Economics Microeconomics: Firms and Markets Syllabus

Give the formula for economic (total) profit.

$$\pi = TR - TC = (AR - ATC) \times Q$$

Why does maximising where MR = MC give maximum profit?

If $MR > MC$, producing more adds to profit; if $MR < MC$, cutting output adds to profit. Profit is greatest when the last unit's added revenue just equals its added cost, $MR = MC$.

What is normal profit?

The minimum reward needed to keep an entrepreneur in the current line of business; it is counted as a cost. Normal profit is earned when $TR = TC$, i.e. economic profit $\pi = 0$ ($AR = ATC$).

What is supernormal (abnormal/economic) profit?

Profit above normal profit, earned when total revenue exceeds total cost including normal profit: $\pi > 0$, i.e. $AR > ATC$.

State the break-even point for a firm.

The output where total revenue equals total cost and the firm earns exactly normal profit: $AR = ATC$ (economic profit $= 0$).

State the short-run shutdown condition.

A firm should shut down in the short run if price fails to cover average variable cost: $P < AVC$ (i.e. $TR < TVC$). If $P \geq AVC$ it continues, covering variable costs and part of fixed costs.

State the long-run shutdown (exit) condition.

In the long run a firm exits the market if it cannot cover total costs: $P < ATC$. It stays only if $P \geq ATC$ (at least normal profit).

What is a firm's short-run supply curve in perfect competition?

The portion of the marginal cost curve that lies above the minimum of the average variable cost curve ($MC$ above $AVC_{min}$).

List the key assumptions of the perfect competition model.

Many buyers and sellers; homogeneous (identical) products; firms are price takers; free entry and exit; perfect information; and no transport costs or externalities.

Describe short-run equilibrium in perfect competition.

Each firm produces where $MR = MC = P$; it may earn supernormal profit ($P > ATC$), normal profit ($P = ATC$), or a loss ($P < ATC$) depending on market price.

Describe long-run equilibrium in perfect competition.

Free entry/exit competes away abnormal profits until each firm earns only normal profit, producing where $P = MR = MC = ATC$ at the minimum of the ATC curve.

Define allocative efficiency and state its condition.

Resources are allocated to reflect consumer preferences so that the value placed on the last unit equals its cost of production: $P = MC$. No welfare gain is possible from reallocating resources.

Define productive efficiency and state its condition.

Output is produced at the lowest possible average cost, i.e. at the minimum of the ATC curve ($MC = ATC_{min}$), so no resources are wasted.

Why is perfect competition considered efficient in the long run?

In long-run equilibrium firms produce where $P = MC$ (allocative efficiency) and at minimum $ATC$ (productive efficiency), delivering both types of efficiency.

What are barriers to entry? Give examples.

Obstacles that prevent or deter new firms from entering a market. Examples: economies of scale, high sunk/capital costs, legal barriers (patents, licences), control of key resources, brand loyalty, and predatory pricing.

List the key assumptions of the pure monopoly model.

A single seller (the firm is the industry); high barriers to entry; the firm is a price maker facing the downward-sloping market demand curve; and (typically) profit maximisation with no close substitutes.

Describe monopoly equilibrium (price and output).

The monopolist produces where $MR = MC$, then charges the price read off the demand (AR) curve above that output. Price exceeds marginal cost: $P > MC$, and abnormal profit ($P > ATC$) can persist in the long run due to entry barriers.

Why is a monopoly allocatively inefficient?

It produces where $MR = MC$ but sets $P > MC$, so output is below the socially optimal level, creating a deadweight welfare loss.

What is price discrimination?

Charging different prices to different consumers for the same good where the price differences are not justified by cost differences, in order to capture more consumer surplus.

State the three conditions required for price discrimination.

(1) The firm must have market (price-setting) power; (2) consumers must have different price elasticities of demand and be separable into groups; (3) markets must be kept separate to prevent resale/arbitrage.

Distinguish first-, second- and third-degree price discrimination.

First-degree: each consumer charged their maximum willingness to pay (perfect discrimination). Second-degree: prices vary with quantity/blocks consumed. Third-degree: different prices to different identifiable groups (e.g. student vs adult).

How does third-degree price discrimination set prices between markets?

The firm charges a higher price in the market with more inelastic demand and a lower price in the more elastic market, equating marginal revenue across markets: $MR_1 = MR_2 = MC$.

What is a natural monopoly?

An industry in which a single firm can supply the entire market at lower average cost than multiple firms, because of very large economies of scale (LRAC falling over the whole range of demand), e.g. utilities and rail networks.

Why is regulation used for natural monopolies, and name common methods.

To prevent monopoly abuse (high prices, low output) while retaining scale economies. Methods include price-cap regulation (e.g. $RPI - X$), rate-of-return regulation, marginal-cost or average-cost pricing rules, and performance targets.

What is the problem with forcing a natural monopoly to price at P = MC?

Because LRAC is falling, marginal cost lies below average cost, so $P = MC$ means price is below average cost and the firm makes a loss, requiring a subsidy; average-cost pricing ($P = ATC$) is often used instead.

List the key characteristics of monopolistic competition.

Many firms; differentiated products; low barriers to entry and exit; some price-setting power (downward-sloping demand); and non-price competition (branding, advertising).

Describe long-run equilibrium under monopolistic competition.

Free entry competes away abnormal profit, so firms earn only normal profit where $P = ATC$ (demand tangent to ATC), producing where $MR = MC$. Because $P > MC$ and output is below minimum ATC, firms have excess capacity and are neither allocatively nor productively efficient.

Define excess capacity in monopolistic competition.

The gap between the profit-maximising output and the output at minimum average cost; firms produce less than the productively efficient quantity, leaving spare capacity.

List the key characteristics of an oligopoly.

A few large interdependent firms dominate the market; high barriers to entry; products may be homogeneous or differentiated; high concentration ratio; and firms' decisions depend on rivals' expected reactions (interdependence).

What does the kinked demand curve model predict about oligopoly prices?

Rivals match price cuts but not price rises, so demand is elastic above the current price and inelastic below it. This produces a kink and a discontinuity in the MR curve, so prices tend to be rigid (sticky) even when costs change.

Distinguish collusive from non-collusive (competitive) oligopoly.

Collusive oligopoly: firms cooperate (e.g. a cartel) to fix prices or output, acting like a monopoly. Non-collusive oligopoly: firms compete independently and strategically, e.g. through price wars or non-price competition.

What is a cartel and why are cartels unstable?

A formal collusive agreement among firms to fix price or restrict output to raise joint profits. They are unstable because each member has an incentive to cheat by secretly increasing output at the high price, and they are usually illegal.

In game theory, what is a dominant strategy?

A strategy that yields a player the best payoff regardless of what rivals choose; a rational player will always play it if one exists.

Define a Nash equilibrium.

A set of strategies, one per player, where no player can improve their payoff by unilaterally changing strategy given the strategies of the others; each is a best response to the others.

Explain the Prisoner's Dilemma in an oligopoly context.

Two firms each have a dominant strategy to compete (e.g. cut price or defect from a cartel), leading to a Nash equilibrium where both are worse off than if they had cooperated. It shows why collusion is hard to sustain.

What is a contestable market?

A market with free (costless) entry and exit and no sunk costs, so the mere threat of new entrants (hit-and-run competition) forces incumbents to keep prices low and earn only normal profit, even with few firms.

What determines the degree of market contestability?

The height of entry and exit barriers, especially the level of sunk costs. The lower the sunk costs, the more contestable (closer to perfectly contestable) the market is.

How does perfect contestability affect incumbent firms' pricing and profit?

To deter hit-and-run entry, incumbents set price close to average cost and earn only normal profit in the long run, and are pushed toward productive and allocative efficiency, despite the market having few firms.