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Microeconomics Summer Exam > 3.4 Market structures > Flashcards

3.4 Market structures Flashcards

1
Q

What are the four types of efficiencies?

A
  1. Allocative efficiency
  2. Productive/technical efficiency
  3. Dynamic efficiency
  4. X-inefficiency
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2
Q

What is allocative efficiency? Why does it occur where it does?

A

This is where production occurs at AR = MC.

If AR>MC: there is more welfare to be gained by producing more, as consumer welfare is greater than the cost of the additional good (under allocation)

If MC>AR: there is welfare loss, as the cost of producing another good is greater than any welfare consumers receive (over allocation) therefore there is WELFARE MAXIMISATION at AC=MR

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3
Q

What is productive efficiency?

A
  • This is where AC = MC.
  • Essentially the turning point of AC, so where costs are minimised for the firm.
  • Most output for the lowest input.
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4
Q

What is dynamic efficiency?

A
  • Long-run concept.
  • If a firm has sufficient profits, it can use those to INVEST and therefore INNOVATE.
  • This innovation reduces costs for consumers in the long term, and increases market share for the firm.
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5
Q

Why can dynamic efficiency be at odds with allocative efficiency?

A

If a firm makes little economic profit, it has little ability to invest and therefore reduce costs in the long-run.

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6
Q

What is X-inefficiency?

A
  • This occurs when a lack of competitive pressures result in organisational failure in a firm.
  • This is because of the principal-agent problem : managers and employees have different objectives to shareholders, e.g. long lunch breaks, ‘boondoggles’, office parties etc.
  • It also may be caused by a lack of shareholder activism.
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7
Q

What is the concentration ratio?

A
  • This is the number and size of firms in the market
  • If a market has a high concentration ratio, it is not competitive
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8
Q

What determines market structure? [4]

A
  1. The number and size of firms in the industry
  2. The homogeneity of the good
  3. The level of information between firms and consumers
  4. Level of entry or exit barriers
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9
Q

What are the characteristics of a perfectly competitive market? [5]

A
  • Lots of firms with small market share and no price setting powers
  • Perfectly homogenous good
  • Perfect information
  • No entry or exit barriers
  • Rational agents
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10
Q

Why are there two forms of equilibrium in perfect competition? (e.g. if there is an increase in demand or if the firms is already making supernormal profit)

A
  • In the short run, the market price will rise following an increase in demand.
  • Firms will now make a supernormal profit in the short-run, incentivising more firms to enter the market (as there are no entry barriers).
  • This shifts supply outwards, driving price down until supernormal profit is eliminated and the market price returns to its long-run equilibrium.
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11
Q

Describe two connected diagrams that show how a long-run equilibrium eliminates supernormal profit in perfect competition

A
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12
Q

What does a long-run equilibrium perfect competition diagram look like?

A
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13
Q

How is allocative efficiency achieved in perfect competition?

A
  • Assuming firms produce where profit is maximised:
  • MC=MR and AR=MR, therefore AR=MC.
  • Essentially, firms can only charge one price (the market price) for the good, so they will produce where the marginal cost is lowest.
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14
Q

How is productive efficiency achieved in perfect competition?

A
  • Firms operate at AC=MR, as this is where their costs are minimised.
  • As there can only be normal profit in perfect competition, MR=AR=AC.
  • Therefore, AC=MC. As firms can only charge one price, profit max is where costs are minimised = productive efficiency.
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15
Q

How is X-inefficiency eliminated in perfect competition?

A
  • If costs are higher than their lowest possible, firms will shut down.
  • Organisational slack only forms from a lack of competitive pressures (not found in equilibrium)
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16
Q

How is dynamic efficiency affected by perfect competition?

A
  • There is a high incentive to achieve dynamic efficiency, as firms want to gain a competitive edge.
  • However, due to lack of supernormal profit, firms do not have the ability to invest in order to innovate.
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17
Q

How realistic is the assumption of a perfectly competitive market?

A
  • Not very realistic, hard to achieve all criteria.
  • Closest thing is ForEx markets and commodities.
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18
Q

What are the characteristics of monopolistic competition [5]?

A
  • Many small firms and a low market concentration
  • Slightly differentiated goods
  • Imperfect knowledge about competitors
  • Low entry barriers
  • Small price setting powers
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19
Q

What is the diagram for monopolistic competition in the short run?

A

It is the same as the one for a monopoly

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20
Q

What happens that causes the short-run equilibrium in monopolistic competition to change?

A
  • As with perfect competitoin, the firm cannot maintain supernormal profits as the near perfect knowledge and low barriers to entry allows other firms to enter the market
  • This erodes profit away until only normal profit is being made
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21
Q

How are efficiences affected in monopolistic competition?

A

IN THE LONG-RUN:

  • AE: AR > MC because AR is downwards sloping but AR has fallen, meaning it is more allocatively efficient than in the short-run
  • PE: Cannot have productive efficiency in the long run, as the AR curve is below the AC
  • DE: Harder to fund as profits are eroded but more competition incentives innovation
  • XIE: Firms can’t afford any slack as ATC might be loss making
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22
Q

What is the diagram for long-run equilbrium in monopolistic competition?

A
  • AR must be drawn at a tangent to AC directly above MC=MR so there is only normal profits
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23
Q

What are the characteristics of oligopoly?

A
  • A few large firms dominate
  • Strong brand loyalty if the good is not able to be differentiated
  • High levels of interpendence between firms
  • Oligopolies can price set but may decide to collude or price fix
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24
Q

What are the two broad ways in which oligopolies can act?

A
  1. They can compete with each other, through pricing strategies or non-price competition
  2. They can co-operate with each other, colluding on strategies
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25
Q

What is price rigidity and what outcome does this lead to?

A
  • This is where prices are fixed at are certain point - also called sticky prices
  • This can be explained on a kinked demand curve
  • Above P1, demand is price elastic as rival firms keep their prices low, and thus consumers can respond to price increase by switching
    • If firms raised their price above P1, revenue would decrease
  • Below P1, demand is price inelastic as rival firms will respond to the reduction by also lowering their price
    • If firms lowered their price below P1, they would not experience much increased demand
  • It therefore makes sense that they fix their price at P1, due to the interpendency of firms, and that they choose to compete on non-price factors
26
Q

Does price rigidity always occur in oligopoly?

A

No - there is a host of pricing strategies that firms may adopt including:

  1. Predatory pricing
  2. Limit pricing
  3. Price wars
27
Q

What is predatory pricing?

A
  • Predatory pricing is a deliberate strategy of driving competitors out of the market by setting very low prices or even sometimes selling below AVC
  • The new entrant has higher costs as it does not have economies of scale, nor does it have access to previous profits to run a loss, meaning it is forced out of the market.
  • This is illegal under competition law (good evaluation – illegal but different to prove, profits made may be larger than reward).
28
Q

What is limit pricing?

A
  • Pricing by the incumbent firm(s) to deter entry or the expansion of fringe firms.
  • The limit price is below the short run profit maximising price but above the competitive level (not loss-making for the firm).
  • Limit pricing means a short-run departure from profit maximisation.
  • If successful, businesses can maintain their market power and make higher profits in the long term.
  • They might combine this with non-price strategies to develop more brand loyalty.
29
Q

What are price wars?

A
  • When goods are weakly branded, firms might fight for market share through aggressive pricing strategies, slashing prices to undercut their rivals.
  • Firms might make short-run losses to gain customers.
  • This is a competitive strategy, and one that is popular with consumers.
30
Q

What is collusion and why might firms choose to do so in an oligopoly?

A
  • Collusion is when firms work together to fix prices and avoid price wars
  • Firms will collude to divide the market, set prices or output, and increase the welfare gains of producers concerned to the detriment of other firms and consumers - esentially limiting competition and raising profits
31
Q

What are the two forms of collusion? Give an example of each.

A

There are two types of collusion - they both lead to the same outcomes of price fixing:

  1. Overt: firms openly fix prices, output, marketing, or the share of consumers
    • an extreme example of this is cartels, which is a formal agreement to act together
  2. Tacit: quiet or ‘behind the scenes’, it also may be implied or be firms operating according to some pattern that has never been agreed but has come into effect
    • this may involve price leadership - a collection of firms avoiding competition and following the actions of a market leader
32
Q

Why is there a temptation for firms to stop colluding?

A
  • To maximise their own sales and lower prices whilst catching rivals unaware
  • They could also gain immunity from prosecution by acting as a whistle-blower
  • It is illegal to collude
33
Q

How can the temptations for firms to stop colluding be illustrated?

A

Game theory - also called the prisoners dilemma

34
Q

How can the game theory matrices model be applied to pricing?

A
  • Two firms and two strategies
  • This shows the interdependency of firms in an oligopoly
  • Pricing low is an optimal strategy (dominant strategy)
    • “Nash Equilibrium”
  • Can show non-price competition
    • At Nash equilibrium, they need to differentiate by other means, e.g. quality
    • Could use an advertising matrix, a quality matrix etc.
35
Q

How are efficiences affected in oligopolies?

A
  • They exibit mostly the same inefficiencies as a monopoly, as they thwart competition and maximise profits
  • However, they may be more dynamically efficient and less x-inefficient as there is more incentive to lower costs through innovation and cutting slack
36
Q

How could a firm compete on factors other than price?

A
  1. Advertising and Branding
  2. Quality
  3. Aesthetics
  4. Loyalty discounts, free delivery etc.
37
Q

What are the characteristics of a monopoly?

A
  1. A large dominant firm
  2. Unique type of product - lack of substitutes
  3. Huge barriers to entry
  4. Price-making ability - downward sloping AR
  5. Long run super-normal profits
38
Q

What does an equilibrium diagram look like for a monopoly?

A

A regular cost-revenue diagram:

39
Q

What are some potential disadvantages of a monopoly and what do they depend on? [5]

A
  1. Higher prices, harms consumer surplus
    • depends on the number of substitutees
  2. X-inefficiency from lack of competitive pressures
    • level of shareholder activism
  3. May take advantage of their buying power - act as a monopsony for supply chain, harming their welfare
    • may be in a reciprocal monopoly, neutering effects
  4. Lack of incentive for investment
    • large amounts of profit for it, incentive to further increase profit
  5. May cross-subsidisize losses in another sector, wasting resources
    • may lead to increased range of goods available that would normally be loss making and not possible, e.g. rural bus services
40
Q

What are some potential advantages of a monopoly and what do they depend on? [3]

A
  1. Can take advantage of internal economies of scale and lower costs, e.g. in a natural monopoloy
    • ​​​depends on the size of upfront costs
  2. Can afford to invest and innovate
    • but there is no incentive to do so as they are already a monopoly
  3. The ability to become a monopoly incentives innovation and innovation
    • once they become a monopoly, consumer welfare falls and barriers to entry keep them that way
41
Q

What are some examples of barriers to entry?

A
  • Retained Profits
  • Economies of scale
  • Brand loyalty
  • Entry costs
  • Legal barriers
42
Q

What is a natural monopoly?

A
  • It occurs when an industry can only support one firm - it requires high sunk costs and entry costs
  • It also requires large levels of output to exploit economies of scale
  • The introduction of competition will not be possible, as competing firms would not be able to obtain sufficient market share to exploit economies of scale
  • An example of this is Thames Water, or BT openreach (telephone lines)
43
Q

What are sunk costs?

A

Costs that a firm cannot recover on exit, such as advertising or labour costs.

44
Q

What is the diagram for a natural monopoly?

A

Economies of scale are so large that diseconomies of scale are never larger than them, so the firm never experiences diminishing returns

45
Q

What is third-degree price discrimination? Give an example.

A
  • Third-degree price discrimination means charging a different price to different consumer groups.
  • For example, rail and tube travellers can be subdivided into commuter and casual travellers, and cinema goers can be subdivided into adults and children.
  • Splitting the market into peak and off-peak use is very common and occurs with gas, electricity, and telephone supply, as well as gym membership and parking charges.
46
Q

What conditions are necessary so that a firm can price discriminate?

A
  1. Firm must have some degree of monopoly power and price setting ability
  2. The firm must be able to identify different market segments (groups of consumers) and the segments must have different PEDs
    • If segments have the same PED, there is only one profit maximising price, meaning that price discrimination is unnecessary.
  3. Market segments must be kept separate, and seepage between market segments must be avoided
    • ‘Arbitrage’ must be prevented, which is resale between segments
47
Q

How can price discrimination be shown diagrammatically?

A
  • The two markets are shown below, and the firm is able to make more supernormal profits rather than the combined market (3rd diagram)
  • The third diagram is not essential, but useful to show what the combined market diagram looks like, and the condition for price discrimination to be successful (blue and red area must be greater than yellow area)
48
Q

What are the effects of price discrimination on consumers?

A
  • Some groups of consumers will be paying a higher price than they would otherwise, reducing their welfare (lower CS surplus)
  • Some consumers might benefit from being priced into markets they wouldn’t otherwise be able to afford
  • Potential benefit: increased profit -> more innovation -> better future products for consumers
49
Q

What are the effects of price discrimination on producers?

A
  • Higher supernormal profits generated by the firm
    • Good for investment/growth in the long run
    • Beneficial to shareholders/owners (profit = income)
  • Potential cost: may attract the attention of regulators
50
Q

How are efficiences affected in monopolies?

A
  • AE: no incentive to produce at QAE and there are no competitive pressures
  • PE: no reason to be productively efficient
  • DE: high profits to invest and innovate, but little reason to do so
  • XIE: no competitive pressures means that there is room for slack and so may become inefficient
51
Q

What is a monopsony?

A
  • A monopsony is a market structure which is dominated by a single buyer (this implies an imbalance of power between the buyer and multiple sellers).
  • This does not mean there is only one buyer within the market (this would be a ‘pure monopsony’), but that the size of the firm who is doing the buying is large enough that they can influence the price at which they buy.
52
Q

What are some examples of monopsonies?

A
  • NHS: pharmaceuticals, doctors/nurses/medical practitioners, medical equipment
  • Army: military equipment
  • Supermarkets: certain products (fruit and veg; meats)
53
Q

What is an impact of a monopsony on firms and an evalutation?

A
  • Lower costs for the monopsony
    • Lower wages mean lower costs, which increases profits
    • Could be used for innovation and further improving consumer welfare in the future
    • BUT, you might not have monopsony power over other inputs, so it depends if the industry is labour-intensive vs. capital-intensive
54
Q

What is an impact of a monopsony on consumers and an evalutation?

A
  • Lower prices for consumers
    • Savings could be passed onto consumers, which would increase their welfare as costs are lower
    • BUT, firms may not pass on these savings and take higher profits, especially if it is a monopoly seller and how competitive is the market it is selling to
55
Q

What is an impact of a monoposony on employees and an evalutation?

A
  • It might result in higher pay for the monopsonists staff if monopsony power is in other inputs
    • Higher profits as costs are lower for other inputs
    • This may be passed down in the form of higher wages
    • BUT, monopsony power is often in labour
56
Q

What is an impact of a monopsony on suppliers and an evalutation?

A
  • Can push suppliers out of the market
    • This means it is not profitable for them to stay in the market, and may have to leave
    • If supplies have no choice but to accept the low price, this may not be enough to cover their costs
    • BUT, is not in firm’s best interests in the long run, so they may avoid it.
57
Q

What are contestable markets?

A
  • A contestable market is one with firms facing zero entry and exit costs. This means there are no barriers to entry and no barriers to exit, such as: no sunk costs (cannot be recuperated); contractual agreements; legal barriers; brand loyalty; and economies of scale.
  • For a market to be perfectly contestable, relevant industry technology would be readily available to potential entrants.
58
Q

What are the implications of a contestable market on firms?

A
  1. Potential entrants can freely enter and leave the market.
  2. Potential entrants could, if they wished, operate a hit and run strategy (enter for a short time and leave when super-normal profits are eroded)
    • The threat of that happening forces firms to keep profit at normal levels
  3. Just the threat of entry is enough to ‘keep firms on their toes’, to the extent that existing firms behave ‘as if’ the market has a highly competitive market structure - even if it doesn’t
59
Q

What are the signs of highly constestable markets and an example?

A
  • Low fixed costs e.g. machinery
  • Low sunk costs e.g. advertising
  • Weak brand loyalty and few patents
  • Low long run profitibality

e.g. Airline industry with low-cost airlines

60
Q

What are the signs of unconstestable markets and an example?

A
  • Strong oligopoly or monopoly power
  • High levels of non-price competition
  • CMA investigations
  • High upfront costs - hence natural monopolies

e.g. Water industries

Microeconomics Summer Exam (7 decks)

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