Imperfect Competition

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Russell Thomas
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1 Imperfect Competition

2 Exam questions on monopoly are usually based on a pure monopoly where 1 firm holds 100% market share A working or legal monopoly is where a firm holds 25%+ market share BUT if the exam paper says MONOPOLY it means PURE MONOPOLY (100% Market Share)

3 The firm is the industry the whole output of the industry is in the hands of 1 firm There are barriers to entry no firm is able to enter the industry

5 Patent laws gives inventor exclusive right to its exploitation for a number of years Copyright music, publications and intellectual property Government nationalises an industry and grants a charter which prohibits competition by law When the incumbent (existing firm in the industry) has exploited the economies of scale and can produce at a much lower cost than any new entrant could. The incumbent would use limit pricing which is setting the cost so low new firms will not enter the industry, or they would start a price war and force the new entrant out almost immediately. When the incumbent creates very high fixed costs which would be sunk costs (irretrievable) if/when the firm exited the market e.g. advertising on a massive scale Legal monopolies (25%+ mkt share) may differentiate their products to distinguish them from competitors products The incumbent already holds all the prime retail outlets The incumbent holds all the control over an essential raw material e.g. local water companies

6 Cost and Revenue MC ATC MR D=AR 20 Quantity

7 What is the revenue? Cost and Revenue MC ATC What is the total cost? What is the profit? What area represents the profit? What kind of profit is it? Why? MR D=AR=P 20 Quantity

8 Cost and Revenue MC ATC MR D=AR Quantity

9 At Profit Max the monopolist is likely to not be at the bottom of its ATC which means it is not productively efficient It will not be spurred on to reduce costs by the risk of new entrants It may be x-inefficient No incentive to achieve Productive Efficiency X-inefficient: sometimes called organisational slack, not reducing costs to their lowest level the gap between the actual and lowest possible cost

10 In perfect competition supernormal profits would be competed away as new firms entered the market In a monopoly this is not the case as a result of the barriers to entry and so supernormal profits can be maintained in the long run

11 Label the following levels of output: Cost and Revenue MC ATC Profit Maximisation Revenue Maximisation MR=0 MR D=AR Quantity

12 Label the following levels of output : Cost and Revenue MC ATC Marginal Cost Pricing: Setting the price at the level of marginal cost AR=MC The point of ALLOCATIVE EFFICIENCY and WELFARE MAXIMISATION (in the absence of external costs) MR D=AR Quantity

13 Label the following levels of output: Cost and Revenue MC ATC Average Cost Pricing: Setting the price at the level of average cost AR=ATC The monopolist is making normal profits, this is the lowest price at which the firm will remain in the industry MR D=AR Quantity

14 1. Explain the term barriers to entry 2. Construct a diagram to show under what circumstances a monopolist can make supernormal profits (think of the relationship between AR and ATC to draw) 3. Explain with examples how barriers to entry operate in the real world

15 There are several interpretations of what a natural monopoly is: It occurs when one large business can supply the entire market at a lower price than two or more smaller ones A natural monopoly is a situation in which there cannot be more than one efficient provider of a good. In this situation, competition might actually increase costs and prices It is an industry where the minimum efficient scale is a large share of total market demand such there is room for only one firm to fully exploit all of the available internal economies of scale An industry where the long run average cost curve falls continuously as output expands

16 Characteristics: Extremely high capital costs to set up Duplication is unnecessary and wasteful The MES does not occur until a very high level of output

Because there is no single definition of a natural monopoly, none of the examples below are purely natural monopolies but it is suggested that their cost structure does stake them close to a

each household The Royal Mail s postal distribution network collection / sorting / delivery Virgin Media owning and running the cable telecommunications network Camelot operating the national network

17 Because there is no single definition of a natural monopoly, none of the examples below are purely natural monopolies but it is suggested that their cost structure does stake them close to a common-sense interpretation: British Telecom building and maintaining the UK telecommunications network for the broadband industry especially the final mile copper wiring from the local exchanges to each household The Royal Mail s postal distribution network collection / sorting / delivery Virgin Media owning and running the cable telecommunications network Camelot operating the national network for the UK lottery National Rail owning, maintaining and leasing out the UK rail network National Grid plc which owns and operates the National Grid high-voltage electricity transmission network in England and Wales. Since April 1, 2005 it also operates the electricity transmission network in Scotland. Owns and operates the gas transmission network (from terminals to distributors). London Underground, Tyne and Wear Metro National Air Traffic Services

18 Cost and Revenue R X P V a b MR 0 Q Q1 LRATC LRMC D=AR Quantity Economies of scale = increasing returns to scale MES is continually not reached Would operate at output OQ to profit maximise however the authorities would not allow a natural monopoly to behave in this way and would have imposed some form of price control or regulation In order to be allocatively efficient the natural monopoly must operate at Q1 where MC=AR but at this output ATC>AR and the firm would be making a loss of AB If the government want the firm to be allocatively efficient (welfare maximisation) the firm will require a subsidy of AB

19 1. Explain what you understand by the term natural monopoly 2. Outline the conditions under which natural monopoly is likely to occur refer to MES and the market size 3. Explain a real world example of a natural monopoly and why it fits this classification

20 Think of each unit separately E.g. Unit 1 The producer supplied it for. But sold it for. The buyer would have paid. But actually got it for. At Unit Q1 the surplus is 0 the supplier supplied it for. And the consumer is only prepared to pay. For it

21 You will be expected to refer to consumer and producer surpluses in essays

22 This corresponds to the first lowest point on the long run average total cost curve and is also known as the output of long run productive efficiency Unlikely to be a single level of output, more likely to be a range Firms that are unable to reach the minimum efficient scale are unlikely to be competitive The level of output required to reach the MES depends on the nature of the industry and its costs structure For example, when fixed costs are extremely large compared to variable costs expanding output will lead to decreasing average costs The size of the domestic market may mean that an economy is only able to support one firm in the industry if the MES is to be achieved A domestic firm wanting to reach the MES may need to export its products to increase the size of its potential market and the authorities may have to accept that a monopolistic structure is likely to be most efficient

23 Scherer (1975) calculated the minimum efficient scale for a number of industries and compared market size with the minimum efficient scale for the USA, Canada and Sweden For example if the market is capable of absorbing 200,000 worth of goods and the MES is 50,000 then 4 firms could operate at the MES He found that in the USA there was only room for 16 firms all producing cigarettes at the MES, while in the show producing industry there was room for 493 firms. This information shows the optimum structure for markets and indicates where monopolies represent the most efficient market structure. Country Cigarettes Steel Weaving Shoes USA Canada Sweden

24 In this industry the cost savings are exhausted very quickly and unit costs rise rapidly after a certain level of output X Firms in such an industry do not a great deal of choice about their size and are all likely to be of a similar size X represents the point of productive efficiency, at this point there are constant returns to scale

25 Over the output range O to A the firm experiences increasing returns to scale Over the range of output A to B the firm experiences constant returns to scale When output exceeds B decreasing returns to scale set in O A B Firms in this industry are likely to be of differing sizes as once they have reached A they have the opportunity to produce thousands more units before decreasing returns to scale set in at B Productive efficiency occurs at any point between A and B

26 In markets such as the UK which are relatively small prices are likely to be higher to cover costs than if there was only one firm who achieved the MES Consumers could actually benefit from monopoly through a firm achieving MES meaning lower prices, this would also benefit the international competitiveness of the firm

The Economist Joseph Schumpeter argued that monopolist were responsible for economic progress due to R&D and innovation He argued that the profits that could be made provided the incentive for

27 The Economist Joseph Schumpeter argued that monopolist were responsible for economic progress due to R&D and innovation He argued that the profits that could be made provided the incentive for innovation and the development of new products Innovation accelerates economic growth and so a greater degree of monopoly in an economy may be a positive thing Reducing monopoly power could reduce growth This is reflected in the UK where monopolies are not declared illegal and the control of monopolies is judged on a case by case basis

28 Price discrimination

29 efficiencies

A2 Micro Business Economics Diagrams

A2 Micro Business Economics Diagrams Advice on drawing diagrams in the exam The right size for a diagram is ½ of a side of A4 don t make them too small if needed, move onto a new side of paper rather than