3.4 - Market Structures

Question 1

What is allocative efficiency?

Answer 1

• This occurs when AR =MC
• Resources are allocated so consumers and producers get the maximum possible benefit
• No one can be made better off without making someone else worse off
  *There is no excess demand or supply

Question 2

What is productive efficiency?

Answer 2

• Occurs at the level of output where MC= AC
  *At this point average costs are minimised
• There is no wastage of scarce resources and a high level of factor productivity

Question 3

What is dynamic efficiency?

Answer 3

• Long-term efficiency is a result of innovation as a firm reinvests its profits
• It results in improvements to manufacturing methods
• this lowers both the short-run and long-run average total costs

Question 4

What is X-inefficiency?

Answer 4

• Occurs when a firm lacks the incentive to control production costs
• The ATC is higher than it should be
  *It often occurs due to a lack of competition in the industry or in a firm that has no consequences for making a loss (e.g. some government owned companies)

Question 5

What are the characteristics of perfect competition?

Answer 5

• There must be many buyers and sellers
• Freedom of entry and exit
  *There must be perfect knowledge
• Products are homogenous (identical)
• Firms are price takers
• They can only make normal profit in the long run (break-even)
• They are productively and allocatively efficient
• X-efficient

Question 6

What is monopolistic competition?

Answer 6

It is 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. Some examples of firms in monopolistic competition are hairdressers, estate agents, and restaurants.

Question 7

What are the characteristics of monopolistic competition?

Answer 7

• There must be a large number of buyers and sellers in the market
  *There are no barriers to entry or exit
• Firms produce differentiated, non-homogenous goods or services
• Can only make normal profit in the long run
• Individual firms do have some price setting power, but no one buyer or seller has a large setting power
  *X-inefficient (some)

Question 8

What are the characteristics of an oligopoly?

Answer 8

• Dominated by a few firms
• High concentration ratio
• High barriers to entry
• Can make economic profit in the long run
• Differentitated products
• Interdependence but can often implement collusive strategies - defined through either its conduct or its structure
• Dynamically efficient
• X-inefficient

Question 9

What key decisions do oligopolies need to make?

Answer 9

• Whether to compete with rivals or collude with them
  *Whether to use price competition or not
  *Whether to leave prices alone and use non-price competition

Question 10

What is the n-firm concentration ratio?

Answer 10

The concentration of supply in the industry can be indicated by the concentration ratio which measures the percentage of the total market that a particular number of firms have. The 3 firm concentration ratio shows the percentage of the total market held by the three biggest firms, etc… it is calculated by adding the percentages of market share for the firms or using the formula, (total sales of n firms / total size of market) x 100

Question 11

What is collusion?

Answer 11

Collusion is when firms make collective agreements that reduce competition. When firms don’t collude, this is a competitive oligopoly

Question 12

Why does collusion occur?

Answer 12

• If firms 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 would reduce industry profits
• Despite this, firms may decide to be a non-collusive oligopoly since 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
• Collusion works best when there are few firms which are all well known to each other; the firms are not secretive about costs and production methods and these 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

Question 13

When is competition more likely than collusion?

Answer 13

It is more likely when:
* one firm has lower costs than the others
*there is a large number of big firms in the market which makes it difficult to see what others are doing
* firms produce very similar products
* entry barriers are low

Question 14

When is collusion more likely than competition?

Answer 14

It is more likely when:
* firms have similar costs
* few large firms in the market which makes it easy to see what others are doing
* lots of brand loyalty exists e.g. customers are less likely to buy from the firm even if their prices are lower
* entry barriers are high

Question 15

What is formal collusion?

Answer 15

OVERT - Formal collusion is an agreement between the firms. This is known as a CARTEL and is usually illegal

Question 16

What is informal collusion?

Answer 16

Informal collusion is TACIT. Firms observe one another and decide that its best for them not to compete on price, so long as the others do the same

Question 17

What is price leadership?

Answer 17

Price leadership is where one firm has advantages due to its size or costs and becomes dominant. Other firms will tend to follow this firm because they would fear taking on the firm in any form of price war. As a result, the dominant firm will decide the price and allow the other firms to supply as much as they wish at this price

Question 18

What is barometric firm price leadership?

Answer 18

This 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

Question 19

What is game theory?

Answer 19

Game theory explores the reactions of one player to changes in strategy by another player. The aim is 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. The easiest way of demonstrating this is where duopoly exists in the market, so there are two identical firms

Question 20

What is the prisoner’s dilemma?

Answer 20

• Both don’t confess - A year each
• A confesses but B doesn’t - A gets 3 months and B gets 10 years
• A doesn’t confess but B does - A gets 10 years and B gets 3 months
• Both confess - 3 years each
• Both prisoners are questioned and kept apart so they can’t communicate

Question 21

What are price wars?

Answer 21

• They are a type of price competition
• These occur when non-price competition is weak; where goods have weak brands and consumers are price conscious - 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

Question 22

What is predatory pricing?

Answer 22

• It is a type of price competition
  *This occurs when an established firm is threatened by a new entrant or if one firm feels that another is gaining too much market share
  *The established firm will set such a low price that other firms are unable to make a profit and so will be driven out of the market - the existing firm is then able to put their price back up
• This is ILLEGAL and only works when one firm is large enough to be able to have low prices and sustain losses

Question 23

What is limit pricing?

Answer 23

• It is a type of price competition
  *In order to prevent new entrants, firms will set prices low (the limit price) - 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
  *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 able to

Question 24

What are the different types of non-price competition?

Answer 24

• Advertising
• Loyalty cards
• Branding
  *Quality
• Customer service
• Product development

Question 25

What are the characteristics of a monopoly?

Answer 25

• Single seller or very low levels of competition
• Price making powers - downward sloping demand curve
  *High barriers to entry and exit
  *Economic profit can be made in both the short term and long term
  *Often use price discrimination
  *Allocatively and productively inefficient
• Low levels of competition in the market
  *Prices tend to be higher, and quantity tends to be lower than in a competitive market
• Dynamically efficient (if they choose to invest)

Question 26

What are the four different types of monopoly?

Answer 26

*Pure - only one firm in the industry (100% of supply)
*Dominant - more than 40% of market share
*Legal - more than 25% of market share
*Natural - the most efficient number of firms in industry is one

Question 27

What is the profit maximising equilibrium for a monopoly?

Answer 27

The profit maximising point is at MC=MR, so this is the output they will produce at

Question 28

What is third degree price discrimination?

Answer 28

• This is when monopolists charge different prices to different people for the same good or service. There are different examples of where this can occur e.g. time of day, prices in different places, different prices for different ages
• In order for price discrimination to occur, the firm must be able to clearly separate the market into groups of buyers, the customers must have different elasticities of demand, and they must be able to control supply and prevent buyers from the expensive market from buying in the cheaper market

Question 29

What are the costs and benefits of price discrimination to consumers and producers?

Answer 29

Benefits - * Firms can offer services which otherwise would be unprofitable
*Some groups benefit from cheaper prices
*Spreads out demand and avoids congestion
*Increased investment from extra profit

Costs - *Some groups pay higher price
* Decline in consumer surplus
*Potentially unfair
*Administration costs
*Company profit takes higher share of GDP

Question 30

What is a natural monopoly?

Answer 30

• Companies that are said to be natural monopolies see economies of scale that are so large, not even a single producer in the industry is able to fully exploit all of them
• It would be pointless to encourage competition since it would raise average costs for the industry
• Natural monopolies tend to be found in industries with very high fixed costs, such as railways

Question 31

What are the costs and benefits of a monopoly to firms?

Answer 31

• Monopolists have the potential to make huge profits through profit maximisation
  *The existence of supernormal profit means firms will have finance for investments and will be able to build up reserves to overcome short term difficulties
• Firms with monopoly power will be able to compete against large overseas organisations
  *Large firms will be able to maximise economies of scale, reducing costs and increasing profit further
• However, firms may not always choose to profit maximise because of x-inefficiencies, sale or revenue maximising, profit satisficing or contestability leading to limit pricing. In the long run, the lack of competition may mean that firms become complacent and so they may not make maximum profits

Question 31

What are the costs and benefits of a monopoly to employees?

Answer 31

• Monopolists produce at lower outputs, so will employ fewer workers
  *However, the inefficiency of the monopoly may mean employees receive higher wages, particularly directors and senior managers. Profit satisficing or sales/revenue maximising may mean output is higher and so more employees are employed

Question 32

What are the costs and benefits of a monopoly to suppliers?

Answer 32

• Stable demand, long-term contracts, potential for higher prices, and investment in quality or innovation
  *But, reduced negotiating power, dependence on a single customer, price pressure, risk or exploitation
  *For suppliers, the impact of a monoplist 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

Question 33

What are the costs and benefits of a monopoly to consumers?

Answer 33

• With a natural monopoly, consumers tend to be better off than if there was competition
• When firms enjoy economies of scale, they will be more efficient and customers will enjoy a higher consumer surplus
• Monopolists may produce an increased range of goods or services due to cross subsidization
• The use of price discrimination will allow for survival of a product or service, and benefits some customers whilst is negative for others
• Consumers may pay higher prices and see a poorer quality service, due to a lack of competition
  *There is less choice for consumers, since there is only one firm producing the good

Question 34

What are the characteristics and conditions of a monopsony?

Answer 34

• This is where there is only one BUYER in the market, and other than this it has the same basic characteristics as monopoly - they can prevent new firms entering the market and aim to profit maximise

Question 35

What are the characteristics of contestable markets?

Answer 35

• Perfect knowledge
  *Freedom of entry and exit
  *Few sunk costs
  *Use the best available technology
  *Low product loyalty
• Assume firms do not collude