Also, firms in oligopoly can emerge with other firms to increase its share of the market.
- Explain why firms operating in a perfectly competitive market would be able to make normal profits only in the long run.
Long run is a time period long enough to change all inputs.
Short run is a time period during which at least one input is fixed and cannot be changed by the firm.
Normal profit is the minimum amount of revenue required by a firm so that it will be induced to keep running, which is equal to part of revenue that covers total opportunity costs (all explicit and implicit costs).
Economic profit is total revenue minus economic costs (or total opportunity costs, or the sum of accounting plus implicit costs).
In the long-run equilibrium of the perfectly competitive market structure, all firms earn normal profits (they earn zero economic profit). The reason behind this important principle is that if firms earn economic profit or make losses in the short run, the profits and losses give rise to a process of entry and exit of firms that makes the short-run profits or loss tend to zero. The long-run equilibrium position of the firm and the industry under perfect competition is graphed below. As a result of entry or exit, the market settles at the price Pe, which is just equal to the firm’s short-run and long-run minimum average total cost (total cost per unit of output), where each firm is earning normal profit. Each firm in the industry produces output Qf, and the industry as a whole produces output Qi (equal to the sum of all the firms’ outputs).
In perfectly competitive long-run equilibrium, firms’ economic profits and losses are eliminated, and revenues are just enough to cover all economic costs so that every firm earns normal profit.
- What are the distinctions between decreasing returns to scale and diminishing marginal returns?
Long run is a time period long enough to change all inputs.
Short run is a time period during which at least one input is fixed and cannot be changed by the firm.
According to the law of diminishing marginal returns, as more and more units of a variable input (such as labor) are added to one or more fixed inputs (such as lands), the marginal product of the variable input at first increases, but there comes a point when the marginal product of the variable input begins decreasing. This relationship presupposes that the fixed input(s) remain fixed, and that the technology of production is also fixed. The law of diminishing marginal returns only applies in the short-run.
Diseconomies of scale are increases in the average costs of production that occur as a firm increases its output by increasing its plant size, i.e. increasing all its inputs. Thus, diseconomies of scale can be seen only in the long-run. Diseconomies of scale are responsible for the upward-sloping part of the long-run average total cost curve: as a firm increases plan size, costs per unit of output increase.
Briefly, a firm gains less benefit from adding an extra unit of one specific input under diminishing marginal returns; on the other hand, under decreasing returns to scale, a firm gains less benefit from adding an extra unit of every input.
Part B: Essay
- There are two ways that firms operating in different market structures compete. First of the two is price competition. Price competition among firms occurs when a firm lowers its price in order to attract customers away from rival firms, and thereby increase its sales at the expense of other firms. The other way is non-price competition which, in contrast to price competition, occurs when firms use methods other than price reductions in order to attract customers away from rivals. The most common forms of non-price competition are product differentiation, advertising and branding. Firms can attract customers by use of these methods increase their monopoly power and their ability to control the price of their product. They can charge a higher without risking loss of buyers to rival firms. In general, the more differentiated the product is from its substitutes and the more successful the advertising and branding as methods of convincing consumers about the superiority of a product, the less elastic will be the demand curve facing the firm, the greater the monopoly power (the ability to control price), and the larger the firm’s potential to increase short-run economic profits.
Monopolistically competitive firms compete with each other on the basis of both price and non-price competition. The more successful they are in increasing their sales and market share through non-price competition methods, the less they need to rely on price competition. By contrast, firms that are less able to achieve consumer loyalty for their product, and whose product is less differentiated from substitutes, may have to rely more on price competition (in other words price reductions) in order to increase their sales and market share.
Unlike firms in monopolistic competition that compete on the basis of both price and non-price competition, oligopolistic firms go to great length to avoid price competition; in other words, they avoid trying to increase market shares by cutting prices. Firms in oligopoly are better off coordinating their pricing behavior where they can (through formal or informal collusion), and when they do not collude they still avoid competitive price-cutting as this is likely to result in lowering their profits. However, oligopolistic firms usually do engage in intense non-price competition. Non-price competition involves efforts by firms to increase their market share by methods other than price, which typically include product development, advertising and branding. This applies to firms under both collusive (the type of oligopoly where firms agree to restrict output and fix the price, in order to limit competition, increase monopoly power and increase profits) and non-collusive (oligopolistic firms do not agree, whether formally or informally, to fix prices or collaborate in some way) oligopoly.
- Competition in economics is a term that encompasses the notion of individuals and firms striving for a greater share of a market to sell or buy goods and services. Many people believe that the more competition there is within each industry the better. Competition has different impacts on consumers in different market structures; positive or negative. For example, competition between firms under monopolistic competition puts a downward pressure on costs as firms compete with each other; these competitive pressures may force less efficient firms to leave the industry. The absence of competition in monopoly does not exact such a downward pressure on costs. Also, free entry and exit under monopolistic competition drives economic profits down to zero in the long run, and allows prices to be lower for the consumer than is possible under monopoly, where barriers to entry allow the firms to maintain profits over the long run.
Oligopolistic firms usually engage in intense non-price competition. In other words, in these firms there are product differentiation, advertising, and branding. Oligopolistic firms try to make their goods more attractive to gain money. In order to make their goods more attractive they increase the quality and try to minimize the price for those goods. As a result, competition provides better products than no competition and consumers benefit from the competition. Governments encourage competition because they want their citizens to gain the most utility they can from procuring differentiated products.
- “Monopoly price is higher and output smaller than is socially ideal. The public is the victim.”
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A comparison of monopoly with perfect competition at the level of the industry reveals that price is higher in quantity of output produced lower in monopoly than in a perfectly competitive industry. The graphs below shows the long-run equilibrium positions of a perfectly competitive industry, composed of many small firms, and of a monopoly, which is the entire industry. Graph (a) shows the standard market demand (=MB or marginal benefit) and supply (=MC or marginal cost) curves for the perfectly competitive industry, determining the equilibrium price and quantity, Ppc and Qpc. The equilibrium position of this industry is given by point a, or the point of point of intersection of the industry demand and supply curves.
Now let us suppose that the numerous small firms in the perfectly competitive industry of graph (a) are bought up by one firm, so that was a perfectly competitive industry becomes a monopoly, shown in graph (b). The MC curve of graph (a), or what was the competitive industry’s supply curve (equal to the sum of all the individual firm supplies, or MC curves), is now the monopolist’s marginal cost curve. The demand curve remains unchanged, but this demand curve takes on a different significance. Under perfect competition, each firm was faced by a perfectly elastic demand curve at the price level Ppc, and the firm’s marginal revenue was equal to price (MRpc = Ppc). But the monopolist is faced with the entire industry demand curve, D, and therefore its marginal revenue (MRm) curve now lies below D. When the monopolist applies the MR=MC rule to determine the profit-maximizing level of output, the result is Qm output; and given the demand curve that determines price for each level of output, the equilibrium price is Pm.
Since Qm<Qpc, the industry under monopoly produces a smaller quantity of output than the industry under perfect competition. And since Pm>Ppc, the monopolist sells output at a higher price than the perfectly competitive industry. Higher prices and lower output go against consumers’ interests.
- It is disputable topic but I do agree that the public is always the “victim” of monopoly; but there is a really important benefit of monopoly on consumers, which is called “economies of scale.” Economies of scale are a major barrier to entry in the case of monopoly, particularly in the case of a natural monopoly. Economies of scale lead to falling average costs over a large range of output and firm scale, and when there is a natural monopoly average costs may continue to fall even at the level of output that satisfies market demand.
Extensive economies of scale are a major argument in favor of large firms that can achieve lower costs as they grow in size.
When a monopoly can achieve substantial economies of scale, it is even possible that its lower costs will permit price and output levels that approach those of a perfectly competitive industry.
This is shown in the graph below, where Qm and Pm are the output and price of the perfectly competitive industry. Let us say now that the monopolist succeeds in achieving significant economies of scale, so that its costs all and its MC curve shifts downward to MCes. The intersection of MCes with the monopolist’s MR curve determines the profit-maximizing level of output Qpc at price Ppc, which is the price of the perfectly competitive industry. Note that if the MCes curve was even lower, then the monopolist would produce a larger quantity of output and sell it at a lower price than the perfectly competitive industry.
Consumers can therefore gain from economies of scale because lower costs of production translate into lower prices, as well as the increased quantity of output. Society as a whole also gains because lower costs of production mean increased efficiency in the use of resources.
By contrast, a perfectly competitive firm, due to its very small size, cannot capture economies of scale.
Part C: Excerpt - Liberalization backfires on Japan’s Taxi Industry
- Explain what is meant by the following terms used in the passage:
- Market liberalization:
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Fixed price involves setting a legal maximum or legal minimum price.
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Free market is based on private ownership of resources and private decision-making, and relies on prices determined in free markets and price rationing to coordinate choices that allocate resources and distribute income/output.
- exposure of markets to free market forces
- the government does not get involved and there are no regulations
- price fixing and market rigidities are abolished
- Cyclical downturns:
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Actual output is the quantity of output produced.
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Potential output is assumed to be achieved when all resources are used in the best possible way.
- Cyclical downturns is a part of the trade cycle
- It is a regular fluctuation in actual output relative to potential output
- Downturn is the phase between boom and recession
- If the Japanese economy recovers from recession, what would you expect to happen to taxi fares? Explain your answer.
Many people who are working in other industries quit and switch to the taxi industry during recession. When they recover from recession these workers return to their old jobs. Thus, a recovery would cause a reduction in the availability of taxis just as demand for taxis increases. As a result taxi fares would increase.
- Using your understanding of business economics, explain which market structure is indicated by the characteristics of the Japanese taxi industry.
The market structure in the Japanese taxi industry is the most similar to perfect competition. Perfect competition has the following characteristics:
- Large numbers of small firms
- Each firm has no control over the price
- There is no product differentiation; homogenous products
- There are no barriers to entry and exit
- Perfect knowledge; thus all firms and all consumers have complete information regarding products, prices, resources and methods of production.
There are numerous taxis in Japan, each of them doing the same service. As there are large numbers of taxi companies, each company’s output is a very small fraction of the total output of the industry so it cannot influence price. Although the brands of taxis can be different, they do the same job to serve the society. There is no consumer preference of taxis. In other words, in the taxi industry there is no differentiation of products (services). It is mentioned in the paragraph 5 that workers from other industries can begin working in the taxi industry when there is recession. Thus there is freedom of entry and exit in the Japanese taxi industry. Everybody knows that they can start working in the taxi industry, considering the costs like gas, by having a car. Consumers (clients) know how much they are charged for a kilometer when they use taxis.
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In paragraph 6 it is claimed that between a third and a half of Japanese taxi companies are losing money. What would you expect to happen to these loss-making companies in the short run and in the long run? Use diagrams to illustrate your answer.
Long run is a time period long enough to change all inputs.
Short run is a time period during which at least one input is fixed and cannot be changed by the firm.
Average fixed cost is the fixed cost per unit of output.
Average variable cost is variable cost per unit of labor.
Average total cost is total cost per unit of output.
Marginal revenue is the additional revenue of a firm arising from the sale of an additional unit of labor.
Marginal cost is the change in cost arising from one additional unit of output.
Average total cost is total cost per unit of output.
Fixed costs are costs that do not change as output changes.
Variable costs are costs that change as output increases or decreases; therefore they are “variable.”
It will be worthwhile for the firm to continue producing even though it is making a loss, because its loss will be smaller than the loss it would make if it stopped to produce. This answers the loss-making firm’s question: it is better to produce rather than shut down, as long as the loss it makes by producing is less than its total fixed cost. This situation is graphed below. The vertical difference between ATC and AVC is equal to AFC (since AFC+AVC=ATC). Therefore the loss per unit which is given by ATC-P3 at output level Q3 (or the vertical difference between points c and d); is smaller than AFC. Therefore this firm should not shut down in the short run; it should produce its loss-minimizing output, because the loss it makes by producing is smaller than its fixed cost.
In general, when ATC>P>AVC at the level of output where MC = MR, the firm is making a loss but should continue to produce because its loss is smaller than its fixed cost.
Additionally, taxi drivers are a form of short run casual labor that exist temporarily during a recession only, and the taxis may cross-subsidize (one group pays a relatively high price and thus enables another group to pay a relatively low price) other forms of economic activity.
The difference between shutting down in the short run and shutting down in the long run is that in the short run, whereas a loss-making firm can choose to produce zero output, it still has a fixed plan for which it incurs fixed costs. In the long run the loss-making firm can shut down its plant completely and stop incurring any costs at all. When you do not have any fixed costs, you can shut down your business.
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Using the text and your knowledge of economic theory, explain why the Japanese government is trying to solve the problems of the taxi industry through deregulation.
Deregulation is the removal or simplification of government rules and regulations that constrain the operation of market forces (Wikipedia definition).
Economic efficiency occurs when firms produce the particular combination of goods and services that consumers mostly prefer. It is achieved when MB=MC; since MB=P, condition can be restated as P=MC.
- Marginal benefit (MB) is the marginal utility of a good or service is the utility gained of a good or service.
- Marginal cost (MC) is the change in cost arising from one additional unit of output.
Productive efficiency occurs when firms produce at the lowest possible cost. The condition for production efficiency is the following. It is achieved when P=minimum ATC.
The Japanese government is aiming to improve the economic efficiency of the taxi industry by deregulation. The stated rationale for deregulation is often that fewer and simpler regulations will lead to a raised level of competitiveness, therefore higher productivity, more efficiency and lower prices overall.
The use of deregulation to expose economic activity to greater market forces, resulting in shorter run unemployment, business failure and falling prices, but greater efficiency and stability in the long run.
Both allocative and productive efficiency are achieved by the perfectly competitive firm when it is at its lower run equilibrium position. At the point of production determined by MR=MC, price is equal to marginal cost, and therefore society’s scarce resources are being allocated efficiently. Also, at the point of production P= minimum ATC, and therefore the lowest possible costs are being achieved; hence there is no waste of resources. The achievement of economic (allocative and productive) efficiency by the firm when it is in long-run equilibrium is summarized by: P=MC=minimum ATC.
