X-Innefficiency

   While we are constructing average-total-cost curve, we assume that firms have the most efficient technology. In other words, the firm owns the technology that permits to achieve the lowest average-total-cost at whatever the quantity output is. X-Innefficiency is the failure of firm to produce any specific output at lowest possible average total cost.
Why does X-inefficiency occurs if it reduces firm’s revenue? The answer is that some entrepreneurs may have such goals as easier work time, corporate growth, avoidance of business risks or giving some jobs to their relatives that aren’t competent in performing them, so these causes may be in conflict with cost minimization. X-inefficiency also may arise when firm’s workers are poor motivated or under-supervised, also it happens when a firm is inert when it comes to making decisions about future business actions.
Question is where more likely X-inefficiency is prevailing: monopolistic or competitive industry? Firms in competitive industry are under pressure from rivals, so that they are forced to be efficient at production if they want to survive and get profit, but monopolists are protected from such competition and pressure by entry barriers, so that lack of this pressure may lead to X-inefficiency.
There is one general evidence that probability of X-inefficiency increases as competition decreases. Also, it is estimated that X-Inefficiency may be 10% or more of costs for monopolies and just 4% on average for oligopolies where four biggest firms produce more than 60% of total output.  There were a saying :” X-inefficiency exists and it’s more possible to be reduced when there is competitive pressure on firm rather than it is isolated”.

In the figure shown above, both costs are higher than minimum ATC, this implies that in this firm(industry) X-inefficiency exists, since the firm(industry) is operating at greater than lowest cost of a specific level of output. For Q1 ATC should be 1, but for Q2 ATC should be 2.

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Output and Price Determination in Pure monopoly

So at what price-quantity combination will pure monopolists choose to operate?
     MC=MR Rule
The monopolist seeking to maximize its profits will have the same rationale as a firm in a competitive industry. It will produce one more unit of output only if it adds more to total revenue than to total cost. The firm will increase its output till the point where MR=MC.
One more way to find profit-maximizing output is by comparing total revenue and total cost at each quantity of production. The quantity for which this difference has the greatest possible value is the one which offers maximum profit.
No Monopoly Supply Curve
   In pure competitive market MR=P (price) and supply curve of a pure competitive firm is determined by applying P=MR=minimum ATC profit-maximizing rule, so in a pure market the seller will maximize profit by supplying the amount of goods for which MC= P. Thus, in a pure competitive market the amount of goods produced depends on the price.
   We may say that pure monopolist’s marginal-cost curve will be also its supply curve, but it is wrong. The pure monopolist has no supply curve, because there is no a unique relation between quantity supplied and price set by a monopolist. Like pure competitor firm, monopolist equalizes MR with MC to determine the quantity output, but for monopolists marginal revenue is less than price. Also, because monopolist doesn’t equalize marginal cost to price, it may have different prices for the same amount of output.

Misconceptions about Monopoly Pricing
Highest Price
   People often believe that monopolists will try to get highest possible price for their goods and services, because they can manipulate price, but this statement isn’t correct. There are some prices for which monopolists will get smaller-than-maximum profit, so they will try to avoid them. Monopolists are trying to get maximum total profit, but not maximum price. Some High prices will reduce dramatically quantity sold and total revenue, so that monopolists will try to produce a decrease in cost.
Profit
   Monopolists seek maximum total product, not maximum unit profit. They will choose smaller unit profit, not the maximum one, because additional sales add to total revenue. For example a profit-seeking monopolist will sell five units of a good at 37$ (total profit 185$) than four units at 40$ (total profit 160$)
Losses
   Monopolists are more likely to get economic profit than pure competitor.  In long run pure competitor is destined to get only normal profit, but price adjustment ability and barriers at entry at monopolists offer them possibility to get economic profit.
   But pure monopoly doesn’t always guarantee profit. It is neither immune to change in taste of consumers that reduces demand for the product nor to change in price of resources. So an industry can suffer great losses because of relatively low demand and high resource prices.
   Like pure competitors, monopolists won’t continue to operate in an industry where they get continued losses. So if they are faced with this situation, pure monopolists may move their resources to alternative uses that offer better opportunities for economic profit. Thus, monopolies can also realize normal profit in long run.

Barriers to entry in a Pure Monopoly

   A pure monopoly is a market model in which entry is blocked. So what factors (barriers to entry) prohibit firms to enter this industry?

Economies of Scale
   Modern technology in some industries is such that it permits extension of economies of scale- declining ATC (average total cost). So a firm’s production price will decline if a wide range of output is produced. Given a market demand, only a few large firms, or even a single one, can achieve low average total costs. When long-run ATC is declining only a single producer, a pure monopolist will be able to produce any particular output at minimum total cost.
   If pure monopoly exists in an industry, then economies of scale will serve as entry barriers and will protect the monopolist from competition. New firms will try to enter the industry as small-scale producers but they won’t be able to produce the output at that small price produced by monopolists, so these small firms won’t be able to obtain normal profits needed for survival. A new firm might try to enter as a big producer, but the massive plant output will require very huge amount of financing, which for a new and untried firm will be very difficult to get. In most cases the financial obstacles and risks to start a big business are hinders, that’s why entering in a pure monopoly market system is rarely successful.
   There may be some cases in which market demand curve is cutting long-run ATC curve in a point where ATC curve is still declining  we say that in this case a natural monopoly exists.  So if ATC curve is declining we might say that this firm may set a lower price for its products, but this doesn’t really happen. Conversely, a natural monopolist might set its product’s price far above ATC, so that it obtains an economics profit, that’s why government has to regulate price charged by natural monopolists.

Patent
    A patent is investor’s right to use his or her own invention. Patent and patent’s law protects inventor from rivals who use the invention without helping with expenses or effort at developing it.
   Research and development is what provides our world with new amazing inventions. Firms may get monopoly power by researching or purchasing patents from other firms so they may strengthen current market position.
   The profit from one patent can finance the research for other patentable products. So, monopoly power achieved through patents may self-sustain firm, even if they eventually expire.

Licenses
   Government may limit entry into an industry by licensing. In a country only a small number of licenses for telephone operators may exist. That’s why new telephone operators can’t enter this industry. In some cases government may license itself at providing some products and that’s how it creates a pure monopoly.

Private Property
   A monopolist may use private property as an obstacle to eliminate rivals. So a firm that controls an important resource needed for production of a specific good may effectively block entry of new rival firms.

Pricing
   In some cases a monopolist may create entry barriers by cutting products’ prices, stepping up advertising, or taking other strategic actions to make entrance for a new firm difficult.

Pure Monopoly

   Pure monopoly happens when one firm is the single supplier of a product for which there are not substitutes. Some of the main characteristics of pure monopoly are:

• Single Seller– A pure monopoly is an industry in which a sole producer is the single supplier of a specific good or service in this market model.
• No Close Substitutes– A pure monopoly’s product is unique and there aren’t any close substitutes for it, so that consumer has to choose to buy or not to buy the product.
• Price-maker– The pure monopolist controls the quantity supplied of good and service, so that it controls the price.  This kind of firm or industry is called price-maker, unlike pure competitors which are price-taker, because they can’t control the price, since quantity produce by them is very small relative to total quantity output. The pure monopolist confronts downward-sloping curve.  So it can change the product’s price by changing the quantity of good that it produces. The monopolist can use this advantage to maximize its profits.
• Blocked entry– A pure monopolist doesn’t have any competitors because there are some barriers that keep competitors away from entering the industry. These barriers may be technological, economical or some other types, but the fact remains that no other firms may enter in our pure monopoly market.

 There are very rare examples of pure monopoly, but there are examples of some less pure forms of it. In many countries many government-owned or government regulated public utilities (gas, water, electricity) may be monopolies. Also, some professional sport teams are thought to be monopolies, because they are suppliers of unique service in large geographic areas. Examples may serve some major football matches like between Real Madrid and Barcelona in Spain, which serve as representative of large cities in Spain.  In some small towns airline service or train-transport may be pure monopolies if they are represented only by one firm in these regions. Also, in some very small areas banks, pharmacies or theaters may be examples of pure monopolies.

Pure Competition and Efficiency

      A purely competitive industry whether decreasing cost, increasing cost or a constant cost one should have some basic characteristics so that in long-run we may be able to talk about its economic efficiency. In a long Run a triple equation exists: P (Marginal Revenue) =MC =minimum ATC, which besides giving us information about economic profit or loss that our firm gains in short-run, tells us that in long-run a firm may get only a normal profit. This equation also suggests certain conclusions about Allocative and Productive efficiency of our economic unit in long-run.

   Productive efficiency requires goods to be produced at least costly way, but allocative efficiency requires goods to be divided among industries that yield most needed combination of products by society. Let’s see how productive and allocatice efficiency is realized in purely competitive market.
Productive efficiency: P= Minimum ATC
   In long run, pure competition forces firms to produce their goods at minimum average total costs and to charge price relative to cost of production, which is a situation that benefits consumers. If firms don’t use these least-cost production methods they may get high losses and at a point in time leave the market. In this case minimum quantity of resources is used to produce these goods.
   Let’s take for example a firm that produces 1000 kg of tomatoes. To cover all its cost of production it should sell all this quantity at price of 5$ per kg ( 5000$ totally). If another firm produces the same quantity for 9000$ then society will face a loss of 4000$ of alternative products. However, this loss can’t happen in pure competition, because this big loss may require our firm to leave the market.
Consumer benefits this kind of efficiency by paying lowest possible cost.

Allocative Efficiency: P=MC
     Productive efficiency alone doesn’t ensure to get the efficient mix of good, also least cost production must be used to provide society the most needed mix of products. But what does the products’ price means?

• Price of any product is the society’s measure of marginal unit of a good. Price of a tomato is the marginal benefit society gets from using it.
• Price of one more unit of any good is the opportunity cost society sacrifice to get it. If we produce any additional tomatoes we sacrifice growing more units of corn.

Let’s see the cases when this equation doesn’t take place.
Underallocation P>MC
     In pure competition a firm realizes the maximum profit when price of a good equals to its marginal cost. Producing tomatoes at points where MR (Price) is greater than MC (P>MC) yields less than maximum profit. This means that society is underallocating resources for producing this good, so that one more unit of tomato is valued by society higher than other products that our resources can produce.
Overallocation P<MC
   Production of tomatoes shouldn’t go beyond the price where marginal cost exceeds marginal revenue (Price). If we produce at a point where MC (marginal cost) is higher than marginal revenue, than the producers won’t obtain maximum profit. So it is an overallocation of resources to this produce. In our case by producing tomatoes at the point where (P<MC) means that we sacrifice goods used at production of tomatoes, which society values higher than tomatoes.
 Efficient Allocation
   So conclusion is that in a pure competition, firms should produce at a point where MR(Price)=MC, so that each item will be allocated efficiently in our society. To produce cucumber at a point where P>MC, means that we sacrifice production of goods, which society values very high, but at the point where P<MC it’s overallocation of resources, at production of which are used resources that may produce goods valued higher.
 Fast Adjustments
   Another important characteristic of purely competitive market is ability to change quantity output when there are some changes in consumer’s taste. So if cucumbers now become more popular initially their price will increase, so that P>MC, this fact will permit cucumber industry to take away resources from less profitable uses, let’s say potato.  So cucumber industry will expand.
   Similarly a change in supply of a particular resource will create a change in labor force, production technique or capital (machines). Thus managers have to reallocate all resources very fast until P=MC.
Invisible Hand
     Highly efficiency of allocating resources in a purely competitive market makes resource suppliers to seek to further their self-interests. This is the invisible hand which operates in our competitive market system. This kind of market system not only makes a patter to maximize profits but also maximized consumers’ satisfaction. Invisible hand operates good suppliers in such a way that society’s interests are maximized by using scarce resources.

Profit-Maximization in Long-Run (Pure competitive Market)

 In Short-Run only a specific number of firms is present in an industry, each of them having fixed and unchanged plant. They can shut down in sense that they may produce zero output, but these firms don’t have enough time to sell their assets and go out of business. In Long-Run, however, firms can expand or contract their output capacity. The number of firms in an industry can increase or decrease, because they can enter or leave this industry.

 Some assumptions related to Long-Run in this article

• Entry and exit only- Firms are able or enter industries only under long-run adjustment
• Identical Costs- Let’s assume that all firms in this industry have identical costs curve, so it’s easier to talk about a firm, knowing that all other firms are affected by any long-run adjustments
• Constant-cost Industry- We assume that leaving or entry of industry by a firm doesn’t affect the price, consequently the position of average-total –cost curve.

   Important Idea

  The main conclusion we should get here is that: After all long-Run adjustments are completed; product price will be equal to each firm’s minimum average cost.

  This conclusion can be proven by the following facts: each firm tries to get profit and to avoid losses and in a pure competition market firms a free to enter and to leave the industry. If the market price of a good will be higher than average total cost of it, then new firms will enter the industry, this industry expansion will create a higher supply, so that the price will fall and will get equal to initial average total cost of this good. Conversely, if price if the price initial is less than average total cost then firms of this industry will support losses. These losses will push some firms to leave the industry, so as they leave, total supply will decrease, which will make the price equal to average total cost.

Long-Run Equilibrium

 Let’s suppose that each firm produces cell phones. Average total cost for producing them is 100$. Marginal Revenue will initially be 100$. But what happens if the demand for these cell phones will increase?

The answer is quite simple, initially there will be an increase in price to (let’s suppose) 120$, because of that increase in demand, then more firms will enter the industry since there is possible to get economic profit (20$). More firms enter the industry then the supple will increase, prices decreases until the point where marginal revenue equal average-total-cost (take care amount of produced goods isn’t the same with initial one).

What happens if the demand of our cell phone decreases?

If the demand decreases then for a period of time marginal revenue will be less that average total cost, so that our firms will get some loss. Some firms will leave the market, so the supply will decrease. Then this supply will make the average total cost equal to marginal revenue. So again this point of intersection shows that no economic profit is made just normal one. Equilibrium price is the same, but equilibrium quantity is different (less).

Long Run Supply for a constant-Cost Industry

In our example we took a constant-cost industry (industry in which entry or exit of new firms doesn’t shift long-run ATC curve of individual firms. In this case industry’s demand for resources is small in comparison to the total demand for resources.  So that industry can expand or contract without affecting resource price and resource costs. How does the demand curve look like in a constant cost industry? Since we saw that demand change doesn’t affect the price, since it always comes back to the original value, then we may say that demand curve is perfectly elastic in constant-cost industry.

 Long-Run Supply for Increasing Cost Industry

  Most of the industries are Increasing Cost Industries, in which average total cost (ATC) moves up as the industry expands and moves downward as it contracts. In Increase cost Industries entry of new firms increases resource prices. Higher resource prices result in higher value of average total cost in long rung for our firms.

If there occurs an increase in demand for the goods of this kind of industry, then new firms will be attracted to it in order to eliminate the economic profit, as we said before more firms-higher ATC value.  For example

50000 units will be sold for 80$, 70000 for 100$ and 90000 for 120$. So if firms leave this increase cost industry then the demand declines, so does the price for goods.

Long-Run Supply for Decreasing Cost Industry

In a decreasing cost industry firm experiences a lower costs as the industry expands. An example can be industry that produces PCs. An increased demand for personal computers made new PC manufactures to enter the marker and greater increased the demand for components used to build them. An increase demand for PC’s components made producers to supply more of them and to expand factories, so that they achieved economies of scale. Supply for PCs increased more than demand, so that the price declined.

 

Profit-Maximization in Short-Run (Pure competitive Market)

   Since the purely competitive firm is a price-taker, then to increase its revenue in short run it can change only quantity output.  Thus it can adjust its output by changes in amount of variable resources (materials, labor) it uses. So to maximize its revenues or to minimize its losses our firm has to adjust its quantity of resources used.
   There are two ways how to calculate the level of output for which our firm, in a pure competitive market, will get highest revenues. One of the methods is to compare total revenues and total costs, and another one is to compare marginal revenues and marginal costs. By the way, these methods can be applied not just in pure competitive market but also in pure monopoly, monopolistic competitive market and oligopoly.

Total Revenue- Total Cost Approach
       Total cost increases with output, because more production require more resources, but the rate of increase in the total cost varies with the efficiency of the firm. Specifically, the cost data reflect law of diminishing returns. Initially it increases with smaller amounts but after a point total cost rise by increasing amounts. Total revenue covers all costs (including normal profit) but there isn’t an economic profit. Economists call break-even point: an output value for which a firm makes a normal profit but not an economic profit. Any output between two break-even points produces an economic profit. The firm achieves maximum profit, where the vertical distance between Total Revenue and Total Cost is greatest.

Marginal Revenue- Marginal Cost Approach
   In this approach the firm compares marginal revenue (MR) and (MC) of each successive unit of output. The firm will produce any output for which marginal revenue is greater than marginal benefit because the firm will add more revenue from selling that item than the costs of producing it.
MR=MC Rule
   In the initial stages of production, when output is relatively low then the Marginal Revenue (MR) is usually greater than Marginal Cost (MC). So it’s profitable to produce in this range of output. But with additional units of output where quantity produced is relatively high, rising marginal cost will become greater than the marginal revenue. That’s why firms will try to avoid output quantity in this range. A point, where marginal revenue equals with marginal cost, separates these two regions.  In the short run, the firm will maximize profits or minimize its loss by producing that quantity of output where marginal cost equals with marginal benefit. This profit maximizing rule is known as MR=MC Rule.
Characteristics of MR=MC rule
    There are some important features of MR=MC rule and they can be stated as follows:

• The rule is applied only if producing is preferable to shutting down.
• The rule of profit maximization is applied to all firms whether they are purely competitive, monopolistic, monopolistically competitive, or oligopolistic.
• In pure competitive market our rule is transformed into P=MC, because demand faced by this seller is perfectly elastic. In this case marginal cost is equal to marginal revenue. So only in pure competitive market we may substitute P (price) instead of MR.

Profit Maximization Rule   
   How to determine the profit maximization output? It’s quite easy, all output values for which marginal revenue is greater than marginal cost add to total revenue, so the maximizing output is the last value for which marginal revenue is bigger than marginal cost. In Short Run the firm produces its goods until total revenue is greater than negative Average fixed Cost, however, if it is smaller, then it is better to shut down. Take care, “shut down” doesn’t mean to get off from market, because in short run a firm can’t leave the market.
   An example of Total Revenue and Total Cost -Quantity Demanded Graph(maximum economic profit is taken randomly, since no values are present) :