Competition provides incentive for firms to find new and more efficient production technologies.

Competition encourages firms to find the optimal scale of production. The optimal scale varies with each industry – it may be large enough to take advantage of economies of scale or small to cater to individual customers.

2.E: Price-Searcher Markets with High Entry Barriers

a: Discuss entry barriers that may protect companies against competition from potential market entrants.

Economies of scale: In some industries, firms experience declining average total costs over the full range of output that consumers are willing to buy. When this is the case, larger firms, relative to the total market, will have lower unit costs.

Government licensing and legal barriers: For example, utilities are granted the exclusive right to supply electricity in certain areas.

Patents or exclusive rights of production are granted to producers of new and innovative products. This encourages research and development.

Resource control: If a single firm has sole control over a resource essential for entry into an industry, it can eliminate potential competitors.

b: Distinguish between the characteristics of a monopoly and those of an oligopoly.

Monopoly is a market structure characterized by:

a single seller of a well-defined product for which there are no good substitutes

high barriers to the entry of other firms into the market for the product.

Oligopoly is a market structure characterized by:

a small number of sellers

interdependence among competitors

large economies of scale

significant barriers to entry

either similar or differentiated products

c: Describe how a profit-maximizing monopolist sets prices and determines output.

A monopolist faces a downward sloping demand curve. Just as price searchers with low entry barriers will expand output until marginal revenue equals marginal cost, so do monopolists. This will maximize profit. Positive economic profits can exist in the long run due to the high entry barriers.

Do monopolists charge the highest possible price? The answer is no, because monopolists want to maximize profits, not price. Monopolists will not make profits if the ATC line is always above the demand curve. Production will expand until MR = MC and give optimal output of Q*. To find the price at which it will sell Q* units you must go to the demand curve. Note that the demand curve itself does not determine the optimal behavior of the monopolist. Just as with the pure competition model, however, it is the intersection or equality of MR and MC that determines the optimal quantity. For a profit to be ensured, the demand curve must lie above the ATC curve at the optimal quantity point P1 - C1 >0.

d: Discuss why oligopolists have a strong incentive to collude and to cheat on collusive agreements.

Oligopolists will recognize that they cannot maximize profit when they are in fierce competition. Hence, they will form associations or cartels to set price and output so as to maximize profits.

Cartels are an organization of sellers designed to coordinate supply decisions so that the joint profits of the members will be maximized. A cartel will seek to create a monopoly in the market.

The demand curve for oligopolists is very elastic or flat meaning that a small change in price will lead to a large change in quantity demanded. This makes it tempting for firms to cheat on collusion agreements because if a firm decreases its price it will steal customers from its rivals.

e: Discuss the obstacles to collusion among oligopolistic companies.

Five obstacles to collusive behavior:

When the number of oligopolists is larger, effective collusion is less likely.

When it is difficult to detect and eliminate price cuts, collusion is less attractive.

Low entry barriers are an obstacle to collusion.

Unstable demand conditions are an obstacle to collusion.

Vigorous antitrust action increases the cost of collusion.

f: Review government policy alternatives intended to reduce the problems stemming from high barriers to entry.

A natural monopoly is one in which economies of scale are so pronounced that total industry production should be produced by one firm. Here, average total cost (ATC) is a declining function of output. Most utilities fit into this definition of monopoly. Thus, restructuring an industry to allow natural monopolies is one policy alternative.

Reduce artificial barriers to trade. This will increase competition and efficiency.

Regulate the protected producer. Since monopolists are allocatively inefficient, regulation attempts to improve allocation by placing price ceilings on monopoly pricing. Regulators can impose:

Average cost pricing. Force the monopolist to reduce price to where the firm’s ATC intersects the Market Demand Curve. This will:

increase output and decrease price,

increase social welfare, and

ensure the monopolist a normal profit (zero economic profit, P - C = 0).

Marginal cost pricing. This forces the monopolist to reduce price to where the firm’s MC intersects the market demand curve. This will increase output and reduce price, but the monopolist will incur a loss, requiring a government subsidy. Average cost pricing is the most common form of regulation for this reason.

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