Question: Book 2 - Efficiency and Monopolies

[oatmeals2]

This is in reference to Book 2 Economics page 120 Figure 1a.

I'm quite stumped here. I've searched online as well and the material I found was not too helpful hence I've decided to ask here.

If you look at Figure 1a, you will see figure for short run output of a monoplistic firm. They are able to make a nice chunk of change from P*-C*.

Now look at Fig1b. This is what the firm will look like because of competition from new entrants (or the threat of) which causes C*= P * which causes economic profit to equal zero.

I know the golden rule of efficiency is: P = MC = MR = LRATC (Long run ATC)
However, MR=MC=P on either fig1a or fig1b is *lower* than P*,C* and even ATC. This obviously violates the "golden rule".

Anyone have any ideas what I am missing?

(Btw, if the "golden rule" is stated many times but you can find it on pg 130 in the first paragraph of LOS23.g.

Thanks in advance!

 

[DeadCat]

Ok, follow these steps:

1) The key thing to remember is that most firms are too small to influence the price - they are price takers. Monopolies are not - they are price makers. When they increase output they reduce the price.

2) Firms will increase output to the point that MC = MR. This is true of all firms. Always. This is the "Golden, Golden, Golden Rule".

3) In perfect competition Price = MR because they are price-takers. So it just happens that MC = MR = Price.

4) In perfect competition there are no barriers to entry, so MC = LRATC. Dont worry about this too much at this stage.

5) Monopolies are price-makers. They will increase output to the point that MC = MR. If they produced one more unit they would make less money (MC>MR), and if they produced one more unit they wouldn't maximise income (MC<MR).

6) Price does not equal MR at this point. This is because they are so large that their output affects the price. If they lower their prices to win over one more customer, they will lose revenue because ALL customers will pay this lower price. After the MR=MC point the net effect is to reduce profits.

7) Since they produce at a point where MR=MC. At this point the price > Average Cost and therefore supernormal profits (AKA 'Economic profits') are made.

8) Clearly such supernormal profits are attractive and this leads to 'Rent seeking' whereby organisations or companies campaign to create monopolies.

 

[DeadCat]

You're welcome, c*nt.