged because the effect on the total industry output will be negligible.
Discern between total, average, and marginal revenue.
- Total revenue is the total amount received by the firm from the sale of a product.
- TR = P x Q
- Average revenue is the amount of revenue per unit sold.
- AR = (P x Q)/Q = P
- Marginal revenue is the change in a firm’s total revenue resulting from a change in its sales by one unit.
- MR = ΔTR/ΔQ = P
- For a competitive price-taking firm, the market price is the firm’s marginal (and average) revenue
Describe short-run decisions based on the firm’s objective.
- The firm’s objective is to maximize profits:
- Profits = TR - TC
- If total revenues are not enough to cover total costs, economic profits will be negative, and we say the firm is making economic losses.
When should a firm produce?
- If the firm produces nothing, it will have an operating loss that is equal to its fixed costs.
- If the firm decides to produce, it will add the variable cost of production to its costs.
- Since it must pay its fixed costs in any event, it will be worthwhile for the firm to produce as long as it can find some level of output for which revenue exceeds variable cost.
- If revenue is less than its variable cost, the firm will lose more by producing than by not producing at all.
When should a firm not produce at all?
- If, for all levels of output, total revenue is less than total variable cost.
- Equivalently, the firm should not produce at all if, for all levels of output, the market price is less than average variable cost.
- The shut down price is the price that is equal to the minimum of a firm’s average variable costs.
- At prices below this, a profit-maximizing firm will produce no output.
What is the shut-down price?
The price that is equal to the minimum of a firm’s average variable costs.
How much should a firm produce?
- If a firm decides that production is worth undertaking, then it must decide how much to produce.
- If any unit of production adds more to revenue than it does to cost, producing and selling that unit will increase profits.
- So a unit of production raises production if the marginal revenue obtained from selling it exceeds the marginal cost of producing it.
- If it is worthwhile for the firm to produce at all, the profit-maximzing firm should produce the output at which marginal revenue equals marginal cost.
How does a firm choose level of output?
- The market determines the equilibrium price. The firm then picks the quantity of the output that maximizes its own profits.
- When the firm is producing Q*, it has no incentive to change its output.
How does the firm choose the level of output which profits are maximized?
- The profit maximizing level of output is the point at which price (marginal revenue) equals marginal cost.
- When the firm is producing Q*, it has no incentive to change its output.
Describe the derivation of the supply curve for a competitive firm.
- A competitive firm’s supply curve is given by the marginal cost curve that is above its average variable cost curve.
Describe the derivation of a competitive industry’s supply curve.
- In perfect competition, the industry supply curve is the horizontal sum of the marginal cost curves (above the level of average variable cost) of all the firms in the industry.
Describe short-run equilibrium in a competitive market. [2]
- When an industry is in short-run equilibrium, the quantity demanded equals quantity supplied, and each firm is maximizing its profits given the market price.
- When the industry is in short-run equilibrium, a competitive firm may be making losses, breaking even, or making profits.
Describe the effect of new entrants attracted by positive profits. [3]
- Positive profits attract new firms.
- Entry leads to an increase in supply. The market supply curve shifts rightward and the price falls.
- Entry stops when all firms are just covering their total costs.
Describe the effect of exit caused by losses.
- Eventual exit of some firms as their capital becomes obsolete/costly
- This exit increases the equilibrium price and increases profits for firms remaining in the market.
Describe short-run versus long-run profit maximization for a competitive firm.
- At Q0, the firm is maximizing short-run profits but not long-run profits.
Describe a typical competitive firm when the industry is in long-run equilibrium.
- In the long-run competitive equilibrium, each firm is operating at the minimum point on its LRAC curve
Describe plants of different vintages in an industry with competitive technological progress. (i.e., changes in technology)
- Consider a competitive industry in long-run equilibrium. Price is equal to average total cost of the existing plants.
- Now suppose that some technological development lowers the cost of newly built plants.
- Plants with new technology earn economic profits. Other new plants enter the industry.
- Expanding industry output drives the price down to equal short-run average total cost of the new plants.
- Plants with old technology may continue, but they will earn losses and eventually exit.
What are the two rules that any firm (any market structure) must follow?
-
Should the firm produce at all?
- “must cover day-to-day costs”
- TR ≥ TVC
- P ≥ AVC
- AR ≥ AVC
-
If so, how much should it produce?
- “marginal profits”
- MR = MC
- MB = MC
What is the general methodology to find maximizing output? [4]
- MR = MC, to find Q1
- TR = P1 x Q1
- TC = AC1 x Q1
- Economic profit = TR - TC = (P1 - AC1) x Q1
