Test: The Theory of the Firm under Perfect Competition- Case Based Type Questions - Commerce MCQ

Direction: Read the following passage and answer the questions that follows:

Market structure is best defined as the organisational and other characteristics of a market. We focus on those characteristics which affect the nature of competition and pricing – but it is important not to place too much emphasis simply on the market share of the existing firms in an industry.

Key Summary on Market Structures

Traditionally, the most important features of market structure are:

• The number of firms (including the scale and extent of foreign competition)

• The market share of the largest firms (measured by the concentration ratio)

• The nature of costs (including the potential for firms to exploit economies of scale and also the presence of sunk costs which affects market contestability in the long term)

• The degree to which the industry is vertically integrated-vertical integration explains the process by which different stages in production and distribution of a product are under the ownership and control of a single enterprise. A good example of vertical integration is the oil industry, where the major oil companies own the rights to extract from oil fields, they run a fleet of tankers, operate refineries and have control of sales at their own filling stations.

• The extent of product differentiation (which affects cross-price elasticity of demand)

• The structure of buyers in the industry (including the possibility of monopsony power)

• The turnover of customers (sometimes known as "market churn") i.e. how many customers are prepared to switch their supplier over a given time period when market conditions change. The rate of customer churn is affected by the degree of consumer or brand loyalty and the influence of persuasive advertising and marketing.

Q. In which market, there is the highest market churn?

Direction: Read the following passage and answer the questions that follows:

The biggest reason why oligopolies exist is collaboration. Firms see more economic benefits in collaborating on a specific price than in trying to compete with their competitors. By controlling prices, oligopolies are able to raise their barriers to entry and protect themselves from new potential entrants into the market. This is quite important, as new firms may offer much lower prices and thus jeopardize the longevity of the colluding firms’ profits.

In most markets, antitrust laws exist that aim to prevent price collusion and protect consumers. Nonetheless, firms have devised ways to achieve price collusion without being detected by regulators. For example, firms might elect a price leader that is tasked with leading changes in prices before other firms follow suit in order to “react to competition”. Firms may also agree to change their prices on specific dates; in such cases, the changes may be seen as merely a reaction to economic conditions such as fluctuations in inflation.

How do oligopolies work?

It is important to note that in real-life oligopolies, the games (instances of collusion) are sequential; meaning that one firm’s behaviour in one game may influence the game’s outcome in future periods. In this scenario, we see that the optimal outcome that generates the most cumulative profits occurs if both firms collude. This situation would be the best long-run equilibrium situation that would provide the most benefit to all the firms.

Nonetheless, in this equilibrium, firms have an incentive to cheat and not collude. For example, if both firms agree to set a price of $10, but Firm A cheats and sets prices at $5, Firm A will essentially capture the entire market (assuming little to no differentiation). While this may result in high profits for Firm A in this game, Firm B now knows that Firm A is a cheater and thus will never collude again.

Therefore, the new equilibrium would be the one where neither firm collude and achieve profits that would occur under perfect competition (which is significantly less profitable than colluding). Thus, to realize the best long-run profits, firms in an oligopoly choose to collude.

Q. Why do firms agree to collude?

Direction: Read the following passage and answer the questions that follows:

More specifically, a price ceiling (in other words, a maximum price) is put into effect when the government believes the price is too high and sets a maximum price that producers can charge; this price must lie below the equilibrium price in order for the price ceiling to have an effect.

The price ceiling is usually instituted via law and is typically applied to necessary goods like food, rent, and energy sources in order to ensure that everyone has access to them.

Benefits and Downsides:

Price ceilings are beneficial to society, and are often necessary, in that they make sure that essential goods are financially accessible to the average person, at least in the short run. By lowering costs, price ceilings also have the beneficial effect of helping to stimulate demand, which can contribute to the health of an economy.

However, there can also be downsides to price ceilings. While they stimulate demand, price ceilings can also cause shortages. Where the ceiling is set, there is more demand than at the equilibrium price. This means that the amount of the good or service supplied is less than the quantity demanded.

For example, in agriculture, medicine, and education, many governments set maximum prices to make the needed goods or services more affordable. Producers may respond to such an economic situation by rationing supplies, decreasing production levels or lowering the quality of production, making the consumer pay extra for otherwise free elements of the good (features, options, etc.), and more.

Q. How do the producers respond to the situation of price ceiling?