Chapter 4

Supply Decisions In A Perfectly Competitive Market

4.1. Production in the short run

Short-run and long-run changes in production
The distinction we are making here is between fixed inputs and variable inputs. A
fixed input is an input that cannot be increased within a given time period (e.g.
buildings). A variable input is one that can.

The distinction between fixed and variable inputs allows us to distinguish between
the short run and the long run. The short run is a time period during which at least
one input is fixed. The long run is a time period long enough for all of a firm’s inputs
to be varied.

Production in the short run: the law of diminishing returns

Production in the short run is subject to diminishing returns, ‘the law of diminishing
returns’; it is one of the most famous of all ‘laws’ of economics. To illustrate how this
law underlies short run production, let us take the simplest possible case where
there are just two inputs: one fixed and one variable.

The law of diminishing marginal returns: When increasing amounts of a variable

input are used with a given amount of a fixed input, there will come a point when
each extra unit of the variable input will produce less extra output than the previous
unit.

Opportunity cost
When measuring costs, economists always use the concept of opportunity cost.
Opportunity cost is the cost of any activity measured in terms of the sacrifice made in
doing it, the cost measured in terms of the opportunities.

Measuring a firm’s opportunity costs

To measure a firm’s opportunity cost, we must first discover what inputs it has used.
Then we must measure the sacrifice involved in using them. To do this it is
necessary to put inputs into two categories.
1. Inputs not owned by the firm: explicit costs.
2. Inputs already owned by the firm: implicit costs.

Costs and inputs

This relationship depends on two elements:
• The productivity of the inputs. The greater their physical productivity, the
smaller will be the quantity of them that is needed to produce a given level of
output, and hence the lower will be the cost of that output.
• The price of the inputs. The higher their price, the higher will be the costs of
production.
Consider a piece of land that a firm rents: the rent it pays will be a fixed cost. Fixed
costs Total: costs that do not vary with the amount of output produced.
The cost of raw materials is a variable cost. Variable costs: Total costs that do vary
with the amount of output produced.

Average and marginal cost

Average cost (AC) is cost per unit of production: AC 5 TC/Q. Marginal cost (MC) is
the extra cost of producing one more
unit, i.e. the rise in total cost per one unit
rise in output: MC TC/Q.

MC = Marginal Cost
AC = Average Cost
AFC = Average Fixed Cost
AVC = Average Variable Cost

4.2. Production And costs: Long run

The scale of production
We can distinguish three possible situations:
1. Constant returns to scale.
2. Increasing returns to scale.
3. Decreasing returns to scale.

Economies of scale
The concept of increasing returns to scale is closely linked to that of economies of
scale. There are several reasons why firms are likely to experience economies of
scale. Some are due to increasing returns to scale, some are not:
1. Specialisation and division of labour.
2. Indivisibilities. The impossibility of dividing an input into smaller units.
3. The ‘container principle’
4. Greater efficiency of large machines.
5. By products.
6. Multi-stage production.

All the above are examples of plant economies of scale. They are due to an
individual factory or workplace or machine being large. There are other economies of
scale that are associated with the business itself being large perhaps with many
factories.
1. Organizational
2. Spreading overheads
3. Financial economies
4. Economies of scope
Diseconomies of scale
There are several reasons for such diseconomies of scale:
• Management problems of coordination may increase as the usiness becomes
larger and more complex, and as lines of communication get longer. There
may be a lack of personal involvement by management. We saw the
emergence of this problem with growing U-form organizations.
• Workers may feel ‘alienated’ if their jobs are boring and repetitive, and if they
feel an insignificantly small part of a large organization. Poor motivation may
lead to shoddy work.
• Industrial relations may deteriorate as a result of these factors and also as a
result of the more complex interrelationships between different categories of
worker.
• Production line processes and the complex interdependencies of mass
production can lead to great disruption if there are hold-ups in any one part of
the business.

The size of the whole industry

As an industry grows in size, this can lead to external economies of scale for its
member firms. What we are referring to here is the industry’s infrastructure: the
facilities, support services, skills and experience that can be shared by its members.
The member firms of a particular industry might, however, experience external
diseconomies of scale.

Long-run average cost

We turn now to long-run cost curves. Although it is possible to draw long-run total,
marginal and average cost curves, we will concentrate on long-run average cost
(LRAC) curves.

Assumptions behind the long-run average cost curve

We make three key assumptions when constructing long-run average cost curves:
1. Input prices are given.
2. The state of technology and input quality are given.
3. Firms operate efficiently.

Transactions costs
These are transactions costs: costs associated with the process of buying or selling.
There are four main categories of transactions costs:
1. Search costs.
2. Contract costs.
3. Monitoring and enforcement cost.
4. Transport and handling costs.

Transactions costs and the scale and scope of the firm

What we are describing here is a vertically integrated firm. Vertically integrated firm:
A firm that produces at more than one stage in the production and distribution of a
product.
Firms may expand their operations vertically by integrating backwards down the
supply chain or forwards up it. Backward integration is where a firm itself produces
the inputs it needs. Thus a car manufacturer may itself produce components such as
body panels, engines and trimmings. Forward integration is where a firm itself moves
into producing stages closer to the end consumer. Thus a manufacturer of building
materials may move into construction or become a builder’s merchant.

4.3. Revenue

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). TR 5 P 3 Q.

Average revenue (AR)

Average revenue is the amount the firm earns per unit sold. Thus: AR 5 TR/Q.

Marginal revenue curves

Marginal revenue (MR) The extra revenue gained by selling one or more units per
time period: MR 5 DTR/DQ.

4.4. Profit maximization

The meaning of ‘profit’
One element of cost is the opportunity cost to the owners of the firm incurred by
being in business. This opportunity cost to the owners is sometimes known as
normal profit, and is included in the cost curves. Any excess of profit over normal
profit is known as supernormal profit.

Short run profit maximizing

In the short run under perfect competition, we assume that the number of firms in
an industry cannot be increased: there is simply not time for new firms to enter the
market.

The long-run equilibrium of the firm

Under perfect competition, we assume that there are no barriers to entry for new
firms and in the long run we assume that there is time for firms to enter the industry.
 PART C
Chapter 5
Pricing and Output Decisions in Imperfectly Competitive Markets

5.1. Alternative Market Structures

Factors affecting the degree of competition
So what influences the degree of competition in an industry? There are four key
determinants:
■ The number of firms.
■ The freedom of entry and exit of firms into the industry.
■ The nature of the product.
■ The shape of the demand curve.

Market power benefits the powerful at the expense of others. When firms have
market power over prices, they can use this to raise prices and profits above the
perfectly competitive level. Other things being equal, the firm will gain at the expense
of the consumer. Similarly, if consumers or workers have market power they can use
this to their own benefit.

Market structures
Traditionally, we divide industries into categories based on the factors above, which
determine the degree of competition that exists between the firms. There are four
such categories. At the most competitive extreme is perfect competition, At the least
competitive extreme is monopoly, In the middle there are two forms of imperfect
competition: monopolistic competition and oligopoly.

Market structure and the conduct and performance of firms

Structure → Conduct → Performance

This does not mean, however, that all firms operating in a particular market structure
will behave in exactly the same way. It is also important to remember that some firms
with different divisions and products may operate in more than market structure.
Also, some firms under oligopoly are highly competitive and may engage in fierce
price cutting, while others may collude with their rivals to charge higher prices.

5.2. Monopoly
What is a monopoly?
A monopoly exists when there is only one firm in the industry.

Barriers to entry
For a firm to maintain its monopoly position, there must be barriers to the 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 take various
forms:
1. Economies of scale
2. Economies of scope
 3. Product differentiation and brand loyalty
4. Lower costs for an established firm
5. Ownership of, or control over, key inputs or outlets
6. Legal protection
7. Mergers and takeovers
8. Retained profits and aggressive tactics

Profit maximizing under monopoly

Average and marginal revenue
Compared with other market structures, demand under monopoly will be relatively
inelastic at each price. The monopolist can raise its price and consumers have no
alternative supplier to turn to within the industry.

Profit maximizing output and price

These profits will tend to be larger the less elastic is the demand curve (and hence
the steeper is the MR curve), and thus the bigger is the gap between MR and price
(AR).

Comparing monopoly with perfect competition

Because it faces a different type of market environment, the monopolist will produce
a quite different output and at a quite different price from a perfectly competitive
industry. Typically a monopolist will charge a price above the market price of an
equivalent industry under perfect competition.

Although a monopoly faces no competition in the goods market, it may face an

alternative form of competition in financial markets. A monopoly, with potentially low
costs, which is currently run inefficiently, is likely to be subject to a takeover bid from
another company. This competition for corporate control may thus force the
monopoly to be efficient in order to prevent it being taken over.
5.3. Oligopoly
Oligopoly occurs when just a few firms share a large proportion of the industry. Most
oligopolists produce differentiated products (e.g. cars, soap powder, soft drinks,
electrical appliances), but some may produce almost identical products (e.g. metals,
petrol).

Interdependence of the firms

Because there are only a few firms under oligopoly, each firm is likely to have a
relatively large market share, and so its actions will affect the other firms in the
industry and it, in turn, will be affected by their actions. As such, before a firm makes
any decisions, it will have to take account of the behaviour of these other firms. This
means that they are mutually dependent: they are interdependent. It is this
interdependence that differentiates oligopolies from the other market structures.

Competition and collusion

Oligopolists are pulled in two different directions:
The interdependence of firms may make them wish to collude with each other. If
they can club together and act as if they were a monopoly, they could jointly
maximise industry profits.
On the other hand, they will be tempted to compete with their rivals to gain a
bigger share of industry profits for themselves.

The following sections examine first collusive oligopoly (When oligopolists agree
(formally or informally) to limit competition between themselves. They may set
output quotas, fix prices, limit product promotion or development, or agree not to
‘poach’ each other’s markets.), where we consider both formal agreements and tacit
collusion, and then non-collusive oligopoly (When oligopolists make no agreement
between themselves – formal, informal or tacit.)

Collusive oligopoly
1. A cartel.
A formal collusive agreement is called a cartel. The cartel will maximize profits
by acting like a monopolist: behaving as if they were a single firm.
2. Tacit collusion
One form of tacit collusion is where firms keep to the price that is set by an
established leader. Such price leadership is more likely when there is a
dominant firm in the industry, normally the largest.
3. Factors favouring collusion
Collusion between firms, whether formal or tacit, is more likely when firms can
clearly identify with each other or some leader and when they trust each other
not to break agreements. It will be easier for firms to collude if the following
conditions apply:
There are only very few firms, all well known to each other.
They are open with each other about costs and production methods.
 They have similar production methods and average costs, and are thus
likely to want to change prices at the same time and by the same
percentage.
They produce similar products and can thus more easily reach
agreements on price.
There is a dominant firm.
There are significant barriers to entry and thus there is little fear of
disruption by new firms.
The market is stable. If industry demand or production costs fluctuate
wildly, it will be difficult to make agreements, partly due to difficulties in
predicting market conditions and partly because agreements may
frequently have to be amended
There are no government measures to curb collusion.

Elements of competition under collusive oligopoly

Even when oligopolists collude over price, they may compete intensively though
product development and marketing. Such ‘non-price competition’.

Non-collusive oligopoly
The kinked demand curve
The kinked demand curve model was developed to explain this observation and it
rests on two key assumptions:
If a firm cuts its price, its rivals will feel forced to follow suit and cut theirs, to
prevent losing customers to the first firm.
If a firm 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.

Oligopoly and the consumer

In two respects, oligopoly may be more disadvantageous than monopoly:
Depending on the size of the individual oligopolists, there may be less scope for
economies of scale and hence lower costs to mitigate the effects of market
power.
Oligopolists are likely to engage in much more extensive advertising and
marketing than a monopolist. Consumers may benefit from product development
and better information about the product’s characteristics. However, advertising
and marketing are costly and may result in higher prices, so the consumer could
lose out.

5.4. Game Theory

The interdependence between oligopolists requires firms to think strategically and
game theory was developed by economists to examine the best strategy that a firm
can adopt, given the assumptions it makes about its rivals’ behaviour.
Single move games
The simplest type of ‘game’ is a single move or single period game. This involves
just one ‘move’ by each firm involved.

Dominant strategy games

Many single period games have predictable outcomes, no matter what each firm
assumes about its rivals’ behaviour. Such games are known as dominant strategy
games.

Nash equilibrium. The equilibrium outcome of a game where there is no collusion

between the players (cell D in the above game) is known as a Nash equilibrium. The
prisoners’ dilemma. This is known as the prisoners’ dilemma: the dilemma faced by
suspects of a crime who are in custody and wondering whether to ‘shop’ their fellow
suspects in the hope of getting a lighter sentence.

More complex games

More complex ‘games’ can be devised with more than two firms, many alternative
prices, differentiated products and various forms of non-price competition (e.g.
advertising).

Multiple move games

Repeated games: Where firms decide in turn, in the light of what their rivals do. Such
games thus involve two or more moves. One of the simplest strategies in a repeated
game is tit-for-tat. This is where a firm will only cut prices (or make some other
aggressive move) if the rival does first.

1. The importance of threats and promises.

2. The importance of timing: decision trees.
3. There is clearly a first-mover advantage here.
4. More complex decision trees.

5.5. Alternative Aims of The Firm

Alternative theories of the firm typically make one or other of two assumptions: either
that managers attempt to maximize some other aim (such as growth in sales); or that
they pursue a number of aims, which might possibly conflict. In either case, they
must still make sufficient profits (the aim of profit satisficing) in order to keep
shareholders happy. Otherwise they risk being taken over and/or losing their job.

Alternative maximizing aims

1. Sales revenue maximization
An alternative theory of the firm which assumes that managers aim to
maximize the firm’s short run total revenue.
2. Growth maximization
An alternative theory which assumes that managers seek to maximise the
growth in sales revenue (or the capital value of the firm) over time.
Multiple aims
Behavioural theories of the firm: satisficing and the setting of targets
These aims in turn will be constrained by the interests of shareholders, workers,
customers and creditors (collectively known as stakeholders), who will need to be
kept sufficiently happy.

Behavioural theories of the firm: organisational slack

To avoid the need to change targets, therefore, managers will tend to be fairly
conservative in their aspirations. This leads to the phenomenon known as
organizational slack. Organizational slack: When managers allow spare capacity to
exist, thereby enabling them to respond more easily to changed circumstances.

Organizational slack, however, adds to a firm’s costs. If firms are operating in a

competitive environment, they may be forced to cut slack in order to survive. In the
1970s, many Japanese firms succeeded in cutting slack by using just in time
methods of production.

The consumer interest

Such firms are less likely to be able to respond to changing market conditions, such
as adjustments in consumer demand or in costs. This would then have an adverse
effect on their efficiency. However, these firms, unlike profit maximizing firms, will be
less concerned with pushing up prices, engaging in aggressive advertising or simply
exploiting their market power. This may therefore be in the public interest. The
overall impact on consumers will depend on factors such as the extent and type of
competition a firm faces and how it responds to its rivals.

5.6. Setting Price

The problem is that firms often do not have the information to do so, even if they
wanted to. In practice, firms look for rules of pricing that are relatively simple to
apply.

Cost-based pricing
One approach is average cost or mark-up pricing. Choosing the mark-up and
variation in the mark up.

Price discrimination
Up to now we have assumed that a firm will sell its output at a single price.
Sometimes, however, firms may practise price discrimination. This is where the firm
charges different prices to different customers based on their willingness to pay.

Conditions necessary for price discrimination to operate

In order for a firm to charge discriminatory prices, three conditions must be met:
The firm must be able to set its price, meaning that it must have some degree of
market power.
It must be possible to split consumers into separate markets and there must not
be any possibility of resale between the markets.
 Willingness to pay and hence demand elasticity must differ in each market.

Advantages to the firm

Price discrimination allows the firm to earn higher revenue from any given level of
sales. Another advantage to the firm of price discrimination is that it may be able to
use it to drive competitors out of business.

Pricing and the product life cycle

New products are launched, become established and then may be replaced by more
up-to-date products. Many products go through such a ‘life cycle’, which typically has
four stages:
1. Being launched.
2. A rapid growth in sales.
3. Maturity: a levelling off in sales.
4. Decline: sales begin to fall as the market becomes satu- rated, or as the product
becomes out of date and obsolete.