3.4 Market structures (perfect and monopolistic competition and monopoly)

Question 1

Perfect competition

Answer 1

Market where there is a high degree of competition (no market is completely perfectly competitive)

Question 2

Perfect competition characteristics

Answer 2

Homogenous (identical) goods/Price takers: buyers and sellers not big enough/no ability to influence the price
Information: perfect information for buyers and sellers
Number of firms: infinite buyers and sellers
Barriers to entry/exit: low
Firms are profit maximisers: will produce where MC=MR

Question 3

Short-run and Long-run equilibrium in perfect competition

Answer 3

Short-run: When supernormal and subnormal profit is being made
Long-run: When normal profit is being made

Question 4

Short-run profit maximising equilibrium (perfectly competitive market)

Answer 4

Firms can make supernormal profits.
The firm is a price taker, and it accepts the industry price of P1 and produces an output of Q1.
- The rectangle shows the area of supernormal
profits earned. It is assumed that firms are short run profit maximisers.

Question 5

Long-run profit maximising equilibrium (perfectly competitive market)

Answer 5

Only normal profits are made as profits are competed away.
The supernormal profits made by existing firms means new firms have an incentive to enter
the industry. Since there are no barriers to entry, new firms are able to enter.
- This causes the supply in the market to increase, supply curve shifts from S1 to S2. The price level in the market falls as a consequence; firms are price takers, they must accept this new, lower price.
Competitive pressure ensures equilibrium is established. The supernormal profits have been competed away, so firms only make normal profits.
The new equilibrium at P=MC means firms produce at the new output of Q2 in the long run.

Question 6

Advantages of a perfectly competitive market

Answer 6

• In the long run, there is a lower price. P=MC, so there is allocative efficiency
• Since firms produce at the bottom of the AC curve, there is a productive efficiency
• The supernormal profits produced in the short-run might increase dynamic efficiency through investment

Question 7

Disadvantages of a perfectly competitive market

Answer 7

• In the long run, dynamic efficiency
  might be limited due to the lack of supernormal profits.
• Since firms are small, there are few or no economies of scale.
• The assumptions of the model rarely apply in real life. In reality: branding, product differentiation, adverts and positive and negative externalities,
  mean competition is imperfect.

Question 8

Monopolistic competition characteristics

Answer 8

• Imperfect competition: firms are short-run profit maximisers
• Product differentiation: non-homogenous goods/services due to branding; XED is high
• Large number of buyers and sellers: relatively small and independent, each seller has the same degree of market power as other sellers, but it’s relatively weak.
• No barriers to entry/exit
• Imperfect information
  Examples: monopolistic competition includes hairdressers and regional plumbers.

Question 9

Short-run profit maximising equilibrium (monopolistically competitive market)

Answer 9

Firms profit maximise at the point MC = MR. The area P1ABC1 shows the supernormal profits that firms earn in the short run.

Question 10

Long-run profit maximising equilibrium (monopolistically competitive market)

Answer 10

New firms enter the market since they are attracted by the profits existing firms are making, making the demand for the existing firms’ products more price elastic which shifts the AR curve (demand curve) to the left. Consequently, only normal profits can
be made in the long-run and the equilibrium point is P1Q1.

Question 11

How can firms try and stay in the short-run?

Answer 11

By differentiating their products and innovating.

Question 12

Advantages of a monopolistically competitive market

Answer 12

• This will shift SRAS to the left (SRAS1 to SRAS2).
• Since firms do not fully exploit their
  factors, there is excess capacity in the
  market. This makes firms productively
  inefficient (also note: the firm does
  not operate at the bottom of the AC
  curve). This is in both the short run
  and long run
• Consumers get a wide variety of
  choice.
• The model of monopolistic
  competition is more realistic than
  perfect competition
• The supernormal profits produced in
  the short run might increase dynamic
  efficiency through investment

Question 13

Disadvantages of a monopolistically competitive market

Answer 13

• In the long run dynamic efficiency might be limited due to the lack of supernormal profits.
• Firms are not as efficient as those in a
  perfectly competitive market, they have x-inefficiency, since they
  have little incentive to minimise their costs.

Question 14

Monopolies characteristics

Answer 14

• Profit maximisation. A monopolist earns supernormal profits in both the short run and the long run.
• Sole seller in a market (a pure monopoly)
• High barriers to entry
• Price maker
• Price discrimination

Question 15

Monopoly power vs Pure Monopolies

Answer 15

When one firm dominates the market with more than 25% market share, the firm has monopoly power e.g. Google dominates the search engine market, with 90% share.
Monopoly power can be gained when there are multiple suppliers. If two large firms in an oligopoly (several large sellers) have greater than 25% market share, they are said to have
monopoly power e.g. Sainsbury’s and Asda have more than 25% market share combined, so they are said to have monopoly power.
- There are very few examples of pure monopolies, but several firms have monopoly power.

Question 16

Monopoly powers influence: Barriers to entry

Answer 16

The higher the barriers to entry, the easier it is for firms to maintain
monopoly power.

Question 17

Examples of barriers to entry which can maintain monopoly power

Answer 17

• Economies of scale: As firms grow larger, the average cost of production falls meaning existing large firms have a cost advantage over new entrants to the market, maintaining their monopoly power: it deters new firms from entering the market because they’re not able to compete with
  existing firms.
• Limit pricing: This involves the existing firm setting the price of their good below the
  production costs of new entrants, to make sure new firms cannot enter profitably.
• Owning a resource: Early entrants to a market can establish their monopoly power
  by gaining control of a resource e.g. BT owns the network of cables so new firms would find it very difficult to enter the market.
• Sunk costs: If unrecoverable costs, e.g. advertising, are high in an industry, new firms will be deterred from entering the market, because if they’re unable to compete, they do not get the value of the costs back.
• Brand loyalty: can be increased with
  advertising, it’s difficult for new firms to gain market share
• Set-up costs: If it is expensive to establish the firm, then new firms will be unlikely to
  enter the market.
  -

Answer 18

• The number of competitors: The fewer the number of firms, the lower the barriers to entry,
  and the harder it is to gain a large market share.
• Advertising: Advertising can increase consumer loyalty, making demand price inelastic, and
  creating a barrier to entry.
• The degree of product differentiation: The more the product can be differentiated, through
  quality, pricing and branding, the easier it is to gain market share. This is because the more
  unique the product seems, the fewer competitors the firm faces.

Question 19

Profit maximising equilibrium

Answer 19

A monopolist earns supernormal profits in both the short run and the long run. This is at the point MC = MR, so the monopolist produces an output of Q1 at a price of P1.
- The shaded rectangle (AR and AC from Q1 to P1 and subsequent P2) shows the area of supernormal profits.

Question 19

Monopoly characteristics on graph

Answer 19

Since the firm is the sole supplier in the market, the firm’s cost and revenue curve is the same as
the industry’s cost and revenue curve. Firms are price makers in a monopoly.
P>MC in the diagram, due to profit maximisation which occurs at MC = MR, so there is allocative
inefficiency in a monopoly.
AR > AC, so there are supernormal profits.

Question 20

Price discrimination

Answer 20

Price discrimination occurs in a monopoly, when the monopolist decides to charge different groups of consumers different prices for the same good/ service. This is not for cost reasons.

Question 21

Third degree price discrimination

Answer 21

When different groups of consumers are charged a different price for the same good or service e.g. the higher price at peak times on
trains is a form of third degree price discrimination, because generally, a different group of consumers (usually commuters) use trains at peak times, than off-peak times. Similarly, adults, students and children pay different prices to see the same film at a cinema. It costs
the cinema the same to show the film, but the consumers have been divided into groups
based on age.

Question 22

Costs of third degree price discrimination to consumers

Answer 22

• Usually, price
  discrimination results in a loss of consumer surplus. Since P > MC, there is a loss of allocative efficiency.
• It strengthens the
  monopoly power of firms, which could result in higher
  prices in the long run for
  consumers.

Question 23

Costs of third degree price discrimination to producers

Answer 23

• If it is used as a predatory pricing method, the firm could face investigation by the Competition and Markets Authority.
  It might cost the firm to
  divide the market, which
  limits the benefits they
  could gain.

Question 24

Benefits of third degree price discrimination to consumers

Answer 24

• Net welfare gain as a
  result of cross subsidisation, if they receive a lower price.
• Some consumers, who were previously excluded by high prices, might now be able to
  benefit from the good/
  service e.g. drug
  companies might charge
  consumers with higher
  incomes more for the same drugs, so that the less well off can also access the drugs
  at a lower price. This can
  yield positive externalities.

Question 25

Benefits of third degree price discrimination to producers

Answer 25

• Producers make better use of spare capacity.
• The higher supernormal profits, which result from
  price discrimination, could help stimulate investment.
• If more profits are made in one market, a different market which makes losses could be cross subsidised,
  especially if it yields social benefits. This will limit/prevent job losses, which might result from the closure of the loss-making market.

Question 26

Costs of monopoly to firms, consumers, employees and suppliers

Answer 26

• The basic model of monopoly suggests that
  higher prices and profits, and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market.
• Monopolies could exploit the consumer by
  charging them higher prices meaning 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.
• Monopolies have no incentive to become
  more efficient, because they have few or
  no competitors, so production costs are
  high
• There is a loss of consumer surplus and gain of producer surplus. If a monopolist raises the market price above the competitive
  equilibrium level, output will fall from Q1 to Q2. This leads to gains in producer surplus.
• Consumers do not get as much choice in a
  monopoly as they do in a competitive
  market.

Question 27

Benefits of monopoly to firms, consumers, employees and suppliers

Answer 27

• 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.
  Moreover, firms are more likely to innovate if
  they can protect their ideas. This is more
  likely to happen in a market where there are
  high barriers to entry, such as in a monopoly.
• If there is a natural monopoly, it might be
  more efficient for only one firm to provide
  the good/service, since having duplicates of the same infrastructure might be wasteful e.g. it might be considered
  inefficient&wasteful to have 2 lots of water suppliers
• Monopolies could generate export
  revenue e.g. Microsoft
  generates a lot of export revenue for America.
• Since monopolies are large, they can exploit
  economies of scale, so they have lower average costs of production.
• High profits could be a source of govt revenue through taxation.

Answer 28

Happens when there are high fixed costs, usually in the form of infrastructure.
For example, water and gas pipes, electricity cables and rail networks are expensive forms of
infrastructure. In these industries, natural monopolies supply the services. The costs of
infrastructure are a form of sunk costs, since the costs are not recoverable if the firm decided
to leave the market. This makes barriers of entry to and exit from the market high.