3 - Market Structures Flashcards
Allocative efficiency
- Where P = MC
- Resources are distributed according to consumer preference
- Social welfare is maximised
Productive efficiency
- Where MC = AC, this is at the bottom of the AC curve
- Products are being produced at the lowest average cost
- It means that a firm is using all its resources in the most efficient way possible, producing the maximum output with the minimum input
Dynamic efficiency
- Achieved when resources are allocated efficiency over time
- Occurs when competition encourages innovation and thus, firms are willing to use supernormal profits to reinvest into the business to bring new products and new production techniques
X-inefficiency
- Occurs when a firm fails to minimise its average cost at a given level of output due to a lack of competition motivation
- Production occurs above the average cost curve
- Typically occurs in a monopoly due to lack of competition however, firms aim to maximise profits
What are the characteristics of perfect competition?
-Perfect Knowledge
-No barriers to entry or exit
-Homogenous goods
-Many buyers and sellers
Assumptions of firms in markets of perfect competition
-Firms are price takers
-Firms are assumed to short-run profit maximise
-In the short-run, it is possible for firms to make a normal profit, supernormal profit or a loss
-In the long-run, firms may only make normal profit
-No economies of scale because there are many firms producing relatively small amounts
What efficiencies are there in a perfect competitive market?
Remember: firms aim to profit maximise (MC=MR) and firms are price takers (MR=AR)
-Allocative efficiency
-Productive efficiency
-No dynamic efficiency because of the existence of perfect knowledge, so the invention of one firm will be adopted by another, so investment will give firms no competitive benefit.
Characteristics of monopolistic competition
-Many buyers and sellers
-Product differentiation
-No barriers to entry or exit
Assumptions of monopolistic competition
-Firms aim to maximise profit
-In the short-run, firms can make normal profit, supernormal profit and a loss
-In the long-run, firms can only make normal profit because there are no barriers to entry or exit
Limitations of the monopolistic competition model
Information may be imperfect so firms will not enter the market as predicted because they are unaware of the existence of supernormal profits
Efficiencies in monopolistic competition
Remember: MR does not equal AR, firm are only able to make normal profit in long run so AR=AC and profit maximise so MR=MC
-No allocative or productive efficiency
-They are likely to be dynamically efficient since there are differentiated products and so know that innovative products will give them an edge over their competitors and enable them to make supernormal profits in the short run. However, since the firms are small, they may struggle to have the retained profits necessary to invest
Characteristics of an oligopoly
-Product differentiation
-Firms are interdependent (the actions of one firm will impact on the other firms in the industry thus, firms make decisions based on the actions and/or reactions of other firms)
-High barriers to entry and exit
-High-concentration ratio (supply in the industry is dominated by a relatively small amount of firms)
-Non-price competition (price cutting will lead to price wars which results in loss of revenue)
-Profit maximisation is not sole objective (market share plays a crucial role)
N-firm concentration ratio
Measures the total share of the market that a particular number of firms have (N)
Collusion definition
- Collusion is where firms make a collective agreement to reduce competition
- This is done by firms through cooperate to fix prices and/or restrict output
What is the difference between overt and tacit collusion?
Overt = formal agreement
Tacit = No formal agreement, collusion is implied (price leadership or no price wars)
Why do firms collude?
- Maximise industry profits (avoids competitive pricing and advertising costs)
- Market stability (reduces uncertainty in the market, avoids price wars)
- Protect market share (increasing barriers to entry - for example predatory pricing)
Price leadership
Price leadership occurs where firms follow the pricing decisions of the dominant firm in the market
What are factors promotion collusive oligopoly?
- Small amount of firms (easier to organise collusion)
- Similar costs (easier to agree on a fixed price)
- High barriers to entry (supernormal profit would attraction new firms otherwise)
- Consumer loyalty (not beneficial to cut prices so cheating is less likely)
What are factors encouraging competitive oligopoly/discouraging collusion?
-Large number of firms
-Low barriers to entry and exit
-Saturated market
-Homogenous goods
-One firm has significant cost advantage
Why is there a temptation to break collusion?
- To maximise a firm’s sales by lowering prices and catching rivals unaware
- To gain immunity from prosecution by acting as a whistle-blower and informing the competitive authorities
How could you explain why oligopoly markets have price rigidity and consequently, non-price competition?
Through kinked demand curve and/or game theory - prisoners dilemma model
What is a dominant strategy and in which model can it be shown?
It’s a course of action that gives the best outcome regardless of what the other firm does.
For example, in a duopoly where firms can choose between high or low prices:
If Firm A sets a high price, Firm B’s best response is to set a low price to capture more market share.
If Firm A sets a low price, Firm B’s best response is still to set a low price to remain competitive.
This can be shown through the prisoner’s dilemma
What is nash equilibrium and what model helps you demonstrate it?
- Nash equilibrium is where neither player is able to improve their position
- They both have a dominant strategy, and have optimised their outcome based on the other players expected decision
- They have no incentive to change behaviour, unless someone else changes theirs
- It is best represented in the prisoners dilemma model
What does the prisoners dilemma model show us?
- That firms in oligopoly are interdependent and thus make decisions based on the other’s actions
- Rational self-interest can lead to collectively suboptimal outcomes
- Price rigidity
- Firms have temptations to collude
- Incentive to cheat on collusive agreement
What are Price Wars?
Price wars are where competitors repeatedly lower prices to undercut each other in an attempt to gain or increase market share
Why do price wars occur?
-Low levels of non-price competition (goods have weak brands and consumers are price conscious)
-Firms find it difficult to collude
A price war can result in firms making a frequent loss, what conditions have to be met for firms to be able to make a loss?
AVC < AR
- This can only happen in the short-run (firms will leave the market if this continues; reducing supply and increasing prices)
Predatory pricing
- This is the practice of lowering prices when a new competitor joins the industry in order to drive them out
- Prices are often lowered to a point below the cost of production.
- Once they have left the market, prices are raised again
- This pricing strategy is usually illegal.
Limit pricing
- Occurs when firms set a limit on how high the price will go in the industry
- A lower price reduces profit and disincentivize other firms from joining the industry
- The greater the barriers to entry the higher the limit price is likely to be as firms are already disincentivized
What are some types of non-price competition?
- Loyalty cards
- Branding
- Product warranties
- Corporate Sponsorship (Red bull)
- Advertising
What are the efficiencies in an oligopoly?
- No productive or allocative efficiency (so statically inefficient)
- Able to explore economies of scale
- Dynamically efficient as are able to make supernormal profit and have competition which encourages investment in innovation however, they may decide to not invest or split the profits with shareholders
Pure monopoly definition
Where one firm is the sole seller of a product in the market, in the real world this rarely exists.
When is a firm legally considered to have monopoly power?
When they have more than 25% of the market share
What are the characteristics of a monopoly?
- One firm in the industry
- Aim to maximise short-run profits
- High barriers to entry
- Will be making supernormal profit as there is no freedom to enter and exit the market
Third degree price discrimination
When monopolists charge different prices to different people for the same good or service.
- It is not illegal
When can third-degree price discrimination occur?
- The firm must be able to separate the market into groups of buyers
- The costumers must have different price elasticities of demand
- They must be able to control supply and prevent buyers from the expensive market from buying in the cheap market
Third degree price discrimination benefits and costs
- Firms are able to increase profits, this can go into research and development; improving dynamic efficiency
- Those in elastic markets are able to pay a lower price than they otherwise would, they benefit from cross subsidisation, these consumers may have not been able to access the good if it weren’t’ for price discrimination so this may increase equality
However,
- Some consumers have to pay higher prices, thus reducing their consumer surplus and increasing producing surplus
