Module 7 Organization of Industries

 

Organization of Industries

Type

# of Firms

Product Type

Entry Barriers

Price Control

Degree of Concentration

Example

Perfect Competition

Very Many

Identical

None

None

0

Agri.

Monopolistic /Imperfect Competition

Many

Differentiated

None/Few

Some

Low

Clothes, Restaurant

Oligopoly

Few

Identical

Scale

Substantial

High

Cars, Chemical, Oil

Monopoly

One

Unique

Scale or Legal

Complete

100%

Public Utilities

Perfect Competition

In the world of perfect competition it is assumed that

                  I.  on the demand side consumers, with perfect knowledge, are utility maximizes

               II.  on the supply side firms, with perfect information, face no restrictions on movement in to and out of any industry.

Underlying Assumptions

 

Demand Side (Customer)

Supply Side (Firm/Company)

1.  Rational consumers

1.  Homogeneous (identical) goods

2.  Utility Maximizing

2.  Profit maximizers

3.  Taste and Preferences known

3.  No entry or exit barriers

4.  Free Information on Price and characteristics of goods

4.  Free Information of opportunity costs of resources.

 

Total Revenue (TR)

Is the price times quantity

TR = P × Q

 

 

 

Average Revenue (AR)

is the revenue received form each unit of output

 

 

 

Marginal Revenue (MR)

the revenue obtained from each additional unit of output

 

 

 

 

Above normal profit(p)

When a firm’s price (average revenue exceeds(>)  average cost)

(p) = (P1 – P2ATC)Q

 

 

 

Perfectly Competitive Long Run Equilibrium

Demand (D) = Price (P)=Average Revenue (AR)=Marginal Revenue(MR) =

P= MCsr=LMC=ATCmin = LACmin

 

 

 

Utility Maximizing Behaviour

Requires that the ration of for all goods

And since

 

 

 

Profit Maximizing behaviour

Ensures that

P = MC for all goods

 

 

 

Economic Efficiency

is achieved when the ration of

for all goods

 

 

 

Consumer Equilibrium

Is when they allocate their budget to maximize utility on a range of goods and serves

same as

Perfectly competitive firms are price takers in both the short run and long run. They can sell all they can produce at the going market price and would therefore never charge a lower price. They can sell nothing at a price higher than the equilibrium price

Monopoly

A Monopolist is a producer that supplies the complete market for a good or service.

Barrier of entry ie patents or market conditions (small town)

Short Run maximizing

Produce output (Q) where Marginal Revenue (MR) = Marginal Cost (MC) but will be able to

sell at a price (P) equal (=)market Demand (D) and/or Average Revenue (AR) giving it a higher than normal profit since price (P) is above the Marginal Cost (MC)

Fair price would have been Price (P) = Average Revenue (AR) =Marginal Cost (MC)    this would have been lower and the monopolist would have produced more.  However the Monopolist would not have maximized profit at that point

Long Run maximizing

May expand or contract by adjusting plant size

LMC

 <

MR

then

ÝQ

MC

>

MR

then

ßQ

In both cases the profits will increase in the long run.

If Monopolist exit in the economy Economic efficiency will not prevail ands the marginal equivalency condition for all goods and services will not be reached Price (P) will not equal Marginal Cost (MC) thus the ration of  are not all equal

Problem with Monopolist is that what consumer pays does not reflect accurately the marginal cost for society of producing that good.

Economies of Scale

May be in society’s interest to have a monopolist if economies of scale exist.

Definition of Economies of scale: the average cost of good declines as output expands.

Sources of Economies of Scale

1.      labour specialization

2.      Increased Capital equipment size à Lower cost per unit (economies of scale)

3.      Bulk Buying of raw materials

Explain in detail why economic efficiency cannot prevail in the presence of monopoly; explain what a government might do to bring about economic efficiency and explain why society might wish to preserve monopolies.

The Suggested Answer

The concept of economic efficiency is captured in the marginal equivalency conditions (MEC)

and is derived from the conditions of utility maximising by households.

and profit maximising conditions by competitive firms in equilibrium

A monopoly faces the industry demand curve because it is the sole supplier and will maximise profit by producing that output level at price marginal revenue (MR) equals marginal cost (MC). There will be a unique price (P) which clears the market. This price (P) must be greater than MC because of the downward slope of the demand curve.

Consumers will attempt to maximise utility in their purchase of goods and services no matter the type of firm producing those goods. Consumers will take the prices as given and equal for all goods.

However when we attempt to substitute MC for P in the MEC equation the monopolist’s MC will be less than P and as a consequence

because MCm< Pm

and therefore of each perfectly competitively produced good.

To attempt to achieve economic efficiency the government must force the monopoly to produce that output level at which price equals MC. If this were done the MEC would be re-established. Resources would flow into the monopolised industry, output would increase and the price decrease.

The government could legislate that the monopoly be broken up into competitive firms. For example if the monopoly in question had exclusive ownership to a formula for a drug for instantaneous relief of all pain with no side effects the removal of exclusivity and the making public of the formula would cause the price of the drug to decrease to its long run marginal cost.

If economies of scale exist the solution is more complex. Breaking up a monopoly in such a situation into a small number of competitive firms could establish a short run equilibrium where P = MC(short run) but if no single firm were allowed to expand beyond a certain size economies of scale would not be realised and P would never equalMC(long run). In this case society could be worse off under ‘forced’ competition with price higher and quantity lower; the only advantage being no firm having monopoly power whether or not it actually exercised that power, i.e. the monopoly to avoid anti trust/monopoly legislation might elect not to maximise profit.

To take advantage therefore of the economies of scale, the government allows the monopoly to continue but tells it to set P = MC(long run).

There are problems, however, not with the solution but in reaching the solution. First the monopolist may inflate costs, i.e. cause the average total cost curve to increase with ‘profligate spending’ thereby shifting the LMRC leftwards from where it would have been had engineering efficiency been a goal. The monopolist has little incentive to pursue engineering efficiency if he is not rewarded for doing so. Thus the government as regulating body faces a principal/agent problem. Second even if engineering efficiency prevailed there is no guarantee that at the P = MC level of output, ATC would be covered. The monopoly might incur losses at this level of output and as consequence would require a subsidy to remain in business

 

Imperfect Competition

Definition: large number of firms, each facing a downward sloping demand curve for its goods or services. 

Demand curve is not completely price-elastic.

Fewer firms exist than in perfect competition

            Firms Have degree of control over price because of several factors

Long Run equilibrium the price (P) of its product will be > that marginal cost (MC)

.

Companies will move into the industry as long as above normal profits are earned and therefore the market supply curve will shift to the left.

Long run equilibrium the Average total cost (ATC) will = Average Revenue (AR) again, but

One implication of an economy having imperfectly competitive firms is ‘spare capacity’ each firm is not operating at the minimum point on its average cost curve

Oligopoly

Oligopoly High degree of concentration, small number of firms, homogeneous product, significant control over price, One firm’s sales depends upon the price it charges and it’s competitors prices.

kink in the oligopolistic

 

1.      The problem an oligopolistic firm faces is that if it increases price and no competitor follows it will lose market share and revenue;

2.      if it decreases price and all competitors follow it will not gain market share and will lose revenue.

The kink in the oligopolistic demand (AR) curve produces a discontinuity in the MR curve, through which the MC curve passes. An alteration in MC still allows the MC curve to intersect the MR curve in its discontinuous range, the profit maximising output at the kink will not change

Cartel

If all firms got together however to form a cartel, the cartel could act as a monopolist facing the market demand curve, equating Marginal Revenue(MR) and Marginal Cost (MC) and earning monopoly profit. Each firm will produce an agreed amount of output and share in the monopoly profit. Each could be better off than operating in isolation

Principal / Agent Problem

Is a conflict of interest,  An agent is an individual or group of individual to whom a principal has designated decision-making authority.  However, the agent might not act in the best interest of the principal as he might have other (conflicting) interests.

 

Regulation and Economic Efficiency

A government can regulates a monopoly, in which economies of scale exist, by

·        Forcing the monopoly to produce that output level at which price equals long run marginal cost.  I.e.; set the output and pricing strategy by government to realize P = MC or

·        taxing a monopolist profit and subsidizing losses, thereby again aiming to achieve P=MC

The problem with these suggestions is that they will not produce any incentive in the monopolist to operate efficiently.

An alternative would be to replace the monopolist with competitive firms.

A profit maximising/loss minimising firm will always produce an additional unit of output if its contribution to revenue (marginal revenue - MR) exceeds its contribution to costs (marginal cost - MC). When MR = MC a further increase in the output level will make profit/return lower than it otherwise would have been. This condition holds for all types of firms.

Review

To spread his risk a farmer with three identical fields plants one with wheat, one with barley and one with oats. He has to wait until harvest time to see what world prices are; only then can he assess which if any of his crops is profitable.

For each field his fixed costs are those costs associated with preparing the land for planting and the seeds. All other costs are associated with spraying and harvesting the crops and drying the grain. Grain merchants, for a fixed percentage of the world prices, collect the grain from the farms.

 

How useful is the model of the perfectly competitive firm in explaining the activities of the farmer?

The Suggested Answer

In the short run after a field has been planted and the crops sprayed and are ready for harvesting the potential output of that field is given, i.e. so many bushels of wheat. Thus the supply is a given amount independent of the world price. The inelastic supply curve however will not begin at the horizontal axis. If the price offered does not yield sufficient revenue to cover the costs of harvesting the grain and drying it out, the farmer will not harvest the crop but will either burn it or plough it in. If total revenue from a crop exceeds all costs, the crop is profitable. If total revenue exceed the harvesting/drying costs but not all costs it still pays the farmer to harvest the crop since all variable costs are covered and something is left to set against fixed costs.

Many farmers hedge typically, i.e. have a variety of agricultural activities, so that losses in one area are, hopefully, more than offset by profits in other areas.

In the long run a farmer may vary the size of his farm but each year (season) the farmer has to make short run decisions, i.e. he can vary the amounts of factor inputs in each/every field. Are last years’ profitable crops a good indicator of what to specialise in this year? If all farmers think ‘yes’ the supply curve of the crops in question will shift to the right and unless matched by corresponding demand shifts, prices will fall. The farmer moans that every year he has a bumper crop, so do most other farmers and the price is low. Every year the price is high he seems to have planted only a little of that crop.