3.4 Market Structures Flashcards
Allocative Efficiency
MC=AR
The socially desireable level of output
Minimising their costs
Productive Efficiency
MC=AC
Where the firm produces at their lowest possible cost
Profit maximising point
MC=MR
Dynamic efficiency
When a firm reinvests into R+D and innovation, become more efficient, reduce costs, increased SNP
Characteristics of Perfect Competition
Very large no of small firms
No barriers to entry/exit
Perfect knowledge of the market
Firms are so small they cannot set prices - price takers
All firms produce homogeneous goods (can’t distinguish/no branding or brad loyalty)
Perfect Comp SN profits (SR)
If AC is below AR, they will be making SNP. Other firms will be attracted to this and as there is perfect info and no barriers, they too will join the market. Meaning that S shifts right, decreasing industry price, demand falls - firms make normal profit
Perfect Comp Losses (SR)
If firms are loss making, they will begin to leave the industry. S will shift right and prices increase. (firms can make normal profit). Isn’t attractive to new entrants. No SNP is being made but costs are covered.
Drawing perfect competition
Draw an S+D graph for the industry which then sets the price for the firm.
Demand is perfectly elastic (if firms increase price, D falls to 0 as goods are homogeneous)
Characteristics of Monopolistic competition
Very large no of small firms
Low barriers to entry/exit
Perfect knowledge of the market
Firms can raise their prices without losing their entire market share
All firms produce slightly differentiated goods (extent of brand loyalty)
Drawing Monopolistic
MR is twice as steep as AR
MC cuts AC at it’s lowest point
Not Productively/Allocatively efficient
Characteristics of Oligopolies
Few firms dominate an industry: a large proportion of the industry’s output is produced by a small number of firms.
Differentiated products
Interdependence of firms
High barriers to entry
Drawing Oligopoly
What is the the concentration ratio
The proportion of market share of the largest firms in the industry.
CR4 = 60% four firms own 60% of MS
Define Barriers to entry
Aspects of a market which are designed to block potential entrants from entering a market profitably
BtE allow firms to continue making SNP in the LR
Types of barriers to entry
Natural (exist due to industry structure): High sunk costs, High fixed costs, EoS, Vertical integration
Artificial (created by firms to deter entrants): Strong brand image, legal restrictions, collusion, pricing strategies[ set P below AVC]
Define collusion
collective agreements between firms that are either formal or tacit with an aim to reduce competition
Who monitors/enforces anti-competitive behaviour
CAM: Competition and markets authority
Anti-competitive behaviour is prohibited in the UK
Leniency programme
Does the CMA’s fine deter firms from colluding
No, as the supernormal profits outweigh the CMA’s fine.
Sanctions for collusions
Leniency programme incentives
Direct the firm to modify or terminate the agreement
Impose a financial penalty of max 10% worldwide turnover (if it has been committed internationally or negligently)
Disqualification of managers of up to 15 years
Possible criminal sanctions - max 5 years prison
Why cartels?
Increase prices by removing competition
Remove the incentive for businesses to operate efficiently and to innovate
Consumer choice is weakened
Overt collusion: Cartel
Overt and most extreme case of collusion - An agreement between businesses not to compete with each other
price fixing, bid rigging, market sharing, output restrictions
Cartel - Estate Agent case study
[Price fixing] Kept their fees high - min commision rates of 1.5% = denied local homeowners the chances of getting a better deal when selling their homes - Decreases CS
Market share was as much as 95%
They took it in turns to police the agreement
Fined £370,000 by the CMA, 6th fine not fined as they confessed their involvement
Cartel - Fender case study
They sold their guitars at/above min price and forced retailers to increase their online prices
Fined £4.5mil but annual SNP of £380mil outweighs the fine, employees deliberately covered up
Means consumers could not shop for the best price, significant decreased CS
Tacit collusion
When firms’ behaviour indicates that they have reached an understanding on pricing and output decisions.
Tacit collusion: price leadership
The dominant firm increases prices and others follow, the price leader will set a price high enough for even the most inefficient firm to still make profit. It can be very complex to prove
i.e rising prices in the UK utility companies
Collusion graph
They work together to set a price
Firms act as a (monopoly) single producer
They charge a monopoly price
Restrict output
Make SNP in SR and LR
Not PE or AE: oligopoly price is much higher and Q is much lower
Market failure: P is greater than the SOL
Q is under-produced
SOL is AE where MC=AR
Demonstrate a CMA fine on a graph
Oligopoly graph, CMA impose the fine (ie £4.5mil)
AC would shift up to AC2
This is a fixed cost and would not change with output. Show old SNP and then reduced.
Game-theory
Nash equilibrium
Each individual in the group makes the decisions for their own personal benefit. Based on what he thinks others will do.
How does the payoff matrix illustrate interdependence
It shows the different decisions a firm may make and how the outcomes of these decisions affect another firm
How does the payoff matrix illustrate the incentive to collude
As there is really a dominant strategy, it shows the incentive as far as firms agree to predict better outcomes for all
Draw the payoff matrix
box, low price, high price, both firms
What is a dominant strategy
A single strategy that provides the best outcome for a firm, irrespective of the strategy which other firms adopt.
What does a kinked demand curve show
Shows the price rigidity because of interdependence and elasticity
Define non-price competition
Firms promotions and marketing strategies which aim to develop brand loyalty and make the AR curve more inelastic and shift AR and MR (artificial barrier to entry)
Why would an oligopolist cut prices below P1
Rivals will feel forced to also lower their prices to avoid losing customers to the other firm. Therefore PED is relatively inelastic (demand is relatively unresponsive to change in P)
What would happen if an oligopolist raises its prices
Competitors will not follow suit, as they will gain customers from the other firm. PED is more elastic as consumers would switch
What happens to profit in non-price competition
Often decreases, IDO on the size of the shift in AC compared to the shift in AR.
AC can shift up
AR can be elastic/inelastic
Why would N-P competition not raise revenue
The amount they spend on the (marketing, advertisement..) can increase their fixed costs, shifting AC up and lowering their SNP
Define price competition and when it takes place
Usually in oligopolistic markets, firms either collude on price or have rigid prices (as evidenced by the kinked DC)
In certain circumstances they may engage in types of price competition
Define predatory pricing
When an established firm is threatened by a new firm entering the market or an existing firm, so they set such low prices so that the new entrant is unable to make profit. Once the entrant leaves the firm, they can raise their prices again. PED is now inelastic due to the lack of available substitutes
Predatory pricing and SRSP
When they reduce their prices, they often take them below AVC (AVC>AR). They are loss making and cannot even cover their average costs.
In the SR they are making a loss, in the LR they are making SNP
It can be financed through retained profits and income from other (sectors/ assets?)
Limit pricing
This occurs when firms set a low enough price to deter new entrants from joining the market. Price is likely to be less than the profit maximising points (MC=AR)
This isn’t always illegal
Price wars
when non-p competition is weak (brand loyalty/advertising)
Often happens with staple goods. PED is relatively elastic. It can be difficult for them to collude.
[Graph]
Why would an oligopoly not want a price war
A kinked demand curve. Showing SNP (because prices were stable/rigid) If there is a price war, they reduce P to P2. Firm is now making a loss
[just show a SNP then move P down to show loss]
[Graph] Limit pricing
Cost revenue diagram showing SNP.
Lower prices
Making less SNP of // Making a loss of
[Graph] Predatory Pricing
SNP of
prices falls to P2
loss of
(make sure AC is big enough for the 2nd quantity)
Why might pricing strategies not increase their revenue
- kinked demand curve = elasticities
- payoff matrix to show if one lowers prices and one leaves the prices the same
Characteristics of Monopoly
- one firm
- market failure [artificially ^ P and artificially low output] they have price setting and output restricting abilities
- lack of available subs = inelastic
- high barriers tp entry and exit
- imperfect knowledge
Drawing monopoly graph
Cost/revenue graph
AR/MR very inelastic
Making SNP (no available subs/ barriers)
Deadweight loss
[can also draw on Perf Comp as a comparison to show Mkt F]
Difference between monopoly and monopoly power
A ‘pure monopoly’ is where there is only one firm in the market, the monopoly is the industry.
Monopoly power is the output restricting and price setting ability which can be seen in oligopolies
Natural monopoly
It is an industry where there is room for only one firm to fully exploit all of the available internal economies of scale. It is characterised by increasing returns to scale over very high levels of output.
Draw a natural monopoly graph
AR and MR
LRAC more flat
LRMC more flat
Features of a natural monopoly
- only one firm can fully exploit all EoS
What is price discrimination
Some buyers in the market are willing and able to pay a higher price for a product than others. Firms respond to this by charging a different price for the same goods or service in different markets.
Bases of price discrimination
Age
Gender
Time
Income
Geographical distance
Degrees of price discrimination
First-degree: where the firm charges each consumer the maximum price he or she is prepared to pay for each unit (haggling in bazaar)
Second-degree: according to how much they purchase. may charge higher for first units and gets cheaper over more units
Third-degree: consumers are grouped into 2 or more independent markets, which are charged different prices
Conditions of price discrimination
PED of buyers must differ
Firms must be able to distinguish between consumers (split the market)
Must be able to keep the markets separate at relatively low cost (prevent arbitrage)
Must possess some monopoly power
Drawing price discrimination graph
Draw 3 side-by-side graphs
One very inelastic market
One very elastic market
One combined market [kinked to show different PEDs]
label as fig 1,2,3
make sure inelastic has greatest profit
combined snp needs to be lower than the other two together
price of elastic needs to be lower than combined
price of inelastic needs to be higher than both
Explain PD graphs using a cinema example
inelastic: Adults have an inelastic PED as the price of a ticket will take up a lower proportion of their income. As a result, the firm can identify this and using 3rd degree price discrimination they will increase the Price. Demand will fall, but less than proportionately. Revenue will increase and they will make an SNP of ….
Elastic: teens have an elastic PED as the price of a ticket will take up a greater proportion of their income. As a result, the firm can identify this and using 3rd degree price discrimination they will decrease the Price. Revenue will increase and they will make an SNP of ….
Combined: If they don’t separate the market segment, and isntead charge one price for everyone, they will generate less SNP. The curves are kicked to show the combined elasticities of consumers
2 Monopsony conditions
- either one buyer in the market or one buyer exhibiting monopsony power (buys significant proportion of sales in the market)
- sellers in the market must not be able to sell their product to other firms outside of the market
Characteristics of a monopsony
Only one buyer in the market (dominant buyer)
Few “pure” monopsonies in the UK but there are many examples of one buyer having monopsony power and dominating the market
A firm with monopsony power can exploit their bargaining power with the supplier to negotiate lower prices
The reduced costs to the firm buying purchasing inputs increases profit margins
Characteristic of a contestable market
Low barriers to entry/exit
(low/no sunk costs)
New entrants exist
New entrants have perfect information
Consumers are willing and able to switch to new entrants
Types of contestability
Low contestability: high barriers to entry
High contestability: low barriers to entry
More contestable: low barriers to entry
less contestable: high barriers to entry
What will happen if the market becomes increasingly contestable
There are low barriers to entry
Therefore new entrants will enter the firm
Meaning the supernormal profit of incumbent firms will be competed away
Explain why a monopoly is likely to be allocatively inefficient
[monopoly diagram/ show AE point]
A firm is likely to allocatively efficient where their cost of production equals the price that consumers are willing and able to pay. A monopoly is likely to be ineficient, as their output is restricted and prices are artificially high at the profit maximising point where MC=MR. The allocatively efficient would be at a higher quantity of Qae Pae
Explain why a firm in monopolistic competition is unlikely to be dynamically efficient in the long run
[monopolistic LR - normal profit]
A firm in the monopolistic competition is unlikely to be dynamically efficient in the long run because they cannot earn supernormal profits in the long run. In long run MC, firms earn normal profit where P=C. Meaning they cannot reinvest retained profits for innovation.
