1
Q
7.1 Winning brands
Define market share
A
A firm’s proportion of the market in which its product is sold. It may be measured as its share of the total revenue in the market, or of the total quantity sold in the market., and the third largest in the world. Keeping the p
2
Q
7.1 Winning brands
Define profit and economic profit
A
A firm’s profit is its revenue minus its total costs. We often refer to profit as ‘economic profit’ to emphasise that costs include the opportunity cost of capital (which is not included in ‘accounting profit’).
3
Q
7.1 Winning brands
Define profit margin
A
The difference between the price of a product and its marginal production cost.
4
Q
7.1 Winning brands
What do firms generate a competitive advantage?
A
Provide characteristics to their products that customers think they cannot find elsewhere. Product differentiation gives firms a competitive advantage to contron price and generate economic rent.
5
Q
7.1 Winning brands
What does a firms profit depend on other than price?
A
- Product range
- Attracting customers
- Producing at lower cost than competitors
- Producing at better quality than competitors
6
Q
7.1 Winning brands
What are the two reasons innovation is important?
A
- Product differentiation
- Can aid in keeping costs lower (e.g. ikea’s innovation of compact furniture also takes up less storage space)
This is more easily achieved by larger firms that can produce at a lower cost
7
Q
7.1 Winning brands
What causes firms to incur costs?
A
- Wages
- Taxes
- Government regulation
- Costs of production
8
Q
7.1 Winning brands
What can firms utilise to reduce costs?
A
- Lower wages and poor working conditions, however firms that require specialised skills draw out better employees with good working conditions and higher incomes
- Find workers willing to work lower wages using gig economy
- Avoiding regulations or taxes, lobbying to reduce them, or relocating to countries with less stringent regulations.
9
Q
7.2 Breakfast cereal: Choosing a price
Define total costs
A
The total costs a firm incurs to produce its output
10
Q
7.2 Breakfast cereal: Choosing a price
Define revenue
A
Firm’s total revenue is the number of units sold times the price per unit.
11
Q
7.2 Breakfast cereal: Choosing a price
How do you calculate total costs, total revenue and total profit?
A
total costs=unit cost×quantity
total revenue=price x quantity
profit=total revenue-total cost
12
Q
7.2 Breakfast cereal: Choosing a price
What is an isoprofit curve?
A
A curve that joins together the combinations of prices and quantities of a good that provide equal profits to a firm. Iso=equal, so all the (Q,P) points represented give the same level of profit.
13
Q
7.2 Breakfast cereal: Choosing a price
What can an isoprofit curve be compared to?
A
A firm’s indifference curve as a firm is indifferent between prices and quantities that give the same level of profit
14
Q
7.2 Breakfast cereal: Choosing a price
What is a demand curve?
A
A demand curve shows the number of units of a good that buyers would wish to buy at any given price. Also known as: demand function.
15
Q
7.2 Breakfast cereal: Choosing a price
Where does the feasible set lie on this demand curve?
A
Anything below the line
16
Q
7.2 Breakfast cereal: Choosing a price
At what point is profit maximised for the firm on this demand curve?
A
You reach the highest possible isoprofit curve inside the feasible set by choosing point E, where the demand curve is tangent to an isoprofit curve.
17
Q
7.2 Breakfast cereal: Choosing a price
What are the two trade-offs to consider while making a profit maximising choice?
A
- the trade-off you are constrained to make by the demand curve
- the trade-off you are willing to make on the isoprofit curve (where all points give you the same profit).
18
Q
7.2 Breakfast cereal: Choosing a price
How can plotting profit against quantity also tell you the ideal point for profit maximisation on the demand curve?
A
The peak of the profit/quantity graph will be the same as the ideal point on the demand curve.
19
Q
7.3 Economies of scale and the cost advantages of large-scale production
Why are large firms often more profitable than small firms?
A
Output produced at a lower cost per unit
20
Q
7.3 Economies of scale and the cost advantages of large-scale production
Why can larger firms produce at lower costs?
A
- Economies of scale/increasing returns
- Cost advantages: smaller effect on cost per unit when output is high
- Larger firms can often purchase more inputs due to more bargaining power
21
Q
7.3 Economies of scale and the cost advantages of large-scale production
What are economies of scale or increasing returns?
A
When increasing inputs by a given amount increases output by a larger proportion.
22
Q
7.3 Economies of scale and the cost advantages of large-scale production
Define diseconomies of scale
A
When production exhibits decreasing returns to scale, increasing all of the inputs to a production process by the same proportion increases output by a lower proportion
23
Q
7.3 Economies of scale and the cost advantages of large-scale production
Describe constant returns to scale
A
When production exhibits constant returns to scale, increasing all of the inputs to a production process by the same proportion increases output by the same proportion.
24
Q
7.3 Economies of scale and the cost advantages of large-scale production
What is LRAC dependent on?
A
- Returns to scale in production
- Effect of scale on the prices it pays for its inputs
25
# 7.3 Economies of scale and the cost advantages of large-scale production
How does specialization within a firm create economies of scale?
* Workers focus on tasks they do best
* Increases productivity
* Reduces mistakes
* Lowers training time by narrowing skill requirements
26
# 7.3 Economies of scale and the cost advantages of large-scale production
Why does specialization reduce training costs?
* Each worker learns a smaller set of skills
* Training is faster and cheaper
* Skills are used repeatedly, improving efficiency
27
# 7.3 Economies of scale and the cost advantages of large-scale production
How do larger firms use inputs more efficiently?
Expensive equipment or facilities:
* Are used more continuously
* Are not left idle
Fixed costs are spread over more output
28
# 7.3 Economies of scale and the cost advantages of large-scale production
What are engineering economies of scale and equipment based economies of scale?
Engineering economies of scale:
* Cost advantages from physical or engineering properties
* Output capacity increases more than proportionally to input use
Equipment based economies of scale:
* Machinery used only briefly in small firms
* In large firms, the same machinery can be in constant use
29
# 7.3 Economies of scale and the cost advantages of large-scale production
What are possible diseconomies of scale for larger firms in terms of organization?
A larger firm needs more layers of management and supervision.Firms are typically organised in hierarchy. The organizational costs will grow as a proportion of the firm’s overall costs.
* If a firm chose to decrase the cost of this by decreasing supervision this may lead to less productivity
* It is more feasible to outsource parts of development so not all parts of production are within firm, which may be cheaper long term
* This specifically works as it targets limiting firm size
30
# 7.3 Economies of scale and the cost advantages of large-scale production
Why can cost per unit fall as output increases, even without increasing returns to production?
* Because fixed costs are spread over more units
* The fixed cost is the same whether output is low or high
* Average (unit) cost therefore falls as output rises
31
# 7.3 Economies of scale and the cost advantages of large-scale production
What are fixed costs?
* Costs that do not depend on output level
* Paid regardless of how many units are produced
* Example: R&D, licences, patents, advertising
32
# 7.3 Economies of scale and the cost advantages of large-scale production
How do fixed costs affect infrastructure industries?
Very high upfront construction costs
Low ongoing operating costs
Example: electricity grids
More output → lower cost per unit delivered
32
# 7.3 Economies of scale and the cost advantages of large-scale production
Why do R&D and product design create economies of scale?
* High upfront cost
* Cost is the same whether one unit or many are sold
* Unit cost falls when output increases
33
# 7.3 Economies of scale and the cost advantages of large-scale production
How can lobbying and political influence be treated as fixed costs?
* Costs are largely independent of output
* Paid to improve regulatory or legal environment
* Benefit all units produced, regardless of quantity
34
# 7.3 Economies of scale and the cost advantages of large-scale production
How does firm size affect input costs?
* Large firms have greater bargaining power
* Can negotiate:
Lower prices
Better contract terms
* Small firms usually cannot
35
# 7.3 Economies of scale and the cost advantages of large-scale production
Describe network economies of scale
A firm experiences network economies of scale when an increase in the number of users of an output of the firm implies an increase in the value of the output to each of them, because they are connected to each other.
Demand side benefits are considered network economies of scale
36
# 7.3 Economies of scale and the cost advantages of large-scale production
Describe how demand side benefits aid a firm
People are more likely to buy a product or service if it already has a lot of users
37
# 7.4 Production and costs: The cost function for Beautiful Cars
Define cost function
The relationship between a firm’s total costs and its quantity of output. The cost function C(Q) tells you the total cost of producing Q units of output (including the opportunity cost of capital).
38
# 7.4 Production and costs: The cost function for Beautiful Cars
What is the oppurtunity cost of capital?
The opportunity cost of capital is the amount of income an investor could have received, per unit of investment spending, by investing elsewhere.
39
# 7.4 Production and costs: The cost function for Beautiful Cars
Describe variable costs
Costs of production that vary with the number of units produced.
40
# 7.4 Production and costs: The cost function for Beautiful Cars
Give the total cost of a firm formula
𝐶(𝑄)=𝐹+𝑐𝑄
cQ is variable costs, F is fixed costs and C(Q) is total cost
41
# 7.4 Production and costs: The cost function for Beautiful Cars
What is the fixed and variable cost given from this graph
F = $80,000 per day, and c = $14,400 per car.
42
# 7.4 Production and costs: The cost function for Beautiful Cars
Given this graph, draw the average cost line
We can calculate the average cost at every value of Q to draw the average cost (AC) function
43
# 7.4 Production and costs: The cost function for Beautiful Cars
What does the slope of the cost function tell us?
How much total cost increases for each additional car produced.
44
# 7.4 Production and costs: The cost function for Beautiful Cars
Define marginal cost
The increase in costs when output increases by one unit
45
# 7.4 Production and costs: The cost function for Beautiful Cars
Give the formula for average cost in terms of total cost and quantity
AC=𝐶(𝑄)/𝑄
46
# 7.4 Production and costs: The cost function for Beautiful Cars
Give the formula for MC (marginal cost) in terms of cost and quantity
MC=Δ𝐶/Δ𝑄
47
# 7.4 Production and costs: The cost function for Beautiful Cars
AC(𝑄) can also be expressed in terms of fixed cost, variable cost and quantity by the formula...
𝑐+𝐹/𝑄, in other words average cost is marginal cost and a share of fixed cost
48
# 7.4 Production and costs: The cost function for Beautiful Cars
Why does Average cost decrease while marginal cost stays the same?
Marginal cost is constant as it is the change in cost/change in quantity which is always the same. Average cost decreases as more quantity of a good is produced.
49
# 7.4 Production and costs: The cost function for Beautiful Cars
Is this a long run or short run cost function
Long-run
50
# 7.4 Production and costs: The cost function for Beautiful Cars
Are firms’ marginal costs always constant?
* No
* Marginal costs can increase when some inputs are hard to adjust
51
# 7.4 Production and costs: The cost function for Beautiful Cars
Why might marginal cost rise in the short run?
Some inputs (e.g. equipment) are fixed
Firms may need:
* Overtime shifts
* Higher wage rates
This raises the cost of producing extra units
52
# 7.4 Production and costs: The cost function for Beautiful Cars
Why can marginal cost be higher than average cost in the short run?
* Extra units require more expensive inputs (e.g. overtime labour)
* Earlier units were cheaper to produce
* So marginal cost rises above average cost
53
# 7.4 Production and costs: The cost function for Beautiful Cars
How come marginal costs can become constant long run?
All inputs can be scaled up together
No need for costly overtime or bottlenecks
Production expands smoothly
54
# 7.5 Demand, elasticity, and revenue
What is a differentiated product?
A product produced by a single firm that has some unique characteristics compared to similar products of other firms.
55
# 7.5 Demand, elasticity, and revenue
When a firm sells a differentiated product what way does the demand curve slope?
Downward-sloping demand curve.
56
# 7.5 Demand, elasticity, and revenue
Given that Beautiful cars is a differentiated good explain why the demand curve is downward sloping?
If the price of a Beautiful Car is high, demand will be low because the only consumers who will buy it are those who strongly prefer Beautiful Cars to all other makes. As the price falls, more consumers, who might otherwise have purchased a Ford or a Volvo, will be attracted to a Beautiful Car.
57
# 7.5 Demand, elasticity, and revenue
Describe WTP (Willingness to Pay)
An indicator of how much a person values a good, measured by the maximum amount they would pay to acquire a unit of the good.
58
# 7.5 Demand, elasticity, and revenue
How do we determine the demand for a good based on price and WTP
If the price set is P and 18 consumers are willing to pay P or more, the demand at P is =18
59
# 7.5 Demand, elasticity, and revenue
What does law of demand suggest?
Inverse relationship of price and quantity demanded
60
# 7.5 Demand, elasticity, and revenue
Firms choice of price depends on the...
slope of demand curve
61
# 7.5 Demand, elasticity, and revenue
If the demand curve is steep what does this mean for where the firm must set price?
Firm can raise price without that much reduction to sales
62
# 7.5 Demand, elasticity, and revenue
What is price elasticity of demand
The percentage change in demand that would occur in response to a 1% increase in price. We express this as a positive number. Demand is elastic if this is greater than 1, and inelastic if less than 1.
63
# 7.5 Demand, elasticity, and revenue
How do you calculate PED?
𝜀=−% change in demand/ % change in price
64
# 7.5 Demand, elasticity, and revenue
What does the minus sign in the PED formula ensure?
As percentage change of demand is negative to positive percentage change in price, the minus sign in the formula for the elasticity ensures that we get a positive number as our measure of responsiveness.
65
# 7.5 Demand, elasticity, and revenue
If the demand curve is almost flat what does this mean about elasticity?
Quantity changes a lot in response to a change in price, so the elasticity is high
66
# 7.5 Demand, elasticity, and revenue
Describe PED in terms of the slope of the demand curve
𝜀=−𝑃/(Q*slope)
67
# 7.5 Demand, elasticity, and revenue
When price is low is demand more or less elastic?
Less
68
# 7.5 Demand, elasticity, and revenue
Calculate elasticity at A,B,C
Elasticity decreases down the curve
69
# 7.5 Demand, elasticity, and revenue
How do we define something as elastic or inelastic?
Demand is elastic when 1% increase in price would lead to a fall of more than 1% in the quantity sold so elasticity is more than 1. If the elasticity is less than 1, we say that demand is inelastic.
70
# 7.5 Demand, elasticity, and revenue
How does competition affect elasticity?
More competition=more PED. If prices are raised, the proportion of consumers that look for alternatives when there is competition is hgiher than if there are less competitors.
71
# 7.5 Demand, elasticity, and revenue
What is the revenue at point E on panel A and B?
100 in both cases. At point E in panel A the demand is inelastic and in panel B it is elastic.
72
# 7.5 Demand, elasticity, and revenue
If output increases to 6 what happens to each graph? What happens in terms of loss and gain in each panel?
In both cases, the firm gains revenue on the extra unit. But the price falls so it will lose revenue on the original five units. However, the reduction in price is more significant in panel A than in panel B. f demand is inelastic, the loss outweighs the gain: revenue falls. If demand is elastic, the gain is bigger than the loss and revenue rises.
73
# 7.5 Demand, elasticity, and revenue
What is the change in revenue when output is increased by 1 called?
Marginal revenue
74
# 7.5 Demand, elasticity, and revenue
When is marginal revenue positive and negative?
* Marginal revenue is positive when demand is elastic (𝜀>1 the firm can increase revenue by raising output because prices fall only a little)
* Marginal revenue is negative when demand is inelastic; the firm can increase revenue by decreasing output because prices rise a lot.
75
# 7.6 Setting price and quantity to maximize profit
What are normal profits?
Normal profits are the returns on investment that the firm must pay to the shareholders to induce them to hold shares. The normal profit rate is equal to the opportunity cost of capital and is included in the firm’s costs. Any additional profit (revenue greater than costs) is called economic profit. A firm making normal profits is making zero economic profit.
76
# 7.6 Setting price and quantity to maximize profit
What is an equation for profit involving Quantity and total costs
profit=𝑄(𝑃−𝐶(𝑄)𝑄)=𝑄(𝑃−AC)
77
# 7.6 Setting price and quantity to maximize profit
What does the horizontal line suggest price is equal to?
Marginal cost
78
# 7.6 Setting price and quantity to maximize profit
If P=AC what does the economic profit equal?
0, this is called the zero profit curve
79
# 7.6 Setting price and quantity to maximize profit7.6 Setting price and q
What does isoprofit line 3 suggest unlike isoprofit line 2 and 1?
The firm is making an economic profit. Profit = Q(P − AC)
80
# 7.6 Setting price and quantity to maximize profit
What do higher prices mean for profit?
Higher price=higher profit
81
# 7.6 Setting price and quantity to maximize profit
Equation of slope of isoprofit curve
-(P-MC)/Q
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# 7.6 Setting price and quantity to maximize profit
Why is E the point at which profit is maximised?
A firms feasible set is all points on or below the demand curve. It obtains the highest profit at E, where the demand curve is tangent to an isoprofit curve.
83
# 7.6 Setting price and quantity to maximize profit
How would you describe this graph in terms of MRS and MRT
MRS is the slope of the indifference curve/isoprofit curve.
MRT is the slope of the feasible frontier/demand curve.
At E, the profit-maximizing point, MRS = MRT.
84
# 7.6 Setting price and quantity to maximize profit
Define price markup
The price minus the marginal cost divided by the price. In other words, the profit margin as a proportion of the price. If the firm sets the price to maximize its profits, the markup is inversely proportional to the elasticity of demand for the good at that price.
85
# 7.6 Setting price and quantity to maximize profit
What is elasticity equation involving price, quantity demanded and slope
𝜀=−𝑃/𝑄×slope
86
# 7.6 Setting price and quantity to maximize profit
Explain through an equation how price mark up is the inverse of PED
(𝑃−𝑐)/𝑃=1/𝜀
87
# 7.6 Setting price and quantity to maximize profit
If price mark up is the inverse of elasticity, when there is less competition with other firms what will the price mark up be?
Less competition means elasticity is low, therefore price markup will be high.
88
# 7.6 Setting price and quantity to maximize profit
How do fixed costs affect a firm’s profit-maximizing price and quantity?
They do not affect the profit-maximizing choice of P and Q
* An increase in fixed costs:
* Lowers profit by the same amount at all price–quantity combinations
* Does not change marginal cost
Isoprofit curves:
* Stay in the same positions
* Are simply relabelled with lower profit levels
* The firm chooses the same P and Q, but earns lower profit
89
# 7.6 Setting price and quantity to maximize profit
If profit = total revenue - total cost what does marginal profit equal?
profitmarginal profit=MR−MC
90
# 7.6 Setting price and quantity to maximize profit
How can marginal revenue and cost be used to calculate profit maximising Q
If MR > MC, the firm could increase profit by raising Q.
If MR < MC, the marginal profit is negative. It would be better to decrease Q.
So at the profit-maximizing Q, MR = MC.
91
# 7.6 Setting price and quantity to maximize profit
Calculate MR when Q=20. Is MR positive?
Yes, Q can be increased to maximise profit
92
# 7.6 Setting price and quantity to maximize profit
Why is marginal revenue always lower than price?
By selling another car, the firm gains some P, however the previously sold cars are now valued at less P, so revenue is lost from those cars.
93
# 7.6 Setting price and quantity to maximize profit
Moving down the demand curve what happens to MR and P relative to each other?
Both fall but MR falls more than P
94
# 7.6 Setting price and quantity to maximize profit
Why is E the profit maximising point? What price should be set?
At E, the MR and MC meet. The highest possible price at E that is feasible should be set.
95
# 7.6 Setting price and quantity to maximize profit
What does this graph tell us about the profit maximising point?
MR=MC can also be found by the point where isoprofit curve meets the demand curve. Both of these show the point at which profit is maximised.
96
# 7.7 Gains from trade: The surplus and how it is divided
What is the surplus people gain in voluntary trade that makes them better off called?
Economic rent
97
# 7.7 Gains from trade: The surplus and how it is divided
Join surplus is a measure of...
gains from exchange/gains from trade.
98
# 7.7 Gains from trade: The surplus and how it is divided
If a consumer is willing to pay $34,000 for a car and a firm has a constant marginal cost, c = 14,400 of producing a car, what is the join surplus by picking a price between these points?
$19,600.
99
# 7.7 Gains from trade: The surplus and how it is divided
Calculate the surplus at 15 cars and 24 cars for this and how it is divided for the consumer and the firm
There is a surplus on each car equal to the difference between the consumer’s WTP and the producer’s marginal cost. The vertical lines in the figure show the surpluses for the transactions with two of the consumers.
100
# 7.7 Gains from trade: The surplus and how it is divided
Define the consumers surplus in this diagram based on WTP and P at E
Beautiful Cars sets a price P* (point E). The buyer’s surplus (in red) is the difference between the WTP and the price, WTP – P*, and the producer receives P* – MC (purple).
101
# 7.7 Gains from trade: The surplus and how it is divided
What is the total surplus in this diagram from 0-32 cars? What part of this areas is the producers total surplus and the consumers?
The shaded area (red + blue) enclosed by the demand curve and the marginal cost curve from 0 to 32 cars represents the sum of the joint surpluses on all 32 cars that are sold at this price. The area enclosed by the demand curve and the price of E is the sum of the surpluses obtained by the 32 consumers (red). The rectangle between the price and MC curve is the sum of the producer’s surpluses on each car, which is equal to (P – MC)Q* (blue).
102
# 7.7 Gains from trade: The surplus and how it is divided
What is the firms profit within the blue shaded region?
The firm’s profit is (P – AC)Q*. The remaining part of the producer’s surplus covers the fixed costs.
profit=(𝑃−𝑐)Q*−𝐹=(𝑃−AC)Q*
103
# 7.7 Gains from trade: The surplus and how it is divided7.7 Gains from tr
Until what point are their potential gains on this diagram?
Till point F, where there are 64 cars that can be sold until MC=Demand curve
104
# 7.7 Gains from trade: The surplus and how it is divided
Why is Point E not pareto efficient?
There are gains up until point F. Only 32 consumers receive cars. So potential gains from trade have not been exhausted: there are some consumers who do not buy cars at the firm’s chosen price, but are nevertheless willing to pay more than it would cost the firm to produce them, so there is potential for pareto improvement.
105
# 7.7 Gains from trade: The surplus and how it is divided
Despite pareto improvement potentials why does the firm only sell 32 cars at point E.
Point E is the best it can do under the rules of the game: it has to set a single price for all consumers. If it could sell 32 cars at $27,200 each to the consumers with highest WTP, and then sell more cars at lower prices to other consumers, it could increase its profit and make these additional consumers better off. But setting different prices for different buyers, known as price discrimination, cannot work unless the firm knows which ones will buy at the higher price.
106
# 7.7 Gains from trade: The surplus and how it is divided
What is the measure of lost surplus referred to as between point E and F?
Deadweight loss. This is a measure of the total loss of surplus (that is, potential gains from trade) relative to the maximum available in the market.
107
# 7.7 Gains from trade: The surplus and how it is divided
What is division of gains in economic interactions depedent on?
The bargaining powers of all participants
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# 7.7 Gains from trade: The surplus and how it is divided
What is market power?
A firm has market power if it can sell its product at a range of feasible prices, so that it can benefit by acting as a price-setter (rather than a price-taker). The firm obtains this power if an individual consumer has no power to bargain for a better deal because the firm has many other potential customers.
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# 7.7 Gains from trade: The surplus and how it is divided
Why can’t this model determine whether Beautiful Cars’ high price is fair?
Fairness concern:
* High prices may exclude lower-income consumers, limiting access to transport and job opportunities.
Limitation of the model:
* It measures consumer gains only in monetary terms (consumer surplus = WTP − price).
* It cannot compare welfare across consumers with different incomes.
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# 7.7 Gains from trade: The surplus and how it is divided
Why should consumer and producer surplus be interpreted with caution as measures of welfare?
Producer surplus limitation:
* Ignores fixed costs, so it can overstate a firm’s true benefit (profit).
Consumer surplus limitation:
* Based on monetary gains, which do not have the same value to different consumers (e.g. rich vs poor).
* Adding consumer surpluses together is therefore a poor measure of total consumer welfare.
111
# 7.8 Price setting, competition, and the market
When there are more models for a product what does this do to elasticity?
When many similar models are available, consumers will be more responsive to price differences. The demand for each one is likely to be quite elastic.
112
# 7.8 Price setting, competition, and the market
Define substitutes
Two goods (or services) are described as substitutes when consumers would readily replace one with the other if the prices were similar. If the price of one of the goods increased, consumers would be more likely to choose the other (so demand for it would increase).
113
# 7.8 Price setting, competition, and the market
What is the equation linking elasticity and price mark up? What would be expect if there are more substitutes for a product?
(𝑃−𝑐)/𝑃=1/𝜀
So we would expect higher markups for products with fewer close substitutes.
114
# 7.8 Price setting, competition, and the market
What is a monopoly?
A firm that is the only seller of a product without close substitutes. Also refers to a market with only one seller. Monopoly power varies in degree depending on how unique the product is
115
# 7.8 Price setting, competition, and the market
Why are most real-world monopolies not “pure” monopolies?
Most firms face some competition, even if they dominate a niche
Rivals may sell similar but not identical products
Monopoly often exists in degree, not in absolute terms
116
# 7.8 Price setting, competition, and the market
Why is demand elasticity a better measure of market power than market share?
* Elasticity captures competition from all substitutes, not just direct rivals
Determines a firm’s ability to:
* Raise price above marginal cost
* A firm with inelastic demand has greater market power
117
# 7.8 Price setting, competition, and the market
How do patents and copyrights create monopoly power?
* Grant exclusive legal rights to produce or sell a product
* Prevent entry by competitors
118
# 7.9 How firms differentiate their products
What is product differentiation?
* When firms offer products or services that differ in characteristics consumers value
* Allows firms to gain market power
119
# 7.9 How firms differentiate their products
How does product differentiation apply to services?
Creating differentiation in quality of service to create consumer loyalty and market power
120
# 7.9 How firms differentiate their products
How does product design affect a firm’s demand curve?
By choosing product characteristics, a firm determines the demand curve it faces
Ideal outcome for the firm:
* High demand (many buyers at each price)
* Low elasticity (few close substitutes)
* This allows the firm to set prices above marginal cost
121
# 7.9 How firms differentiate their products
Why is successful product differentiation difficult? How can technological innovation increase market power?
Markets often already contain many competing brands
Consumers have diverse preferences
Small differences may be easily copied by rivals
Sustained differentiation usually requires innovation:
* Innovation can create products with few close substitutes
* Temporarily lowers demand elasticity
* Gives firms a first-mover advantage
122
# 7.9 How firms differentiate their products
How does advertising affect a firm’s demand curve? Why may a firm employ this?
* Advertising can shift the demand curve outward
* More consumers buy the product at each price
* Particularly important for differentiated products
* To inform consumers about product existence and characteristics
* To attract consumers away from competitors
* To create brand loyalty, reducing demand elasticity
123
# 7.10 Markets with few firms: Strategic price setting
Why is changes in price with markets with few firms different to market with many firms?
Where there are only a few competing firms, a change in price by an individual firm will change the demand available to the others. In this situation, pricing decisions are mutually interdependent.
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# 7.10 Markets with few firms: Strategic price setting
What are the Nash equilibrium and the dominant strategy?
(H,H) and (L,L). Nash equilibrium is an economic outcome where none of the individuals involved could bring about an outcome they prefer by unilaterally changing their own action.
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# 7.10 Markets with few firms: Strategic price setting
Why does this game only have one Nash Equilibrium?
With 26 loyal customers, Kit and Wanda both have a dominant strategy: to choose H. So there is only one Nash equilibrium, in which both firms price high. In this case, product differentiation gives the firms a lot of market power; demand is not very responsive to price differences and they can profit from setting high prices.
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# 7.10 Markets with few firms: Strategic price setting
What type of game is this?
A prisoners dilemma: Wanda and Kit would still make the highest profits if both chose H, L is a dominant strategy. The only Nash equilibrium is for both to set low prices (to the benefit of their customers).
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# 7.11 Firms and markets with decreasing long-run average costs
Why do producers of differentiated products have market power?
* Differentiation reduces direct competition
* Consumers have preferences for specific characteristics
* Leads to low elasticity of demand
* Firms can set price > marginal cost
* Result: higher profits + deadweight loss
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# 7.11 Firms and markets with decreasing long-run average costs
How do decreasing average costs create market power?
* Average cost (AC) falls as output increases
* Marginal cost (MC) is below AC at all output levels
* Firm must set price ≥ AC to avoid losses
Therefore price > MC, even without differentiation
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# 7.11 Firms and markets with decreasing long-run average costs
Why do decreasing average costs limit competition?
* Only large-scale firms can operate profitably
* Small firms have higher unit costs
* Entry is discouraged
* Market served by few large firms
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# 7.11 Firms and markets with decreasing long-run average costs
Define competition policy or antitrust policy
Government policy to reduce market power and encourage competition. This will normally arise in markets where one or a few dominant firms have high market share. But they only intervene if they conclude that firms have the ability and incentive to abuse their market power.
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# 7.11 Firms and markets with decreasing long-run average costs
How does a patent provide market power to a firm?
Creates barriers to entry for others firms: Patents incentivize R&D by providing temporary market power to a firm. Once they come to an end, we expect rival firms to enter the market.
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# 7.11 Firms and markets with decreasing long-run average costs
What can merging with another firm do?
Reduce rivarly
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