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Chapter 11

Economics 101: Chapter 11

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ECON 101
Robert Gateman

Economics 101: Principles of Microeconomics Chapter 11 1.1 The Structure of the Canadian Economy Industries with Many Small Firms:   Some industries are not described by perfect competition, even though they contain several small firms o Firms advertise and are able to influence consumers, price taking firms not able to do this o Stores in unique location may have market power, and therefore influence on market price Industries with a Few Large Firms:  o Most common monopolies today are electric utilities, telephone, cable, TV and internet providers  These firms are subject to government regulations o Today most industries are dominated by several large firms  Service industries that used to be made up of several small firms are now dominated by large multi-national corporations  Oligopoly: industries with small number of large firms with market power, active competition Concentration Ratios:  Highly concentrated: industry with a small number of relatively large firms  concentration ratio: shows the fraction of total market sales controlled by the largest sellers o Often taken as the largest four or eight firms  Share of shipments for the top four firms vary significantly from industry to industry Defining the Market:  Difficult to accurately and reasonably measure the power of the firms o Depends heavily on the size of the industry relative to the whole country  Change in transportation costs and innovation has increased the sense of globalization o Even though there is one firm in Canada, there maybe several more firms in other countries o These companies may be large relative to the Canadian market, but small globally  Firm in industries where products are traded internationally, concentration ratios can still be used to provide valuable information about the degree in a given market is concentrated in a few firms 11.2 What is Imperfect Competition?  Imperfectly competitive: not dealing with a monopoly or perfect competition Economics 101: Principles of Microeconomics o Firms choose the variety of the product that they produce and sell o Firms choose the price at which they sell that product Firms Choose Their Products:  Differentiated product: group of commodities that are similar enough to be called the same product, buy dissimilar enough to be sold at different products  Most firms in imperfectly competitive markets sell differentiated products o The firm itself must choose which characteristics to give the products that it will sell Firms Choose Their Prices:  When different firms sell different products, firms must set the price of the products  Manufacturers will have several product lines that differ from each other and other competitors o Each product has a price that must be set by its producer  Price setters: firms must choose their prices o Firms have expectations about the quantity it can sell at each price that it might set  In market structures other than perfect competition, firms set prices and then demand determines sales o Changes in market conditions are signalled to the firm by changes in the firm's sales o In market with differentiated products, prices change less than in perfect competition  Imperfect competitive firms respond to fluctuations in demand by changing output rather than prices o Only after a firm determines changes in demand will persist, will it change prices o The internet makes it much easier for firms to continuously change prices Non-Price Competition:  Many firms spent substantial amounts on advertising o Firms attempt to shift the demand curve for the industry's products and attracts consumers o Perfectly competitive firms face perfectly elastic demand; therefore not beneficial to advertise o Monopolist has no competitors in the industry; therefore does not need to advertise  Will advertise to convince consumers to shift spending to the firm  Many firms engage in non-price competition (quality, product guarantees etc.) o Warranties, guarantees, and awards allow firms to advertise these benefits/differences  Firms engage in activities that appear to be designed to limit entry of new firms o Preventing erosion of profits o Price matching by competitors Two Market Structures:  Game theory plays a central role in the theory of oligopoly  Strategic behaviour is a key difference between these two market structures 11.3 Monopolistic Competition  Monopolistic competition: market structure that allows entry/exit, but each firm has products somewhat differentiated from the others, giving the firm price control Economics 101: Principles of Microeconomics  Product differentiation leads to brand name and advertising o Gives each firm a degree of market power (competition's price has little influence)  Market power is restricted in the short-run and the long-run o Short-run restrictions: presence of similar products sold by competition  Causes demand curve for each firm to be very elastic o Long-run restrictions: free entry industries permits new firms to compete with existing firms  This comprises the competition part of the theory Assumptions of Monopolistic Competition:  Theory is based on four key simplifying assumptions 1. Each firm produces one specific brand of the industry's differentiated product a. Each firm faces highly elastic demand curve because of several close substitutes 2. All firms have access to the same technology knowledge, and have the same costs curves 3. Industry contains so many firms, a firm doesn't consider competitor's actions when setting prices/output 4. Freedom of entry/exit in the industry means if existing firms are earning profits new firms have an incentive to enter the market a. When new firms enter the industry, the demand must be shared by all firms Short-Run Decisions of the Firm:  Short-run monopolistically competitive market structure are similar to that of a monopoly o Faces a negatively sloped demand curve and maximizes profits by equation marginal cost and marginal revenue Long-Run Equilibrium of the Industry:  Profits in an industry attract new firms and therefore all firms must share demand o Each firm in the end get a smaller share of the industry (overall demand of the industry) o Demand shifts to the left, thus decreasing market prices o Entry continues until profits are eliminated  Demand curve is tangent to the LRAC curve (no output where costs are covered) o Exit will continue until the demand curve for remaining firms touches/tangent to the LRAC curve Excess-Capacity Theorem:  Monopolistic competition forces firms into a position of excess capacity o Each firm is producing an output less than the lowest point on its long-run average cost curve o If firms increased output, it would reduce its cost per unit, but no demand for extra supply  In the long-run equilibrium in monopolistic competition, goods are produces at a point where average total costs are not at their minimum  Long-run equilibrium for perfect competition has price equal to the minimum of the LRAC curve Economics 101: Principles of Microeconomics  Excess-capacity theorem suggest that modern market economies are systematically inefficient o Excess capacity does not necessarily indicate waste of resources o Some benefits accrue to consumers who can choose among the variety of products  From society's point of view, there is a trade-off between producing more brands to satisfy diverse tastes and producing fewer brands at a lower cost per unit o Monopolist competition produces a range of products, higher cost per unit than perfect competition o Product differentiation is wasteful only if costs of providing variety exceed benefit 11.4 Oligopoly and Game Theory  Oligopoly: industries that are made up of a small numbers of large firms o Contains two or more firms, at least one produces a significant portion of the industry's output o Highly concentrated ratio for the firms that are serving one particular market o These firms face a negatively sloped demand curve  Number of competitors is so small, firms realize competitors will re
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