Perfectly competitive industries
1a). Buy The Book is a bookbinding firm which operates in a perfectly competitive industry, with average total cost ATC1, marginal cost MC1, and price P1. Construct a diagram showing Buy The Book in long-run equilibrium.
(ii) Suppose a new process patented by Buy The Book, which only they can use for the life of the patent, reduces the cost of binding books. Explain, with the aid of a diagram, what happens to Buy The Book’s cost structure (marginal cost and average total cost) and level of profits as a result.
(iii) Explain what happens when the patent expires and all bookbinding firms can use the new technology.
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In a perfectly competitive industry where there is long-term stability economic profit (P1 - ATC1) by any particular company is not guaranteed as all companies (of which there are an inifinity of) have equal chance of success selling a product to an infinite market of buyers who are able and wish to buy (ie demand) the product at a certain price P1 - the 'going rate'.
In long-run equilibrium then MC1 = MR1 = ATC1 = P1 = D where MC1 is marginal cost, MR1 marginal revenue, ATC1 average total cost , P1 price and D demand. The company, on order to be surviving in the long term, will produce Q products so that this relationship holds. The relationship is shown in the first attached figure.
i) If the company Buy The Book acquire a new patent that decreases the cost of production/services they then have a market advantage or monopoly in the short-term. In this state the company earns abnormal profit if they still charge the market price P1 but their marginal costs MC and average total costs ATC reduce due the reduced cost of production per product/service event. If the ATC of a normal firm is say 25% higher than the new ATC for Buy The Book then the change in MC and ATC (and hence profit: P - ATC) is as shown in the second attached figure. In this scenario, if legal, Buy The Book could undercut other firms by introducing predatory pricing and achieving a de facto market monopoly by reducing market competition.
ii) When the patent expires, the market may return again to the original perfectly competitive industry, as in the first figure. The price P might remain the same at P1 and all the firms make more profit. Or, an increasing trend in predatory pricing might gradually bring profit margins down to be equivalent to previous levels as the typical price of the product/service will have reduced. In any case, the market may return to being stable, as in the first attached figure.
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