The short run is defined as a period when at least one of the factors of production is fixed, therefore it is possible in the short run for individual firms to make supernormal profits or losses. Suppose the price determined by the market forces of demand and supply is high due to high demand relative to supply.
Price Costs D S and MC Revenue P MR AC 0 Quantity 0 Q Quantity
The firm maximizes its profits when the price and output combination is such that the marginal revenue of an additional unit of output is equal to the marginal cost of producing it. This is at output OQ were MC = MR. At this level of output, the AR (representing TR) is much higher than AC (representing TC). In short, the price charged is greater than the long run average costs
MC AC P= AR= MR Q 0 QUANTITY
incurred, the difference are the supernormal profits made by the firm (represented by the shaded area).
Alternatively, the firm can make losses if the price determined by the market forces of demand and supply is low. This can happen when market demand is low while market supply is high.
Costs Price and Revenue MC AC D S 0 Quantity 0 Q Quantity
The firm maximizes profits at output OQ where MC = MR, at this level of output, AC is much higher than AR and the firm makes losses.
2.3 Long run equilibrium position
There are no barriers to entry, firms are free to enter and to exit. Profits and losses can only occur in the short run. Where profits are made, they are competed away through the entry of new firms and where losses are made, firms will leave.
REVENUE AND
The firm maximizes its profits at OQ where MC = MR. At this output level, AR is also equal to AC. Individual firms earn normal profits only, in the long run.
In addition, at this level of output, AC is also equal to MC, the firm is operating at its most cost effective point, where costs are at their lowest level, an indication that the firm is technically efficient.
The firm is also allocatively (or economically) efficient since the price charged to the consumer equals the marginal cost of its supply. The price is equal to the demand curve and the marginal cost curve is in effect the individual firm’s supply curve. Economic efficiency occurs where demand equals supply.
The unique feature of the long run equilibrium position is that all firms in the industry have MR = MC = AC = AR = P = D.
Perfect competition is a theoretical model, but it sets a benchmark for efficiency and firms should strive to attain the desired benchmarks.
3.0 MONOPOLY
In this market structure, one firm is the sole supplier of a product or service that has no close substitutes. The firm makes up the industry.
3.1 Characteristics
The following characteristics features must be met for a monopoly to exist. - There is only one supplier of the product or services
- The product or service has no close substitutes - There are barriers to entry
3.2 Demand curve
A monopolist being the sole supplier has market power and therefore the firm is a “price maker”. However, the firm can only determine either the price or the quantity, but not both at the same time. At high prices, few quantities are bought, while at low prices, demand is high.
Therefore, the monopolist is faced with a downward sloping “normal” demand curve.
MC Q* P 0 PRICE OUTPUT CO LMR Economic Profit Price P = D = AR Output
3.3 Equilibrium position
The firm maximizes its profit at OQ where MC = MR. The price charged, the average revenue is greater than the average cost. This difference is the supernormal or Economic profits earned by the monopolist, represented by the shaded area of the rectangle.
The monopolist is likely to earn supernormal profits in both the short run and the long run because of the barriers to entry, the supernormal profits are not ‘competed away’ by other firms.
The equilibrium position is illustrated in the diagram below.
AC AR
3.4 Barriers to entry
Barriers limit competition in the market. Firms are prevented from increasing the supply, pushing the supply curve to the right or pushing the demand curve to the left, which reduces the price, and eliminates the supernormal profits.
Barriers to entry explain why monopolies continue to exist. Some of the entry barriers are as follows:-
- Government legislation.
Governments may play a major role in the creation of monopolies. A good example is the Zambia Electricity Supply Corporation (ZESCO), which is the sole supplier of electricity. The government may also be more comfortable when one organization is marketing an essential product like maize. Such as the former grain marketing boards (NAMBOARD) or the Food Reserve Agency (FRA).
- Control of the source of supply for raw materials.
This gives the firm an advantage, as the other firms do not have access to the necessary raw materials to produce a product.
- Legal barriers in terms of patent and copyrights
These grant a creative and innovative person or firm that has invented a product, written a book, composed a song, the exclusive right to enjoy the benefits or profits from that work, preventing others from exploiting that work.
- Immobility of factors of production.
Resources are not mobile, including labour. This is worsened by the formation of trade unions and professional associations. In addition, a single firm may control a natural
resource such as copper, which is found in the copper belt, no close substitute, and no other firm can set up a competing firm.
- Indivisibilities, the amount of fixed costs that a new firm would have to sustain would act as a natural barrier to entry.
- The minimum efficiency scale, which is the level of output at which the average costs first reach their minimum point, may be at a very high level. A new entrant might need to spend a lot on advertising, and sales promotion in order to compete effectively with existing companies and to increase the market share. The cost involved might again, act as a natural barrier to entry.
3.5.0 Price discrimination
Price discrimination means charging different prices to different groups of consumers for the same product or service. Price discrimination is the same product or service being sold at different prices in different markets. A firm may increase its revenue by charging high prices in some markets while lowering the price in other markets but the sales volume increases, given the fact that TR = Quantity X Price. Either an increase in the quantity sold or an increase in the price leads to an increase in the total revenue. A monopolist cannot control both the price and quantity even if the firm is in an advantageous position and has market power.