Question

QUESTION 4 (30) 4.1 Lonewolf Ltd is the sole manufacturer and supplier of solar panels in the country. As a result of this the CEO claimed in a recent meeting that he can set any price he wishes and sell as many units of his product as he wants at that price. Is this correct? Motivate your answer. (7) 4.2 Explain using properly labelled diagrams, why a perfectly competitive firm will earn only normal profit in the long-run. (16) 4.3 Explain SEVEN (7) conditions necessary for a perfectly competitive market to exist. (

Answer 1

4.1 Lonewof limited is the monopolist in the country. The pricing stratergy they claimed is not correct. The reason is that, yet the monopoly firm is said to be the price maker, that it sets price, and it does that indeed, but it doesn't do so according to their own independence, but via satisfying certain condition. The cost of the firm have some basic characteristics, such as the average cost decreases to a level as the quantities produced increases, and after that, increases, and the marginal cost increases as the number of quantity increases. The demand curve the monopoly firm faces is downward sloping, which basically shows their only independence, that they can set a different set of price, but it will correspond to different quantity as per the demand curve, and not according to the will pf monopolist. Aslo, a downward sloping demand curve refelect as downward sloping, or decreasing marginal revenue with increase in quantity. The equilibrium quantity is set where the marginal revenue becomes equal to the marginal cost; equilibrium being referred to as the profit maximizing point, and that is the point at where the production shold reach, no more - or no less than that, otherwise the profit won't be maximum.

Hence, even neglecting the violation of law of demand when it is claimed that they can set any price they wishes and sell as many units of his product as he wants at that price, as one have to regard the law when setting the price, otherwise inventories would flucutate more than desired rate, the claim is wrong even on the level that profit maximizing quantity and price is not unique (which is not the case for downward sloping demand and/or upward sloping marginal cost).

4.2 The cost curves of the firm is stated as below.

In the above diagram/graph, the usual average cost - AC, marginal cost - MC, two price lines, and an additional average variable cost - AVC, are shown. In the short run, due to less firms because of any reason, there might be supernormal profits, as shown by the grey shade, if the equilibrium price in the market is P1. But in the long run, and no barriers to entry of firms in the perfectly competitive markets, several firms might enter seeing the profits. As they enter, the supply curve shifts down/right, as there is more quantity that can be supplied at the same price. As a result, the price level decrease in the market, upto the point price line comes to P2. At that price, the average cost of the firm is minimum and is equal to the price, and hence there is no super-normal profit remaining in the market.

This goes one to the long run, fluctuating by the P2. There might be a grater push, so that the price level would decrease more than P2, in which case firm faces loss, but doesn't shutdown, as it covers its variable cost. In the long run, several firms, which sees no profit at all, or even loss, leave the market, and the long run price level is set at P2 by the market forces. The long run average cost curve of a particular firm, 'envelopes' several average cost curves according to different time. In the long run, the average cost curves shifts down, and so does the price. Hence, even in the long run, all the same happens, and hence the price is set by the market forces, at the minimum of the long run average cost.

4.3 The seven conditions for perfectly competitive markets to exist are as below:

• Number of buyers and sellers should be large. That ensures the individual firms being price takers, and so does the customer.
• Products should be homogeneous. Products should not be just similar, but also the same or homogeneous.
• No barriers to entry and exit of the firms. The free entry and exit is what ensures the long run and even short run change in price level, which is matched in the end at the lowest long run average cost of every firm.
• Profit maximization is the sole goal of the firm.
• Laissez faire should be there, ie no interference from government is appreciated in the industry.
• Perfect mobility of factors of production.
• Perfect knowledge among buyers and sellers about the price and the product. Absence of this assumption might cause a producer's supernormal profit or even a loss, as they may coordinate the price/quantity to a level other than the market price/quantity. The same can happen to the buyers as well.