Theory of the Firm
- Market power is the ability of a firm to raise the market price of a good or service above the marginal cost.
- The firm is able to influence market outcomes by restricting output in order to increase price.
Market Structure
- The categorizing of firms in a particular industry, based on:
- The number and size of firms in the industry.
- The nature of barriers to entry to the industry (extent to which the market is contestable).
- The degree and intensity of price and non-price competition in the market.
Types of Markets
Perfect Competition
- Many small firms
- Identical/homogeneous products (many substitutes)
- Low or no barrier to entry
- Perfect knowledge for everyone
- No market power = no control over price
- Firms are price takers
- Perfect competition is typically efficient
- Only theoretical
- Not preferred by firms due to no profit
Monopoly
- Single dominant firm
- Unique product (no close substitutes)
- Extremely high barriers to entry (difficult for firms to enter and exit the makret)
- Dominant market power = control over price
- Firms are price makers
Monopolistic Competition
- Many firms
- Differentiated products (similar but different)
- Low barriers to entry (easy for firms to enter and exit the market)
- Limited market power
- Rely heavily on branding and advertising
- Everyone has a really small monopoly for their own brand
- Each firm tries to increase the size of its monopoly
Oligopoly
- A few large firms
- Identical or differentiated products
- High barriers to entry (easy for firms to enter and exit the market)
- Limited market power
- Strong interdependence between firms
- BARRIERS TO ENTRY
- The term "barriers to entry" refer to the degree of difficulty involved with firms entering or exiting a market
Types of Barriers to Entry
Economies of Scale
- Economies of scale is how production becomes cheaper when the quantity of production is increased.
- For example, to start a small factory, you have to pay for the real estate and a large building and lots of infrastructure to be constructed.
- However, to increase production, you only need to purchase new machinery, which is cheaper in comparison.
Innovative technology
- Some firms use very complicated technology to produce their products.
- This technology might not be available for other firms, possibly due to protection such as patenting.
- In that case, the research and development costs required for the technology will be discouraging for firms that want to enter the market.
Geography or Ownership of Raw Materials
- Certain firms have access to geographic advantages and raw materials that other producers do not have access to.
For example DeBeers has access to much of the world's diamond mines, making competition very difficult.
Government Created Barriers
- The government may only approve certain firms to enter markets.
- The additional requirements for licensing or approval can be a deterrent to those wanting to enter the market.
- For example only firms whose products have been approved by the government can sell medicine.