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ECON11026 Principles Of Economics Mangement

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Question:

Explain with reasoning as to why the governments all over the world allow monopoly firms to continue the supply of water and transmission of electricity.

What are the legal, technical and economic sources of barriers to entry? In each case, give examples and explain how each of these barriers protects the established producer.

What conditions allow a monopolistic firm to price discriminate? Give example and illustrate first and third degree price discrimination.

(i) How much will the firm produce if it seeks to maximise profits?

(ii) What is the socially efficient level of output?

(iii) How much is the marginal external cost at this level of output?

(iv) What size of tax would be necessary for the firm to reduce its output to the socially efficient level?

Consider the following externalities, and explain if there would be external effects associated with any of the following activities, and if so, what would be the nature of the externality in each case?

(i) Population is vaccinated for polio, influenza or swine flu.

(ii) Single use plastic bags litter our environment, rivers and seas.

(iii) Can you think of government policies that might deal with each of the above two external effects of negative externality?

 

Answer:

In a perfectly competitive market setting, a firm is a price taker as it cannot have any say in setting the prices of its goods and has merely to accept the market price. According to Agarwal (2017), there are two key reasons why a firm cannot get away with fixing its price above the market price. First, there is no variance between its merchandise and that of each other firm in the market. As a result, no single customer would be willing to pay additional costs for the firm’s merchandise. Second, if a firm were to make it in fixing a higher price, more firms would enter the market, enticed by the higher profits that are available. This would rise supply and drive down the cost of the firm’s merchandise.

 


In the long run according to Agarwal (2017), no any single factor of production is fixed (all are variable) and there are free entry and exit of firms. Thus, firms making an abnormal profit, in the long run, will entice new firms which would enter freely. This would raise the industry supply (the supply curve would be made to shift to the right) and thus lower the industry price.  Consequently, new firms will stop arriving in the market once current firms make zero-economic margins.

Figure 1: Long-run curve in a perfectly competitive market

Source: www.intelligenteconomist.com

Contrary, firms supplying making losses or operating at break-even point will exit the market as it is not able to withstand competition in the market thus cutting industry supply (shift the supply curve to the left) (Pettinger, 2016). This will increase the industry price. Firms will continue exiting the market until those left behind make the normal profit again. Thus, all firms in perfectly market make a normal profit.

In a perfectly competitive market setting, a firm supplies a product at a point in which marginal cost (MC) equals the price (Seth, 2015). If the price exceeds MC, it motivates the firm to raise its output level to equal its price. Conversely, if the price below (is less than) MC, it is making losses. As a result, it will decrease its production (output) until the level at which price will be equal to MC (Seth, 2015). Thus, in perfect competition, the MC curve is the firm's supply curve. Since the MC curve is upward sloping due to the law of diminishing marginal returns, the firm's supply curve is also upward sloping.

Figure 2: Supply curve of a perfectly competitive firm

Source: https://www.economicsdiscussion.net

Most governments across the world permit monopoly firms to continue the supplying water and electricity to the public since MC of supplying to an extra consumer is very minimal, after the fixed outlays of the entire system have been settled. (Pettinger, 2016) For instance, once the main water pipes are placed in a locality, the MC of supplying water to another household is fairly low.

 


Likewise, once power cables are mounted through an area, the MC of supplying electricity to a new household is very minimal. Briefly stated, it would be costly and duplicative for a second provider of water or firm to enter the market and invest in an entire second set of main water pipes, or electricity lines (Pettinger, 2017). These industries provide an ideal case where, due to economies of scale, one manufacturer can attend to the whole market more ably than many smaller manufacturers that would be required to make replica physical capital investments.

Monopolies often obtain their market power from several and different barriers to entry. First, they make sure they control the vast proportion of natural resources. For instance, De Beers own the most significant share of the diamond reserves in the entire world, permitting only specific fractions of diamonds to be extracted each year and thus the reason for the higher price of diamonds. Second, setting up of these monopoly firms require high capital outlays. Some production systems often necessitate substantial investments in equity and expansion outlays which make it hard for new firms to enter the market. Examples include space transport, pharmaceuticals, steel production. Third, monopolies also benefit from economies of scale. According to Lumen Candela (n.d.), monopolies experience declining costs with increased production levels. Falling costs alongside huge setup outlay give monopolies a cost-plus in production over would-be competitors as they have not yet attained economies of scale.

Fourth, legal barriers also create a monopoly of goods and services. Intellectual property rights, for instance, copyright, patents, etc., gives the rights of ownership for the manufacturing and sale of particular products.  Lastly, government backing also helps firms to monopolise the market.  In many nations, the collective government monopolies are witnessed in public goods like hospitals, schools, railroads, telecommunications systems, etc.

Price discrimination happens when different customers are made to pay different prices in separate markets for the same supplies, or when the same purchaser is obliged to pay different prices for the same goods and services, and the different prices are not owing to differences in supply charges (Alkas Blog, 2011). For price discrimination to be sufficient, three conditions must hold. First, the market must have some imperfections or monopoly power so that suppliers can make instead of taking the market price. Second, the discriminating supplier can split the market into distinct segments and keep them separate, so that it is hard to transfer its products from one person to another. Lastly, the price elasticity of demand in every single market must be different.

 


First-degree price discrimination happens when a business charges a different price for each unit consumed (Pettinger, 2017). Examples of first price discrimination include age discounts, coupons, retail incentives, occupational discounts on financial aid and gender-based pricing. Third-degree price discrimination entails charging a different price to different customer groups (Pettinger, 2017). For instance, tube and rail travellers can be split into casual and commuter travellers, and cinema-goers can be divided into children and adults. Another example is people booking seats with a particular airline, could be charged differently based on travel history, often flyer involvement and whether the trip is proposed for leisure or business.

Two assumptions are made in this scenario. First, if the leader company (say Company A in this case) lowers its price below the normal market price, i.e. $ 185, the follower (B in this case) will also drop its prices. Company B will not like to lose market share if company A decreases its price. Therefore, the price decrease will be matched; the demand for company A will be highly elastic below $180. The second assumption is that if company A raises its price above the market price, company B will keep its price at $ 185. If company A price increases, we can assume that company B will capture much of the market share since company B’s price remains low.

Figure 3 : Oligopoly Kink Demand Curve

Source: student

The above two assumptions still holds for this part. The calculations are obtained as follows:

  • TR of the follower; this is delivered by multiplying the output of the follower by respective prices. The assumption made here is that for where Company’s A price is above the market price which is $185, Company B will keep $185 as its price. When Company A lowers its price below $185, Company B will also lower hers. If Company A keeps its price at $ 185, Company B will also keep this price.
  • The marginal revenue (MR) is calculated as the change in total revenue divided by the change in output demanded.
 

Table 1: TR and MR

1

2

3

4

5

6

7

8

Competitors Quantity Demanded

Price ($) (Leader)

Total Revenue (leader)

Competitors follow: Quantity Demanded

Price ($) (follower)

Total Revenue (follower)

Marginal Revenue (MR)

Marginal Cost  (MC)

20

200

4000

35

185

6475

0

150

30

195

5850

40

185

7400

185

150

40

190

7600

45

185

8325

175

150

50

185

9250

50

185

9250

165

150

60

180

10,800

55

180

9900

155

150

70

175

12,250

60

175

10500

145

150

Source: student

Profit will be maximized = (P-AVC)* maximum quantity demanded

P-$ 185

AVC in this case is 150 (as the marginal cost is constant)

Maximum quantity demanded-50

Thus, maximum profit is given by (185-150)*50=$1500

Represented in graph;

Figure 4: Maximizing Company’s Profit.

Source: Student

* An image was captured after drawing the graph as group of all the variables is distorting the shape of the graph

The firm will produce 5 units of output based if it seeks to maximize profits. This is because the profit will be maximized where MR equals MC which in this case is 27.

The socially efficient level of output is 4 where MSB=MSC=AR which is 42.

Table 2: Marginal External Cost

Output

MC

MSC

MEC

1

23

35

12

2

21

34

13

3

23

38

15

4

25

42

17

5

27

46

19

6

30

52

22

7

35

60

25

8

42

72

30

The marginal external cost at this level of output is 25.

The government will set the necessary tax at any point where MSC>MSB i.e. above 42

Yes. Both positive and negative externalities.  For positive externality, the risk of being infected by vaccinated people is very low compared to the unvaccinated people.  For the negative externality, if the used injection needles and cylinders containing the vaccination content are not disposed of well they would pollute the environment. The used materials could also hurt people either by inflicting cuts and other physical injuries.

Yes. A negative externality. Plastic bags are non-biodegradable and thus will interfere with the ecology.

For negative externality in (i) above, the government may reduce the externalities by imposing strict fines on individuals who are caught carelessly discarding the used vaccination materials. For (ii), the government may totally ban the use of plastics to prevent these externalities.

 

References

Agarwal, P. (2017, December 10). Perfect Competition Long Run | Intelligent Economist. Retrieved from https://www.intelligenteconomist.com/market-structure-perfect-competition-long-run/

Alkas Blog. (2011, January 26). 'Explain the necessary conditions for price discrimination to take place. 'Discuss the advantages and disadvantages of price discrimination for consumers and producers.? Retrieved from https://12onoal.wordpress.com/2011/01/25/explain-the-necessary-conditions-for-price-discrimination-to-take-place-%E2%80%9Cdiscuss-the-advantages-and-disadvantages-of-price-discrimination-for-consumers-and-producers/

Lumen Candela. (n.d.). Barriers to Entry: Reasons for Monopolies to Exist | Boundless Economics. Retrieved from https://courses.lumenlearning.com/boundless-economics/chapter/barriers-to-entry-reasons-for-monopolies-to-exist/

Pettinger T. (2016, October 28). Natural Monopoly - Economics Help. Retrieved from https://www.economicshelp.org/blog/glossary/natural-monopoly/

Pettinger T. (2017, March 16). Examples of Price Discrimination - Economics Help. Retrieved from https://www.economicshelp.org/blog/7042/economics/examples-of-price-discrimination/

Seth T. (2015, August 14). Short-run and Long-run Supply Curves (Explained With Diagram). Retrieved from https://www.economicsdiscussion.net/articles/short-run-and-long-run-supply-curves-explained-with-diagram/1677

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