1.

3 Theory of the Firm (HL ONLY) Part II

Sub-topic
Perfect Competition
Assumptions of
the model
Revenue curves

Profit
maximization in
the short run

HL Core Assessment Objectives

AO2 Describe the assumed characteristics of perfect competition:

A large number of firms, a homogeneous product, freedom of entry and
exit, perfect information and perfect resource mobility.
The shape of the perfectly competitive firms average revenue and
marginal revenue curves is perfectly elastic because each firm is a price
taker.
The perfectly competitive firms average revenue and marginal revenue
curves are derived from market equilibrium for the industry.
It is possible for a perfectly competitive firm to make economic profit
(supernormal profit), normal profit or negative economic profit in the
short run based on the marginal cost and marginal revenue profit
maximization rule.

AO4 Draw the diagram for perfect competition in the short run.
Normal Profits in Short Run

Abnormal Profits in the Short Run

Losses in the Short Run

Profit
maximization in
the long run

AO4 Draw the diagram for perfect competition in the long run.

AO3 Explain, using a diagram, why, in the long run, a perfectly

competitive firm will make normal profit. Explain, using a diagram, how a
perfectly competitive market will move from short- run equilibrium to
long-run equilibrium.

A firm might make abnormal profits in the short run. But in the long run,
since there is perfect knowledge and no barriers to entry, firms outside
of the industry that could also produce the good will also start to enter
the industry. As a result supply will increase and shift from S to S1. Since
firms in perfect competition are pricetakers, the price that they can
charge will start to fall and their demand curves will start to shift
downwards. This means that the abnormal profits that they had been
making will start to be competed away.

Efficiency

Similarly, a firm can make losses in the short run. But in the long run,
since there is perfect knowledge and no barriers to entry, firms will start
to leave the industry. As a result supply will increase and shift from S1 to
S2. Since firms in perfect competition are pricetakers, the price that
they can charge will start to rise and their demand curves will start to
shift upwards. This means that in the long run, in perfect competition,
firms will always make normal profits.
The condition for allocative efficiency is P = MC (or, with externalities,
MSB = MSC). The condition for productive efficiency is that production
takes place at minimum average total cost.
AO3 Explain the meaning of the term allocative efficiency.
Allocative Efficiency is where MC = AR. If price is greater than marginal
cost, then consumers value the good more than the cost to make it. If
both sets of stakeholders were to meet at the optimal mix, then output
would expand until price equals marginal cost. If marginal cost is greater
than the price, then society would be using more resources to produce
the good than the value it gives to consumers, and output would fall.

AO3 Explain the meaning of the term productive/technical efficiency.

A firm is productively efficient if it produces products at the lowest

average cost, where MC = AC.

AO3 Explain, using a diagram, why a perfectly competitive market

leads to allocative efficiency in both the short run and the long run.
Explain, using a diagram, why a perfectly competitive firm will be
productively efficient in the long run, though not necessarily in the short
run.

A firm in perfect competition will have both allocative (MC = AR) and
productive efficiency (MC = AC) in the long run as can be seen from the
diagram above. As previously explained, abnormal profits in the short
run will be competed away in the long run while losses will readjust to
normal profits due firms leaving the industry (no barriers to entry or

exit).
In the short run, however, there can be abnormal profits (see diagram
directly above) or losses. Even though production does not happen at
MC = AC, meaning that there is not necessarily productive efficiency,
there is allocative efficiency as production happens at MC = AR.
From this one can see that perfectly competitive firms can have
allocative efficiency in both the short and long run and productive
efficiency in the long run, but not necessarily the short run.

Monopoly
Total revenue,
average revenue
and marginal
revenue

AO2 Distinguish between total revenue, average revenue and

marginal revenue.
Total revenue (TR) is the total amount of money that a firm receives
from selling a certain amount of a good or service in a given time period
(TR = pq). Average revenue (AR) is the revenue that a firm receives per
unit of its sales (AR = TR/q = pq/q = p). Marginal revenue (MR) is the
extra revenue a firm gains when it sells one more unit of a product in a
given time period (MR = TR/q).

AO4 Illustrate, using diagrams, the relationship between total

revenue, average revenue and marginal revenue.

As previously stated, AR is equal to price and so it falls as output

increases, since the price has to be lowered in order to sell more
products. This is shown in the diagram above where the demand curve
is labeled as AR. MR also falls as output increases but twice as steeply
as AR and also goes below the x-axis. This relationship holds for all
downward sloping AR curves and the MR curves relating to them. MR is
below AR because in order to sell more products the firm has to lower
the price of the products being sold losing revenue on the ones that
could have been sold at a higher price in order to get the revenue from
the extra sales. For TR, extra units are being sold so TR rises; however,
in order to do this the price has to be lowered. As a result, for a normal
downward sloping demand curve TR rises at first but eventually starts to
fall due to lowered prices.
NOTE: You must be able to calculate total revenue, average revenue and
marginal revenue from a set of data and/or diagrams.

Profit
Assumptions of
the model

Barriers to entry

Revenue curves

Profit
maximization

AO2 Describe the assumed characteristics of a monopoly: (a single or

dominant firm in the market; no close substitutes; significant barriers to
entry.)
The assumed characteristics of a monopoly are that one firm is the
industry, there are barriers to entry and there can be abnormal profits in
the long run.
AO2 Describe, using examples, barriers to entry including economies
of scale, branding and legal barriers.
The barriers to entry include legal (e.g. pharmaceutical companies my
have a monopoly over a certain drug by getting a patent for it),
government granted monopoly (nationalized industry, e.g. water
company), brand loyalty (extreme brand loyalty can cause the brand
name to become the product, e.g. Scotch, Kleenex, Hoover etc.), anticompetitive behavior (a firm in a monopoly might charge restrictive
prices to stop competition, there may be a price war to force out the
new firm), natural monopoly (there is only space for one firm in the
industry, e.g. MVG in Munich) and economies of scale (these will work in
favor of the firm in the monopoly and against firms trying to enter the
market, for instance, banks may charge the new firms high interest on
loans while the monopoly firm will enjoy financial economies of scale).
The average revenue curve for a monopolist is the market demand
curve, which will be downward sloping. Know the relationship between
demand, average revenue and marginal revenue in a monopoly. A
monopolist will never choose to operate on the inelastic portion of its
average revenue curve because he/she will lose profits.
AO4 Draw the diagram for monopoly in the short and long-run

A monopoly can make abnormal profits in the short and long run so the
same diagram could represent both the short and long run of a
monopoly.

AO3 Explain the role of barriers to entry in permitting the firm to earn

Revenue
maximization

abnormal profit in the long run.

Since others cannot enter the industry due to barriers to entry, a
monopoly firms profits cannot be competed away and it can continue to
make an abnormal profit in both the short and long run.
AO3 Explain, using the diagram below, the output and pricing decision
of a revenue maximizing monopoly firm vs. a profit maximizing firm.
Be able to calculate from a set of data and/or diagrams the revenue

maximizing level of output.

Natural monopoly

Instead of profit maximizing, by producing at MC = MR a monopoly

firm may wish to revenue maximize by producing where MR = 0, as
can be seen from the diagram above. This means that the
monopolist will reduce the price from P1 to P2 and at the same time
increase output from Q1 to Q2.
AO3 With reference to economies of scale, and using examples,
explain the meaning of the term natural monopoly.
An industry is a natural monopoly if there are only enough economies of
scale available in the market to support one firm. For instance,
industries that supply utilities such as water, electricity and gas only
have room for one firm.
AO3 Explain the diagram illustrating a natural monopoly below.

Monopoly and
efficiency

Policies to
regulate
monopoly power

In this case, the monopolist is the industry and has the demand curve
D1. The long-run average cost curve faced by the monopolist is LRAC
and its position and shape are set by the economies of scale
experienced by the firm. The monopolist is able to make abnormal
profits by producing between q1 and q2 because the average revenue is
greater than the average cost for that range of output.
Despite inefficiencies, a monopoly may be considered desirable for a
variety of reasons, including the ability to finance research and
development (R&D) from economic profits, the need to innovate to
maintain economic profit, and the possibility of economies of scale.
AO3 Explain, using diagrams, why the profit maximizing choices of a
monopoly firm lead to allocative inefficiency (welfare loss) and
productive inefficiency.

As seen from the diagram, if a monopoly

profit maximizes by producing at MC=MR and produces at q1, it will not
have productive or allocative efficiency as production does not happen
at MC = AC, at q2, or MC = AR, at q3.
AO3 Evaluate the role of legislation and regulation in reducing
monopoly power.
Since monopolies have neither productive nor allocative efficiency, can
charge a higher price for a lower level of output and can exercise anti-

The advantages
and
disadvantages of
monopoly
compared with
perfect
competition

competitive behavior to keep other companies out of their industry,

governments can pass laws to restrict monopoly power. For instance, the
EU fined Microsoft for anti-competitive practices in 2009 due to bundling
Internet Explorer into its Windows operating system. Also, governments
can charge pharmaceutical companies for patents so that after a certain
number of years, that company no longer has a monopoly over a certain
type of drug.
Be able to draw diagrams and use them to compare and contrast a
monopoly market with a perfectly competitive market, with reference to
factors including efficiency, price and output, research and development
(R&D) and economies of scale.

Unlike a firm in perfect competition that will find it difficult to invest in

research and development, a monopolist can invest in R&D as they are
in a better situation through being able to make abnormal profits. This
would, in the long run benefit consumers, who would have better
products and even more choice.

Also, monopolists usually gain large

economies of scale pushing the MC cost downwards. As a result, unlike a
firm in perfect competition, it may be able to produce a higher output at
a lower price.

On the other hand, if significant economies

of scale do not exist, a monopolist may choose to lower output and
charge a higher price.
Also, monopolies have neither productive nor allocative efficiency (if
they choose to profit maximize), can charge a higher price for a lower
level of output and can exercise anti-competitive behavior to keep other
companies out of their industry, while a perfectly competitive firm has
both productive and allocative efficiency, are price takers and have no
barriers to entry.