PDF Business Degree Essays #2: Competitiveness

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If firms in a perfectly competitive market are making supernormal profit, potential firms will enter the market in the long run due to the absence of barriers to entry. As the number of firms in the market increases, the market supply will increase which will lead to a fall in the market price resulting in a fall in the profits of the firms. This process will continue until firms in the market make only normal profit.

In the above diagram, the supernormal profit represented by the shaded area induces potential firms to enter the market in the long run, which leads to a rightward shift in the market supply curve S from S 0 to S 1. When this happens, the market price P falls from P 0 to P 1. At P 1 , as firms in the market make only normal profit, the incentive for potential firms to enter the market disappears. If firms in a perfectly competitive market are making subnormal profit, they will leave the market when their fixed factor inputs need replacing.

Those that cannot cover their total variable costs will leave the market immediately. As the number of firms in the market decreases, the market supply will decrease which will lead to a rise in the market price resulting in a fall in the losses of the firms. This process will continue until firms in the market start making normal profit. In the above diagram, the subnormal profit represented by the shaded area induces firms to leave the market, which leads to a leftward shift in the market supply curve S from S 0 to S 1.

When this happens, the market price P rises from P 0 to P 1.

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At P 1 , as firms in the market start making normal profit, the incentive for them to leave the market disappears. If a firm is making supernormal profit i. However, if a firm is making subnormal profit i. In the short run, a firm should continue production so long as the total revenue is greater than or equal to the total variable cost. In other words, in the short run, a firm should only take into consideration variable costs and ignore fixed costs when it is deciding whether to continue or shut down production as fixed costs will be incurred in any case.

Assume that a firm is making subnormal profit as the total revenue is less than the total cost. If the firm shuts down production, it will not incur variable costs as it will not need to employ labour or buy materials which means that the total variable cost will be zero. In this case, no sale will be made as there will be no production and hence the total revenue will also be zero. However, the firm will incur fixed costs as it will incur rent and possibly other costs that do not vary with the output level such as interest payments on loans which means that the total fixed cost will be positive.

Therefore, it will make a loss equal to the total fixed cost. If the firm continues production, it will incur variable costs as it will need to employ labour and buy materials which means that the total variable cost will be positive.

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In this case, sale will be made as there will be production and hence the total revenue will also be positive. In addition, the firm will incur fixed costs as it will incur rent and possibly other costs that do not vary with the output level such as interest payments on loans which means that the total fixed cost will also be positive. Therefore, it will make a loss equal to the total revenue minus the total fixed cost and the total variable cost.

In this case, whether the firm will make a loss greater or less than the total fixed cost which is the loss that it will make if it shuts down production, will depend on whether the total revenue is greater or less than the total variable cost. If the total revenue is less than the total variable cost, the shortfall will add to the loss. In this case, the firm will make a loss greater than the total fixed cost.

Assume that the variable costs are the cost of labour and the cost of materials and the only fixed cost is the rent. If the total revenue is less than sufficient to pay for the costs of labour and materials, the shortfall will add to the loss and hence the firm will make a loss greater than the rent which is the loss that it will make if it shuts down production. Therefore, the firm should shut down production. However, if the total revenue is greater than the total variable cost, the excess will partially offset the total fixed cost.

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In this case, the firm will make a loss less than the total fixed cost. Using the above example, if the total revenue is more than sufficient to pay for the costs of labour and materials, the excess will partially offset the rent and hence the firm will make a loss less than the rent which is the loss that it will make if it shuts down production. Therefore, the firm should continue production.

If the total revenue is equal to the total variable cost, the firm will make the same amount of loss whether it continues or shuts down production. In this case, the firm should continue production as doing so may enable it to make supernormal profit in the future as the market conditions may improve.


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In the event that the market conditions worsen, the firm can shut down production without being worse off than if it had shut down production now. It follows that a firm should continue production if the total revenue is greater than or equal to the total variable cost, and shut down production if the total revenue is less than the total variable cost. In the long run, as all costs are variable, there is no distinction between fixed costs and variable costs.

Therefore, in the long run, if a firm makes subnormal profit which means that the total revenue is less than the total cost, it should shut down production and leave the market. It follows that in the long run, a firm should continue production if the total revenue is greater than or equal to the total cost. In the short run, unlike the long run, if a firm shuts down production, it does not leave the market. Recall that the supply of a good is the quantity of the good that firms are able and willing to sell at each price over a period of time, ceteris paribus, and the supply curve shows the quantity supplied at each price.

The portion of the marginal cost curve above the average variable cost curve of a perfectly competitive firm is the supply curve. As the supply curve shows the quantity supplied at each price, this means that given the price of a good, the quantity supplied is determined entirely by the supply curve.

In the above diagram, given the market price of the good P 0 that is determined by the market forces of demand and supply, the quantity supplied Q 0 is determined entirely by the marginal cost MC. Intuitively, given the price of a good, the quantity supplied is determined by the marginal revenue and the marginal cost. However, in the case of a perfectly competitive firm, price is equal to marginal revenue.

Therefore, given the price of the good produced by a perfectly competitive firm, the quantity supplied is determined entirely by the MC curve. Furthermore, at a price below the average variable cost AVC , the firm will shut down production to avoid making a loss greater than the total fixed cost. Therefore, the supply curve of a perfectly competitive firm is the portion of the marginal cost curve above the average cost curve. The industry supply curve of a perfectly competitive industry is the horizontal summation of the supply curves of all the firms in the industry.

This occurs when it is x-efficient and uses the least-cost combination of factor inputs to produce any amount of output. A firm is x-efficient when it is not lax in cost control. In other words, it is not overstaffed, it does not lack the incentive to use the most efficient production technology, it does not occupy premises that are larger than necessary for the output level, etc.

Due to competition in the market, perfectly competitive firms are not lax in cost control. Therefore, perfectly competitive firms are x-efficient and hence productively efficient. A firm is allocatively efficient when it cannot change the allocation of resources in the economy in a way that will make someone better off without making anyone else worse off.

This occurs when it charges a price equal to its marginal cost, assuming no externalities. When the price of a good is equal to the marginal cost, the marginal benefit that consumers place on the last unit of the good is equal to the forgone marginal benefit that they place on the amount of other goods that could have been produced using the same resources. Therefore, the firm cannot change its output level to increase the total benefit for consumers and hence is allocatively efficient. In perfect competition, price equals marginal revenue and firms maximise profit by producing the output level where marginal revenue equals marginal cost.

Therefore, perfectly competitive firms charge a price equal to their marginal cost and are hence allocatively efficient. In the above diagram, at the profit-maximising output level Q 0 where marginal cost MC is equal to marginal revenue MR , the price P 0 is equal to the marginal cost MC 0. Firms with greater market power are able to charge a higher price relative to their marginal cost compared to firms with less market power.

Unlike a monopoly that has substantial market power, perfectly competitive firms have no market power and hence the price charged by perfectly competitive firms is lower than the price that would be charged by a monopoly operating in the same market, assuming the cost structure of a monopoly is the same as that of a perfectly competitive industry.

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As perfectly competitive firms can make only normal profit and monopolists and oligopolists can make supernormal profit in the long run, the distribution of income in an economy that abounds with perfectly competitive markets will be more equitable than one that abounds with monopolistic markets and oligopolistic markets. Perfectly competitive firms are price-takers and hence they are unable to exploit consumers through price discrimination. Price discrimination is commonly considered a form of consumer exploitation as it will convert some of the consumer surplus to the producer surplus.

Price discrimination will be explained in greater detail in Section 6. Firms which reap more economies of scale are able to pass on their lower average costs of production to consumers in the form of a lower price. As a perfectly competitive firm is smaller than a monopoly, a perfectly competitive industry reaps less economies of scale than a monopoly and hence the price charged by perfectly competitive firms may be higher than the price that would be charged by a monopoly operating in the same market.

Perfectly competitive firms do not engage in research and development due to lack of ability and incentive and hence are dynamically inefficient. Product innovations will lead to greater product variety or higher product quality and process innovations will lead to a lower cost of production which may be passed on to consumers in the form of a lower price. However, research and development requires high expenditure which perfectly competitive firms are unable to finance as they can make only normal profit in the long run.

Furthermore, due to perfect knowledge, any innovation can easily and quickly be copied by other firms. Perfectly competitive firms sell homogeneous products and hence offer consumers no variety of choices. In contrast, monopolistically competitive firms sell differentiated products which offer consumers a great variety of choices.


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  • This output level is known as the minimum efficient scale. Nevertheless, it is good for them to state the condition. As discussed in Chapter 1, although productive efficiency is a necessary condition for allocative efficiency at the level of the economy, this is not true at the level of the firm. Therefore, a firm is economically efficient when it is productively efficient and allocatively efficient. In monopoly, there is a single large firm which dominates the whole market. A monopoly is a price-setter in the sense that it is able to set its price by setting its output level.

    In other words, a monopoly faces a downward sloping demand curve. In monopoly, there are high barriers to entry which means that the firm can make supernormal profit in the long run. An example of monopoly is the television broadcast market in Singapore. In the above diagram, the demand curve D of the monopoly, which is the average revenue curve AR , is downward sloping. If the firm wants to sell one more unit of the good, it must decrease the price. However, as the lower price will also apply to all the previous units of the good, the marginal revenue is lower than the price and hence the marginal revenue curve MR is lower than the demand curve.