ECON11026 Principles Of Economics

a. Why are perfectly competitive firms’ price takers?

a. Assume that a firm discharges waste into a river. As a result, the marginal social costs (MSC) are greater than the firm’s marginal (private) costs (MC). The table below shows how MC, MSC, AR and MR vary with output. Assume that the marginal private benefit (MB) is given by the price (AR). Also assume that there are no externalities on the consumption side, and that therefore MSB = MB. Study the table and answer the following

 

 

1. (a) Definition

One of the key features of perfectly competitive firms is that they are price takers and not price makers. This happens due to primarily two reasons. One of these is because of the small size of all the producers due to which no firm has the ability to influence the industry by the underlying economic decisions it makes. This prevents any particular firm from bringing changes in the price. The second reason is that the products sold by perfectly competitive firms are homogeneous and hence the consumers would tend to buy only at the price decided by the underlying industry demand and supply.

Assumption

A producer charging any excess price would make zero sales as the buyers have perfect information about the market. Also, there are no entry and exit barriers (Arnold, 2015).

Diagram

The relevant diagram is shown below.

                                                                                 

Analysis

It is apparent that the industry price on the left is decided on the basis of demand and supply. This same price is used by the individual firm and it cannot influence price by taking economic decisions. It can only decide output level for profit maximisaiton.

(b) Definition

Perfectly competitive firms make normal profit in the long run is because there are no entry and exit barriers. As a result, even if firms are able to make abnormal profits in the short run, this would not be the case in long run since new sellers would enter the market in order to earn the abnormal profits. In the process the supply would increase and lead to decrease in price to the extent the profit is normalised (Mankiw, 2014).

Assumption

There are no entry and exit barriers.

Diagram

Consider the following firm in the perfectly competition in the short run (Krugman& Wells, 2014).

                                                                                 

                                                                                 

Analysis

In the short run, abnormal profits are being made by the above firm. But the in the long run with the entry of new firms, the supply would increase and the lower the price to a level where there is normal profits as shown below (Arnold, 2015).

(c) Definition

With regards to perfectly competitive firm, the supply curve in the short run would be the portion of marginal cost curve for which the output tends to exceed the break even output level based on the underlying variable costs.

Assumption

In the short run, the supply cannot be altered by change in fixed factors but only the variable factors are at play. Thus, in the short run, a given firm would keep supplying goods till the prices atleast matches the variables costs.

Diagram

The relevant diagram for a competitive firm in the short run is illustrated below (Mankiw, Mankiw& Taylor, 2011).

                                                                                                 

Analysis

From the above diagram, the upward slope of the short run supply curve of firm in perfect competition can be explained. When the price of the industry is P and assuming that there are 100 firms with each producing M units, the total production would be 100M. Now, when there is a higher price P₁, it is apparent that the MR curve would also shift since in perfect competition, the MR curve is the price charged. For profit maximisation, MR=MC and hence the marginal cost curve would have to be upwards sloping to intersect the new MR curve at M₁ output. Thus, it is apparent that the in the short run, the unit production for a firm is dependent on the underlying price owing to which the supply curve is upward sloping (Nicholson & Snyder, 2014).

2. (a) Definition

Monopoly is a market structure where there is only one seller and multiple buyers. Also, firm the monopoly is driven by maximising the profit and hence tends to maintain a lower than sub-optimal output so as to maintain artificial scarcity so as to keep the prices high. The end result is that the monopolistic firm tends to earn a supernormal profit even in the long run since no new seller can enter the market (Krugman& Wells, 2014). 

Assumptions

• High entry and exit barrier
• No competition exists

Diagram

The intervention of the government in the monopoly firms providing utilities to public can be justified on the basis of the following equilibrium diagram in case of monopoly.

                                                                                                   

The underlying inefficiency in case of monopoly is reflected using the following graph which compares the output and price levels for deriving fair return and socially optimum scenario with those in monopoly (Mankiw, 2014).

                                                                             

Analysis

The equilibrium parameters for monopoly for indicated by Q_m and P_m which highlight equilibrium quantity and equilibrium price. It is noteworthy that even in the equilibrium position, the AC curve does not attain the bottom position which hints at productive inefficiency. 

The above figure clearly highlights that monopoly leads to lower quantity of supply than desirable for efficient resource usage. Also, the price charged is significantly higher. As a result, the government needs to intervene and insert a price cap so that the affordability of these basic utilities can increase. Further, since there is no competition, hence the service quality of these utilities may diminish owing to which the government introduces minimum service quality standards to be met by these basis utilities providers. In certain cases, government even might consider allowing private firms to enter the market (Nicholson& Snyder, 2014).

(b) Definition

Monopoly is based on presence of entry barriers so that there is only one seller. The various types of barriers to entry are explained below.

Legal barriers – This typically happens when there is a law which prohibits entry of any new players in the market and provides rights to operate only to one player.

Technological barriers – This typically happens to industries which are primarily driven by technology and owing to lack of technology, other firms cannot enter the market.

Economic barriers – This typically happens when the upfront cost is very high and hence economies of scale tend to become crucial.

Assumption

• Barriers do not allow entry of new firm and also tend to act as exit barrier for the current firm

Analysis

Legal barriers - An example of this would be Australia Post where legal barriers do not allow entry (Novak, 2014). This is typically done in strategically key industries such as defence, telecommunications and utilities where public interest is paramount and hence it is assumed that this could be better safeguarded by government entity which is not necessarily driven by profit motive (Arnold, 2015).

Technological Barrier - This was quite prevalent in the past when companies such as AT&T possessed the technology for long distance communication and thereby no other player could provide services. In case of technological oriented products such as high end chips, technology based barriers still exist (Mankiw, 2014).

Economic Barrier - This is typically the case in utilities where the upfront infrastructure required is very costly and hence acts as a barrier for new entrants. Another example is organised retail in Australia with players like Woolworths and Coles already dominating the market with low prices, a new player would find it very difficult to match the offered prices owing to lack of economies of scale (Mankiw, Mankiw& Taylor, 2011).

3. (a) Definition

Price discrimination can be carried by a monopolistic firm owing to the following reasons (Arnold, 2015).

• The monopolistic firm has some power to dictate prices to the customers owing to existence of imperfect competition.
• Further, owing to differentiation of products and services from the competition, a monopolistic firm can charge higher prices

Assumption

There is enough differentiation of products to allow for pricing power and also perfect substitutes are not available. Besides, market segmentation is possible for price discrimination.

Diagram

                                                                                                       

Analysis

First Degree Price Discrimination

It is also called as perfect price discrimination as the firm charges separate price for each unit of product and is able to price the products or services so as to capture the complete consumer surplus by ensuring that every customer willing to buy the product is provided the product at the maximise price that each individual consumer is willing to pay. This is close to impossible to practice in real life. The relevant diagram is shown below (Pindyck. &Rubinfeld, 2015).

Third Degree Price Discrimination

This is the most common form of price discrimination which is typically witnessed in the airline and rail transport. There are differential ticket prices for travelling in peak timings as compared to lean timings. As apparent, this price discrimination does not maximise the profit earned since it relies only on broad segmentation based on demand (Mankiw, 2014).

(b) (i) The requisite graph is shown below.

                                                                                   

It is apparent that only when the market price is above $ 198 would the marginal revenue for a follower would be positive or else it would be negative as apparent above (Krugman& Wells, 2014).

(ii) The completed columns in the table are shown below.

                                                                                                 

(iii) For profit maximisation MR = MC, however, in the given case such condition is not being achieved owing to which it implies that the entry of follower is not a preferable strategy (Pindyck. &Rubinfeld, 2015).

4. (a) (i) To maximise the profits MR should be equal to MC. This is happening at output level 5 when MR =MC =27. Hence, the firm would need to produce 5 units of output (Krugman& Wells, 2014).

(ii) The socially efficient level of output is produced when MSC and MR are equal. This is happening at output level 4 when MSC=MR=42. Hence, the firm would be socially efficient when the output would be 4 units (Mankiw, 2014).

(iii) Marginal External Cost = Marginal Social Cost - Marginal Cost

At output level 4, MSC = 42 while MC = 25

Hence, Marginal External Cost = 42-25 = 17

(iv) The objective of the tax is to reduce the output of the firm from level 5 to level 4 so that production is socially efficient. At level 4, the MR = 30 while the MC = 25. Hence, a tax of 5 should be sufficient as it would ensure that MR =MC =30.

(b) (i) If the population is vaccinated against polio, influenza or swine flu, then it would have a positive impact of the health outcome of not only those impacted but also those who may be vulnerable. In the absence of any vaccination, any outbreak of the above diseases could impact healthy individuals and thus lead to loss in productivity. Thus, positive externality is associated with this action (Pindyck. &Rubinfeld, 2015).

(ii) The practice of single use plastic bags tends to have adverse impact on the environment which in the long run could have adverse impact on the health of the people especially those living in the vicinity of the dumping grounds. It is apparent that negative externality is associated with the use of single use plastic bags and hence recyclable plastic bags would be preferred (Arnold, 2015).

(iii) With regards to vaccination of population, the government should ensure that these vaccinations are mandatory for every child so that there is no outbreak of any of these diseases which can adversely impact productivity and lead to wastage of financial resources in controlling the outbreak (Mankiw, Mankiw& Taylor, 2011).

In relation to limiting the negative externality associated with single use plastic bags, the government should put a blanket ban over the use of single use plastic bags. Only plastic bags that can be recycled should be allowed and also there needs to be a mandatory policy for recycling of these (Pindyck&Rubinfeld, 2015).

References

Arnold, A.R. (2015) Microeconomics. 9th ed. Sydney: Cengage Learning.

Krugman, P. & Wells, R. (2014) Microeconomics 2nd ed. London: Worth Publishers.

Mankiw, G. (2014) Microeconomics. 6th ed. London: Worth Publishers.

Mankiw, G.N., Mankiw, G.N. and Taylor, P. (2011) Microeconomics. 5th ed. Sydney: Cengage Learning.

Nicholson, W. & Snyder, C. (2014) Fundamentals of Microeconomics.11th ed. New York: Cengage Learning.

Novak, J. (2014) Australia Post: Lets free it up, Retrieved from https://www.smh.com.au/opinion/australia-post-lets-free-it-up-20140624-zsjy0.html

Pindyck, R. &Rubinfeld, D. (2015) Microeconomics 5th ed. London: Prentice-Hall Publications