3.4 Market Structures Flashcards
Types of efficiency
- allocative efficiency
- productive efficiency
- dynamic efficiency
- X-inefficiency
Allocative efficiency
Shows whether resources allocated at point consumer satisfaction maximised (AR/D = S/MC)
No surpluses of demand or supply = resources allocated most efficiently
Productive efficiency (with diagram)
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
Dynamic efficiency
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
X-inefficiency (diagram + why)
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
Types of market structures (from most to least competitive)
- perfect competition
- monopolistic competition
- oligopoly
- monopoly
Characteristics of perfect competition
- 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)
Perfect comp - profit maximising equilibrium in short run
- 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
Perfect comp - profit maximising equilibrium in long run
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
What are the advantages and disadvantages of perfectly competitive markets (efficiency)
+ 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)
Characteristics of monopolistically competitive markets
- 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
Monopolistic comp - Profit maximising equilibrium in short run
- 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
Monopolistic comp- Profit maximising equilibrium in long run
- 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
Monopolistic comp efficiencies (+ and -)
- 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
Characteristics of oligopoly
- 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
Kinked demand curve to show oligopoly market (interconnectedness of firms and price rigidity)
- 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
Game theory (prisoners dilemma in simple two firm model)
- 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
Monopoly - profit maximising equilibrium
- 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)
Monopoly- third degree price discrimination (def, examples, diagram)
= 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
Costs & benefits of monopoly to firms, consumers, employees, suppliers
+ 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)
Natural monopoly (def, diagram, examples)
= 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 PQ (& 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
Characteristics & definition of a monopsony (example & diagram)
= 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)
Monopsony in the labour market (diagram)
= 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)
Implications of Contestable markets for behaviour of firms (monopoly with diagram)
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)
