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
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 and 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.
Normal Profits in Short Run
Abnormal Profits in the Short
Run
Losses in the Short Run
Profit maximization in
the long 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. Explain, using a diagram, how a perfectly competitive market will
move from short- run equilibrium to long-run equilibrium.
A firm might make abnormal profits in the short run. But in the long run, since there is perfect
knowledge and no barriers to entry, firms outside of the industry that could also produce the
good will also start to enter the industry. As a result supply will increase and shift from S to
S1. Since firms in perfect competition are price–takers, the price that they can charge will
start to fall and their demand curves will start to shift downwards. This means that the
abnormal profits that they had been making will start to be competed away.
Efficiency
Similarly, a firm can make losses in the short run. But in the long run, since there is perfect
knowledge and no barriers to entry, firms will start to leave the industry. As a result supply
will increase and shift from S1 to S2. Since firms in perfect competition are price–takers, the
price that they can charge will start to rise and their demand curves will start to shift
upwards. This means that in the long run, in perfect competition, firms will always make
normal profits.
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 where MC = AR. If price is greater than marginal cost, then consumers
value the good more than the cost to make it. If both sets of stakeholders were to meet at
the optimal mix, then output would expand until price equals marginal cost. If marginal cost
is greater than the price, then society would be using more resources to produce the good
than the value it gives to consumers, and output would fall.
AO3 – Explain the meaning of the term productive/technical efficiency.
A firm is productively efficient if it produces products at the lowest average cost, where MC =
AC.
AO3 – Explain, using a diagram, why a perfectly competitive market leads to allocative
efficiency in both the short run and the long run. Explain, using a diagram, why a perfectly
competitive firm will be productively efficient in the long run, though not necessarily in
the short run.
A firm in perfect competition will have both allocative (MC = AR) and productive efficiency
(MC = AC) in the long run as can be seen from the diagram above. As previously explained,
abnormal profits in the short run will be competed away in the long run while losses will
readjust to normal profits due firms leaving the industry (no barriers to entry or exit).
In the short run, however, there can be abnormal profits (see diagram directly above) or
losses. Even though production does not happen at MC = AC, meaning that there is not
necessarily productive efficiency, there is allocative efficiency as production happens at MC =
AR.
From this one can see that perfectly competitive firms can have allocative efficiency in both
the short and long run and productive efficiency in the long run, but not necessarily the short
run.
Monopoly
Total revenue,
average revenue and
marginal revenue
AO2 – Distinguish between total revenue, average revenue and marginal revenue.
Total revenue (TR) is the total amount of money that a firm receives from selling a certain
amount of a good or service in a given time period (TR = pq). Average revenue (AR) is the
revenue that a firm receives per unit of its sales (AR = TR/q = pq/q = p). Marginal revenue
(MR) is the extra revenue a firm gains when it sells one more unit of a product in a given time
period (MR = ∆TR/∆q).
AO4 – Illustrate, using diagrams, the relationship between total revenue, average
revenue and marginal revenue.
As previously stated, AR is equal to price and so it falls as output increases, since the price
has to be lowered in order to sell more products. This is shown in the diagram above where
the demand curve is labeled as AR. MR also falls as output increases but twice as steeply as
AR and also goes below the x-axis. This relationship holds for all downward sloping AR
curves and the MR curves relating to them. MR is below AR because in order to sell more
products the firm has to lower the price of the products being sold – losing revenue on the
ones that could have been sold at a higher price in order to get the revenue from the extra
sales. For TR, extra units are being sold so TR rises; however, in order to do this the price has
to be lowered. As a result, for a normal downward sloping demand curve TR rises at first but
eventually starts to fall due to lowered prices.
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
Revenue curves
Profit maximization
AO2 – Describe the assumed characteristics of a monopoly: (a single or dominant firm in
the market; no close substitutes; significant barriers to entry.)
The assumed characteristics of a monopoly are that one firm is the industry, there are
barriers to entry and there can be abnormal profits in the long run.
AO2 – Describe, using examples, barriers to entry including economies of scale, branding
and legal barriers.
The barriers to entry include legal (e.g. pharmaceutical companies my have a monopoly over
a certain drug by getting a patent for it), government granted monopoly (nationalized
industry, e.g. water company), brand loyalty (extreme brand loyalty can cause the brand
name to become the product, e.g. Scotch, Kleenex, Hoover etc.), anti-competitive behavior (a
firm in a monopoly might charge restrictive prices to stop competition, there may be a price
war to force out the new firm), natural monopoly (there is only space for one firm in the
industry, e.g. MVG in Munich) and economies of scale (these will work in favor of the firm in
the monopoly and against firms trying to enter the market, for instance, banks may charge
the new firms high interest on loans while the monopoly firm will enjoy financial economies
of scale).
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
A monopoly can make abnormal profits in the short and long run so the same diagram could
represent both the short and long run of a monopoly.
Revenue
maximization
AO3 – Explain the role of barriers to entry in permitting the firm to earn abnormal profit
in the long run.
Since others cannot enter the industry due to barriers to entry, a monopoly firm’s profits
cannot be competed away and it can continue to make an abnormal profit in both the short
and long run.
AO3 – Explain, using the diagram below, the output and pricing decision of a revenue
maximizing monopoly firm vs. a profit maximizing firm.
Be able to calculate from a set of data and/or diagrams the revenue maximizing level of
output.
Instead of profit maximizing, by producing at MC = MR a monopoly firm may wish to
revenue maximize by producing where MR = 0, as can be seen from the diagram above.
This means that the monopolist will reduce the price from P1 to P2 and at the same time
increase output from Q1 to Q2.
Natural monopoly
Monopoly and
efficiency
Policies to regulate
monopoly power
The advantages and
disadvantages of
monopoly compared
with perfect
competition
AO3 – With reference to economies of scale, and using examples, explain the meaning of
the term “natural monopoly”.
An industry is a natural monopoly if there are only enough economies of scale available in
the market to support one firm. For instance, industries that supply utilities such as water,
electricity and gas only have room for one firm.
AO3 – Explain the diagram illustrating a natural monopoly below.
In this case, the monopolist is the industry and has the demand curve D1. The long-run
average cost curve faced by the monopolist is LRAC and its position and shape are set by the
economies of scale experienced by the firm. The monopolist is able to make abnormal profits
by producing between q1 and q2 because the average revenue is greater than the average
cost for that range of output.
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.
As seen from the diagram, if a monopoly profit
maximizes by producing at MC=MR and produces at q1, it will not have productive or
allocative efficiency as production does not happen at MC = AC, at q2, or MC = AR, at q3.
AO3 – Evaluate the role of legislation and regulation in reducing monopoly power.
Since monopolies have neither productive nor allocative efficiency, can charge a higher price
for a lower level of output and can exercise anti-competitive behavior to keep other
companies out of their industry, governments can pass laws to restrict monopoly power. For
instance, the EU fined Microsoft for anti-competitive practices in 2009 due to bundling
Internet Explorer into its Windows operating system. Also, governments can charge
pharmaceutical companies for patents so that after a certain number of years, that company
no longer has a monopoly over a certain type of drug.
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.
Unlike a firm in perfect competition that will find it difficult to invest in research and
development, a monopolist can invest in R&D as they are in a better situation through being
able to make abnormal profits. This would, in the long run benefit consumers, who would
have better products and even more choice.
Also, monopolists usually gain large economies of scale
pushing the MC cost downwards. As a result, unlike a firm in perfect competition, it may be
able to produce a higher output at a lower price.
On the other hand, if significant economies of scale do
not exist, a monopolist may choose to lower output and charge a higher price.
Also, monopolies have neither productive nor allocative efficiency (if they choose to profit
maximize), can charge a higher price for a lower level of output and can exercise anticompetitive behavior to keep other companies out of their industry, while a perfectly
competitive firm has both productive and allocative efficiency, are price takers and have no
barriers to entry.