Nikki Yturriaga

FIN - 222
Market Structures

(A) Give examples and evaluate the extent to which it is possible for a firm in perfect
competition to earn abnormal profits. Show it by using a graph.

Perfect competition is defined as a situation "in an industry made up of many small firms
producing homogeneous products, when there is no impediment to firm entry or exit, and
when full information is available" (Baumon and Blinder, 2011, p.200)

The interaction of supply and demand results in market equilibrium in the short run, which can
be defined as short-run perfect competition (See Figure 1).

Figure 1: Short-Run Perfect Competition

● When marginal revenues (MR) match marginal costs, an individual firm's profit can be
maximized under short-run perfect competition (MC). As shown in Table 1 above, a
company can produce a Q1 amount for P1 in order to achieve maximum profit levels.
● Additionally, as shown in Table 1, the company can produce abnormal or supernormal
profits in the near term for the duration of the time that the P1 price remains higher
than the average cost level (AC).

It's crucial to keep in mind, though, that not every business has the ability to make earnings that
are above average. Particularly, certain companies with greater average costs wouldn't be able
to make supernormal income.
Large numbers of businesses making abnormally high profits will encourage new businesses to
enter the same industry and increase output from already existing enterprises. If the level of
demand stays constant, this inescapable scenario will result in a price decrease from P1 to P2.
As a result, there won't be any more opportunities for businesses to make supernormal profits;
instead, they'll only be able to make normal incomes. (Figure 2)

Figure 2: Long-Run Perfect Competition

● It is crucial to note that a set of market entry barriers, such as capital and knowledge
requirements, scarcity of unique resources, technological factors, and so on, may have a
positive impact on businesses that are already operating in the industry in terms of
being able to generate abnormal profit for a long period of time.
● In certain statements, because of market entry barriers, new competitors may be
unable to enter the industry, allowing firms to generate abnormal profits for extended
periods of time. To demonstrate this point, consider the abnormal profits generated by
pharmaceutical and oil companies as a result of market entry barriers.

In summary, under perfect competition, businesses are free to enter and exit. When profits
are abnormally high, new businesses will be encouraged to enter the market. In order to
eliminate irrational gains, this raises market supply while lowering market pricing. In the long
run, a company cannot make excessive profits in a market with perfect competition.
 (B) Draw the diagram of a non-collusive Oligopoly. Explain the reason why firms will want
to keep their prices stable (price rigidity). Give judgment of good points and the
limitations with evidence.

The kinked-demand curve explains why oligopolistic enterprises resist pricing adjustments. If
one of them increases the price, the others will gain market share. If it lowers its pricing, the
competition will follow suit and all the businesses would make less money.

● P1 is the oligopoly's unit cost of production.

● In the event that one company raises its price (D1) but none of the others follow suit,
revenue will fall despite the price increase.
● If the company lowers its pricing (D2), the competition will follow suit in order to
maintain market share.
● The marginal revenue curve has a gap because the demand curve has a kink (MR1 -
MR2). Firms will maintain the price of their product as long as the marginal cost is
between MC1 and MC2, which explains why oligopolistic firms change prices less
frequently than firms operating under other market models. Firms maximize profit by
producing the quantity where marginal cost = marginal revenue.

While the kinked-demand model explains why oligopolies maintain pricing, its detractors
point out that it does not explain how its items were first priced. The fact that an oligopoly's
firms frequently alter prices when the economy undergoes considerable change, particularly
when there is high inflation, is also not explained. Oligopolistic businesses may even
participate in a price war in which they compete to offer the lowest price in order to acquire
market share.
The kinked demand model explains that any price increase will inevitably lead to a fall in the
firm's market share, whereas any price decrease will not lead to a rise in market share.
Additionally, businesses worry that every price reduction could lead to a pricing war. As a result,
an oligopoly experiences substantial pricing rigidity.

Example
Arryn, Inc. manufactures gaming consoles.

If there is no price competition, it faces a demand curve D1 given by the following demand
function:
P = 600 - 6Q
Alternatively, if other firms strongly match its price, its demand curve is D2:

P = 400 - Q
The following chart plots both the demand curves.

When a company raises prices and its rivals do not, it loses a large portion of its sales. The
demand curve D2 serves as a representation of this. However, when the company lowers its
price, its rivals likewise react, preventing the company from increasing its market share. The
demand curve D1 is steeper, which is a sign of this.

The firm's marginal revenue curve is discontinuous. Prices over the going rate are covered by
MR2, and prices below the going rate are covered by MR1. The marginal revenue curve is
vertical at the output level of 40. Assume that the marginal cost curve crosses the marginal
revenue curve at this point, resulting in an output of 40 that maximizes profit and corresponds
to a price of 360. This indicates that even if the marginal cost changes at this output level, the
profit-maximizing output level will not change. The price won't change if the output that
maximizes profits stays the same. This demonstrates how sticky prices are in an oligopoly.

References:

https://thismatter.com/economics/oligopoly-pricing-models.htm

https://research-methodology.net/profit-levels-in-short-run-and-long-run-perfect-
competition/
References: Baumol, W. & Blinder, A. (2011) “Microeconomics: Principles and
Policy” 12th edition
https://byjus.com/question-answer/why-can-a-firm-not-earn-abnormal-
profits-under-perfect-competition-in-the-long-run
https://ask.learncbse.in/t/why-can-a-firm-not-earn-abnormal-profits-under-
perfect-competition-in-the-long-run-explain/8942