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Economics Questions
Steven Ma Ching
Green Bay High School
1. State ALL requirements/special behaviour/characteristics/features of the
following market situations you can think of (don't leave anything out :P, write
whatever you know):
- Perfect competition
- Monopolistic competition
- Oligopoly
- Duopoly
- Monopoly
Perfect competition:
Requires perfect knowledge, perfect information, perfect mobility of factors.
All buyers are price-takers, all sellers are price-takers i.e. there is no market
dominance that can be exploited to change price, all must accept the equilibrium
price. There are many buyers and many sellers.
Firms sell a homogenous product, and therefore cannot charge more than another
competitor as consumers will simply shift to a cheaper supplier. Increasing price by a
fraction of a cent results in nothing sold, and no competitor would lower price (their
output is so insignificant that they would not gain market share from doing so).
There is freedom of entry/exit. If supernormal profits are made in the long term,
market supply will increase (perfect information alerts entrepreneurs to join the
market), and price will fall until normal profits are made. The reverse happens when
subnormal profits are made in the long term, as market supply will decrease and price
will rise.
The demand curve faced by an individual firm is horizontal, i.e. D = P = AR = MR.
Perfect competitors operate at P=MC, or marginal cost pricing.
Monopolistic competition:
Monopolist competition introduces slight product differentiation into the perfectly
competitive market. This is the sole difference between the two market structures.
Monopolistic competition is a form of imperfect competition, while being the closest
to perfect competition.
Because there is slight product differentiation (e.g. colour/location/service), the
monopolistic competitor is able to make supernormal profits in the short term. This
relies on brand loyalty, because if they raise price then not all customers will go
elsewhere – the monopolistic competitor faces a downwards sloping demand curve.
In the long term, the monopolistic competitor loses it’s edge over competitors as they
copy whatever allows another firm to make supernormal profits. Monopolistic
competition has weak barriers to entry and many sellers.
Oligopoly:
Economics Questions
Steven Ma Ching
Green Bay High School
An oligopoly is when few very large firms dominate the market. Each sells a strongly
differentiated product and has strong price control due to market share. The barriers to
entry are very high, often in the form of capital costs as unless a start up was large, the
other competitors could easily eliminate it from the market by charging lower prices.
Price competition is avoided as it can result in price wars (which are illegal in New
Zealand). This is when firms repeatedly undercut each other’s prices until all firms are
making losses, if this continues in the long run then only one firm will survive, and
gain monopoly power.
An oligopoly faces a kinked demand curve, if a competitor tries to increase price –
competitors will not change their prices and quantity demanded from the individual
firm will fall more than proportionately to the increase in price (elastic demand). If
price is lowered, then competitors will lower their prices to match and quantity
demanded from the individual firm will increase less than proportionately than the fall
in price (inelastic demand).
Non-price competition is extremely high, especially advertising. A lot of waste is
created from an oligopoly as so much is spent to get a consumer to simply switch
brands (e.g. toothpaste ads, new toothpastes come out almost every week, this
requires marketing, development, etc. when any toothpaste will do).
Duopoly:
A duopoly is very similar to an oligopoly, except with only two very large firms.
Barriers to entry are very strong, there is strong product differentiation.
Often duopolistic competitors will hide behind several brands or names to give the
appearance of increased competition. For example, supermarkets in New Zealand and
owned by Progressive and Foodstuffs, there are a few independent operators, but this
is virtually a duopoly.
Monopoly:
The ‘no-competition’ market structure. A single firm dominates over the market
completely, and there are no close substitutes to the product the firm offers.
The monopoly faces the entire market demand curve, and is able to choose the
quantity it sells by raising/lowering price. Therefore the firm can operate at MC=MR
(the profit maximising point) and gain supernormal profits in the long term without
concern of competition – barriers to entry are so great (sheer size of the existing firm,
patents, legal costs, capital costs) that no other firm can enter the market.
A monopoly will not advertise as there is no need. Monopolies avoid duplication of
services (e.g. why would we need 4 different railway providers in Auckland, or seven
malls in one area?) and often they can produce more efficiently/cheaply than other
market structures, reaping benefits such as economies of scale.
Economics Questions
Steven Ma Ching
Green Bay High School
2. Explain what type of profit a perfect competitor may make in the short term
and how this changes over time.
A perfectly competitor can make subnormal, normal, or supernormal profits in the
short term.
If a perfectly competitive market is producing supernormal profits (AR>AC) then
because there is perfect information and no barriers to entry, entrepreneurs will join
the market, and market supply will increase, decreasing the market price. Perfect
competitors are price takers, and must now accept a lower price. Supernormal profits
are eventually eliminated.
If a perfectly competitive market is product subnormal profits, the reverse situation
occurs. Market supply decreases as firms who are unable to compete leave the market
as there is no barriers to entry. As market supply decreases, the market price increases
and firms now gain a higher price for their goods. Subnormal profits are eliminated in
the long term.
A perfectly competitive market produces normal profit in the long term.
3. Explain why an oligopoly faces a kinked demand curve.
(Taken from question one…lazy)
An oligopoly faces a kinked demand curve, if a competitor tries to increase price –
competitors will not change their prices and quantity demanded from the individual
firm will fall more than proportionately to the increase in price (elastic demand). If
price is lowered, then competitors will lower their prices to match and quantity
demanded from the individual firm will increase less than proportionately than the fall
in price (inelastic demand).
4. Explain the profit maximising rule and how it applies to perfect competition
and a monopoly.
The profit maximising rule is where MC=MR. This is also called the loss minimising
rule. If MC>MR, then some units are costing more to produce than the revenue they
are generating and output should decrease to maximise profit. If MC<MR, then costs
of producing a unit could still rise before no profit is generated from producing the
unit, so output should increase to maximise profit.
A perfect competitor is a price taker, so P=MR=AR=D. In the long run, AC=AR so
normal profits are made at the profit maximisation point.
A monopoly is able to choose either the market price or quantity, and generally
operates at MC=MR in the long term, so if this results in supernormal profits
(AR>AC) then they can maintain these as long as they retain monopoly power.
Economics Questions
Steven Ma Ching
Green Bay High School
5. Explain the law of diminishing marginal utility and how it relates to the
demand curve.
As more of a good/service is consumed, the additions to total utility will decrease. i.e.
marginal utility will fall as consumption rises.
Rational consumers will only consume up to the point P=MU, as if P>MU the
satisfaction gained is less than the price.
Therefore, if a consumer is going to demand more of a good or service, the price
must fall to match the decreased marginal utility. Therefore the demand curve is the
same as MU=P.
6. Explain the law of diminishing returns and how it relates to the production
possibility curve and the supply curve.
The law of diminishing returns states that in the short term, at least one factor is fixed
and therefore as output rises more and more units of a variable factor are required to
produce an extra unit. i.e. the variable factors contribute less and less to total product
as output rises. In the long term, firms can expand all factors and do not face
diminishing returns.
A concave-to-the-origin production possibility curve shows that resources are better
suited to producing one good than another. As we reach the extreme ends of the
curve, the opportunity cost (the amount of production of another good sacrificed)
increases at an increasing rate. There are diminishing returns because there is a fixed
amount of available resources and technology. Over time, we can discover more
resources/improve technology and our productive capacity increases (at which point
we can increase production without having to sacrifice production of another good,
i.e. no opportunity cost).
A firm will only supply a good/service if the price they receive is at least the cost of
producing it (e.g. MC=P). In the momentary period, all factors are fixed and quantity
supplied cannot increase at all (perfectly inelastic supply). In the short term, costs of
producing an extra unit of output are greater (as diminishing returns occur). In the
long term, firms do not face diminishing returns (and costs are lower) and their supply
is more elastic.
7. Explain the difference between accounting profit and economic profit, give an
example to show the difference.
Profit in both accounting and economics is measured as revenue less costs. The
difference between accounting profit and economic profit is how costs are measured.
Accounting costs are explicit costs, ones which can be easily measured, e.g. rent,
electricity. Economic costs are accounting costs plus implicit costs/opportunity cost.
Economic profit will therefore always be less than accounting profit, as there is
always an opportunity cost.
Economics Questions
Steven Ma Ching
Green Bay High School
For example – a firm uses old technology and therefore is losing sales to competitors
with newer technology, the old technology cost the firm very little to buy. An
accountant argues that the only cost is the running costs. However an economist
argues that it costing them both to run, and in the opportunity cost of using newer
technology, being more efficient and having greater sales.
8. Explain the terms 'break-even point' and 'shut-down point'
The break-even point is where P=MC=AC, i.e. the lowest point of the AC curve. This
represents the point where a firm is making just enough to stay in operation long term,
i.e. normal profit.
The shut-down point is where P=MC=AVC, i.e. the lowest point of the AVC curve.
And represents the point where a firm will stop operation immediately if price falls
any lower.
If P<AVC then the firm is not covering variable costs and every unit produced is done
so at a loss. They are better off shutting down, producing nothing and paying only
fixed costs and waiting to see if conditions improve.
If P>AVC, then they are covering the costs of producing extra units (variable costs),
but not all fixed costs. Operation should continue until fixed costs recur as anything
left after paying variable costs contributes towards fixed costs.
In the long term, a firm will shut down completely if it falls below break even.
9. What is product differentiation? Give examples.
The creation of real or imagined differences from a similar product through the use of
advertising, branding, product innovation, etc.
For example, imaginary differences can be made through advertising, spending on
packaging. How many of you believe that the budget brands (which offer no fancy
packaging) are inferior to other brands? People prefer Watties over Oak spaghetti, but
they are produced in the same place and are almost identical except for the label.
Real differences are created through other methods such as product innovation,
service. For example, the first manufacturer to product a plasma television
differentiated their product by offering something new and exciting.
10. State how price-competition and non-price competition relate to the following
market structures:
- Perfect competition
- Monopolistic competition
- Oligopoly
- Monopoly
Economics Questions
Steven Ma Ching
Green Bay High School
Perfect competition: There is no price-competition or non-price competition, all firms
are price-takers and sell a homogenous product.
Monopolistic competition: There is price competition, and some non-price
competition (a slightly differentiated product).
Oligopoly: Price competition is avoided as it results in price wars, non-price
competition is extremely high because it is the easiest way to gain market share.
Monopoly: There is no price-competition or non-price competition, there is no
competition at all.