Market Structures in Economics: Perfect Competition, Monopoly, and Oligopoly
Short-Run vs. Long-Run Periods
The short-run period is defined as the time during which at least one factor of production is fixed. The long-run period is when all factors of production are variable.
Key Formulas
TR = P x Q
AR = TR / Q
MR = change in TR / change in Q
MC = change in TC / change in Q
TC = TVC + TFC
TC = ATC x Q
ATC = TC – TFC
AC = TC / Q
AFC = TFC / Q
AVC = TVC / Q
ATC = TC / q
Shut down point: MC = AVC
Break-even point: MC = TC
Profit Maximisation: MC = MR
Revenue maximisation: MR = 0
Profit = TR – TC
Profit = (AR x Q) – (AC x Q)
Profit = Q(AR – AC)
Normal profit: TR = TC
Abnormal profit: TR > TC
Losses: TR
Price Elasticity of Demand (PED) and Revenue
When PED is elastic/inelastic, the firm should lower/raise the price to increase revenue.
Short-Run and Long-Run Cost Curves
Law of Diminishing Marginal Return (Short-Run Only)
When a firm continuously adds more variable factors to a fixed factor (e.g., farmers adding more labor to a fixed piece of land), marginal product eventually decreases. This decrease may occur due to overcrowding or insufficient machinery/tools for labor. The decrease in marginal product from additional labor implies that additional output is produced at a higher cost.
Diagram: MP and AP both slope downwards, while MC and AVC both slope upwards.
Goals of a Monopoly
Profit Maximization (MC = MR)
A monopoly aims to maximize profits by producing at the quantity (Q1) where marginal cost (MC) equals marginal revenue (MR). This corresponds to a price (P1) on the demand curve.
Revenue Maximization (MR = 0)
A monopoly maximizes revenue by producing at the quantity (Q2) where marginal revenue (MR) equals zero. This corresponds to a price (P2) on the demand curve.
Growth Maximization (AC = AR)
Firms pursuing growth maximization aim to produce the maximum output (Q4) without incurring losses. This occurs where average cost (AC) equals average revenue (AR), corresponding to a price (P4) on the demand curve.
Allocative Efficiency (MC = AR)
Allocative efficiency is achieved when the monopoly produces at the quantity (Q3) where marginal cost (MC) equals average revenue (AR). This corresponds to a price (P3) on the demand curve.
Satisficing and Corporate Social Responsibility
Some monopolies may prioritize satisficing, aiming for a satisfactory level of profit rather than maximum profit. Others may focus on corporate social responsibility, considering the interests of stakeholders like consumers. This might involve charging lower prices to make goods more affordable.
Perfect Competition and Normal Profit in the Long Run
In perfect competition, firms can only earn normal profit in the long run due to the following factors:
- Free entry and exit: If firms are earning abnormal profits, new firms will enter the market, increasing supply and driving down prices until only normal profits remain.
- Homogeneous products: Firms sell identical products, meaning consumers have no preference for one firm over another. This prevents firms from charging higher prices and earning abnormal profits.
- Perfect information: Consumers and firms have access to all relevant market information, including prices and costs. This prevents firms from exploiting information asymmetries to earn abnormal profits.
Why Firms May Not Shut Down Despite Short-Run Losses
Firms may not shut down even when making losses in the short run if they can cover their variable costs. In the short run, fixed costs are sunk costs and cannot be recovered. As long as the firm can cover its variable costs and contribute towards its fixed costs, it may continue operating in the hope of returning to profitability in the long run.
Monopoly and Abnormal Profit in the Long Run
Monopolies can earn abnormal profits in the long run due to high barriers to entry, which prevent new firms from entering the market and competing away profits. These barriers can include legal barriers (e.g., patents, licenses), economies of scale, control of essential resources, and brand loyalty.
Characteristics of a Monopoly
- One dominant seller
- High barriers to entry
- Unique goods or services with few substitutes
- Imperfect information
- Price searcher/maker
Example: MTR in Hong Kong, electricity providers in Hong Kong (China Light Power dominated services in Kowloon and the New Territories).
How Monopolies Earn Abnormal Profit (Diagram)
A profit-maximizing monopolist produces at the quantity (Q) where MC = MR. At this quantity, the monopolist charges a price (P) higher than the average total cost (ATC). The shaded area in the diagram represents the monopolist’s abnormal profit.
Profit = TR – TC = (AR – AC) x Q
Due to high barriers to entry, the abnormal profit can be sustained in the long run.
Natural Monopoly
Definition
A natural monopoly arises when it is more efficient for one firm to dominate the market and exploit economies of scale to be profitable than for many smaller sellers to compete.
Example: Electricity providers in Hong Kong.
Characteristics of a Natural Monopoly
- High fixed costs (e.g., establishing a network, electric generators)
- Small firms producing less than a certain quantity would be unprofitable as ATC > AR
- Larger firms exploit economies of scale to be profitable (e.g., purchasing economies of scale, financial economies of scale)
Government Control of Monopoly Power
Arguments for Government Intervention
- Allocative inefficiency: Monopolies do not achieve allocative efficiency (MC = AR). Production is lower than the socially optimal level, leading to underproduction and welfare loss. Consequences include higher prices and lower output levels (e.g., MTR’s reluctance to extend services to rural areas in Hong Kong).
- Productive inefficiency: Monopolies do not produce at minimum average cost (AC). Consequences include higher costs that may be passed on to consumers.
Methods of Government Intervention
- Regulation: Regulating price increases (e.g., price ceilings, limiting percentage increases to below the inflation rate), regulating profit earned (e.g., limiting net profit to below 9.9%).
- Legislation: Enacting anti-monopoly practices legislation (e.g., prohibiting predatory pricing, vertical agreements) through competition ordinances.
Arguments Against Government Intervention
- Costly and time-consuming investigations: By the time a judgment is made, the monopolist may have already enjoyed substantial profits.
- Reduced effectiveness: Government intervention may not always be effective in achieving its goals.
- Higher business costs: Regulations can increase business costs, potentially reducing the competitiveness of local businesses.
Advantages of Monopoly
- Economies of scale: Larger firms enjoy lower long-run average costs (LRAC), which can be passed on to consumers through lower prices.
- Research and development: The existence of abnormal profit in the long run provides an incentive for firms to invest in research and development, leading to more innovative products for consumers.
Monopolistic Competition and Normal Profit in the Long Run
In monopolistic competition, firms can only earn normal profit in the long run due to the following factors:
- Many small firms: The market is characterized by a large number of small firms, each with limited market power.
- Product differentiation: Firms sell slightly differentiated products, giving them some degree of price-setting ability.
- Free entry and exit: If firms are earning abnormal profits, new firms will enter the market, increasing competition and driving down prices until only normal profits remain.
Price Stability Under Oligopoly
Prices tend to be stable under oligopoly due to the following factors:
- Barriers to entry: Oligopolies are characterized by significant barriers to entry, limiting the number of firms in the market.
- Interdependence: Firms in an oligopoly are interdependent, meaning their actions affect each other’s profits. This leads to strategic behavior and a reluctance to engage in price wars.
- Kinked demand curve: The demand curve for an oligopoly is often kinked, reflecting the asymmetric response of competitors to price changes. This makes it less attractive for firms to change prices, leading to price stability.
Collusion vs. Competition in Oligopoly
Reasons for Collusion
Oligopolists may collude to:
- Increase profits: By coordinating their actions, firms can reduce competition and increase profits.
- Reduce uncertainty: Collusion can reduce the uncertainty associated with competition, making it easier for firms to plan and invest.
- Avoid price wars: Collusion can help firms avoid destructive price wars that can harm all participants.
Disadvantages of Collusion
/ collusion may break down
There is a incentive for the firms to cheat
This happens when firm A agrees to increase P but secretly reduce P, firm A is able to enjoy a higher payoff of $30
large number of firms make it difficult to control, difficult to reach a consensus since individual firm may have different objectives
Shrinking market demand – demand for oil decreases due to the appearance of new energy, individual firms place their benefit over collateral benefit as they seek survival.
Para 4 – Explain why firms may compete / ways of competition
Price competition: Sales promotion, But only short run strategy, Turn out to be a price war
Non-price competition: Quality of goods ands services, More variety of goods, Delivery services, Branding, Loyalty card
E – Non-price competition is often costly
Collusion is SR strategy / more suitable for smaller firms who cannot stand on their own
Competition is LR strategy / more suitable for larger firms who can establish their brand name and differentiate from other competitors
Explain the reasons for monopoly to practice price discriminations and the conditions for it to happen. [10]
Define – same good, same cost, charge different groups of consumers different price
E.g. Students / Adults in cinema, transportation
Industry demand is the sum of the two markets
Without price discrimination, firm would produce at Q, charging P, old profit shown in Diagram 3
With price discrimination, firm would charge higher price Pa in inelastic market (adult)
Charge lower price Pb in elastic market (students)
The sum of profits earned in the two markets in larger than the old profit.
Firm practices price discrimination to maximize their profit.
Condition
Certain market power, enable them to have the price setting ability
Different groups of consumers should have different price elasticity
The market must be separated to prevent resale of the product