3.4 Market Structures Flashcards
6 main assumptions of perfect competition
- many suppliers & buyers - lots of competition
- firms are price takers - no price setting ability (take ME)
- homogeneous product - products & perfect substitutes
- firms all profit maximisers - Q = MC = MR
- perfect knowledge - all prices are known by everyone
- no barriers to entry or exit - firms can move in & out of markets easily
what happens if a firm increases their prices in a perfectly competitive market
- dont sell anything because perfect substitutes are cheaper
what is perfect competition
in the long-run, productively and allocatively efficient
what happens if a firm decreases their prices in a perfectly competitive market
- all other firms follow because they don’t have perfect knowledge
making supernormal profits in a perfectly competitive market leads to …
signals other firms to move into the market - increase supply
making losses in a perfectly competitive market leads to …
signals firms to leave the market - decrease supply
strengths of the perfect competition model
- use it to understand market behavior
- why gov wants to reduce barriers to entry & exit
weaknesses of the perfect competition model
- firms want to avoid it
- no real life example
4 assumptions of monopolistic competition
- many suppliers & buyers
- firms are profit maximisers
- no barriers to entry & exit
- products are not homogeneous so demand is not perfectly elastic and firms can influence price
why is producing supernormal profits in a perfectly competitive market not dynamic efficient
- re-invest to improve quality
- need supernormal profits to achieve re-investment
what is the outcome of monopolistic competition
in the long-run, normal profits because there is no barriers to entry & exit
- if a firm is producing supernormal profits other businesses try to replicate them and decrease supernormal profits
what is monopolistic competition
not
- dynamic
- productive
- allocative
efficient
describe the payoff matrix
when two firms have a choice of setting prices high or low and their profit depends partly on the strategy of their competitior
what is the maximax profit outcome
- best outcome
- dominant strategy = low
what is the maximin strategy
- best minimum return
- dominant strategy = low
what is the nash equilibrium
- dominant strategy = LP x LP
- firms cannot deviate away as benefit will reduce
describe the kink demand curve
- prices are rigid
- shallow demand curve = elastic = increase P means decrease D
- steep demand curve = inelastic = decrease P other firms follow
- if one firm raises its price, the other firms in the market will not follow, leading to a sharp drop in demand for the first firm’s products, which can result in reduced profits
what is an oligopoly
a few large firms dominate a market and therefore posses some degree of market power
what is a duopoly
form of oligopoly with only 2 firms
how does an oligopoly work
an oligopolistic firm affects its rivals through its output and pricing decisions as well as its own revenue & profits being affected by its competitors output and pricing decisions. this leads to price rigidity and an absence of price wars
what is interdependence
various decisions such as output, price, advertising, and so on, depend on the decisions of the other firm
what is a perfect oligopoly
- produce a homogeneous good
- perfect substitutes
- elastic XED
what is an imperfect oligopoly
- produce differentiated goods
- not perfect substitutes
- inelastic XED
what is a competitive oligopoly
- rival firms are interdependent in the sense that they must take each others likely reactions into account during decision making
- do not collude or co-operate
- uncertainty
what is a collusive oligopoly
- any form of cartel behaviour between oligopolists
- increased certainty
what is a market concentration ratio
- the extent to which a small group of firms control a given percentage of output sales
- horizontal mergers increase market concentration
- markets with high levels of concentration often given increased market power to the largest firms
what is collusion
when two or more firms work together with the result that the competition is distorted
what is tacit collusion
it is against the public interest/or at nash equilibrium
what is open collusion
not always illegal
examples of types of collusion
- price fixing
- limiting access to raw materials or finished goods
- erecting artificial barriers to entry
- pricing so as to discourage market entry or to eliminate competitors (limit/predatory pricing)
- agreeing levels at which contracts will be bid for (competitive tendering)
incentives for collusion
- increase certainity
- limit competition
- maximise profits
disadvantages of collusion
damaging for firms due to reducing efficiency and innovation
advantages of collusion
sharing resources and development expenses can lead to enhanced innovation and efficiency
how does price collusion work
- allowing the least efficient firm normal profits
1. most efficient firm = supernormal profit = incentive to stay in cartel
2. middle-efficiency firm = supernormal profit
3. least efficient firm = normal profit = not undercut and pushed out the market by other firms
what are pricing startegies
short-term strategies for businesses
what is predatory pricing
- a deliberate strategy for driving competitors out of the market by setting very low prices or selling below AVC (short-term shutdown point)
- the aim is to reduce competition and increase monopoly power & profits of firms who benefit from it
short term effects of predatory pricing
- decrease price
- increase in consumer surplus
- bad for other firms as they have to leave the market
long term effects of predatory pricing
- increase monopoly power
- decrease in consumer profits
- supernormal profits
what is limit pricing
- pricing by incumbent firms to deter entry or expansion of fringe firms
- designed as a barrier to entry in order to protect firm’s monopoly power & supernormal profits
- below the normal profit maximisation but above the competitive level. the monopolist is charging a price lower than the estimated AC for a rival
what happens if limit pricing is successful
- risks of entering are too high
- may make a sizeable loss & might not have the resources to sustain those losses
what is a monopoly
one dominant firm in market with high barriers to entry has price setting ability and is profit maximising to make supernormal profits
what is a pure monopoly
when there is one firm in an industry
what is a local monopoly
one firm in that area (convenience = high PED)
why are monopolies able to profit maximise
- lack of substitutues so they are not competed away
- high barriers to entry
what are the three main reasons for high barriers to entry
- productive efiiciency of competitor firms
- brand loyalty and habitual behaviour
- sunk costs
why is productive efficiency of competitors a barrier to entry
they have a lower MES and have already exploited e of s so firms will struggle to compete when moving into a market
why is brand loyalty and habitual behaviour a barrier to entry
- competitors have an inelastic XED
- first mover advantage
- new firms can’t compete as they don’t have enough traction
why are sunk costs a barrier to entry
- can’t be recovered when the firm leaves the market (advertising & marketing)
- opp. cost
define allocative efficiency
- where P = MC so AR = MC
- paying the actual costof producing the good
- beneficial to society
define productive efficiency
- MES on the LRATC curve
- stopping diminishing returns
define dynamic efficiency
re-investment:
- increasing quality
- research & development
- innovating new products
why would monopolies choose to be dynamically efficient
- increasing barriers to entry
- stopping new alternatives from entering the market
- sustaining market share
- allows them to lower MES so can then be productively inefficient
why would monopolies choose not to be productively efficient
- restricting supply = increase in prices
- reduce excess demand
- not operating at MES
define x-inefficiency
as a business if costs increase then the price of the product will rise rather than taking cost saving measures and this then gets passed on to consumers due to the lack of substitutes
- inelastic demand
why is x-inefficiency usually not found
- doesn’t help maintain share prices because rising costs reflect badly
- regulation by gov to try stop it
what is price discrimination
when a firm charges different prices to different consumers for the same product for reasons not associated
what is first degree price discrimination
- charging each consumer what they are willing to pay
- requires perfect segmentation/knowledge of consumer preference
what is second degree price discrimination
- selling off ‘packets’ of surplus
what is third degree price discrimination
different prices in different sub-markets seperating the market normally by time or geography
what are the conditions required for price discrimination
- sufficient monopoly power: price setting ability
- identify different market segments: groups of consumers with different PED
- ability to separate different groups: requires information on purchasing behaviours gained from buying patterns
- prevent re-sale (arbitrage): no secondary markets where arbitrage can take place at intermediate prices. limiting by = restrictions
- does not happen in perfectly competitive markets: firms must have some discretion/power over the pricxes they can change
what are the effects of price discrimination for producers
- increase producer surplus - increase p in inelastic market/now selling in elastic market
- consumer surplus extracted and turned into SNP - producer maximises rev if the consumer pays the max they are willing to pay
- increase output = e of s & increase productive efficiency
- predatory pricing strategy
- loss making activities with social benefits may be cross subsidised through price discrimination
- conduct indicator examined by OFT when looking for monopoly power abuse
what are the effects of price discrimination for consumers
- decrease consumer surplus
- decrease consumer welfare - degree of reduction depends on how far above MC the price is set in each case
- low income consumers may be priced into the market at lower prices & may benefit - if there are postive externalities then welfare increases
what is a natural monopoly
occurs when one large firm can supply at a lower price than smaller ones. there may be room for only one supplier to fully exploit E of S, MES and achieve productive efficiency
natural monopoly chain of reasoning
- special case where one large business can supply the entire market at a lower unit cost than multiple providers
- this is because of the nature of costs in a natural monopoly industry. very high fixed costs and low marginal costs
- as a result, fixed costs are enormous but the marginal cost of adding an extra user is very low
- therefore, the average total cost will continue to fall as extra users are added to the network. internal econmy of scale
- LRATC may fall across all ranges of output. one firm reaches MES
aims of price discrimination
- increase total revenue by extracting consumer surplus and turning it into prodcuer surplus
- increase total profit
- generate cash-flow
- increase market share and build customer loyalty
- efficent use of a company’s spare production capacity
- reduce the amount of waste
what is the case against monopolies
- loss of economic efficiency: allocative, productive, x-inefficiency
- fewer E of S being exploited
- less drive to innovate
- diseconemies of scale
what is the case for monopolies
- profits can be used to fund research & development
- large economies of scale
- can be regulated by “proxy consumers”
- price discrimination may help some consumers if they are charged a lower price
define arbitrage
simultaneous buying and selling os securities; currency or commodities in different markets to tae advantage of differing prices for the same asset
define bi-lateral monopoly
where a monopsony buyer faces a monopsony seller in a market
define contestability
how easy it is to compete
characteristics of contestable markets
- low barriers to entry & exit
- new firms who are willing, able and ready to enter the market
- equal access to available industry technologies
- high rates of customer switiching - no brand loyalty
chain of reasoning for how increased contestability affects firms
- absence of composition or threat of a rival entering a market an uregulated firm could profit maximise
- if a market becomes more contestable through a policy of liberalization, then competitive pressures will keep prices down
- instead of profit maximising, existing firms would have an incentive to cut prices perhaps to a level where normal profit is made
- firms make enough peofit to stay in the market without attracting rivals
- actual and threatened competition intesifies incentives for businesses to control their unit costs by avoiding any x-inefficiencies
types of startegic entry deterrence
- hostile takeovers and acquistions
- product differentiation
- capacity expansions
- predatory pricing
examples of sunk costs
- asset-write-offs
- closure or project cancellation costs
- loss of business reputation and goodwill
