Question 2 (a)

Profit has a number of meanings in economics. At its most basic level, profit is the reward gained by risk taking entrepreneurs when the revenue earned from selling a given amount of output exceeds the total costs of producing that output. This simple statement is often expressed as the profit identity, which states that: Total profits = total revenue T!" # total costs T$" %conomists distinguish between different types of profit and they are as follows: 1. Normal Profit &ormal profit is defined as the minimum reward that is 'ust sufficient to keep the entrepreneur supplying their enterprise. (ecause we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its A$ then it is making normal profits. )n markets which are perfectly competitive, the profit available to a single firm in the long run is called normal profit. This exists when total revenue, T!, e*uals total cost, T$. )n other words, the reward is 'ust covering opportunity cost .That is, 'ust better than the next best alternative. &ormal profit is earned in perfectly competitive market in the long run, as if profit was abnormally high, more competitors would appear and drive prices and profit down. )f profit was abnormally low, firms would leave the market and the remaining ones would drive the prices and profit up. +arkets where suppliers are making normal profits will neither expand nor shrink and will, therefore, be in a state of long,term e*uilibrium. &ormal profits reflect the opportunity cost of using funds to finance a business. -or example if someone put !s .//,/// of savings into a new business, those funds could have earned a low risk rate of return by being saved in a bank account. 0e might use the rate of interest on that !s .//,/// as the minimum rate of return that he needs to make from his investment $onsider the diagram below. -irms are operating in perfectly competitive market. The demand curve is the Average !evenue and +arginal !evenue. )t can be seen that T! = T$. This is the breakeven point for a firm. )t is the minimum profit level to keep the firm in the

industry in the long run thus it can be said that the firms are making normal profit in the long run.

2. Abnormal profit Abnormal profit is any profit achieved in excess of normal profit. )t is also known as supernormal profit. 1hen firms are making abnormal profits, there is an incentive for other producers to enter a market to try to ac*uire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly, where firms can successfully block the entry of new firms. The level of super,normal profits available to a firm is largely determined by the level of competition in a market. That is the more competition the less chance there is to earn abnormal profits. Abnormal profit can be derived in three general cases: .. (y firms in perfectly competitive markets in the short run, before new entrants have eroded their profits down to a normal level. 2. (y firms in less than competitive markets, like firms operating under monopolistic competition and competitive oligopolies, by innovating or reducing costs and earning head start profits.

3. (y firms in highly uncompetitive markets, like collusive oligopolies and monopolies, who can erect barriers to entry protect themselves from competition in the long run and earn persistent above normal profits.

(elow is an example of a perfectly competitive firm making abnormal profits in the short run. The firm maximises profit when marginal cost e*uals marginal revenue. )t can sell output 4 at price P. The profit per unit = P # AT$, that is PA$(. Total profits are shown by the red shaded area. (ecause price exceeds average total cost, we can say that the firm is earning abnormal profits in this situation.

0owever in monopolistically competitive industry super normal profits is made same as perfectly competitive firms in the short run. The diagram will be exactly as same as the one for the perfectly competitive5 the firm maximises profit by setting +$ = +!, giving price P and *uantity 4. The one difference is that that the A! and +! curves are much flatter. !emember that monopolistically competitive firms face a lot of competition and therefore, the demand for their product is very elastic. The firms are not price takers, but they do have very little power. )n most, imperfect competitive markets don6t have these features of perfect information and freedom of entry and exit. +ost markets have a degree of barriers to entry and exit. There are

sunk costs which deter entry. Therefore, even if firms are making supernormal profit, new firms may not be able to enter and compete. -or example 7hell makes profits in the region of 829bn. This is clearly abnormal profit. (ut, there are strong barriers to entry in this market. The diagram below shows the abnormal profit made by monopoly:

Therefore, it can be concluded that if a firm is able to make supernormal profits in perfection competition market other firms will be aware of this fact. As there are no barriers to entry, firms will be encouraged to enter the market until price falls. This shall in turn make price to falls until normal profits are made. Thus it can be said that only normal profits will be made in the long run. (ut however firms in imperfect competition can earn abnormal profit all the time to due to barrier to entry and as it the sole seller in the industry.

Question 2(b) +arket structure is defined by economists as the characteristics of the market. )t can be organi:ational characteristics or competitive characteristics or any other features that can best describe a goods and services market. The ma'or characteristics that economist have focused on in describing the market structures are the nature of competition and the mode of pricing in that market. A monopoly markets structure has the biggest level of barriers to entry while the perfectly competitive market has :ero percent level of barriers to entry. The other factors that influence the firm behavior under a market structure are the efficiency. -irm will be more efficient in a competitive market while firms will be least efficient in a monopoly structure. There are several types of market structure and the two mentioned below form part of it. 1. Perfect competition

Perfect competition in that situation of the market wherein there are large number of buyers and sellers of a homogeneous product and the price of such product is determined by the market forces, that is the industry. All the firms sell the product at this price. -or example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can 'ust turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits. After +arshall, a famous .;th century, economist, used a fish market as an example of perfect competition. -or the sake of agreement, consider a fishmonger selling $od. 0ow would he price his product< -irst, he would looks around and find out at what price his numerous competitors were selling cod. 0e certainly could not price above the competitors, since cod is pretty much identical and consumers should not care from whom they purchase. -urthermore, in fish markets, it is *uite easy for customers to compare price. 7o, if he priced above his competitors, he would not sell any fish. 7uppose he decided to price below his competitor. All of the customers would certainly purchase from him. 0owever, if he were still making a profit at the lower price and would march the price cut in order to retain their customers. They may even consider lowering price more, if they could still make a profit and capture further customers. A fish monger will be a price,taker, setting his price identically to his competitor6s prices.

Perfectly competitive markets have the following characteristics:

There is perfect knowledge, with no information failure or time lags. =nowledge is freely available to all participants, which means that risk,taking is minimal. There are no barriers to entry into or exit out of the market. -irms produce homogeneous, identical, units of output that are not branded. &o single firm can influence the market price, or market conditions. The single firm is said to be a price taker, taking its price from the whole industry. There are a very large numbers of firms in the market. There is no need for government regulation, except to make markets more competitive.
There are assumed to be no externalities, that is no external costs or benefits.

-irms can only make normal profits in the long run, but they can make abnormal profits in the short run.

+anagers are more concerned with perfect competition in the short run as firms can make super,normal profits or losses. As long as revenue is greater than cost, a perfectly competitive firm can opt to produce more to maximi:e profit in the short run. Thus managers shall increase production so as to maximise profits. This can be shown in the diagram below:

(ut however managers should also take into consideration what will happen in the long run as other firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down price until the point where all super,normal profits are exhausted. )f firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises price and enables those left in the market to derive normal profits as shown below:

Therefore if the manager found that his firm is making loses he must leave the industry as his AT$ will not be covered. Perfect competition in the long run acts as a shut down point for the firm. The firm decides whether to continue operating or shut down his business as cost are greater than revenue.

2. Monopoly +onopoly is the least competitive market structure of all. A pure monopoly is a market with only one producer who produces .//> of the output. 1e would expect a monopoly market to have the highest price and the lowest total production of any market structure. )t produces a good or service which has no close substitutes. -or the purposes of regulation, monopoly power exists when a single firm controls 2?> or more of a particular market. 1henever a firm has a monopoly in a particular market or markets, the economic theory states that it still must adhere to the +!= +$ rule to maximise its short,run profit because it a price maker.

+onopolists tend to have the following features:

0igh profit levels in comparison with the normal levels of similar levels. (arriers to entry and exit. $ontrol over the price in the market. %vidence of price discrimination. !educed level of service.

+onopoly helps managers to gain many advantages. The monopolist is able to raise prices without competitors entering the market. This allows the firm to make abnormal profit. The monopolist has a downward sloping demand curve because, unlike in perfect competition, when the firm raises its prices it will retain some customers. Therefore demand is price inelastic .The monopolist is the only seller in the market, so the firm@s demand curve is the same as that of the industry. The output is lower and the price is higher than under perfect competition. This is e*uilibrium. Profits are not eroded long run because of the existence of barriers to entry. (elow is an example of a monopoly making abnormal profit:

+anagers are aware that monopolies can maintain abnormal profits in the long run. As with all firms, profits are maximised when +$ = +!. )n general, the level of profit depends upon

the degree of competition in the market, which for a pure monopoly is :ero. At profit maximisation, +$ = +!, and output is 4 and price P. Aiven that price A!" is above AT$ at 4, supernormal profits are possible area PA($".

)t should be noted that in the real world both monopoly and perfect competition does not exist. The cross between perfect competition and monopoly is monopolistic competition. )t has a large number of sellers, fairly easy entry and exit, perfect knowledge of the market and the ability to differentiate their product through brand name, packaging advertising and location. This allows the firm to charge a higher price than its competitors. Although unrealistic, it is still a useful model in two respects. -irstly, many primary and commodity markets, such as coffee and tea, exhibit many of the characteristics of perfect competition, such as the number of individual producers that exist, and their inability to influence market price. 7econdly, for other markets in manufacturing and services, the model is a useful yardstick by which economists and regulators can evaluate levels of competition that exist in real markets.