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Summary of the price system and the theory of the firm
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Summarised part of the price system and the theory of the firm
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MCAT
C
P
P Optimum
Cost/ 1
revenue
D=AR
MR
Output
Barriers to entry
The existence of substantial barriers to entry is what differentiates an oligopoly and
monopoly from perfect and monopolistic competition.
Natural monopoly: Where a single supplier has substantial cost advantages such
that competing producers would raise costs and where duplication will produce an
inefficient use of resources.
Barrier to exit: Any restriction that prevents a firm leaving a market.
Limit pricing: Where firms deliberately lower prices and abandon a policy of profit
maximisation to stop new firms entering the market.
Below are some of the main barriers:
● In some countries, it may be impossible for new firms to enter the market
because the monopoly is state-owned or the goods are produced under
licence from the government. This is a legal monopoly usually created to
achieve social and political objectives. The economic justification might lie in
the concept of a natural monopoly, where it is more efficient to have a single
, producer than to have competing firms, for example in the case of railways.
When moving from a planned economy to a free market, privatisation and
deregulation is justified because economists believe the economy would
benefit from increased competition and will bring additional economic and
social benefits through a more efficient allocation of resources.
● The high fixed cost or setup cost in activities such as electricity generation,
aircraft and car production and pharmaceuticals may deter potential entrants.
The barrier here is access to capital. Research and development will
represent a large proportion of total costs and it will require a large amount of
sales over a long period of time to make profit.
● If a firm is shutting down and some costs such as research and development
cannot be recovered. The resources are specialised and are not easily
transferable to other uses. They are regarded as sunk costs and act as
barriers to exit from the industry because the capital investment will be lost.
It is therefore the risk of entering and the high cost of failure which may deter
new entrants.
● Advertising and brand names with a high degree of consumer loyalty may
prove a difficult obstacle to overcome.
● Economies of scale can be a barrier because the existing large producers
are able to produce at a lower average cost than those starting up. They also
give large firms an opportunity to cut their prices so that no high-cost
producers can keep up. This is predatory pricing.
● A patent may be protecting a legal monopoly as new firms cannot enter the
market without their permission. This idea wants to guarantee rewards to
entrepreneurs with original ideas for a reasonable period of time. The barrier
here is access to technology or information.
● Some existing firms may have monopoly access to raw materials and
resources. Vertically integrated businesses where a firm is specialist in
various stages of production, will be protected by the fact that their rivals’
costs will be higher.
● The pace of product development is important in industries such as
consumer electronics, where producers will be creating a new generation of
products while selling the current ones. Unless the new entrants have original
ideas or can exploit a new market segment, they are destined to fail.
● Existing firms may hide abnormal profit to deter new entrants by limit pricing.
If firms agree to this, it becomes a form of collusion.
● Collaboration between existing producers to develop new products may act
as a barrier in that the resources necessary to compete are beyond the
means of single new producers.
● Market conditions such as a fall in demand resulting from recession, will
leave firms with surplus productive capacity and this will deter entry.
Oligopoly
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