Lecture 9: Competition and Market Power

Question 1

What sort of profits does a perfect competition (PC) firm make

Answer 1

normal profits

Question 2

Does a PC (perfect competition) firm have market power?

Answer 2

• No
• They have no power to set price.
• Firms in PC are called price takers.

Question 3

What are PC firm’s goals?

Answer 3

• A PC firm must maximise profit to survive.
• Every firm’s goal would be to make super-normal profit.

Question 4

What is profit

Answer 4

the difference between revenue and costs

Total Revenue - Total Costs

P = TR – TC

Question 5

What does a firm need to do to maximise profits?

Answer 5

• Not necessarily focusing on maximising revenue
• Not necessarily focusing on minimising costs
• Focus on increasing the gap between the two

Question 6

What is marginal revenue?

Answer 6

• the addition to total revenue by
• the production and sale of one more unit.

Question 7

What is marginal cost

Answer 7

• the additional to total cost incurred by producing one more unit.

Question 8

What happens if MR is bigger than MC?

Answer 8

• profit can be increased by increasing output, because more will be added to revenue than costs.

Question 9

What happens if MR is smaller than MC

Answer 9

• we make a loss on this extra unit therefore profit can be increased by decreasing output.

Question 10

What happens if MR=MC

Answer 10

• then nothing can be gained by either increasing or decreasing output.

Question 11

What is the profit maximisation rule?

Answer 11

Produce where MR=MC

Question 12

What is The marginalist principle?

Answer 12

Defined

• NB = TB – TC
• NB is maximised where MB = MC
• NB = Net Benefit
• TB = Total Benefit

Question 13

What is the principal-agent problem?

Answer 13

• The principal-agent problem arises where the principal and the agents incentives don’t align
• there is sometimes a gap in knowledge
• eg. Car mechanic saying you need repairs

Do you trust that he’s telling the truth?

You are the principal

Mechanic is the agent

Your incentive is to not spend so much money, his incentive might be to get your money

Issue lies where you don’t get things repaired and wait until your car breaks down

Question 14

How do we solve the principal - agent problem?

Answer 14

• Institutional controls - example Board of Directors.
• Share price - bad performance leads to threat of takeover.
• Remuneration schemes with part of remuneration at risk – stock options.

Question 15

Use the marginalised principle for wages

Answer 15

MC=MB

MC = wage rate (w)

MB = value of extra unit of labour produces

extra unit of labour produces a marginal product (MP)

MB=MRP

MP times MR (marginal revenue product)

• Optimal quantity of labour is found where
  
  • w=MRP

Question 16

What are the limitations of neoclassical view of labour?

Answer 16

• Labour is not bought and sold like other goods.
• Once hired it still has to be trained, motivated …
• “Units of labour” are heterogeneous … all different

Question 17

What are transaction costs?

Answer 17

• Represent the costs that arise in striking a deal in the market, a cost incurred in making an economic exchange.
• Transaction costs can be especially high for labour.
• Labour is hired long-term to lower transaction costs.

Question 18

How do firms balance between transaction costs and managerial costs?

Answer 18

• Find the balance of what can be done internally and what needs to be done externally
• eg. consider the airline industry and the following costs:

maintenance, airport services, catering and bookings … which ones make sense to do “in house” and which ones would it be better to “outsource”?

Question 19

How can a firm sustain market power?

Answer 19

• The rational firm maximises profit.
• The perfectly competitive firm MUST maximise profit because it makes only normal profit.
• No firm wants to be working under perfect competition so it will strive to be in a position to exert market power to make super-normal profit.

Question 20

Define monopoly

Answer 20

• At the other extreme of market
• structure from perfect competition.
• Only one firm
• Firm IS the market.
• Monopolist need not profit maximise to survive.
• Unlike PC, can make super-normal profit.
• The monopolist chooses to restrict quantity and therefore increase price.
• Might not want to make its position look too good!

Question 21

As a monopoly increases price, it?

Answer 21

It reduces CS and Total surplus

Question 22

What are the components of the case against monopolies?

Answer 22

• Static: the deadweight loss – causes a loss in total surplus (economic welfare)
• Dynamic: X-inefficiency, slack!

Question 23

What is an oligopoly

Answer 23

• A few firms dominate the industry.
• More like what “competition” means in everyday terms.
• Examples: supermarkets, petrol supply, commercial TV
• Oligopolists prefer non-price competition. (branding, loyalty, marketing)

Question 24

Why might a monopoly not want to make it’s position look good?

Answer 24

• Very high profits can attract new entrant or attract attention of regulators! (for abusing market power/ripping off consumers).

Question 25

What are some strategies to keep market power?

Answer 25

* Architecture – corporate culture, strong relationship with suppliers, customers and staff. * Reputation – customer loyalty. * Innovation – keep the leading position. * Economies of scale. A natural monopoly exists if average costs keep falling as output rises. * Exclusive ownership of resources or know-how.

Question 26

what are some examples of unfair ways to keep market power?

Answer 26

* Predatory pricing – cut prices very low when rivals enter the market. * Dumping – selling below cost. * Limit-pricing – selling below the profit-maximising level but not incurring in a loss. * Concealment of profits – costs inflated to make the industry look unattractive or continued investment to indicate that the industry requires a lot of investment in capital.