Rn ee OXFORDERENT 3 cunts ol coon means that opportunity cost fs what you give up in areer to have something else, For example, if you decide te buy a DVD for §15 rather than have a meal oul, then the opportunity st of the DVB is the meal oul that you go without, It is not the $15, as opportunity cost Is never expressed in monetary terms, Ifa good or service has an opportunity cost then: it must be relatively scaree, so it will have a price and be classified as an “economic good” ‘Thete are a few things, such as air and salt water, that are not limited in supply and so do not have an opportunity cost when they are consumed, We do not have to give up something else in order to breathe, These things are known as “hee goods", as they ate not relatively scarce and so Will not have a price, The basic economic problem We have already seen that resources are relatively saree and wants are infinite, which leads to choices to he made. These choices are often expressed in terms of three questions and represent the basic economic problem. The questions are = What should be produced and in what quantities? Using these scarce Tesaurees, how many computers should be produced, how many bicycles, how much wheat, and how much milk? This has to be decided for all economle goods, = How should things be produced? There are many different ways of Producing things and there are different combinations of resources that may be used in production. Should sports shoes be produced bby an automated production line of by manual workers? Shauld ‘crops he grown with a high usage of fertilizer or organically? © Who shauld things be produced for? Should they go-to these who ean afford thera or be shared aut in some "aie" manner? How will the total income {the natlanal income) of the ecanomy be disteibuted? Will teachers get higher Whatever the system used tu allocate resources, it needs to be able to answer these questions, There are two theoretical allocation (rationing) systems—the free market system and the planned economy, In reality, all ‘economies are mixed economies, which are a combination of the free market and planning, ‘The extent to which governments should intervene im any econemy is a constant source ‘of debate and will be addressed throughout this companion,ERMINE 3 costs revere ond pot Copy out the tab and fl inthe missing velues in Using the PED figures that you have calculated, wy = the other columns, 10 identity: One piece of graph paper, drew a vertical axis, the elastic region of the demand curve: labelled Price (8), going ftom ~ 12 to +60, Then add sharia no doar 2 horizontal ais, beled Quantty Demanded, going Meet agion of the demand cume from O10 10 so the point where PED = 1 Ploithe-demand cune on the graph Ce. pla price 7 Carnplete the following sentences: against quantty demanded}, Label the cure D. Pet the Average Revenve cuve, What do you notice? How add "= AR! Plat the Total Revenue-cunve, Plat the haginal Revenue cunve, remembering 1 at the halF-nay marks 00 the hosizanial a ‘= the clastic region afthe demand cure, as price fas, total revenue '@ Inthe inelastic region of the demand cure, 35 price fas, total revenue . ‘= Total revenue is rhaximized wheve PED is equal we ____ and winese the marginal Assessment advice: the use of diagrams Fs workpoint 6.4, you dtew an important diggram shaming the relationship between demand, average revenue, marginal revenue, toal revenue, and PED. should look much bike Figure 6.10 Ihis very helpful you ave confident in your understanding of these relationships and if you can draw the diagram showing the relationships without any figures this is wort practising! Homever, yau eho heve to be able to use and interpret he dete and you may be asked, an HU paper 3, to celle tel average and ‘marginal evenue lor a set of data and/or eisgrams Profit theory [Ap economist and ai accountant were talking about the accounts of 4 company. The accountant said that the owner of the fiem, Nermin, would be very happy because the profit for the year was $80 000. The economist, however, Inoked at the same set of figures and said that the owner would be satisfied, Dut only just "Why is that?" said the accountant. “Profit is total revenue minus, total cost and when L work that aut the profit figure is very healthy.” “Yes sale the economist, “Tagiee with your definition af profit, but what you need te understand is that we do not take the same view fom how to calculate costs, As an economist I would say that profit is total revenue minus ecanomic east. Economie cost includes explicit costs (costs that involve the diteet payment of money) and len costs (earnings that the firm could have had if it employed its factors of production in other ways). In Nermin’s ease there Is only ane implicit cost that 1 woud Include that you do nat include, but Ht is the most important cost that the firm faces." "Which cost is thar?" asked the accountant, “1 include the opportunity cost af the awner of the firm, the entrepreneur.” said the economist. “I an owner does not manage ta cover his or her-apportunity cost in the lang run then they will close the firm down and move on to their next best alternative occupation.fects cones vd pott AEN 2 Thus, the upportunity cost is the most important ome for the firm ty cover: ILis the difference between survival and non-survival, tn Nermin’s case,” said the economist, “L know that she expects to make $80 000 per year, since she could eam the same amount if she clased own the firm andl went back to ber old fob as a marketing manager, That means that she is satisfied with what she has made this year, bur no more.” The conversation above explains haw economists measure profit Total prolit = Total revenue ~ exonomie cost (explicit and implicit costs) “swaUEREOKN From this point forward we will assume that we are now ceonomists| and that when we say tatal cost we are inchuding explicit costs and implicit costs. Total revenue i equal To Total cost We say that a firm is making normal prolit (or zeeo exonomie profit), TE total revenue is greater than jotal cst then we say that the firm fs making abnormal profit (also known as ecenemic profit), tf cotal revenue is less than gaial cost then we say that the firin is making a loss (or negative econamic profit), in Table 6.5 we can see these three situations. Total revenut 200000 “Total variable cost yano00 ble 65 Revenue and cost nfomation fo one yee forms A,B and C Firm A is making an abnormal prof (economic profit) of $20 000. This means that the revenue earned by the firm js not only covering all the economic costs but Is in fact $20 000 more. This will make the ntrepreneur happy as she was expecting t cover her Implicit costs, including opportunity costs, of $60 000 but exceeds ber expectations by $20-000. Firm 2 is making normal profit (zero economic profit). The revenue carned by the firm exactly covers all of the economic costs. The entrepreneur will be satislied. Firm ¢ is making lusses. Although an accountant would say that ihe firm is making a profit of $40 400 ($200 000 - $160 00D), the entrepreneur will nat be happy since fixed and variable casts (explicit casts} ate covered, but implicig costs are not being covered. The entrepreneur will close the firm down and move on te his or her next best occupation For the remainder of this companion we will use the terms abnormal profit, normal profit, and lugs, bur you must remember that these are the same as economic profit. zero economic profit, and negative £ economic profit.ERE 6 = sts tev ond prot | Mlcoeconeris We now m dt consider three different scenarios: 1 the shut-down price 2. the break-even pri 3 > the profit-maximising level of omput, The shut-down price 13s not unusual to sce firms continue to operate. in the short run, even if they are making a loss. It is also not unusual to sce firms shut down for a short period of time and then open up again. Let us look at these twa situations. Tit wants to, a firm may close down, temporarily, in the short run and produse nothing, 1 t does this, then it will only lose its total fixed costs. the casts that are unavoidable, stich as rent or interest repayments on loans, Ta make things easiet, we will now indlude opportunity cost as a fixed cost and not shaw it on its awn, 0 iL is also nat being covered, This may be better than producing and nat geting enough revenue to cover the variable casts, thts losing the fixed custs and the part of the variable ensis that have not been cove ‘This cam be best explained by using an example, Suppase that there are three firms, all producing comics, and all making lasses at the moment. The firms are called Archie, Bateal, and Charlie. Their monthly revenue and cost figures are given in Table 6.6. Total revere (8) 0000 ‘20000 “80000 “ez variable cast if) ra0080 wood 120000 90000 ‘Table 6.6 Reverwe and cost figures for Archie, Batcet, and Charlie Archie would be better not producing at all in the short run and slosing down temporarily. This is because the revenue gained has failed to cover all of the variable costs, so Archie lnses the $20 000 of variable sosts that are not covered by the total revenue and all of the $100 000 of fixed costs. So by pruducing, Archie has lost $120 000, whereas it would only lase $100 000 of lixed easis if it did not produce. } Batcat loses $100 000 whether it produces or nat, The revenue gained means that the variable costs are just covered, so they will lose the fixed costs, $100-000, whether they produce or not, In this, situation, it is likely that Bateat will continue ta produce in order to maintain the continuity of production, thus pleasing customers, and to maintain the employment af workers and the usage of inputs, thus pleasing the workforee and the suppliers, Chatlle loses $90 000 by producing. since their total revenue covers their variable costs and also contributes $10 400 rowards their fixed costs. If chey did nat produce then Charlie would lose their fixed £ costs of $100 000. So Charlie will praduce in the short run6ecots enies vd pot ENS However, all three firms are making lasses in the short run and they cannot do this for ever, Whether they produce oF not in the shart ran, the firms need to plan ahead in the long mip in order to change their combinations of factors and to devise a situation where they are able wo cover all of their casis and make normal profits, I they cannot {Jo this then they will have ta close down permanently, From this example, we can derive a definition for the shut-down price: Im Figure 6,12, the shut-down price is PAT this price, the fiers is able to cover its variable costs ity the short run, because P= AVG, and so ply lasing its fixed costs, AT any prige below B, the firm will shut down in the short run, soqwauEDeC. Although this may seem fike theory, there are in faet many real + examples of this behaviour. In Vienna, Austria, there is an ice cream store that shuts down each October, because the demand for ils products fs low aver the winter and so the revenue earned would not ive enough 10 cover even its variable costs. In Aprtl each year, it opens up again, when demand is beginning to rise and it makes impressive profits until the end of September, The act of temporarily closing down, because i cannot cover its variable costs, fs a good example of Sept ig a firm that is not reaching its shut-down price in the short run. Figure 6.12 8 general diagram showing short mun ATC, AMC, and MC ‘The break-even price The break-even price is the price at which a firm is able to make normal profit in the long run. This means that it will break even, . covering all of its costs, including the opportunity cost. The break-even price is the level of price that enables a firm to cover all of its costs in the fong run, Le. its the price where price = average total costs. H price does nat cover average total cuss ins the long run, them the firen will shunt down far good In Figure 6.12, the break-even price is P,. Ad this prise, the firm is able tv sover its total susts, because P, ~ ATC, and so all costs a covered, ‘The profit-maximising level of output cea Reonomists usually assume that the main aim of a Ger is to maxirnise profits. Ifthis is the ease, then firms need to know what level of output they have to praduce in onder tw achieve maximum profits o Ca firm finds that at its present level of output the cost of producing another unit (MC) is fess than the revenue that the unit would bring in (MR, itis clear that the firm could increase its profits by increase production oak Pricey Cat (99 producing mare, Wherever the firm finds shat MR>MC, i should ni: We can sce the marginal cost and marginal revenue situation for a firm with a perfectly clastic demand curve in Figure 6.13. AS we can see in Figure 6.1348}, the MC curve cuts the MR curve at two paints, The first point where MC — MR, q,, is the paint of profit ‘minimisation (los maximisation). The fn has made 8 loss an every gue 618 Revense ad-seats for fm i Unie produced up otis evel of out eeanse MC is rete nan’ wae dae demesne” — Ep utput (8)ERE 6 = sts tev ond prot 1 Mlctscanerics MR, From gy 1oq,, the firm makes a profit an every extra unit [Praduced, heeause the MR is greater than the ME, As long as the profit made between q, and gy is greater than the loss made on the first q, units, then the firm willl be making abnormal profits, Any unit that is produced beyond q, will make a foss, because MC would again he above MR, Sa if the firm produces mare than q,, the level ‘of abnormal profit will begin to fall, His at q, where profits are maximised Because profit minimisation is not what a firm would want, to avoid confusion the left hand part of the MC curve is normally ‘omitted in diagrams. This means that only the profit maximising ‘output. qz- is shown. as in Figure 6.13 (1). As a gencral rule, we can say that Ia firm wishes te maximise its profits, it should praduce at the level of output where Marginal Cost (MOG) cuts Marginal Revenue (MR) from below, ‘The profit-maximising autput for a normal demand and MR curve is shown im Figure 6.14 fit is maximised by producing where MC = MR, at allevel of autput of q. To find the price. we look at what consumers are willing to pay for this quantity, This is shown on the demand curve. It fs found by going from q up to the demand curve and then across to the yoaais, In order to show a measurable amount of prafit on a diagram, Le. a simple shape like a rectangle, the average cost curve (AC) is added to the diagram, ‘You must remember to make sure that the MC curve cuts the AC curve at the lowest point on the AC. This is shown in Figure 6.15. The profitzmaxtmising oonput i q and the price isp. The profit per unit of producing q i the difference henween AR and AC. Thus the profit per unit is 2 ~ b. Since q units are produced, the tial abnormal profit is the shaded area, ab 0 Whether an abnormal profit is made will depend upon the position of the AC curve. The AC curve isa stustent's hest friend? This is because it can be moved around to show what we want, ic. abnormal profit, normal profit. or losses. Thisis shown in Figure 6.16 If the average cost is at AC, shen the diagram shows an abmormal profit ‘of pabe, ICthe average cost is represented by AC), then normal profit is being made, because p = ¢, and so there is no abnormal profit rectangle, If average cost is shown by AC,, then a lnss is being made and itis represented by the rectangle peda Assessment Advice Ts HL paper 5 you may' be asked to calevlate different profit levels from 9 set of data and/or diagrams You may also be asked to celeulte the shut down price and the breek-even # price hom a set of data Figure 6.14 The prt ‘of autput for ancimal demand curve vipat Figure 6.15 Showing an area of profit using the AC curve ‘utp (nits) Figure 6.16 Using AC to show diferent profit and loss situations6+ Costs eenes, and pot = Final note on profit theory In reality firms may not always have the main aim of maximising profits. Not everyone has studied ccartomics! Other aimns followed by entrepreneurs may be: © Revenue mraxindsation: entrepreneurs «fie measure success by the amount of revenue that they make. If Us Is the case then they may attempt to maximise thelr sales revenue by praducing where is zero, They will actually produce above the the marginal reve profit maximising level of output, (See Figure 6.8) + Growrl maximisation: companies may set thelr target to achieve grow0h in the short run, father than profits, 4p enter iw gain a Jarge market share and them dominate the marker im the lang rum. Growih may be measured ina number of ways, sueh as the smployment of the percentage of soqwauEDeC. quantity af sales, sales revenue market share + Satisfving: there are now economic theories that doubt whether entrepreneurs ever, in reality, attempt to maximise profits, They claim that what entrepreneurs actually do is to *satisfice” Satisticing is where an economie agent aims to perform satisiactorily rather than to 4 maximum fevel, in order to be able ta pursue ather goals. For example, if people wa fiems they will work hard enough to make a reasonable living (sever thei opportunity casts}, but will not really push themselves further, preferring to fellow other goals, such as the pursuit of lelsure In many cases firms are run by people wha do not actually own them. An example of t firm owned by shareholders who are not involved in running the company and are therefore managed by employed non-owners. In this ease the managers do not have a geeat deal ta gain if the firm makes maximum profits I1fs likely that the managers will make enough profit to keep the owners af the firm happy, thereby keeping their jabs, but no wauld be more. They will “satislice © Corporate social responsibility (CSR}: this is where a business includes the “public Interest” in its decision making. te adopts an ethical code that accepts respansibility for the impact of its activities on areas such as the worklurce consumers, the local community, and the environment Diiferent businesses may adopt different approaches tw CSR. Some may concentrate on encouraging development in the workforce and the local community thraugh educational projects and {air trade projects. Some may concentrate on. reducing their negative effect on the environment by cutting emissions and the use of sustainable resources. Some may make the provision of aid to less developed communities a priority. In some eases businesses may adopt all af the above approaches to sume extent There are a number of advantages to adopting a CSR approach such as attracting and keeping a hettcr workforee, building up reputation and developing brand loyalty tor being an ethical business. IL companies adopt appropriate corporate social responsibility policies and are active in addressing social and environmental issucs it can 5 also reduce the need for government intervention in businessERNE 6 co eres ond pt activities. There has been a solid increase in “ethical consumerism” and CSR since the mmid-1980s, As consumers become mare aware of global and environmental issues they are more likely 1o favour businesses that promote ethical considerations, However, there have been concems regarding CSR. Some econamis have argued that companies may be adopting a CSR approach to gain 8 goad reputation in arder to take peaple’s attention away from their main product. This has especially heen suggested for companies that produce cigarettes and alcohol Student workpoint 6.5 Be an inquirer Consider the impact ofa company on others and the environment Using the internet. research the corporate social responsibilty policy of a large muitinatondl company. References to the company’s pabcies are ‘often found on the company's homepage under the tile “Corporate Sotial Responsibility” or “Sustainebilsy. Moke a display poster or 9 powerpoint presentation to ilustrate your ‘company’s approach to CSR, itis highly likely that the company will oly present the expected positive ouicomes of its actions. As you investigate ty 20 think critically about these polices, both the exteat ta nhich the company fulfs is commitments and the reasons for doing so, Doing 2 bit more rescerch might even uncover some negative consequences of the company’s behaviour that its homepage would not reveal. Debate the following topic with your classmates What are the real motivations behind corparete social respansibity?HL paper 3 question 6econts emies rd poit ENEMY The total cost information for a firm, i dollars (S), = gwen in the table belo eet cbc Le) i) tus) a 0 0 160 20 a 320 rt fwerage | Average —_| Average ae mand ua) (arc) avo) (ato) a a i538 10 4 667 |& Complete the cost information in the table above forall evels of output 1b Explain why the AFC valves falls nutpat increases ‘© On the graph below pos and label TEC, TVG and TC. costs) 00 ’| Dearne a " , j 51 Why is a fim in perfect : : : competiton 2 ‘picetaker? | : i. i 2. Draw the following : {___, diagrams. Be sure to use @ ° @ ° quaey. queney ruler and include accur labals. Alo be sure that your MC curves cross at the minimum of AC K Microssonemics. Figuie 27 Longgrun equilbrium in perlect competition In Figure 7.7, the firms are making normal profits in the long run, ‘They are selling at the price P, which they are taking from the industry, MC is equal to MR so they are maximizing profits by producing q, and at that output P is equal to AC so they are making normal profits. 4A firm in perlect competition earring abnormal profits 1b Afirm in pertect competition making! ‘economic losses ; Jn this situation there is na incentive for firms to enter or leave the industry and so the equitibrium will persist until there is a change in elther the industry demand curve or im the costs that the firms face. If Se aban cone this does happen, then firms will he making either short-run abnormal Somat faite i profits or short-run losses and the industry will once again adjust, : with firms entering or leaving until long-run equilibrium is restored = " © A firm in periect ‘competition ints long. Productive and allocative efficiency in perfect competition Productive efficiency One of the efficiency measures used by economists Is that of productive efficiency. A firm ts said to be productively efficient if t produces its product at the lowest possible unit cnst (average cast). This is shown, fn Figure 7.8. con oy Atthe output q, the firm in Figure 7.8 Is able to produce at the most cfficient Level of output, he, the lowest average cust of production. This ivthe cost ¢. So q in known as the productively efficient level of outpat. ‘We know from chapter 6 that MC always cuts AC at its lowest point, Ouapet and so we can say that the productively efficient level is where: eee ne Mc = Ac Productive efficiency is important in economics, because if a firm is producing at the productively efficient level of output then they are combining their resources as efficiently as passible and resources are not being wasted by inefficient use Allocative efficiency This measure of efficiency is sometimes abo called the sacially optimum level of output. Allucative efficiency occurs where suppliers are producing the ‘optimal mix of goods and services required by consumers.Price reflects the value that consumers place an a good and is shower: on the demand curve (average revenue), Marginal eost reflects the ‘casi fo sogiety of all the resources used in praducing an extra unit of a guod, including the normal profit required for the firm 4 stay in business, 1 price were (a be greater thary marginal cost, then the cansumers wauld value (he good mere than It eust (make Lt, 1 bette sels of stakeholders are to meet al the optimal mix, then eurpur wauld expand (o the point where price equals marginal cost, Similarly, ifthe marginal cost were to be greater than the price, then society would be using mere resources te praduice the good than the value it gives to consumers and output would fall, Allocative efficiency occurs where marginal cost (the cost of producing fone more unit) is equal to average revenue (the price received for a unit. Thus the allocatively efficient level of output is where: wc =a fet Trees _Tho whe Pre 8) Price 8) DAR output output Figure 7.9 Allocaive eficency In Figure 7.9, we can sce the allacatively efficient level of aurput for a firm with a normal demand curve and fora firm with a perfectly clastic demand eurve. In both cases we are looking for the eurput where MC=AR —q, forthe firm with a normal demand curve and 4: when the demand is pesiecity clastic. Allocative effistency is important in econemis, because if firm is producing at the allocatively efficient level of output there is & situation. of "Pareto optimality” where it is impossible to make one person better off without making someone else warse off, We will Jook at this in more detail when we consider market failure in Chapter 12. Productive and allocative efficiency in the short run in perfect competition Ha finn fs making abnormal profits in the short tun in perfect competition, we can see from Figure 7.10 that although they are producing at the profit- maximizing level of output, q {where MC=MR). and the allocatively efficient level of output, 4; (here MC=AR), the firm is not producing at the most efficient level of output, q; (where MC=AC), 17» Peatect competition SHUOUEREOLIINPRR 2 2 corpetton so he fre Price 8} Price 48) vominy a vane Figure 7.10 Productne and allocative eficency nth shartaun profs in perfect campettion In the same way, Ifa firm is making losses in the short run in perfect competition, we can see from Figure 7.11 that although they are producing at the profitemaximising level of output. q (where MC=MR), and the allacatively efficient level of aurpun, qs (wrhere ME=AR). once again the firm is not producing at the most effictent level of output, q, (where MC AC) Me indety The fm Quantity Chosny Figure 711 Proshctve and allocative efficiency with shorteun losses in perfec competion ! Productive and allocative efficiency in the long run in perfect ! competition } as we can see in Figure 7.12, profit-maximizing firms in the long $ rum in perfect competition all praduce at the fowes| poing of their } Jong-ran average cost curves. Because we assume that there is perfect ! knowledge in the industry, all of the Gms will ace the same cast ¥ curves, and so they are all selling at the same pr and minimizing their average costs by producing where MC= AC, the may neem S 2 uc 8 8 & € = ° TR dead eens) aantny eon # igure 7.12 Productive and allocveeficeniy in the lng nun x perfect competionTePetec competion MEIER 2 Also shown in Figure 7.12 és the (aet that all of the profit-maximizing firms in the long run in perfect eomperition are also producing at the allocatively eificient level of ouput, because they produce where MC=AR, 2 Student workpoint 7.2 Film the spaces in the table below with either a yes or a ne ny men mo eet ee ae ed : mMonopoly By the end of this chapter, you shauid be able to: wt explan the assumptions of manopaly i defing, explain, and ghe examples of sources of monopoly povien! — barrier enty define, explain, and ilustrate 2 natural manopoly explain and ilustrate the damand curve facing the monopolist explain end illustrate possible profit situations in monapaty explain, ilusrata, nd caleulate the ravanue maximizing lavel of output and price explain and thustate levels of eficency in monopoly compare monopoly and pedact competion 1 Mlctscanerics HL: Assumptions of the model Th the theory of monopoly, we assume thats © There is only one firm producing the product so the firm is the industry. ‘© Barriers to entry exist, which stop new firms from entering the industry and maintains the monopoly. © As a consequence of barriers to entry the monopolist may be able to make abnarmal profits in the lung run. However, whether a firm really fs a monopoly depends upon how narrowly we define the industry. For exarmple, Micrasoft may be the only producer of a particular kind of software, but itdoes not have a monopoly of all software. The vegetable shop in your area may have a monopoly of the sale of vegetables in that area, but itis not the only seller of vegetables and if the area is widened then the shop loxes its monopoly. ‘The important question here is not whether or not a firm is a monopoly, but rather how much monspoly power the firm has, ‘To what extent is the firm able to sct its own prices without worrying about other firms and to what extent can it keep people out of the industry? The strength of monopoly power possessed by a firm will really depend upon how many competing substitutes are available. For example, the underground railway in a city may have the monepoly of underground travel, but it will fave competition from other industries, such as buses. taxis, and private transport. 12‘Be tonepely Student workpoint 8.1 Be reflective—use your own experience » each case belovs, suggest which anes are monopaties and also define the width of the industry that you are assuming: 1 the canteen ip your school 2 your doctor the local refuse dispose service your schoo! the national telephone service the national postal service. Sources of monopoly power/barriers to entry A monopaly may continue to he the only producer in an industry if i is able to stop other firms {rom entering the industry in some way. These ways of preventing entry to the industry are known as barriers (o entry, There are a number of possible barriers to entry as follows. 1 Economies of scale As we have seen in Chapter 6, firms gain average cost advantages as heir size increases: these are known as econonties af scale, Things such as specialization, Ute division of labour, bulk-buying, and financial economies may lead Lo cust savings and fower unit costs. Ha monapoly is large, then they will be experiencing economies of scale. Any Liem wishing (a enter the industry will probably Ihave to start up) in a relatively small way and so will not have the economies of seale hat are enjoyed by the monopalist, Even if ihe new finn were able (0 start up will the same size as the monopolist, it would still not have the economies that come [rom expertise im the industry, such as managerial eeonomies, promational economies, antd research ane evelopment Without equal economies of seale, a wauld-be entrant to the industry Knows that it would not be able to compete with the existing monopolist, whe would simply have to reduce price to the level of normal profits. At this level the new entrant would be making losses, because the average costs would be higher, so the lack of economies of scale acts as a deterrent to firms that might want to enter a monopoly industry. 2 Natural monopoly Some industries ate classified as natural monopolies. Am industry is a natural monopoly if there are only enough economies of scale available in the market to support ane firm. This is best shown by a diagram, such as Figure 8.1 in. this case, the monopolist is the industry and has the demand curve D,. The longerun average cost curve faced by the monopolist is LRAC and ity pasition and shape are set by the economies of scale that th m iy experiencing, The monopolist is able ww make abnormal pra by prouucing am ousput between q, and qz, because the average F revenue is greater than the average cost far tbat range of output, Figure 8: A natusal monopoly ‘Quam demanded us sStuouessonn 1PREY 3 i= foundations of exoncrnies Hall production is devated ta building schools, at paint ¥, then quantity ¥ of schools will be praguced and no motorcars. Point X. at the other end of the PPC, shows the situation where no schools are being built, anly motorcars, At point Z resources are being shared between the production of motorcars and the building of schaols, The points on the PPC show the possible combinations of school building and motursar production. As you can see, its Impossible to bil more schools without also produsing fewer motorears. The opporiunity e9st ‘of more schools fs the number of motorcars thal are Hot produced, ‘The PPC is a curve because not all of the factors of production used to build schools and produce motorears are cqually good at both occupations, As we move towards point X, where few schools are being built, itis unfikely that the workers who usually build schools will be as productive as the workers wha usually produce ears. In the same way, as point ¥ is approached, car workers will have ta be invalved in building schools and are unlikely ta be as productive as the normal school builders. At paint Z, the skilled workers in each, industry will be specializing in the praduction at which they are best and so both sets of warkers will he at sheir most productive Figure 11 & production possisliies cure vis posstble to produce at any paint inside the PPC, but it means that nat all of the factors of production in the economy are being used or that they are being used inefficiently. In reality, economies are abways producing within their PPCs, since there are always some unemployed factors of production in a country. For example, there is nat a single economy in the warld where the entire potential worklorce Is actually working at any given time=there will always be some unemployment in an economy. Point V is inside the PPC and represents a combination of actual ‘output, If there is a movement from point V towards the PPC, for example to point W, then we say that there has been actual growth, ‘The point 7, is unanainable for an economy as itis outside the PPC. It could only he achieved if the PPC itself moved nutwards, For example, if the PFC moved from YX 10 ¥,X,. then the point 2, would be achievable. Any point on the PPC shaws potential ourpur, for example point 7, A PPC movement from YX to ¥,X, represents an increase in potential ‘output and so a movement from Zt0 Z, Would be potential growth An outward shift of the PPC can only be achieved if there is an improvement in the quantity and/or quality of factors of production, If this shift is achieved. there is an inerease in potential output but this does nat necessarily mean that there is an inerease in actual ‘output. That would require a movement of the current point of acital outpat towards the new PPC. A fallin the quantity of factors uf praduction would eause the PPC Lo shift inwards, This might be due 10 war or natural disasters,1 Mlctscanerics a 8 ¢ Monopoly another firm were w enter the industry, then the firms would take demand from the monopolist and the monopolist’s demand curve would shifl (o the left i this case to D,. Since we can assume that the situation will be the same for bot firms, the (wo firms would now be im a position where i is impossible for them to make even normal profits, Their LRACS Would be above AR at every level of output In this industry, the LRAC, which is shaped by the economies of seale experienced by the monopolist, will only give an abnormal profit if the monopolist is able to satisfy all of the demand im the market. The industry is a natural monopoly, because the market will only support ‘one firm. Examples of natural monopolies include the industries that supply utilities such as water, electricity. and gas 3. Legal barriers In cenain situations, a firm may have been given a legal right to be the only producer in an industry, je. the legal right 1 be a monopoly. This i the case with patents, which give a firm the right to be the only producer of a product for a certain number of years after it has been invented. Patents are usually valid for approximately 20 years, ‘When a patent expires other praducers will then be allawed to produce and sell the praduct. Patents exist as a means to encourage invention, 1f individuals or firms put time and money into E inventions, only to find that they were copied as soon as they were successful, then there would be little incentive to do s0, However, if a firm knows that, if its invention is suecessful, it will have a protected monopoly fora number of years, then it is more likely to invest in research and development, Patents, along with copyrights and trademarks, are examples of intellectual property rights, tmtetlectual property relers to the creations of the mind, Just as private property rights allow peuple to own physical property, so patents guarantee the creators of ideas the rights 10 own their ideas. A very good example of patent protection is found in the pharmaceutical industry. Another example of legal barriers is where the government of a couniry grants the right to produce a praduct so a single firm. It may do this by setting up a nationalised industry, such asa state postal serviee, and then banning other firms from entering that industry, or it may simply sell the right to be a sole supplier to a private firm, such as the right to be the only network provider far mobile phones. once again banning other firms. 4 Brand loyalty Ie may be that a monopolist produces a product that has gained huge brand loyalty. The consumers think of the product as the brand. For example, in the carly days af the vacuum cleaner they were simply known by their brand name, Hoover. If the brand loyalty isso strong then new firms may be put off from entering the industry, since they will fecl that they are not able to produce a praduct that wil be sufficiently different in order to generate such strong brand loyalty. TongrateLations! Your years of rere tted te Predece this Student workpoint 8.2 Be raflective-use your own experience Can you think of any athe praducts that dominate ‘he matket $0 heavy that the praducts knowa. by is brond name rather than ts product nama? Can you thik of any praducte that have lst this market dominance to competitors?Student workpoint 8.5 Be reflective Use the informetion below to explain the possible advantages and disadvantages of pharmaceutical patents for the different stakeholders involved Discoveries of new drugs have led ta significant improvements in health and longevity. None of this would have been possible # pharmaceutical companies hadn't had the incentive to cary out the research, development, and testing necessary to bring these drugs conto the market. Estimates of the costs of developing and testing new crus in the US range from 8800 min to $2 bilion and it can take anywhere from 12 te 15 yeats to bring a new drug onta the market. Given these figures tis not surprsing that drug developers went to have some guarantee that they vill bee able to be the exclusive providers so that they can { macover teit east and masimize thelr profits. This is wwhy patents are justihed. n fact. pharmaceutical companies continually lobby governments to have increased patent protectin for their products, ‘as soon as the patent on a drug expires, other pharmaceutical companies can produce and sel their gum version of the drug. These are commonly now, as generic drugs or simply generics. A generic drug is ‘enact the same as ts patented version in terms ot dosage, safety, stength, intended use, risks, and berets They are sad to be “bio-equivalen” ‘The producers of the generic drug can develop the drug while the brand name drug is pratected by it patent ee ionic IE and release it as saan as the patent expites Generic drugs are vastly less expensive than the brand name drugs quite simply : because the pharmaceutical companies that produce the generic drug do not have the huge development ond testing casts. The generics have to meet the county's heat and safety standards, but it takes much lass time and money than the original, With lower cos they can charge lower prices. Drug companies spend 2 lot af money an advertising to try to make sure that the consumess of their drugs maintain brand loyalty. The i particularly important when a drug is facing its patert expiry. They hope th. their consumers will stick with their drug even viher cheaper generics are an the market. f the drug is a prescription drug. the pharmace ymparies may find ways to convince éactors that thay should Keep prescribing the brand came drugs soqwauEDeC. There are deep ethical issues ivolred in the question af patents on life-saving drugs. The fact that people die from preventable diseases because they cennot afford to buy the patented medicines, even though generic drugs may be made available ata fraction of tre pice, is curently under debate, 5. Anti-competitive behaviour A monopolist may alse attempt to stop competition by adopting resirictive practices, which may be legal or illegal. For example, an established monopoly should be in a strong position to start a “p war’ if another firm enters the industry. The monopoly can lower its price 10 a loss-making level and should he able to sustain the losses for a longer time than the new entrant, thus forcing the new firm out of the industry. Indced, knowledge of this possibility should Ihe enough to dissuade new firms from even attempting to enter the industry. Im 2004, the Eugopean Union Competition Commission fined Microsoft €497 million for ‘bundling’ its Windows Media Player And messaging technolagles into its Windows operating system, The commission claimed that this prevented potential competitors from, reaching consumers. It also otdered Mictasoft to make public technical Information to allow other companies the ability to produce goods that are cummpatible with Mictosoft to give Mictesaft mote competition In 2006, Microsoft received an additional fine of €280.5 billion for alleged failure to comply with the 2004 fine, Microsoft appealed the £ fine, but lost the appeal in September 2007. Microsoft was fined usERE 8 = bicnspoty 1 Mlctscanerics 16 5 software priesarily for Internet Explorer which ultimately risks wrderm again in 2008 for failure to comply with the ruling, and was ordered 10 pay €899 million Euras, the largest fine ever given by the ;pean Competition Commissian, ‘That is not the end of it, however. In 2009, the EU Competition Commission again found Microsoft guilty of anti-competitive practices. this time far bundling its Internet Explorer browser into its Windows operating system. According to the commission: “The evidence gathered during the bnvestigation leads tte Comonistion to believe Het the tying of lveenes Exper stds Widows, wldele makes hetereet Explores available om 90% of the world's PCs, distorts competition: om ie merios between competing web browsers insofar as it provides interieet Explorer swith an aetaficial distribution advantage which othr web browsers are suitable to match, The Commission is concerned dad through the ding, Microteft shields tatertet Explovee Siow head to head competition with ollrer Browsers ick sdetrimental to the pace of product innovation aiid to the quality of products while consumers ultineately obtabi, in aldition, the Gommistion is concerned that the ubiquity of Inierned Explorer ereates artficad stecentives for content providers ard software developers ee design websites or competion and inreovation in the provision of services Jo comsumers.” Source: Europa press release, January 17%h, 2003 : The demand curve and the profit-maximizing level ‘of output in monopoly As we know, the monepolist Is the industry and so the monopolist’s demand curve is the industry demand curve and js downward sloping. The monopolist can therefore contol either the level of output or the price of the product, but not both. Students often assume that monopolists can charge whatever price they like and sith sell their products, but this is nor the case. In order 10 sell more they must lower their price. ‘The demand curve facing a monopolist is shown in Figure 8.2. The monopolist has a normal demand curve, with marginal revenue below it, and maximizes profil by producing at the level of output where marginal cost is equal to marginal revenue ‘We can see that, in this case, the menapolist sells a quantity q at price per untt of f Possible profit situations in monopoly IC a monopolist fs able to make abnormal profits in the short run, and if the monopolist has effective barriers to entry, then other firms cannot enter the industry and compete anay the profits that are being earned In this situation, the monopolist i able te make abnormal profits bn the Tong run, for as long as the barriers to entry hold out, This situation fs shawn in Figure 83. ‘The monopolist s maximizing profits and is making abnormal profits shown by the shaded area, PabC. Without the entry of new firms to the industry this situation will continue. Be ai inquirer—conduct research and assess the © outcomes 1 Make an ennoteted time Se te beefy explain the of events ane decisions so the Mictosoft legal battle with the Eusopean Unien Competition Commission, 2 what ex and against arguments for lange fine? rice an Coat (3) tpt Figure 8.2 The demand curve facing a manopalist e Tn ten jgore 8.3 Abriorral profits inthe long ‘un in manapely111s sometimes assumed that a monopoles will always earn abnormal profits, but this is not true, If the monopalist produces something for Which there is flsle demand, then 4 will not earn abtiormal profis, If a manopolist were making losses in the short run, then it would have ‘he gption of closing dawn temporarily (if iL was mot covering Hts variable costs) er gontinving praduction for the time being, However, i: wauld plan ahead in the long run 1o see whether changes could be made so that normal profits, at Feast, could be earned, IC this were not possible, then the ronopelist would close down the fem and, since the firm is the industry, the industry would gease to exist, This situation is shows in Figure 4, Figure 84 A manopokst making losses in thelog nn output Here, the firm is not able to cover costs in the long run, since the average cost is greater than the average revenue at all levels of output Since there is nothing that ean he done to rectify the situation. this will be an industry in which no firm will be willing to produce. There will be no industry. Revenue maximization in monopoly itis possible that a monopolist may decide te maximise revenue rather than profits, This situation is shown in Figure 8.5. Instead of maximizing profits, andl proxducing where MC = MR, the monopolist will produce where MR = 0 (see Chapter 6, Figure 6.10 and explanation). This means that the monopolist will reduce price from Pry, {0 Pyy ahd at the same time increase output {rom Gps, £0 Gea usu ‘The revenue maximizing level af output is clear from a diagram, ce itis the Level of autput where the MR curve cuts the horizontal Figuje 4.5 Revenue masimizing 3s It can alsa be identified from a sce of revenue figures such as the gpposed to proft mamiane im menapclyERE 8 = bicnspoty 1 Mlctscanerics 18 Here we can clearly see that, if revenue is maximized where MR = 0, then the revenue maximization level of ourput isbetween 50 and 40 units, Le, 55 units, Efficiency in monopoly Untike perfect competion, the monopolist produces atthe level of lourptn where there Is neither productive elficeney nor allocative elficlency. This Is shown in Figure 8.6. ‘The monopolist is producing at the profit-maximizing level of output, q. ‘Ouiput is being restricted in order to force up the price and to maximize profit, However, the most efficient level of output, q, and the allocatively: sffisicnt level of output, qa, are not being achieved, rice ane Coat) ouput Advantages and disadvantages of monopoly comparison with perfect competition Figure 8.6 Productive and allocative “Although they are both theoretical market forms, there bas always Fiend a: moroeade been much debate about the relative melts and demerits of perfect competition and monopolies. The advantages of monopoly in comparison with perfect competition ‘Monopolies may be able to achieve large economies of scale simply because of their size, Monopolies da not have to be big, but ifthe industry is big. then the monopolist should gain substantial economies ‘of scale. [Fthis pushes the MC curve down, then it is possible that the monopolist may produce at a higher output and at a lower price than in perfect competition. This idea of relative price and output in monopoly and perlesi competition is wery debateable. The situation is shown in Figure 8 Inc ep ct campstion ec mesapa\ rice (8) utp Figure & Econtemies of scale in monopoly In perfect competition, the equilibrium price and quantity will be ‘where demand is equal to supply. This means that the price will be P, and that a total output of Q, will be produced. However, if the industry Is a monopoly, with significant economies uf seale, then the MC curve may well be substantially below the MC curve in perfect competition, which is the industey supply curve. If this is the case. then the monopolist will produce where MC=MR, maximizing profits and producing a greater quantity than perfect competition, Qy, ata lower price, Py.von A second advantage may be that there sill be higher levels of Investment in research and development im monapalies, Firms in perfect competition are, by definition, relatively small, and so ma find 8 difficult we Hnvest in research and development, However, a monapolist making abnormal profits fs in a better situation to use some of those profits t fund researeh and development, This would, in the Tong run, benefit consumers, who would have better products and even more eeeeeFe oe edi vig Fiquie 10.1 CR, ratios in ferent market smuctres For example, in the US malt beverages industry. there are 166 firms, and the CR, is 90%, Thus the four largest firms produce 90% af the industry’s output and it js an industry with a high concentration af market power among the largest four companies. In the frazen fish and seafood industry, there are 600 firms and the CR, is 19, suggesting low concentration, We may conclude that the malt industry is an coligopaly and the frozen fish and seafood industry is In monopolistic G28) | npettionStudent workpoint 10.1 Be a thinker—slassify the folloning, How wauld you classify each of the folowing industries in the US? 11 Breakfast cereal manufacturing: 49 firms, CRe = 82.9% 2 Textile mils: 3,863 firms, CR, = 13.8% 3 Breweries: 494 fims, CR = 99.7% 4 Wineries: 637 fms, CR = 43.2% Student workpoint 10.2 an inquirer The CRe tes us how the market share in the industy is concentrated among the four largest farns, but a doesn’t necessarly reveal the extent of the Ccompetiton in the industry. A CR, of 80% would suggest high concestration, but that marker share were to be diided up with the lagest company having 654% of the market and the other three having 5% each, then this ‘would be very efferent flom each of the four having 20% equal share, [An akemative indicator of concentration in an indusiey is known as the Herfindahl-Herschmann index Research task Whot is the Herindsh#erschmann index? How might it be a better indicator of concentration than the CR? What are the lavals of the CR. values that distinguish between diferent categories of competition? Oligopolistic industries may be very different in nature. Some produce almost identical products, c.g. petrol, where the product is alms! exactly the same and only the names of the ail companies are ifferent. Some produce highly differentiated products, c.g. mator cars. Some produce slightly dilferentiated products, e.g. shampoo, but spend huge budgets to persuade peuple that their product is better, In. most examples of oligopoly, there are distinct barriers 1 entry, usually (he large-scale production of the strong branding of Use Cominane ftrens, but tis fs mot always the case, In some oligapelies, there may be low bartives ta entry, However, the key feature that is common in all oligopolies is that there is interdependence. Whereas in perleet competition and monapolistic campetition the firms are all tao small relative to the size of the market 1 be able to influence the market, in oligopaly there is a small, umber of large firms dominating the industry. As there are just a few firms, cach necds to take careful notice af cach other's actions. Interdependence tends to make firms want to collude and so avoid surprises and unexpected outcomes, If they can collude and act asa monopoly. then they can maximize industry profits. However, there is alse a tendency for firms ta want to compete vigorously with each other in arder to gain a greater market share. Allin all, however, aligopoly tends to be characterized by price rigidity, Prices in oligopoly tend to change much less than in more 1ercixeoy EE sunueseoine 1ee competitive markets oligopolistic fiems afien Ie n when there are production-cost ch: we their prices unchanged ! Collusive and non-collusive oligopoly { Gollusive oligopoly exists when the firms in ait oligepolistie market £ sullude to charge the same prices for their products, In effect acting as ‘a monopoly, and so divide up any monopoly profits that may be made, ‘There are two types of collusion. Formal collusion takes place when firms openly agree an the price that they will all charge, although sometimes it may be agreement on market share or on marketing expenditure Instead. Sueh a collusive aligopoly is often called a cartel Since this results in higher prices and less output for cansumers, this is usually deemed to be against the interest of consumers and so. collusion is generally banned by governments and 1 against the law in the majority of countries. If a country’s anti-trust authority finds that firms have engaged in anti-competitive behaviour such as price fixing agreements, then the firms will be penalized with fines or other punishments. 1 Mlctscanerics Formal collusion between governments may be permitted. The prime example is OPEC (ihe Organisation for Petroleum Exporting Countries), which sets production quotas and prices for the world oil markers, ‘Tacit collusion exists when firms in an oligopoly charge the same prices without any formal collusion. This is nat as difficult as it sounds. A firm may charge the same price as another by laoking at the prices of a dominant firm in the industry, or at the prices of the main competitors. It is not necessary to communicate to lre able to charge the same prices. In bos formal anu tacit collusion, the process is the same, The firms behave like a monopolist (single producer}, charge the monopoly price, make monopoly profits, and share them according tu market Figure 10.2 Olgopolists acing as a share, This is shown in Figatre 10.2, monopalst Dapat Collusive oligopoly offers one explanation of price rigidity in oligopoly. If firms arc colluding. cither formally or tacitly, and they are making their share of long-run monopaly profits, then they may ary to keep prices stable in order that the situation continues. Non-collusive oligopaly exists when the fitnss in an oligopoly do. not collude and so have ta be very aware of the reactions of other firms when making pricing decisions, We say that the behaviour of iris in an oligopoly is strategic behaviour as they must develop strategies that take inte account all possible actions of rivals. In order ta explain how firrns behave in these situations, economists ‘often use “game theory", Game theary considers the optimum strategy that a firm could undertake in the light of different possible decisions by rival Lirms For simplicity we will look at a situation where there are only twa firms making up a market, This is known as a duopoly, We assume that the firme have equal costs, identical products and share the market every, so the initial demand for their gauds is the same. (Rather large assumptions!)The situation is showe in Table 10,1 where firms A and B are cuntemplating what would be the passible profit outcomes if they were io change the prices of their identieal products, Table 10.1 The predicted profits for firs A and B with diferent possible price combinations Let us start by assuming that both firms are currently charging a price of $5.50 for their products and so they are bath making profits of $6 million. Now let us assume that they are not colluding. but they are both separately considering lowering their prices to $5.00, We can start hy considering fem A's eholces, Firm A has twa choiges: Ir can leave tts price unchanged or it can lower Lt I firm A is pessimistic, or cautious, it might consider the worst possible scenarios following its choices, where firm B responds in the may that is most damaging ta firm A. Tf it docs not lower its price and firm B docs, then its profit would fall from $6 million to $2 million. If lowers its price and firm B also lowers its price, then its profit would fall irom $6 million to $4 million. This means that the best option, if one considers the worst possible outcomes, is to lower prices. The firm is maximizing its minimum profit options and is therefore known as a *maximin” strategy. The strategy is to adopt the policy that has the least worst outcarne. If Firm A {s optimistic ft might consider the best possible scenarios following its shoices, where firm B responds in the way that is best for firm she it does not lower its priee and firm B does not lower Its price, them firm A will make $6 million. {firm a lowers is price and firm B docs not lower Its price, then fim A will make $8 million. Once again the best option {s for fim A to lower price. The stratezy of ying to make the maximum profit available fy knuwa. as a “maxinax” sirategy. Firm A’s “maxlmin” and “maximax” strategies are both to lower price if we turn the tables and look at the situation from the pitt af view of firm B the same logic applics and so the “maximin” and “maximax” strategies for firm B are also to lower price. I both firms adopt the strategy of lowering prices, which seems to be logieal, then they will end up making lower profits of $4 million each, Thus, a price cutting exercise is actually harmful to bot firms. ‘They would have been better leaving their prices where they were ‘They would have benefitted from the abilicy to collude, If they could have done so. wes oesy SIIPREY 10 = clcvst } The different strategies and outcames are shown in Figure 10.3 Rees ‘bee pte” mena trey) somes sete Figure 10.3 Game theory outcomes for Frms A and 8 Game theory is useful for firms if they are able to predict, relatively accurately, the outcomes that will follow any set of decisions. ! However, this is net necessarily easy todo, Also, the more firms there ate in an inelustry the more difficult it will be to estimate all the possible combinations af decisions and also eutcomes. So, game theary Is mostly useful when there are only & few firms in an industry, there are only @ small number of passible options, and the ouicomes ean be accurately predicted, ge The prisoner's dilemma The concept ofthe “prisoners lemma was developed by Flood and Drasher and formalised by albert Tucker 1992. The prisoner's dilemma uses the example of two men being arrested by the police. The police require more evidence and so separate the men and offer each of them the following conditions. 1 Testify for the prosecutton. if you do, you go free and yout partner in cfime gets 10 years in pson. Grip the fist one to confess gets the affet 2 Say nothing end you get 5 years in prison, Each prconer has the choice of cooperating wth the other and saying nothing oc baraying the het, and co erases issues of ust cooperation. and betrayal sit human nat to save onesel atthe expense of others? Should one saciice one's own wellbeing forthe common good? The principle of he prsoners dilemma can be applied to teal world situations, such as qycling. Sometimes two fiders get away from the main group of riders (known as, the peloton). ifthe two fiders cooperate, each taking 2 shave of the lead so that the ether can shaker from the vind, they nil irish fist and second. f they don't cooperete, the peloton will cach ther up. What sometimes happens is thatone der (the cooperator) does all hard work atthe front whe the other fidar (the betrayer) sis in the slipstream of the first der Gust behind the leader) ‘The betrayar almost always wins. Theorists have adapted the prisoner's dfemme as part of game theory. Economists apply to the actons of firms, mainly thase in oligopoly. 11 What does it mean to say that firms in an oligopoly ate interdependent? 2. Examine some of the price and nan-price strategies ‘9pen to a firm in an aligapoly to improve its postion ina matket (Bo you think itis better for a firm in an oligopoly to ‘cooperate wih the others?vescieedy REI f One way of attempting to explain the siwation in a nan-eollusive oligapaly is the kinked demand curve, devised in the 1930s by an American economist called Paul Sweezy (1910-2004), Although the theory has been ealled into question, it does pravoke some Interesting thoughts and discussion concerning non-callusive oligapoly, The kinked demand curve is shown in Pigure 10.4 We start by making the assumption that, in reality, a firm only knows one point on its demand curve, the one that it halds at present. This is shown as point “a" in Figure 10.4. Now, consider what reactions the firm would expect from its competitors if it were to change its price Figure 104 The kinked demand aurve I the firm raises its price then i is unlikely that its competitors would raise theirs abd se a lot of demand would be lost 10 the other firms, This implies that demand would be relatively elastic above the point "4°, sinwe a stnall fnereage in price would lead to a large fall in quantity demanded, the firm were to lower its price then iti likely that competitors would follow, Moreto the point, itis likely that they would undercut the price of the first fern in order to regain any lost sates. This implies that demand would be less elastic below the point “a”, since a de price is unbikely to lead to a noticeable increase in quantity demanded. Hecause of these expectations. we see that the demand curve will be kinked around the point *2*, 11 will also possess an MR curve that bas the vertical section be, since each part of the MR curve will be cwice ay steeply sloping as the twa parts of the demand curve The kinked demand curve offers an explanation of wlay there tends to be price rigidity in non-collusive oligopoly. There are three reasons. 1 Firms are afraid to raise prices above the current market price, because other firms will not follow and so they will lose trade sales, and probably profit 2 Firms are afrald to lower their prices below the current market price, because other firms will fallow, undercutting them, and so. creating a price war that may harm afl the firms involved. The shape of the MIR curve means that if marginal costs were to rise, then. it is possible that MC would still equal MR and so the firms, being profit maxineizers, would not change thelr prices oF outputs, This can be seen in Figure 10.4. If we assume that the firm is operating on MC,, then they are maximizing profits by producing Q and selling at P, Marginal costs could rise as high as MC, and the firm would siill be maximizing profits by producing at Q and charging P Thus ihe market remains stable, even though there have brea significant price changes. Non-price competition Because firms in oligopoly tend nat te compete in teres of price, the concept of non-price competition becomes important. There are many kinds of non-price competition, such as the use of brand names, packaging. special features, advertising, sales promotion personal selling, publicity, sponsorship deals, and special distribution features, such as free delivery and after-sales service. Oligepoly is Br