2.F.THE THEORY OF THE FIRM II: MARKET STRUCTURES HL
wHAT: PERFECT COMPETITION
How: be able to...
- Describe, using examples, the assumed characteristics of perfect competition: a large number of firms; a homogeneous product; freedom of entry and exit; perfect information; perfect resource mobility.
- Explain, using a diagram, the shape of the perfectly competitive firm’s average revenue and marginal revenue curves, indicating that the assumptions of perfect competition imply that each firm is a price taker.
- Explain, using a diagram, that the perfectly competitive firm’s average revenue and marginal revenue curves are derived from market equilibrium for the industry.
- Explain, using diagrams, that it is possible for a perfectly competitive firm to make economic profit (abnormal profit), normal profit (zero economic profit) or negative economic profit in the short run based on the marginal cost and marginal revenue profit maximisation rule.
- Explain, using a diagram, why, in the long run, a perfectly competitive firm will make normal profit (zero economic profit).
- Explain, using a diagram, how a perfectly competitive market will move from short- run equilibrium to long-run equilibrium.
- Distinguish between the short run shut-down price and the break-even price.
- Explain, using a diagram, when a loss-making firm would shut down in the short run.
- Explain, using a diagram, when a loss-making firm would shut down and exit the market in the long run.
- Calculate the short run shut-down price and the break-even price from a set of data.
- Explain the meaning of the term allocative efficiency.
- Explain that the condition for allocative efficiency is P = MC (or, with externalities, MSB = MSC).
- Explain, using a diagram, why a perfectly competitive market leads to allocative efficiency in both the short run and the long run.
- Explain the meaning of the term productive/technical efficiency.
- Explain that the condition for productive efficiency is that production takes place at minimum average total cost.
- Explain, using a diagram, why a perfectly competitive firm will be productively efficient in the long run, though not necessarily in the short run.
WHY: pERFECT COMPETITION IS AN ABSTRACT MODEL OF THE MARKET SYSTEM IN WHICH PARETO EFFICIENCY IS ACHIEVED, THE REALITY IS THAT OTHER MARKET STRUCTURES EXIST AND ALLOCATIVE AND PRODUCTIVE EFFICIENCY ARE NOT ACHIEVED IN PRACTICE.
pERFECT cOMPETITION qUESTIONS
HOW: BE ABLE TO...
- Describe, using examples, the assumed characteristics of a monopoly: a single or dominant firm in the market; no close substitutes; significant barriers to entry.
- Describe, using examples, barriers to entry, including economies of scale, branding and legal barriers.
- Explain that the average revenue curve for a monopolist is the market demand curve, which will be downward sloping.
- Explain, using a diagram, the relationship between demand, average revenue and marginal revenue in a monopoly.
- Explain why a monopolist will never choose to operate on the inelastic portion of its average revenue curve.
- Explain, using a diagram,
- the short- and long-run equilibrium output and pricing decision of a profit maximising (loss minimising) monopolist, identifying
- the firm’s economic profit (abnormal profit), or losses.
- Explain the role of barriers to entry in permitting the firm to earn economic profit (abnormal profit).
- Explain, using a diagram, the output and pricing decision of a revenue maximising monopoly firm.
- Compare and contrast, using a diagram, the equilibrium positions of a profit maximising monopoly firm and a revenue maximizing monopoly firm.
- Calculate from a set of data and/or diagrams the revenue maximising level of output.
- With reference to economies of scale, and using examples, explain the meaning of the term 'natural monopoly'.
- Draw a diagram illustrating a natural monopoly.
- Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency.
- Explain why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including the ability to finance research and development (R&D) from economic profits, the need to innovate to maintain economic profit (abnormal profit), and the possibility of economies of scale.
- Evaluate the role of legislation and regulation in reducing monopoly power.
- Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale.
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- Describe, using examples, the assumed characteristics of a monopolistic competition: a large number of firms; differentiated products; absence of barriers to entry and exit.
- Explain that product differentiation leads to a small degree of monopoly power and therefore to a negatively sloping demand curve for the product.
- Explain, using a diagram, the short-run equilibrium output and pricing decisions of a profit maximizing (loss minimizing) firm in monopolistic competition, identifying the firm’s economic profit (or loss).
- Explain, using diagrams, why in the long run a firm in monopolistic competition will make normal profit.
- Distinguish between price competition and non-price competition.
- Describe examples of non- price competition, including advertising, packaging, product development and quality of service.
- Explain, using a diagram, why neither allocative efficiency nor productive efficiency areachieved by monopolistically competitive firms.
- Compare and contrast, using diagrams, monopolistic competition with
- Describe, using examples, the assumed characteristics of an oligopoly: the dominance of the industry by a small number of firms; the importance of interdependence; differentiated or homogeneous products; high barriers to entry.
- Explain why interdependence is responsible for the dilemma faced by oligopolistic firms – whether to compete or to collude.
- Explain how a concentration ratio may be used to identify an oligopoly.
- Explain how game theory (the simple prisoner’s dilemma) can illustrate strategic interdependence and the options available to oligopolies.
- Explain the term 'collusion', give examples, and state that it is usually (in most countries) illegal.
- Explain the term 'cartel'.
- Explain that the primary goal of a cartel is to limit competition between member firms and to maximise joint profits as if the firms were collectively a monopoly.
- Explain the incentive of cartel members to cheat.
- Analyse the conditions that make cartel structures difficult to maintain.
- Describe the term 'tacit collusion', including reference to price leadership by a dominant firm.
- Explain that the behaviour of firms in a non-collusive oligopoly is strategic in order to take account of possible actions by rivals.
- Explain, using a diagram, the existence of price rigidities, with reference to the kinked demand curve.
- Explain why non-price competition is common in oligopolistic markets, with reference to the risk of price wars.
The role of game theory in oligopolistic markets
- Describe price discrimination as the practice of charging different prices to different consumer groups for the same product, where the price difference is not justified by differences in cost.
- Explain that price discrimination may only take place if all of the following conditions exist: the firm must possess some degree of market power; there must be groups of consumers with differing price elasticities of demand for the product; the firm must be able to separate groups to ensure that no resale of the product occurs.
- Draw a diagram to illustrate how a firm maximises profit in third-degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand.
- Some market power
- Separation of consumers into groups to avoid the possibility of resale
- Different price elasticities of demand
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