3.4 Market Structures

Question 1

allocative efficiency

Answer 1

• diagram 1
• occurs when AR = MR
• resources are allocated in a way that maximises utility; consumers and producers get the maximum possible benefit
• no one can be made better off, without making someone else worse off
• there’s no excess demand or supply as demand = supply, so resources follow consumer demand, meaning there’s greater choice and lower prices, so consumer surplus is maximised
• static (concerned with resource allocation at a given point in time)

Question 2

productive efficiency

Answer 2

• diagram 1
• occurs on the lowest point of the AC curve, i.e. when MC = AC (as MC cuts AC at the lowest point)
• average costs are minimised, there’s no wastage of scarce resources, and there’s a high level of factor productivity
• in the long-run, output is maximised by exploiting all economies of scale (minimum efficient scale);
• lower prices can be passed onto consumers, increasing consumer surplus
• producers have a higher output at a lower cost and can retain / increase market share
• static (concerned with resource allocation at a given point in time)

Question 3

dynamic efficiency

Answer 3

• diagram 2
• efficiency in the long-term as a result of optimal innovation allowing a firm to reinvest its long-run supernormal profits, resulting in improvements to manufacturing methods and lower production costs
• consumers gain new innovative products, lower prices, and thus a higher consumer surplus
• producers benefit from greater market share and long-run profit maximisation
• short-run costs may be increased in order to cause long-run costs to fall
• dynamic efficiency can be evaluated by;
• considering the long time lag between making an investment and having falling average costs
• considering how some firms will face a trade-off between giving their shareholders dividends and making an investment

Question 4

X-inefficiency

Answer 4

• diagram 3
• when costs rise as a firm lacks the incentive to control production costs
• lack of incentive occurs due to a lack of competition, e.g. in monopolies, or in a firm that has no consequences for making a loss
• costs are higher than they would be with competition in the market, e.g. due to organisational slack, poor management, wastages in the production process, etc.
• X-efficiency occurs when competitive pressures cause firms to produce on the lowest possible AC curve, leading to;
• low prices and increased consumer surplus
• low costs, greater profits, and an increase in market share for producers

Question 5

efficiency / inefficiency in different market structures

Answer 5

• diagram 4

Question 6

perfect competition

Answer 6

• a market structure in which individual firms have no market power and are unable to influence prices due to the amount of competition

Question 7

characteristics of perfect competition

Answer 7

• many buyers and sellers
• sellers are price takers (accept prevailing price)
• no barriers to entry / exit the market
• perfect knowledge
• homogenous goods (firms are unable to build brand loyalty as perfect substitutes exist, and any price changes results in loss of customers)
• price is determined by the interaction of demand and supply in the market (individual firms are too small to influence price)
• firms are short-run profit maximisers - new firms enter the market when existing firms make profits, as the market seems profitable, so they increase supply in the market which lowers the average price, thus the existing firm’s profit is competed away in the long-run
• E.G. India’s rickshaw industry

Question 8

perfect competition - short-run profit maximisation

Answer 8

• diagram 5
• in the short-run, firms can make supernormal profits

Question 9

perfect competition - long-run profit maximisation

Answer 9

• diagram 6
• in the long-run, profits are competed away so only normal profit is made

Question 10

perfect competition - short-run losses and long-run equilibrium

Answer 10

• diagram 7
• firms making a short-term loss may be forced to shut down, returning the other firms in the industry to a state of making normal profit

Question 11

advantages and disadvantages of a perfectly competitive market

Answer 11

+ in the long-run, there’s a lower price; P=MC so there’s allocative efficiency
+ productively efficient in the long-run as firms produce at the bottom of the AC curve
+ supernormal profits produced in short-run may increase dynamic efficiency through investment
- in the long-run, dynamic efficiency may be limited due to lack of supernormal profits
- since firms are small, there’s a lack of economies of scale
- perfect competition rarely occurs in real-world markets; factors such as branding, product differentiation, adverts, externalities, etc. mean that competition is mostly imperfect in reality

Question 12

imperfect competition

Answer 12

• most markets are imperfectly competitive (where firms have some market power and can influence prices)
• e.g. monopolistic competition, oligopolies, monopolies, and monopsonies

Question 13

monopolistic competition

Answer 13

• a market structure in which there are many firms offering similar products but with slight product differentiation

Question 14

characteristics of monopolistically competitive markets

Answer 14

• large number of buyers and sellers
• low barriers to entry and exit (increased competition)
• products are slightly differentiated (non-homogenous), but there are many relatively close substitutes
• firms have a low degree of market power and price setting power
• demand curve is downwards sloping; firms can raise prices without losing all customers
• e.g. hairdressers, coffee shops, restaurants, etc.

Question 15

monopolistic competition - short-run and long-run profit maximisation

Answer 15

• diagram 8
• firms make supernormal profits in the short-run, but they’ll be eroded in the long-run due to increased competition from the entry of new firms

Question 16

advantages and disadvantages of monopolistically competitive markets

Answer 16

+ consumers get a wide variety of choice
+ the model of monopolistic competition is more realistic than perfect competition
+ the supernormal profits produced in the short-run may increase dynamic efficiency through investment
- in the long-run, dynamic efficiency may be limited due to lack of supernormal profits
- firms aren’t as efficient as those in a perfectly competitive market - in a monopolistically competitive market, firms are allocatively inefficient (P>MC) and productively inefficient (doesn’t operate at the bottom of AC curve) in both the short and long-run

Question 17

oligopoly

Answer 17

• a market structure in which a few large firms dominate the industry with each firm having significant market power

Question 18

characteristics of an oligopoly

Answer 18

• high barriers to entry and exit (making the market less competitive); start-up costs tend to be high and leaving the industry is hard due to the high level of sunk (unrecoverable) costs
• high concentration ratio; only a few firms supply the majority of the market, i.e. 5 or fewer firms account for 60% of total market sales, e.g. UK supermarket industry (67%)
• interdependence of firms; with relatively few competitors, firms study each other’s behaviour and are highly interdependent, i.e. the actions of one firm affect another firm’s behaviour
• product differentiation; products tend to be highly differentiated, but may occasionally be similar, e.g. petrol, and firms differentiate products using branding (non-price competition; brand loyalty)

Question 19

calculation of n-firm concentration ratios and their significance

Answer 19

• this reveals the combined market share that a specific number of firms have in a market
• e.g. 5-firm concentration ratio; market share of top 5 firms would be added together; a result of around 60% is considered an oligopoly
• the higher the concentration ratio, the less competitive the market, as fewer firms are supplying the bulk of the market

Question 20

UK supermarket 5-firm concentration ratio (2023)

Answer 20

• tesco - 27%
• sainsbury’s - 14.9%
• asda - 14%
• aldi - 10.1%
• morrisons - 8.7%
• 5-firm concentration ratio = 74.7%

Question 21

collusive behaviour

Answer 21

• collusive behaviour occurs if firms agree to work together on something, e.g. cooperate to fix prices and restrict output
• collusion leads to a lower consumer surplus, higher prices and greater profits for the firms colluding
• firms in an oligopoly have a strong incentive to collude - by making agreements, they can maximise their own benefit and restrict their output, to cause the market price to increase; this is anti-competitive as it deters new entrants

Question 22

non-collusive behaviour

Answer 22

• non collusive behaviour occurs when firms are actively competing to maintain / increase market share
• reasons for non-collusive behaviour;
• when there are several firms
• when one firm has a significant cost advantage
• goods are homogenous
• the market is saturated
• because firms grow by taking market share from rivals

Question 23

overt collusion

Answer 23

• when a formal agreement is made between firms to limit competition or raise prices
• it’s illegal in the EU, US, and many other countries
• it works best when there are only a few dominant firms, so one doesn’t refuse
• cartels are a form of overt collusion

Question 24

cartels

Answer 24

• a group of 2 or more firms who have agreed to control prices (price fixing - agreeing a fixed price usually higher than market equilibrium), limit output (so price naturally rises), or prevent the entrance of new firms into the market
• e.g. OPEC who fixed their output of oil, as they controlled over 70% of the market, thus manipulating the world price of oil
• cartels reduce uncertainty of firms, but can cause higher prices and restricted output for consumers

Question 25

tacit collusion

Answer 25

• tacit collusion is when firms avoid formal agreements, but closely monitor each other’s behaviour
• nowadays, collusion is mainly tacit, as it’s designed to be hidden from legal authorities
• price leadership is the most common form of tacit collusion
• it can take other forms, e.g. unwritten rules such as not taking away existing customers from firms, or an understanding that advertisement expenditure should be kept low
• provides similar benefits to firms and consequences to consumers as overt collusion, but to a lower degree

Question 26

price leadership

Answer 26

• this is when one firm (the largest/dominant) in the market changes their price, and other firms follow as they monitor this and adjust their prices to match
• other firms are forced into changing their prices, otherwise they risk losing market share
• this explains why there’s price stability in oligopolies
• price leader often has the best knowledge of prevailing market conditions and sets a price so they can earn supernormal profits, but also allows price followers to earn a higher profit than would be the case if competition broke out in the market
• however, the kinked demand theory suggests firms will respond differently to price increases and price cuts

Question 27

kinked demand theory

Answer 27

• diagram 9
• suggests firms in an oligopoly will respond differently to price increases and price cuts
• when the price leader increases prices, firms won’t follow as consumers will switch to them, so demand is elastic
• when prices are cut, firms will follow and reduce their prices, so the price leader doesn’t see a huge increase in demand and increased market share, so demand is inelastic when prices fall
• explains price stability in an oligopoly, so non-price competition may dominate the battle for market share

Question 28

costs and benefits of collusion

Answer 28

+ industry standards can improve as firms can collaborate on technology and improve it, e.g. in the pharmaceutical industry
+ excess profits can be used for investment, which may improve efficiency in the long-run (dynamic), or alternatively, they may be used on dividends
+ it saves on duplicate research and development
+ by increasing their size, firms can exploit economies of scale, which will lead to lower prices
- loss of consumer welfare as prices are raised and output is reduced
- absence of competition means a lack of efficiency (x-inefficiency), which increases costs of production
- reinforces monopoly power of existing firms and makes it hard for new firms to enter
- a lower quantity supplied leads to a loss of allocative efficiency

Question 29

game theory

Answer 29

• illustrates the interdependence of firms in an oligopoly
• it’s used to predict the outcome of a decision made by one firm, when it has incomplete info about another firm (uncertainty)
• each game is represented in a payoff matrix which has 3 elements; players (firms), strategies available to them, and payoffs (outcomes) for each combination of strategies
• it can be explained using the prisoner’s dilemma

Question 30

the prisoner’s dilemma

Answer 30

• diagram 10
• a model based around 2 prisoners who can either deny or confess a crime
• they aren’t allowed to communicate, but can consider what the other is likely to choose - relates to the uncertainty in an oligopoly
• represented in a pay-off matrix
• the dominant strategy is the best option, regardless of what the other player chooses, so it carries the least risk, i.e. to confess
• the nash equilibrium is the best option if collusion was allowed, i.e to deny
• however, the nash equilibrium is unstable as each prisoner has an incentive to cheat, as it could reduce their own sentences drastically

Question 31

how firms use game theory

Answer 31

• firms typically use it when making decisions about;
• whether to raise or lower prices
• new advertising and brand initiatives
• investment in product innovation
• product bundling
• represented in a payoff matrix, representing the likely profits for each strategy for each firm
• analysed in the same way as the prisoner’s dilemma - a dominant strategy with least risk, or the nash equilibrium which is unstable as one firm can cheat

Question 32

price competition

Answer 32

• non-collusive firms in an oligopoly market engage in 3 types of price competition;
• price wars
• predatory pricing
• limit pricing

Question 33

price wars

Answer 33

• involves firms constantly cutting their prices below that of its competitors
• their competitors then lower their prices to match, and the retaliation continues
• e.g. in supermarkets

Question 34

predatory pricing

Answer 34

• an illegal procedure which involves setting low prices to drive other existing firms out of the industry
• in the short-run, it leads to them making losses as prices are set below the average cost of production (AVC)
• as firms leave, the remaining firms can raise their prices to slowly regain their revenue
• it occurs when an established firm is threatened by a newer entrant
• e.g. the big 4 accounting firms have been accused of this

Question 35

limit pricing

Answer 35

• not necessarily illegal, but it involves cutting prices to a point below profit maximising level, where new possible entrants can’t sustain and compete, so it discourages their entry
• by doing so, the existing firm sacrifices supernormal profit in the short-run, but they can sustain their position in the long-run as they still have lower costs
• in evaluation; low profits of existing firms may dissatisfy shareholders as they recieve lower dividends

Question 36

non-price competition

Answer 36

• aims to increase product differentiation, brand loyalty, and market share which means firms can attract and keep more customers, which makes demand more inelastic
• kinked demand curve suggests prices tend to be stable in oligopolies, causing firms to concentrate more on non-price competition

Question 37

types of non-price competiton

Answer 37

• strategies used for non-price competition include;
• good customer and after sales service; positive brand reputation and encourages repeat purchases
• special offers, loyalty cards, or rewards; attracts consumers
• advertising and branding and celebrity / influencer endorsement; makes the brand more known and influences consumer preferences (however, it may be ineffective for some and lead to high sunk costs)
• delivery policies; more available delivery times is more convenient for customers (Amazon Prime)
• unique selling point; differentiated, customised products are more appealing to consumers that mass-produced homogenous goods
• product warranties; helps alleviate consumer’s concerns, so they’re more likely to purchase
• firms can do all of this if they have supernormal profits to reinvest

Question 38

monopoly

Answer 38

• pure monopoly; a market that only contains one seller, so they own all of the market share (extremely rare), e.g. the Royal Mint
• near pure monopoly; a market structure in which there’s one dominant seller, so they own almost all of the market share, e.g. Google who own 90%
• monopoly power; in the UK, the CMA says a firm has this if they own more than 25% market share, e.g. Tesco with 30% - it can be gained with multiple sellers in a market

Question 39

characteristics of a monopoly

Answer 39

• sole seller in a market (a pure monopoly)
• high barriers to entry
• profit maximisation (earns supernormal profits in short and long-run)
• price maker
• price discrimination

Question 40

factors influencing monopoly power

Answer 40

• high barriers to entry make it easier for firms to maintain the power, e.g. through;
• economies of scale; existing firms have a large cost advantage, maintaining their monopoly power and deterring new entrants as they’re unable to compete
• limit pricing ensures new firms can’t enter profitably
• controlling a resource
• high sunk costs in an industry, e.g. advertising, deters new firms as they won’t get these back if they’re unable to compete
• high set-up costs makes it unlikely for new firms to enter
• if brand loyalty is high, e.g. through advertising, it makes demand price inelastic, creating a barrier to entry

Question 41

monopoly - profit maximising equilibrium

Answer 41

• diagram 11
• as the firm is the sole supplier, they are the entire market, so their cost and revenue curve is the same also the industry’s cost and revenue curve
• profit maximising firm which earns supernormal profits
• not static efficient, but are dynamically efficient as they earn long-run supernormal profits which can be reinvested

Question 42

third degree price discrimination

Answer 42

• occurs when a monopolist charges different prices to different consumers for the same good / service
• consumers are often sub-divided based on time (peak/off-peak), age (e.g. student discount), income, and geographic location

Question 43

third degree price discrimination - necessary conditions

Answer 43

1. market power; the firm must have the ability to change prices, and it works best when there are no/few substitutes
2. ability to prevent resale; it must be able to prevent consumers buying in the low-price sub-market and reselling it in the higher ones
3. varying consumer PED; the firm must identify the different consumer sub-markets which have different price elasticities of demand, as this allows the market to be split and different prices to be charged

Question 44

third degree price discrimination - diagrammatic analysis

Answer 44

• diagram 12
• the different elasticities in a market means the monopolist can charge different prices; inelastic demand group will have a higher price and it’ll be lower for the elastic group
• by charging different prices, the monopolist can maximise their overall profits
• it must not cost the monopolist much to split up the market, or else it won’t be financially worthwhile

Question 45

third degree price discrimination - costs and benefits to consumers and producers

Answer 45

consumers;
+ some consumers will benefit as they take advantage of lower prices
+ consumers who were previously excluded by high prices may now be able to afford the good, e.g. drug companies may charge those on lower incomes less for the same drug, making it affordable for them and this can yield positive externalities
+ higher prices will decrease quantity demanded, which results in increased consumer utility for some, e.g. helps limit over-crowding on train services
- loss of consumer surplus as they pay higher prices
producers;
+ increased producer surplus (but at the expense of a decrease in consumer surplus)
+ higher supernormal profits can help stimulate investment
+ if profits are made in one market, it can cross-subsidise another market that’s making a loss, which limits job losses that may otherwise arise from the closure of the loss-making market
- it may cost the firm to divide the market, which limits the benefits they could gain
- if it’s used as a predatory pricing method, the firm could face investigation by the CMA

Question 46

costs of monopoly to firms, consumers, employees and suppliers

Answer 46

firms;
- a lack of competition may lead to diseconomies of scale as firms become complacent - their efforts are focused on protecting market dominance so they have less incentive to be efficient, so they’re not statically efficient
consumers;
- less consumer choice as one firm dominates
- reduced consumer surplus due to higher prices and lower output
- lack of competition may lead to lower quality goods
- other firms can’t establish themselves in the market as they’re forced out by limit pricing before they even have a chance
employees;
- having only one supplier in the industry limits the opportunity to change employers
- issues with diseconomies of scale, e.g. no voice in a huge workforce, longer time for decisions to be made, etc.
suppliers;
- less competition for their products
- a monopoly often has monopsony power to dictate what price they’ll pay, so they may reduce the supplier’s profits by paying the minimum price

Question 47

benefits of monopoly to firms, consumers, employees and suppliers

Answer 47

firms;
- supernormal profits allows for increased dividends for shareholders, investments, and the build up of reserves to overcome short-term difficulties
- they can exploit economies of scale to further reduce costs (MES)
- market power increases global competitiveness
consumers;
- product innovation due to the firm’s supernormal profits may result in a better-quality product
- cross subsidisation can lower prices on some products
employees;
- better job security
- supernormal profits may be passed onto workers, e.g. through bonuses or higher wages
suppliers;
- a secure outlet could be offered to suppliers, e.g. contracts to a supermarket

Question 48

natural monopoly

Answer 48

• occurs when one large firm can supply the entire market at a lower long-run average cost, contrasted with multiple providers
• there are high fixed costs, usually in the form of infrastructure, which tend to be sunk costs, making barriers to entry / exit high and making it rational for 1 firm to supply the entire market, so there’s no wasteful duplication
• the economies of scale are so large that even a single producer isn’t able to fully exploit them all, so new entrants would find it impossible to match the costs and prices of the established firm
• such monopolies have considerable power as there are no good substitutes for their products
• they maintain their position as the sole supplier due to high barriers to entry, e.g. legal barriers (such as patents), access to specific materials, high fixed / sunk costs, etc.
• usually occurs in utility industries and are regulated by the govt, e.g. through maximum prices, to ensure consumers aren’t charged higher monopoly prices
• e.g. London underground

Question 49

natural monopolies in the long-run

Answer 49

• diagram 13
• govts. regulate their output, moving it to the social optimum level so they’re allocatively efficient
• this means the monopolist makes a loss, so the govt. comes in and subsidises that loss, as they’re essentially public services, e.g. gas, electricity, rail, etc.
• so, firms recieve normal profits

Question 50

comparing perfect competition with monopolies

Answer 50

• diagram 14 - the Williamson tradeoff

Question 51

monopsony

Answer 51

• a market structure in which there’s only one buyer
• pure monopsonies are rare but many firms have monopsony power if they’re the dominant buyer (e.g. in an oligopoly / monopoly)
• firms with monopsony power are price makers as they determine the prices they pay, meaning they exploit bargaining power with a supplier (price takers) to negotiate lower prices, e.g. supermarkets with farmers
• monopsony employers are those who are the sole employer of a particular type of labour, e.g. in the UK the main buyer of the labour of doctors and nurses is the NHS

Question 52

characteristics of a monopsony

Answer 52

• profit maximisers; they’ll pay their supplier the lowest price possible to minimise their costs and make the most of their position as the only buyer, enabling them to profit maximise
• price makers; a firm with monopsony power can negotiate lower prices as their suppliers have nowhere else to sell to, as they’re the only buyer
• wage makers; monopsony employers have high buying power over their employees, so they can can exploit them by paying lower wages
• they purchase a large portion of the market supply provided by sellers

Question 53

monopsony power in the labour market

Answer 53

• diagram 15
• employers with monopsony power can exploit employees by using their high buying power to under-pay them
• the govt. may intervene with a minimum price to solve this
• issues;
• workers are paid less than their MRP
• lower wages increases inequality in society
• employers may have a degree of monopoly selling power, so they can make high profits at the expense of consumers and workers
• employers may care less about working conditions as workers don’t have many alternatives to the main firm

Question 54

costs of monopsony to firms, consumers, employees and suppliers

Answer 54

firms;
- may experience reputational damage for the way they treat their suppliers
- conflicts may arise with suppliers
- they may drive suppliers out of business in the long-run, causing supply-chain issues
consumers;
- quality of products may decrease as suppliers attempt to cut their own costs in response to the price pressure from the firm
- may lead to a fall in supply as the firm buys fewer inputs (but this is dependent on PES)
employees;
- they may not agree with their company’s values / ethics
- if suppliers are forced out of business, it reduces the firm’s profits which can lead to job losses or wage cuts
suppliers;
- firms may use their monopsony power to squeeze lower prices out of suppliers, thus reducing their profits
- they may even be driven out of business in the long-run

Question 55

benefits of monopsony to firms, consumers, employees and suppliers

Answer 55

firms;
- gain higher profits by purchasing at lower prices
- higher profits leads to more return for shareholders and increases investment funding
- achieve purchasing economies of scale (from bulk-buying)
consumers;
- lower average costs for the firm may result in lower prices for consumers, increasing their consumer surplus
- potentially better quality products if profits are invested into investment
employees;
- monopolists may pass on their higher profits through higher wages for employees
suppliers;
- supplying to a large well-known firm may enhance their reputation and open up new opportunities
- long term contracts with firms guarantees regular business for them, reducing uncertainty
- if the supplier has monopolist power, it can counteract the monopsonist, i.e. in a bilateral monopoly with one buyer and one seller - e.g. negotiation between the govt. employing teachers and a trade union for teachers

Question 56

contestability

Answer 56

• a measure of the ease within which firms can enter or exit an industry
• so, a contestable market is one with a high threat of new entrants, which keeps firms producing at a competitive level
• it’s different from perfect competition as it involves differentiated products and one firm can have price setting power
• e.g. the fast food industry is highly contestable

Question 57

characteristics of contestable markets

Answer 57

• no significant barriers to entry
• no / low sunk costs (unrecoverable costs that can’t be recouped if the firm closes down, e.g. money spent on advertising)
• perfect knowledge, e.g. when supernormal profits are being made, or as all have access to relevant technology / capital
• firms are short-run profit maximisers (but realistically they only make normal profits to avoid hit and run competition)
• firms are in competition and don’t wish to collude
• the number of firms may vary

Question 58

implications of contestable markets for firms

Answer 58

• the more contestable a market, the more the behaviour of firms resembles that of perfect competition, as existing firms act as though there’s lots of competition, e.g. they’re more likely to be allocatively efficient, and in the long-run, more productively efficient as they operate at the bottom of the AC curve
• firms making supernormal profits in the short-run are wary of hit and run competition

Question 59

hit and run competition

Answer 59

• diagram 16
• when existing firms make supernormal profits, it incentivises new firms to enter, benefit from the higher profits, and then exit the market when normal profit is made again
• to combat this, existing firms making SNP may change their pricing strategy from profit maximising to limit pricing, e.g. by setting price where AR=AC, reducing hit and run competition and disruption to the market, and resulting in normal profits

Question 60

costs and benefits of contestable markets

Answer 60

+ reduced prices and higher output, so greater choice and better consumer surplus
+ firms are allocatively and productively (statically) efficient
+ regulation can minimise the dangers
- with no supernormal profits, firms can’t be dynamically efficient
- firms need to cut costs if they move production from profit maximising point to a productively efficient point, so this may impact the quality of goods, or may lead to job losses / lower wages

Question 61

types of barrier to entry and exit

Answer 61

• structural barriers; innocent, and exist simply due to the nature of the business of the market;
• high start-up costs for capital, i.e. high sunk costs
• economies of scale means new firms are unable to produce on the same AC curve as large, incumbent firms as they wouldn’t cope
• vertical integration means one firm can gain more control of the market, creating a barrier to entry
• strategic barriers; deliberately imposed, and may be seen as anti-competitive;
• predatory pricing; prices reduced so low that some existing firms are driven out of the market, so it would be very difficult for any new firms to enter
• limit pricing; discourages entry of new firms due to low prices and only normal profits being made
• marketing barriers, e.g. high levels of advertising build up consumer loyalty / brand establishment, so demand becomes more price inelastic as they’re less likely to switch to new brands
• statutory barriers; legally imposed barriers by authorities;
• e.g. patents, market licences (e.g. taxi industry), and exclusive rights to production (e.g. with television), makes it harder for other firms to enter the market

Question 62

sunk costs

Answer 62

• a barrier to contestability
• costs which can’t be recovered once spent
• e.g. advertising incurs a sunk cost
• high sunk costs reduce incentive for new firms to enter as the risks associated with entering the market are high
• they increase barriers to exit, so they’re likely to push a market towards similar production levels to a monopoly (as firms in highly contestable markets tend to make normal profits due to the threat of hit and run competition)

Question 63

degree of contestability

Answer 63

• the degree of contestability is measured by the extent to which the gains from market entry for a firm outweigh the costs of entry
• e.g. the higher the sunk costs, the higher the barriers to exit, so the less contestable the market
• a market with no sunk costs and no barriers to entry / exit is a perfectly contestable market
• the low-cost airline industry can be seen as having some degree of contestability, e.g. if firms can rent planes cheaply and choose less popular landing slots, e.g. Ryanair

Question 64

increased contestability in markets in recent years

Answer 64

• globalisation is a cause for this, e.g. it’s easier for foreign firms in the EU to enter domestic markets
• competition policies mean firms can’t use anti-competitive policies such as predatory pricing

Question 65

reasons for collusive behaviour

Answer 65

• few firms / competitors; makes it easier to collaborate on prices / output
• similar revenue; competitors’ goods sell for similar prices as there’s little incentive to lower them, as other firms would respond and do the same and this would just decrease profits
• high barriers to entry; unlikely that new entrants will emerge to disrupt the status quo (current situation)
• ineffective regulation; a lack of regulation empowers firms to collude as there’s little consequences for their actions, e.g. easier for them to engage in anti-competitive practices
• brand loyalty; usually a high degree in oligopolies & firms have an established market share, which decreases benefits of competition as consumers are unlikely to change brands, so they may as well collude