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Theory of firm revision questions
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09/02/2015 IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL) 1/18
IBEconomics/Microeconomics/TheoryoftheFirm(HL)
Contents
12.3TheoryoftheFirm(HL)1.1Costtheory1.2Shortrun1.3Longrun1.4Revenues1.5Profit1.6PerfectCompetition1.7MonopolisticCompetition1.8Oligopoly1.9Monopoly1.10PriceDiscrimination
2.3TheoryoftheFirm(HL)
LimitedLiability
Financialliabilityislimitedtoafixedvalue,commonlyaperson'sinvestmentinacompany/partnershipestablishedwithlimitedliabilityTheseparationofmanagementandownershipthroughlimitedliability500yearsagoisthekeytowhyfirmshavebeenabletogrowsorapidlyandtobecomesolarge
IntheUSonly1000companiesaccountfor60%oftheGDP,theremaining40%isproducedby11millionbusinessesandotherinstitutionsThelargefirmsare17,000timeslargeronaveragethanthesmallfirms
Limitedliabilityallowscompaniestoraisemoneyeasily,becauseindividualsarenotsoafraidoflosingeverythinginthecaseofbankruptcy
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Atypicalcompanypaysouthalfitsearningsintheformofdividends,therestisreinvestedFirmsfinance:
Fixedcapital(usuallyassociatedwithK)byborrowingmoneyfromthebankorbysellingbondsinthebondmarketorthroughretainedearningsRiskcapital(usuallyassociatedwiththeentrepreneurialinput)byissuingsharesWorkingcapital(usuallyassociatedwiththeLandNRusedinproduction)fromretainedearningsorbyshorttermloansfrombanks
FirmsmustprofitmaximizeinordertoearnatleasttheOpportunityCostRateofReturn,otherwisetheirsharevaluewillfall,andanotherfirmwillbuythemoutandforcethemtoearnatleasttheOpportunityCostRateofReturn
Multinational/Transnationalcompanies/Multinationalenterprise
Enterprise/firmthatmanagesproductionordeliversservicesinmorethanonecountryAcorporationwhichhashismanagerialheadquartersinonecountryknownastheHOMEcountryandoperateonseveralothercountriesknownastheHOSTcountry(ILO)Internationallythereare600multinationalcompanies(MNCs),morethanhalfareinvolvedinbankingandfinance,petroleumandchemicalsMNCshaveflourished:
Ratherthanfighttariffandnontariffbarriers,MNCsjustsetupproductioninthehostcountryTastesaredifferent,MNCsproducelocallytotailorservicestothelocalmarketAdvancesintelecomandtransportationhaveallowedfirmstoglobalizeTransferpricingallowspricesofFoPWITHINanorganization(thismayreducetaxablerevenuewithinacountry)Verypowerful:somehavebudgetsthataregreaterthanentirecountryGDPs
SmallFirms:mostsmallcompaniesfailforthreereasons:
Marketing:ownersdonotunderstandhowtoservethemarketPoorfinancing:mostdonotknowhowtoinvestmoneysothatitrepaysthecapitalaswellasthecarryingcostsPoormanagement:mostownersdonotknowhowtodelegatetasks,organizeabusinessinanefficientmanner,orcoordinatetasks
Costtheory
CompaniesmustbalancerevenuesandcostssoastomaximizeprofitsFactorsofproductionarepricedatopportunityorusercost:
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Labour:firmspayawageforlabourserviceCapitalcanberentedbutisoftenowned,acostmustbeimputed(estimated)forthecapitalservices,where:
Preferstothecostofthecapital,rreferstotheinterestontheloantobuythecapitalorifthecompanyownsthecapitalitistheOpportunityCostRateofReturnthatcouldhavebeenearnedonthemoneytiedupinthecapitalisthedepreciationrateonthecapital
Naturalresourcesareeithertreatedlikecapitalifthefirmownsthem,ortreatedasaninputthatmustbepurchased
Firmscarryinventorieswhichactasshockabsorberssoproductionandsalesneverneedtostop
Therearethreetypes:rawmaterials,intermediate(semifinished)goods,andfinalgoodsInventoriesmustbefinancedbyworkingcapitalandrequirestoragespace
Typesofcosts
Totalcostisthesumoffixedandvariablecosts:
Fixedcostsareassociatedwiththefixedfactor,usuallycapital,sometimesreferredtoasoverheadcost
CostsafirmbearsintheshortrunregardlessofoutputAfirmcouldproduceabsolutelynothingandstillfacefixedcosts(e.g.,rent,oranythingthatiscontractedforaperiodoftime)
Variablecostsareassociatedwiththevariablefactors,usuallylabourandrawmaterials
Costswhichdependonthelevelofproduction
Averagecostistotalcostdividedbyquantityofoutputorthesumofaveragefixedandaveragevariablecosts:
Totalcostdividedbyunitsofoutput
http://commons.wikimedia.org/wiki/File:Shortruncostcurves.jpg
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Iffixedcostsaretrulyfixed,thenasoutputincreases,averagefixedcostsmustbedecliningsteadily
Marginalcostisincrementalcost:
CostofproducingoneextraunitofoutputFixedcostsarefixed,therecanbenoincrementalcostscomingfromKMarginalcostisequaltomarginalvariablecostsonly
Shortrun
PeriodoftimeinwhichatleastonecostforFoPisfixed(quantityofatleastoneinputisfixed)
Intheshortruncapitalisfixed,firmsdonothavetimetobuildnewplantandequipmentorgetridofobsoleteones
Onlylabourcanbevariedintheshortrun
Asmorelabourisaddedtoafixedplant,totalproductwillincrease
Averageandmarginalproductivitywillriseatfirstandthentendtofallasworkershavelessandlesscapitalequipmenttoworkwith
Inthelongruncapitalcanbevaried,newplantandequipmentcanbebuilt,oldonesdestroyedorsoldoff
Itisaplanningperiodtoallowthebuildingofnewcapital,itcanactuallybeshorterthantheshortrun!
Intheverylongrun,itisassumedthatnewtechniquescanbeinventedandappliedwhichwillincreaseproductivity
Lawofdiminishingreturns
Asadditionalvariableunitsareaddedtofixedunits,afteracertainpointthemarginalproductofthevariableunitdeclinesAsmoreandmoreofthevariablefactorisappliedtoafixedamountoftheotherfactor,eventuallyeachadditionalunitofthevariablefactorwilladdlesstoproductivity
http://commons.wikimedia.org/wiki/File:Marginalproduct.jpg
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Totalproduct:Totaloutputproducedbyfactorsofproduction
Averageproduct:Theoutputperunitofvariablefactor
Marginalproduct:Theextraoutputfromemployinganadditionalvariablefactor
ProductionFunction
Describestheprecisephysicalrelationshipbetweenfactorinputsandoutput:
Marginalproductistheincrementinoutputfromanextraworker:
MPrisesatfirstaseachworkercanspecializeindoingthetaskforwhichtheyaretrained(specializationanddivisionoflabour),buteventuallystartstodeclineatthepointofdiminishingmarginalproductivity
Averageproductivityisgivenby:
Eventually,eachadditionalworkerwilladdlesstooutputthanthepreviousworker,andAPwillstarttodecline(diminishingaverageproductivity)TheAPcurveslopesupaslongasMPisabovethecurve:iftheincrementisgreaterthantheaverage,thenitmustpulluptheaverageAssoonasMPfallsbelowAP,itmuststartpullingitdown:MPisequaltoAPatthemaximumpointofAP
ShortRunCostCurves
Unlikeproductivitycurves,costcurvesvarywithoutput:greaterproductivityonthepartoflabourmeansmoreoutputforlesslabourcostACandMCtendtofallatfirstforthesamereasonthatAPandMProse:specializationanddivisionoflabour,itcostslesstoproducethenextunit
AFCisconstantlyfallingAtfirstAC(orATC)isfallingbecausebothAFCandAVCarefalling:wLQ/L,andafteracertainpointthiseffectoutweighstheconstantlyfallingAFCandpullsuptheACcurveTheMCcurvecutstheACcurveatitsminimumpoint
TheverticaldifferencebetweenACandAVCisjusttheAFC,andgetsnarrowerasAFCgetssmaller
WeneverneedtodrawAFCagain,asweknowitisalreadyonthediagrambetweenACandAVC
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TheoutputassociatedwithminimumACiscalledthecapacityofthefirm:
ThelargestoutputthatcanbeproducedwithoutaveragecostsrisingFirmsoperatingbelowthispointarereferredtoashavingexcesscapacityAfirmcanproducebeyondthispoint,buttodosowouldleadtorisingunit(average)costs
InputorFactorCosts
UptonowwehaveassumedthatinputpricesremainconstantCostsriseandfallstrictlybecauseofchangesinproductivitynotbecauseofchangesinfactorcoststhemselves(wagesperhourstayconstantforlabour)Ariseinthepriceofanyoftheinputswillleadtothewholesetofcurvesshiftingupward
IfitisariseinthecostofK,thenAFCwillshiftupIfitisariseinwages,thenAVCandMCwillshiftupward
Afallinthepriceofinputsleadstoafallinthecurves
IfthereisanincreaseinK,thenproductivitywillriseandtheAVC,MC,andACcurveswillallshiftdown
ThereisadifferentsetofcurvesforeachamountofK,thatissizeofplant
Longrun
PeriodoftimewhenallcostsforFoParevariable(quantitiesofallinputsarevariable)
Thefirmreacheslongrunequilibriumwhenthereisnoopportunityforcostreducingsubstitutions:theratioofMPstofactorcostsisequalFirmsaremotivatedtouselessoffactorsthatbecomescarcertotheeconomyandmoreofthefactorsthatbecomemoreplentifulThesamewillbetrueforregionsandnations:ifacountryhasrelativelymorelandthanlabour,farmingwilltendtousethecheaperlandmoreextensivelywhileeconomizingonthemoreexpensivelabourInChinawherelabourisabundantandKisscarce,amuchlessmechanizedmethodofproductionisappropriate
LongRunAverageCost
Inboththelongrunandtheshortrunaminimumachievablecostcanbefoundforeachpossiblelevelofoutput,andacurvecanbeconstructedcalledthelongrunaveragecostcurve(LRAC)
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Factorpricesareassumedtobefixediffactorpricesrise,thewholeLRACrisesTechnologyisassumedtobefixed
TomovefromonepointontheLRACtoanotherisverydifferentfromtheshortrunAC:itrequiresanadjustmentinallfactors,anewplantmustbebuilt
AllthepossibilitiesaregivenbyavarietyofSRACcurves,oneforeachplantTheLRACistheenvelopeoftheSRACs,itistangentatjustthatoutputwhereKisoptimalintheMP/Pformulaabove
LRACisfallingatfirstduetoeconomiesofscale(increasingreturnstoscale)whicharisefrom:
Increasedopportunitiesforspecializationanddivisionoflabourduetolargerplantsize:abiggercompanycanemployspecialiststaffSomefactorsofproductionareindivisible,sothattomakefullofthemalargeoutputisrequired:large,specializedequipmentwhichcanonlybeprofitableifusedatlargevolumesofoutputFallingresearchanddevelopment(R&D)costsCertaintypesofmarketingwhicharecheaperthemoreunitsmadeandsoldEconomiesrealizedthroughbulkbuying,cheaperfinancing,andtransportationdiscounts
Economiesofscale=anincreaseinafirm'sscaleofproductionleadstoloweraveragecostsperunitproduced
Afterapoint,LRACstartstoriseduetodecreasingreturnstoscale(diseconomiesofscale)whicharisefrom:
DifficultiesofmanagingandcontrollinglargeenterprisesNomoreopportunitiestosubstitutelargescalemachinesLimitstotheeconomiesassociatedwithdiscountsforlargescalepurchases
Diseconomiesofscale=anincreaseinafirm'sscaleofproductionleadstoahigheraveragecostperunitsproduced
Forsomeindustries,thereisaflatsectionbetweenthefallingandrisingparts,andthisisreferredtoasconstantreturnstoscale
TechnicalInnovation
InthelongrunthereisgreatpotentialtodropcoststhroughtechnicalinnovationIndeed,sustainablegrowthinthefuturecannotcomeaboutthroughgreaterandgreateruseofnaturalandenvironmentalresources,itmustcomefromtechnologicalchange
Lossoftechnicalknowledgeisveryrare,thustechnicalchangealwayscausestheLRACcurvetofall:
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Labour:throughbetterhealthandeducation,productivityoflabourinputscanrisedramaticallyNaturalresources:throughbetterengineeringandrefiningandprocessingtechniques,bettermaterialscanbeobtainedfromnaturalresourcesNewproductsareinventedwhichreducecostsdramaticallysuchasthenewwallscreenTVswhichwillbeoutshortlyCapital:
DuringtheindustrialrevolutioncapitalhasbeensubstitutedforlabourWiththeinformationrevolution:thinkingmachinesarereplacinghumanintelligence
Resequencingofproductionhasledtoanewleanproductionsystemasworkerslearnbydoing:
Workersareorganizedasteams,individualityandinitiativeareemphasizedPartsaredeliveredbysuppliersjustintimeAworkerstopsproductionwhenafaultisdiscoveredDefectivepartsandproblemsareanalyzedforapatternofcausesthatneedtobeunderstoodAsthesourcesofproblemsarefoundandsolved,workstoppagesdecreaseDesignteamsarenonspecializedandworkcloselywithproductionengineersandpartsproducers:
Asnewproductsaredeveloped,tooldesignerscanstartdevelopingthetoolsthatwillbeneeded
MeasuringTechnicalChange
Therateofincreaseinproductivityprovidesameasureoftheprogresscausedbytechnicalchange:
Q/L:WeusuallymeasureproductivityasoutputperhouroflabourK/L:Asthepriceoflabourrelativetocapitalhasrisen,firmshavesubstitutedKforLQualityofK:Machineshavegrownmoreandmoreproductiveovertime(Q/K),butthishasincreaseddependenceonenergyNolimitstogrowth:Thegrowthinknowledgeanditsapplicationhasexpandedsorapidlythatfirmsarenowabletosqueezemoreoutoflimitedresourcesfasterthantheexpandingpopulation
Technicalchangeisoftenendogenous(itisinresponsetosomethinggoingonintheproductionprocessratherthanjustsomeaccidentaldiscoverygoingoninatotallyunrelatedway)OftenitistheresultofR&Dexpenditures,andtendstoriseasprofitincentivesrise
TheUS,GermanyandJapanhaveallinvestedheavilyinR&D,andproductivitygrowthhasbeenexcellentforthem
SlowdownsinProductivityGrowth
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Therehavebeenslowdownsinproductivitygrowth:
ForindustrializedcountriesthereislesspossibilitiesforgainsinproductivityRisingoilpricesinthe1970scontributedtoaslowingdowninproductivitygrowthTherehasbeenashiftinthepopulationfromyoungertoolderpeople(olderpeoplearehardertotraininnewtechniquesandlessinnovative)
Services:overthelast15yearstherehasbeenamassiveshiftovertotheservicesector
WehavemovedfromgoodsindustrieswhereincreasesincapitalperworkerledtoenormousincreasesinproductivityThegrowthinproductivitydoesnotappeartobeasrapidforservicesastherearelessopportunitiestosubstitutemachinesforpeople
Pollution:therehasalsobeenincreasingpollutionandenvironmentaldegradationwhichhasloweredthequalityoflifeCrowdingout:governmentdeficitshavedrainedthesavingsfromtheprivatesectorwhichwouldnormallyhavebeeninvestedinKandinR&DTheinstitutionalclimatehasbecomeveryhostiletoinnovation(thisisoneofthemainreasonsfortheemphasisonderegulation)
Revenues
Priceofthegoodtimesthenumberofunitssold
Totalrevenue:totalamountthatafirmtakesinfromthesaleofitsproduct
Averagerevenue:revenuegainedfromthesaleofasingleproduct
Marginalrevenue:additionalrevenuethatafirmtakeswhenitincreasesoutputbyoneadditionalunit
Profit
Differencebetweentotalcostsandtotalrevenues(sometimesalsocallednetrevenue)
Ifasalaryisimputedfortheowner,andacostofcapitalimputedfortheowner'sinvestment:
Onewouldexpecttheretobezeroprofitsonaverage,Ifprofitisgreaterthanzero,thefirmisearningsupernormalorabnormalorpureoreconomicprofits
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Returnoninvestment(ROI)(intheUSitiscalledIRR:internalrateofreturn):
ThenetrevenueisdividedbythetotalinvestmentinthefirmIfthereisnoattempttoimputeasalaryandcostofcapitalfortheowner:
ThereturnoninvestmentwouldbeexpectedtobeequaltotheOpportunityCostRateofReturn,andfirmswillstayintheindustryIfitisgreaterthantheopportunitycostrateofreturn,thefirmisearningasupernormalprofit,thiswillbecomeknownandfirmswillattempttoentertheindustryIfitislessthantheopportunitycostrateofreturn,firmswillleavetheindustry
Profitmaximization
Asprofitmaximizers,firmswouldliketoincreaserevenuesanddecreasecosts(thusprofitmaximizationimpliescostminimization)InthelongrunallfactorsofproductionarevariableShortruncostcurvesshowminimumcostperunitfordifferentlevelsofoutput,givenafixedfactorThereareaninfinitenumberofshortruncurves:asafirmchangesitsfixedfactorovertime,anewshortrunaveragecostcurveemergesFirmssubstituteinputsinthelongrununtiltheyachievethemostcostefficientcombination
Where:PKreferstotherentalpriceofcapital(PK{r+d})PLreferstothewagerate
IfthepriceofKrises:o:thefirmwillsubstituteLforK:oTheMPofLwillfall,andMPofKwillrise,equalitywillberestored.
Profitmaximizationoccurswhenthemarginalrevenue(revenuegainedfromproducingoneextraunitofoutput)equatesthemarginalcostofproducingthatextraunit
Thoughafirmmayhaveitsprimarygoalofprofitmaximizationinthecaseofmostcorporations,othergoalsmayexiste.g.,salesvolumemaximization,themaximizationofrevenue,andenvironmentalconcerns)Forexample,theBodyShopbeforebeingincorporated,proceededtoincludemanyanimalfriendlymeasures,whichpreventedthefirmfrommaximizingprofit
However,themaingoalisindeedprofitmaximization,rarecasesexistwhereitisotherwise,andindeedthesearevalidexamples,buttheyareasmallminorityintoday'sbusinessworld
Distinctionbetweennormal(zero)andsupernormal(abnormal)profit
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Normal(zero)profitiswhereallcostsarecoveredincludingtheexpectedreturnoftheentrepreneur,anythinggainedbeyondthatisconsideredsupernormalprofit
PerfectCompetition
Industrystructureinwhichtherearemanyfirms,nonelargeenoughtoinfluencetheindustry,producinghomogeneousproducts=pricetakers
Assumptionsofthemodel:Perfectcompetitionisanindustrystructurewhichholdsnumerousassumptions.Itisalsotheoretical.
Therearenumerousbuyersandsellersofwhichnoneareabletoinfluencethemarket.ProductsarehomogeneousTherearenobarrierstoentryandnobarrierstoexitthemarketEveryonebothbuyersandsellershaveperfectinformationaboutthemarket
Examplesincludetheagriculturalmarketandstockmarket
Demandcurvefacingtheindustryandthefirminperfectcompetition
Profitmaximizinglevelofoutputandpriceintheshortrunandlongrun
TheprofitmaximizinglevelofoutputiswhereMC=MR.
Thepossibilityofabnormalprofits/lossesintheshortrunandnormalprofitsinthelongrun.
ShortrunyesLongrunnever.
Shutdownprice,breakevenprice.
Companyhastoshutdown(intheshortrun)ifvariablecostsarenotbeingcovered.Inthelongrunit'sallaboutcoveringtheaveragecosts.
Definitionsofallocativeandproductive(technical)efficiency
Allocativeefficiencyoccurswhenoutputisatsociety'soptimumlevel.P=MC
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Productiveefficiencyiswhenafirmproducesatthelowestpossiblecostperunit.AC=MC
Efficiencyinperfectcompetition
Perfectcompetitionisbothallocativelyandproductivelyefficient.However,itisnotdynamicefficient,inthesensethatproductscan'tbedifferentiatedandnonewtechnologycanbeproduced.Inthelongrun,nofirmwillhaveanyprofittospendonresearchanddevelopment.
MonopolisticCompetition
Industrystructureinwhichtherearemanyfirms,producingslightlydifferentiatedproductseachfirmhasasmall'monopoly'onitsownproduct
Assumptionsinthemodel
Largenumberofsmallfirms.(Almost)perfectknowledge.Differentiatedproducts/brandingimportantThereareclosesubstitutesfortheproductofanygivenfirmcompetitorshaveslightcontroloverpriceTherearerelativelyinsignificantbarrierstoentryorexitandsuccessinvitesnewcompetitorsintotheindustryExamplesincludehomebuildersandrestaurants
Shortrunandlongrunequilibrium:
Intheshortrunabnormalprofitscanbeearned(atMC=MR)Inthelongrunonlynormalprofitscanbeearned.
Productdifferentiation:
MCfirmssellproductsthathaverealorperceivednonpricedifferences.However,thedifferencesarenotsogreatastoeliminategoodsassubstitutes.Technicallythecrosspriceelasticityofdemandbetweengoodswouldbepositive.InfacttheXEDwouldbehigh.MCgoodsarebestdescribedasclosebutimperfectsubstitutes.Thegoodsperformthesamebasicfunctions.Thedifferencesarein"qualities"andcircumstancessuchastype,style,quality,reputation,appearance,andlocationthattendtodistinguishgoods.Forexample,thefunctionofmotorvehilcesisbasicallythesametogetfrompointAtoBinreasonablecomfortandsafety.Yettherearemanydifferenttypesofmotorvehicles,motorscooters,motorcycles,trucks,carsandSUVs.
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Efficiencyinmonopolisticcompetition:
Monopolisticcompetitionisaninefficientmarketstructure.Intheshortrun/longrunneitherallocativenorproductiveefficiencyisachieved!
Oligopoly
Industrystructureinwhichthereareafewfirmsproducingproductsthatrangefromslightlydifferentiatedtohighlydifferentiated
Assumptionsofthemodel:
Competitionbetweenafewfirmsmanybuyers,fewsellersdifferentiatedproductsoligopolistswilltrytoblockentrytheoligopolistbelievesthatifheputshispricedownhiscompetitorswillfollowhisexamplethereforeinoligopolisticcompetitionthereisnonpricecompetition,forexamplesupermarketscompeteintermsof:
carparksloyaltycardstrollies
EachfirmislargeenoughtoinfluencethisindustryBarrierstoentryandexitaredifficult,butexistExamplesincludeaircraftmanufacturers,tiremanufacturers,camera/electronicsmanufatureres,carmanufacturers,supermarkets
Collusiveandnoncollusiveoligopoly:
NoncollusiveOligopoly:wherefirmscompeteagainsteachotherinanormalwayCollusiveOligopoly:wherefirmstrytocometoanagreementtoreducetheamountofcompetition.
Itisusuallyillegaltheywillfixtheoutputoftheindustryandthensharetheoutputbetweenthemthisisoftencalledacartel
Cartels:
Whenfirmshaveaformalagreement.Oneexample:OPEC
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Kinkeddemandcurveasamodeltodescribeinterdependentbehaviour:
Thekinkeddemandcurvebasicallyillustratesthedownwardstickinessofprices.Thekinkeddemandcurveshowshowachangeine.g.rawmaterialcostsdoesnotbringaboutachangeinthepriceofthefinalgood,duetotheconceptofdownwardstickiness.Thefearofchangingpricesandthenloosingnumerouscustomersistoobigtoactuallychangeprices.
Importanceofnonpricecompetition:Oligopolisticfirmsavoidcompetingthroughpricecuts.Suchstrategycouldleadtoacompetitivedownwardspiralinprices(apricewar)whichcouldleaveallfirmsworseoff.Nonpricecompetitioncantakeseveralformssuchas:advertising,branding,gifts,coupons,continuosproductdifferentiation,extendedguarantees,aftersalesserviceandvolumediscounts.Theoryofcontestablemarkets:
Thecontestablemarkettheoryassumesthateveninamonopolyoroligopoly,theexistingcompanieswillbehavecompetitivelywhenthereisalackofbarriers,suchasgovernmentregulationandhighentrycosts,topreventnewcompaniesfromenteringthemarket.
Monopoly
Industrystructurewhereasinglefirmproducesaproductforwhichtherearenoclosesubstitutespricemakers
Assumptionsofthemodel
Onesinglefirmdominatesamarketforwhichtherearenoclosesubstitutes.Barrierstoentryandexit.
Monopolistscansetprice=pricemakersbutareconstrainedbymarketdisciplineBarrierstoentryandexitexistandinordertoensureprofits,amonopolywillattempttomaintainthemExamplesincludeMicrosoft's(former)virtualmonopolyovertheglobalPCoperatingsystemmarketandhistoricalexamplesofAT&TandStandardOil(US)Antitrustlegislationusedtobreakupmonopolieswhoabusemonopolypowerviapricegougingandlackofrespondingtoconsumerconcerns
Sourcesofmonopolypower/barrierstoentry
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Governmentlegislation.Patentsandcopyrights.ControloversuppliesCostadvantage,suchasmassiveeconomiesofscale.Productdifferentiation.Useofforce.
Naturalmonopoly
Amonopolywhichhasgaineditsstatusbecauseofmassiveeconomiesofscale.
DemandcurvefacingthemonopolistProfitmaximizinglevelofoutput
AmonopolymaximizesprofitswhenMC=MR.
Advantagesanddisadvantagesofmonopolyincomparisonwithperfectcompetition.
Monopoly:pricehigher,Outputlower,ProfitAbnormal,ProduceswhereAveragecostsarehigher(inefficient)
However,amonopolymayuseeconomiesofscalethereforereducingcostsandincreasingoutput
PerfectCompetition:PriceLower,outputhigher,Profitnormal,ProducesWhereaveragecostsarelowest(efficient)
Efficiencyinmonopoly
Amonopolistisneitherallocativelyorproductivelyefficient.Itmaybedynamicallyefficientifitwishestomaintainitsmonopolisticposition.
Howtocontrolamonopoly
DogmaticApproach:ThisistheapproachintheUSA.Monopolyisillegal.AntitrustlegislationbansmonopolyIfafirmisaccusedofbeingamonopoly,theyaretakentocourtandiffoundguilty,theyarebrokenup.
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PragmaticApproach:Lookingatmonopolywithanopenmindlookingatadvantagesanddisadvantagesandcomingtoaconclusiontheconclusionmaybe,forexample,loweringprices
Statecontrol:thegovernmenttakesoverthemonopolybecauseitisassumedthatthegovernmentwillrunthefirmforthe'benefit'ofthecountry
Alicence:youaregivenalicencetorunamonopoly.Ifyourunitwell,itwillberenewed,ifnotitwillbecancelled.
PriceDiscrimination
Definition:
Pricediscriminationoccurswhendifferentcustomergroupsarechargeddifferentpricesforexactlythesamegood.
FirstDegree
Eachpersonbuyingagoodorservicepaysasmuchastheyarewilingtopay.Auctionsareagoodexampleofthis,asarethetradesatlocalmarketsandbazaars.
Inthediagrambelow,wecanseethatconsumersurplushasbeenerodedbecausecustomerswillingtopayaboveequilibriumwillbechargedtakingthatintoaccount.Ideally,noconsumerwillpaylessthanheorsheisprepared.Thedarker,triangular,boxrepresentsconsumersurplus,andtheprofitsattainedthroughfirstdegreepricediscrimination.
SecondDegree
Consumersarechargeddifferingpricesdeterminedbythequantitythattheypurchase.
ThirdDegree
Differentmarketsegmentsidentifiedbythesellerarechargedatvaryingrates.Highlydependentonseparatingthemarketsegments.Goodexamplesareyouthdiscountsorseniorcitizenrates.
ConditionsforPriceDiscrimination:
Pricesettingability(canonlyoccurinanimperfectmarket)ConsumerswithdifferentPriceElasticitiesofDemandConsumersmustbeseparatedsotheyproductscannotberesoldbetweenconsumers
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andtheremustbenoleakagebetweenmarketse.g.cigarettesinUKare5poundsandinPolandare1pound,butmarketsarekeptapart
GeographicseparationLackofknowledgeAge
Reasonsforpricediscrimination(Advantagestofirm)
TomaximizeprofitsbyerodingconsumersurplusCreatesfavorableconditionsforeconomiesofscaleasmoreproductsaresoldDrivecompetitorsoutofanelasticmarketbyusingprofitsfromaninelasticmarkettosubsidizetheproductintheelasticmarket.
Effectontheconsumer
Advantages
Canallowpoorerconsumerstopurchaseaproductthatwouldn'tnormallybewithintheirpurchasingpower
Lawyersoftenchargelowerratesforpoorerclientsbutoffsetthelosswithhigherprofitsfromwealthierclients.
Usuallyincreasesoutputofaproductinthemarket,makingitavailabletomoreconsumers.Bettereconomiesofscalemayresultinoveralllowercoststhroughoutmarketsegments.
Disadvantages
ConsumersurplusiseliminatedSomeconsumerswillhavetopaymorethattheywouldhaveinanondiscriminantmarket.
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