Question

Firm A is a perfectly competitive firm, and firm B is a monopoly firm. Both firms are currently earning profits. Which firm is less likely to be earning profits in the future? Explain your answer.

Short answer

In consideration of the characteristics of their market structures, the perfectly competitive firm A is less likely to be earning profits in the future compared to monopoly firm B.

Step-by-step solution

Understanding Perfect Competition

Perfectly competitive firms are price takers due to the large number of firms producing identical goods, meaning they cannot influence the market price. If a firm in a perfectly competitive market is earning profit, this gives incentive for new firms to enter the market. As new firms enter, the supply increases which then drives the market price down. As the price decreases, the profit decreases and eventually gets to a break-even point where firms make no economic profit.

Understanding Monopoly

A monopoly is a market with only one producer with exclusive control over a product or service because of barriers to entry. These barriers prevent other firms from entering the market, allowing the monopolist to enjoy high profits in the long term as there is no competition. The monopolist also chooses the price at which the goods are sold.

Making the comparison

Considering these concepts, it can be discerned that a monopolist firm (B) has a higher probability of continuing to earn profits into the future, as it decides the price and can prevent competition due to barriers. Conversely, perfectly competitive firms have no influence on market price and face constant threat of new competitors due to absence of barriers, hence firm A is less likely to be earning profits in future.

Key concepts

Barriers to Entry

Barriers to entry are obstacles that make it difficult for new firms to enter a market. In the context of a monopoly, these barriers are significant. They can take many forms, such as legal restrictions, resource ownership, or high initial investment costs. These barriers protect the monopolist from new competitors trying to enter their market and compete away profits.

For example, if a firm holds an exclusive patent, it can prevent others from producing and selling the same product. This control ensures that the monopolist can dictate prices without fear of new entrants undercutting them. On the other hand, in a perfectly competitive market, barriers to entry are minimal or non-existent.

New firms can easily enter when they observe existing firms earning profits. As these new firms join the market, increased competition leads to higher supply, which then drives down prices and profits.

In summary, barriers to entry are a crucial factor in determining a firm's ability to sustain long-term profits. Monopolies benefit from high barriers, while in perfect competition, low barriers result in transient profits.

Market Structure

The market structure significantly influences a firm's behavior and profitability. Perfect competition and monopoly represent two ends of the market structure spectrum. Perfect competition is characterized by a large number of firms offering standardized products, with no single firm being able to influence market prices.

In contrast, a monopoly exists when a single firm dominates the market as the sole provider of a product or service. This firm exercises significant control over the market price and output.

• Perfect competition results in uniform prices due to numerous sellers and buyers.
• Monopolists can set prices higher due to lack of alternatives for consumers.

These differences in market structure explain why monopolistic firms have a better chance to sustain profits, while firms in perfectly competitive markets face dwindling profit margins as more competitors enter the space.

Understanding market structure helps illustrate why firm A, in a perfectly competitive market, faces a more uncertain profit future than firm B, the monopoly.

Economic Profit

Economic profit is the difference between a firm's total revenue and its total costs, including both explicit and implicit costs. A firm in a perfectly competitive market typically aims for zero economic profit in the long run.

As competition increases, profits get squeezed, and firms tend to reach what is known as the break-even point, where total revenues just cover total costs, leaving no economic profit.

• In the short run, firms might enjoy profits due to limited competition.
• Over time, new firms enter due to profit opportunities, leading to zero economic profits.

For a monopoly, the scenario differs markedly due to high barriers to entry. The monopoly can maintain economic profits over time by restricting market entry and controlling prices barely influenced by competitors.

• Monopolists can enjoy sustained economic profits due to limited competition and market control.

Thus, while perfectly competitive firms might see dwindling economic profits as market conditions change, monopolies can maintain theirs due to their control over market dynamics.