3.4 - Market Structures

Question 1

Types of efficiency

Answer 1

1. Allocative
2. Productive
3. Dynamic
4. X-inefficiency

Question 2

Allocative efficiency

Answer 2

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

Question 3

Productive efficiency

Answer 3

When products are produced at the lowest average cost so 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

Question 4

Dynamic efficiency

Answer 4

When all resources are allocated efficiently over time, and the rate of innovation is at the optimum level, which leads to falling long run average costs. It is related to the rate of innovation, which might lead to lower costs of production in the future, or the creation of new products

Question 5

X-inefficiency

Answer 5

When a firm fails to minimise its average costs at a given level of output. It often occurs where there is a lack of competition so firms have little incentive to cut costs

Question 6

Perfect competition

Answer 6

Market where there is a high degree of competition. In reality, the assumptions made rarely hold and no market is completely perfectly competitive

Question 7

Characteristics of perfect competition

Answer 7

1. Many buyers and sellers
2. Homogeneous goods
3. Freedom of entry and exit from the industry
4. Perfect knowledge

Question 8

Efficiency in perfect competition

Answer 8

Perfect competition is productively efficient, since they produce where MC=AC. They are also allocatively efficient since they produce where P=MC. Thus, they are static efficient. However, they are not dynamically efficient . No single firm will have enough for research and development and small firms struggle to receive finance. The existence of perfect information also means one firms’ invention will be adopted by another firm and so the investment will give the firm no competitive benefit

Question 9

Monopolistic competition

Answer 9

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

Question 10

Characteristics of monopolistic competition

Answer 10

1. Large number of buyers and sellers
2. No barriers to entry or exit
3. Differentiated goods
4. Imperfect information

Question 11

Efficiency in monopolistic competition

Answer 11

Since they can only make normal profit in the long run, AC=AR and since they profit maximise, MC=MR. 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. However, 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

Question 12

Oligopolistic competition

Answer 12

Where there are a few firms that dominate the market and have the majority of market share

Question 13

Characteristic of oligopolistic competition

Answer 13

1. High barriers to entry and exit
2. High concentration ratio
3. Interdependence of firms
4. Product differentiation

Question 14

N-firm concentration ratio

Answer 14

The percentage of the total market that a particular number of firms have. The higher the concentration ratio, the less competitive the market, since fewer firms are supplying the bulk of the market

Question 15

Collusion

Answer 15

When firms make collective agreements that reduce competition. For example, they might choose to set a price or fix the quantity of output they produce, which minimises the competitive pressure they face

Question 16

Overt collusion

Answer 16

When firms come to a formal agreement

Question 17

Tacit collusion

Answer 17

When there is no formal agreement

Question 18

Cartel

Answer 18

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

Question 19

Benefits of collusion

Answer 19

1. Industry standards could improve, because firms can collaborate on technology and improve it
2. Excess profits could be used for investment, which might improve efficiency in the long run. Alternatively, they might be used on dividends
3. By increasing their size, firms can exploit economies of scale, which will lead to lower prices.

Question 20

Costs of collusion

Answer 20

1. Loss of consumer welfare, since prices are raised and output is reduced
2. Absence of competition means efficiency falls. This increases the average cost of production
3. Reinforces the monopoly power of existing firms and makes it hard for new firms to enter
4. Lower quantity supplied leads to a loss of allocative efficiency

Question 21

Game theory

Answer 21

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

Question 22

Prisoner’s Dilemma

Answer 22

Model based around two prisoners, who have the choice to either confess or deny a crime. The consequences of the choice depend on what the other prisoner chooses

Question 23

Types of price competition

Answer 23

1. Price wars
2. Predatory pricing
3. Limit pricing

Question 24

Price wars

Answer 24

Firms constantly cutting their prices below that of its competitors. Their competitors then lower their prices to match. Further price cuts by one firm will lead to more and more firms cutting their prices

Question 25

Predatory pricing

Answer 25

Firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses. As firms leave, the remaining firms raise their prices slowly to regain their revenue. They price their goods and services below their average costs

Question 26

Limit pricing

Answer 26

Low prices that discourage the entry of other firms, so there are low profits. It ensures the price of a good is below that which a new firm entering the market would be able to sustain. Potential firms are therefore unable to compete with existing firms

Question 27

Types of non-price competition

Answer 27

1. Advertising 2. Loyalty cards 3. Branding 4. Quality 5. Customer service 6. Product development

Question 28

Pure monopoly

Answer 28

Where one firm is the sole seller of a product in a market

Question 29

Characteristics of a monopoly

Answer 29

1. Profit maximisation 2. High barriers to entry 3. 25% or more market share

Question 30

Factors influencing monopoly power

Answer 30

1. Barriers to entry 2. Economies of scale 3. Sunk costs 4. Limit pricing 5. Brand loyalty 6. Degree of product differentiation

Question 31

Third degree price discrimination

Answer 31

When monopolists charge different prices to different people for the same good or service, for example peak and off-peak train times or child and adult tickets

Question 32

Benefits of third degree price discrimination

Answer 32

1. Consumers could benefit from a net welfare gain as a result of cross subsidisation, if they receive a lower price 2. Some consumers, who were previously excluded by high prices, might now be able to benefit from the good or service 3. Firms benefit since they are able to increase their profits. This can go into research and development, improving dynamic efficiency

Question 33

Costs of third degree price discrimination

Answer 33

1. Usually, price discrimination results in a loss of consumer surplus. Since P > MC, there is a loss of allocative efficiency 2. Strengthens the monopoly power of firms, which could result in higher prices in the long run for consumers 3. Might cost the firm to divide the market, which limits the benefits they could gain

Question 34

Benefits of a monopoly

Answer 34

1. Monopolies can earn significant supernormal profits, so they might invest more in research and development. This can yield positive externalities, and make the monopoly more dynamically efficient in the long run. There could be more invention and innovation as a result 2. If there is a natural monopoly, it might be more efficient for only one firm to provide the good or service, since having duplicates of the same infrastructure might be wasteful 3. Monopolies could generate export revenue 4. Since monopolies are large, they can exploit economies of scale, so they have lower average costs of production 5. High profits could be a source of government revenue through taxation

Question 35

Costs of a monopoly

Answer 35

1. Basic model of monopoly suggests that higher prices, profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market 2. Monopolies could exploit the consumer by charging them higher prices. This means the good is under-consumed, so consumer needs and wants are not fully met. This loss of allocative efficiency is a form of market failure 3. Monopolies have no incentive to become more efficient, because they have few or no competitors, so production costs are high 4. Consumers do not get as much choice in a monopoly as they do in a competitive market

Question 36

Natural monopoly

Answer 36

Where a single firm can supply the entire market's demand for a good or service at a lower cost than multiple firms could. This typically happens in industries with high fixed costs and significant economies of scale, making it inefficient for multiple firms to compete

Question 37

Monopsony

Answer 37

When there is only one buyer in the market

Question 38

Benefits of a monopsony

Answer 38

1. Monopsony receives higher profits by being able to buy at lower prices. This increases the funding for research and development and leads to more return for shareholders 2. Achieve purchasing economies of scale, which will lower costs and increase profits 3. Customers may gain from lower prices as reduced costs are passed on

Question 39

Costs of a monopsony

Answer 39

1. Could lead to a fall in supply, since the business buys fewer inputs. The extent to which supply to customers will fall depends on the price elasticity of supply 2. May be a fall in quality as prices are driven down 3. Employees are likely to lose out with lower wages 4. Workers might become unproductive if wages are low 5. Suppliers will sell less goods and so employ less people 6. Suppliers will lose out as they will receive lower prices ; less will be supplied leading to some firms leaving the market

Question 40

Contestable market

Answer 40

Market with a high threat of new entrants, which keeps firms producing at a competitive level. Even in a monopoly, a firm may be forced to be efficient due to the potential of new entrants to the market. Any attempt to make a huge profit will mean other businesses will be attracted to the industry

Question 41

Characteristics of contestable markets:

Answer 41

1. Perfect knowledge 2. Freedom of entry and exit 3. Low product loyalty 4. Assume firms are short run profit maximisers 5. Assume firms do not collude with each other

Question 42

Types of barrier to entry and exit

Answer 42

1. Legal barriers 2. Marketing barriers 3. Pricing decisions of incumbent firms 4. Sunk costs 5. Economies of scale

Question 43

Legal barriers

Answer 43

Laws that are put in place which make it more difficult for firms to enter the market or explicitly mean they cannot enter

Question 44

Marketing barriers

Answer 44

High levels of advertising that build up consumer loyalty, so demand becomes more price inelastic, and consumers are less likely to try other brands

Question 45

Sunk cost

Answer 45

A fixed cost that a business cannot recover if it leaves the industry. It includes property (if the lease is longer than it is actually used for), machinery and equipment that cannot be resold, and advertising

Question 46

Degree of contestability

Answer 46

The extent to which the gains from market entry for a firm exceed the costs of entering the market