3.4 Market Structures

Question 1

Types of efficiency

Answer 1

• allocative efficiency
• productive efficiency
• dynamic efficiency
• X-inefficiency

Question 2

Allocative efficiency

Answer 2

Shows whether resources allocated at point consumer satisfaction maximised (AR/D = S/MC)

No surpluses of demand or supply = resources allocated most efficiently

Question 3

Productive efficiency (with diagram)

Answer 3

Where economies of scale fully exploited, at minimum point of firms AC (average cost) curve
(point A on diagram)

So firms more competitive as firms may pass on some of costs savings to consumers in lower prices

Productive efficiency at point A

Question 4

Dynamic efficiency

Answer 4

Attained by firm achieving supernormal profits (can be reinvested into firm to increase efficiency & lower costs over time = dynamic efficiency

Firm may achieve supernormal profits in short term but wont be dynamically efficient in long term if don’t reinvest into firm

Question 5

X-inefficiency (diagram + why)

Answer 5

Firms are wasteful = higher average cost than could be at quantity level

(operating at point not on AC (average cost) curve, eg. point B)

Why:
- firm in monopoly so low competition so don’t need to lower prices so can be inefficient without being forced out of market
- lack of profit motive in public sector so no motive to lower average costs so inefficiency

Question 6

Types of market structures (from most to least competitive)

Answer 6

• perfect competition
• monopolistic competition
• oligopoly
• monopoly

Question 7

Characteristics of perfect competition

Answer 7

• homogenous goods (all goods/services same = price takers as no differentiation so no price setting powers)
• many buyers/sellers (lots of consumer choice)
• no barriers to entry/exit (easily enter & exit market at any time, no LT supernormal profit as market attracts new entrants = increased supply = decrease of price so removal of SP)
• perfect information (for buyers & sellers = know when firm changes prices so consumers will switch firms or all firms will lower prices too = price takers, no competitive advantage)
• firms profit maximise (MC=MR)

Eg. No market completely perfectly competitive, closest is agriculture, bananas (but some gov intervention)

Question 8

Perfect comp - profit maximising equilibrium in short run

Answer 8

• AR=MR=D line perfectly elastic as firms are price takers
• firm can make normal profit, supernormal profit or a loss

Supernormal profit:
- firms are profit maximisers so set high prices if high demand (MC=MR)
- but due to no barriers to entry/exit & perfect info, new firms enter market to earn same profits = increased supply (AR1 to AR2) so fall in price (P1 to P2) to normal profits

Loss:
- ATC above P1 so making loss
- some firms would leave industry as cant survive = decreased supply = increased prices (P1 to P2) to normal profit

Question 9

Perfect comp - profit maximising equilibrium in long run

Answer 9

Only normal profits can be made in LR as perfect info (if prices change, consumers will know and demand will fall)
Firms produce at MC=MR, price level p1 (firms price takers so same as industry p)
AR=AC so no supernormal profits

Question 10

What are the advantages and disadvantages of perfectly competitive markets (efficiency)

Answer 10

+ AR=MC in long run so there is allocative efficiency
+ firms produce at bottom of AC curve in SR and LR = productive efficiency
+ supernormal profits obtained in ST = might increase dynamic efficiency through investment (but wiped out fast)

• in LR, dynamic efficiency limited as no supernormal profits, lack of quality
• firms are small so few or no economies of scale
• model rarely applies in real life (branding, product differentiation, adverts mean comp is imperfect)

Question 11

Characteristics of monopolistically competitive markets

Answer 11

• product differentiation (similar goods, so firms have some price making powers through design, marketing, quality, demand curves downward sloping but very elastic as small degree so many close substitutes)
• low barriers to entry/exit (new firms seek to differentiate slightly, but still remove supernormal profits in LR)
• many buyers & sellers (each have relatively weak market/price setting power so AR and MR elastic)
• non-price competition (compete through advertising, brand loyalty, quality rather than lowering prices)
• firms profit maximise (MC=MR)
• imperfect knowledge

Eg. Hairdressers, estate agents, takeaways

Question 12

Monopolistic comp - Profit maximising equilibrium in short run

Answer 12

• AR and MR downwards sloping as firms have some price setting powers but elastic as small degree of profit differentiation (close substitutes)
• profit maximise at MC=MR up to AR gives price P1
• ## C1 below P1 so firms make supernormal profit

Question 13

Monopolistic comp- Profit maximising equilibrium in long run

Answer 13

• supernormal profit in SR attracts new entrants as low barriers to entry/exit
• increase in market supply = decrease in price level to normal profits (C1 = P1)
• still profit maximising at MC=MR

Question 14

Monopolistic comp efficiencies (+ and -)

Answer 14

• not producing at bottom of AC curve so not productivity efficiency in SR or LR
• price above marginal cost, AR ≠ MC so no allocative efficiency in SR or LR
  + likely to have dynamic efficiency as differentiated products so need edge over competitors to make profits BUT as firms are small, and goods close substitutes, may be hard to retain profits needed to invest or finance, not as much motivation
• firms less efficient and higher prices but
  + more choice for consumers & may benefit from economies of scale

Question 15

Characteristics of oligopoly

Answer 15

• high barriers to entry & exit (high startup costs eg. expensive planes, high level of sunk costs if firms leave market eg. car product development, market research, tech)
• high concentration ratio (few large dominant firms so lower levels of comp)
• interdependence of firms (firms need to consider reaction of competitors when changing prices, firms often follow each other so overall revenue will fall = prices often rigid)
• product differentiation (high degree so firms have ability to set price = downward sloping demand curves, compete through non-price factors eg. advertising, brand loyalty)
• firms profit maximise (MC=MR)

Eg. UK Supermarkets, airline industry, car manufacturers

Question 16

N-firm concentration ratio (calculation and significance)

Answer 16

• measures percentage of total market a particular number of firms have (eg. 3 firm concentration ratio shows percentage of total market held by 3 biggest firms)
• higher concentration ratio in oligopoly = lower levels of comp in market

= (total sales of n firms / total size of market) x 100. Or by adding market share of top n

Question 17

Kinked demand curve to show oligopoly market (interconnectedness of firms and price rigidity)

Answer 17

• firms profit maximise at MC=MR giving P1 and Q1
• kink in AR=D curve shows price rigidity & interconnectedness of firms
• above p1 = price elastic so change in quantity demanded greater than change in price so firms total revenue/profit decreases
• below p1, slightly price inelastic as if 1 firm reduces prices, other firms will follow so firm would gain no price advantage & no large increase in quantity demanded = all firms suffer decrease in revenue/profits = prices rigid, comp through non-price factors
• discontinuity in MR curve = constant price of p1 despite marginal cost changes within discontinuity = prices rigid

Question 18

Collusion definition

Answer 18

= firms make collective agreements that reduce competition (occurs in oligopoly)

Eg. UK energy market

Question 19

Types of collusion

Answer 19

Tacit collusion:
- informal collusion originating from price leadership
- other firms follow dominant firms prices as dominant firm benefits from large economies of scale, small firms cant compete price wise

Overt collusion:
- firms work together to formally set market price for good/service
- no price comp so firms can set high prices = large profits
- banned in UK & many countries as very high prices and uncompetitive outcomes (poor quality, poor customer service) leads to exploitation of consumers

Question 20

Reasons for collusive behaviour

Answer 20

• small number of firms (easier to collude, less conflicting interests & comp)
• similar costs (firms have similar advantage, less chance of price war, easier to agree on fixed price as similar profit margins)
• high barriers to entry (no worry abt new firms entering market in LR with lower prices so can maintain supernormal profits)
• ineffective comp policy (firms more likely to get away with collusion)
• high consumer loyalty (less chance of one firm breaking deal as may be high consumer loyalty for other firm, leading to no increase in revenue for firm that lowers prices, less risky)

Question 21

Reasons for non-collusive behaviour

Answer 21

• large number of firms (difficult to set price, align objectives)
• cost advantage (firm with much lower costs can offer much lower prices driving out comp = supernormal profits & can become monopoly & price level difficult to agree on)
• low barriers to entry (easy for firms to enter market with low prices = no supernormal profits made by collusion in LR)
• homogenous goods (lack of price setting powers to fix prices)
• saturated market (lots of comp & price wars so higher chance of collusive cheating)

Question 22

Game theory (prisoners dilemma in simple two firm model)

Answer 22

• demonstrates interdependence of firms & price rigidity in oligopoly market
• if both firms raise prices, both firms would make the same high profit (£20 million)
• if firm B raised prices, & firm A reacted by lowering prices, firm B would make less profit (£10 million) and firm A would make more profit (£24 million) & vice versa
• if both firms were to lower prices, both firms would make the same mid profit (£15 million)

Best outcome for both firms with least risk = Nash equilibrium = both lower price (£15 million profit)

Most efficient outcome for both firms = both raise prices (£20 million profit) but need collusion to stop both competitions lowering prices

Question 23

Types of price competition

Answer 23

Price wars:
firms lower prices to undercut each other & gain market share (may sell at loss in ST) = consumer surplus increases but firms hit profit margins

Predatory pricing:
Set price below competitors costs to force comp out of market (comp can’t sustain loss in long run) = firm can enjoy monopoly power & set higher prices = increased profits (illegal in UK under comp laws)

Limit pricing:
Firms operate at point below profit maximisation to remove incentive for new firms to enter market if low barriers to entry/exit = normal instead of supernormal profits in SR but no increased comp in LR

Question 24

Types of non-price competition

Answer 24

Spending on advertising = strong brand presence so increased sales so increased competitiveness (Kelloggs)

Quality of good/service = competitive advantage so can charge higher prices (Waitrose)

Loyalty cards = encourages repeat customers so regular flow of revenue (esp retail eg. Tesco) = more loyalty when prices change, less consumer switching

Customer service = more positive reputation so more consumer loyalty

Product development = first firm to release new product

Question 25

Characteristics of monopoly

Answer 25

- single seller (pure = 1 seller so no comp, full price setting power but legal def = firm has 25% or more of market share) - high barriers to entry/exit (no threat of new entrants taking away LR supernormal profits) - unique products (no similar products or direct substitutes = high levels of price setting power) - imperfect information (firm may know more than consumer = exploitation) - profit maximisation (MC=MR) Eg. Google (98% market share in UK), water & electricity companies in UK

Question 26

Monopoly - profit maximising equilibrium

Answer 26

- operate at profit maximisation (MC=MR) at P1 and Q1 - can fix price but quantity still constrained to law of demand so higher price = lower quantity demanded - price higher than AC so firms make supernormal profit - supernormal profits maintained in LR due to high barriers to entry (SR and LR diagram same)

Question 27

Monopoly- third degree price discrimination (def, examples, diagram)

Answer 27

= monopoly firm charges different prices to different consumers for the same good/service with no differences in costs of production, firm serve rates market based on different PEDs - done between diff times of day(off vs on peak), diff places(London vs small towns), diff incomes/ages (children, elderly) Eg. Railway company (peak = inelastic, off peak = elastic) - constant MC - firm profit maximised at MC=MR - in inelastic market, charge higher prices so make more supernormal profit at Q1P1 - in elastic market, charge lower prices so make less supernormal profit at Q2P2 - firm maximises joint profit by charging 2 prices

Question 28

Monopoly- third degree price discrimination (conditions)

Answer 28

- differences in PED (in order to maximise profits, if cant identify consumer groups well revenue will fall & there will be irregular sales, need info to serve rate market) - some degree of price making power (so need high barriers to entry - monopoly) - prevent market seepage / re-sale (make sure consumers abide by prices, stringent, one group cant sell on to another)

Question 29

Monopoly- third degree price discrimination (costs & benefits)

Answer 29

+ dynamic efficiency (greater profits = more reinvestment potential) + economies of scale (higher quantity, so lower prices to consumers in future) + some consumers benefit (price elastic segment) + cross subsidisation (higher profits can subsidise loss making goods/services elsewhere in business so can still be provided to consumers) - allocative inefficiency (exploiting some consumers with high prices) - inequalities (inelastic segment of third degree, esp if consumers on low incomes) - anti-competitive pricing (in price elastic segment, if low prices drive out competitors, firm can have pure monopoly power in LR)

Question 30

Costs & benefits of monopoly to firms, consumers, employees, suppliers

Answer 30

+ dynamic efficiency (reinvest supernormal profits = innovative new products with higher quality for consumers, better tech, pot lower prices overtime, producers can patent ideas, gain market share, lower costs overtime, higher wages for employees) EVAL: profit can be given to shareholders through higher dividends, repay debts, pay workers higher salaries + exploit greater economies of scale due to size eg. Car manufacturing (despite not being productivity efficient, can still have lower P & higher Q than comp market) EVAL depends on size of firm, can be DofS + regulated natural monopoly (desirable outcome with less waste & inefficiency in certain markets) + cross subsidisation (supernormal profits subsidise loss making good/service that is socially desirable) - allocative inefficiency (consumers exploited = lower consumer surplus, restrict output & choice, quality issues) = consumer deadweight loss in diagram EVAL what if objective isn’t profit max, may want to be better for society, principal-agent problem - productive inefficiency (forgo economies of scale, dont minimise costs due to lack of comp) EVAL legal monopoly - only 25% so can still be lots of comp eg. Tesco in supermarket market, prevent inefficiencies, if market is Contestable = threat of comp - X inefficiency (waste in production process due to lack of comp, produce beyond AC curve) EVAL regulation can reduce inefficiencies - inequalities in necessity markets (low incomes suffer most eg. food/drink third degree price discrimination (EVAL - type of good/service, if more luxury good, less effect, dont mind paying high prices)

Question 31

Natural monopoly (def, diagram, examples)

Answer 31

= more efficient for only one firm to operate in market rather than multiple firms competing (large cost advantage for first firm that enters market due to high fixed costs so large economies of scale can be exploited, new firms pushed out of market) - Unnecessary duplication of resources is wasteful, increasing comp undesirable, will increase average costs & consumer prices as economies of scale cant be fully exploited (results in allocative & productive efficiency) - In gov best interest BUT/EVAL regulation needed (quality control & performance targets) to ensure efficiency & no consumer exploitation - Firms are not allocative or productivity efficient unless regulated by gov Eg. Rail industry(National Rail), National Grid (electricity distribution) LRAC & LRMC downward sloping for huge Q range, Minimum efficiency scale point occurs at very high Q level, huge potential for economies of scale at very high Q Firms profit maximise at MC=MR Firm makes large supernormal profit but quantity restricted to Q1 (not enough for necessity eg water) so regulation used to bring prices to P=MC (allocative efficiency) at P*Q* (& productive efficiency) But AR below AC here so firms make loss at very low prices, often subsidised by gov of ab per unit so firms dont leave market

Question 32

Characteristics & definition of a monopsony (example & diagram)

Answer 32

= market structure in which there is only one single buyer in a given market - price/wage makers (no other firm employing same profession of workers/buying some good/service so can determine price or supplier wont earn any revenue) - profit maximisers (MR=MC), pay suppliers lowest price possible to minimise costs due to power Eg. Rarely exist irl, but firms may experience monopsony power when buy large % of market (Coal mine owner in town where coal mining is primary source of employment, NHS buy nearly all prescripted medicine from pharmaceutical companies in UK) Produce at MC=MC/D at Q1P1 (lower prices, lower quantity)

Question 33

Monopsony in the labour market (diagram)

Answer 33

= sole employer of labour in a given professions (eg. State employ teachers & nurses in UK) - wage maker - maximise revenue from workers by hiring where MC=MR - monopsony will employ workers up till where MRP=MCL at QmWm - in comp market workers employed at MRP=ACL at QcWc - so monopsonist reduces employment & lower wages then comp labour marker (Wm also much lower than MRP so very poor) very inefficient & distorted efficient labour market outcomes, lead to trade unions, strikes (MRP = marginal revenue productivity)

Question 34

Costs & benefits of monopsony to firms, consumers, employees, suppliers

Answer 34

+ lower prices for consumers (reduced costs passed on), + employees of monopolist may receive higher wages (higher profits) but less employees of supplier + purchasing economies of scale (lower costs, higher profits) + higher profits so increased R&D funding, higher dividends to shareholders - suppliers driven out of business (low prices, low supply, low profit) - supplier may provide lower quality to remain profitable - could lead to fall in supply as Q lower (EVAL depends on PES, inelastic = small fall) - exploitation of power by monopsonist

Question 35

Characteristics & def of a contestable market

Answer 35

Contestability determined by threat of new entrants into market, caused by absence of barriers to entry & exit Degree of contestability = extent to which gains from market entry for a firm exceed the costs of entering the market (no barriers/sunk costs = perfectly contestable market - not poss in reality) - absence of/low barriers to entry & exit (determines threat of new entrants into market, taking supernormal profit away from incumbent firms, sunk costs are main cause) - pool of potential entrants (absence of barriers only matters if there are lots of firms with potential & willingness to enter market EVAL) - good information (new entrants easily gain access to same tech/costs & consumer info eg. no patents) - incumbent firms subject to hit and run competition (when firms enter market making short run supernormal profit, take some profit then leave market without enduring sunk costs)

Question 36

How has technology increased contestability (EVAL)

Answer 36

- decreased barriers to entry & exit (online business reduces start ups costs, less workers need to be hired, easier to achieve tech EofS, advertising online easier) - increased pool of potential entrants (greater innovation so new firms can disrupt market eg.Uber, firms can find cheaper ways of producing things, dont need to offer something new, lower production cost methods) - improved information (internet, easier to access info costs, communication improved) BUT reduces contestability through patents, copyrights etc

Question 37

Types of barriers to entry & exit

Answer 37

- sunk costs (= fixed costs firms can’t retrieve once leaving the market eg. advertising, machinery high sunk costs = hit & run comp less likely so less contestable) - predatory & limit pricing by incumbent firms (predatory pricing = firm within market prices goods/services at level comp cant match without making loss so forces comp out of market) (Limit pricing = firms produce at AC=AR to make normal profit so no incentive for new entrants, unprofitable due to lack of economies of scale) BUT reduces profit margins - economies of scale (larger incumbent firms can exploit more economies of scale so lower AC than new entrants, can remain profitable at lower prices new entrants will make losses at) - patents (legislative means, new entrants wont have access to new tech, incumbent firms have huge advantage)

Question 38

Implications of Contestable markets for behaviour of firms (monopoly with diagram)

Answer 38

Contestability can occur in any market structure Eg. Monopoly market structure: - monopoly produces at MC=MR (profit max) gives P1Q1 with supernormal profit - due to low barriers to entry & exit, new entrants can take away LR supernormal profits - so firms produce at entry ‘limit price point’ (AC=AR in perfectly contestable markets, large threat = closer to this point for markets with diff degrees of contestability) making normal profits (new entrants dont have incentive to enter market, cant compete with low prices)

Question 39

Costs & benefits of contestable markets

Answer 39

+ allocative efficiency (limit price at AC=AR, lower prices so more consumer surplus, higher quality & quantity, greater choice) + productive efficiency (greater exploitation of economies of scale so lower costs & prices) + X-efficiency (minimising waste so lower costs & prices as firms need to prepare for new entrants) + job creation (higher quantity so more jobs as labour is derived demand) EVAL job losses - lack of dynamic efficiency (lower profit margins due to limit/predatory pricing BUT EVAL new firms may come in with innovative ideas so progress in market) - cost cutting in dangerous areas (health & safety to reduce contestability) EVAL regulation - creative destruction so job losses (if new entrants push out existing firms if contestability high) BUT EVAL if new firms are larger, more profitable, workers can move to new firm with higher wages in same industry - anti-competitive strategies (eg. Predatory pricing, limit pricing, flooding market, heavy advertising, mergers to eliminate threat, may not be efficient in LR) EVAL regulation EVAL length of contestability(may be affected by tech, patents), role of tech, regulation (minimise cost cutting, anti-comp strategies)