Imperfect Competition

An explanation of the equilibrium of a firm operating under conditions of imperfect competition

Conditions / Assumptions 23/05/2019 Conditions / Assumptions There are many firms in the industry, each producing goods that are unique but which are also substitutes for each other. There are many buyers in the industry. Product differentiation takes place. Firms aim to make maximum profit. There is full knowledge of profit levels being earned in the industry. There is freedom of entry into and exit from the industry. The firms do not have a perfectly elastic supply of the factors of production, i.e. the firms may have to compete for the factors of production. R Delaney

Short Run Equilibrium Initially one firm sets up the industry. This firm is thus a monopolist in the short run. The short run equilibrium in imperfect competition is the same as that of a monopolist.

Short Run Equilibrium Quantity The firm aims to make maximum profit. AR MR Quantity AC MC Price Quantity The firm aims to make maximum profit. Thus it will produce the quantity where MR = MC so long as MC > MR after that, i.e. 120. 120

Short Run Equilibrium Price AR MR Quantity AC MC Price 120 Price To get the price (AR) for quantity 120, draw a line from 120 on the Quantity (x-)axis up to the AR curve and across to the Price (y-)axis. €15 This gives a price (AR) of €15.

Short Run Equilibrium Profit level €15 AR MR Quantity AC MC Price 120 Profit level Profit level is the difference between AR and AC. (In this case, AR is €15.) The AC is €7. €7 As AR > AC the firm is earning supernormal profit (SNP).

New Firms Enter the Market Because SNPs are being earned in the industry, other firms are attracted into the market. This increases the total supply of the industry, thus causing a downward shift in AR (price). Quantity Price AR (1) AR (2) AR (2)

Costs Increase The increase in the output of the industry causes an increase in the demand for the factors of production being used. This in turn causes an increase in their price, i.e. the cost of the factors of production begin to increase – thus AC increases. AC2 Quantity Price AC1 AC2 AC1

Thus the SNPs eventually will be eliminated. 23/05/2019 Movement of AR & AC Curves Thus two things happen together: AC2 Quantity Price 1. AR goes down. AC1 2. AC goes up. This continues as more firms enter the market. AR1 Thus the SNPs eventually will be eliminated. AR2 Q1 R Delaney

LR Equilibrium in Imperfect Competition Quantity Quantity Price AR MR The firm aims to make maximum profit. MC AC Therefore it will produce the quantity where MR = MC as long as MC > MR after that, i.e. 125. AR MR 125

LR Equilibrium in Imperfect Competition Price Quantity Price MR AR To get the price for quantity 125, draw a line from 125 on the Quantity axis up to the AR curve and across to the Price axis: €17. MC AC €17 AR MR 125

Note that AC is not at its lowest at the equilibrium quantity. LR Equilibrium in Imperfect Competition Profit level Quantity Price MR AR The AR is €17 and the AC is also €17, therefore the firm is earning normal profit. MC AC €17 Note that AC is not at its lowest at the equilibrium quantity. AR MR 125

Summary AR = AC because the firm is earning normal profit. MR = MC because the firm is earning maximum profit. AR and AC > MR and MC. AC is not at its lowest point.

Why AC is not at its lowest point 23/05/2019 Why AC is not at its lowest point There is an extra “non production” cost of competitive advertising. AR is a tangent to AC at equilibrium. Thus the degree of slope of both AR and AC must be identical at the point where they touch. AR (a normal demand curve) is downward sloping; therefore, AC must also be downward sloping at that point. Therefore AC can’t be at its lowest point at equilibrium. R Delaney

Advantages of Imperfect Competition It offers the consumer a choice of goods. The competitive advertising undertaken by the industry creates employment in the advertising industry. Extra sales generated by the advertising may create extra employment. The money spent on advertising often reduces the price of newspapers, magazines, etc. to the consumer. This same logic applies to sponsorship by companies of sporting, cultural and social activities. Consumers are not exploited as only NPs are made.

Disadvantages of Imperfect Competition The firm does not produce at the lowest point on the AC curve. This indicates a waste of economic resources. The cost of the competitive advertising undertaken by the firms is frequently passed on to the consumer in the form of increased prices. This is a waste of the consumers’ resources. Excess capacity. No firm is producing to the full extent of its capacity. There are so many firms in the industry competing with each other that none of the firms can fully gain the advantages of the economies of scale.