Weebly - Revenue, Profit Maximisation and Market...

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Revenue, Profit Maximisation and Market Structure We define a firm’s total profit as its total revenue minus its total costs of production. We distinguish between three revenue concepts: total revenue (TR), average revenue (AR) and marginal revenue (MR). Total, average and marginal revenue Total revenue (TR) Total revenue is the firm’s total earnings per period of time from the sale of a particular amount of output (Q). For example, if a firm sells 1000 units (Q) per month at a price of £5 each (P), then its monthly total revenue will be £5000: in other words, £5 × 1000 (P × Q). Thus TR = P x Q Average revenue (AR) Average revenue is the amount the firm earns per unit sold. Thus AR = TR/Q. So if the firm earns £5000 (TR) from selling 1000 units (Q), it will earn £5 per unit. But this is simply the price! Thus AR = P. (The only exception to this is when the firm is selling its products at different prices to different consumers. In this case, AR is simply the (weighted) average price.) Marginal revenue (MR) Marginal revenue is the extra total revenue gained by selling one more unit (per time period). So if a firm sells an extra 20 units this month compared with what it expected to sell, and in the

Transcript of Weebly - Revenue, Profit Maximisation and Market...

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Revenue, Profit Maximisation and Market Structure

We define a firm’s total profit as its total revenue minus its total costs of production. We distinguish between three revenue concepts: total revenue (TR), average revenue (AR) and marginal revenue (MR).

Total, average and marginal revenue

Total revenue (TR)Total revenue is the firm’s total earnings per period of time from the sale of a particular amount of output (Q). For example, if a firm sells 1000 units (Q) per month at a price of £5 each (P), then its monthly total revenue will be £5000: in other words, £5 × 1000 (P × Q). Thus

TR = P x QAverage revenue (AR)Average revenue is the amount the firm earns per unit sold. Thus AR = TR/Q. So if the firm earns £5000 (TR) from selling 1000 units (Q), it will earn £5 per unit. But this is simply the price! Thus AR = P. (The only exception to this is when the firm is selling its products at different prices to different consumers. In this case, AR is simply the (weighted) average price.)

Marginal revenue (MR)Marginal revenue is the extra total revenue gained by selling one more unit (per time period). So if a firm sells an extra 20 units this month compared with what it expected to sell, and in the process earns an extra £100, then it is getting an extra £5 for each extra unit sold: MR = £5. Thus

MR = ΔTR/ΔQ

We now need to see how each of these three revenue concepts (TR, AR and MR) varies with output. We can show this graphically in the same way as we did with costs. The relationships will depend on the market conditions under which a firm operates. A firm that is too small to be able to affect market price will have different-shaped revenue curves from a firm that is able to choose the price it charges. Let us examine each of these two situations in turn.

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Revenue curves when price is not affected by the firm’s output – Price Taker

Average revenueIf a firm is very small relative to the whole market, it is likely to be a price taker. That is, it has to accept the price given by the intersection of demand and supply in the whole market. But, being so small, it can sell as much as it is capable of producing at that price. This is illustrated inFigure 6.1.

The left-hand part of the diagram shows market demand and supply. Equilibrium price is £5. The right-hand part of the diagram looks at the demand for an individual firm that is tiny relative to the whole market. (Look at the differences in the scale of the horizontal axes in the two parts of the diagram.)

Being so small, any change in its output will be too insignificant to affect the market price. It thus faces a horizontal demand ‘curve’ at the price. It can sell 200 units, 600 units, 1200 units or whatever without affecting this £5 price. See table in Figure 6.2.

Average revenue is thus constant at £5. The firm’s average revenue curve must therefore lie along exactly the same line as its demand curve.

Marginal revenueIn the case of a horizontal demand curve, the marginal revenue curve will be the same as the average revenue curve, since selling one more unit at a constant price (AR) merely adds that amount to total revenue. If an extra unit is sold at a constant price of £5, an extra £5 is earned.

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Figure 6.1 Price taking Firm’s AR and MR curve.

Figure 6.2 Table showing MR, AR, Price and the firm’s TR curve

Revenue curves when price varies with output – Non Price Taker

The three curves (TR, AR and MR) look quite different when price does vary with the firm’s output. If a firm has a relatively large share of the market, it will face a downward-sloping demand curve. This means that if it is to sell more, it must lower the price. It could also choose to raise its price. If it does so, however, it will have to accept a fall in sales.

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Average revenueRemember that average revenue equals price. If, therefore, price has to be lowered to sell more output, average revenue will fall as output increases.

Table 5.8 gives an example of a firm facing a downwardsloping demand curve. The demand curve (which shows how much is sold at each price) is given by the first two columns.

Note that, as in the case of a price-taking firm, the demand curve and the AR curve lie along exactly the same line. The reason for this is simple: AR = P, and thus the curve relating price to quantity (the demand curve) must be the same as that relating average revenue to quantity (the AR curve).

Marginal revenueWhen a firm faces a downward-sloping demand curve, marginal revenue will be less than average revenue, and may even be negative. But why?

If a firm is to sell more per time period, it must lower its price (assuming it does not advertise). This will mean lowering the price not just for the extra units it hopes to sell, but also for those units it would have sold had it not lowered the price.

Thus the marginal revenue is the price at which it sells the last unit, minus the loss in revenue it has incurred by reducing the price on those units it could otherwise have sold at the higher price. This can be illustrated with Table 6.1.

Assume that the price is currently £7. Two units are thus sold. The firm now wishes to sell an extra unit. It lowers the price to £6. It thus gains £6 from the sale of the third unit, but loses £2 by having to reduce the price by £1 on the two units it could otherwise have sold at £7. Its net gain is therefore £6 − £2 = £4. This is the marginal revenue: it is the extra revenue gained by the firm from selling one more unit. (Notice that in Table 5.1 the figures for MR are entered in the spaces between the figures for the other three columns.) There is a simple relationship between marginal revenue

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Table 6.1

and price elasticity of demand, that if demand is price elastic, a decrease in price will lead to a proportionately larger increase in the quantity demanded and hence an increase in revenue. Marginal revenue will thus be positive. If, however, demand is inelastic, a decrease in price will lead to a proportionately smaller increase in sales. In this case, the price reduction will more than offset the increase in sales and as a result revenue will fall. Marginal revenue will be negative. If, then, at a particular quantity sold marginal revenue is a positive figure (i.e. if sales per time period are 4 units or less in Figure 6.3), the demand curve will be elastic at that quantity, since a rise in quantity sold (as a result of a reduction in price) would lead to a rise in total revenue. If, on the other hand, marginal revenue is negative (i.e. at a level of sales of 5 or more units in Figure 6.3), the demand curve will be inelastic at that quantity, since a rise in quantity sold would lead to a fall in total revenue. Thus the demand (AR) curve in Figure 5.17 is elastic to the left of point r and inelastic to the right.

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Figure 6.3

Total revenueTotal revenue equals price times quantity. This is illustrated in Figure 6.4. The TR column from Table is plotted. Unlike the case of a price-taking firm, the TR curve is not a straight line. It is a curve that rises at first and then falls.

But why? As long as marginal revenue is positive (and hence demand is price elastic), a rise in output will raise total revenue. However, once marginal revenue becomes negative (and hence demand is inelastic), total revenue will fall (see Figure 6.5). The peak of the TR curve will be where MR = 0. At this point, the price elasticity of demand will be equal to 1.

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Figure 6.4

Figure 6.5

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PROFIT MAXIMIZATIONWe are now in a position to put costs and revenue together to find the output at which profit is maximised, and also to find out how much that profit will be.

There are two ways of doing this. The first and simpler method is to use total cost and total revenue curves. The second method is to use marginal and average cost and marginal and average revenue curves. Although this method is a little more complicated (but only a little!), it is more useful when we come to compare profit maximising under different market conditions.

We will look at each method in turn. In both cases, we will concentrate on the short run: namely, that period in which one or more factors are fixed in supply. In both cases, we take the instance of a firm facing a downward-sloping demand curve.

Short-run profit maximisation: using total curves

Figure 6.6 shows the total revenue and total cost curve. These figures Total profit is found by subtracting TC from TR. Where TC>TR, profit is negative, the firm is making a loss. Total profit is maximised at an output of 3 units, where there is the greatest gap between total revenue and total costs. At this output, total profit is £4 (£18 − £14). The TR, TC and profit curves are plotted in Figure 6.6. The size of the maximum profit is shown by the arrows.

Figure 6.6

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Short-run profit maximisation: using average and marginal curves

Finding the maximum profit that a firm can make is a two-stage process. The first stage is to find the profit maximising output. To do this we use the MC and MR curves. The second stage is to find out just how much profit is at this output. To do this we use the AR and AC curves.

Stage 1: Using marginal curves to arrive at the profit-maximising output

There is a very simple profit-maximising rule: if profits are to be maximised, MR must equal MC. From Figure 6.7 it can be seen that MR=MC at an output of 3. This is shown as point e But why are profits maximised when MR =MC? The simplest way of answering this is to see what the position would be if MR did not equal MC.

Figure 6.7

Referring to Figure 6.7, at a level of output below 3, MR exceeds MC. This means that by producing more units there will be a bigger addition to revenue (MR) than to cost (MC). Total profit will increase. As long as MR exceeds MC, profit can be increased by increasing production. At a level of output above 3, MC exceeds MR. All levels of output above 3 thus add more to cost than to revenue and hence reduce profit. As long as MC exceeds MR, profit can be increased by cutting back on production.

Profits are thus maximised where MC=MR: at an output of 3. Students worry sometimes about the argument that profits are maximised when MR=MC. Surely, they say, if the last unit is

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making no profit, how can profit be at a maximum? The answer is very simple. If you cannot add anything more to a total, the total must be at the maximum.Take the simple analogy of going up a hill. When you cannot go any higher, you must be at the top.

Stage 2: Using average curves to measure the size of the profit

Once the profit-maximising output has been discovered, we use the average curves to measure the amount of profit at the maximum. First, average profit (AR-AC) is found. At the profit-maximising output of 3, this gives a figure for Average Profit of £6 −£4.50 =£1.50. Then total profit is obtained by multiplying average profit by output:

Figure 6.8

This is shown as the shaded area. It equals £1.50x3=£4.50.

Loss minimising

It may be that there is no output at which the firm can make a profit. Such a situation is illustrated in Figure 6.9: the AC curve is above the AR curve at all levels of output.

In this case, the output where MR=MC will be the loss minimising output. The amount of loss at the point where MR=MC is shown by the shaded area in Figure 6.9. Even though the firm is making losses, there is no ‘better’ level of output at this point.

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Figure 6.9

Whether or not to produce at all

The short run. Fixed costs have to be paid even if the firm is producing nothing at all. Rent and business rates have to be paid, etc. Providing, therefore, that the firm is able to cover its variable costs, it is no worse off and therefore will continue to produce. Of course, if the firm’s revenues are more than its variable costs, then it is able to go some way to covering the fixed costs and again it will continue to produce. What happens if the firm’s revenue is not enough to cover its variable costs: that is, if the AVC curve is above, or the AR curve below, the position illustrated in Figure 6.10?

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Figure 6.10

In that case the firm is worse off than if it only has fixed costs and it will shut down production. This situation is known as the short-run shut-down point. The long run. All costs are variable in the long run. If, therefore, the firm cannot cover its long-run average costs (which include normal profit), it will close down. The longrun shut-down point will be where the AR curve is tangential to the LRAC curve.

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Profit Maximising under Perfect Competition and Monopoly

PERFECT COMPETITION

Perfect Competition refers to a market that is characterised by the absence of rivalry.

Assumptions:

• Firms are price takers. There are so many firms in the industry that each one produces an insignificantly small portion of total industry supply, and therefore has no power whatsoever to affect the price of the product. It faces a horizontal demand ‘curve’ at the market price: the price determined by the interaction of demand and supply in the whole market.

• There is complete freedom of entry into the industry for new firms. Existing firms are unable to stop new firms setting up in business. Setting up a business takes time, however. Freedom of entry, therefore, applies in the long run.

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• All firms produce an identical product. (The product is ‘homogeneous’.) There is therefore no branding or advertising.

• Producers and consumers have perfect knowledge of the market. That is, producers are fully aware of prices, costs and market opportunities. Consumers are fully aware of the price, quality and availability of the product.

The short-run equilibrium of the firmThe determination of price, output and profit in the short run under perfect competition can best be shown in a diagram.

Figure 6.11 shows a short-run equilibrium for both an industry and a firm under perfect competition. Both parts of the diagram have the same scale for the vertical axis. The horizontal axes have totally different scales, however. For example, if the horizontal axis for the firm were measured in, say, thousands of units, the horizontal axis for the whole industry might be measured in millions or tens of millions of units, depending on the number of firms in the industry.

Let us examine the determination of price, output and profit in turn.

PriceThe price is determined in the industry by the intersection of demand and supply. The firm faces a horizontal demand (or average revenue) ‘curve’ at this price. It can sell all it can produce at the market price (Pe), but nothing at a price above Pe.

OutputThe firm will maximise profit where marginal cost equals marginal revenue (MR=MC), at an output of Qe. Note that, since the price is not affected by the firm’s output, marginal revenue will equal price.

ProfitIf the average cost (AC) curve (which includes normal profit) dips below the average revenue (AR) ‘curve’, the firm will earn supernormal profit. Supernormal profit per unit at Qe is the

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vertical difference between AR and AC at Qe. Total supernormal profit is the shaded rectangle in Figure 6.11.

Figure 6.11

What happens if the firm cannot make a profit at any level of output? This situation would occur if the AC curve were above the AR curve at all points. This is illustrated in Figure 6.12, where the market price is P1. In this case, the point where MC=MR represents the loss-minimising point (where loss is defined as anything less than normal profit). The amount of the loss is represented by the shaded rectangle.

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Figure 6.12

As we saw previously, whether the firm is prepared to continue making a loss in the short run or whether it will close down immediately depends on whether it can cover its variable costs.

The long-run equilibrium of the firm

In the long run, if typical firms are making supernormal profits, new firms will be attracted into the industry. Likewise, if established firms can make supernormal profits by increasing the scale of their operations, they will do so, since all factors of production are variable in the long run.The effect of the entry of new firms and/or the expansion of existing firms is to increase industry supply. This is illustrated in Figure 6.13. At a price of P1 supernormal profits are earned. This causes industry supply to expand (the industry supply curve shifts to the right). This in turnleads to a fall in price. Supply will go on increasing and price falling until firms are making only normal profits. This will be when price has fallen to the point where the demand ‘curve’ for the firm just touches the bottom of its long-run average cost curve. QL is thus the long-runequilibrium output of the firm, with PL the long-run equilibrium price.

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Figure 6.13

Since the LRAC curve is tangential to all possible shortrun AC curves, the full long-run equilibrium will be as shown in Figure 6.14 where LRAC=AC=MC=MR=AR

Figure 6.14

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Other Short run positions of the perfectly competitive firm

In the short run the can also make losses. These losses can adopt three principle permutations; these are non-immediate shutdown losses, on the margin of shutdown and immediate shutdown losses.

With non-immediate shutdown losses, the firm has an average total cost curve such as ATC3, which is above the average revenue line (see Figure 5.8(a)). At the same time though, the average revenues of the firm cover average variable costs. In equilibrium this perfectly competitive firm will produce a level of output Q* at an average total cost per unit of $C3 and an average variable cost of production $AVC3. Clearly, this firm will be able to cover its variable costs of production but not its total costs. This firm will stay in business in the short run and put the block of resources (C3 – P*)Q* towards reducing its losses on the total fixed costs.

In another permutation (Figure 5.8 (b)), the firm can operate with costs curves such as ATC4, AVC4 and MC4. With these cost curves, the firm is on the margin of leaving the industry immediately. A firm is this position receives marginal and average revenue equal to its average variable costs, indicating that the firm is not making anything more than its variable cost of production. Because the firm is only just able to purchase its variable factor inputs, it will be on the border of leaving the industry. In (b), therefore, it can be said that the firm is producing that level of output Q**, which corresponds to its shutdown point.

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In Figure 5.8 (c), the firm is making losses and will shut down immediately. Specifically the firm cannot even recover its variable costs of production and so by virtue of producing it is making an ever-increasing loss. This firm will therefore leave the industry immediately and profit maximise by only making a loss equivalent to its fixed costs.

Determination of a firm’s supply curve

The firm’s short-run supply curve will be its (short-run) marginal cost curve.

A supply curve shows how much will be supplied at each price: it relates quantity to price. The marginal cost curve relates quantity to marginal cost. But under perfect competition, given that P MR, and MR MC, P must equal MC. Thus the supply curve and the MC curve will follow the same line.

For example, in Figure 6.3(b), if price were P1, profits would be maximised at Q1 where P1

MC. Thus point a is one point on the supply curve. At a price of P2, Q2 would be produced. Thus point b is another point on the supply curve, and so on.

So, under perfect competition, the firm’s supply curve is entirely dependent on costs of production. This demonstrates why the firm’s supply curve is upward sloping. Given that marginal costs rise as output rises (due to diminishing marginal returns), a higher price will be necessary to induce the firm to increase its output.

Note that the firm will not produce at a price below AVC because it would not be able to cover its operational costs. Thus the supply curve is only that portion of the MC curve above point e.

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Profit Maximising under Imperfect Competition

MONOPOLY

A monopoly is a market structure that is characterised by only one seller who produces a commodity or service for which there are no close substitutes.

Barriers to entryFor a firm to maintain its monopoly position, there must be barriers to entry of new firms. Barriers also exist under oligopoly, but in the case of monopoly they must be high enough to block the entry of new firms. Barriers can be of various forms.

Product differentiation and brand loyalty. If a firm produces a clearly differentiated product, where the consumer associates the product with the brand, it will be very difficult for a new firm to break into that market. Rank Xerox invented, and patented, the plain paper photocopier. After their legal monopoly (see below) ran out, people still associated photocopiers with Rank Xerox. It is still not unusual to hear someone say that they are going to ‘Xerox the article’ or, for that matter, ‘Hoover their carpet’. Other examples of strong brand image include Guinness, Kellogg’s Cornflakes, Coca-Cola, Nescafé and Sellotape. In most cases, such loyalty would not be enough to block entry, but it might well reinforce other barriers.

Lower costs for an established firm. An established monopoly is likely to have developed specialised production and marketing skills. It is more likely to be aware of the most efficient techniques and the most reliable and/or cheapest suppliers. It is likely to have access to cheaper finance. It is thus operating on a lower cost curve. New firms would therefore find it hard to compete and would be likely to lose any price war.

Ownership of, or control over, key inputs. If a firm governs the supply of vital inputs (say, by owning the sole supplier of some component part), it can deny access to these inputs to potential rivals. On a world scale, the de Beers company has a monopoly in fine diamonds because all diamond producers market their diamonds through de Beers.

Ownership of, or control over, wholesale or retail outlets. Similarly, if a firm controls the outlets through which the product must be sold, it can prevent potential rivals from gaining access to

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consumers. For example, Coca-Cola supplies chilled display units free of charge to shops on the condition that they stock only Coca-Cola’s range of drinks in them.

Legal protection. The firm’s monopoly position may be protected by patents on essential processes, by copyright, by various forms of licensing (allowing, say, only one firm to operate in a particular area) and by tariffs (i.e. customs duties) and other trade restrictions to keep out foreigncompetitors. Examples of monopolies protected by patents include most new medicines developed by pharmaceutical companies (e.g. anti-AIDS drugs), Microsoft’s Windows operating systems, and agro-chemical companies, such as Monsanto, with various genetically modified plant varieties and pesticides.

Mergers and takeovers. The monopolist can put in a takeover bid for any new entrant. The mere threat of takeovers may discourage new entrants.

Aggressive tactics. An established monopolist can probably sustain losses for longer than a new entrant. Thus it can start a price war, mount massive advertising campaigns, offer an attractive after-sales service, introduce new brands to compete with new entrants, and so on.

Intimidation. The monopolist may resort to various forms of harassment, legal or illegal, to drive a new entrant out of business.

Equilibrium price and output

Since there is, by definition, only one firm in the industry, the firm’s demand curve is also the industry demand curve. Compared with other market structures, demand under monopoly will be relatively inelastic at each price. The monopolist can raise its price and consumers have noalternative firm in the industry to turn to. They either pay the higher price or go without the good altogether. Unlike the firm under perfect competition, the monopoly firm is a ‘price maker’. It can choose what price to charge. Nevertheless, it is still constrained by its demand curve. A rise in price will lower the quantity demanded. Be careful not to fall into the trap of thinking that a monopoly can control both price and output simultaneously.

As with firms in other market structures, a monopolist will maximise profit where MR=MC. In Figure 6.15, profit is maximised at Qm. The supernormal profit obtained is shown by the shaded area. These profits will tend to be larger the less elastic is the demand curve (and hence the

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steeper is the MR curve), and thus the bigger is the gap between MR and price (AR). The actual elasticity will depend on whether reasonably close substitutes are available in other industries. The demand for a rail service will be much less elastic (and the potential for profit greater) if there is no bus service to the same destination.

Figure 6.15

Since there are barriers to the entry of new firms, these supernormal profits will not be competed away in the long run. The only difference, therefore, between short-run and long-run equilibrium is that in the long run the firm will produce where MR=long-run MC.

Monopolistic Competition

Assumptions of monopolistic competition• There are quite a large number of firms. As a result, each firm has an insignificantly small share of the market, and therefore its actions are unlikely to affect its rivals to any great extent. This means that when each firm makes its decisions it does not have to worry how its rivals will react. It assumes that what its rivals choose to do will not be influenced by what it does. This is known as the assumption of independence. (As we shall see later, this is not the case under oligopoly. There we assume that firms believe that their decisions do affect their rivals, and that their rivals’ decisions will affect them. Under oligopoly, we assume that firms are interdependent.)

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• There is freedom of entry of new firms into the industry. If any firm wants to set up in business in this market, it is free to do so.In these two respects, therefore, monopolistic competition is like perfect competition.

• The situation differs from perfect competition, however, in that each firm produces a product or provides a service in some way different from those of its rivals. As a result, it can raise its price without losing all its customers. Thus its demand curve is downward sloping,albeit relatively elastic given the large number of competitors to whom customers can turn. This is known as the assumption of product differentiation. Restaurants, hairdressers and builders are all examples of monopolistic competition.

A typical feature of monopolistic competition is that, although there are many firms in the industry, there is only one firm in a particular location. This applies particularly in retailing. There may be many hairdressers in a town, but only one in a particular street. In a sense, therefore, it has a local monopoly. People may be prepared to pay higher prices for their haircuts there to avoid having to go elsewhere.

Equilibrium of the firm

Short run

As with other market structures, profits are maximised at the output where MC =MR. The diagram will be the same as for the monopolist, except that the AR and MR curves will be more elastic. This is illustrated in Figure 6.17(a). As with perfect competition, it is possible for the monopolistically competitive firm to make supernormal profit in the short run. This is shown as the shaded area.

Just how much profit the firm will make in the short run depends on the strength of demand: the position and elasticity of the demand curve. The further to the right the demand curve is relative to the average cost curve, and the less elastic the demand curve is, the greater will be the firm’sshort-run profit. Thus a firm facing little competition and whose product is considerably differentiated from that of its rivals may be able to earn considerable short-run profits.

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Figure 6.16 a Figure 6.16 b

Long runIf typical firms are earning supernormal profit, new firms will enter the industry in the long run. As they do, they will take some of the customers away from established firms. The demand for the established firms will therefore fall. Their demand (AR) curve will shift to the left, and will continue doing so as long as supernormal profits remain and thus new firms continue entering.

Long-run equilibrium is reached when only normal profits remain: when there is no further incentive for new firms to enter. This is illustrated in Figure 6.16(b). The firm’s demand curve settles at DL, where it is tangential to the firm’s LRAC curve. Output will be QL: where ARL =LRAC. (At any other output, LRAC is greater than AR and thus less than normal profit would be made.)

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OLIGPOLY

Assumptions

The government does not intervene into the operations of the oligopolistically competitive firm in the market unless the oligopolist violates the laws of the land.

The industry has a few large sellers and a large number of buyers.

This market structure has strong barriers to entry.

The firms operating in this oligopolistically competitive product group may or may not produce a homogenous good.

For simplicity we assume perfect knowledge exists.

In 1939 a theory of non-collusive oligopoly was developed simultaneously on both sides of the Atlantic: in the USA by Paul Sweezy and in Britain by R. L. Hall and C. J. Hitch. This kinked demand theory has since become perhaps the most famous of all theories of oligopoly. The model seeks to explain how it is that, even when there is no collusion at all between oligopolists, prices can nevertheless remain stable.

The theory is based on two asymmetrical assumptions:

• If an oligopolist cuts its price, its rivals will feel forced to follow suit and cut theirs, to prevent losing customers to the first firm.

• If an oligopolist raises its price, however, its rivals will not follow suit since, by keeping their prices the same, they will thereby gain customers from the first firm. On these assumptions, each oligopolist will face a demand curve that is kinked at the current price and output (see Figure 6.17). A rise in price will lead to a large fall in sales as customers switch to the now relatively lower-priced rivals. The firm will thus be reluctant to raise its price. Demand is relatively elastic above the kink. On the other hand, a fall in price will bring only a modest increase in sales, since rivals lower their prices too and therefore customers do not switch. The firm will thus also be reluctant to lower its price. Demand is relatively inelastic below the kink. Thus oligopolists will be reluctant to change prices at all.

The non collusive oligopolistic firm faces a kinked demand curve. The MR curve associated with this demand curve will also have a break or gap at the level output, Q1 shown in Figure 6.18, which corresponds to the point where the demand curve is kinked.

For a firm operating under these conditions of market conditions, the profit maximisation output level can only be obtained at Q1, where the MC curve can cut the MR anywhere within the break or gap. Significantly, as Figure 6.18 helps to illustrate, despite of the fact that costs levels change as evidenced by MC curves 1 and 2, the market price of the commodity remains P0.

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Oligopolistic market structures are therefore characterised by price stickiness and for this reason oligopoly firms tens to compete more on the basis of non-price competition rather than on price.

Figure 6.17 Figure 6.18

Factors that influence the Pricing and Output Decisions

In order to determine a suitable price for its output, a firm must take into consideration a multitude of factors. The main factors to consider are:

1. Competitors: as demonstrated in the previous section, one of the key determinants of price is the degree of competition. On one extreme, firms operating under perfect competition are price takers who have no choice but to accept the given market price, whilst firms under imperfect competition have a sufficient market power to set their own prices. In reality, as perfect competition is only a theoretical possibility, firms would typically be price setters. However, at the same time, consideration would have to be given to the price set by rival firms in the industry.

2. Costs of Production: the only way a firm can stay in business in the long run is if it sets a price which covers all its cost and provides at least normal profits to the entrepreneur. In the short-term, the firm may accept a price is below the average costs of production as long as it covers the AVC of production. In this case, the sale of each unit leaves a surplus to cover some of the fixed costs of production. In the long run, losses incurred by such a firm would induce it to exit the industry

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3. Demand: firms would also need to forecast consumer demand trends by attempting to quantify the demand curve they face. This is necessary in order to estimate what volume of sales they will turn at different prices, as well as the degree of consumer response or price elasticity as prices changes.

4. Business objectives: quite importantly, the firm’s pricing policy must be consistent with the overall objectives of the firm. These objectives may include:

a. The traditional profit maximization objectiveb. Market domination or sales revenue maximizationc. Corporate growth.