Please work on one question each week – based on weekly topic and in a timely manner.
Q1. Market structures chapter 5
(a) Draw graphs and explain why perfectly competitive firms’ are price takers?
(b) Draw graphs and explain why perfectly competitive firms make short run loss, short run economic profit, and normal profits in the long run?
Q2. Market structures chapter 5
(a) Why a firm is called a natural monopolist? Give examples, draw a graph and explain.
(b) Is a profit maximising monopoly firm always technically efficient? Draw a graph
and explain. (3.5 marks)
Q3. Market structures Chapter 6
(a) What do you understand by the concept of interdependence of firms under oligopoly market structure? Give examples and explain.
(b) What assumptions concerning a rival’s responses underlie the kinked demand curve? Give example, draw a graph and explain.
(c) Draw graphs and explain the long run situation of monopolistic competition and perfect competition?
(d) In what way is monopolistic competitive firm superior and inferior to perfect competition? In other words serves the public interest. Based on the assumptions and referring to graphs from part c, explain.
Q4. Market Failure and Externalities Chapter 7
(a) What are the three types of goods classified by Economist? List and explain their characteristics with examples.
(b) The Table 1 below gives the costs and benefits of an imaginary firm operating under perfect competition whose activities create a certain amount of river pollution. (It is assumed that the costs of pollution to society can be accurately measured).
In a perfectly competitive market, firms are price taker as none of them can change the market price. New firms can enter into the market without any restrictions and each of them sells similar products. Therefore, each firm possesses a very small portion of the entire market. According to the characteristic of this market, each firm and each consumer has perfect knowledge of others (Cowell, 2018). If one of them change price then other firms can also change accordingly in order to earn higher profit. Therefore, market price remains stable at equilibrium level. The following diagram represents this situation accordingly.
Figure 1: Price taker firm in a perfectly competitive market
The above figure represents the equilibrium condition of a perfectly competitive industry. The market receives its equilibrium price when demand and supply equate with each other. At this price, each firm set their demand curve, which is a horizontal straight line.
In short-run, a perfectly competitive firm incur loss or earn economic profit. However, this firm earns only normal profits in long-run. This happens as firms can enter or exit freely. In short run, firms may earn economic profit and this further can attract others to enter into the market gradually (Currie, Peel & Peters, 2016). On the contrary, firms can incur loss in short run and this further may lead some existing firms to exit from the market. As a result, those firms, who earn normal profit, remain into the market.
Figure 2: Short-run and long-run condition of a perfectly competitive firm
The above figure represents both short-run and long-run condition of a perfectly competitive firm. Initially, the firm makes short-run loss by CP1 amount. In this situation, the supply curve of the firm is S1. However, the firm tends to decrease its supply to avoid loss. As a result, the curve shifts leftward from S1 to S2. Therefore, in long-run the firm will earn normal profit only at P0 price, where marginal cost, average cost and marginal revenue equate with each other. Some firms may leave the market to avoid such losses. On the contrary, a firm may increase its supply or other firms may enter into the market for increasing supply when existing firms enjoy economic profit in short-run.
The situation “natural monopoly” occurs when s firm performs in the entire industry. Due to higher fixed costs, it becomes impossible for other firms to enter into the market for conducting the same business. Moreover, natural monopoly may arise due to unique raw materials or technology that more than one firm cannot use. The firm that operates in this situation is called natural monopolist (Lim & Yurukoglu, 2018). If other firms enter into the market to compete then costs and prices will increase significantly. This situation can be described with a suitable diagram where the average cost curve decreases continuously as firm produces more output. At each level of output, the firm experiences increasing returns to scale. One of the chief examples of natural monopoly is British Telecom that builds and maintains the telecommunications network of the United Kingdom.
Figure 3: Natural Monopoly
The diagram represents the condition of a natural monopoly. Due to increasing return to scale, the long run average cost (LRAC) decreases as production increases. As production increases, the economies of scale decreases and this further helps the economy to produce efficiently.
To evaluate the performance of a firm, the concept of efficiency is required. This concept also measures the performance of the market as well entire economy. Technical efficiency means how much output a firm can produce by using a given input. This input can be either a machine or a worker or combined of more two inputs (Stiglitz & Rosengard, 2015). The firm can maximise technical efficiency through maximising output when inputs of the firm is given. Therefore, it can be said that a profit maximising monopoly is technically efficient. The following figure represents a profit maximising condition of a technically efficient monopolist.
Figure 4: profit maximising condition of a technically efficient monopolist
The above diagram represents profit maximising condition of a firm when it is technically efficient. Through using limiting inputs, the firm maximises its output efficiently and consequently earns excess profit. The difference between P and C represents excess profit that the monopolist earns in technically efficient way.
In a market, oligopoly occurs when limited number of firms sell homogeneous product. This market structure has two types, which are collusive and non-collusive. The chief characteristic of this type of market is mutual interdependency among firms (Matsumura & Okamura, 2015). This happens as each firm considers the reaction of rival firms at the time of implementing price and output policy. This process makes a firm highly dependent on others.
The auto industry can be considered as an oligopoly market, where interdependence can be observed among various automobile manufacturing companies, such as Ford, General Motors and Chrysler. Ford set its price and output strategy considering the reaction of GMC and Chrysler.
In a oligopoly market, a rival’s responses regarding the kinked demand curve depends on some assumptions. Firstly, rivals will reduce price level and responses with the price cut strategy. Secondly, rivals ignore the strategy of price increase. If one firm increases prices for its product, other firms will not follow this (Head & Spencer, 2017). From these assumptions it can be said that oligopolistic firms can protect and maintain their market share. Rivals firms react asymmetrically with the strategy of price changes of other firms.
The long-run monopolistic competitive market:
Figure 5: Monopolistic Competitive Market in Long-run
The above figure represents the long-run condition of a monopolistically competitive market. In this market, the firm earns normal profit only during long-run as other firms can enter or exit from the market freely (Bertoletti & Etro, 2016). This characteristic can be observed in a perfectly competitive market as well. However, some features of a monopoly firm can also be observed. For this, the demand curve slopes downward.
Figure 6: Perfectly Competitive Market in Long-run
The above figure represents a perfectly competitive market in representing the long-run situation. In this condition, no firm can earn economic profit or cannot incur any losses (Hayek, 2016). Each firm earns normal profit only as marginal revenue becomes equal with marginal cost and average cost curves.
The monopolistically competitive firm can be superior to a perfectly competitive firm if the former one can earn excess profit. As the firm experiences a downward slopping demand curve, it can charge any price like a monopolistic firm. On the contrary, the perfectly competitive firm cannot earn economic profit, as it acts as a price-taker. However, the monopolistically competitive firm can be inferior to a perfectly competitive firm as well (Mahoney & Weyl, 2017). This is because firms under monopolistically competitive market incur losses. However, a perfectly competitive firm cannot experience such possibilities, as it cannot influence market price.
Three types of goods classified by Economists are private goods, public goods and club goods. Each type of goods has some characteristics considering two key concepts rivalry and excludability. Private goods are rival and excludable by nature. This means only one consumer consumes a private good. An example of this type of good is foods (Benson, 2017). Public goods are non-excludable as well as non-rival. This implies many consumers can purchase this item at the same time. Public Park is an example of public good. Club-goods, on the contrary, have the nature of both private good and public good. This type of goods is excludable though non-rival by nature. Cable television can be considered as club goods.
i) The profit maximising level of output of the competitive firm is 7. At this level of output, price per unit of output becomes equal with marginal private costs of that firm (Van Oort, 2017). According to the concept, a competitive firm can maximise its profit when marginal cost equates with marginal revenue.
ii) The socially efficient level of output is 5. At the level, marginal social benefit (MSB) becomes equal with marginal social costs.
iii) The marginal pollution costs increase as the firm produces products, which create negative externalities. According to the cost theory, production cost increases at a decreasing rate then reaches to minimum point and then starts to increase at an increasing rate (Kaplan & Menzio, 2016). This implies that after a certain level of product, the starts to produce pollution by large amount.
Benson, B. L. (2017). Are Roads Public Goods, Club Goods, Private Goods, or Common Pools?. In Explorations in Public Sector Economics (pp. 171-213). Springer, Cham.
Bertoletti, P., & Etro, F. (2016). Monopolistic competition when income matters. The Economic Journal, 127(603), 1217-1243.
Cowell, F. (2018). Microeconomics: principles and analysis. Oxford University Press.
Currie, D., Peel, D., & Peters, W. (Eds.). (2016). Microeconomic Analysis (Routledge Revivals): Essays in Microeconomics and Economic Development. Routledge.
Hayek, F. A. (2016). The meaning of competition. Econ Journal Watch, 13(2), 360-373.
Head, K., & Spencer, B. J. (2017). Oligopoly in international trade: Rise, fall and resurgence. Canadian Journal of Economics/Revue canadienne d'économique, 50(5), 1414-1444.
Kaplan, G., & Menzio, G. (2016). Shopping externalities and self-fulfilling unemployment fluctuations. Journal of Political Economy, 124(3), 771-825.
Lim, C. S., & Yurukoglu, A. (2018). Dynamic natural monopoly regulation: Time inconsistency, moral hazard, and political environments. Journal of Political Economy, 126(1), 263-312.
Mahoney, N., & Weyl, E. G. (2017). Imperfect competition in selection markets. Review of Economics and Statistics, 99(4), 637-651.
Matsumura, T., & Okamura, M. (2015). Competition and privatization policies revisited: the payoff interdependence approach. Journal of Economics, 116(2), 137-150.
Stiglitz, J. E., & Rosengard, J. K. (2015). Economics of the public sector: Fourth international student edition. WW Norton & Company.
Van Oort, F. G. (2017). Urban growth and innovation: Spatially bounded externalities in the Netherlands. Routledge.
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