Question

5)What is the long run average cost (LRAC) of a firm? How would you obtain the LRAC curve from the short run average cost (SRAC) curves? Illustrate your answer by using appropriate diagrams and underlying assumptions.

6. What are the types of price discrimination a monopolist can practice? What conditions must hold for price discrimination to be successful?

10. Explain and diagrammatically represent the concept of “Excess capacity “ in monopolistic competition.

Answer 1

5. Curve relating average cost of production to output when all inputs, including capital, are variable is known as Long Run Average Cost Curve.

The figure shows the relationship between SRAC and LRAC. Assuming that a firm is uncertain about the future demand for its product and is considering three alternative plant size. The SRACs for the three plants are given by SAC₁, SAC₂ and SAC₃​​​​​​. The decision is important because, once built, the firm may not be able to change the plant size for some time.

We have three possible plant sizes. If the firm expects to produce q₀ units of output, then it should build the smallest plant. Its average cost of production would be p₀. ( if it then decided to produce an output of q₁, its SRAC would still be p₀​​​​​​). However, if it expects to produce q₂, the middle-size plant is best. Similarly, with an output of q₃, the largest of the three plants would be the most efficient choice.

​​In the long run, the firm can change the size of its plant. In doing so, it will always choose the plant that minimizes the average cost of production.

The LRAC is given ​​​by the crosshatched portions of the SRAC because these show the minimum cost of production for any output level. The LRAC curve is the envelope of the SRAC curves. It envelopes or surrounds the short run curves.

6. In the monopoly market the single seller has the capability to charge different prices for the same quantity of a particular product to different consumers or charge same price for different quantities of a particular product to different consumers, this is known as price discrimination. It is of three types

1. First degree price discrimination - in this case monopolist charge every buyer the max. price they are willing to pay. Hence, for each buyer, price wiling to pay = price actually paid. Therefore, consumer surplus is zero. The entire consumer surplus is extracted by the monopolist and it becomes producer surplus.
2. Second degree price discrimination - in this case seller marks a distinction between different groups of buyers according to their quantities bought. Normally, for larger blocks of quantities purchased the consumer is charged a lower price per block. This is called block pricing, where quantity discount is provided for large buyers.
3. Third degree price discrimination - the monopolist often discriminate among the buyers on the basis of geographical location, need for the product etc. and accordingly discriminate with respect to price.

For price discrimination to hold, the condition are as follows

1. The firm must have market power.
2. The firm must be able to recognise differences in demand.
3. The firm must have the ability to prevent arbitration or resale of product.

10. The firm under monopolistic competition faces a downward sloping demand cure. Since, the firm is forced to operate at zero profit, the average cost curve is tangent to the demand curve at equilibrium point. With falling average cost " excess capacity" is said to exist.

In the above diagram, firm under long run equilibrium, at output OM, marginal revenue = marginal cost and price is equal to average cost. At output OM, LRAC is falling and goes on falling upto output ON and reduce his LRAC to the minimum. Ideal output is output at which LRAC is minimum. The firm is producing MN less than the ideal output. Thus, MN represents excess capacity under monopolistic competition.