Chapter

7: Firms and How They Operate II

1. Comparison of the 4 Markets

Type
Perfect Competition
Number of
! Large
buyers / sellers ! No one buyer / seller
can influence price
! Firm price taker
Barriers to
entry

!
!
!
!

None
FOP perfectly mobile
No transaction /
transportation costs
Minimal sunk costs

Monopoly
! Only one firm
! Firm price setter

Oligopoly
! Few large firms
! Interdependent

!
!

!
!
!

Substantial
Natural
Artificial: legislation,
collusion / mergers,
non-price
competition,
advertising

Homogeneous /
differentiated

Nature of
products

!
!

Homogeneous
Buyers no preference
for any firm

!
!

Monopolistic Competition
! Large
! FOP relatively mobile
! When firm makes
decisions, does not
have to worry how its
rivals will react
High
! No / Low
Natural: huge sunk costs ! Firm lowers price
(AFC falls over very
profits spread thinly
large output AC falls
over many rivals
continuously enjoys
rivals suffer negligibly
huge IEOS), exclusive
! Retaliation unlikely
ownership of essential
! No collusion keen
raw materials
competition
Artificial: non-price
competition, contrived
barriers (cartel), legal
protection: exclusive
rights (patents, tariffs to
block foreign firms)
No close substitutes
! Differentiated:
CED and PED very low
quality, design,
location, promotion
! Demand price elastic

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Knowledge

!
!

Perfect
!
Seller knows rivals
!
prices, market costs and
available technology

Buyers know all sellers
prices, quality and
availability of products
will not purchase at a
higher price than
equilibrium price

Imperfect
Consumers not fully
aware of COP

!
!
!

Imperfect
!
Production methods and
prices
Cost structures differ as
some firms enjoy more
favourable locations /
rentals

Imperfect

Firms curve

P = AR = MR

!
!

P > MR
Cannot increase both
output and price at the
same time as curve is
downward sloping

!
!
!

P > MR
Some degree of control
over own prices
No single equilibrium
price in market no
market demand curve

!
!
!

P > MR
Firm increases price
other firms will not
Firm decreases price
other firms follow
may lead to price war
Price rigidity: menu
costs, fear of harming
firms image (fall in
price fall in quality)

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Examples

Firms SR
equilibrium
Firms LR
equilibrium

!
!
!

Stock market
Forex market
Agricultural products:
many farmers in LDCs

!
!
!

Utilities
Starhubs EPL coverage
SMRT for NS and EW
lines

Bubble tea

Supernormal, normal / subnormal profits

! MC = MR and MC must be rising
Normal / supernormal
! Normal profits
profits
Firm will shut down if
subnormal profits

!
!
!
!

UK brewery industry
Taxi companies
OPEC
Mobile service
provision

Normal /
supernormal

!
!

Normal profits
New firms will enter
industry to erode
supernormal profits

!
!

LR
equilibrium
curve

Productive
efficiency

!
!

Efficient
Firm produces at MES

Allocative
efficiency

!
!

Efficient
P = MC

Inefficient unless by
coincidence

Inefficient
! Inefficient unless by
Will settle at LRAC that
coincidence
is not necessarily at
MES
! Firms POV: all points on LRAC
! Societys POV: MES
! Inefficient
! P > MC
! Could be seen as premium society pays for product differentiation
!
!

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2. Analysis of Imperfect Market Structures

Type
Monopoly
Economic
! Allocative inefficiency: P > MC,
efficiency
output below optimum
! Productive inefficiency
! X-inefficiency but increasingly
reduced due to globalisation,
reduced customs duties and
barriers to trade
! Dynamic efficiency: r+d
Variety of
! Unique
products
! Possible innovation and new
products: BTE stimulus to the
creativity required to destroy
barriers monopoly profits
stimulates new entrants
producing new and competing
products
R+d and
! Profits lead to unequal income
new profits
distribution: dollar votes + shift of
consumer surplus to producer
! Supernormal profits plough into
r+d better quality products +
better methods of production
lower AC but there is no
guarantee that monopolies will do
this

Monopolistic Competition
! Allocative inefficiency: P > MC
! Productive inefficiency: do not
utilise optimal plant capacity, do
not exhaust potential for further
EOS because all small firms
! Dynamic inefficiency: no r+d

Oligopoly
! Allocative inefficiency: P > MC,
output below optimum
! Productive inefficiency
! Dynamic efficiency: r+d

Large variety increase in

consumer welfare

Differentiated

More equity: no redistribution of

income from consumers to
shareholders
Normal profits: no additional
profits to plough into r+d

Supernormal profits ploughed into

r+d

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Theory vs
empirical
evidence

MES high IEOS lower MC than

PC industry lower P and higher
o/p but monopolies charge high
prices by restricting output

P/R/C
MCpc

MCm
Pc

Pm



MR
AR
0

Q Q
Q
! Practise
p
rice
d
iscrimination
[has
c m
both costs and benefits]
! Natural monopolies
! Perfectly contestable markets:
costs of entry and exit by
potential rivals are zero, and when
such entries can be made very
rapidly eg. deregulation of airline
industry in 1978
! Hit and run competition: market
contestable for certain seasons
eg. parcels service during festivals
! Reduces wasteful competition
(instead of extensive advertising,
money can be spent to produce
more goods)

!
!

Wasteful competition
Advertising provides better
consumer information which
helps move market structure
closer to PC model but loss of
consumer sovereignty

!
!

!
!

High price rigidity: price stability

Wasteful competition: more likely
to engage in extensive advertising
encourages price competition,
with increased sales volume and
reaping of EOS, price reduce
further
But possible monopoly power
through collusion
But multiple branding gives
consumers misguided information
in thinking products are from
different firms

36