3.4 Market Structures Flashcards
What is **allocative efficiency **
when the value to society from consumption is equal to the marginal cost of production, where P=MC.
What is productive efficiency
firms produce at the bottom of the AC curve, in the short run this is where MC=AC, has to be technically efficient
What is **dynamic efficiency **
his is achieved when resources are allocated efficiently over time. It is concerned with investment,will be achieved in markets where competition encourages innovation but where there are differences in products and copyright/patent laws.
Supernormal profit is required to provide firms with the incentive to invest and the ability to do so.
What is static efficiency
oncerned with the most efficient combination of existing resources at a given point in time.
Allocative + prod effieiencies
What is a x-inefficiency
If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is organisational slack. It often occurs where there is a lack of competition so firms have little incentive to cut costs.
What are the 2 types of dynamic efficiency
- Cost Reducing Innovation
- Creative Destruction
What makes up cost reducing innovation
* Product innovation
○ Small-scale and frequent subtle changes to the characteristics and performance of a good or a service
* Process innovation
○ Changes to the way in which production takes place or is organised
○ Changes in business models and pricing strategies
Innovation has demand and supply-side effects in markets and the economy as a whole
What is social efficiency
- The socially efficient level of output and/or consumption occurs when marginal social benefit (MSB) = marginal social cost (MSC)
What are the impacts of Monopoly allocative inefficiency
- The monopolist will seek to extract a price from consumers above the cost of resources used in making the product.
Higher prices mean that consumers’ needs and wants are not being satisfied, as the product is being under-consumed.
Higher prices cause a loss of consumer surplus & welfare and will disproportionately affect lower income families.
What effiencies does Perfect Competition have
- Allocative efficiency: In both the short and long run, price is equal to marginal cost (P=MC)
- Productive efficiency: in the long run
so static efficiency
Dynamic efficiency: no room to innovate because homogeneity or enough for R+D
● Competition should keep costs, and therefore prices, low. However, firms will be unable to benefit from economies of scale and this may mean costs are higher than they otherwise could be.
What efficiencies does Monopolistic Competition have
- Prices are above marginal cost – meaning that the equilibrium is not allocatively efficient
- Saturation of the market may lead to businesses being unable to exploit fully economies of scale - causing average cost to be higher – therefore not productively efficient
- Debate over the social costs of packaging and negative externalities is linked to monopolistic competition
Monopolistic competition associated with extensive consumer choice and innovation – good for dynamic efficiency
Do takeovers boost economic efficiency
- Economies of scale from horizontal integration (productive efficiency)
- Higher supernormal profits leads to increased R&D spending and more innovation (dynamic efficiency)
Firms with monopoly power still face competition in contestable markets (allocatively efficient prices)
Do takeovers boost economic efficiency
- Increased market power can lead to X-inefficiency (managerial slack, waste)
- Risks of diseconomies of scale (rising long run AC)
- Many takeovers fail to achieve forecast cost gains
Growing number of de-mergers points to limited impact of takeovers on overall economic efficiency
Economic case against monopolies
- Prices are higher than under competitive conditions
Leads to a loss of allocative efficiency (price > MC)
**Regressive effects **on lower-income households - Absence of genuine market competition may lead to production inefficiencies
○ X-Inefficiencies such as wasteful production and advertising spending
○ Higher prices can limit the final output in a market and lead to fewer economies of scale being exploited - Protected markets – perhaps less drive to innovate
Monopoly may get too big – diseconomies of scale
What is the economic case for monopoly power
High market concentration does not always signal absence of competition; can reflect the success of firms in providing better-quality products, more efficiently, than their rivals.
- Profits used to fund investment & research
- Natural monopoly – economies of scale
- Domestic monopoly faces global competition
- Monopolistic firms can be regulated – i.e. industry regulator acting as a proxy consumer
- Price discrimination may help some consumers (cross-subsidisation)
What did Schumpeter argue about monopolies and creative destruction
· Schumpeter argued that firms have a very real incentive to invest in R and D,
· He stated that firms would fear Creative Destruction. Where new firms enter the market with technological advancement a force out existing firms. Incumbents fear this.
* They invest therefore in R and D and this is likely to come in the **form of the product/process. **
What does investment in the product result in (quality)
· Scarce resources are effectively allocated to meet consumer needs and wants.
· Consumers utility is met/improved and although consumers may face higher prices one could argue this level of product development and meeting the consumers’ needs is not possible in a competitive market due the absence of abnormal profit in the long run.
What does investment in the process result in (cost)
Investment in production-invention or innovation.
Investment in process is an example of technological EOS and the impact of tech improvement will drive down average and marginal cost. This can be shown. (see diagram)
What are the 4 key characteristics of a perfectly competitive market
1.There must be many buyers and sellers. This means that no one will be able to influence the market
2. freedom of entry and exit from the industry
3. There must be** perfect knowledge**
4. Homogenous products
Why must there be freedom of entry and exit for a perfectly competitive market
when a business is making profits anyone can enter that market and start producing that product for themselves.
As a result, business are unable to make SNP in the long run and if they are making losses they are able to leave. In the long run, they make normal profits.
Why must there be perfect information for a perfectly competitive market
This enables firms to know when other firms are making profits which will attract them to join the market. Moreover, all firms have the same costs as they can use the same production techniques.
It also means that any attempt to raise prices above the level determined by the market will lead to no sales, as customers will be aware they can buy the same good for a lower price and firms know there is no point lowering the price as they will sell all their goods at the higher price determined by the market.
Why must there be homogeneity for a perfectly competitive market
it means if a firm raises it price above the competitors’ no one will buy it and they will not gain from lowering their price because they can sell all of your product at the same price as everyone else.
What possibilities are there for perfectly competitive firms in the short run
Firms are assumed to short run profit maximise and so the firm will produce at MC=MR. In the short run, it is possible for the firm to make a normal profit, a supernormal profit or a loss
What possibilities are there for perfectly competitive firms in the long run
Only normal profits :0
How do PC firms go from SR SNP to LR NP
SR SNP signals to other firms to enter the market (perfect competition + no barriers) so they enter causing a shift out in supply of the industry so firms have to sell at a lower and lower price (price-taker) until SNP disappears
How do PC firms go from SR subnormal profits (loss) to LR NP
PC firms will know they are making a loss and leave to produce their opportunity cost (no barriers to exit). This causes a shift in of supply in the firm causing firms to increase their price ( price taker ) until there is no loss and normal profit is left
When drawing PC market structures what do you always have to includes
The market (s+d diagram) because firms are price takers
How would you evaluate the PC model
- Most firms have some amount of price-setting power – they are price makers not price takers!
- Dominance in real world markets of differentiated / branded products
- Highly complex products, there always information gaps facing
consumers - Impossible to avoid search costs even with the spread of digital/web technology
- Patents, control of intellectual property, control of key inputs are all ignored by the competitive model
- Rare for entry and exit in an industry to be costless
What are the characteristics of Monopolistic Competition
● There must be a large number of small, independent buyers so no one buyer or seller has a large price setting power.
● There are no barriers to entry or exit
● The difference is that in monopolistic competition firms produce differentiated, non-homogenous goods or services.
* The entrepreneur has a more significant role than in firms that are perfectly competitive because of the increased risks associated with decision making.
How do MC profit maximise in the short-run
Firms are assumed to be short run profit maximisers
As a result, they produce Q1 at MC=MR and make a supernormal profit
Why do MC produce normal profits in the long run
new firms will enter the industry as they know that supernormal profits are being earnt.
This will cause demand for the individual firm to decrease and therefore the AR and MR curves will shift to the lift and so the firm is making normal profits.
If the firm was making a loss, firms would leave the industry and thus demand for the individual firm would increase as they had less competition. This would lead to normal profits in the long run.
What are the limitations of the MC model
- that information may be imperfect and so firms will not enter the market as predicted as they are unaware of the existence of abnormal profits.
- firms are likely to be different in their size and cost structure as well as in their products, which may allow some firms to maintain supernormal profits because firms cannot compete on equal terms.
What are the efficiencies of the MC model
● Since they can only make normal profit in the long run, AC=AR and since they profit maximise, MR=MC. Therefore, the firm will not be allocatively or productively efficient, as MR does not equal AR so AC cannot equal MC and AC cannot equal MR.
● 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 receive finance or have the retained profits necessary to invest.
● In monopolistic competition compared to perfect competition, less is sold at a higher price and firms may not necessarily be producing at the lowest cost. However, the market will offer greater variety and may be able to enjoy some degree of economies of scale.
What are some advantages of monopolistic competition
· There are no significant barriers to entry; therefore markets are relatively contestable.
· Differentiation creates diversity, choice and utility.
The market is more efficient than monopoly but less efficient than perfect competition - less allocatively and less productively efficient.
What are the disadvantages of monopolistic competition
· Some differentiation does not create utility but generates unnecessary waste, such as excess packaging. Advertising may also be considered wasteful, though most is informative rather than persuasive.
· there is allocative inefficiency in both the long and short run. This is because price is above marginal cost in both cases.
In the long run the firm is less allocatively inefficient, but it is still inefficient.
There may be a lack of dynamic efficiency in the long run due to the absence of long run abnormal profit
Why is there a tendency for excess capacity in MC
- There is a tendency for excess capacity because firms can never fully exploit their fixed factors because mass production is difficult. This means they are productively inefficient in both the long and short run.
What are the characteristics of an oligopoly
- products are generally differentiated
- supply in the industry must be concentrated in the hands of a relatively small number of firms
- firms must be interdependent so the actions of one firm will directly affect another
- there are barriers to entry.
Explain the kinked demand curve theory
· At P1 if one firm increased their price, other firms would not follow suits. Consumers would buy from the other firms therefore the firms raising price would face a PED elastic response on the AR curve would lose a large share of the market, revenue and likely profit
· If one firms cut price then they could gain a big increase in market share, however it is unlikely that firms will allow this. Therefore, other firms follow suit and cut price as well. Therefore demand will only increase by a small amount: Demand is inelastic for a price cut and revenue would fall for all firms
· This model suggests price will be rigid because there is no incentive for firms to change the price, they are risk averse.
What are the limitations of the kinked demand theory
- It assumes there is an intial price set
- It does explain why prices tend to be stable
What was the n-firm conc. ratio
total sales of n firms x100 /total size of market
What is collusion
- Collusion is when firms make collective agreements that reduce competition .
- When firms don’t collude, this is a competitive oligopoly.
What are the advantages of collusion
● if they work together, they could maximise industry profits.
● Collusion reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising, which will reduce industry profits.
What are the disavantages of collusion
● collusion is illegal and due to the risks of collusion , such as other firms breaking the cartel or prices being set where they don’t want it.
● A firm with a strong business model and something that sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors.
When does collusion work best
there are a few firms which are all well known to each other
the firms are not secretive about costs and production methods and the costs and production methods are similar
they produce similar products
there is a dominant firm which the others are happy to follow
the market is relatively stable; and there are high barriers to entry.
What are the 2 types of collusion
overt and tacit collusion.
Overt collusion is when firms come to a formal agreement whilst tacit collusion means there is no formal agreement.
What is a cartel
A formal collusive agreement is called a cartel, which is a group of firms who enter into agreement to mutually set prices.
The rules will be laid out in a formal document which may be legally enforced and fines will be charged for firms who break these rules.
What are the 2 ways a cartel can operate
1) agree on a price for the goods and then compete freely using non-price competition to maximise their market share
2) agree to divide up the market according to the present market share of each business.
What are the problems with cartels
● there is constant temptation to break the cartel. The more successful the cartel, the greater the incentive to break it; it is important for firms to be the first to break it and not the firm who is left to deal with the after effects.
● Since collusion is illegal, firms may be involved in tacit collusion such as price leadership and barometric firm.
What is price leadership
Price leadership is where one firm has advantages due to its size or costs and becomes the dominant firm to set the price
Other firms will tend to follow this firm because they would be fearful of taking on the firm on in any form of price war.
What is barometric price leadership
● Barometric firm price leadership is where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their leader.
What are 2 strategies a firm can take
- MaxiMin Policy - firms working out the strategy where the worst possible outcome is the least bad (minimising losses)
- MaxiMax Policy - firms working out the policy with the best possible outcome.
If Minimax policy and Maximax policy are the same what is this strategy
Dominant Strategy
What is a Nash Equilibrium
where neither player is able to improve their position and has optimised their outcome based on the other players expected decision.
They have no incentive to change behaviour, unless someone else changes theirs.
Use a Game Theory matrix to explain why oligopolies have stable prices
What does the prisoners dilema show about the Nash Equilibrium
What are the types of price competition
- Price Wars
- Predatory Pricing
- Limit Pricing
What are price wars and when do they occur
● These occur in markets where non-price competition is weak ; where goods have weak brands and consumers are price conscious. They also occur when it is difficult to collude.
● A price war will drive prices down to levels where firms are frequently making losses. In the short term, firms will continue to produce if their AVC is below AR but in the long run, they will leave the market and prices will have to rise since supply falls.
● It lowers industry profits.
What is predatory pricing
●Threat of Competition means Firms sets such a lower price so firms are unable to make a profit
● This is illegal and only works when one firm is large enough to be able to have low prices and sustain losses.
What is **limit pricing **
● In order to prevent new entrants, firms will set prices at AC=AR to ensure normal profits
● The greater the barriers to entry, the higher the limit price. It is mainly used in contestable markets.
● The drawback of this is that it means firms cannot make profits as high as they would be otherwise be able to.
What is cost plus pricing
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Firms add on a percentage increase to their average costs; doesn’t consider the market
What is pychological pricing
Firms utilising non-rounded prices to given an impression that the price is cheaper than it is
What is market led pricing
Firms follow pricing set by other firms; ignores cost
What is price skimming
new products can have high prices to cover R+D and supress demand
This can be lowered over time
Draw a Cartel Firm’s SNP when staying within the quota of output
Draw the incentive to cheat shown by a Cartel Firm’s SNP
Draw a monopoly market
Draw a diagram for 3rd degree price discrimination based on separation by PED
The diagram shows the seperate markets for separate groups: those with inelastic demand and those with elastic demand. Assumption of constant cost
This shows that by price discriminating and having two separate markets, the inelastic market and the elastic market, rather than a combined market, the firm can make higher profits. The orange area plus the purple area is larger than the yellow area.
Draw a diagram for 3rd degree price discrimination based on separation by PED
The diagram shows the seperate markets for separate groups: those with inelastic demand and those with elastic demand. Assumption of constant cost
This shows that by price discriminating and having two separate markets, the inelastic market and the elastic market, rather than a combined market, the firm can make higher profits. The orange area plus the purple area is larger than the yellow area.
Draw a natural monopoly
Draw the Williamson trade off and describe the areas of DWL, falls in consumer surplus, gains in producer surplus
Analyse this diagram
- As a profit maximiser the monopoly will restrict output to Q1 in order to achieve MC=MR.
- Consumers suffer through a lack of choice but also high prices reducing surplus to [5,6,7].
- Producer benefits by capturing surplus from the consumer, a transfer in welfare [1,2,11,12]. Total producer surplus is now [1,2,13,14].
- The monopoly is not allocatively efficient as P≠MC, This creates a welfare loss of [8,9,10] made up of lost consumer and producer surplus.
- The firm is not productively efficient it doesn’t not produce at the lowest point of the AC curve
- there is likely to be a degree of x-inefficiency. This results in higher AC, higher prices and poor service.
- The monopoly does not fully exploit its EoS on the graph as it does not produce at the MES point since it restricts output.
What is 1st Degree Price Discrimination (Perfect Price Discrimination)
- Each consumer in theory is charged the maximum they individually are willing to pay so extracts all consumer surplus.
- In reality, this is an unrealistic theory as consumers are unlikely to reveal their true preferences
What is third degree price discrimination (direct price discrimination)
This involves charging different prices to different groups of people
Draw a predatory pricing diagram
Draw a limit pricing diagram
Draw a monopsony diagram
They will produce where the cost to them (MC) is equal to the value they get (AR). Hence, they will produce where MC=D.
Draw the effect of contestability
· There is downward pressure on prices because high prices and profits act as incentives for new producers to compete away monopoly profit.
· Normal profit will occur AC=AR (link to alternative objectives)
· An improvement in c/s and welfare will occur.
