2.11 Market Failure - Market Power Flashcards
Fixed costs
expenses that do not change with the level of output
variable costs
expenses linked directly to the level of output
marginal cost
additional cost of producing an extra unit of output
change of TC/ Change in Q
marginal revenue
additional revenue received from the sale of an extra unit of output
change in TR / change in Q
profit maximised when
-marginal cost = marginal revenue
-
economic costs
explicit and implicit costs of all resources, including the opportunity cost of foregoing the next best alternative
explicit costs
identifiable and accountable costs
abnormal profits
profit of a firm that is over or above the point where total revenue exceeds total economic costs, profit is greater than that of its next best alternative
AR> AC
finances R&D and innovation
normal profit
the amount of profit needed to cover explicit and implicit costs, therefore normal profit is the amount needed to generate production
AR = AC
loss
- production costs exceed total revenue
- AR < AC
- loss-making firm is operational in the short run but not long-term sustainable
economies of scale
cost saving benefits from lower average cost of production brought about by an increase in the volume of production
factors giving rise to internal economies of scale
specialization, efficiency, marketing, purchasing,
internal economies of scale
lower average costs fur to increase in the size of a firm itself
specialization and internal economies of scale
- specialised labour is highly productive
- reduces average cost of production
efficiency and economies of scale
- specialized machinery is more efficient
- technical economies of scale
- raise output, reduce average costs
marketing and economies of scale
reduce marketing cost per unit of sales
purchasing and economies of scale
large plants or factories can only function efficiently if large volumes of output are generated
external economies of scale
cost saving benefits from lower average costs of production brought about by an increase in the size of an industry
benefits of external economies of scale
lower recruitment costs, ancillary services
ancillary costs
services provided by other firms that support an industry
diseconomies of scale
inefficiencies caused by an increase in the scale of production leading to increasing long run average costs of production
internal diseconomies of scale
caused by problems with coordination, control and communication
external diseconomies of scale
eg traffic congestion, higher rental costs, labour shortages
revenue
money received from the sale of a firms output of goods or services
marginal product
-change in total product that occurs when the usage of a particular resource increases by one unit and all other resources remain constant
fungible goods
perfectly interchangeable with goods from other producers
monopoly
- single firm operating in the entire market
- strong barriers to entry and exit
Oligopoly
- market structure where only a few firms operate
- fierce competition between firms even though the whole market is not very competitive
- difficult to compete on price, so there is strong non-price competition
monopolistic competition
- most common market structure
- many firms, each with relatively small market shares compared with the size of the market
- similar but not identical goods
- branding sets firms apart
marginal cost and marginal price per unit in perfect competition
- marginal revenue and price per unit are constant and equal
- profit maximised when MC curve intersects flat MR curve
market power
ability of a firm to manipulate the price of a good or service by manipulating the level of demand or level of supply
degree of market power a firm has determines the market structure in which it operates
perfect competition - profit maximisation in the short run
- in the short run, perfectly competitive firms can earn abnormal, negative or normal profit
- price > short run average cost when producing at the MC=MR point = abnormal profit
- firms in perfect competition eventually compete away their profits
Marginal cost and average costs
- marginal cost intersects average costs at the minimum point
- left of the optimum quantity, MC> AC so AC is declining with output (economies of scale)
- to the right of Q* MC>AC so AC rises (diseconomies of scale)
criteria of perfect competition
- all firms sell identical products
- all firms are price takers
- all firms have a small market share
- there is perfect information
- there is freedom of entry and exit
market structure
categorization of firms based on their level of market power
perfect competition
market structure characterized by an intense degree of competition where no individual firm is large enough to influence the price or quantity traded, in theory it is ideal
Barriers to entry and exit and perfect competition
firms increase their prices = signal for new firms to join the market = increases supply = increases competition= decreases prices=competes away profits = firms leave = supply decreases = firms charge higher prices, repeat
allocative efficiency
best use of an economy’s resources thereby maximising the possible ratio of total national output to total factor inputs
occurs when P=MC or MSB= MSC
conditions held in perfect competition
- profit maximisation (MC = MR)
- allocative efficiency (D=MC)
- cost minimisation (MC = MES)
- firms compete away their abnormal profit and cut costs to operate at bottom of LRAC curve
- MC = AC means no wastage
assumptions of monopoly
- single seller
- no close substitutes
- significant barriers to entry
barriers to market entry
- economies of scale making small firms non competitive
- branding and brand loyalty
- legal barriers and patents
- control of essential resources
Monopolist, cost and price
- produces where MC = MR
- set the price higher than marginal cost ( P = AR>MC)
- AR curve = Demand curve
- AR gradient is double MR
monopolist and profit
- monopolist can make abnormal profit in the long run
- possible to make a loss, suggests that costs are too high or demand is too low, firm should leave market
monopolist and allocative inefficiency
- will not achieve productive efficiency
- lacks incentive to operate at bottom of cost curve
- consumers pay more for a lower amount of output
natural monopoly
market structure that occurs when the market can only sustain one firm in a profitable way. The industry can only tolerate one supplier to avoid wasteful competition and achieve economies of scale to operate efficiently
characteristics that lead to natural monopolies
- extremely high set up costs
- high fixed costs
- costs that cant be recovered after exit (sunk costs)
- one provider needs value of all sales to survive
advantages of large market power
- economies of scale can reduce waste
- abnormal profits can lead to innovation
- oligopolistic firms allow for more choice
risks associated with large market power
- output as the lack of competition means monopolistic firms are unlikely to supply the socially optimum output level
- price risk: enables a dominant firm to extract consumer surplus
- consumer choice and quality: lack of competition means less incentive to improve and innovate
government responses to market power
- legislation and regulation: prohibits anti-competitive acts and abuse of monopoly power (prevent mergers, promote competition, forced pricing, forced asset sale)
- government ownership/ nationalization
- fines and punitive measures
characteristics of monopolistic competition
- many firms with small market power
- low barriers to entry
- product differentiation
market concentration
measures the extent to which sales revenue is dominated by one or more of the largest firms
concentration ratio
measures the degree of market power in an industry by adding the combined market shares of the largest firms in the industry
- higher concentration ratio = more oligopolistic
herfindahl-hirschman index
-gives a larger weighting to the market share of larger firms by squaring the value of their market share
- highest value = 10,000= monopoly
- higher the HHI, the more concentrated the industry
-Eg: firm a = 30%, firm b= 25%, firm c = 20%
industry HHI= 30^2 + 25^2 + 20^2 = 1,625
monopolistic competition profit in the short run
- firm operates where MC = MR
- P > ATC so firm earns economic profit
- long run absence of barriers reduces market price so that AR=P=AC and reverts firms to normal profit (reverse for loss)
monopolistic competition and allocative efficiency
- not allocatively efficient
- gains consumer surplus
- does not operate at lowest point on cost curve bc limited economies of scale
- ## choice can cause inefficiency and market failure
oligopoly
market structure in which a few large firms, each with a high degree of market power dominate the industry
- can be collusive or non-collusive
collusive oligopoly
agreement between two or more oligopolistic firms to limit competition by using restrictive trade practices such as price fixing or collectively limiting output to manipulate market price
aim of forming a cartel
reduce competition in the industry and increase profits of oligopolistic firms by acting as a group of monopolists
- difficult to identify and break up as may be tacit or open
non collusive oligopoly
- in direct competition with mutual interdependence
- consider actions and reactions/ strategies of competitors when pricing
- one firm lowers prices, others follow
price wars
potential under competitive oligarchy, fitms continually reduce prices in attempt to undercut rival firms, not beneficial to firms especially with inelastic demand
allocative inefficiency in a monopoly
- P + AR> MR
- earns supernormal profit
- less competitive in a collusive oligarchy
- suboptimal output and anti-competitive behaviour
game theory
economic model that attempts to explain the nature of strategic interdependence in oligopolistic markets
Nash equilibrium
- circumstances where firms acting in their best interests can make themselves and the market worse off
- suboptimal situation that arises due to oligopolistic firms competing
