Quiz 8: The Economics of Big Business: Who Does What to Whom


Concentration ratio: The concentration ratio is ratio of market share derived from the total output produced in an industry by leading cluster of firms in the industry. The most common used concentration ratios are CR4 and CR8, which explains the market share of the four is represented as CR4 and the market share of the eight largest firms is represented as CR8. Concentration ratio: As a measure of monopoly power: The most common concentration ratio of CR4 shows the proportion of industrial sales controlled by the four largest companies in a sector. Thus, an imperfectly competitive sector with four or less than four companies would have a concentration ratio of 100%, and a very elevated degree of monopoly power is believed to exist. However, an industry with a big amount of tiny companies could have a concentration of 10% or 20%, with very little monopoly power that is believed to exist. In short, if the concentration ratio reaches 70% or 80%, one might suspect a substantial degree of monopoly power. Shortcomings of concentration ratio: Even if the concentration ratio is a good measure of degree of monopoly power, it has certain shortcomings. Some of them are listed below: • The concentration ratio may provide a misleading result. That is, the market situation is based solely on the result of the concentration ratio without more information. • A high concentration ratio will imply that a small number of businesses control a large part of a particular industry. It is not always true. • Using concentration ratio to measure monopoly and oligopoly power may lead to inaccurate data within the results. • Concentration ratio does not account for inter-industry competition. • The concentration ratio does not reveal the dispersion of size among the top four firms. Thus, these are some of the shortcomings of the concentration ratio.

Marginal revenue (MR): The marginal revenue is the change in the total revenue that occurs when the firm hires additional unit of input like labor Marginal cost: Marginal cost refers to the additional cost to the firm for producing one more additional good. Profit maximization in a competitive firm: The profit maximization condition in a competitive firm occurs at the point where the MR equals to MC. The reason is that the MR is the demand curve of the firm, while the MC is the supply curve of the firm. Therefore, the equilibrium price and the equilibrium quantity is determined at the point where MR equals MC. The profit of the firm is the difference between the total revenue and total cost of the firm. Thus, if the MR is higher than MC, then the firm can earn a profit, although it is possible until the point where MR reaches equal to MC. Once MR = MC, then an increase in output per unit adds nothing to profit. After that point, if output increases, then the MR becomes less than MC. As a result, the profit of the firm starts to decrease. Therefore, a competitive firm achieves profit maximization at the point where MR equals MC. Profit maximization in a competitive firm: The profit maximization condition remains the same for a monopolist who will produce the level of output where MR = MC. At any level of output, if the MR is greater than MC, then the production should be increased to increase profit. At any point, where MR is less than MC, then the production needs to be reduced to increase the profit by reducing cost. Thus, the profit maximization condition is the same for firms with a monopoly market.

Market barriers to entry: The market barriers to entry are the hurdles faced by the new firms that prevent them or make it difficult for them to enter an industry or area of business. The barriers to market entry: There are many ways to put barriers to entry. Some of them are listed below: • Economics of scale: Many markets can produce a large amount of product at lower per-unit cost than lower amount of product, in which it is impossible for a new firm to start from lower quantity and then grow up to be a large firm. • Licensing: Licensing is a permit to operate in a trade or profession. Thus, it ensures some minimum level of competency, and it also restricts entry into fields. • Product differentiation: Product differentiation makes a product different from other products in the eyes of the buyer. For a new entrant, the advertising cost may be too high. Thus, they can keep themselves away. • Patents: The patents give the firm legal protection to produce a product for a number of years. Hence, it stops the entry of new firms. • Price limiting: The firms may implement predatory pricing policies by selling goods at such low prices that it deter any new firms to enter the market. Hence, these are some of the barriers that stand in front of the new entry of firms. Consequences of market barriers to entry: These market barriers sometimes inhibit the proper functioning of the market. • Creation of monopoly power: The market barriers to entry of the new firms may create monopoly power in the economy. • Fewer employment opportunities: Market barriers stop to create employment and production in the economy. As a result, employment opportunities reduce. • Less competition: The market barriers save the existing firms from the outsiders. As a result, competition among firms will reduce. It will affect the quality of products. • The market power: The market power concentrated on a few firms leads to underproduction, higher prices, supernormal collusion, inefficiency, and price discrimination. Thus, due to these reasons, the market barriers inhibit the proper functioning of a market.