3.4 Market Structures Flashcards
Efficiency
used to judge how well the market allocates resources, and the relationship between scarce inputs and outputs
Allocative efficency
This is achieved when resources are used to produce goods and services which consumers want and value most highly and social welfare is
maximised. It will occur when the value to society from consumption is equal to the marginal cost of production, where P=MC.
Productive efficiency
- A firm has productive efficiency when its products are produced at the lowest average cost so the fewest resources are used to produce each product.
- The minimum resources are used to produce the maximum output.
- This can only exist if firms produce at the bottom of the AC curve, in the short run this is where MC=AC.
Dynamic efficiency
This is achieved when resources are allocated efficiently over time. It is concerned with investment, which brings new products and new production techniques. The alternative is static efficiency: efficiency at a set point in time. Allocative and productive efficiency are examples of static efficiency.
X-inefficency
If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is organisational slack. This is a specific type of productive inefficiency as it occurs when they fail to minimise their cost for that specific output.
X-inefficiency example
- The minimum point on the AC curve may be at 100 goods at a cost of £5 each. The firm is producing 125 goods and so is not productively efficient. It costs them £8 to produce each good, but they could produce 125 goods at £7.
- Therefore, they are X-inefficient since they are not producing on the lowest AC curve. It often
occurs where there is a lack of competition so firms have little incentive to cut costs.
Perfect competition
a market where there is a high degree of competition, but the word
‘perfect’ does not mean it maximises welfare or produces ideal results.
Charactersitics of perfect competition
- price takers
- many buyers and sellers
- freedom of entry and exit from the industry
- perfect knowledge
- homogenous goods
Profit in perfect competition
Short run = supernormal profit
Long run = normal profit as firms will enter the market.
Efficiency in perfect comeptition
- They are productively efficent and allocatively efficient.
- They are not dynamically efficent
- Competition keeps prices low so cannot benefit from economies of scale
Monopolitistic competition
a form of imperfect competition, with a downward sloping
demand curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely exist in a pure form in real life.
Characterisitics of monopoltistic competition
- large number of buyers and sellers
- no barriers to entry and exit
- differentiated, non-homogenous goods
Profit of monopolisitc competition
In the short run, firms can make supernormal profits, losses or normal profits. However, due to the lack of barriers to entry/exit, firms can only make normal profits in the long run.
Limitations of monopolistic competition
- 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.
Efficiency in monopolistic competition
- 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.
- They are dynamically efficient.
- less is sold at a higher price
- greater variety and economies of sclare
Oligopoly
there are a few firms that dominate the market and have the majority of
market share, although this does not mean there won’t be other firms in the market.
Characteristics of oligopoly
- high barrier to entry and exit
- high concentration ratio
- interdependence of firms
- production differentiation
concentration ratio
The percentage of the total market that a particular number of firms have.
concentration ratio calculations
total sales of n firms
——————————- x100
total size of markets
Collusion
When firms make collective agreements that reduce competition
Why do firms collude?
- maximise industry profits
- reduces the uncertainty firms face
Where 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.
two-types of collusion
- overt
- tacit
Overt collusion
when firms come to a formal agreement (cartel)
Tacit collusion
there is no formal agreement
two ways a cartel works
- agree on a price
- divide up the market
problem with cartel
- constant temptation to break the cartel.
price leadership
where one firm has advantages due to its size or costs and becomes the dominant firm.
Barometric firm price leadership
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.
Kinked demnad curve
- If a firm raises its price, other firms will not follow since they know their comparitovely lower prices means they are more competitive
- On the other hand, if a firm lowers price, other firms will follow since they want to remain competitive
Game theory
The reactions of one player to changes in strategy by another
player
The aim of Game Theory
To examine the best strategy a firm can adopt for each assumption about
its rival’s behaviour and it provides insight into interdependent decision making that occurs in competitive markets.
maximin policy
involves firms working out the strategy where the worst possible outcome is the least bad.
maximax policy
involves firms working
out the policy with the best possible outcome.
Nash Equilibrum
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.
How does Game theory expalin stable prices in an oligopoly
- there is no dominant strategy for X. The maximin strategy will be to keep prices unchanged, as profits will not change, whilst the maximax policy is to raise prices
- Firm Y will also choose to leave its prices unchanged if it pursues a maximin strategy
- Therefore, both firms will leave their price unchanged and there is a Nash equilibrium since neither firm is able to improve their position given the position of the other player.
Prisioners Dilemma
two people are questioned over their involvement in a crime and are kept apart so they can’t ommunicate. The dominant strategy in this situation is to confess: it’s the greatest reward (3
months rather than a year) and the least bad (3 years rather than 10 years). However, if the prisoners could collude or had confidence in one another, the best option would be to deny the crime; this is the Nash equilibrium.
Types of price competition
- price wars
- predatory pricing
- limit pricing
Price wars
- non-price competition is weak; where goods have weak brands and consumers are price conscious. They also occur when it is difficult to collude.
- drive prices down to levels where firms are frequently making losses.
- lowers industry profits
Predatory pricing
- an established firm is threatened by a new entrant or if one firm
feels that another is gaining too much market share. - established firm will set such a low price that other firms are unable to make a
profit and so will be driven out the market. - illegal and only works when one firm is large enough to be able to have low prices and sustain losses.
Limit pricing
- prevent new entrants, firms will set prices low. The price needs to be high enough for them to make at least normal profit but low enough to discourage any other firm from entering the market.
- contestable market
- It means firms cannot make profits as high as they would be otherwise be able to.
Other types of pricing
- Cost-Plus
- Psychological
- Market-led pricing
- Price Skimming
- Penetration pricing
Types of non-price competition
- advertising
- loyalty cards
- branding
- quality
- customer service
- product development
Efficiency of oligopoly
- statically inefficient, since they are not productively or allocative efficient.
- dynamically efficient, they make supernormal profits, so have the funds to invest, and they have an incentive to invest, due to competition.
- economies of scale
Characteristics of a monopoly
- price setters
- high barriers to entry and exit
- more than 25% of market share
- imperfect information
Pure monopoly
one firm is the sole seller of a product in a market.
Profit of monopoly
- Firms can make super normal profit in long and short term due to high barriers to entry
- produce at MC=MR
monopoly power
refers to cases where firms influence the market in some way through their behaviour
determinents of monopoly power
- influencing prices
- influencing output
- erecting barriers to entry
origins of monopoly
- through growth of the firm
- through amalgamation, merger or takeover
- through acquiring patent
- through legal means- nationalisation
Problems with model of monopoly
- higher prices, lower output
- allocative inefficiency
- productive inefficiency
- x-inefficiency
- supernormal profit
- higher prices to supplier
- diseconomies of scale
advantages of monpoly
- economies of scale
- research and development
- a firm becomes a monopoly due to efficiency
- natural monopolies
Price discrimination
involves charging a different price to different for the same good. Requires different elasticities
Types of price discrimination
- first degree
- second degree
- third degree
first degree
this involves changing consumers the maximum price
second degree
this involves charging different prices depending on quality consumed
third degree
this involves charging different prices to different groups of people.
Conditions necessary for price discrimination
- the firm must operate in imperfect competition - price makers
- the firm must be able to seperate markets and prevent resale.
- different. consumer groups must have different elasticities - PED for adults is inelastic.
advantages price discrimination
- firms will be able to increase revenue
- revenue can be used for research and developmet
- some consumers will benefit from lower fares
disadvantages of price discrimination
- some consumers will end up paying higher prices.
- decline in consumer surplus
- those who pay higher prices may be the poorest
- there may be administration costs in seperating markets
- profits from price discrimination could be used to finance predatory
Economies of scale in a natural monopoly
economies of scale are so large that even a single producer is not able to fully exploit all of them.
Characteristics of natural monopoly
- high fixed cost
- large-scale infrastructure
- LRAC falls continuously over a large range of output
- there is only room in a market for one firm
Cost and benefits of monopoly on firm
- huge profits
- have finance for investments. and build up reserves to overcome short term difficulties
- can compete against large overseas organisation
- maximise economies of scales
- firms may not always choose to profit maximise because of X-inefficiencies, lack of competition
Cost and benefits of monopoly on employees
- low amount of jobs avaliable due to low output
- inefficiency may mean higher wages
Cost and benefits of monopoly on suppliers
For suppliers, the impact of a monopolist will depend on the extent to which the monopolist is also a monopsonist. If the monopolist buys all or most of the suppliers’ goods (so is a monopsonist), it will reduce the suppliers’ profits as the monopolist will decrease prices.
Cost and benefits of monopoly on consumers
- natural monopoly means consumers are better off
- economies of scale means higher consumer surplus
- increased range of goods
- survivial of a product or service
- less choice for consumers
Efficiency of monopolies
- A monopoly is productively inefficient, since they don’t produce at MC=AC. They
are also not allocative efficient as P>MC. - They are dynamically efficient
- X-inefficiency
- large economies of sclae
Schumpter on monopolies
monopolies will have large retained profits and will be able to exploit new products or production techniques without worrying about competitors. This would make them more productively efficient, as costs are lower, more
allocative efficient, as there are new products in the market, and dynamically efficient.
Monopsony
only one buyer in the market
Characteristics of monopsonys
They can prevent new firms entering the market and aim to profit maximise.
Pure monopsonies in real life
In real life, pure monopsonies rarely exist but many firms experience monopsony power, when they buy a large percentage of the market.
What will monopsonys pay suppliers
the lowest price possible to minimise their costs and
make the most of their position as the only buyer.
Cost and benefits of monopsonys - firms
- The monopsony gains higher profits by being able to buy at lower prices
- purchasing economies of scale
Cost and benefits of monopsonys - consumers
- Customers may gain from lower prices as reduced costs are passed on.
- fall in supply
- counter-weight to monopolists
- fall in quality
Cost and benefits of monopsonys - employees
- Monopsonists may pay higher wages as they are making higher profits.
- The supplier will sell less goods and so employ less peoples
Cost and benefits of monopsonys - suppliers
- recieve lower prices
Model of contestable markets
This model is concerned with the possibility of other firms entering the market if they see the
opportunity to make money, rather than the number of firms in the industry at a point in time.
Contestable markets
One with a high threat of new entrants, which keeps firms producing at a competitive level.
Characteristics of contestable markets
- perfect knowledge
- freedom of entry and exit
- low sunk costs
- low product loyalty
implications contestable markets
- The only way to prevent this is by using limit pricing, which reduces the incentive for firms to enter the market
- firms will only be able to make normal profits and
produce where AC=AR because new firms will enter the market if price was any higher and they were making monopoly profits. - Firms are likely to be productive and allocative efficient.
Types of barrier to entry and exit of contestable markets
- legal barriers
- marketing barriers
- pricing decisions of incumbent firms
- capital start up costs
- economies of scale
sunk costs
a fixed cost that a business cannot recover if it leaves the industry.
how is contestability measured
the extent to which the gains from market entry for a firm exceed the costs of entering the market.
reasons for increasing contestability
- The recession has meant the entrpreneurs do not accept the exisiting market structure is fixed
- The deregulation of markets has allowed a reduction of some barriers to entry in some industries
- the european single market has opened up new markets for firms so these firms can enter into the market, making them contestable
- chnages in technology has reduced entry costs as capital is more emobile.
