Perfect competition, monopoly, and shut-down Flashcards
(17 cards)
Review of key conditions for a perfectly competitive industry:
What is the Herfindahl-Hirschman Index (HHI) for a perfectly competitive industry?
What type of products are offered in a perfectly competitive industry?
What are the entry and exit conditions for firms in a perfectly competitive industry?
How do firms behave in terms of pricing in a perfectly competitive industry?
What is the level of information available to consumers in a perfectly competitive industry?
What is the Herfindahl-Hirschman Index (HHI) for a perfectly competitive industry?
- HHI = 0
What type of products are offered in a perfectly competitive industry?
- Homogenous products
What are the entry and exit conditions for firms in a perfectly competitive industry?
- Free entry and exit
How do firms behave in terms of pricing in a perfectly competitive industry?
- All firms are price takers (therefore all face the same industry demand curve)
What is the level of information available to consumers in a perfectly competitive industry?
- Perfect information in the marketplace (therefore consumers will only purchase from the lowest-cost firm)
Demand at the Level of the Market and the Firm (picture, two graphs)
What is the supply function of the industry?
What condition must the MC function meet?
Why must the firm cover its short-run average costs (SRAC) to produce any output?
What is the supply function of the industry?
- The supply function of the industry is the sum of each firm’s short-run marginal cost (SRMC) function: (see picture)
What condition must the MC function meet?
- The MC function must be above the minimum point of the firm’s short-run average cost function.
Why must the firm cover its short-run average costs (SRAC) to produce any output?
- To produce any output, the firm must at least cover its short-run average costs (SRAC); the minimum price a firm is willing to accept is determined by the intersection of SRMC and SRAC, and points above this show the firm’s supply function.
Short Run Quantity Decision: Revenue-Cost Approach (picture of graph)
Why does the cost function have a positive intercept?
What condition must be met for profit (π) maximization?
What does it mean that MC is not decreasing?
Why does price (P) equal marginal revenue (MR) in a perfectly competitive industry?
What is the significance of P = MC in profit maximization?
Why does MC = MR not necessarily mean profits are earned?
Why does the cost function have a positive intercept?
- The cost function has a positive intercept because fixed costs exist, which must be paid regardless of the level of output.
What condition must be met for profit (π) maximization?
- Profit maximization requires marginal cost (MC) to equal marginal revenue (MR).
What does it mean that MC is not decreasing?
- It ensures the cost function behaves correctly and does not lead to negative marginal costs.
Why does price (P) equal marginal revenue (MR) in a perfectly competitive industry?
- Firms in a perfectly competitive industry are price takers, meaning they can sell any quantity at the market price, making P = MR.
What is the significance of P = MC in profit maximization?
- It means the firm produces the quantity where the cost of making an extra unit equals the revenue gained from selling it.
Why does MC = MR not necessarily mean profits are earned?
- While MC = MR determines the optimal production level, profit depends on the gap between total revenue and total costs, not just marginal values.
Short Run Quantity Decision: Marginal Approach
What does MC = MR yield?
How is profit calculated at Q*?
How does profit affect incumbent firms in the short run?
How does profit impact industry entry in the long run?
What happens to total supply over time?
What condition holds at long-run equilibrium?
What defines short-run equilibrium?
What is the condition for price at short-run equilibrium?
Picture of graph
What does MC = MR yield?
- MC (Marginal Cost) equals MR (Marginal Revenue), which determines the quantity Q*.
How is profit calculated at Q*
- Profit is the difference between Average Revenue (AR) or Price (P) and Average Total Cost (ATC) at Q*.
How does profit affect incumbent firms in the short run?
- Profit encourages firms already in the industry to expand their supply.
How does profit impact industry entry in the long run?
- Profit attracts new firms to enter the industry in the long run.
What happens to total supply over time?
- Total supply increases until long-run equilibrium is achieved.
What condition holds at long-run equilibrium?
- P (AR) equals the minimum Long-Run Average Total Cost (LRATC) when MC = MR.
What defines short-run equilibrium?
- Short-run equilibrium occurs when market supply and demand balance temporarily.
What is the condition for price at short-run equilibrium?
- P (AR) equals the minimum Short-Run Average Total Cost (SRATC) when MC = MR.
Is adjustment instantaneous?
If all firms are ‘identical’ and there are no exit or entry costs, what might this imply?
What happens if the change in demand is not persistent?
What occurs if the change in demand is persistent?
How do the previous diagrams work in reverse?
Is adjustment instantaneous?
- Adjustment speed depends on various factors, including firm flexibility and market conditions.
If all firms are ‘identical’ and there are no exit or entry costs, what might this imply?
- It implies that firms can quickly enter or exit the market without facing additional financial burdens, leading to a dynamic equilibrium.
What happens if the change in demand is not persistent?
- Incumbent firms adjust their supply accordingly without new firms entering the industry.
What occurs if the change in demand is persistent?
- New firms enter the market, and existing firms modify their scale of operations until equilibrium is reached.
How do the previous diagrams work in reverse?
- If firms incur losses, some exit the industry, reducing supply until equilibrium is restored.
Effects of Entry and Exit on Market Price and Firm Profit
Summary of Effects (3)
Summary of Effects
- Entry of new firms increases overall supply, reducing the market price.
- Lower market prices decrease the revenue for individual firms, impacting their profitability.
- Exit of firms (reverse effect) would shift supply left, increasing market price and improving firm profitability.
Always start by calculating the profit maximising level of output
What is economic rent?
What happens if price equals ATC?
What happens if price is less than ATC?
Under what conditions should a firm stay in business despite losses?
What does it mean if price equals the minimum SAVC?
When should a firm shut down?
What is economic rent?
- If ( P ) (AR) > ATC, profits are earned (economic rent).
What happens if price equals ATC?
- Normal profits are earned (transfer payment).
What happens if price is less than ATC?
- The firm incurs losses.
Under what conditions should a firm stay in business despite losses?
- If SAVC < P (AR) < ATC, the firm covers variable costs and contributes to fixed costs, so it should stay in business.
What does it mean if price equals the minimum SAVC?
- The firm is indifferent between continuing production and shutting down.
When should a firm shut down?
- If ( P ) (AR) < min SAVC, the firm should shut down.
What is a monopoly?
What are the characteristics of a monopoly? (5)
What are the determinants of a monopoly? (2)
What is a monopoly?
- A single firm supplies the entire market for a product.
What are the characteristics of a monopoly?
- No close substitutes exist.
- Cn HHI = 1.
- Barriers to entry prevent competition, leading to ( P > ATC ) in the long run.
- The firm’s demand curve is the same as the market demand curve.
- The monopolist can set price or output, but not both.
What are the determinants of a monopoly?
- Structural factors.
- Strategic factors.
price is endogenous with a monopoly as they can have an effect on market prices
Monopoly determinants
What are structural (natural) barriers based on?
What are strategic barriers?
Structural (Natural) Barriers
- Control of essential resources – Firms with exclusive access to critical resources (like oil or diamonds) can prevent competitors from entering.
- Marketing advantages & consumer inertia – Established brands benefit from customer loyalty, making it harder for new firms to compete.
- Financial barriers – High costs of securing funding, especially in industries requiring heavy investment, deter new entrants.
- Economies of scope – Firms producing multiple related products can reduce costs by sharing resources across them.
- Economies of scale & natural monopoly – Larger firms reduce costs per unit, making small competitors unsustainable.
Strategic Barriers
- Limit pricing – The monopolist sets prices so low that new firms cannot enter profitably.
- Predatory pricing – Prices are deliberately lowered after entry to force competitors out.
- Excess capacity – The monopolist maintains unused production capability to scare off new entrants.
- Heavy advertising & product differentiation – Large marketing budgets help firms dominate consumer preference, making entry difficult.
- Asymmetric information & credible deterrence – Incumbents use insider knowledge to create uncertainty, discouraging competition.
Would you like real-world examples for some of these?
Economies of Scale (picture)
(3)
Key Concepts:
- Economies of Scale – As production increases, ATC decreases up to ( Q^M ), meaning firms can lower costs by expanding output.
- Two-Firm vs. Single-Firm Market – If two firms share the market, each produces Q^M/2, resulting in a higher ATC, ATC Q^M/2.
- Natural Monopoly Conditions – A single firm producing at Q^M achieves a lower average cost (( ATC(Q^M) )), showing why monopolies can sometimes be more cost-efficient.
Quantity Decision (Picture)
(8)
What are the output and price decisions for a monopolist?
- A monopolist sets output where Marginal Revenue (MR) = Marginal Cost (MC).
- Price is determined based on the demand curve at that quantity.
- Unlike firms in perfect competition, the monopolist can influence price due to the absence of rivals.
Why is MR < AR?
- In a monopoly, to sell additional units, the firm must lower the price for all buyers, making MR decline faster than AR.
Why is the MR curve twice the slope of the AR curve?
- The MR curve is steeper because MR accounts for both the revenue from selling an extra unit and the revenue loss from reducing price on previous units.
What is the significance of MR = 0?
- At MR = 0, total revenue is maximized.
- This occurs at the unit elastic point on the demand curve where price elasticity equals 1.
What is the formula for monopoly profit?
- Profit = ( (P^M - ATC(Q^M)) \times Q^M ).
Check your understanding
The Deadweight Loss from Monopoly (picture)
How do we measure welfare costs?
How do we measure welfare costs?
- Welfare costs of monopoly are analyzed through allocative inefficiency.
- Key conditions:
- MC = MR
- P (AR) > MR
- P > MC
- ( Q^M < Q^C )
