Notesale: Turn your study into money

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Perfect competition
Perfect competition (example of this type of market could be the wheat industry) is a theoretical
model based on precise assumptions:
• the industry is made up of a very large number of firms
• each firm is so small relative to the size of the industry that it is not able to alter it’s own level of
output to have a noticeable effect upon the output of the industry as a whole—> a firm can
neither affect the supply or the price of the good, meaning they must sell at a price where supply
and demand in the industry meet as a whole, making them price takers
• firms sell identical, homogenous products as it is not possible to distinguish a product of one firm
from that of another firm
...

- consumers are also fully aware of prices, the quality and the availability of goods
• despite the firms are free to enter and leave the industry, there are significant costs in either
transition and these may affect decisions of firms
• firms produce at an output level where they maximise profits, MC=MR
Graph for demand perfect competition

Finding equilibrium in perfect competition
As firms are small relative to the size of the industry and a change in their output would not have a
significant effect on the industries output as a whole, a firm in perfect competition is a price taker
and so must sell at whatever the market price is
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Possible short run profit and loss situations in perfect competition
Short run abnormal profit graph

On the short run, a firm that belong to a perfectly competitive market can achieve abnormal profits
...

At that quantity, where the costs per unit, C, and the revenue per unit P, average costs are less
than the average revenue, allowing the firm to make abnormal profits
Short run loss graph
Other than making abnormal profits in the short run, a firm that belong to a perfectly competitive
market can make short term losses, meaning it is not able to cover their total costs:

• even in this situation, the firm is producing at an output level where profit is maximised and that is
where MC=MR
...
At a point where
MC=MR, rather than maximising profits, they are minimising losses as at any other output point,
losses would become greater
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After a period of time (not immediately because firms are small relative in size),
where a large number of firms enter the market, the industry supply curve will shift to the right
(increase)
...
Abnormal profits will be competed away
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Eventually, the supply curve for the industry will settle at S1 where
price is P1
...
As there are no more abnormal profits to attract new firms in the industry, a long run
equilibrium situation is found (no one will either enter or leave)—> as a result, a much bigger
industry is created that produces at Q1 and many small firms that each produce q1 units
...
As there is a shift from S to S1 there
is going to be an increase in price from P to P1—> firms are price takers and will therefore
charge their goods for a greater price and their demand curves will start to shift upwards, leading
to minor losses
...
Firms are satisfied
because they are able to cover all costs, including opportunity costs and there would be no
reason to leave the industry as the firm would not be able to do better elsewhere
...
The outcome will be a
smaller industry producing Q1 units with slightly larger firms each producing q1 units

Transition from short run losses to long run normal profits graph

It can be concluded that in the long run, firms in perfect competition make normal profits, without
considering the initial situations in the short run—> the industry will adjust with firms entering or
leaving the industry until a normal profit situation is reacher:
• firms sell at new price P where MC=MR and so they are maximising profits by producing q
...
With this situation,
there is no incentive for firms lo enter or leave the industry and so equilibrium will persist until
there is a new change in demand curve or costs the firm has to face leading to new short run
situations
...
If a firm is able to produce at this level, then it is allocating and combining it’s resources as
efficiently as possible and they are not wasted
Allocative efficiency occurs when suppliers are producing the optimal mix of goods and services
required by consumers and it occurs where marginal costs (the cost of producing one more unit) is
equal to the average revenue (the price received for unit) MC=AR—> beneficial to consumers

Short run
If a firm is making short run abnormal profits, as seen in the graph, it is a producing at an output
level where they are profit maximising (MC=MR), but also at a point where the price of the good is
equal to the costs for the production of that good(MC=AR)
...

If a firm is making short run losses, they are also producing at a level where they are profit
maximising or, loss minimising and at the allocatively efficient level of output, but not producing at
the most efficient level of output
...
Due to the fact there is perfect knowledge, all firms will face the same costs
curves, indicating they are selling at the same price and minimising average costs where MC=AC
as it cuts at it’s minimum point
...

- economies of scale: when firms gain average cost advantages as their size increases
(specialisation, division of labour, bulk buying lead to lower unit costs)
...
Even if
they were able to bargain the same price as the monopolist, they would not be able to benefit
from economies that come from expertise in the industry like research and development—<
unable to compete with existing monopolist (simply reduce price and lead other firm in loss)
...
The monopolist faces a downward sloping demand curve and the LRAC curve position is
dictated by the economies of scale it experiences
...
If another firm were to enter the industry, the demand
curve would shift to the left
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This shows how a natural monopoly will only make abnormal profits if it is able to satisfy
all the demand in the market (water, electricity and gas)

Natural monopoly graph

- legal barriers: in certain situations, firms are given legal rights to be the only producer in an
industry and thus act as monopoly—> patent—> act as an incentive for creation and invention of
new goods as a firm is guaranteed to be the only producer in that industry, thus more likely to
invest time and money, research and development
...
Another example would be when a government grants the right to produce a
product to a single firm (nationalise industry to ban other firms from entering) or sell the right to
be the sole sole supplies to a private firm (network provider for firms)
- brand loyalty: sometimes, when consumers think of a good, they think of the brand—> if the
brand loyalty is so strong then new firms may be put off from entering the industry because they
feel they would not be able to produce a similar product that is different enough to generate such
brand loyalty
...
Examples would include price wars—> monopolies lower it’s
prices to a loss making level because they are able to sustain this situation for a longer period of
time compared to the new entrant, thus forcing it out of the industry
• monopoly is a measure of how much monopoly power the firm has, and to what extent it is able
to set it’s own prices without worrying about other firm’s actions and keep them out of the
industry—> monopoly power is dictated by the number of competing substitutes available

Possible profit situations in monopoly
As monopolies have a demand curve that is the industry demand curve and down sloping, it can
either control prices or output, not both
...
A monopoly is usually a profit maximised as it produces at a level of output where
MC=MR (however, this is not always the case):
• profit maximising situation
• loss situation—> the assumption that monopolies always make abnormal profits is not true—> if
they produce something for which there is little demand for, then they will not earn abnormal
profits
...
If this was not
the case, the firm would close down and, because the firm is the industry, the industry would
cease to exist
...
Together with the decrease in price, the firm
will increase it’s output from q1 to q2
...
When maximising profits, the firm minimised output in
order to force up the price
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As in perfect competition firms are small, it is
hard for them to invest in research and development
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Monopoly vs perfect competition graph

• they are allocatively and productively inefficient
• they can exercise anti competitive behaviour to keep their monopoly power (high profits might
seem unfair compared to competitive firms or those on low incomes)
• all of these disadvantages mean monopolies act against public interest and as a result,
government have laws and policies to limit monopoly power

Monopolistic competition
A monopolistically competitive market is one with many competing firms where each has a little bit
of market power
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Examples of firms that fall into this category includes restaurants
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Product differentiation is an
important concept in this type of market—> when a good or service is perceived to be different
from another good or service in some way
...
This implies they are price makers
despite the fact the demand curve will be relatively elastic because there are a large quantity of
substitutes
• there are not barriers to entry, meaning firms are free to enter or leave the industry
• firms that belong to this type of market produce at maximising profit point, where MC = MR

Monopolistic competition situation in the short run
• like in perfect competition, it is possible for firms in monopolistic competition to make abnormal
profits in the short run
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Long run and short run monopolistic competition graphs

Monopolistic competition situation in the long run
• whereas in the short run, monopolistic competition firms can make both abnormal profits or
losses, in the long run, because there is freedom of entry or exit, there will be long run
equilibrium, where all firms in the industry make normal profits
...
The firms that remain will experience a shift to the right
of their demand curves (increase) as they pick up trade from the leaving firms
• what happens to firms that make short run abnormal profits? On the long run, other firms will be
attracted to the industry (no barriers to entry)—> they will take business away from other, already
existing firms whose demand curves will shift to the left (decrease)
• on the long run, with no regards to the initial short run situation, monopolistic competition firms
will make normal profits
...


Equilibrium long run monopolistic competition graph (normal profits)

Productive and allocative efficiency in monopolistic competition
• productive efficiency is achieved at a level of output where a firm produces at the lowest possible
cost per unit, the point where ATC is at it’s minimum—> where the MC curve cuts the AC curve
• allocative efficiency is achieved at a level of output where the MC curve cuts the AR curve
• in a monopolistic competition situation firms only produce at a level of output where profit is
maximised and therefore neither allocative or productively efficient
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The difference with perfect completion is
due entirely to consumer desire to have differentiated products—> rather than dealing with a
market where consumers pay lower prices for homogenous goods, monopolistic competition
gives consumers the opportunity of making a choice, meaning they are prepared to pay a higher
price for the products they need
...
The concentration of an industry is measured through the
concentration rate CR
...

• Industries may be different in nature as some might produce identical products such as petrol
where it is the same of the company that changes, highly differentiated products like motor cars,
or slightly differentiated produced like shampoo where advertisement plays a key role in
persuading people to buy the good
...
However, this might not always be the case as some industries have low barriers
to entry
• the key feature that all industries share is the fact that there is interdependence
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Despite this, there can be vigorous competition in order
to gain greater market share
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A collusion can happen in two ways: formal collusion and tacit collusion
...

- formal collusion—> this takes place when firms openly agree on the price that they will charge
(can be market share or marketing expenditure)
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It
results in higher prices and lower output for consumers (against the interest of the consumers)
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Firms that do engage in this
type of anti competitive behaviour face fines or other punishments
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- tacit collusion occurs when firms in an oligopoly charge the same prices without any formal
collusion
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Not necessary to communicate
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• non collusive oligopoly—> this occurs when the firms in an oligopoly do not collude and so have
to be aware of the reactions of other firms when making pricing decisions
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To explain firm behaviour in these types of situations, economists look at the game
theory

Oligopoly acting as a monopolist graph

The game theory considers the optimum strategy that a firm could undertake in the light of different
possible decisions by rival firms
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In order to draw this graph, we must assume that a firm only knows one point on it’s
demand curve, the one that it holds at present
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This is can
be represented on the graph as beyond point a, demand is relatively elastic since a small
increase in price would lead to a large fall in quantity demanded
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- decrease prices? If a firm were to lower prices, then it is likely competitors would follow
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This implies below point a, the demand curve would be less elastic as a decrease in
price would lead to a noticeable increase in quantity demanded
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• the shape of the MC curves mean that if marginal costs were to rise, the it is possible that, due to
the fact oligopolies are profit maximisers, they would still carry out production at a point where
MC=MR and thus would not change their prices or outputs
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Examples of this type of competition include:
- brand names
- packaging
- special features
- advertisements / publicity
- sales promotions
- personal selling
- sponsorship deals
- free delivery / after-sale services
In particular, taking a closer look at oligopolies, they are characterised by very large advertising
and marketing expenditures to try and develop bran loyal and make demand for their goods less
elastic
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In fact, firms undertake all kinds of behaviour to
guard and extend their market share—> this increases barriers to entry for new firms

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