Economics 1110

Topic 6
Firms & Markets
Reference: Chs 7 & 8
The Firm and Its Economic Problem
• A firm is an institution that hires factors of
production and organises them to
produce and sell goods and services.
• A firm’s goal is to maximise profits.
• Profit = total revenue – total costs
• If the firm fails to maximise profits it is
either eliminated or bought out by other
firms seeking to maximise profit.
The Firm and Its Economic Problem
In economics, costs can be divided into:
Explicit costs
• A cost that involves spending money:
payments for wages, raw materials,
rent, interest on borrowed funds
Implicit costs
• A non-monetary opportunity cost
(foregone salary, foregone interest).
Economic Profit
• Economic Profit =
TR – explicit + implicit costs
• Accounting Profit = TR – explicit costs
• Economic profit < accounting profit
• When economic profit = 0, firms are said
to earn a ‘normal profit’
• Most firms earn a normal profit
Example
Tony Abbott quits his $250,000 job to open
a pizza bar: Tony’s Pizza
He uses $100,000 of his savings (earning
5%) to finance the café
In first year, sales = $300,000
$ expenses = $100,000
accounting profit = ?
economic profit = ?
Example
Acc. profit = TR - explicit costs
= $300,000 - $100,000
= _____________
Econ profit = TR – (explicit + implicit)
= $300,000 – ($100,000 + $255,000)
= _____________
Should Tony keep the business?
Example
Acc. profit = TR - explicit costs
= $300,000 - $100,000
= $200,000
Econ profit = TR – (explicit + implicit)
= $300,000 – ($100,000 + $255,000)
= _____________
Should Tony keep the business?
Example
Acc. profit = TR - explicit costs
= $300,000 - $100,000
= $200,000
Econ profit = TR – (explicit + implicit)
= $300,000 – ($100,000 + $255,000)
= -$55,000
Should Tony keep the business?
Example
Acc. profit = TR - explicit costs
= $300,000 - $100,000
= $200,000
Econ profit = TR – (explicit + implicit)
= $300,000 – ($100,000 + $255,000)
= -$55,000
Should Tony keep the business? NO!!
Market Structures
How is a firm’s pricing and output decisions
affected by the type of market the firm
operates in
There are 4 types of market structure
• Perfect Competition (chapter 7)
• Monopoly (chapter 8)
• Monopolistic Competition (chapter 9)
• Oligopoly (chapter 9)
 The four market structures
Characteristic Perfect Monopolistic Oligopoly Monopoly
competition competition
Number of Many Many Few One
firms
Type of Identical Differentiated Identical or Unique
product differentiated
Ease of High High Low Entry
entry blocked
Examples of – Apples – Selling cars – Banking – Aust
industries – Wheat – cafes – Coke/Pepsi post
–boutiques – Coles/Woolies – Tap
water

11
 Market Structures
Many firms Few One

PC MC O M

Number & relative size of firms

Identical or differentiated products
Nature of demand
Entry/exit conditions
 Market Structure

Many firms Few One

PC MC O M

Number of firms __________

Size of firms ____________
Elasticity of demand __________
Barriers to entry _________
Economic profit ___________
Total surplus/efficiency ____________
 Market Structure

Many firms Few One

PC MC O M

Number of firms decreases

Size of firms ____________
Elasticity of demand __________
Barriers to entry _________
Economic profit ___________
Total surplus/efficiency ____________
 Market Structure

Many firms Few One

PC MC O M

Number of firms decreases

Size of firms increases
Elasticity of demand __________
Barriers to entry _________
Economic profit ___________
Total surplus/efficiency ____________
 Market Structure

Many firms Few One

PC MC O M

Number of firms decreases

Size of firms increases
Elasticity of demand decreases
Barriers to entry _________
Economic profit ___________
Total surplus/efficiency ____________
 Market Structure

Many firms Few One

PC MC O M

Number of firms decreases

Size of firms increases
Elasticity of demand decreases
Barriers to entry increase
Economic profit ___________
Total surplus/efficiency ____________
 Market Structure

Many firms Few One

PC MC O M

Number of firms decreases

Size of firms increases
Elasticity of demand decreases
Barriers to entry increase
Economic profit increases
Total surplus/efficiency ____________
 Market Structure

Many firms Few One

PC MC O M

Number of firms decreases

Size of firms increases
Elasticity of demand decreases
Barriers to entry increase
Economic profit increases
Total surplus/efficiency decreases
Demand in different markets

Monopoly Oligopoly

D D

Monopolistic Perfect
Competition Competition
D
D
 What is Perfect Competition?
The conditions that make a market perfectly
competitive are:
1. There are many buyers and sellers, all of
whom are small relative to the market.
2. All firms sell identical products.
3. There are no barriers to new firms entering
the market or to existing firms leaving the
market.
Example = lawnmowing
21
What is Perfect Competition?

A perfectly competitive market has the

following outcomes:
• Theindividual firm produces a tiny
portion of total market output.
• The firm has no market power - cannot
influence the market price
• Firmsare price takers – they face a
perfectly elastic demand curve
What is Perfect Competition?
Importance
Underlies the theory of the market
Considered the ‘ideal’ market structure
Why? Because it maximises total surplus
Provides a benchmark to evaluate other
market structures
 Market demand and individual firm demand
Price of oats 1. The intersection of market
Price of oats
(dollars per supply and market demand (dollars per
bushel) determines the equilibrium price bushel) 2. …which must be
of oats... accepted by Farmer
Jones and every
Supply of oats other seller of oats.

Demand for
Farmer
Jones’ oats
$4 $4

Demand for oats

0 0 7500
80 000 000
Quantity of oats (bushels per year) Quantity of oats (bushels per year)

(a) Market for oats (b) Demand for an individual

farmer’s oats
24
The entry and exit of firms

Economic profit and the entry or exit decision

 Economic profit: A firm’s revenues minus
all its costs, implicit and explicit.
 Economic profit in a perfectly competitive
industry is only a short-run occurrence.
 Economic profit leads to the entry of new
firms into the industry.

25
 The effect of entry on economic profits

1. At price of $15, firms are

making an economic profit.
2. New firms will enter the
market
3. The market S curve will shift
to the right
4. Price falls to $10 where firms
earn zero economic profit.

26
The entry and exit of firms

Economic profit and the entry or exit decision

 Economic loss: The situation in which a
firm’s total revenue is less than its total cost,
including all implicit costs.
 Economic loss in a perfectly competitive
industry is only a short-run occurrence.
 Economic loss leads to the exit of some firms
from the industry.

27
 The effect of exit on economic losses

1. A decrease in D causes
price to fall to $7
2. Firms now make an
economic loss
3. This will cause some firms to
exit the market shifting the
market S curve to the left
4. Price rises back to $10
where firms break even.

28
Perfect Competition and
Efficiency
1. Firms produce goods at the lowest cost:
This is called productive efficiency
2. Firms produce goods that consumers want
and in the optimal quantity MB = MC
This is called allocative efficiency
3. Firms have an incentive to innovate and
adapt to changes in consumer tastes
This is called dynamic efficiency
Review
Which of the following is not a characteristic
of a perfectly competitive market?
A. Firms are price takers.
B. There are many sellers in the market.
C. Goods offered for sale are largely the
same.
D. Firms have difficulty entering the market.
Review
Which of the following would satisfy the
attributes of a perfectly competitive market?
A. The market for electricity.
B. The market for fast food.
C. The market for soft drinks.
D. The market for Valentine’s Day roses.
Review
The entry of new firms into a competitive
market will:
A. decrease market supply and increase
market prices.
B. increase market supply and increase
market prices.
C. increase market supply and decrease
market prices.
D. decrease market supply and decrease
market prices.
Monopoly

A firm is considered a monopoly if...

...it is the sole seller of its product.
...it has no close substitutes.
...it has market power.
…it can restrict the entry of new
firms into the market
Example = Big summer blowout
Monopoly

 What is market (monopoly) power?

 The ability to increase price by
reducing output
 Why does a monopolist want to
increase price? . . . . to increase
profit
 Market Power
Price
Supply

Monopoly
price

Competitive
price

Demand

0 Monopoly Efficient Quantity

quantity quantity
Where Do Monopolies
Come From?
Monopolies emerge due to a lack of
competition created by barriers to entry:
1. Government imposed barriers
2. Ownership of a key resource

3. Network externalities
4. Large economies of scale
Where Do Monopolies
Come From?
Government barriers to entry create a legal
monopoly - competition and entry are
restricted by:
1. granting a patent or copyright to an
individual or firm, which gives it the exclusive
right to produce a product or service.
2. granting a firm a public franchise, which
makes it the exclusive legal provider of a
good or service.
Where Do Monopolies
Come From?
By owning or
controlling a key
resource

OPEC & oil

De Beers & the diamond monopoly – the
most successful monopoly in history?
Where Do Monopolies
Come From?
• Network externalities: these exist
when the usefulness of a product
increases with the number of
consumers who use it.
• Examples – Apple iphone, email,
ebay, Facebook, Microsoft windows
Where Do Monopolies
Come From?
 An industry is a natural monopoly when
a single firm can supply a good or service
to an entire market at a lower cost than
two or more firms.
 Why . . . because the economies of scale
are so large
 Examples - water supply, electricity
Review
A local electricity-generating company has a
monopoly that is protected by an entry
barrier that takes the form of
A) control of a key raw material.
B) network externalities.
C) economies of scale.
D) perfectly inelastic demand curve.
Efficiency of Monopoly
 How does a monopoly’s price and output
compare with perfect competition?
 In perfect competition, the market
produces where Demand = Supply
 Monopoly restricts output & increases
price to increase profits:
 Qm < Qc

 Pm > Pc
Efficiency of Monopoly
How does a monopoly affect economic
efficiency?
Because monopoly restricts output &
charges a higher price
1. Monopoly causes a decrease in
consumer surplus.
2. Monopoly causes an increase in
producer surplus.
3. Monopoly causes a deadweight loss.
 Monopoly & Competition
Price

Supply

Consumer
Surplus Perfect competition
maximises total
Competitive P
surplus
Producer
Surplus

Demand

0 Qc Quantity
 Monopoly & Competition
Price
Deadweight
loss S (Marginal cost)
Consumer
Surplus
Monopoly P

Producer
Competitive P
Surplus
Monopoly creates
a deadweight loss

Demand

0 Qm Qc Quantity
Case For Monopoly
 Is there a case for monopoly?
 Incentive to innovate
 Because monopoly firms earn high profits,
they can devote more resources to
research & development
 Does this mean that large firms with
market power will be more innovative?
Evidence?
Government Policy Toward
Monopolies
 Monopoly is an example of market failure
 Government usually responds to the
problem of monopoly by
 Government ownership e.g. state owned
utilities
 Government competition policy – The
Australian Competition & Consumer
Commission (ACCC) – prohibits price
fixing & collusion
Price Discrimination
 The practice of selling goods or services
at different prices to different buyers
unrelated to costs
 Common practice by firms with
monopoly power Why?
 Price discrimination converts consumer
surplus into economic profit.
Price Discrimination
 Many examples
- firms charging different prices
according to age e.g. cinemas
- firms charging different prices
according to sex e.g. hairdressers
- firms charging different prices
according to time e.g. airlines
Price Discrimination
 Necessary conditions:
1 Market power
2 Separate groups of buyers
3 Different elasticities of D
4 Resale impossible
 Example: Hairdressers
 Two groups – males & females
 Which group has more elastic D?
 Which group has more inelastic D?
Price Discrimination
Example
 Males have the more elastic D
. . . price for males and TR will . . .
 Females have more inelastic D

. . . price for females and TR will . . .

 With price discrimination total
consumption will be higher
Price Discrimination
Example
 Males have the more elastic D
Lower price for males and TR
increase
 Females have more inelastic D

. . . price for females and TR will . . .

 With price discrimination total
consumption will be higher
Price Discrimination
Example
 Males have the more elastic D
Lower price for males and TR increase
 Females have more inelastic D
Raise price for females and TR will
increase
 With price discrimination total consumption
will be higher
Price Discrimination
 Is price discrimination good?
 Price discrimination benefits the producer:
total revenue & profits are higher
 Some consumers lose & some gain – but
total consumption is higher
 Price discrimination can increase total
surplus and decrease the deadweight loss
 Price discrimination is therefore
efficient
Imperfect Competition

 Market structures that lie between

perfect competition & monopoly
 Monopolistic competition
 Oligopoly
 Industries in which firms have
competitors but do not face so much
competition that they are price takers -
they can set price (market power).
What is Monopolistic
Competition?
 Monopolistic competition is a market with
the following characteristics:
 A large number of small firms.

 Each firm produces a differentiated

product
 Firms compete on product quality, price,
marketing and branding.
 Firms are free to enter and exit.
Starbucks: growth through
product differentiation –
decline through competition
Starbucks has been competing
in a highly competitive market
for over three decades, but was
able to maintain profits and
expand its operation across the
globe thanks to a successful
differentiation strategy. It is only
recently that Starbucks ran into
trouble, with its strategy no
longer successful in all markets.
What is Oligopoly?
A few firms that dominate the market
Natural or legal barriers prevent the
entry of new firms
Firms are interdependent - the actions
of one firm affect the profits of other firms
Firms need to act strategically
Examples: retail; fast food; cars; soft
drink; beer; cinemas; banking
Example = Dark Knight
Oligopoly
 Do oligopoly firms act like a monopoly
or a competitive firm?
 If oligopoly firms cooperate (collude)
and act like a monopoly – profits will be
highest
 If oligopoly firms act independently &
compete – prices are lower & profits
are lower
Review
Which of the following is an example of an
implicit cost?
A. Wages paid to part-time workers
B. Wages the owner could have earned
working for someone else
C. Interest paid on a business loan
D. Costs of raw materials purchased now for
use later
Review
 In comparison with perfect competition, a
monopoly
A. generates a smaller consumer surplus and a
larger economic profit.
B. generates a larger consumer surplus and a
larger economic profit.
C. generates a smaller consumer surplus and a
smaller economic profit.
D. generates a larger consumer surplus and a
smaller economic profit.
Review
Small pizza shops exist in just about every
town. Anyone can open a pizza shop and
the pizzas at one shop typically have
different taste, texture and size than pizzas
from another shop. This is an example of
a. perfect competition
b. monopolistic competition
c. oligopoly
d. monopoly.