09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

IBEconomics/Microeconomics/TheoryoftheFirm(HL)
Contents
12.3TheoryoftheFirm(HL)
1.1Costtheory
1.2Shortrun
1.3Longrun
1.4Revenues
1.5Profit
1.6PerfectCompetition
1.7MonopolisticCompetition
1.8Oligopoly
1.9Monopoly
1.10PriceDiscrimination

2.3TheoryoftheFirm(HL)
LimitedLiability
Financialliabilityislimitedtoafixedvalue,commonlyaperson'sinvestmentinacompany/partnershipestablishedwithlimitedliability
Theseparationofmanagementandownershipthroughlimitedliability500yearsagoisthekeytowhyfirmshavebeenabletogrowso
rapidlyandtobecomesolarge
IntheUSonly1000companiesaccountfor60%oftheGDP,theremaining40%isproducedby11millionbusinessesandother
institutions
Thelargefirmsare17,000timeslargeronaveragethanthesmallfirms
Limitedliabilityallowscompaniestoraisemoneyeasily,becauseindividualsarenotsoafraidoflosingeverythinginthecaseof
bankruptcy
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

1/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Atypicalcompanypaysouthalfitsearningsintheformofdividends,therestisreinvested
Firmsfinance:
Fixedcapital(usuallyassociatedwithK)byborrowingmoneyfromthebankorbysellingbondsinthebondmarketorthrough
retainedearnings
Riskcapital(usuallyassociatedwiththeentrepreneurialinput)byissuingshares
Workingcapital(usuallyassociatedwiththeLandNRusedinproduction)fromretainedearningsorbyshorttermloansfrombanks
FirmsmustprofitmaximizeinordertoearnatleasttheOpportunityCostRateofReturn,otherwisetheirsharevaluewillfall,andanother
firmwillbuythemoutandforcethemtoearnatleasttheOpportunityCostRateofReturn
Multinational/Transnationalcompanies/Multinationalenterprise
Enterprise/firmthatmanagesproductionordeliversservicesinmorethanonecountry
AcorporationwhichhashismanagerialheadquartersinonecountryknownastheHOMEcountryandoperateonseveralothercountries
knownastheHOSTcountry(ILO)
Internationallythereare600multinationalcompanies(MNCs),morethanhalfareinvolvedinbankingandfinance,petroleumand
chemicals
MNCshaveflourished:
Ratherthanfighttariffandnontariffbarriers,MNCsjustsetupproductioninthehostcountry
Tastesaredifferent,MNCsproducelocallytotailorservicestothelocalmarket
Advancesintelecomandtransportationhaveallowedfirmstoglobalize
TransferpricingallowspricesofFoPWITHINanorganization(thismayreducetaxablerevenuewithinacountry)
Verypowerful:somehavebudgetsthataregreaterthanentirecountryGDPs
SmallFirms:mostsmallcompaniesfailforthreereasons:
Marketing:ownersdonotunderstandhowtoservethemarket
Poorfinancing:mostdonotknowhowtoinvestmoneysothatitrepaysthecapitalaswellasthecarryingcosts
Poormanagement:mostownersdonotknowhowtodelegatetasks,organizeabusinessinanefficientmanner,orcoordinatetasks
Costtheory

Companiesmustbalancerevenuesandcostssoastomaximizeprofits
Factorsofproductionarepricedatopportunityorusercost:
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

2/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Labour:firmspayawageforlabourservice
Capitalcanberentedbutisoftenowned,acostmustbeimputed(estimated)forthecapitalservices,where:
Preferstothecostofthecapital,
rreferstotheinterestontheloantobuythecapitalorifthecompanyownsthecapitalitistheOpportunityCostRateofReturn
thatcouldhavebeenearnedonthemoneytiedupinthecapital
isthedepreciationrateonthecapital
Naturalresourcesareeithertreatedlikecapitalifthefirmownsthem,ortreatedasaninputthatmustbepurchased
Firmscarryinventorieswhichactasshockabsorbersso
productionandsalesneverneedtostop
Therearethreetypes:rawmaterials,intermediate
(semifinished)goods,andfinalgoods
Inventoriesmustbefinancedbyworkingcapitaland
requirestoragespace
Typesofcosts
Totalcostisthesumoffixedandvariablecosts:
Fixedcostsareassociatedwiththefixedfactor,
usuallycapital,sometimesreferredtoasoverhead
cost
Costsafirmbearsintheshortrunregardless
ofoutput
Afirmcouldproduceabsolutelynothingand
stillfacefixedcosts(e.g.,rent,oranythingthatiscontractedforaperiodoftime)
Variablecostsareassociatedwiththevariablefactors,usuallylabourandrawmaterials
Costswhichdependonthelevelofproduction
Averagecostistotalcostdividedbyquantityofoutputorthesumofaveragefixedandaveragevariablecosts:
Totalcostdividedbyunitsofoutput
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

3/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Iffixedcostsaretrulyfixed,thenasoutputincreases,averagefixedcostsmustbedecliningsteadily
Marginalcostisincrementalcost:
Costofproducingoneextraunitofoutput
Fixedcostsarefixed,therecanbenoincrementalcostscomingfromK
Marginalcostisequaltomarginalvariablecostsonly
Shortrun

PeriodoftimeinwhichatleastonecostforFoPisfixed(quantityofatleastoneinputisfixed)
Intheshortruncapitalisfixed,firmsdonothavetimetobuildnewplant
andequipmentorgetridofobsoleteones
Onlylabourcanbevariedintheshortrun
Asmorelabourisaddedtoafixedplant,totalproductwill
increase
Averageandmarginalproductivitywillriseatfirstandthentendto
fallasworkershavelessandlesscapitalequipmenttoworkwith
Inthelongruncapitalcanbevaried,newplantandequipmentcanbe
built,oldonesdestroyedorsoldoff
Itisaplanningperiodtoallowthebuildingofnewcapital,itcan
actuallybeshorterthantheshortrun!
Intheverylongrun,itisassumedthatnewtechniquescanbe
inventedandappliedwhichwillincreaseproductivity
Lawofdiminishingreturns
Asadditionalvariableunitsareaddedtofixedunits,afteracertainpointthemarginalproductofthevariableunitdeclines
Asmoreandmoreofthevariablefactorisappliedtoafixedamountoftheotherfactor,eventuallyeachadditionalunitofthevariablefactor
willaddlesstoproductivity
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

4/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Totalproduct:Totaloutputproducedbyfactorsofproduction
Averageproduct:Theoutputperunitofvariablefactor
Marginalproduct:Theextraoutputfromemployinganadditionalvariablefactor
ProductionFunction
Describestheprecisephysicalrelationshipbetweenfactorinputsandoutput:
Marginalproductistheincrementinoutputfromanextraworker:
MPrisesatfirstaseachworkercanspecializeindoingthetaskforwhichtheyaretrained(specializationanddivisionof
labour),buteventuallystartstodeclineatthepointofdiminishingmarginalproductivity
Averageproductivityisgivenby:
Eventually,eachadditionalworkerwilladdlesstooutputthanthepreviousworker,andAPwillstarttodecline(diminishingaverage
productivity)
TheAPcurveslopesupaslongasMPisabovethecurve:iftheincrementisgreaterthantheaverage,thenitmustpulluptheaverage
AssoonasMPfallsbelowAP,itmuststartpullingitdown:MPisequaltoAPatthemaximumpointofAP
ShortRunCostCurves
Unlikeproductivitycurves,costcurvesvarywithoutput:greaterproductivityonthepartoflabourmeansmoreoutputforlesslabourcost
ACandMCtendtofallatfirstforthesamereasonthatAPandMProse:specializationanddivisionoflabour,itcostslesstoproducethe
nextunit
AFCisconstantlyfalling
AtfirstAC(orATC)isfallingbecausebothAFCandAVCarefalling:wL<Q/L
Eventually,withdiminishingreturns,AVCmustturnupbecause,wL>Q/L,andafteracertainpointthiseffectoutweighsthe
constantlyfallingAFCandpullsuptheACcurve
TheMCcurvecutstheACcurveatitsminimumpoint
TheverticaldifferencebetweenACandAVCisjusttheAFC,andgetsnarrowerasAFCgetssmaller
WeneverneedtodrawAFCagain,asweknowitisalreadyonthediagrambetweenACandAVC
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

5/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

TheoutputassociatedwithminimumACiscalledthecapacityofthefirm:
Thelargestoutputthatcanbeproducedwithoutaveragecostsrising
Firmsoperatingbelowthispointarereferredtoashavingexcesscapacity
Afirmcanproducebeyondthispoint,buttodosowouldleadtorisingunit(average)costs
InputorFactorCosts
Uptonowwehaveassumedthatinputpricesremainconstant
Costsriseandfallstrictlybecauseofchangesinproductivitynotbecauseofchangesinfactorcoststhemselves(wagesperhourstay
constantforlabour)
Ariseinthepriceofanyoftheinputswillleadtothewholesetofcurvesshiftingupward
IfitisariseinthecostofK,thenAFCwillshiftup
Ifitisariseinwages,thenAVCandMCwillshiftupward
Afallinthepriceofinputsleadstoafallinthecurves
IfthereisanincreaseinK,thenproductivitywillriseandtheAVC,MC,andACcurveswillallshiftdown
ThereisadifferentsetofcurvesforeachamountofK,thatissizeofplant
Longrun

PeriodoftimewhenallcostsforFoParevariable(quantitiesofallinputsarevariable)
Thefirmreacheslongrunequilibriumwhenthereisnoopportunityforcostreducingsubstitutions:theratioofMPstofactorcostsisequal
Firmsaremotivatedtouselessoffactorsthatbecomescarcertotheeconomyandmoreofthefactorsthatbecomemoreplentiful
Thesamewillbetrueforregionsandnations:ifacountryhasrelativelymorelandthanlabour,farmingwilltendtousethecheaperland
moreextensivelywhileeconomizingonthemoreexpensivelabour
InChinawherelabourisabundantandKisscarce,amuchlessmechanizedmethodofproductionisappropriate
LongRunAverageCost
Inboththelongrunandtheshortrunaminimumachievablecostcanbefoundforeachpossiblelevelofoutput,andacurvecanbe
constructedcalledthelongrunaveragecostcurve(LRAC)
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

6/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Factorpricesareassumedtobefixediffactorpricesrise,thewholeLRACrises
Technologyisassumedtobefixed
TomovefromonepointontheLRACtoanotherisverydifferentfromtheshortrunAC:itrequiresanadjustmentinallfactors,anewplant
mustbebuilt
AllthepossibilitiesaregivenbyavarietyofSRACcurves,oneforeachplant
TheLRACistheenvelopeoftheSRACs,itistangentatjustthatoutputwhereKisoptimalintheMP/Pformulaabove
LRACisfallingatfirstduetoeconomiesofscale(increasingreturnstoscale)whicharisefrom:
Increasedopportunitiesforspecializationanddivisionoflabourduetolargerplantsize:abiggercompanycanemployspecialiststaff
Somefactorsofproductionareindivisible,sothattomakefullofthemalargeoutputisrequired:large,specializedequipmentwhich
canonlybeprofitableifusedatlargevolumesofoutput
Fallingresearchanddevelopment(R&D)costs
Certaintypesofmarketingwhicharecheaperthemoreunitsmadeandsold
Economiesrealizedthroughbulkbuying,cheaperfinancing,andtransportationdiscounts
Economiesofscale=anincreaseinafirm'sscaleofproductionleadstoloweraveragecostsperunitproduced
Afterapoint,LRACstartstoriseduetodecreasingreturnstoscale(diseconomiesofscale)whicharisefrom:
Difficultiesofmanagingandcontrollinglargeenterprises
Nomoreopportunitiestosubstitutelargescalemachines
Limitstotheeconomiesassociatedwithdiscountsforlargescalepurchases
Diseconomiesofscale=anincreaseinafirm'sscaleofproductionleadstoahigheraveragecostperunitsproduced
Forsomeindustries,thereisaflatsectionbetweenthefallingandrisingparts,andthisisreferredtoasconstantreturnstoscale
TechnicalInnovation
Inthelongrunthereisgreatpotentialtodropcoststhroughtechnicalinnovation
Indeed,sustainablegrowthinthefuturecannotcomeaboutthroughgreaterandgreateruseofnaturalandenvironmentalresources,itmust
comefromtechnologicalchange
Lossoftechnicalknowledgeisveryrare,thustechnicalchangealwayscausestheLRACcurvetofall:
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

7/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Labour:throughbetterhealthandeducation,productivityoflabourinputscanrisedramatically
Naturalresources:throughbetterengineeringandrefiningandprocessingtechniques,bettermaterialscanbeobtainedfromnatural
resources
NewproductsareinventedwhichreducecostsdramaticallysuchasthenewwallscreenTVswhichwillbeoutshortly
Capital:
Duringtheindustrialrevolutioncapitalhasbeensubstitutedforlabour
Withtheinformationrevolution:thinkingmachinesarereplacinghumanintelligence
Resequencingofproductionhasledtoanewleanproductionsystemasworkerslearnbydoing:
Workersareorganizedasteams,individualityandinitiativeareemphasized
Partsaredeliveredbysuppliersjustintime
Aworkerstopsproductionwhenafaultisdiscovered
Defectivepartsandproblemsareanalyzedforapatternofcausesthatneedtobeunderstood
Asthesourcesofproblemsarefoundandsolved,workstoppagesdecrease
Designteamsarenonspecializedandworkcloselywithproductionengineersandpartsproducers:
Asnewproductsaredeveloped,tooldesignerscanstartdevelopingthetoolsthatwillbeneeded
MeasuringTechnicalChange
Therateofincreaseinproductivityprovidesameasureoftheprogresscausedbytechnicalchange:
Q/L:Weusuallymeasureproductivityasoutputperhouroflabour
K/L:Asthepriceoflabourrelativetocapitalhasrisen,firmshavesubstitutedKforL
QualityofK:Machineshavegrownmoreandmoreproductiveovertime(Q/K),butthishasincreaseddependenceonenergy
Nolimitstogrowth:Thegrowthinknowledgeanditsapplicationhasexpandedsorapidlythatfirmsarenowabletosqueezemore
outoflimitedresourcesfasterthantheexpandingpopulation
Technicalchangeisoftenendogenous(itisinresponsetosomethinggoingonintheproductionprocessratherthanjustsomeaccidental
discoverygoingoninatotallyunrelatedway)
OftenitistheresultofR&Dexpenditures,andtendstoriseasprofitincentivesrise
TheUS,GermanyandJapanhaveallinvestedheavilyinR&D,andproductivitygrowthhasbeenexcellentforthem
SlowdownsinProductivityGrowth
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

8/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Therehavebeenslowdownsinproductivitygrowth:
Forindustrializedcountriesthereislesspossibilitiesforgainsinproductivity
Risingoilpricesinthe1970scontributedtoaslowingdowninproductivitygrowth
Therehasbeenashiftinthepopulationfromyoungertoolderpeople(olderpeoplearehardertotraininnewtechniquesandless
innovative)
Services:overthelast15yearstherehasbeenamassiveshiftovertotheservicesector
Wehavemovedfromgoodsindustrieswhereincreasesincapitalperworkerledtoenormousincreasesinproductivity
Thegrowthinproductivitydoesnotappeartobeasrapidforservicesastherearelessopportunitiestosubstitutemachinesforpeople
Pollution:therehasalsobeenincreasingpollutionandenvironmentaldegradationwhichhasloweredthequalityoflife
Crowdingout:governmentdeficitshavedrainedthesavingsfromtheprivatesectorwhichwouldnormallyhavebeeninvestedinKandin
R&D
Theinstitutionalclimatehasbecomeveryhostiletoinnovation(thisisoneofthemainreasonsfortheemphasisonderegulation)
Revenues

Priceofthegoodtimesthenumberofunitssold
Totalrevenue:totalamountthatafirmtakesinfromthesaleofitsproduct
Averagerevenue:revenuegainedfromthesaleofasingleproduct
Marginalrevenue:additionalrevenuethatafirmtakeswhenitincreasesoutputbyoneadditionalunit
Profit

Differencebetweentotalcostsandtotalrevenues(sometimesalsocallednetrevenue)
Ifasalaryisimputedfortheowner,andacostofcapitalimputedfortheowner'sinvestment:
Onewouldexpecttheretobezeroprofitsonaverage,
Ifprofitisgreaterthanzero,thefirmisearningsupernormalorabnormalorpureoreconomicprofits
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

9/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Returnoninvestment(ROI)(intheUSitiscalledIRR:internalrateofreturn):
Thenetrevenueisdividedbythetotalinvestmentinthefirm
Ifthereisnoattempttoimputeasalaryandcostofcapitalfortheowner:
ThereturnoninvestmentwouldbeexpectedtobeequaltotheOpportunityCostRateofReturn,andfirmswillstayintheindustry
Ifitisgreaterthantheopportunitycostrateofreturn,thefirmisearningasupernormalprofit,thiswillbecomeknownandfirmswill
attempttoentertheindustry
Ifitislessthantheopportunitycostrateofreturn,firmswillleavetheindustry
Profitmaximization
Asprofitmaximizers,firmswouldliketoincreaserevenuesanddecreasecosts(thusprofitmaximizationimpliescostminimization)
Inthelongrunallfactorsofproductionarevariable
Shortruncostcurvesshowminimumcostperunitfordifferentlevelsofoutput,givenafixedfactor
Thereareaninfinitenumberofshortruncurves:asafirmchangesitsfixedfactorovertime,anewshortrunaveragecostcurveemerges
Firmssubstituteinputsinthelongrununtiltheyachievethemostcostefficientcombination
Where:PKreferstotherentalpriceofcapital(PK{r+d})PLreferstothewagerate
IfthepriceofKrises:o:thefirmwillsubstituteLforK:oTheMPofLwillfall,andMPofKwillrise,equalitywillberestored.

Profitmaximizationoccurswhenthemarginalrevenue(revenuegainedfromproducingoneextraunitofoutput)equatesthemarginalcost
ofproducingthatextraunit
Thoughafirmmayhaveitsprimarygoalofprofitmaximizationinthecaseofmostcorporations,othergoalsmayexiste.g.,salesvolume
maximization,themaximizationofrevenue,andenvironmentalconcerns)
Forexample,theBodyShopbeforebeingincorporated,proceededtoincludemanyanimalfriendlymeasures,whichpreventedthefirm
frommaximizingprofit
However,themaingoalisindeedprofitmaximization,rarecasesexistwhereitisotherwise,andindeedthesearevalidexamples,but
theyareasmallminorityintoday'sbusinessworld
Distinctionbetweennormal(zero)andsupernormal(abnormal)profit
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

10/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Normal(zero)profitiswhereallcostsarecoveredincludingtheexpectedreturnoftheentrepreneur,anythinggainedbeyondthatis
consideredsupernormalprofit
PerfectCompetition

Industrystructureinwhichtherearemanyfirms,nonelargeenoughtoinfluencetheindustry,producinghomogeneousproducts=pricetakers
Assumptionsofthemodel:Perfectcompetitionisanindustrystructurewhichholdsnumerousassumptions.Itisalsotheoretical.
Therearenumerousbuyersandsellersofwhichnoneareabletoinfluencethemarket.
Productsarehomogeneous
Therearenobarrierstoentryandnobarrierstoexitthemarket
Everyonebothbuyersandsellershaveperfectinformationaboutthemarket
Examplesincludetheagriculturalmarketandstockmarket

Demandcurvefacingtheindustryandthefirminperfectcompetition
Profitmaximizinglevelofoutputandpriceintheshortrunandlongrun
TheprofitmaximizinglevelofoutputiswhereMC=MR.
Thepossibilityofabnormalprofits/lossesintheshortrunandnormalprofitsinthelongrun.
Shortrunyes
Longrunnever.
Shutdownprice,breakevenprice.
Companyhastoshutdown(intheshortrun)ifvariablecostsarenotbeingcovered.Inthelongrunit'sallaboutcoveringtheaverage
costs.
Definitionsofallocativeandproductive(technical)efficiency
Allocativeefficiencyoccurswhenoutputisatsociety'soptimumlevel.P=MC
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

11/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Productiveefficiencyiswhenafirmproducesatthelowestpossiblecostperunit.AC=MC
Efficiencyinperfectcompetition
Perfectcompetitionisbothallocativelyandproductivelyefficient.However,itisnotdynamicefficient,inthesensethatproducts
can'tbedifferentiatedandnonewtechnologycanbeproduced.Inthelongrun,nofirmwillhaveanyprofittospendonresearchand
development.
MonopolisticCompetition

Industrystructureinwhichtherearemanyfirms,producingslightlydifferentiatedproductseachfirmhasasmall'monopoly'onitsownproduct
Assumptionsinthemodel
Largenumberofsmallfirms.
(Almost)perfectknowledge.
Differentiatedproducts/brandingimportant
Thereareclosesubstitutesfortheproductofanygivenfirmcompetitorshaveslightcontroloverprice
Therearerelativelyinsignificantbarrierstoentryorexitandsuccessinvitesnewcompetitorsintotheindustry
Examplesincludehomebuildersandrestaurants

Shortrunandlongrunequilibrium:
Intheshortrunabnormalprofitscanbeearned(atMC=MR)
Inthelongrunonlynormalprofitscanbeearned.
Productdifferentiation:
MCfirmssellproductsthathaverealorperceivednonpricedifferences.However,thedifferencesarenotsogreatastoeliminategoodsassubstitutes.
Technicallythecrosspriceelasticityofdemandbetweengoodswouldbepositive.InfacttheXEDwouldbehigh.MCgoodsarebestdescribedasclose
butimperfectsubstitutes.Thegoodsperformthesamebasicfunctions.Thedifferencesarein"qualities"andcircumstancessuchastype,style,quality,
reputation,appearance,andlocationthattendtodistinguishgoods.Forexample,thefunctionofmotorvehilcesisbasicallythesametogetfrompoint
AtoBinreasonablecomfortandsafety.Yettherearemanydifferenttypesofmotorvehicles,motorscooters,motorcycles,trucks,carsandSUVs.
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

12/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Efficiencyinmonopolisticcompetition:
Monopolisticcompetitionisaninefficientmarketstructure.
Intheshortrun/longrunneitherallocativenorproductiveefficiencyisachieved!
Oligopoly

Industrystructureinwhichthereareafewfirmsproducingproductsthatrangefromslightlydifferentiatedtohighlydifferentiated
Assumptionsofthemodel:
Competitionbetweenafewfirms
manybuyers,fewsellers
differentiatedproducts
oligopolistswilltrytoblockentry
theoligopolistbelievesthatifheputshispricedownhiscompetitorswillfollowhisexample
thereforeinoligopolisticcompetitionthereisnonpricecompetition,forexamplesupermarketscompeteintermsof:
carparks
loyaltycards
trollies
Eachfirmislargeenoughtoinfluencethisindustry
Barrierstoentryandexitaredifficult,butexist
Examplesincludeaircraftmanufacturers,tiremanufacturers,camera/electronicsmanufatureres,carmanufacturers,supermarkets
Collusiveandnoncollusiveoligopoly:
NoncollusiveOligopoly:wherefirmscompeteagainsteachotherinanormalway
CollusiveOligopoly:wherefirmstrytocometoanagreementtoreducetheamountofcompetition.
Itisusuallyillegal
theywillfixtheoutputoftheindustryandthensharetheoutputbetweenthemthisisoftencalledacartel
Cartels:
Whenfirmshaveaformalagreement.Oneexample:OPEC
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

13/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Kinkeddemandcurveasamodeltodescribeinterdependentbehaviour:
Thekinkeddemandcurvebasicallyillustratesthedownwardstickinessofprices.Thekinkeddemandcurveshowshowachangeine.g.raw
materialcostsdoesnotbringaboutachangeinthepriceofthefinalgood,duetotheconceptofdownwardstickiness.Thefearofchanging
pricesandthenloosingnumerouscustomersistoobigtoactuallychangeprices.

Importanceofnonpricecompetition:Oligopolisticfirmsavoidcompetingthroughpricecuts.Suchstrategycouldleadtoacompetitive
downwardspiralinprices(apricewar)whichcouldleaveallfirmsworseoff.Nonpricecompetitioncantakeseveralformssuchas:
advertising,branding,gifts,coupons,continuosproductdifferentiation,extendedguarantees,aftersalesserviceandvolumediscounts.
Theoryofcontestablemarkets:
Thecontestablemarkettheoryassumesthateveninamonopolyoroligopoly,theexistingcompanieswillbehavecompetitivelywhenthereisalackof
barriers,suchasgovernmentregulationandhighentrycosts,topreventnewcompaniesfromenteringthemarket.
Monopoly

Industrystructurewhereasinglefirmproducesaproductforwhichtherearenoclosesubstitutespricemakers
Assumptionsofthemodel
Onesinglefirmdominatesamarketforwhichtherearenoclosesubstitutes.
Barrierstoentryandexit.
Monopolistscansetprice=pricemakersbutareconstrainedbymarketdiscipline
Barrierstoentryandexitexistandinordertoensureprofits,amonopolywillattempttomaintainthem
ExamplesincludeMicrosoft's(former)virtualmonopolyovertheglobalPCoperatingsystemmarketandhistoricalexamplesof
AT&TandStandardOil(US)
Antitrustlegislationusedtobreakupmonopolieswhoabusemonopolypowerviapricegougingandlackofrespondingtoconsumer
concerns

Sourcesofmonopolypower/barrierstoentry
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

14/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

Governmentlegislation.
Patentsandcopyrights.
Controloversupplies
Costadvantage,suchasmassiveeconomiesofscale.
Productdifferentiation.
Useofforce.
Naturalmonopoly
Amonopolywhichhasgaineditsstatusbecauseofmassiveeconomiesofscale.
Demandcurvefacingthemonopolist
Profitmaximizinglevelofoutput
AmonopolymaximizesprofitswhenMC=MR.
Advantagesanddisadvantagesofmonopolyincomparisonwithperfectcompetition.
Monopoly:pricehigher,Outputlower,ProfitAbnormal,ProduceswhereAveragecostsarehigher(inefficient)
However,amonopolymayuseeconomiesofscalethereforereducingcostsandincreasingoutput
PerfectCompetition:PriceLower,outputhigher,Profitnormal,ProducesWhereaveragecostsarelowest(efficient)

Efficiencyinmonopoly
Amonopolistisneitherallocativelyorproductivelyefficient.Itmaybedynamicallyefficientifitwishestomaintainitsmonopolistic
position.
Howtocontrolamonopoly
DogmaticApproach:ThisistheapproachintheUSA.Monopolyisillegal.
Antitrustlegislationbansmonopoly
Ifafirmisaccusedofbeingamonopoly,theyaretakentocourtandiffoundguilty,theyarebrokenup.
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

15/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

PragmaticApproach:Lookingatmonopolywithanopenmind
lookingatadvantagesanddisadvantagesandcomingtoaconclusion
theconclusionmaybe,forexample,loweringprices
Statecontrol:thegovernmenttakesoverthemonopolybecauseitisassumedthatthegovernmentwillrunthefirmforthe'benefit'ofthecountry
Alicence:youaregivenalicencetorunamonopoly.Ifyourunitwell,itwillberenewed,ifnotitwillbecancelled.
PriceDiscrimination

Definition:
Pricediscriminationoccurswhendifferentcustomergroupsarechargeddifferentpricesforexactlythesamegood.
FirstDegree
Eachpersonbuyingagoodorservicepaysasmuchastheyarewilingtopay.Auctionsareagoodexampleofthis,asarethetradesatlocal
marketsandbazaars.
Inthediagrambelow,wecanseethatconsumersurplushasbeenerodedbecausecustomerswillingtopayaboveequilibriumwillbechargedtakingthat
intoaccount.Ideally,noconsumerwillpaylessthanheorsheisprepared.Thedarker,triangular,boxrepresentsconsumersurplus,andtheprofits
attainedthroughfirstdegreepricediscrimination.
SecondDegree
Consumersarechargeddifferingpricesdeterminedbythequantitythattheypurchase.
ThirdDegree
Differentmarketsegmentsidentifiedbythesellerarechargedatvaryingrates.Highlydependentonseparatingthemarketsegments.Good
examplesareyouthdiscountsorseniorcitizenrates.
ConditionsforPriceDiscrimination:
Pricesettingability(canonlyoccurinanimperfectmarket)
ConsumerswithdifferentPriceElasticitiesofDemand
Consumersmustbeseparatedsotheyproductscannotberesoldbetweenconsumers
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

16/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

andtheremustbenoleakagebetweenmarketse.g.cigarettesinUKare5pounds
andinPolandare1pound,butmarketsarekeptapart
Geographicseparation
Lackofknowledge
Age
Reasonsforpricediscrimination(Advantagestofirm)
Tomaximizeprofitsbyerodingconsumersurplus
Createsfavorableconditionsforeconomiesofscaleasmoreproductsaresold
Drivecompetitorsoutofanelasticmarketbyusingprofitsfromaninelasticmarket
tosubsidizetheproductintheelasticmarket.
Effectontheconsumer
Advantages
Canallowpoorerconsumerstopurchaseaproductthatwouldn'tnormallybe
withintheirpurchasingpower
Lawyersoftenchargelowerratesforpoorerclientsbutoffsetthelosswithhigherprofitsfromwealthierclients.
Usuallyincreasesoutputofaproductinthemarket,makingitavailabletomoreconsumers.
Bettereconomiesofscalemayresultinoveralllowercoststhroughoutmarketsegments.
Disadvantages
Consumersurplusiseliminated
Someconsumerswillhavetopaymorethattheywouldhaveinanondiscriminantmarket.
Retrievedfrom"http://en.wikibooks.org/w/index.php?title=IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)&oldid=2762414"

Thispagewaslastmodifiedon6February2015,at21:51.
TextisavailableundertheCreativeCommonsAttributionShareAlikeLicense.additionaltermsmayapply.Byusingthissite,youagreetothe
TermsofUseandPrivacyPolicy.
http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

17/18

09/02/2015

IBEconomics/Microeconomics/TheoryoftheFirm(HL)Wikibooks,openbooksforanopenworld

http://en.wikibooks.org/wiki/IB_Economics/Microeconomics/Theory_of_the_Firm_(HL)

18/18