Question 1
From analysing the table, it can be deduced that Professor Birks is entering a perfect competition market. Markets of perfect competition are defined as markets which have several buyers and sellers, with the sellers producing homogenous/identical products, in this case the haircuts, whilst being exposed to perfect information. Firms in perfect competition markets are also price takers, meaning that demand dictates price and demand is elastic, which can be seen in the table as the average revenue remains at £3 whilst the output (number of haircuts per week) increases. I would advise Professor Birks to enter this market if he were looking only to stay in it for the short run, as firms in markets of perfect competition make abnormal economic profits in the short run, whereas in the long run they make normal (0) economic profits. This is due to the fact that capital is fixed in the short run and therefore firms can’t freely exit or enter the market, therefore firms can sell and produce as much output as it wants at the given market price as the demand curve is horizontal (perfectly elastic).
Question 3
Average total cost is calculated by adding average fixed costs and average variable costs (ATC = AFC + AVC). Professor Birks’ short run average total cost curve will be U-shaped, and this is caused and explained by the law of diminishing marginal returns. Initially, there will be a decline in the curve, as the law of diminishing marginal returns states that there is a point where, when demand increases and firms add additional units of labour, it will lead to less productivity because capital is fixed (in the short run). In the case of Professor Birks, the points where average total cost declines as output increases can be represented with the values 4.2-1.8. However, the curve will begin to incline at a certain point, as employing more workers/labour leads to increases in marginal cost. This eventual incline can be seen in Professor Birks’ average total cost curve with the values 1.87-2.24.
Question 4
All firms strive to maximise their profits, which essentially means maximising the difference between their total revenue and their total costs. Total revenue is worked out by multiplying the price by the quantity sold, whereas total costs are the opportunity costs of producing the good(s). The point of maximum profits is when marginal revenue is equal to marginal cost. In Professor Birks’ market, the marginal revenue is equal to marginal cost (£3) at 750 haircuts per week, as marginal cost is plotted at the midpoints between each quantity. Therefore, this is the optimal level of output to maximise profits. It can be seen from the table that as output increases, marginal revenue stays the same, as firms in this market are price takers, and diverging from the market price wouldn’t be beneficial, as it would lead to decreases in profit and therefore there’s no incentive to change, so the optimal price for Professor Birks is £3.
Question 5
Question 6
Under a market of perfect competition, it is impossible for Professor Birks to earn these abnormal profits in the long run due to the nature of the structure of these markets. This is because firms are exposed to perfect information, and no barriers to entry or exit in the long run. This makes the market attractive to outside firms, and the abnormal profits being made in the short run signal other firms to enter the market. When firms enter perfectly competitive markets, the supply curve shifts to the right as supply is increasing with no change to demand. This leads to a decrease in the market price and will eventually lead to elimination of economic profit for all firms because they move down their supply curves and therefore produce less. This principle is shown in the diagram below (shift from S1 to S2). Consequently, economic profit will reach 0, which leads to no further entry into the market, and existing firms leaving the market due to the fact they are making an economic loss. As firms begin to exit, the supply decreases, leading to a leftward shift of the supply curve. Prices then increase due to demand, and economic loss begins to decrease and exit from the market stops. However, this only means that Professor Birks will be earning sufficient profits to keep him in the market (normal profits). In conclusion, if he wants to maintain abnormal economic profits in the long run, Professor Birks will need to alter the structure of the market or move into another market as it’s impossible to maintain this level of profits in a perfectly competitive market.
Part B
Question 7
The market that Professor Birks is now operating in is a market of monopolistic competition, which is classified as a market with many firms and many buyers and perfect information, similar to the previous market of perfect competition. However, the key differences are that the products being sold in a market of monopolistic competition are differentiated, meaning they aren’t homogenous and therefore firms in the market are price givers. The way I determined that this market was one of monopolistic competition was that in the table it can be seen that price decreases as output increases. This is because in a market of monopolistic competition, the marginal revenue curve depreciates at twice the rate of the downwards sloping demand curve.
All firms strive to maximise their profits, which essentially means maximising the difference between their total revenue and their total costs. Total revenue is worked out by multiplying the price by the quantity sold, whereas total costs are the opportunity costs of producing the good(s). The point of maximum profits is when marginal revenue intersects with marginal cost. In this case, the point of profit maximisation is when the level of output is 625 haircuts per week and the price is £3.75. The profit maximising level of output in this market is lower than that of the previous whereas the profit maximising price is higher than the perfect competition market as the demand curves are different. In the market of perfect competition, the demand curve was a horizontal, perfectly elastic one whereas in this monopolistic competition market, the demand curve is downwards sloping, with the marginal revenue curve depreciating at twice the rate. In addition, in markets of monopolistic competition, firms can markup their prices, meaning that the amount that buyers have to pay for the good is higher than the marginal cost, which therefore increases the marginal revenue.
Question 9
Point elasticity of demand demonstrates the responsiveness of the demanded quantity/output to a change in price, which therefore determines a firm’s revenue. Point elasticity of demand is calculated by using the equation . Professor Birks’ profit maximising level of output (Q) is 625 and his profit maximising price is 3.75, therefore his point elasticity of demand can be calculated as = 3. As the calculated value is more than 1, it can be stated that Professor Birks’ demand is elastic at this point, meaning that the quantity demanded responds significantly to a change in price. This is useful information as he will need to base his prices and output on this information if he wishes to maintain maximum profits.
Question 10
If Professor Birks desires to maintain this level of profits in the long run, he won’t be able to stay in the perfect competition market (as explained in question 6). Similarly to perfect competitive markets, there are no barriers to entry or exit in monopolistic markets. Therefore, the profits made in the short run are attractive to firms outside of the market, and as they enter, demand begins to decrease because there are more substitutes. This leads to a depreciation of the profit maximizing quantity and price, which means that firms are only able to make normal profits to sustain them in the market. However, it could be possible to retain profits in a monopolistic competition market in the long run if Professor Birks ensures that there is still a relatively constant demand for his product. There are several means by which he can do this. Firstly, differentiating his haircuts from others in the market allows him to have slight discretion over the prices he charges (e.g. based on the style of cut or the colour). However, it is important to note that the prices he charges cannot be too diverged from that of the other firms as the products in a monopolistic competition market are all close substitutes, and demand is elastic, meaning that the quantity demanded responds significantly to changes in price. In addition, Professor Birks could use price discrimination and markups, meaning that he charges increased/decreased prices based on the customer, for the same goods. For example, giving student discounts or charging more based on the customer’s length of hair. Lastly, he could invest more in advertising his products, as this aids customers to be aware of the product differentiation, as well as showing them that investing in his product is the better product choice to be made than others. In conclusion, it would be difficult to continue making abnormal profits in the long run based