Economics Lecture Notes – Chapter 6

MARKET STRUCTURE will be taught in the first, second, third and fourth weeks of term 2 in economics tuition.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1 INTRODUCTION

Economists are interested to study the behaviour of firms such as whether they will charge a high or low price, whether they will make a large or small amount of profit and whether they will produce efficiently. The answers to these questions will depend on the market structure. Market structure refers to the characteristics of a market such as the number of firms, the nature of their products, the availability of knowledge and the extent of barriers to entry which affect the behaviour of the firms in the market. For example, a firm that faces competition from many firms is likely to charge a low price, make a small amount of profit and produce efficiently. The converse is also true. To maximise profit, a firm may not charge the same price for each unit of a good and this practice is known as price discrimination. Price discrimination affects the firm, consumers and society as a whole. Although firms generally seek to maximise profit, some firms seek to maximise market share, sales revenue and long-run profit. This chapter provides an exposition of the four types of market structures: perfect competition, monopoly, monopolistic competition and oligopoly, price discrimination and the alternative objectives of firms.

2 PERFECT COMPETITION

2.1 Characteristics of Perfect Competition

Large Number of Small Firms

In perfect competition, there are a large number of small firms each with a small market share.

Homogeneous Products

In perfect competition, firms sell homogenous products that are perfect substitutes.

Perfect Knowledge

In perfect competition, consumers and firms have perfect knowledge about the price, quality, availability and production technology of the product.

Price-takers

Due to small market share, product homogeneity and perfect knowledge, perfectly competitive firms are price-takers in the sense that they are unable to influence the market price by changing their output levels. Therefore, perfectly competitive firms can only sell their output at the market price that is determined by the market forces of demand and supply. In other words, perfectly competitive firms face a perfectly price elastic demand curve at the market price. At the market price, perfectly competitive firms can sell an infinite amount of output and hence they do not have the incentive to charge a lower price. Furthermore, perfectly competitive firms do not have the incentive to charge a price higher than the market price as the quantity demanded is zero.

No Barriers to Entry

In perfect competition, there are no barriers to entry which means that firms can make only normal profit in the long run. This will be explained in greater detail in Section 2.3.

Perfect competition does not exist in reality due to the unrealistic assumption of perfect knowledge.

Market Representative firm

In the above left-hand diagram, the market price (P₀) is determined by the market demand (D) and the market supply (S). In the above right-hand diagram, the perfectly competitive firm faces a perfectly price elastic demand curve (D₀) at P₀. At P₀, the quantity demanded of the good produced by the firm is infinite. Total revenue is the amount of money received from selling a quantity of a good which is the product of the price and the quantity. Average revenue is revenue per unit of a good. It is calculated by dividing total revenue by the quantity. Therefore, average revenue is the price of the good and hence the average revenue curve (AR₀) is the demand curve. Marginal revenue is the additional revenue resulting from selling one more unit of a good. It is calculated by dividing the change in total revenue by the change in the quantity. If the perfectly competitive firm wants to sell one more unit of the good, it does not need to decrease the price. Therefore, marginal revenue is equal to the price of the good and hence the marginal revenue curve (MR₀) is the demand curve.

Note: The word ‘perfect’ in ‘perfect competition’ does not mean ‘the best’ or ‘the most desirable’. Rather, when it is used with the word ‘competition’, perfect means ‘of the highest degree’.

Although perfect competition does not exist in reality, there are some markets which approximate perfect competition, such as the agriculture market.

Perfect competition will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

2.2 The Profit-maximising Condition

A firm will maximise profit when it produces the output level where marginal cost is equal to marginal revenue.

In the above diagram, profit is maximised at Q₀ where marginal cost (MC) is equal to marginal revenue (MR). If the firm increases output from Q₀, both total revenue and total cost will rise. However, at an output level higher than Q₀, such as Q₁, MC is higher than MR. Therefore, the increase in total cost will be greater than the increase in total revenue and hence the increase in output will lead to a decrease in profit. If the firm decreases output from Q₀, both total revenue and total cost will fall. However, at an output level lower than Q₀, such as Q₂, MR is higher than MC. Therefore, the decrease in total revenue will be greater than the decrease in total cost and hence the decrease in output will lead to a decrease in profit. Since profit cannot be increased by changing output from Q₀, it must be maximised at Q₀. The profit is represented by the shaded area, assuming the firm is making supernormal profit.

Furthermore, MC is equal to MR at two output levels, Q₀’ and Q₀. At Q₀’, where MC is falling, profit is NOT maximised. Between Q₀’ and Q₀, MR is higher than MC. If output increases from Q₀’ to Q₀, a profit will be made on each unit of output and this means that the profit at Q₀ is higher than the profit at Q₀’. Therefore, the profit of a perfectly competitive firm is maximised at the output level where MC is equal to MR, assuming MC is rising.

Note: Although the profit-maximising condition states that marginal cost must be equal to marginal revenue for profit to be maximised, the condition is generally not applied in practice. This is mainly due to the difficulty in measuring marginal cost in reality. For firms that engage in mass production on assembly line, marginal cost is virtually impossible to measure. This is also true for firms that provide services. In practice, most firms set their prices by adding a certain percentage mark-up to their average costs and this is known as cost-plus pricing.

2.3 Equilibrium of a Perfectly Competitive Market

A perfectly competitive market is in short-run equilibrium when all the firms in the market are producing the profit-maximising output level. However, this does not necessarily mean that they are making positive economic profit. In the short run, a perfectly competitive firm can make three types of profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and subnormal profit (negative economic profit or economic loss).

Supernormal Profit

In the above diagram, at the profit-maximising output level (Q₀) where marginal cost (MC) is equal to marginal revenue (MR), average revenue (AR) is higher than average cost (AC). Therefore, the firm is making supernormal profit represented by the shaded area.

Normal Profit

In the above diagram, at the profit-maximising output level (Q₀) where marginal cost (MC) is equal to marginal revenue (MR), average revenue (AR) is equal to average cost (AC). Therefore, the firm is making normal profit.

Subnormal Profit

In the above diagram, at the profit-maximising output level (Q₀) where marginal cost (MC) is equal to marginal revenue (MR), average revenue (AR) is lower than average cost (AC). Therefore, the firm is making subnormal profit represented by the shaded area.

A perfectly competitive market is in long-run equilibrium when firms that wish to leave the market and potential firms that wish to enter the market have done so. In other words, a perfectly competitive market is in long-run equilibrium when the number of firms in the market is constant. In a perfectly competitive market, this occurs when firms make normal profit.

If the firms in a perfectly competitive market are making supernormal profit, potential firms will enter the market in the long run due to the absence of barriers to entry. As the number of firms in the market increases, the market supply will increase which will lead to a fall in the market price resulting in a fall in the profits of the firms. This process will continue until the firms in the market make only normal profit.

Market Representative firm

In the above diagram, the supernormal profit represented by the shaded area induces potential firms to enter the market in the long run, which leads to a rightward shift in the market supply curve (S) from S₀ to S₁. When this happens, the market price (P) falls from P₀ to P₁. At P₁, as the firms in the market make only normal profit, the incentive for potential firms to enter the market disappears.

If the firms in a perfectly competitive market are making subnormal profit, they will leave the market when their fixed factor inputs need replacing. Those that cannot cover their total variable costs will leave the market immediately. As the number of firms in the market decreases, the market supply will decrease which will lead to a rise in the market price resulting in a fall in the losses of the firms. This process will continue until the firms in the market start making normal profit.

Market Representative firm

In the above diagram, the subnormal profit represented by the shaded area induces firms to leave the market, which leads to a leftward shift in the market supply curve (S) from S₀ to S₁. When this happens, the market price (P) rises from P₀ to P₁. At P₁, as the firms in the market start making normal profit, the incentive for them to leave the market disappears.

2.4 The Shut-down Condition

If a firm is making supernormal profit (i.e. positive economic profit) which means that the total revenue is greater than the total cost, it is obvious that it should continue production. However, if a firm is making subnormal profit (i.e. negative economic profit or economic loss) which means that the total revenue is less than the total cost, it does not mean that it should shut down production. In the short run, a firm should continue production so long as the total revenue is greater than or equal to the total variable cost. In other words, in the short run, a firm should only take into consideration variable costs and ignore fixed costs when it is deciding whether to continue or shut down production as fixed costs will be incurred in any case.

Assume that a firm is making subnormal profit as the total revenue is less than the total cost. If the firm shuts down production, it will not incur variable costs as it will not need to employ labour or buy materials which means that the total variable cost will be zero. In this case, no sale will be made as there will be no production and hence the total revenue will also be zero. However, the firm will incur fixed costs as it will incur rent and possibly other costs that do not vary with the output level such as interest payments on loans which means that the total fixed cost will be positive. Therefore, it will make a loss equal to the total fixed cost. If the firm continues production, it will incur variable costs as it will need to employ labour and buy materials which means that the total variable cost will be positive. In this case, sale will be made as there will be production and hence the total revenue will also be positive. In addition, the firm will incur fixed costs as it will incur rent and possibly other costs that do not vary with the output level such as interest payments on loans which means that the total fixed cost will also be positive. Therefore, it will make a loss equal to the total revenue minus the total fixed cost and the total variable cost.

In this case, whether the firm will make a loss greater or less than the total fixed cost which is the loss that it will make if it shuts down production, will depend on whether the total revenue is greater or less than the total variable cost. If the total revenue is less than the total variable cost, the shortfall will add to the loss. In this case, the firm will make a loss greater than the total fixed cost. Assume that the variable costs are the cost of labour and the cost of materials and the only fixed cost is the rent. If the total revenue is less than sufficient to pay for the costs of labour and materials, the shortfall will add to the loss and hence the firm will make a loss greater than the rent which is the loss that it will make if it shuts down production. Therefore, the firm should shut down production. However, if the total revenue is greater than the total variable cost, the excess will partially offset the total fixed cost. In this case, the firm will make a loss less than the total fixed cost. Using the above example, if the total revenue is more than sufficient to pay for the costs of labour and materials, the excess will partially offset the rent and hence the firm will make a loss less than the rent which is the loss that it will make if it shuts down production. Therefore, the firm should continue production. If the total revenue is equal to the total variable cost, the firm will make the same amount of loss whether it continues or shuts down production. In this case, the firm should continue production as doing so may enable it to make supernormal profit in the future as the market conditions may improve. In the event that the market conditions worsen, the firm can shut down production without being worse off than if it had shut down production now. Therefore, the firm should continue production. It follows that a firm should continue production if the total revenue is greater than or equal to the total variable cost, and shut down production if the total revenue is less than the total variable cost.

In the long run, as all costs are variable, there is no distinction between fixed costs and variable costs. Therefore, in the long run, if a firm makes subnormal profit which means that the total revenue is less than the total cost, it should shut down production and leave the market. It follows that in the long run, a firm should continue production if the total revenue is greater than or equal to the total cost.

Note: The short-run and long-run shut-down conditions discussed above apply to firms in all market structures.

In the short run, unlike the long run, if a firm shuts down production, it does not leave the market.

Shut-down condition will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

2.5 Supply Curve in Perfect Competition

Recall that the supply of a good is the quantity of the good that firms are able and willing to sell at each price over a period of time, ceteris paribus, and the supply curve shows the quantity supplied at each price. The portion of the marginal cost curve above the average variable cost curve of a perfectly competitive firm is the supply curve. As the supply curve shows the quantity supplied at each price, this means that given the price of a good, the quantity supplied is determined entirely by the supply curve.

In the above diagram, given the market price of the good (P₀) that is determined by the market forces of demand and supply, the quantity supplied (Q₀) is determined entirely by the marginal cost (MC). Intuitively, given the price of a good, the quantity supplied is determined by the marginal revenue and the marginal cost. However, in the case of a perfectly competitive firm, price is equal to marginal revenue. Therefore, given the price of the good produced by a perfectly competitive firm, the quantity supplied is determined entirely by the MC curve. Furthermore, at a price below the average variable cost (AVC), the firm will shut down production to avoid making a loss greater than the total fixed cost. Therefore, the supply curve of a perfectly competitive firm is the portion of the marginal cost curve above the average cost curve. The industry supply curve of a perfectly competitive industry is the horizontal summation of the supply curves of all the firms in the industry.

2.6 Advantages and Disadvantages of Perfect Competition

Advantages of Perfect Competition

Productive Efficiency

A firm is productively efficient when it produces on its long-run average cost curve, from firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is not lax in cost control. In other words, it uses the most efficient production technology, it is not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm is technically efficient when it uses the least-cost combination of factor inputs to produce its output level which means that the last dollar of each factor input that it employs produces the same additional output. From society’s perspective, a firm is productively efficient when it produces at the minimum efficient scale. Due to competition in the market, perfectly competitive firms are not lax in cost control. Therefore, perfectly competitive firms are x-efficient and hence productively efficient.

Allocative Efficiency

A firm is allocatively efficient when it cannot change the allocation of resources in the economy in a way that will increase the welfare of society. This occurs when it charges a price equal to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that they place on the amount of other goods that could have been produced using the same resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence is allocatively efficient. In perfect competition, price equals marginal revenue and firms maximise profit by producing the output level where marginal revenue equals marginal cost. Therefore, perfectly competitive firms charge a price equal to their marginal cost and are hence allocatively efficient.

In the above diagram, at the profit-maximising output level (Q₀) where marginal cost (MC) is equal to marginal revenue (MR), the price (P₀) is equal to the marginal cost (MC₀).

Lower Price

Firms with greater market power are able to charge a higher price relative to their marginal cost compared to firms with less market power. Unlike a monopoly that has substantial market power, perfectly competitive firms have no market power and hence the price charged by perfectly competitive firms is lower than the price that would be charged by a monopoly operating in the same market, assuming the cost structure of a monopoly is the same as that of a perfectly competitive industry.

In the above diagram, the perfectly competitive price (P_PC) is lower than the monopoly price (P_M).

Income Equity

As perfectly competitive firms can make only normal profit and monopolists and oligopolists can make supernormal profit in the long run, the distribution of income in an economy that abounds with perfectly competitive markets will be more equitable than one that abounds with monopolistic markets and oligopolistic markets.

No Price Discrimination

Perfectly competitive firms are price-takers and hence they are unable to exploit consumers through price discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will convert some of the consumer surplus to the producer surplus. Price discrimination will be explained in greater detail in Section 6.

Disadvantages of Perfect Competition

Higher Price

Firms which reap more economies of scale are able to pass on their lower average costs of production to consumers in the form of a lower price. As a perfectly competitive firm is smaller than a monopoly, a perfectly competitive industry reaps less economies of scale than a monopoly and hence the price charged by perfectly competitive firms may be higher than the price that would be charged by a monopoly operating in the same market.

In the above diagram, the perfectly competitive price (P_PC) is higher than the monopoly price (P_M).

Dynamic Inefficiency

Perfectly competitive firms do not engage in research and development due to lack of ability and incentive and hence are dynamically inefficient. Research and development will lead to product innovations and process innovations. Product innovations will lead to higher product quality and better product features and process innovations will lead to a better production technology and hence a lower cost of production which may be passed on to consumers in the form of a lower price. However, research and development requires high expenditure which perfectly competitive firms are unable to finance as they can make only normal profit in the long run. Furthermore, due to perfect knowledge, any innovation can easily and quickly be copied by other firms.

No Variety of Choices

Perfectly competitive firms sell homogeneous products and hence offer consumers no variety of choices. In contrast, monopolistically competitive firms sell differentiated products which offer consumers a great variety of choices.

Note: From society’s perspective, a firm is productively efficient when it produces on the lowest point of its long-run average cost curve. This output level is known as the minimum efficient scale. However, a discussion of society’s perspective of productive efficiency at the level of the firm is usually not required in the examination due to the time constraint, unless the main focus of the question is on efficiency.

Students are not required to explain technical efficiency as a condition for productive efficiency in the examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. Nevertheless, it is good for them to state the condition.

As discussed in Chapter 1, although productive efficiency is a necessary condition for allocative efficiency at the level of the economy, this is not true at the level of the firm. Therefore, a firm is economically efficient when it is productively efficient and allocatively efficient.

The advantages and disadvantages of perfect competition will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3 MONOPOLY

3.1 Characteristics of Monopoly

Single Large Firm

In monopoly, there is a single large firm which dominates the whole market.

Unique Product

A monopoly sells a unique product that has no close substitutes.

Price-setter

A monopoly is a price-setter in the sense that it is able to set its price by setting its output level. In other words, a monopoly faces a downward sloping demand curve.

High Barriers to Entry

In monopoly, there are high barriers to entry which means that the firm can make supernormal profit in the long run.

An example of monopoly is the television broadcast market in Singapore.

In the above diagram, the demand curve (D) of the monopoly, which is the average revenue curve (AR), is downward sloping. If the firm wants to sell one more unit of the good, it must decrease the price. However, as the lower price will also apply to all the previous units of the good, the marginal revenue is lower than the price and hence the marginal revenue curve (MR) is lower than the demand curve. With the use of differential calculus, we can show that the slope of the marginal revenue curve is twice that of the demand curve.

Note: In reality, a monopoly is defined as a firm that has more than a certain percentage of the market share and the percentage varies from country to country.

The demand curve of a monopoly is also the market demand curve as it is the single firm in the market.

3.2 Barriers to Entry

A barrier to entry is an obstacle which restricts potential firms from entering a market to compete with the incumbent firm or firms.

Economies of Scale

A monopoly may emerge naturally if it can reap very substantial economies of scale due to very high capital costs such that the market can accommodate only one firm. In such a market where the market demand is low which results in a high minimum efficient scale relative to the market demand and hence the long-run average cost curve falling over the entire range of market demand, a single firm can meet the market demand at an average cost which allows it to make supernormal profit. However, with two or more firms, all firms will make subnormal profit as there is simply no price that will allow any firm to cover its average cost. A monopoly that emerges in this way is known as a natural monopoly. An example of a firm with the characteristics of a natural monopoly is an electricity utility firm.

In the above diagram, the monopoly which faces the demand curve (D₁) can make at least normal profit by producing anywhere within the output range from Q_MIN to Q_MAX. With two firms in the market, each firm faces the demand curve (D₂), which lies entirely below the long-run average cost (LRAC) curve and hence neither firm can make at least normal profit regardless of the output level. Even if a market can accommodate more than one firm, if the monopoly is experiencing substantial economies of scale, potential firms may decide not to enter the market as it will be difficult for them to achieve the same level of cost competitiveness and hence the same level of price competitiveness.

Financial Barriers

Some industries have high start-up costs which are difficult to finance. These high start-up costs which make it difficult for potential firms to enter the industries may be due to expensive capital goods. They may also be due to heavy advertising which is costly especially when there are established brand names in the market.

Legal Barriers

A firm may have obtained its monopoly position through the acquisition of a patent or copyright. A patent is granted to an inventor to allow him the exclusive right to produce the good or use the production process that is patented. In the latter, potential firms cannot enter the market as they do not have access to the technology. The aim of awarding patents is to promote research and development. A copyright, which is similar to a patent, is granted on plays, textbooks, novels, songs, computer software, and the like. Patents and copyrights are known as intellectual properties.

Control of Key Factor Inputs or Wholesale and Retail Outlets

If a firm controls the supply of some key factor inputs, it can deny access to these factor inputs to potential firms which will make it difficult for them to enter the market. Similarly, if a firm controls the outlets through which the good is sold, it can prevent potential firms from gaining access to consumers which will make it difficult for them to enter the market.

3.3 Equilibrium of a Monopolistic Market

A monopolistic market is in short-run equilibrium when the monopoly is producing the profit-maximising output level. However, this does not necessarily mean that it is making positive economic profit. In the short run, a monopoly can make three types of profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and subnormal profit (negative economic profit or economic loss).

Supernormal Profit

Normal Profit

Subnormal Profit

Unlike perfectly competitive firms, a monopoly can make supernormal profit in the long run. If a monopoly is making supernormal profit, potential firms would like to enter the market. However, due to high barriers to entry, they are unable to do so. Therefore, apart from normal profit, a monopoly can make supernormal profit in the long run.

3.4 Advantages and Disadvantages of Monopoly

Advantages of Monopoly

Lower Price

Firms which reap more economies of scale are able to pass on their lower average costs of production to consumers in the form of a lower price. As a monopoly is larger than a perfectly competitive firm, a monopoly reaps more economies of scale than a perfectly competitive industry and hence the price charged by a monopoly may be lower than the price that would be charged by perfectly competitive firms operating in the same market.

In the above diagram, the monopoly price (P_M) is lower than the perfectly competitive price (P_PC).

Dynamic Efficiency

As a monopoly can make supernormal profit in the long run, it has the ability to engage in research and development. Therefore, a monopoly may engage in research and development and hence be dynamically efficient. Research and development will lead to product innovations and process innovations. Product innovations will lead to higher product quality and better product features and process innovations will lead to a better production technology and hence a lower cost of production which may be passed on to consumers in the form of a lower price.

Price Discrimination

A monopoly is a price-setter and hence it may be able to practise price discrimination which may be beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise would not be reached or to produce a good that otherwise would not be produced. Price discrimination will be explained in greater detail in Section 6. Furthermore, if the increase in profit from price discrimination is ploughed back into research and development, more benefits to consumers will be created.

Disadvantages of Monopoly

Productive Inefficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is not lax in cost control. In other words, it uses the most efficient production technology, it is not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm is technically efficient when it uses the least-cost combination of factor inputs to produce its output level which means that the last dollar of each factor input that it employs produces the same additional output. From society’s perspective, a firm is productively efficient when it produces at the minimum efficient scale. Due to the absence of competition in the market, a monopoly may be lax in cost control. Therefore, a monopoly may be x-inefficient and hence productively inefficient. However, if a monopoly faces potential competition, it may be x-efficient and hence productively efficient to prevent potential firms from entering the market. A monopoly may also be x-efficient and hence productively efficient due to the pursuit of greater profit.

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the economy in a way that will increase the welfare of society. This occurs when it charges a price equal to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that they place on the amount of other goods that could have been produced using the same resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence is allocatively efficient. In monopoly, price is higher than marginal revenue and the firm maximises profit by producing the output level where marginal revenue equals marginal cost. Therefore, a monopoly charges a price higher than its marginal cost and is hence allocatively inefficient.

In the above diagram, at the profit-maximising output level (Q₀) where marginal cost (MC) is equal to marginal revenue (MR), the price (P₀) is higher than the marginal cost (MC₀).

Higher Price

Firms with greater market power are able to charge a higher price relative to their marginal cost compared to firms with less market power. Unlike perfectly competitive firms that have no market power, a monopoly has substantial market power and hence the price charged by a monopoly is higher than the price that would be charged by perfectly competitive firms operating in the same market, assuming the cost structure of a monopoly is the same as that of a perfectly competitive industry.

In the above diagram, the monopoly price (P_M) is higher than the perfectly competitive price (P_PC).

Dynamic Inefficiency

Although a monopoly has the ability to engage in research and development as it can make supernormal profit in the long run, it may not have the incentive to engage in research and development due to the absence of competition in the market. Therefore, a monopoly may not engage in research and development and hence be dynamically inefficient.

Income Inequity

As a monopoly can make supernormal profit and perfectly competitive firms and monopolistically competitive firms can make only normal profit in the long run, the distribution of income in an economy that abounds with monopolistic markets will be less equitable than one that abounds with perfectly competitive markets and monopolistically competitive markets.

Price Discrimination

A monopoly is a price-setter and hence it may be able to exploit consumers through price discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will convert some of the consumer surplus to the producer surplus.

Note: The advantages and disadvantages of monopoly will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

3.5 Natural Monopoly

A natural monopoly is a monopoly that emerges when it can reap very substantial economies of scale due to very high capital costs such that the market can accommodate only one firm. In such a market where the market demand is low which results in a high minimum efficient scale relative to the market demand and hence the long-run average cost curve falling over the entire range of market demand, a single firm can meet the market demand at an average cost which allows it to make supernormal profit. However, with two or more firms, all firms will make subnormal profit as there is simply no price that will allow any firm to cover its average cost. The very high capital costs also result in an average cost curve falling over the entire range of the market demand. An example of a firm with the characteristics of a natural monopoly is an electricity utility firm.

In the above diagram, at the profit-maximising output level (Q_M) where marginal cost (MC) is equal to marginal revenue (MR), the price (P_M) is higher than the marginal cost (MC_M) and this leads to allocative inefficiency. The profit-maximising output level (Q_M) is lower than the allocatively efficient output level (Q_AE) where price is equal to marginal cost. As a natural monopoly is a very large firm, the government may see a need to intervene in the market. In the event that the government wishes to intervene in the market, it can do so through marginal cost pricing, average cost pricing, subsidy or nationalisation.

Marginal Cost Pricing

The government can pass a pricing regulation that requires the monopoly to charge a price equal to its marginal cost to achieve allocative efficiency, assuming no externalities, and this is known as marginal cost pricing.

In the above diagram, marginal cost pricing leads to a fall in the price (P) from P_M to P_MC and an increase in the output level (Q) from Q_M to Q_MC. As the price (P_MC) is equal to the marginal cost (MC_MC), allocative efficiency is achieved. The output level (Q_MC) is equal to the allocatively efficient output level (Q_AE). However, to make more profit, the monopoly may provide false information about its cost structure to the government by overstating its marginal cost. If this happens, the use of marginal cost pricing in a monopolistic market will not achieve allocative efficiency. Furthermore, assuming the monopoly is unable to use a two-part tariff, marginal cost pricing will cause the monopoly to make a loss represented by the shaded area as the price (P_MC) is lower than the average cost (AC) at Q_MC. Therefore, the government needs to give the monopoly a lump-sum subsidy to allow it to cover its loss. However, if the government is unwilling or unable to do so, marginal cost pricing will not be feasible.

Average Cost Pricing

In the event that marginal cost pricing is infeasible, the government can pass a pricing regulation that requires the monopoly to charge a price equal to its average cost to reduce allocative inefficiency and this is known as average cost pricing.

In the above diagram, average cost pricing leads to a fall in the price (P) from P_M to P_AC and an increase in the output level (Q) from Q_M to Q_AC. As the difference between the price (P) and the marginal cost (MC) decreases from (P_M – MC_M) to (P_AC – MC_AC), allocative inefficiency is reduced. The output level (Q_AC) is closer to the allocatively efficient output level (Q_AE). However, although the use of average cost pricing in a monopolistic market will reduce allocative inefficiency, it will not achieve allocative efficiency.

Subsidy

The government can give a subsidy to the monopoly to achieve allocative efficiency. A subsidy will lead to a fall in the cost of production. When this happens, the monopoly will increase output which will reduce allocative inefficiency.

In the above diagram, a subsidy leads to a fall in the average cost (AC) curve and the marginal cost (MC) curve. If the new AC curve and the new MC curve are AC’ and MC’, the price (P_M’) will be equal to the marginal cost before subsidy (MC_M’) and hence allocative efficiency will be achieved. The profit-maximising output level (Q_M’) will be equal to the allocatively efficient output level (Q_AE). However, to make more profit, the monopoly may provide false information about its cost structure to the government by overstating its marginal cost. If this happens, the use of subsidy in a monopolistic market will not achieve allocative efficiency. Furthermore, the subsidy will increase the profit of the monopoly which is already making supernormal profit. As it will be financed by taxpayers’ money, the government may be reluctant to use it to avoid hurting its popularity rating.

Nationalisation

Nationalisation refers to the conversion of a private firm to a state-owned firm. The government can nationalise the firm to produce the good itself. In order to achieve allocative efficiency, it can charge a price equal to its marginal cost. However, opponents of nationalisation argue that as state-owned firms do not need to consider factors such as profitability and survival, they are likely to be x-inefficient and hence productively inefficient. Therefore, although nationalisation can solve the problem of allocative inefficiency, it is likely to create the problem of productive inefficiency.

4 MONOPOLISTIC COMPETITION

4.1 Characteristics of Monopolistic Competition

Large Number of Small Firms

In monopolistic competition, there are a large number of small firms each with a small market share.

Differentiated Products

In monopolistic competition, firms sell differentiated products that are close substitutes. Differentiated products are products that are sufficiently similar to be distinguished as a group from other products. An example is restaurant foods.

Price-setters

Monopolistically competitive firms are price-setters in the sense that they are able to set their prices by setting their output levels. In other words, monopolistically competitive firms face a downward sloping demand curve.

Low Barriers to Entry

In monopolistic, there are low barriers to entry which means that firms can make only normal profit in the long run.

An example of monopolistic competition is the restaurant market.

In the above diagram, the demand curve (D) of the monopolistically competitive firm, which is the average revenue curve (AR), is downward sloping. If the firm wants to sell one more unit of the good, it must decrease the price. As the lower price will also apply to all the previous units of the good, the marginal revenue is lower than the price and hence the marginal revenue curve (MR) is lower than the demand curve. With the use of differential calculus, we can show that the slope of the marginal revenue curve is twice that of the demand curve.

Note: As monopolistically competitive firms sell differentiated products, there are no market demand and market supply curves in monopolistic competition. Therefore, the theory of monopolistic competition is only analysed at the level of the firm.

4.2 Equilibrium of a Monopolistically Competitive Market

A monopolistically competitive market is in short-run equilibrium when the firms in the market are producing the profit-maximising output level. However, this does not necessarily mean that they are making positive economic profit. In the short run, a monopolistically competitive firm can make three types of profit: supernormal profit (positive economic profit), normal profit (zero economic profit) and subnormal profit (negative economic profit or economic loss).

Supernormal Profit

Normal Profit

Subnormal Profit

A monopolistically competitive market is in long-run equilibrium when firms that wish to leave the market and potential firms that wish to enter the market have done so. In other words, a monopolistically competitive market is in long-run equilibrium when the number of firms in the market is constant. In a monopolistically competitive market, this occurs when firms make normal profit.

If the firms in a monopolistically competitive market are making supernormal profit, potential firms will enter the market in the long run due to low barriers to entry. As the number of firms in the market increases, the demand for the good produced by each firm will decrease which will lead to a fall in the price resulting in a fall in the profits of the firms. This process will continue until the firms in the market make only normal profit.

In the above diagram, the supernormal profit represented by the shaded area induces potential firms to enter the market in the long run, which leads to a leftward shift in the demand curve of each firm (D) from D₀ to D₁. When this happens, the price (P) falls from P₀ to P₁. At P₁, as the firms in the market make only normal profit, the incentive for potential firms to enter the market disappears.

If the firms in a monopolistically competitive market are making subnormal profit, they will leave the market when their fixed factor inputs need replacing. Those that cannot cover their total variable costs will leave the market immediately. As the number of firms in the market decreases, the demand for the good produced by each firm will increase which will lead to a rise in the price resulting in a fall in the losses of the firms. This process will continue until the firms in the market start making normal profit.

In the above diagram, the subnormal profit represented by the shaded area induces firms to leave the market, which leads to a rightward shift in the demand curve of each firm (D) from D₀ to D₁. When this happens, the price (P) rises from P₀ to P₁. At P₁, as firms in the market start making normal profit, the incentive for them to leave the market disappears.

Note: The extent of barriers to entry in a market does not only determine the type of profit made by firms in the long run, it also determines the number of firms in the market. For example, low barriers to entry in monopolistic competition lead to a large number of firms in the market and high barriers to entry in monopoly result in a single firm in the market.

4.3 Advantages and Disadvantages of Monopolistic Competition

Advantages of Monopolistic Competition

Productive Efficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is not lax in cost control. In other words, it uses the most efficient production technology, it is not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm is technically efficient when it uses the least-cost combination of factor inputs to produce its output level which means that the last dollar of each factor input that it employs produces the same additional output. From society’s perspective, a firm is productively efficient when it produces at the minimum efficient scale. Due to competition in the market, monopolistically competitive firms are not lax in cost control. Therefore, monopolistically competitive firms are x-efficient and hence productively efficient.

Lower Price

Firms with greater market power are able to charge a higher price relative to their marginal cost compared to firms with less market power. Monopolistically competitive firms have less market power than a monopoly and hence the price charged by monopolistically competitive firms may be lower than the price that would be charged by a monopoly operating in the same market. The price charged by monopolistically competitive firms may also be lower than the price that would be charged by a monopoly operating in the same market due to low barriers to entry which does not allow them to charge a price higher than their average cost in the long run.

Income Equity

As monopolistically competitive firms can make only normal profit and monopolists and oligopolists can make supernormal profit in the long run, the distribution of income in an economy that abounds with monopolistically competitive markets will be more equitable than one that abounds with monopolistic markets and oligopolistic markets.

Variety of Choices

Monopolistically competitive firms sell differentiated products which offer consumers a great variety of choices. In contrast, perfectly competitive firms sell homogeneous products and hence offer consumers no variety of choices.

Disadvantages of Monopolistic Competition

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the economy in a way that will increase the welfare of society. This occurs when it charges a price equal to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that they place on the amount of other goods that could have been produced using the same resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence is allocatively efficient. In monopolistic competition, price is higher than marginal revenue and firms maximise profit by producing the output level where marginal revenue equals marginal cost. Therefore, monopolistically competitive firms charge a price higher than their marginal cost and are hence allocatively inefficient.

In the above diagram, at the profit-maximising output level (Q₀) where marginal cost (MC) is equal to marginal revenue (MR), the price (P₀) is higher than the marginal cost (MC₀). However, the difference between the price and the marginal cost and hence the extent of allocative inefficiency in a monopolistically competitive market is smaller than that in a monopolistic market. This is due to the larger number of substitutes in a monopolistically competitive market which leads to the higher price elasticity of demand for the good produced by each firm.

Higher Price

Firms which reap more economies of scale are able to pass on their lower average costs of production to consumers in the form of a lower price. As a monopolistically competitive firm is smaller than a monopoly, monopolistically competitive firms reap less economies of scale than a monopoly and hence the price charged by monopolistically competitive firms may be higher than the price that would be charged by a monopoly operating in the same market. Furthermore, firms with greater market power are able to charge a higher price relative to their marginal cost compared to firms with less market power. Unlike perfectly competitive firms, monopolistically competitive firms have market power and hence the price charged by monopolistically competitive firms may be higher than the price that would be charged by perfectly competitive firms operating in the same market.

Dynamic Inefficiency

Monopolistically competitive firms do not engage in research and development due to lack of ability and hence are dynamically inefficient. Research and development will lead to product innovations and process innovations. Product innovations will lead to higher product quality and better product features and process innovations will lead to a better production technology and hence a lower cost of production which may be passed on to consumers in the form of a lower price. However, research and development requires high expenditure which monopolistically competitive firms are unable to finance as they can make only normal profit in the long run.

Note: The advantages and disadvantages of monopolistic competition will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

5 OLIGOPOLY

5.1 Characteristics of Oligopoly

Small Number of Large Firms

In oligopoly, there are a small number of large firms each with a large market share.

Differentiated Products

Oligopolists generally sell differentiated products such as cars and electrical appliances. Some oligopolists, however, sell homogeneous products such as cement and steel.

Price-setters

Oligopolists are price-setters in the sense that they are able to set their prices by setting their output levels. In other words, oligopolists face a downward sloping demand curve.

High Barriers to Entry

In oligopoly, there are high barriers to entry which means that firms can make supernormal profit in the long run.

Strategic Interdependence (also known as Mutual Interdependence)

In oligopoly, due to the small number of large firms and hence the large market share of each firm, the actions of one firm affect and are affected by the actions of the other firms in the market, and this is known as strategic interdependence. When an oligopolist changes its price, it will have a significant effect on the other firms in the market. The rival firms will hence react by changing their prices which will affect the first firm. Therefore, when an oligopolist makes pricing and output decisions, it must take into consideration the reactions of the other firms in the market. In this sense, the pricing and output decisions of an oligopolist depend on the behavior of competitors.

An example of oligopoly is the pharmaceutical market.

5.2 Collusive versus Competitive (non-collusive) Behaviour

Due to strategic interdependence, oligopolists may collude or compete.

Collusive Behaviour

Formal Collusion

Oligopolists can collude overtly by having a formal collusive agreement and this is known as formal collusion. Formal collusion typically takes the form of cartelisation. In cartelisation, the firms agree on a common target price which is higher than the prices that they currently charge. To achieve the common target price, the firms will agree on a set of output quotas to decrease production. A likely method to decide on the set of output quotas is to divide the market according to the market shares of the firms. There are certain factors that favour cartelisation. Cartelisation is more likely in a market where there are no government measures to prevent collusion, there are a small number of firms, the firms produce homogeneous products, the firms have the same cost structure, the demand is stable and the barriers to entry are high which will prevent disruptions to the agreement by new firms. Cartelisation is illegal in many countries. For example, the competition policy in Singapore and the anti-trust laws in the United States prohibit attempts to distort competition.

Tacit Collusion

In countries where cartelisation is illegal, such as Singapore and the United States, oligopolists can collude covertly without having a formal agreement and this is known as tacit collusion. Tacit collusion typically takes the form of price leadership. In price leadership, the price leader will set the price and the price followers will take the price set by the price leader. The price followers will also follow any price increase or decrease by the price leader. The price leader may be the firm with the largest market share which is called the dominant firm price leadership. The price leader may also be the firm with the most information about the market conditions which is called the barometric firm price leadership. Apart from price leadership, tacit collusion may also take the form of a rule of thumb. An example is mark-up pricing. In mark-up pricing, which is also known as cost-plus pricing, a firm sets its price by adding a certain mark-up for profit to its average cost. Firms may engage in tacit collusion by following the same mark-up pricing.

Competitive Behaviour

If oligopolists collude, there will be price stability. At first thought, if they do not collude, price war will be inevitable. However, price stability has been found to be an empirical regularity in most oligopolistic markets, even in those where the firms do not collude. This phenomenon can be explained by the theory of the kinked demand curve.

The theory of the kinked demand curve is based on two asymmetrical assumptions. First, if a firm in an oligopolistic market increases its price, its rivals will not follow suit because by keeping their prices the same, they can attract consumers from the firm. Accordingly, if a firm in an oligopolistic market increases its price, its quantity demanded will decrease by a larger percentage as consumers will switch from the firm to the rivals which will lead to a fall in revenue for the firm. Second, if a firm in an oligopolistic market reduces its price, its rivals will follow suit to avoid losing consumers to the firm. Accordingly, if a firm in an oligopolistic market reduces its price, its quantity demanded will increase by a smaller percentage as consumers will not switch from the rivals to the firm, which will lead to a fall in revenue for the firm. Therefore, oligopolists do not have the incentive to change their prices, assuming no substantial changes in the cost of production.

The theory of the kinked demand curve can be illustrated with a diagram. A firm in an oligopolistic market faces a demand curve that is kinked at the equilibrium and the kink on the demand curve leads to a discontinuity on the marginal revenue curve.

In the above diagram, as the price (P) and the output level (Q) are P₀ and Q₀, the marginal cost (MC) curve must be cutting the marginal revenue (MR) curve at the discontinuity. A change in the cost of production will lead to a shift in the MC curve. However, as long as the MC curve lies between MC’ and MC”, the price will remain constant and this explains price stability in oligopolistic markets where there is no collusion. In the event of a substantial change in the cost of production, the MC curve will shift out of the range between MC’ and MC” which will lead to a change in the price and the output level. If this happens, firms may plunge into a price war before they reach a new equilibrium and the new demand curve will be kinked at the new equilibrium.

Although the theory of the kinked demand curve can explain price stability in the absence of collusion, it does not explain how the price is set in the first place. Furthermore, price stability may be due to other factors. For example, oligopolists may not want to change price too frequently to prevent upsetting consumers.

Note: Although the diagram of the kinked demand curve has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus, it is good for students to include it in their responses as it demonstrates a better understanding of the theory.

5.3 Non-price Competition

Firms engage in non-price competition through product development and product promotion. Product development will improve the quality and the features of the good and product promotion will increase the awareness and the appeal. Product development and product promotion will lead to an increase in the demand for the good. Furthermore, they will make the demand for the good less price elastic as the good will become more different from its substitutes and this is known as product differentiation. There are two types of product differentiation: real product differentiation and imaginary product differentiation. Product development will lead to real product differentiation as it will result in physical changes of the good. Product promotion will lead to imaginary product differentiation as it will only affect the perception of consumers.

5.4 Advantages and Disadvantages of Oligopoly

Advantages of Oligopoly

Productive Efficiency

Recall that a firm is productively efficient when it produces on its long-run average cost curve, from firm’s perspective. This occurs when it is x-efficient and technically efficient. A firm is x-efficient when it is not lax in cost control. In other words, it uses the most efficient production technology, it is not overstaffed, it does not occupy premises that are larger than necessary for its output level, etc. A firm is technically efficient when it uses the least-cost combination of factor inputs to produce its output level which means that the last dollar of each factor input that it employs produces the same additional output. From society’s perspective, a firm is productively efficient when it produces at the minimum efficient scale. As oligopolists face competition in the market, they are not lax in cost control and this is true even in the presence of collusion as oligopolists which collude still face non-price competition. Therefore, oligopolists are x-efficient and hence productively efficient.

Lower Price

Firms which reap more economies of scale are able to pass on their lower average costs of production to consumers in the form of a lower price. As an oligopolist is larger than a perfectly competitive firm and a monopolistically competitive firm, oligopolists reap more economies of scale than perfectly competitive firms and monopolistically competitive firms and hence the price charged by oligopolists may be lower than the price that would be charged by perfectly competitive firms and monopolistically competitive firms operating in the same market.

Dynamic Efficiency

As oligopolists can make supernormal profit in the long run, they have the ability to engage in research and development. Furthermore, competition gives them the incentive to engage in research and development and this is true even in the presence of collusion as oligopolists which collude still face non-price competition. Therefore, oligopolists engage in research and development and hence are dynamically efficient. Research and development will lead to product innovations and process innovations. Product innovations will lead to higher product quality and better product features and process innovations will lead to a better production technology and hence a lower cost of production which may be passed on to consumers in the form of a lower price.

Variety of Choices

Oligopolists generally sell differentiated products which offer consumers a variety of choices. In contrast, perfectly competitive firms sell homogeneous products and hence offer consumers no variety of choices.

Price Discrimination

Oligopolists are price-setters and hence they may be able to practise price discrimination which may be beneficial to consumers. Price discrimination may allow a firm to reach a market that otherwise would not be reached or to produce a good that otherwise would not be produced. Price discrimination will be explained in greater detail in Section 6. Furthermore, if the increase in profit from price discrimination is ploughed back into research and development, more benefits to consumers will be created.

Disadvantages of Oligopoly

Allocative Inefficiency

Recall that a firm is allocatively efficient when it cannot change the allocation of resources in the economy in a way that will increase the welfare of society. This occurs when it charges a price equal to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that they place on the amount of other goods that could have been produced using the same resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence is allocatively efficient. In oligopoly, price is higher than marginal revenue and firms maximise profit by producing the output level where marginal revenue equals marginal cost. Therefore, oligopolists charge a price higher than their marginal cost and are hence allocatively inefficient.

In the above diagram, at the profit-maximising output level (Q₀) where marginal cost (MC) is equal to marginal revenue (MR), the price (P₀) is higher than the marginal cost (MC₀).

Higher Price

Firms with greater market power are able to charge a higher price relative to their marginal cost compared to firms with less market power. Unlike perfectly competitive firms that have no market power and monopolistically competitive firms that have little market power, oligopolists have substantial market power and hence the price charged by oligopolists may be higher than the price that would be charged by perfectly competitive firms and monopolistically competitive firms operating in the same market. Furthermore, an oligopolist is likely to be smaller than a monopoly. Therefore, oligopolists are likely to reap less economies of scale and hence charge a higher price than a monopoly.

Income Inequity

As oligopolists can make supernormal profit and perfectly competitive firms and monopolistically competitive firms can make only normal profit in the long run, the distribution of income in an economy that abounds with oligopolistic markets will be less equitable than one that abounds with perfectly competitive markets and monopolistically competitive markets.

Price Discrimination

Oligopolists are price-setters and hence they may be able to exploit consumers through price discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will convert some of the consumer surplus to the producer surplus.

Note: The advantages and disadvantages of oligopoly will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

5.5 Market Concentration Ratio

The market concentration ratio, or simply known as the concentration ratio, is a measure of the combined market share of a specified number of the largest firms in the market. It is calculated by summing the market shares of a specified number of the largest firms in the market. The market share of a firm is the domestic sales of the firm expressed as a percentage of the domestic sales of all the domestic firms in the market. The concentration ratio can range from close to 0% to 100%.

It is commonly believed that the degree of competition in a market is directly related to the number of firms. Although this is true to some extent, the number of firms in a market is not a perfect indicator of the degree of competition. In a market where there are a large number of firms, the degree of competition may be low if the bulk of the market share is concentrated in the hands of a few large firms. To overcome this problem, economists use the concentration ratio to show the extent of market control of a specified number of the largest firms in the market and hence the degree to which the market is oligopolistic. A commonly used concentration ratio is the four-firm concentration ratio (CR₄). The four-firm concentration ratio (CR₄) measures the combined market share of the four largest firms in the market. A four-firm concentration ratio (CR₄) of between 0% and 50% indicates low market concentration and a market with low concentration may be monopolistic competition or an oligopoly. In this range, the higher the concentration ratio, the more likely the market is oligopolistic and vice versa. A four-firm concentration ratio (CR₄) of between 50% and 80% indicates medium market concentration and a market with medium concentration is likely to be an oligopoly. A four-firm concentration ratio (CR₄) of between 80% and 100% indicates high market concentration and a market with high concentration may be an oligopoly or a monopoly. In this range, the lower the concentration ratio, the more likely the market is oligopolistic and vice versa.

Apart from the four-firm concentration ratio (CR₄), the one-firm concentration ratio (CR₁) is also commonly used. The one-firm concentration ratio (CR₁) measures the market share of the largest firm in the market. It is used to indicate the degree to which the largest firm in the market is monopolistic. In the United Kingdom, the largest firm is considered a monopoly if the one-firm concentration ratio (CR₁) is 25% and above. Such a monopoly is commonly known as an actual monopoly as opposed to a pure monopoly which is a single large firm in a market. In Singapore, the largest firm is considered a dominant firm, which can be interpreted as a monopoly, if the one-firm concentration ratio (CR₁) is 60% and above.

The concentration ratio is subject to several limitations. First, the concentration ratio does not provide information about the distribution of the market shares among the specified number of the largest firms in the market. For example, assuming the four-firm concentration ratio (CR₄) in a market is 80%, the degree of competition will be lower if one firm has 70% of the market share and the other three firms have the remaining 10%, compared to the case where each of the four firms has 20% of the market share. Second, the concentration ratio does not provide a comprehensive picture of the market shares of all the firms in the market as only the market shares of the specified number of the largest firms are included. In contrast, the Herfindahl-Hirschman index (HHI), which is another measure of market concentration, takes into account the market shares of all the firms in the market. Third, the concentration ratio does not capture all aspects of competition in the market. For example, it does not capture any collusive behaviour among the firms in the market or potential competition. Fourth, the concentration ratio does not take into account the domestic sales of foreign firms as it only includes the domestic sales of domestic firms rather than the total domestic sales. The omission of imports from the concentration ratio causes it to understate the degree of competition in the market. Fifth, the concentration ratio is a national total but the relevant market may be regional or local due to the characteristics of the good or high transport costs. If this happens, the concentration ratio will overstate the degree of competition in the relevant market.

Note: The Herfindahl-Hirschman index (HHI) is another measure of market concentration. It is calculated by squaring the market share of each firm in the market and then summing the results. The HHI can range from close to zero to 10,000. The U.S. Department of Justice and the Federal Trade Commission consider a market with an HHI of less than 1500 to be an unconcentrated market, a market with an HHI of between 1500 and 2500 to be a moderately concentrated market and a market with an HHI of greater than 2500 to be a highly concentrated market. Students are not required to explain the HHI in the examination as it is not in the Singapore-Cambridge GCE ‘A’ Level Economics syllabus.

Market concentration ratio will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

6 PRICE DISCRIMINATION

6.1 Types of Price Discrimination

Price discrimination is the practice of using a pricing scheme more sophisticated than charging the same price for each unit of a good to increase profit. According to Arthur Cecil Pigou, although discriminatory pricing can take many forms, it can usefully be classified into three degrees: first-degree, second-degree and third degree.

First-degree Price Discrimination

First-degree price discrimination is the practice of charging each consumer the highest price that they are able and willing to pay for each unit of the good. Therefore, under first-degree price discrimination, the consumer surplus is zero.

In the above diagram, if the firm wants to sell one more unit of the good, it must decrease the price. However, under first-degree price discrimination, as the lower price will not apply to all the previous units of the good, the marginal revenue is equal to the price and hence the marginal revenue curve (MR) is the demand curve (D). The profit-maximising output level where marginal cost (MC) is equal to marginal revenue (MR) is Q₀. In reality, first-degree price discrimination is uncommon because it is likely to make consumers feel exploited.

Second-degree Price Discrimination

Second-degree price discrimination is the practice of using a pricing scheme to approximate first-degree price discrimination; that is to appropriate to the firm all the consumer surplus. There are three types of second-degree price discrimination: quantity discount, block pricing and two-part tariff. Block pricing is a pricing scheme where a certain price is charged for the first so many units of a good for which there are no substitutes, a lower price for the next so many units, and so on. Many public utility firms use block pricing.

In the above diagram, the profit-maximising output level where marginal cost (MC) is equal to marginal revenue (MR) is Q₂. For the first block of Q₀ units of the good, the price of P₀ is charged for each unit, for the second block of (Q₁ – Q₀) units of the good, the price of P₁ is charged for each unit, and for the third block of (Q₂ – Q₁) units of the good, the price of P₂ is charged for each unit. The marginal revenue curve is a series of steps comprising P₀ for the first block of Q₀ units of the good, P₁ for the second block of (Q₁ – Q₀) units of the good and P₂ for the third block of (Q₂ – Q₁) units of the good. A two-part tariff is a pricing scheme where a lump-sum charge is imposed in addition to a per-unit charge. The lump-sum charge may take the form of admission fee, registration fee, connection fee, etc. For example, when the Disneyland in the United States first started operations, it imposed an admission fee in addition to a charge for each ride. Under a two-part tariff, the lump-sum charge will convert the consumer surplus to the producer surplus. Therefore, the firm will produce the output level where price is equal to marginal cost to maximise the total surplus and hence the producer surplus in order to maximise profit, assuming consumers have the same demand for the good.

In the above diagram, the profit-maximising output level under a two-part tariff where price is equal to marginal cost (MC) is Q₀ and the profit-maximising price is P₀. The lump-sum charge is represented by the shaded area.

Third-degree Price Discrimination

Third-degree price discrimination is the practice of charging different prices for the same good in different markets. For example, cinema operators charge different prices for the same movies to different groups of consumers. To practise third-degree price discrimination, a firm must be able to identify at least two distinct markets which differ in terms of their price elasticities of demand. In addition, it must be able to prevent consumers in the lower-priced market from reselling the good to consumers in the higher-priced market which is known as arbitrage prevention. Suppose that a good is sold in two different markets, market A and market B, at two different prices. Under third-degree price discrimination, profit will be maximised when the marginal revenue in market A (MR_A), the marginal revenue in market B (MR_B) and the marginal cost (MC) are equal. If MR_A is not equal to MR_B, profit can be increased by selling less of the good in the market with the lower MR and more of the good in the market with the higher MR. If MC is not equal to MR_A and MR_B, profit can be increased by changing the output level. The firm will charge a higher price in the market with the lower price elasticity of demand and a lower price in the market with the higher price elasticity of demand.

In the above diagram, the sum of the output level in market A (Q_A) and the output level in market B (Q_B) is equal to the market output level (Q_T). MR_A is equal to MR_B which is equal to MC. The price in market A (P_A) with the lower price elasticity of demand is higher than the price in market B (P_B) with the higher price elasticity of demand.

Note: For a firm to be able to practise price discrimination, it must have price-setting ability and this is true for all types of price discrimination. Therefore, only a firm that operates in an imperfect market may be able to practise price discrimination.

Although the cost of business-class air travel is higher than that of economy-class air travel, the cost difference does not fully account for the price difference due to the lower price elasticity of demand for business-class air travel than for economy-class air travel. Therefore, airlines do engage in third-degree price discrimination.

When explaining third-degree price discrimination, students should explain why the price elasticities of demand in the markets differ.

Price discrimination will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

6.2 Desirability of Price Discrimination

Firms

From the firm’s perspective, price discrimination is desirable. Price discrimination will convert some of the consumer surplus to the producer surplus. Therefore, price discrimination will lead to an increase in the producer surplus which is desirable for the firm.

In the above diagram, without price discrimination, the profit-maximising output level where marginal cost (MC) is equal to marginal revenue (MR) is Q₀’ and the profit-maximising price is P₀’. The producer surplus is represented by area B. With first-degree price discrimination, the profit-maximising output level where marginal cost (MC) is equal to marginal revenue (MR_FDPD) is Q₀. As the firm charges each consumer the highest price that they are able and willing to pay for each unit of the good, the producer surplus is higher which is represented by the sum of area A, area B and area C.

Consumers

From consumers’ perspective, price discrimination is generally undesirable. Price discrimination is commonly considered a form of consumer exploitation as it will convert some of the consumer surplus to the producer surplus. Therefore, price discrimination will lead to a decrease in the consumer surplus which is undesirable for consumers.

In the above diagram, without price discrimination, the profit-maximising output level where marginal cost (MC) is equal to marginal revenue (MR) is Q₀’ and the profit-maximising price is P₀’. The consumer surplus is represented by area A. With first-degree price discrimination, the profit-maximising output level where marginal cost (MC) is equal to marginal revenue (MR_FDPD) is Q₀. As the firm charges each consumer the highest price that they are able and willing to pay for each unit of the good, the consumer surplus is zero.

Price discrimination may be desirable for consumers because it may allow a firm to produce a good that otherwise would not be produced. An example is first-degree price discrimination. If the cost of production for a good is high, it may be unprofitable to produce. If this happens, first-degree price discrimination which will increase the producer surplus may allow a firm to make a profit and hence produce the good.

In the above diagram, without price discrimination, the output level where marginal cost (MC) is equal to marginal revenue (MR) is Q₀’. However, as the average cost (AC) is higher than the average revenue (AR) at this output level, a loss will be incurred and hence the good will not be produced. With first-degree price discrimination, the output level where marginal cost (MC) is equal to marginal revenue (MR_FDPD) is Q₀. Since the total revenue is area A plus area C and the total cost is area B plus area C, a profit can be made if area A is greater than area B and hence the good will be produced. Furthermore, if the increase in profit from price discrimination is ploughed back into research and development, more benefits to consumers will be created.

Price discrimination may also be desirable for consumers because it may allow a firm to reach a market that otherwise would not be reached. An example is third-degree price discrimination. If the firm cannot practise third-degree price discrimination, the uniform price that it will charge may be too high for consumers in the market with the lower ability and willingness to pay. However, if the firm can practise third-degree price discrimination by charging a higher price in the market with the higher ability and willingness to pay and a lower price in the market with the lower ability and willingness to pay, both markets will be reached. If this happens, consumers will be better off.

Government

From the government’s perspective, price discrimination may be desirable because it may lead to a decrease in allocative inefficiency. In imperfect competition, allocative inefficiency occurs as the firm or firms charge a price higher than their marginal cost which leads to under-production. Under first-degree price discrimination, the price that the firm charges for the last unit of the good is equal to the marginal cost. Therefore, allocative efficiency is achieved under first-degree price discrimination.

From the government’s perspective, price discrimination may be undesirable as it will worsen income inequity. Price discrimination will lead to an increase in the profits of firms. As firms are generally owned by high income individuals, this will lead to a less equitable distribution of income.

7 ALTERNATIVE OBJECTIVES OF FIRMS

Firms generally seek to maximise profit. However, some firms seek to maximise market share, sales revenue and long-run profit.

Profit Maximisation

Firms generally seek to maximise profit for several reasons.

A firm generally seeks to maximise profit as it can be used to finance expansion of its scale of production. A firm can expand its scale of production by ploughing back its profit into increasing its production capacity. It can also expand its scale of production by using its profit to take over other firms that produce the same good which is known as horizontal acquisition. An increase in the scale of production will enable a firm to lower its average cost which is known as economies of scale, assuming the firm is not producing on the upward sloping portion of its long-run average cost curve. Due to globalisation, among other factors, the business environment is becoming increasingly more competitive. Therefore, to ensure its survival, it is imperative that a firm increases its cost-competitiveness to increase its price-competitiveness.

A firm generally seeks to maximise profit as it can be used to engage in non-price competition such as product development and product promotion. Engaging in non-price competition is important particularly if the firm operates in an oligopolistic market where there exists strategic interdependence. Product development will improve the quality and the features of the good and product promotion will increase the awareness and the appeal. Product development and product promotion will lead to an increase in the demand for the good. Furthermore, they will make the demand for the good less price elastic as the good will become more different from its substitutes and this is known as product differentiation. There are two types of product differentiation: real product differentiation and imaginary product differentiation. Product development will lead to real product differentiation as it will result in physical changes of the good. Product promotion will lead to imaginary product differentiation as it will only affect the perception of consumers.

A firm generally seeks to maximise profit as it can be used to build up cash reserves for recession years.

A firm generally seeks to maximise profit as it can be used to make dividend payments to its shareholders.

Market Share Maximisation

A firm may seek to maximise market share. For example, if a firm is a new entrant, it may want to maximise market share to compete with the incumbent firms. In this case, although profit will not be maximised, the larger market share may ensure the survival of the new entrant. For example, when StarHub entered the telecommunications market in Singapore in 2000, it charged prices lower than those charged by the incumbent firms, namely SingTel and M1. The objective of StarHub was to induce mobile phone users to switch service providers so that it could capture sufficient market share to compete with SingTel and M1. To maximise market share, a firm will produce the output level where price is equal to average cost, assuming it wants to make at least normal profit.

In the above diagram, market share is maximised at Q_MS where price (P) is equal to average cost (AC), assuming the firm wants to make at least normal profit. Beyond this output level, price is lower than average cost and hence a loss will be incurred.

Sales Revenue Maximisation

A firm may seek to maximise sales revenue. For example, in many large firms today, there is a separation between ownership and management. Although it may be in the interest of the shareholders to have the management maximise profit and hence dividend, it may be in the interest of the management to maximise sales revenue if it is the key performance indicator. To maximise sales revenue, a firm will produce the output level where marginal revenue is equal to zero.

In the above diagram, sales revenue is maximised at Q_SR where marginal revenue (MR) is equal to zero. If output increases from Q_SR, total revenue will fall as MR is negative. If output decreases from Q_SR, some revenue will be forgone as MR is positive.

Long-run Profit Maximisation

A firm may seek to maximise long-run profit. For example, one of the potential problems of a monopoly maximising profit is that the profit-maximising price may attract potential firms to enter the market. If this happens, the profit of the firm will fall in subsequent periods. Therefore, to maximise long-run profit, the firm may need to practise limit pricing which is a pricing strategy where a monopoly charges a price below the profit-maximising price with the objective of preventing potential firms from entering the market. In this case, although profit will not be maximised, long-run profit may be maximised.

Note: Student should not confuse limit pricing with predatory pricing. Limit pricing is a pricing strategy where a monopoly charges a price below the profit-maximising price with the objective of preventing potential firms from entering the market. Predatory pricing is a pricing strategy where an oligopolist charges a price below the profit-maximising price with the objective of driving competitors out of the market.

The alternative objectives of firms will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

8 GROWTH OF FIRMS

8.1 Types of Growth of Firms

Firms can grow internally or externally.

Internal Growth

A firm can expand by ploughing back its profit into increasing its production capacity. It can also expand by increasing its production capacity through issuing shares, issuing bonds or getting bank loans.

External Growth

A firm can expand by joining with other firms which is known as a merger. A firm can also expand by acquiring or taking over other firms which is known as an acquisition or takeover. Merger and acquisition are the two types of integration. In practice, however, the term ‘merger’ is loosely used to refer to both merger and acquisition. There are three types of mergers: horizontal merger, vertical merger and conglomerate merger.

Horizontal Merger

A horizontal merger is a merger between two firms that produce the same good. An example of a horizontal merger is the merger between Exxon and Mobil in 1999. The merger is a horizontal one as Exxon and Mobil were both oil companies.

Firms that produce the same good may merge to expand the scale of production in order to reap more economies of scale and to reduce the number of firms in the market in order to reduce competition.

Vertical Merger

A vertical merger is a merger between two firms where one firm is a supplier or a customer of the other firm. When a firm merges with a supplier, the act is known as a backward merger. When a firm merges with a customer, the act is known as a forward merger. An example of a vertical merger is the merger between America Online and Time Warner in 2000. The merger is a vertical one as Time Warner, which was a media conglomerate, supplied content to consumers through properties like CNN and Time Magazine, while America Online, which was an internet provider, distributed such information via its internet service.

A vertical merger is usually initiated by the customer. A firm may initiate a backward merger to achieve greater control and stability in the supply of factor inputs, eliminate transaction costs which include the costs of negotiating, monitoring and enforcing a contract, restrict the supply of factor inputs to competitors and prevent leakage of vital information pertaining to the firm’s product.

Conglomerate Merger

A conglomerate merger is a merger between two firms that produce different and unrelated goods. In the case where the two firms produce different but related goods, the act is known as a lateral merger. For example, many of the chaebols in South Korea such as Samsung Group and LG Group were formed through conglomerate mergers.

Firms that produce different goods may merge to reap more economies of scope, spread risk and create an internal capital market.

8.2 Reasons for Growth of Firms

Large firms have advantages over small firms.

Cost Advantage of Large Firms

Large firms have a cost advantage over small firms due to economies of scale. Large firms have a lower average cost than small firms because of their larger scales of production. When a firm expands the scale of production, average cost will usually fall and this phenomenon is called economies of scale. Economies of scale occur due to several reasons. For example, division of labour is the process whereby each job is broken up into its component tasks and each worker is assigned one or a few component tasks of the job. An expansion of the scale of production may enable the firm to engage in greater division of labour and hence greater specialisation which will lead to higher labour productivity resulting in a fall in average cost. Furthermore, larger machines are often more efficient than smaller machines as they generally make more efficient use of materials and labour. Therefore, an expansion of the scale of production may enable the firm to use larger machines that are often more efficient than smaller machines which will also lead to higher labour productivity resulting in a fall in average cost. Larger firms may be able to afford to create more specialised departments where specialists perform specific administrative functions. These specific administrative functions include human resource, purchasing, finance and marketing. Greater specialisation in these areas of expertise will lead to greater efficiency resulting in a fall in average cost.

Large firms may also have a cost advantage over small firms due to economies of scope. Large firms may have a lower average cost than small firms because of their greater financial resources which allow them to produce more types of goods. When the types of goods produced increase, average cost will usually fall. The decrease in average cost due to an increase in the size of the firm associated with an increase in the types of goods produced rather than an increase in the scale of producing any one good is called economies of scope. Economies of scope occur due to several reasons. For example, an increase in the types of goods produced will lead to a fall in the research and development cost per unit of output if the technologies that are used to produce the goods are related. An increase in the types of goods produced will also lead to a fall in the marketing cost per unit of output if the goods use the same branding.

Revenue Advantage of Large Firms

Large firms have a revenue advantage over small firms due to their greater appeal to consumers. For example, large supermarkets carry a wider range of goods than small retail stores which makes them more appealing to consumers who place a premium on convenience resulting in a higher total revenue.

Large firms may also have a revenue advantage over small firms due to their greater ability to practise price discrimination, particularly third-degree price discrimination. Recall that third-degree price discrimination is the practice of charging different prices for the same good in different markets. For example, cinema operators charge different prices for the same movies to different groups of consumers. To practise third-degree price discrimination, a firm must be able to identify at least two distinct markets which differ in terms of their price elasticities of demand. In addition, it must be able to prevent consumers in the lower-priced market from reselling the good to consumers in the higher-priced market which is known as arbitrage prevention. Most large firms sell their goods in more than one country which may allow them to prevent arbitrage and hence give them the ability to practise third-degree price discrimination. Conversely, most small firms sell their goods in only one country which makes arbitrage harder to prevent and hence precludes them from practising third-degree price discrimination.

Other Advantages of Large Firms

In addition to cost advantage and revenue advantage, large firms have other advantages over small firms. First, large firms are more likely to survive a recession than small firms. Due to their great financial resources, large firms are able to sustain losses for a long period of time. Furthermore, apart from bank borrowings, large firms also have other sources of funds such as share issue and bond issue and hence if banks reduce lending in a recession, such as what happened in the 2008-2009 Subprime Mortgage Crisis, large firms can raise funds through other means to tide them over the difficult period. In contrast, small firms are more vulnerable in a recession due to their limited financial resources and this is particularly true if banks reduce lending. Second, as large firms have greater financial resources and more sources of funds than small firms, they are likely to be able to undercut small firms to drive them out of the market. Small firms, however, are much less likely to be able to do so due to their limited financial resources and their limited sources of funds.

8.3 Survival of Small Firms

Although the advantages of large firms over small firms have driven many small firms out of the market, there are small firms which are able to survive.

Personalised Services

Small firms that provide personalised services are able to survive. For example, small medical clinics and small law firms exist today. In these markets, there is limited room for economies of scale due to the nature of the services provided and this limits the cost advantage of large firms over small firms which enables small firms to survive.

Niche Market

Small firms that cater for niche markets are able to survive. For example, small firms that sell plus size clothing to obese women and small firms that sell organic foods to health-conscious consumers exist today. In these markets, there is limited benefit of economies of scale due to the small sizes of the markets which enables small firms to survive.

Supporting Role

Small firms that play a supporting role to large firms are able to survive. Many large firms outsource certain functions and activities to small firms for several reasons such as reducing costs, increasing flexibility and focusing on core competences. Small firms that play a supporting role through performing these functions and activities for large firms do not face competition from large firms which enables them to survive.

Convenience

Small firms that cater for consumers in a particular area are able to survive. For example, small retail stores located in the neighbourhoods that cater for the residents exist today. Due to their proximity to the residents in the neighbourhoods, these small retail stores have more appeal than large supermarkets located further away which enables them to survive.

Note: The survival of small firms will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

9 THE THEORY OF CONTESTABLE MARKETS

The theory of contestable markets was put forward in 1982 by William Baumol who was a renowned American economist. The theory of contestable markets is commonly considered an alternative theory to the theory of market structure. Proponents of the theory of contestable markets argue that the behaviour of firms in a market depends on whether there is threat of competition rather than on the structure of the market.

A perfectly contestable market is a market where there are no barriers to entry, zero exit costs and all firms have equal access to production technology. In the words of William Baumol, “A contestable market is one into which entry is absolutely free, and exit is absolutely costless.” By “freedom of entry”, William Baumol was referring to absence of barriers to entry and equal access to production technology for all firms. In reality, barriers to entry and exit costs do exist and hence what is discussed is the degree of contestability of a market. The lower the barriers to entry and exit costs in a market, the more contestable the market, and vice versa. As stated in the definition, the absence of barriers to entry, the absence of exit costs and equal access to production technology for all firms are the three key characteristics of a perfectly contestable market. The absence of barriers to entry provides potential firms the ability to enter the market. Recall that a barrier to entry is an obstacle which restricts potential firms from entering a market to compete with the incumbent firm or firms. In the absence of such obstacles, potential firms are able to enter the market when a profit opportunity arises. In contrast, high barriers to entry prevent potential firms from entering the market even if the incumbent firm or firms are making substantial supernormal profit. The absence of exit costs provides potential firms the incentive to enter the market. If potential firms enter the market, there is always a possibility that they will make subnormal profit (i.e. economic loss) which will induce them to exit the market. If they are unable to sell or transfer their capital to other uses without incurring a loss substantially greater than the normal depreciation, their exit costs which are also known as sunk costs, will be high which will discourage them from entering the market in the first place. In contrast, the absence of exit costs will encourage them to enter the market. Equal access to production technology for all firms provides potential firms both the ability and the incentive to enter the market. If potential firms do not have equal access to production technology as the incumbent firm or firms, the former will have a cost disadvantage over the latter which will reduce their chances of making supernormal profit. In contrast, if potential firms have equal access to production technology as the incumbent firm or firms, the former will be able to compete with the latter on an equal footing which will enable and incentivise them to enter the market.

The crucial feature of a contestable market is its vulnerability to hit-and-run competition. If the incumbent firm or firms in a perfectly contestable market are making supernormal profit, potential transient entrants will enter the market to exploit the profit opportunity by charging prices slightly lower than those charged by the incumbent firm or firms. When this happens, the incumbent firm or firms will respond by reducing their prices to levels lower than those charged by the transient entrants. This will induce the transient entrants to reduce their prices to levels lower than those charged by the incumbent firm or firms which will prompt the latter to further reduce their prices. This process will continue until the prices fall to the levels which correspond to normal profit, at which point the transient entrants will exit the market. According to the proponents of the theory of contestable markets, the prospect of such hit-and-run competition from potential transient entrants will induce the incumbent firm or firms in the market to behave in a way which firms in a highly competitive market do, even if there are only one or a few firms in the market. In other words, in a perfectly contestable market, firms will be x-efficient and hence productively efficient and they will charge a price lower than the price that would be charged if the market was less or non-contestable. The lower price will be equal to the average cost resulting in normal profit in the long run and hence an equitable distribution of income.

The implication of the theory of contestable markets for government policy is that the government may increase the degree of contestability of a market to achieve results closer to those of a perfectly competitive market. There are several measures which the government can take to increase the degree of contestability of a market. If a firm controls the supply of some key factor inputs, it can deny access to these factor inputs to potential firms which will make it difficult for them to enter the market. Therefore, the government can lower the barriers to entry by preventing these key factor inputs from being controlled by the incumbent firm or firms in the market. For example, it can block proposed vertical mergers which may result in such a situation. The government can also lower the barriers to entry by granting more licenses to operate in the market. For example, it can grant more licenses to operate the same routes in the airline industry. Apart from lowering the barriers to entry, the government can also increase the degree of contestability of a market by increasing access to the same production technology of the incumbent firm or firms in the market. For example, it can compel the incumbent firm or firms in the market to open up their infrastructure to other firms.

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