1.3 Theory of the Firm (HL ONLY) Part II
Sub-topic
Perfect Competition
Assumptions of
the model
Revenue curves
Profit
maximization in
the short run
Profit
maximization in
the long run
HL Core – Assessment Objectives
AO2 – Describe the assumed characteristics of perfect competition:
a large number of firms; a homogeneous product; freedom of entry and exit; perfect information;
perfect resource mobility.
The shape of the perfectly competitive firm’s average revenue and marginal revenue curves is
perfectly elastic because each firm is a price taker.
The perfectly competitive firm’s average revenue and marginal revenue curves are derived from
market equilibrium for the industry.
It is possible for a perfectly competitive firm to make economic profit (supernormal profit), normal
profit or negative economic profit in the short run based on the marginal cost and marginal
revenue profit maximization rule.
AO4 – Draw the diagram for perfect competition in the short run.
AO4 – Draw the diagram for perfect competition in the long run.
AO3 –Explain, using a diagram, why, in the long run, a perfectly competitive firm will make
normal profit.
In the long period, economic profit cannot be sustained. The arrival of new firms or
expansion of existing firms (if returns to scale are constant) in the market causes the
(horizontal) demand curve of each individual firm to shift downward, bringing down at the
same time the price, the average revenue and marginal revenue curve. The final outcome is
that, in the long run, the firm will make only normal profit (zero economic profit).
Explain, using a diagram, how a perfectly competitive market will move from short- run
equilibrium to long-run equilibrium.
A perfectly competitive market achieves long-run equilibrium when all firms are earning
zero economic profits and when the number of firms in the market is not changing.
Efficiency
The condition for allocative efficiency is P = MC (or, with externalities, MSB = MSC). The condition
for productive efficiency is that production takes place at minimum average total cost.
AO3 – Explain the meaning of the term allocative efficiency.
Allocative efficiency is a type of economic efficiency in which economy/producers
produce only those types of goods and services that are more desirable in the society and
also in high demand
AO3 – Explain the meaning of the term productive/technical efficiency.
Productive efficiency occurs when the economy is utilizing all of its resources efficiently.
AO3 – Explain, using a diagram, why a perfectly competitive market leads to allocative
efficiency in both the short run and the long run.
This is because firms are free to enter or leave the industry as they wish/can and the firms do
not affect each other individually strongly. There must be a huge change in price between a lot
of firms for something to happen to the allocative efficiency of the whole industry.
Explain, using a diagram, why a perfectly competitive firm will be productively efficient in the
long run, though not necessarily in the short run.
This is because in the long run the firms will notice how much they can sell and how much they
want to price it, and how much workers they need for it to work. In the short term however,
the firms might be experimenting around to find the best way to be productively efficient.
Monopoly
Total revenue,
average revenue
and marginal
revenue
AO2 – Distinguish between total revenue, average revenue and marginal revenue.
Total Revenue-may be defined as the total receipts of (Hi firm from its sale. Total revenue
is equal to total number of commodities multiplied by price per unit of commodity. Total
revenue depends on the total sale. For example if a firm sells 60 of commodities at unit
price Rs.20, the total revenue of the will be equal to 60 X Rs.20 - Rs.1200.
Average Revenue is the revenue per unit of the commodity it is calculated by dividing total
Revenue by the number of old to the customers. For example if the total amount of 60 units
of shirts is Rs.3000, the average revenue per unit list.3000 -r 60 = Rs.50.
Marginal revenue at any level of firm's output is the net revenue added to the total revenue
by selling an additional unit of the product. In other words Marginal Revenue is the
addition to total revenue earned by selling n units of product instead of (n-1) units
AO4 – Illustrate, using diagrams, the relationship between total revenue, average revenue
and marginal revenue.
NOTE: You must be able to calculate total revenue, average revenue and marginal revenue
from a set of data and/or diagrams.
Profit
Assumptions of
the model
Barriers to entry
AO2 – Describe the assumed characteristics of a monopoly:
a single or dominant firm in the market; no close substitutes; significant barriers to entry.
AO2 – Describe, using examples, barriers to entry including economies of scale, branding and
legal barriers.
The legal barriers are the rights that some firms have so they are the only producer in the
industry. (ie the legal right to be a monopoly)
Patents, copyrights and trademarks are examples of intellectual property rights and also
hinder other firms to take their ideas. This links to branding, as only one firm can have a
individual name if they have copyrighted the name. For example a restaurant, which sells
burgers, cannot just call themselves “McDonalds” because that name has been patented.
The new firms coming into the industry will not enjoy the economies of scale which the
monopolists enjoy. This is a small barrier, as it will be very hard for the new firm to compete
with the huge firms already in the industry.
Revenue curves
The average revenue curve for a monopolist is the market demand curve, which will be downward
sloping. Know the relationship between demand, average revenue and marginal revenue in a
monopoly. A monopolist will never choose to operate on the inelastic portion of its average
revenue curve because he/she will lose profits.
AO4 – Draw the diagram for monopoly in the short and long-run
Profit
maximization
Revenue
maximization
AO3 – Explain the role of barriers to entry in permitting the firm to earn abnormal profit in
the long run.
The role of barriers is very important as with other firms not being able to enter the industry
and compete against the profits that are being earned by the monopoly, they don’t have to
worry about their abnormal profits as these stay constant in the long term then.
AO3 – Explain, using the diagram below, the output and pricing decision of a revenue
maximizing monopoly firm vs. a profit maximizing firm.
The output and pricing of the maximizing
monopoly firm will be more than in that of the profit maximizing firm as they are trying to sell
as much as they can, at what ever price they can allow themselves to do so. They do not firstly
look at the costs/benefits of what they are doing. The profit-maximizing firm is trying to earn
Natural
monopoly
the most money, while not having to pay as much for quantity.
Be able to calculate from a set of data and/or diagrams the revenue maximizing level of output.
AO3 – With reference to economies of scale, and using examples, explain the meaning of the
term “natural monopoly”.
A natural monopoly by contrast is a condition on the cost-technology of an industry
whereby it is most efficient (involving the lowest long-run average cost) for production to
be concentrated in a single firm. In some cases, this gives the largest supplier in an
industry, often the first supplier in a market, an overwhelming cost advantage over other
actual and potential competitors.
AO3 – Explain the diagram illustrating a natural monopoly below.
The natural monopoly in this diagram is clearly shown as it
is lowering its prices and its quantity to be very efficient. It is a single firm, and it has a cost
advantage over the other firms in that industry.
Monopoly and
efficiency
Despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including
the ability to finance research and development (R&D) from economic profits, the need to
innovate to maintain economic profit, and the possibility of economies of scale.
AO3 – Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to
allocative inefficiency (welfare loss) and productive inefficiency.
Monopolies may also be allocatively inefficient – it is not necessary for the monopolist to
set price equal to the marginal cost of supply. In competitive markets firms are forced to
‘take’ their price from the industry itself, but a monopolist can set (make) their own price.
Consumers cannot compare prices for a monopolist as there are no other close suppliers.
This means that price can be set well above marginal cost.
Even accounting for the extra profits derived by a monopolist, which can be put back into
the economy when profits are distributed to shareholders, there is a net loss of welfare to
the community. Welfare loss is the loss of community benefit, in terms of consumer and
producer surplus, that occurs when a market is supplied by a monopolist rather than a large
number of competitive firms.
Policies to
regulate
monopoly power
AO3 – Evaluate the role of legislation and regulation in reducing monopoly power.
 If a monopoly results in a misallocation of resources, it is inefficient
Regulation may be required
 However, prior to regulation degree of inefficiency should be determined
Because cost of regulation may exceed any benefits gained
 A firm with monopoly power may choose to not exercise its power (called limit
price analysis)
Either because they are concerned that restricting output and increasing
price will result in other firms entering market or
That they will be regulated
 Even threat of entry by another firm or threat of regulation may cause a firm to
expand output by equating price to marginal cost and operate efficiently
For instance, threat of antitrust actions and entry of new firms in industry
has resulted in cereal industry becoming more competitive
The advantages
and
disadvantages of
monopoly
compared with
perfect
competition
Be able to draw diagrams and use them to compare and contrast a monopoly market with a
perfectly competitive market, with reference to factors including efficiency, price and output,
research and development (R&D) and economies of scale.