In the short run, a firm will produce the output that equates its marginal cost of production with the market price of its product, providing price exceeds average variable cost. This is because the sale price at which the firm can just cover its average variable cost when producing at its most profitable level of output is called the shutdown point – at this point firms cannot cover variable costs therefore are losing money for every unit produced. Strong firms may produce at this point (making a loss) but can only do so for the short term until other weaker competitors drop out of the industry, resulting in the stronger firm pushing up prices (in the longer term) as market share is now stronger resulting in pure profits where a firm can produce at MR = MC leads to the firm replacing capital as it wears out. This can attract firms into the industry where as if losses are made firms will leave.
Perfect competition is a unique case that exists in only a few sectors where the product is homogenous and there are so many buyers and sellers that no one of them can influence the market price by altering the amount they buy or sell. None the less, the model of perfect competition gives us some key insights into the working of any market economy. It shows a simple example within which to understand the principles of profit maximization and highlights the incentives played by profits in driving the entry and exit of firms. Finally, it provides a target for the optimal allocation of resources.
The other extreme of market structure is Monopoly. A pure monopoly is an industry composed of a single seller/producer with hardly any substitute and with high barriers to entry. Unlike the firm under perfect competition, the monopoly firm is a ‘price-maker’. The firm is generally seen as inelastic, as a change in price will lead to a very small change in quantity demanded because consumers have no alternative firm to turn to within the industry. They either pay the higher price, or go without the good altogether. However, monopoly firms cannot set whatever price they like, they can only charge the maximum price that the consumer is willing to pay as it is still constrained by its demand curve.
As with firms in other market structures, a monopolist will maximise profit where MC=MR. This results in super-normal profits and can attract other firms into the market.
In the short-run monopolies maximise its profits by producing where marginal cost equals marginal revenue, both are less than the price it charges for output. This is because the firm’s marginal revenue curve is always below the demand curve. Because the monopolist is the only producer in an industry, there is no need for separate analysis of the firm and the industry. Therefore, the short-run profit maximisation position of the firm is also the short run equilibrium of the industry.
Longer-term, if a monopoly firm is making profits, other firms will wish to enter the industry in order to earn more than the opportunity cost of their capital. If such entries occur the equilibrium price will change and the firm will cease to be a monopolist. Therefore if the monopoly firm’s profits are to continue in the long run, effective entry barriers must prevent new firms from joining the industry.
These barriers may be man-made, such as patents or exclusive franchises - such as the mobile phone group O2 supplying a deal with apple being a soul distributer of the i-phone. Also, natural barriers such as economies of scale, and large start up costs may deter companies entering the market.
It has also been known for oligopolies to form a cartel – a form of monopoly which all dominant firms in an industry come together to take a collective action in order to reduce output and drive up price. Not only does this behaviour maximise the industries joint profits but also prevents competitive entry of new firms.
A monopoly has the power over the market in which it sells. Monopolies faced with a large number of consumers can exploit them, forcing up the market price by restricting their output. As a result, monopolies are rarely left alone by government, and monopoly profits create incentives for others to invent new products. Few monopolies last for very long, and if they do their actions are generally heavily restricted by regulation or public ownership.
In contrast a monopoly will produce a lower output but yet charge a higher price in the short run than a firm in perfect competition. If we assume that both a perfectly competitive firm and monopoly firm face the same cost curves, the monopoly will produce where MC = MR. However under perfect competition a firm will produce more and charge less. The reason being that each firm in that industry produces at MR = P because perfect competition faces a perfectly elastic demand curve, which is also equal to MR. Consequently, producing at MC = MR = P.
In the long-run, under perfect competition, freedom of entry eliminates supernormal profits and forces firms to produce at the bottom of their long run average cost curve. In contrast, under monopoly barriers to entry allow profits to remain supernormal in the long run as they are not forced to operate at the bottom of the AC curve.
The sheer survival of a firm in the long run under perfect competition relies on efficient techniques and develops new techniques when possible. The monopolist, however is sheltered by barriers to entry and therefore has no pressure to be efficient and so therefore can continue to make large profits with no incentive of improving efficiency.
Overall, a monopoly can react the same way as a firm in perfect competition. For example if a monopoly is protected by high barriers to entry (i.e. it owns all the raw materials) then it will be able to make supernormal profits with no fear of competition.
If however, another firm innovates a similar product, it will behave more like a competitive firm possibly focusing on customer relation or price reduction. Thus concluding the threat of competition has a similar effect to actual competition.
Another similarity in terms of production is any firm (in any market structure) who does not equate the marginal cost of production of an identical product between production plants, is failing to maximise profits. Firms could reduce total costs for the same output by rearranging production between its plants.
To finish off, it’s imperative to know (as a firm) what market structure you are in as this has massive implications on your business activity and decisions i.e. efficiency, price of products, negotiation tactics etc. It could also be said that significant attention should be on competitors at all times as their actions will have a ripple effect on your business. Therefore its vital for any firm in either perfect competitive or monopoly, to not get complacent, as one unnoticed move, or late reaction (be it a reduction in price or introduction of a new product), could put the future of your company in severe peril.
Bibliography
Lipsey & Chrystal (2007), Economics, 11th edition, Oxford University Press
John Sloman & Mark Sutcliffe (2004), Economics for business, 3rd Edition, Pearson Education Limited
References
John Sloman & Mark Sutcliffe (2004), Economics for business, 3rd Edition, Pearson Education Limited
