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ib economics hl notes
IB ECONOMICS HL

Basics of Economics: Perfect Competition, Monopoly, Kinked Demand, Game Theory, Externalities, Barriers to Entry, Game Theory

UPDATED ON - 22 OCT 2019

Learning Points:

  1. Profit
  2. Perfect Competition
  3. Monopoly
  4. Monopol​​istic Competition
  5. Oligopoly
  6. Price Discrimination
  7. Market Failure
  8. Externalities
  9. Abuse of Monopoly Powers

Profit                                                                                           

Economic profit is different from accounting profit.

        Profit = TR – TC
        Profit = (AR x Q) – (AC x Q)
        Profit = Q (AR – AC)

TR = TC results in normal profit.
TR > TC results in Supernormal (abnormal) profit.
TR < TC results in losses.

Profit maximization involves maximizing the degree to which TR > TC. Firms will want to produce ever single good that contributes more to total revenue (MR) than it contributes to total costs (MC). A profit-maximizing firm will, therefore, produce every single well with an MR greater than its MC.

 

 

A firm should keep increasing its output as long as MR is greater than MC

Profit maximizing equilibrium is where MC = MR.

Perfect Competition                                                                                      

Assumptions                                                                                                  

  • There are many buyers and sellers
  • There is perfect information so buyers know what products are on offer and at what price
  • The product is similar (homogeneous) so firms cannot differentiate their product
  • There are no barriers to entry so firms can enter and leave the industry in the long run
  • Producers have similar technology and there are perfectly mobile resources (so one firm cannot maintain an advantage over another)
  • Examples: agriculture, wheat farmers, orchardists

The Firm As A Price Taker                                                                                    

Each firm in perfect competition is a price taker. This means that changes in the output by one firm do not shift the industry supply curve sufficiently to alter the price. If the whole industry makes more or less output the supply will shift and the price will change, but not if one firm increases or decreases output. This means each firm can sell all it wants at the given market price. This also means that marginal revenue equals price.

                                                                                     

The Short Run and Long Run in Perfect Competition 

  • In the short run, firms in perfectly competitive markets can make abnormal profits or losses. In the long run, they can only make normal profits.

  • If firms are making abnormal profits, other firms will enter the market in the long run. This will shift supply to the right and lead to a fall in price. This will continue until only normal profits are earned, e.g. price falls from p0 to p1.

  • If firms are making losses, they will leave the industry, shifting the industry supply to the left. This will cause the price to increase. This will continue until the firms left in the industry are making a normal profit, e.g. the price increases from p2 to p1.

 

 

At long run equilibrium, P = Q = AR = MR = D = AC = MC, and here both allocative and productive efficiency are achieved.

Allocative efficiency is achieved when price = marginal cost.

Productive (technical) efficiency is achieved where AC is at a minimum (MC = AC).

Long run industry supply curves                                                                         

  • Constant cost industries
    • Long-run supply curve is horizontal. Demand increases, price rises, and existing firms make an abnormal profit; this is an incentive for other firms to enter, shifting supply to the right until the price returns to its old level.
    • Decreasing cost industries
    •  When firms enter they bring with them new technology; or the increase in the size of the industry allows suppliers to gain economies of scale, reducing costs. The new equilibrium price is below the old level. The long-run supply is downward sloping.
    • Increasing cost industries
    • When firms enter input prices are bid up; the new equilibrium price is above the old equilibrium price; the long-run supply is upward sloping.

 

Why are perfectly competitive markets desirable?

  • In the long-run firms only make normal profits
  • Firms are Allocatively efficient because they produce where the extra benefit of a unit (represented by the price consumers are willing to pay for it) equals the extra cost, e.g. P = MC
  • Productively efficient, i.e. firms produce at the minimum of the average cost curve; this is the lowest possible cost per unit
  • If a firm becomes more efficient than the others it can earn abnormal profit in the short run; there is an incentive for firms to innovate and become more efficient

However, firms may not be able to afford research and development because they do not earn abnormal profits in the long run and there is a lack of variety for consumers because the products are not differentiated.

Monopoly

Assumptions                                                                                                                                                 

A single seller that produces 100% of market output, although it is assumed that any firm with a market share in excess of 25% will have market power.

  • Produces branded goods
  • Creates barriers to entry
  • Maximises profits
  • Examples: Australia Post, gas/water (natural monopolies)

As the firm is the market, the firm’s revenue curves will be downward sloping. It is barriers to entry (economies of scale, legal barriers, sunk costs, capital costs, brand loyalty, control of inputs, predatory pricing) that give a monopoly its market power (power to change price).

 

 

A firm will maximize its profits where MC = MR. P0, Q0 is both the short run and the long-run equilibrium, because barriers to entry stop new firms entering, and supernormal profits persist in the long run. In the long run, a monopoly produces at a point which is both allocatively and productively inefficient.

 

 

P > MC. Consumers are willing to pay a price higher than it costs to produce the product. In perfect competition, the output would increase, so P = MC.

Q is not at minimum average cost. The monopoly is not using the most efficient combination of factors.

A monopoly is assumed to be “bad” because it is both Allocatively and productively inefficient and because it increases prices and reduces output.

A monopoly aiming to maximize total revenue will produce where MR = 0. A monopoly aiming to maximize output will produce where AR = AC.

Barriers to Entry                                                                                                                          

Perfect Competition and Monopoly Compared

It has already been shown that a monopoly is not Allocatively and productively efficient, whereas perfect competition is.

        The diagram shows that a monopoly will increase the price
        (PM) compared to that of perfect competition (PPC) and
        reduce output (QM) compared to perfect competition
        (QPC). The shaded area represents welfare loss.
        Perfectly competitive equilibrium has been generated
        from the AR curve, because in perfection competition  = Q = AR = MR = D = AC = MC.

 

However, this initial comparison is flawed. The assumption is that cost conditions are identical for both firms. A monopoly is likely to benefit from economies of scale, thus reducing marginal costs to MC*. If the monopoly can reduce marginal costs far enough, it might be able to produce the level of output (QM*) that is greater than QPC and reduce the price (PM*) below PPC.

Arguments in favor of monopolies                                                                         

  • The monopolist produces more than any single firm would in a perfectly competitive market. This may lead to economies of scale and, therefore, lower costs than in a perfectly competitive market. This, in turn, might lead to lower prices and higher output than perfect competition.
  • The abnormal profits may be used to invest in research and development which may lead to cost-saving innovations. Joseph Schumpeter argued that monopolists are a positive force in the economy - to gain monopoly position firms often have to innovate; they then gain abnormal profits which encourage other firms to innovate in other areas to gain similar rewards and take away the first firm's market. This may be true in some markets but certainly not all monopoly situations.
  • Competitive markets may over-produce, e.g. in the case of a negative externality - by restricting output the monopolist may actually improve resource allocation.

Arguments against monopolies                                                                                  

²The monopolist can earn abnormal profits even in the long run due to barriers to entry.

² The monopolist is allocatively inefficient, i.e. the price charged is greater than the marginal cost. This causes a welfare loss.

²The monopolist may be productively inefficient, i.e. it may not produce at the minimum of the average cost curve.

² Compared to a perfectly competitive industry with the same cost and demand conditions, the monopolist will charge a higher price for less output.

² X inefficiency - because a monopolist dominates a market, it may have less incentive to be efficient and keep costs down. Overtime costs may rise because of inefficiency and complacency. This idea was put forward by Liebenstein.

Monopolistic Competition                                                                                              

Assumptions                                                                                                                    

Many small firms

  • Product differentiationVery few barriers to entry
  • Firms have the ability to set prices
  • Wide consumer choice
  • Examples:
    • Retail
    • Trades/services
    • Restaurants / Café
    • Hairdressers                    

 In the short run, firms make supernormal profits. These supernormal profits attract new firms. New firms enter the market and so long-run equilibrium only exists when normal profits exist.        

The new firms cause the demand (AR) curve, or current firms, to fall until long-run equilibrium (normal profits where AR = AC) is reached.           

Oligopoly                                                                          

Oligopoly is the predominant existing market structure.

Assumptions                                                                    

  • Few large firms
  • Large barriers to entry
  • Examples: newspaper industry, supermarkets, airlines
  • Firms are interdependent and their behaviour will depend on what they think other firms will do. There are therefore different models with different assumptions.

Kinked Demand Curve                                                                

We assume:

  • If the firm increases its price other firms do not follow so demand is price elastic
  • If the firm decreases its price the other firms do follow so demand is price inelastic This model explains price rigidity in oligopoly, i.e. why prices do not change very much and firms tend to compete via non-price competition, e.g. advertising, sales promotions.

This can be explained in two ways:

  • If the price is increased, demand is price elastic and revenue falls; if the price is cut, demand is price inelastic and revenue falls, i.e. any price change leads to a fall in revenue, and so the firm leaves price unchanged.
  • The kinked demand causes a discontinuity in the marginal revenue curve; changes in marginal cost between MC1 and MC3 do not change the profit-maximizing price and output, i.e. prices are likely to be relatively fixed despite cost changes.

     

Collusive Model (cartel)                                                                             

Firms collude, i.e. work together and act like a profit-maximizing monopolist. They fix a profit-maximizing price and output and give each other quotas. This maximizes the industry's profits, but there is an incentive for individual producers to cut their price and exceed their quotas to increase their own profits at the expense of the industry, i.e. cartels tend to break down as there is an incentive to cheat unless there is an effective policing mechanism (an effective means of ensuring that firms are not producing too much or undercutting the agreed price).   

   

                 

What makes collusion more likely?                                                              

  • If there are only a few firms, it is easier to check on each other and share information.
  • Effective communication and monitoring systems mean that any cheating can be identified early on.
  • Stable cost and demand conditions mean that quotas are easy to allocate and measure and the policy is easy to administer.
  • Similar production costs so they make similar profits.

Pricing and Non-Pricing Strategies                                                                    

  • Cost-plus pricing: Firms add a percentage profit on to their costs. This is a relatively straightforward strategy to implement (e.g. just add 10% to costs) and is often used by retailers. However, it ignores demand conditions.
  • Predatory pricing: This occurs when firms deliberately undercut their competitors to force them out of the market; it is anti-competitive.
  • Limit pricing: Selecting the highest price possible without encouraging entry. If competitors entered the extra supply would drive the price down to a level at which they could not survive, therefore they do not enter.                 
  • Price wars: These occur when firms in an oligopoly try to undercut each other. The aim is to gain sales from the competition. It often happens when there is overcapacity in the industry, e.g. cars and PCs.
  • Price leadership: Sometimes in an oligopoly, there is an obvious price leader, i.e. all firms follow the pricing decisions of one of the other firms. This may be because the price leader is the dominant
    firm in the industry and so the other firms do not want to challenge it by making different decisions. The decision to follow may be clearly agreed between the firms or it may occur without
    any formal agreement (this is known as 'tacit collusion').

Game theory                                                                                                                

The decision that a firm makes in an oligopoly depends on its assumptions about other firms. This means firms will try to calculate the best course of action depending on how others behave. Economists try to build models of this behavior; this is known as 'game theory', e.g. the prisoner's dilemma.

Non Price Competition                                                                                                    

This is quite common in oligopoly. Rather than using price changes which can easily be followed, firms
look for other means to compete, for example:

  • Advertising.
  • Branding, i.e. developing a well-known brand name and brand loyalty.
  • Sales promotions, i.e. offers (such as buy one get one free) and competitions.
  • Distribution, i.e. controlling distribution to retail outlets.

In industries such as confectionery, cigarettes, cleaning products, and jeans, spending on promotional
campaigns are very high.

Role of advertising:

  • Can informs.
  • It can increase demand.

But:

  • Can mislead.
  • Can create barriers to entry by making demand more inelastic, by shifting the demand for other firms' products inwards, and by making the costs of entry higher.

Price Discrimination                                                                                             

Price discrimination is when units of a product that cost the same to produce are sold at different prices to different customers. An alternative type of price discrimination is when a product with different costs or production is sold at the same price. For example, postage costs.

There are various methods of price discrimination, some examples are:

  • Time. E.g. Different rates at different times of day (e.g taxis).
  • Geography. Different rates in different regions
  • Branding. Some firms sell their products under their own brand name and then also under a supermarket’s brand name at a lower price.   

Reasons for Price Discrimination                                                                              

Different people put different values on the same product. That means that different people are willing to pay different prices for a product. A downward-sloping demand curve reflects this. Only a few people are willing to pay a high price for a product, whereas many are prepared to demand it at a lower price. Most products have a single price irrespective of who is buying. Firms hope to turn consumer surplus into profit through price discrimination.

Necessary Conditions for Price Discrimination                                                          

  • Supplier must have monopoly power, ie the supplier must be a price maker. Therefore, price discrimination cannot occur in perfect competition. The greater the monopoly power, the easier it is for firms to price discriminate.
  • There must be groups of buyers with different elasticities of demand for the product, ie different consumers must be willing to pay different prices.
  • Different groups need to be clearly identifiable and separated. Price discrimination cannot work if one group can buy and resell it to another group.

Market Failure                                                                                                                   

Market failure occurs where the market fails to bring about an “efficient outcome”, i.e. too little or too much is produced.

Reasons for market failure include:

• Positive and negative externalities

• Short-term and long-term environmental concerns

• Lack of public goods

• Underprovision of merit goods

• Overprovision of demerit goods

• Abuse of monopoly power

Externalities                                                                                                                             

An externality is a cost or benefit that arises from the production or consumption of a product and which falls on a third party (who is not involved in the transaction). A negative externality imposes an external cost and a positive externality creates an external benefit.

The four possible types of externality are:

 

  • Negative production externalities: This is a very common type of production externality. Examples are noise from aircraft, logging, and clearing of forests, and pollution.
  • Positive production externalities: This is less common than negative production externalities. Example: a beekeeper locates beehives in an orange-growing area. The bees can pollinate the orange trees.
  • Negative consumption externalities: Negative consumption externalities are a common part of everyday life. Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.
  • Positive consumption externalities: Examples include: When you get a flu vaccination, everyone you come into contact with benefits, or when the owner of a historic building restores it, everyone who sees the building benefits.

 

Private Costs and Social Costs                                                                                                  

Marginal private cost (MC) is the private cost of producing one more unit of a good or service.

A marginal external cost is a cost of producing one more unit of a good or service that falls on people other than the producer.

Marginal Social Cost (MSC) = MC + Marginal external cost (see below)

 

Inefficiency With External Costs 

Marginal external costs are taken into account by the market and hence not reflected in either the demand or the supply curves. When taking into consideration marginal external cost, we should have market efficient equilibrium at e2. However, since firms only take in marginal private costs into consideration, the supply curve remains at MC and we have an inefficient equilibrium at e1, creating deadweight loss.

 

Negative externalities: Pollution                                                                                              

There are four main methods that the government uses to cope with external costs (especially one like pollution):

            – Property rights

            – Taxes

            – Emission charges

            – Licenses and marketable permits

Of all the possible government policies to increase efficiency relative to the unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process
rather than replace it.

In the case of cost externalities like pollution, the government can choose from three policies: emissions charges, pollution taxes, or tradable pollution permits. All three policies require the government to initially assess the social marginal costs and benefits from pollution activities to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in

 

i) the benefits of the goods or services made by the polluting process, or

ii) the costs of pollution abatement.

 

The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies.

 

The optimum level of pollution is not zero, but where MSC of pollution = MSB from polluting activity.

Property rights are legally established titles to the ownership, use, and disposal of factors, goods, and services that are enforceable in the courts. The establishment of property rights achieves an efficient outcome because firms can buy the “right to pollute” as long as the above equilibrium is achieved.

Emissions Charges: The government sets a price per unit of pollution so that the more a firm pollutes, the higher are its emissions charges (however, difficult to calculate).

Tradable Permits: Each firm is assigned a permitted amount of pollution per time period and firms trade permits. The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome.

Taxes: The government can set a tax equal to the marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost: MC + Tax = MSC

Private Benefits and Social Benefits                                                                                              

Marginal private benefit (MC) is the private benefit of producing one more unit of a good or service.

The marginal external benefit is the benefit of producing one more unit of a good or service that falls on people other than the producer.

Marginal Social Benefit (MSB) = MB + Marginal external benefit (see below)

Inefficiency with external benefits

Similar to external costs, having external benefits can also cause inefficiency in the same way.

Positive externalities                                                                                                   

There are three main methods that the government uses to cope with external benefits:

        – Private subsidies

        – Vouchers

        – Patents and copyrights

Private Subsidies: A subsidy is a payment by the government to private producers. If the government pays the producer an amount equal to the marginal external benefit for each unit produced, the quantity produced increases.

Vouchers: A voucher is a token that the government provides to households, which can be used to buy specified goods or services. A school voucher allows parents to choose the school their children will attend and to use the voucher to pay part of the cost. The school cashes the voucher to pay its bills.

Patents and Copyrights: Knowledge is productive and generates external benefits and public policies are required to ensure an efficient level of effort. Intellectual property rights give the creator of knowledge the property right to the use of that knowledge. The legal device for granting intellectual property rights is through patent or copyright.

Environmental concerns                                                                                                  

Another cause of market failure may also be environmental concerns (aside from pollution) such as climate changes or overconsumption of common resources that cannot be replaced. Environmental concerns such as these threaten sustainable development, which is balancing the fulfilment of human needs with the protection of the natural environment so that these needs can be met not only in the present but in the indefinite future.

If our consumption of resources today is not contributing to sustainable development, it may cause more severe cases of market failures in the future, resulting in a more severe lack of resources.

Remedies:

        - International cooperation among governments: In the case of acid rain, for example, International cooperation among governments is necessary in order to reduce its occurrence.

Public goods                                                                                                                          

A good or service or a resource is:

        • Excludable if it is possible to prevent someone from enjoying its benefits.

        • Nonexcludable if it is impossible (or extremely costly) to prevent someone from benefiting from it

        • Rival if its use by one person decreases the quantity available for someone else

        • Nonrival if its use by one person does not decrease the quantity available for someone else

The four-fold classification of goods:

Therefore, a public good is a good that is nonexcludable and nonrivalrous. It is a good or service that is consumed simultaneously by everyone and from which no one can be excluded.

There are two problems with public good that leads to market failure or inefficiency:

            – Public goods create a free-rider problem – the absence of an incentive for people to pay for what they consume. The free-rider problem exists with public goods because of the quantity of the good that a person is able to consume isn’t influenced by the amount the person pays for the good.

            – This leads to the tragedy of the commons – the absence of an incentive to pay for, prevent the overuse and depletion of a resource

Because of the tragedy of the commons where there is no incentive to pay for public goods, a shortage of it may occur.

Merit and demerit goods 

​​​​​​​A merit good is a private good/service with positive externalities, for example, education, healthcare, and sports centres. A demerit good is a private good/service that comes with negative externalities, e.g. prostitution, alcohol, cigarettes. Left on their own, there will usually be an underprovision of merit goods and overprovision of demerit goods.

Remedies:

            – Positive advertising, subsidize the production of merit goods. Also, legislation to make school attendance compulsory.

            – Negative advertising, tax, or ban demerit goods.

            – Direct provision of merit and public goods: Governments can control the supply of goods that have positive externalities by supplying a high amount of education, public roads, parks, libraries, etc.

Abuse of monopoly powers                                                                                               

Monopolies prevent the allocation of resources from being efficient. A monopoly, being a price maker, can increase profit by restricting output and increasing the price. Thus, MSB is not equal to MSC. MSC is equal to MR.

Remedies:

            – Legislation: Anti-trust legislation can be brought in an attempt to break the monopoly power and collusive oligopolies.

            – A major activity of the government also should be to regulate monopolies and enforce laws that prevent cartels and other restrictions to competition, thus reducing the chances of monopolies forming.

 

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