Rock Street, San Francisco

Part A
(1). From the evidence provided in the table what type of market do you think Professor Birks would be entering? Would you enter this market? Explain your reasoning (5 marks).
The table shows us that Professor Birks is entering a market that is in perfect competition. This is evident as the Average Revenues (AR) of the firm remain constant, however much output is produced per week; the AR remains at a price of 3 units. This means that the AR curve would be perfectly elastic, as they do not change. This is a characteristic of a market in perfect competition, the AR remains the same however much output is produced. In a perfectly competitive market all goods are homogenous, there is not differentiation between goods. This means that the firm can produce however much of the good they like, but they will always get the same amount of revenue from it as the AR=MR=D curve stays the same.

Lastly, in a market with perfect competition the firms are price takers because there is much competition from other firms, producing homogenous goods. Therefore, the firms in the market cannot set their own prices. This shows why the professors AR are quite low and constantly the same. The professor is not able to increase prices as the customers will just go to another seller who offers the exact same good. This is another element from the table that proves the market is in perfect competition.
The diagram below (diagram 1) shows the Professors firm in the short run, producing economic profits (the shaded blue area), where AR>ATC. I would enter the market in the short run as there are economic profits available.
Although, in the long-run, economic profits are not possible. This is because the economic profits attract many other firms, and due to no barriers of entry and exit into the market firms can enter easily to gain the short run economic profits. The increase in the number of barbers has increased the supply of haircuts, hence shifting the supply curve to the right, this can be seen in the diagram below (diagram 2). This shifts the market equilibrium downwards, decreasing the price at which the goods can be sold; shown on diagram 2 as P shifting to P1. Therefore, the AR=MR=D curve has also shifted downwards, shown on diagram 2 as AR=MR=D shifting to AR=MR=D1. The diagram shows the industries quantity supplied increasing, shown as Q going to Q1, whilst on the right-hand side the diagram of the firm shows a decrease in supply, shown as Q shifting to Q1.  This means that the professor is only gaining

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normal profits in the long run. Arguably, it is still worth being in the market as he would still be paying for all his costs including labour costs, which means he would still be getting paid.
Overall, I would enter the market in order to gain the economic profits in the short run, and then also to gain normal profits in the long run. The normal profits would provide me with a stable and certain income, and would enable me to make accurate revenue forecasts, due to the forecasts being constant.

(2). Calculate Total Revenue (TR), Marginal Revenue (MR), Total Costs (TC), Average Fixed Costs (AC), Average Variable Costs (AVC), Average Total Costs (ATC), Marginal Costs (MC) and Profits (?) for each level of output (q). (Write your results in tabular format) (6 marks)

Output (N haircuts per week)

AR

TR

MR

TC

AFC

AVC

ATC

MC

Profit

0

0

0

0

400

0

0

0

0

-400

100

3

300

3

420

4

0.2

4.2

0.2

-120

200

3

600

3

480

2

0.4

2.4

0.6

120

300

3

900

3

580

1.33

0.6

1.93

1

320

400

3

1200

3

720

1

0.8

1.8

1.4

480

500

3

1500

3

900

0.8

1

1.8

1.8

600

600

3

1800

3

1120

0.66

1.2

1.86

2.2

680

700

3

2100

3

1380

0.57

1.4

1.97

2.6

720

800

3

2400

3

1680

0.5

1.6

2.1

3

720

900

3

2700

3

2020

0.44

1.8

2.24

3.4

680

(3). Explain the shape of Professor Birks short run ATC curve (4 marks).
The ATC curve for the Professor is downward sloping until it intersects with the MC curve at 1.8 units. After the intersection, the curve begins to slope upwards. Hence, the ATC decrease, then they remain constant between 400 and 500 units of output, and then they increase. The ATC decreases from 100 units of output until 400 to 500 units of output produced due to increasing returns to scale and then the ATC begins to increase up until 900, due to diminishing returns to scale. As the level of output increases the level of costs in proportion to the level of output decreases. All of this data shows that the curve is U shaped, this can be seen

in the diagram below.
Originally as output increases both the AVC and the AFC increase too. But over time, as more output is produced the proportion of AFC to output decreases, as there are less AFC in proportion to the units of output being produced. Hence, AFC continues to decrease in proportion as output increases. At first the AVC decrease. Although, as more output is produced a higher level of AVC is needed, in order to produce the output. This is because AVC includes labour costs. More labour is employed to increase the number of units of output produced. For example, where 500 units of output have been produced, where the ATC are at their lowest at 1.8, it is likely that Professor Birks would want to employ more labour in order to increase output. After this point the ATC increase, showing diminishing returns to scale. This is likely due to the increase in labour costs, increasing the AVC.

(4). How many haircuts should Professor Birks and his business undertake in order to earn maximum profits? And what price should he charge per haircut? Explain your answer (4 marks).
The profit maximising point is where MR = MC, where the abnormal profits are at the highest possible level. The point where MR = MC is where they both are equal to 3. Therefore, according to the first table, the output level that meets with MR and MC when they equal 3 is 800. Hence, the profit maximisation level would be at 800 units of output. At this point he would be gaining the highest amount of profit that is shown on the table, 720. He will need to charge the same amount for every haircut, which will be £3, as the market is in perfect competition, hence the price and demand for the product stays the same. If the professor was to produce at a point beyond MR=MC, where the MC>MR then the firm would be making a loss, the firm would be losing profit. After the point where MR=MC, the cost of producing each extra unit of output becomes more than the revenues received from producing it. Professor Birks should stay producing at a price level of 3, because the market is in perfect competition, hence the PED is infinite, this can be shown on the perfectly elastic demand curve shown below. If he raised prices demand would drop to 0.
(5). On graph paper, plot accurately the ATC, MC, AR and MR functions for Professor Birks business. Clearly indicate the profit-maximising price and output and shade in the area representing profits. (5 marks)
The profit maximising point is where there is 750 units of output being produced and the price is set at 3.

X-Values

MC

ATC

MR

AR

0

0

0

0

0

100

0.2

4.2

3

3

200

0.6

2.4

3

3

300

1

1.93

3

3

400

1.4

1.8

3

3

500

1.8

1.8

3

3

600

2.2

1.86

3

3

700

2.6

1.97

3

3

800

3

2.1

3

3

900

3.4

2.24

3

3

(6). Under what conditions can Professor Birks earn these profits in the long run? Use relevant diagrams and explain your answer fully (6 marks).

In the long run, the Professor would not be able to keep on gaining economic profit, in a perfectly competitive market. This is because in a perfectly competitive market there are no barriers of entry and exit into the market, there is also perfect information. Hence, firms would know about the economic profits that are possible in this market, they would then be able to enter the market freely. This pushes the market supply curve to the right as market supply increases due to there being more firms in the market (S shifting to S1). This can be seen on the diagram below.  This will cause the Professors D=AR=MR curve to shift downwards as the increase in supply has caused the price level to decrease too (P shifting to P1). As the D curve, has shifted downwards (AR=MR=D to AR=MR=D1) the professor is now only gaining normal profits, compared to previously gaining economic profits. Therefore, the Professor needs to try and change the market structure that his firm belongs to, in order to carry on gaining economic profit.
Professor Birks needs to enter into an oligopoly. If he entered a market in monopolistic competition, he would still just gain normal profits in the long run. In an oligopoly however, he would be able to gain economic profits in the long run. An oligopoly is a 5-firm concentration ratio of more than 50%. There is interdependence between firms, high barriers to entry and differentiated products. The Professor could differentiate his product in order to move closer to an oligopolistic market e.g. by increasing the quality of the service, or with non-price factors such as producing advertisement for the product.  Professor Birks may be able to become a part of an oligopoly if he decides to reinvest his previously made economic profits, in order to make his product differentiated, and more popular. Birks could also potentially merge with another firm to increase market share and the size of his firm. If Birks kept producing at the profit maximisation point and reinvested his previously made economic profits he could also set up a chain, he would be able to create another store with this money, and then create further economic profits due to having a higher market share.

The Professor could also take part in tacit collusion, which is an informal agreement between firms. If there is evidence it is illegal. Collusion is where firms set prices at a rate that benefits all of the firms. Collusion will happen only between a small number of firms. Birks could therefore do this in his area with other hairdressers. This would lead to higher profits as the hairdressers could all increase their prices and the people in the local area would have no choice but to pay more for their haircuts. Collusion would prevent other firms from entering the market, as the oligopoly would have the power to change prices, hence providing a barrier to entry for new firms. This would allow Professor Birks to gain economic profits in the long run.

Part B

Q

0

100

200

300

400

500

600

700

800

900

P

5

4.8

4.6

4.4

4.2

4.0

3.8

3.6

3.4

3.2

Assume now that Professor Birks faces the demand curve below (note the cost function is the same as before):

(7). What type of market do you think Professor Birks is now operating in? Explain your answer fully (3 marks).

The x-axis = the quantity, whilst the y-axis = the price. The new demand curve shows that there is a new type of market, a market in monopolistic competition. The demand curve is now sloping downwards, hence the MR and the AR is sloping downwards too, meaning that prices are able to change. Although the demand curve is very price-elastic, hence a change in price will lead to a very large change in demand. This shows that the product is still not very differentiated from the other products in the market although there is some differentiation. Therefore, there is still less control over the amount that the price can change, because the consequence of a price change would be very large. Hence, the market is likely to be a monopolistic market. The diagram on the right represents a market in short term monopolistic competition, with the sloping demand curve, which resembles the new demand curve of Professor Birks. The MR curve has also split away from the AR= D curve, another feature of a market in monopolistic competition. A monopolistic market has various features that link closely with that of a hairdressing industry such as, some but limited differentiation in product, few barriers of entry and exit into the market, close to perfect information and some differentiation in price.

(8). What is the profit maximising price and level of output for Professor Birks business? Why is your answer different to that calculated in (5) above? (5 marks).

Q

AR

TR

MR

ATC

MC

0

5

0

100

4.8

480

4.8

4.2

0.2

200

4.6

920

4.4

2.4

0.6

300

4.4

1320

4.0

1.93

1

400

4.2

1680

3.6

1.8

1.4

500

4.0

2000

3.2

1.8

1.8

600

3.8

2280

2.8

1.87

2.2

700

3.6

2520

2.4

1.97

2.6

800

3.4

2720

2.0

2.1

3

900

3.2

2880

1.6

2.24

3.4

The profit maximising point is where MC=MR. As shown on the graph, the point where they both equal each other is at a price of 3.75, where 625 units of the good are being produced, both the MC and MR are equal to 3.75. The answer is different to part one as the market has changed from a market in perfect competition to a monopolistic market. Hence, the curves have shifted. The MR curve has broken away from the AR=D curve. And now instead of being completely elastic they are sloping downwards; they are still elastic.

(9). What is the point elasticity of demand at this profit maximising price and level of output and why is this information useful to Professor Birks? (4 marks)
=   Point Elasticity of Demand
=  (-)3
This value shows the Professor that the haircuts he produces are elastic at this price and level of output. This means that demand is very responsive to a change in price. This information is useful as it provides information about where the Professor should set prices. In this case, it shows that the Professor should not increase prices as it would lead to a bigger % fall in demand compared to if the good was inelastic. It also means that if the Professor wants to increase market share by increasing the number of sales, it will be possible as the % change in demand will increase a lot due to the elastic demand curve. Although, this may cause losses due to less profit per item sold, also other firms may decrease prices too in the market, leading to a price war, and hence making the demand curve more inelastic.

(10). Advise Professor Birks about his options and tactics if he wishes to stay in business and maintain this level of profits in the long run (8 marks).

In the long run, it will not be possible for Mr Birks to gain economic profits in monopolistic competition; the market structure prevents these profits. There are limited barriers of entry and exit into the market. Hence, when the Professor makes economic profits in the short run, it will attract many other firms into the market. The profits will therefore be lost. As more firms enter the market the demand and revenue curves will shift downwards for the firm as each firm will gain less demand due to the higher supply of the good, this can be seen on the diagram below. This will cause the ATC curve to intersect the AR=D curve, creating the possibility to only make normal profits, this is shown on diagram below. Hence, he has to come up with other ways in which to make economic profits in the long run. The Professor will have to look at changing the market structure that he is positioned in, from a firm in monopolistic competition to a firm in oligopolistic competition.
The Professor could firstly go about moving towards an oligopoly by colluding with his competing firms, performing tacit collusion. He could create a cartel, enabling him to gain a larger market share, hence he could earn long run profits. By colluding he would eliminate a large amount of his competition as well as creating a barrier to enter to the market. This is because the cartel would be able to set prices that best suits them, hence, if many firms were trying to enter they could set the prices very low, making the market not profitable for other firms, so they will not join the market. This would work well if he set up a cartel in his local area with all of the barbers, because it would mean that the locals would not have a substitute, they would have to pay higher prices if higher prices were set. Although, collusion is illegal, this is why he would take part in tacit collusion. Tacit collusion is an informal agreement. This would be a good way for the Professor to keep economic profits in the long run.
The Professor should also use non-price tactics in order to boost his business, and create the potential for long run profits. An example would be advertising. Increased expenditure on advertising will likely lead to higher revenues, as more consumers will know of the product that he is selling. An example of increased advertisement would be putting posters around his town.
The Professor should try to use game theory in order beat his competitors and gain higher long run profits. He should try and predict what decisions his opponents are going to take and how they will behave, in terms of pricing. The Professor will be able to win over their profits. It would make pricing a lot easier, because in an oligopoly it is hard to make decisions on pricing as all firms are interdependent, they rely on each other. So, game theory would hugely help Birks to create long term economic profit. For example, if he knew that the other firms were setting higher prices, but he was able to set a lower price but still gain economic profit then, he would be able to gain a larger market share, increasing his economic profits in the long run.
The Professor should look at creating barriers of entry and exit in the market, perhaps agreeing on the barriers with the cartel. Predatory pricing would be a good barrier, therefore tactic to increase economic profits in the long run. This is where he and perhaps the members of the cartel would set prices very low. This would force rivals out of the market as well as prevent other firms from entering the market due to very low revenue potentials. In the short run this may lead to very low profits, maybe even losses, but in the long run it would lead to much lower competition, hence the possibility to have economic profits in the long run.
The Professor should look at the tactic of increasing dynamic efficiency, this is where the productive efficiency of a firm increases over time. It involves the optimal rate of innovation and investment to improve production processes. The Professor should do this by re-investing his previous profits into the firm. He could invest in capital, aiming to increase the capitals efficiency. This may allow the Professor to increase the number of people’s hair he can cut within a week. He could also get increased training for example, making him more efficient at cutting hair. If he was able to cut more peoples hair in the same amount of time, he would get more revenue in the same space of time. This may also increase the demand for his service, because consumers will see him as being more efficient, hence they will be more attracted to his product.