Theory of the Firm (HL)

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



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:



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



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



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



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)



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:



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



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



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



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



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.



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



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



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.



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



andtheremustbenoleakagebetweenmarketse.g.cigarettesinUKare5poundsandinPolandare1pound,butmarketsarekeptapart

GeographicseparationLackofknowledgeAge

Reasonsforpricediscrimination(Advantagestofirm)

TomaximizeprofitsbyerodingconsumersurplusCreatesfavorableconditionsforeconomiesofscaleasmoreproductsaresoldDrivecompetitorsoutofanelasticmarketbyusingprofitsfromaninelasticmarkettosubsidizetheproductintheelasticmarket.

Effectontheconsumer

Advantages

Canallowpoorerconsumerstopurchaseaproductthatwouldn'tnormallybewithintheirpurchasingpower

Lawyersoftenchargelowerratesforpoorerclientsbutoffsetthelosswithhigherprofitsfromwealthierclients.

Usuallyincreasesoutputofaproductinthemarket,makingitavailabletomoreconsumers.Bettereconomiesofscalemayresultinoveralllowercoststhroughoutmarketsegments.

Disadvantages

ConsumersurplusiseliminatedSomeconsumerswillhavetopaymorethattheywouldhaveinanondiscriminantmarket.

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Theory of the Firm (HL)