A Look At Three Types Of Price Searchers Economics Essay

A monopoly is a firm producing a commodity for which there is no close substitute. There are usually some forms of barriers of entry. It is difficult to define a pure monopoly as close substitutes are difficult to define. For example, there are no close substitutes for cigarettes, but there are many substitutes for Marlboro.

1.1 Characteristics

• Features

(a) Only one seller.

(b) Restricted entry by barriers.

(c) Market information is not free and perfect.

• Barriers to entry

(a) Legal barriers create legal monopolies.

(i) Public franchise: exclusive right to run a business, e.g. TVB.

(ii) Government licence: exclusive right to entry into a business, e.g. taxi licence.

(iii) Patent: exclusive right to use an invention, e.g. right to produce a drug.

(b) Natural barriers create natural monopolies.

(i) The average cost falls over a large volume of output before it rises. LRAC would be lower if an industry were under monopoly than if it was shared between two or more competitors.

(ii) Control the supply of an essential raw material, e.g. most diamond mines in the world are controlled by De Beers Ltd.

(iii) Economies of scale: The large fixed cost of production requires a large output to pull down the average cost, e.g. electricity generated by China Light Power Ltd.

1.2 Output And Price Decisions

Definition

A single-price monopoly is one that charges the same price for every unit of output it sells.

The monopoly must decide how much to produce and what price to charge. It is a price-searcher.

Definition

A price searcher is a seller with sufficient market power to set its price by adjusting supply.

Since there is only one firm in the industry, the demand curve of the firm is also the demand curve of the industry, and the seller faces a downward sloping demand curve.

Table 1 illustrates the demand function of a petrol station. The marginal revenue is less than and falls faster than the price charged. The price is also equal to average revenue (AR).

Table 1: Demand and marginal revenue

Price (P,

$/Litre)

Quantity

Demanded (Q)

Total Revenue

(TR = P x Q, $)

Marginal Revenue

(MR = ΔTR = ΔQ)

($/Extra Litre)

18

0

0

–

16

1

16

16

14

2

28

12

12

3

36

8

10

4

40

4

The monopoly maximises its profit by producing the level of output to MR = MC.

Given the total cost as in Table 2, we can find that the best output level to maximise profit is at three litres, where both MC and MR are equal. The price charged is $12.

Table 2: Demand and marginal cost

Price (P,

$/Litre)

Quantity

Demanded (Q)

Total

Revenue

(TR=P x Q, $)

Marginal revenue

(MR = ΔTR / ΔQ,

$/Extra Litre)

Total Cost

(TC, $)

Marginal Cost

($/Extra Liter)

18

0

0

–

15

–

16

1

16

16

18

3

14

2

28

12

22

4

12

3

36

8

30

8

10

4

40

4

41

11

Graphically, the same conclusion can be derived in Figure 1.

Figure 1 A monopoly’s output and price

The price is determined by demand curve corresponding to the equilibrium quantity at which the MR equals to MC. The profit or loss is again determined by the ATC with reference to the quantity sold and the price charged.

Owing to barriers to entry, economic profits will not be eliminated away in the long run. The only difference between short-run and long-run equilibrium is that in the long run, the firm will produce where MR = LRMC.

1.3 Single-price Monopoly Versus Perfect Competition

A monopoly and perfect competition are two completely different market structures leading to different price and output decisions. We can summarise their differences as follows:

Perfect Competition

Monopoly

• Price-taker

• Monopoly influences its price

• Produce where MR = MC

• Produce where MR = MC

• P = MR = MC

• P > MC; P > MR

• No barriers to entry

• Restricts output, charges a higher price

In terms of output, a monopoly is always accused of restricting output in order to push the price above the marginal cost. This is known as allocative inefficiency, leading to loss in social welfare.

In Figure 2, PM and QM are the price and output decisions of a monopoly, which are less than the corresponding output and price decisions in perfect competition. We can see that the PC and PM for perfect competition are set at P = AR = MR = MC.

Figure 2 Price and output decisions in a monopoly and in perfect competition

Similarly, the output level is reduced from QC to QM, which will hurt both consumers and producers in terms of loss in consumer surplus and producer surplus. The sum of such loss is known as deadweight loss.

Definition

A deadweight loss is a loss to society that cannot be recovered.

Figure 3 Inefficiency of a monopoly

In Figure 3, some of the losses of consumers have been captured by the producer as monopoly gain. However, there is still deadweight loss as illustrated by the area of the triangle. In this respect, a monopoly reduces the potential gain to society in term of social welfare.

1.4 Shortcomings Of A Monopoly

A monopoly has the following shortcomings:

• Higher price and lower output than under perfect competition in both short run and long run.

• Possibility of higher cost due to lack of competition.

• Unequal distribution of income as income concentrates on monopolies.

• Lack of incentive in invention and innovation.

1.5 Advantages Of A Monopoly

A monopoly has the following advantages:

• Economies of scale.

• Possibility of lower cost curve due to more research and development and more incentives.

• I

nnovation and new products.

2. Monopolistic Competition

The second type of price-searcher is monopolistic competition.

Definition

Monopolistic competition consists of features of perfect competition and monopoly. A firm in such a market structure is also referred to as open market price-searcher as it is not protected by barriers.

2.1 Characteristics

• Large number of sellers

(a) Each firm has a small market share.

(b) This implies independence of firms.

• Freedom of entry

• Product differentiation

Each firm has some market power over its loyal customer.

• Each seller’s product is a close substitute for many other sellers’ products

(a) Products are made slightly different from others, i.e. differentiation.

Definition

In differentiation, products are made slightly different from others by brand, packaging, sales location and services.

(b) Non-price competition is common.

2.2 Demand Curve

Because of product differentiation, a firm can raise its price without losing all its customers.

Therefore, the demand curve is downward sloping because a price rise results in the loss of some, but not all customers.

The demand curve is relatively elastic because of substitutes from other firms. However, the actual elasticity depends on the degree of product differentiation. Generally, the less differentiated the product is, the more elastic the demand will be, and vice versa.

2.3 Price And Output Determination

2.3.1 Short run

A firm in monopolistic competition faces a downward sloping demand curve. The marginal revenue (MR) curve of the firm in monopolistic competition is downward sloping. The profit is maximised where marginal revenue equals marginal cost.

The profit-maximising output level is determined by the intersection of MR and MC curves. The profit-maximising price is determined by the demand curve.

The firm can make a normal profit, an economic profit or a loss, depending on the difference between the price and the average total cost. Since each firm is small and has market power, no single firm can effectively influence what other firms do. If one firm changes its price, this action has no effect on the actions of the other firms.

Figure 4 Monopolistic competition in the short run

2.3.2 Long run

Economic profits in the short run will attract new entrants. When new firms enter, they share the market demand. The existing firm’s demand curve shifts inwards, representing less demand. This process continues until all economic profits are exhausted.

When only normal profits remain, there is no incentive for new entrants. In Figure 5, the price and quantity are $140 and 60 units respectively. As the price is just equal to ATC, there is no economic profit.

Figure 5 Monopolistic competition in the long run

The long-run equilibrium will be a position where the downward sloping demand curve is tangent to the LRAC curve. However, the demand curve will never be tangent to the bottom of LRAC because it is downward sloping. The profit-maximising output is 60 units and price is $140.

The firm in monopolistic competition has excess capacity as it does not produce at the optimum level of output where the LRAC is the lowest.

Figure 6 Excess capacity in monopolistic competition

2.4 Shortcomings

Monopolistic competition has the following disadvantages:

• Owing to monopoly power, long-run equilibrium brings a higher price and lower output than perfect competition.

• Owing to downward sloping demand curve, the firm’s demand curve will never be tangent to the bottom of the LRAC curve, implying that it will not produce at the least-cost point. Therefore, product differentiation in monopolistic competition creates excess capacity (i.e. creates inefficiency).

• Less scope for economies of scale as share among many sellers.

• Lack of economic profits in the long run for research and development.

2.5 Advantages

Monopolistic competition has the following advantages:

• Demand curve is highly elastic due to the large number of substitutes.

• Diversity of products is available. (However, it has been argued that the cost of diversity is excess capacity which is a type of inefficiency.)

• Greater freedom of entry when compared with monopoly.

• Absence of economic profits in the long run helps to keep prices down for consumers.

3. Oligopoly

Definition

An oligopoly occurs when only a few firms share a large proportion of the industry.

3.1 Characteristics

• Few number of sellers

Competition among a few, e.g. two to 20.

• Products may be identical or differentiated

• Barriers to entry

Entry may be relatively difficult or impossible (e.g. petroleum).

• Interdependence of firms

Oligopolists react to the pricing policy of rivals.

The outcome is that there is no single generally accepted theory of oligopoly. Firms may react differently and unpredictably. A firm’s policy will depend on how it thinks its competitors will react to its move and the consequence depends on how its competitors really react.

3.2 Collusion And Competition

The interdependence of firms in an oligopoly drives firms into one of the following two incompatible policies:

• Collusive oligopoly: Oligopolists have formal or tacit agreement to limit competition among themselves to reduce uncertainty. For example, they may set output quotas, fix prices and limit product promotion. The typical collusive oligopoly is a cartel price leadership.

• Non-collusive oligopoly: There is no formal agreement among oligopolists. Firms compete for bigger shares of industry profits.

3.3 Collusive Oligopoly

A typical collusive oligopoly has these features:

• Cartel

Firms acts like a monopoly to maximise industry profits.

(a) Cartel by non-price competition: Market price is set by joint profit maximisation and each firm observes that price. However, they compete for customers in the form of non-price competition.

(b) Cartel by quotas: Another way is to set the price by joint profit maximisation. Each firm observes that price, but each firm will take its share or quota of the total quantity demanded at the controlled price.

Thus, both cases require adherence to the price-setting by joint profit-maximisation among oligopolists. The only difference is whether the quantity demanded at the controlled price is competed among the firms in the form of non-price competition or is divided among themselves in the form of quotas.

• Price leadership

The demand curve of price leader represents the market share of the leader. The leader first maximises its profits at the point where leaders’ MC = MR. The corresponding price of leader’s demand curve becomes the market price which every other firm has to follow. The leader supplies at its equilibrium quantity and the followers supply the rest representing the difference between market demand and leader’s supply.

3.4 Kinked Demand Curve Model

There are many theories to explain different kinds of phenomena in oligopoly. One such theory, the kinked demand curve, is put forward by Paul M. Sweezy to explain the price rigidity or sticky price in an oligopoly industry.

Assumptions:

• If a firm raises its price, others will not follow. Thus, the demand curve will be more elastic in this range.

• If a firm cuts its price, so will the other firms. The demand curve in this range will be less elastic.

These assumptions result in the kinked demand curve.

In Figure 7, because the demand curve has kinked, the MR has broken as is illustrated by the gap between “a” and “b” on the graph. And the output and price would be the same even though the MC rises due to the same level by the equality of MR and MC.

Thus, the price will be sticky when the cost increases within a certain range.

Figure 7 The kinked demand curve

3.5 Shortcomings

An oligopoly has the following disadvantages:

• Shares all the same disadvantages of monopoly, as discussed earlier in this chapter.

• Less scope for economies of scale than monopoly.

• More extensive advertising than monopoly, e.g. non-price competition.

3.6 Advantages

An oligopoly has the following advantages:

• Economic profits: returns for research and development.

• Incentive for innovation: for capturing larger market share.

• Greater choice: non-price competition through product differentiation.

4. FACTOR MARKET

For the production of goods and services, a firm has to acquire factors of production. The markets for factors of production are similar to those of the product market, as they can be categorised into perfect or imperfect markets.

The demand for a factor of production is dependent upon the demand of goods that use the factor. Hence, the demand for factors of production is a derived demand.

Definition

Derived demand is demand for a productive resource that results from the demand for the goods and services produced by the resource.

Figure 8 Illustration of the factor and product markets

Factor payment is the income for the owner of the factor of production for use of the factor over a period of time. The factor income for labour, land, capital and entrepreneurship are wages, rent, interest and normal profit respectively.

In a perfectly competitive factor market, the factor payment is determined by the forces of demand and supply.

Figure 9 Demand and supply in the factor market

5. MARGINAL PRODUCTIVITY THEORY

This theory explains that the demand for a factor depends on the marginal revenue product (MRP) of the factor.

Definition

Marginal revenue product (MRP) is the additional sales revenue resulting from employing an additional worker.

Marginal product (MP) is the extra output produced by the additional worker. The MP curve is downward sloping because of the law of diminishing returns.

MRP = MP (factor) x MR (goods)

The MRP curve is downward sloping from left to right. It is identical in shape to the MP curve because MR (i.e. price of a good) is constant under perfect competition in the product market.

Figure 10 Marginal product for labour and marginal revenue product

6. DEMAND FOR A FACTOR

Marginal cost (MC) is the extra cost of employing an additional unit of factor of production. In a perfectly competitive factor market, a firm’s MC graph for a factor is horizontal because the firm is facing a perfectly elastic supply of the factor.

Therefore, MC = Price of the factor (i.e. MC of labour = Wages)

6.1 Profit Maximisation

The firm maximises profits when:

Marginal cost of hiring an extra unit of labour = Marginal revenue from the labour’s output to the firm

In equilibrium, MC (labour) / Wages (factor price) = MRP

Hence, the firm’s demand curve for labour is identical to its MRP curve.

Figure 11 Demand for labour

The market demand curve for labour is the sum of quantities of labour demanded by all firms at each wage rate.

Chapter Review

• A monopoly is a price-searcher who is a seller with sufficient market power to set his

price by adjusting supply.

• The monopoly maximises its profit by producing the level of output to MR = MC.

• A monopoly restricts output in order to push price above the marginal cost. Such allocative inefficiency leads to a loss in social welfare.

• Because of product differentiation, a firm in monopolistic competition can raise its price without losing all its customers.

• The firm in monopolistic competition has excess capacity as it does not produce at the optimum level of output where the LRAC is the lowest.

• Due to the interdependence of firms, oligopolists react to the pricing policy of their rivals.

• The kinked demand curve explains that the price will be sticky when the

cost increases within a certain range.

• A firm will maximise profits when the marginal cost of hiring an extra unit of labour = the marginal revenue from the labour’s output to the firm

What You Need To Know

• Monopoly: A firm producing a commodity for which there is no close substitute.

• Deadweight loss: Loss to society that cannot be recovered.

• Single-price monopoly: Monopoly that charges the same price for every unit of output it sells.

• Monopolistic competition: This market structure consists of features of perfect competition and monopoly.

• Differentiation: Products are made slightly different from others by brand, packaging, sales location and services.

• Oligopoly: Only a few firms share a large proportion of the industry.

• Derived demand: Demand for a productive resource that results from the demand for the goods and services produced by the resource.

Work Them Out

1. Which of the following is NOT a characteristic of a monopoly?

A The monopolist faces an inelastic demand for its product

B There is only one seller in the market

C Barriers of entry exist

D The monopolist can influence the price

2. Which of the following statements is NOT true?

A As an oligopolist responds to competitors’ actions, it can be considered a perfectly competitive firm.

B Products in an oligopoly may be differentiated.

C A cartel is like a monopolist with power to maximise industry profit.

D Oligopoly is a market structure favourable to collusion.

3. The characteristic of a monopoly is

A its large scale of production

B the existence of barriers to entry

C the huge initial investment

D the necessity for a large market

4. A natural monopoly exists when

A a franchise is granted to a firm

B economies of scale are necessary

C a firm can prevent the entry of competitors

D a firm specialises in natural resources extraction

5. The monopolist can make economic profits because

A entry is prevented

B it charges a high product price

C it has low promotion costs

D it has a large market share

6. Economic profits earned by a monopolist are most likely due to

A barriers of entry

B an unexpected rise in the price of its product

C good luck

D the rate of return allowed by the government

7. Which of the following is NOT a feature of oligopoly?

A Only a few firms dominate the industry.

B There are no barriers to entry into the industry.

C The product may be either homogeneous or differentiated.

D Firms in an oligopoly face downward-sloping demand curves.

8. Which of the following is NOT a characteristic of monopolistic competition?

A A single price exists for similar goods.

B Only normal profit exists in the long run.

C Products are differentiated.

D Excess capacity exists in the long run.

9. Which of the following statements is NOT true?

A There are numerous sellers in perfect competition.

B Products are differentiated in monopolistic competition.

C Firms in perfect competition maximise profits.

D Information is perfect in monopolistic competition.

10. What is the likely market structure of coffee shops in Hong Kong?

A Monopoly

B Oligopoly

C Monopolistic competition

D Perfect competition

SHORT QUESTIONS

What factor(s) enable(s) a monopoly to earn economic profits in the long run?

Why do perfectly competitive firms maximise their profits by producing so that their marginal cost equals the price, but monopolists maximise their profits by setting a price that is greater than marginal costs?

What are the characteristics of a market that allows a monopolist to successfully price discriminate between groups?

Explain how a firm in an oligopoly can differentiate its product.

ESSAY QUESTIONS

1. Peter’s Toy Factory, a single-price monopoly, has the following demand schedule and total cost for luxury toys:

Quantity (Toys)

Price ($/Toy)

Total Cost ($)

0

10

1

1

8

3

2

6

7

3

4

13

4

2

21

5

0

31

Calculate Peter’s total revenue schedule.

Calculate Peter’s marginal revenue schedule.

Calculate Peter’s profit-maximising levels of :

(i) output

(ii) price

(iii) marginal cost

(iv) marginal revenue

(v) profit

2. Mr Ma started a recycling business in Hong Kong this month. He employs students to sort and collect bottles, paying 10 cents for each bottle collected. The students can sort the following number of bottles in an hour.

Number Of Students

Number Of Bottles

1

200

2

450

3

750

4

1,150

5

1,450

6

1,700

7

1,900

8

2,050

9

2,150

(a) Why does the students’ marginal product decline?

(b) If all other firms pay the students $25 an hour to collect bottles, how many students will Mr Ma hire?

If the fee for each collected bottle rises to 12.5 cents and the students’ wages increases to $37.50 an hour,

(c) Calculate and show the changes to the students’ marginal revenue product in a table.

(d) How many students will Mr Ma hire?