1.5 Perfect competition, imperfectly competitive markets, and monopoly Flashcards
Market
anywhere where buyers and sellers come together, a price is agreed and a transaction takes place
Market structure
the characteristics of a market which determine the behaviour of firms within the market
Price taker
a firm which passively accepts the ruling market price set by market conditions outside its control
Price maker
a firm possessing the power to set the price within the market
Characteristics of perfect competition (6)
• a large number of buyers and sellers
• all buyers and sellers possesses perfect market information
• buyers/sellers can buy/sell as much as they wish at the market price
• any single buyer or seller is unable to influence the market price
• the goods being sold are homogeneous
• no barriers to entry or exit
Homogeneous goods
goods which are identical
Barriers to entry
make it difficult or impossible for new firms to enter a market
Consumer surplus
a measure of the economic welfare enjoyed by consumers: surplus utility received over and above the price paid for a good
Producer surplus
a measure of the economic welfare enjoyed by firms or producers: the difference between the price a firm succeeds in charging and the minimum price it would be prepared to accept
Deadweight loss
the loss of welfare when the maximum attainable level of total welfare is not achieved
Allocative efficiency
A state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it
Describe perfect competition in the short run
- firms can be making abnormal profit
- new firms cannot enter the market due to there being at least one fixed factor of production
Describe perfect competition in the long run
- new firms enter the market
- the equilibrium price in the market falls, just until firms are making normal profit
Monopoly power
power to set prices and other aspects of the market such as differentiation. Firms in market structures other than perfect competition possess a degree of monopoly power
Monopoly
a market structure with only firm in the market
Natural monopoly
when there is only room in a market for one firm benefiting from economies of scale to the full
Differentiated goods
goods which are different from other goods
Market failure
when the market mechanism leads to a misallocation of resources in an economy, either completely failing to provide a good or service or providing the wrong quantity
Oligopoly
a market structure where there are a small number of interdependent firms
Collusion
agreements between firms to restrict competition
How does monopoly power lead to market failure? (4)
- redistributes welfare away from consumers to producers
- consumers are exploited as they pay a price above the marginal cost of production
- reduces total welfare
- producers’ net gain is smaller than the loss inflicted on consumers
Barriers to entry in a monopoly (9)
- patents + trademarks
- limit pricing
- advertising + marketing
- control over outlets
- control over suppliers
- reaction of existing firms
- legislation
- cost-advantage
- differentiation
Legislation
government may restrict the ability of firms to compete in the market. e.g. for 350 years Royal Mail was the only firm allowed to deliver letters in the UK
Differentiation
making a good different from the competition through marketing and branding can prevent a new firm from being able to enter a market and gain market share
Ways to differentiate a product (8)
- improved product
- wider product range
- nicer packaging
- compatibility with complements
- better quality of service
- advertising
- easier to use products
- production methods
Brand loyalty
when consumers repeat purchase from the same firm, instead of swapping and switching between firms. It can be expensive for new firms to develop a brand image to break existing loyalties within the market
Control over outlets
if a firm controls the place where a product is sold it means their competitors may not be able to sell their products
Patents and trademarks
legal protection which prevents other firms from imitating existing ideas
Control over suppliers
if a firm controls the materials needed to make a good it means potential new firms may not be able to produce their goods
Cost advantage
if a firm has achieved a lower average cost because of the economies of scale, this means potential competitors may not be able to compete as they cannot produce as cheaply
Reaction of existing firms
new firms may not enter a market if they think it will trigger a price war
Limit pricing
prices set low enough to make it unprofitable for new firms to enter a market
Divorce of ownership from control
the owners and those who manage the firm are different groups with different objectives
Principle-Agent Problem
When the agent (worker or manager) doesn’t act in the best interest of the principle (owner).
solutions to principal-agent problem (3)
- employee share ownership schemes
- long-term employment contracts for senior management
- long-term stock commitment
Firm
A productive organisation which turns inputs into goods
Revenue maximisation occurs at
MR = 0
Profit maximisation occurs at
Mc = MR
Sales maximisation
occurs when revenue is maximised (while still generating normal profit); AR=ATC
Market share maximisation
occurs when a firm maximises its percentage share of the market in which it sells its product
Economic surplus maximisation
- occurs where a firm maximises the size of the consumer and producer surplus, achieving allocative efficiency
- occurs where MC=AR
Survival
occurs where a firm avoids making or reduces the size of subnormal profit, or potential subnormal profit
Quality maximisation
occurs where a firm maximises the quality of the goods that they are selling
Growth maximisation
The objective of increasing the size of the firm as much as possible (e.g. could be measured through no. of employees, market capitalisation)
Stakeholders
People with an interest in an organisation
Shareholders
owners of shares in a company
Satisficing
achieving a satisfactory outcome rather than the best possible outcome
Profit satisficing
Making enough profit to satisfy the needs of the firm’s owner(s)
Productively efficient
the level of output at which average costs are minimised
X-inefficiency
a lack of competition in a market means that average costs are higher than they would be with competition
Dynamic efficiency
occurs in the long run, leading to the development of new products and more efficient processes that improve productive efficiency
Market share
the proportion of the market that is held by a firm, a product, or a brand; measured through number or sales or revenue
Concentration ratio
A ratio which indicates the total market share of a number of leading firms in a market, or the output of these firms as a percentage of total market output
Advantages of monopoly (6)
- abnormal profits spent on investment and R&D
- help the firm achieve dynamic efficiency and so produce higher quality goods and services at lower prices
- more likely to innovate due to high barriers to entry
- large economies of scale, allowing them to produce at lower prices.
- internationally competitive due to large economies of scale and therefore generate export revenue and thus help improve a nation’s position on its balance of payments.
- High revenue/profit may be a source of government tax revenue.
Disadvantages of monopoly (3)
- may exploit consumers by charging high prices - result in a loss of allocative efficiency.
- no incentive to become more efficient, so are not productively efficient.
- Consumers do not get as much choice in a monopoly as they do in a competitive market.
Market share formula
Firm’s sales/Total Market Sales X 100
Cartel
a group of firms who collude with each other
Price fixing
agreeing prices with your competitors, or agreeing to offer discounts at the same time, or agreeing to raise prices at the same time
Market sharing
dividing a market (e.g. by region or customer type), and agreeing not to sell to each other’s customers
Consumer inertia
the tendency of consumers to buy or continue buying a good, even when superior options exist
Quantity fixing
agreeing with your competitors to decide the quantity you’re going to offer to sell
Price war
occurs when rival firms continuously lower prices to undercut each other with the aim to gain or defend market share
Impact of sub-normal profit under perfect competition
- sub-normal profit in the short run means firms leave the market
- price then returns to equilibrium in long run
impact of abnormal profit under perfect competition
- abnormal profit in the short run attracts firms to the market
- price and quantity then return to equilibrium in long run
impact of perfect competition on economic welfare
- leads to allocative efficiency
- maximum possible mutually beneficial transactions take place
- absence of deadweight loss
How is productive efficiency shown on a cost/revenue diagram?
AC minimised (where MC=AC)
How is allocative efficiency shown on a cost/revenue diagram?
P=MC
resource misallocation
when resources are allocated in a way which does not maximise economic welfare
Conditions of monopoly (6)
- only one firm in the market
- there may be imperfect information
- the firm has a trade-off between price and quantity due to having a downward-sloping demand curve
- the firm is a price setter
- the goods in the market are differentiated
- there are barriers into the market
Shutdown point
the level of output (in the short-run) where a firm has no economic benefit of producing; occurs where AR=AVC
shutdown price
the minimum price a firm needs to charge to justify remaining in the market in the short run
Characteristics of monopolistic competition (6)
- if a firm raises its price, it does not lose all of its customers
- large number of firms in the market
- no barriers to entry or exit in the long-run
- Goods produced by various firms are partial but not perfect substitutes.
- the entry of new firms, attracted by short-run abnormal profits, brings down price until only normal profits can be made in the long-run
- each firm’s MR curve is below its AR curve
How efficient is monopolistic competition?
neither productively nor allocatively efficient in the long run and short run
short-run impacts of abnormal profits under monopolistic competition
- new firms attracted to market
- however they cannot enter in short run due to fixed costs
Long-run impacts of abnormal profits under monopolistic competition
- incumbent firms cannot maintain abnormal profit due to new firms entering the market because of the absence of barriers to entry, and goods being partially substitutable
interdependence
in market theory, when the actions of one firm will have an impact on other firms in the market
Cooperation
when firms agree to work together in a legal manner, such as joint development of new goods
Game theory
the study of mathematical models of strategic interaction among rational decision makers
Payoff matrix
a matrix that shows the outcomes of a game for the players given different possible strategies
Nash equilibrium
a situation where no player can improve their position given the choice of the other players
The Competition and Markets Authority (CMA)
government agency responsible for advising on and implementing UK competition policy
Resale Price Maintenance (RPM)
imposing minimum prices on distributors such as shops
Bid rigging
agreeing with your competitors in the process of bidding for a contract lender
Sharing information
sharing information with other firms that might reduce competition between you (e.g. information about prices, production, your suppliers, customers, or the markets you sell or plan to sell to). This includes sharing information about a third party, for example a trade association.
Predatory pricing
cutting prices below cost in order to force a smaller or weaker competition out of the market
Tacit collusion
where firms collude without any formal agreement and where there has been no explicit communication between firms about market conduct strategy
Bounded rationality
when making decisions, an individual’s rationality is limited by the information they have, the limitations of their minds, and the finite amount of time available in which to make decision
Creative destruction
a process where firms produce or create innovative goods that replace or destroy existing goods in the market
Internal economies of scale
long-run average costs falling caused by growth of the firm
Advantages of oligopoly (4)
- small number of firms makes it easier for consumers to compare different goods, thus avoiding problems with bounded-rationality
- abnormal profits can be used for research and development leading to new goods, and forming part of the creative destruction process
- firms benefit from internal economies of scale, perhaps lowering prices
- abnormal profits used for R&D lead to dynamic efficiency, perhaps lowering prices
Disadvantages of oligopoly (2)
- barriers to entry may prevent new firms who would innovate from joining the market
- firms will restrict output and charge higher prices that under competitive conditions
Describe the shape of the AR curve under oligopoly
- kinked
- more price elastic at a lower level of output than the kink
- more price inelastic at a higher level of output
Price discrimination
charging different prices to different customers for the same product or service, with the price based on different willingness to pay
Market seepage
consumers purchasing at the low price in a relatively price elastic sub-market, then reselling to other consumers in the relatively price inelastic sub-market at a higher price
First-degree price discrimination
where a firm charges each customer for each unit the maximum price which the customer is willing to pay for that unit
First-degree price discrimination example (1)
- a market stall trader not putting any prices on the wares, instead choosing to haaggle
Second-degree price discrimination
where a firm charges a consumer so much for the first so many units purchased, a different price for the next so many unit purchased, and so on
Second-degree price discrimination examples (3)
- electricity is more expensive for the first number of units
- after 10 minutes calls become cheaper
- loyalty cards reward frequent buyers with discounts on future products
Third-degree price discrimination
where a firm divides consumers into different groups and charges a different price to consumers in different groups, but the same price for all consumers within a group
Third-degree price discrimination examples (4)
- student discounts
- cheaper prices by the time of the day (e.g. happy hours in pubs)
- senior citizen rail card
- peak/ off-peak travel
Effects of price discrimination that directly benefit consumers (4)
- some consumers will benefit from lower prices and products that might not otherwise be supplied
- allows firms to cross-subsidise loss-making services
- may increase total sales and generate economies of scale, perhaps lowering prices
- better capacity utilisation by firms will lower costs and may lead to lower prices
Effects of price discrimination that DO NOT directly benefit consumers (5)
- some consumers will face a higher price
- can be used as a barrier to entry, reducing competition
- allows the producer to convert consumer surplus into producer surplus
- allows producers to reduce fixed costs by spreading demand more evenly
- allows producer to increase revenue and profit
Conditions required to price discriminate (3)
- firm must have some monopoly power
- it must be possible to identify different groups of customers for the good. This can happen because of differing knowledge or differing ability to shop around. At any particular price, the different groups must have different PEDS.
- markets must be separated to prevent seepage
Contestable market
a market in which the potential exists for new firms to enter the market. A perfectly contestable market has no entry or exit barriers and no sunk costs, and both incumbent firms, and new entrants have access to the same level of technology
Conditions of contestable markets
- absence on entry barriers
- absence of exit barriers (sunk costs)
- incumbent firms vulnerable to hit-and-run competition (consumers don’t have total brand loyalty to incumbent firms)
Hit and run competition
occurs when a new entrant can ‘hit’ the market, make profits and ‘run’, given that there are no or low barriers to entry
Sunk costs
costs that have already been incurred and cannot be recovered
Break even
- occurs when the number of sales is maximised while still generating normal profit
- AKA sales maximisation
- AC = AR
incumbent firms
firms which are already present in the market
Equilibrium of the firm
when a firm is satisfied with the existing level of output, choosing to adjust neither price nor output
