3.4 test Flashcards
Allocative Efficiency
Reached when no one can be made better off without making someone the worse off. Also known as Pareto efficiency/ optimality. Occurs when the value that the consumers place on a product ( reflected in the price they are willing and able to pay) equals the marginal cost of factor resources used up in production. The condition required for allocative efficiency in a market is that Price = Marginal Cost Of Supply.
-Maximises total consumer welfare (economic welfare maximised), Consumer and producer surplus maximised.
Price = Marginal Cost of Supply
Productive efficiency
Refers to a state where a company is producing goods or services at lowest possible average cost, using fewest possible resources. This means that a company can produce to maximum output with the given inputs, without any waste or inefficiencies. In other words the company is using resources in the most efficient way possible. Productive efficiency is achieved at an output that minimizes the unit cost (AC) of production. Productive efficiency where AC = MC.
Perfect Competition -> Pure Monopoly
Perfect competition-> monopolistic competition -> oligopoly -> Duopoly -> Monopoly -> Pure Monopoly
as go left gets more competitive ( fewer imperfections)
as go right gets less competitive (greater degree of imperfections)
Perfect Competition Assumptions
A model of an extreme market structure, based on certain assumptions.
Basic Assumptions:
-Homogenous products (they are all perfect substitutes)
-All Firms have equal access to factors of production
-Many buyers + sellers (no monopoly or monopsony power)
-Sellers must act independently (there is no price collusion)
-Free (costless) entry and exit to the market
-Perfectly elastic demand curve for each individual firm
-Perfect knowledge/ info from buyers/ sellers about prices and quality of what is being sold.
-Profit maximisation is assumed as the default objective of firms - (MC=MR) and consumers are assumed to be utility maximisers when making purchasing decisions.
Industry and Firm MC/AC/D/S graphs
-Market price is set in the market
-The market price comes over to the firm and the firm has a perfectly elastic demand curve
-The individual firms supply curve is represented by the MC curve
-The firm will produce at the profit maximisation point (MC=MR)
-In the long run firms will make normal profits (AC=AR)
Abnormal Losses in the SR - graph
-Firms are making abnormal losses
-Because of no exit barriers some firms start to leave the market
-As firms leave the market supply shifts to the left, causing price to rise
-This continues until we attain normal profits in the long run
Abnormal Profits in the SR - graph
-Firms are making abnormal profits
-perfect knowledge- evreyone knows abnormal profits
-Because of no entrance barriers some firms start to enter the market
-As firms enter the market supply shifts to the right, causing prices to fall.
-This continues until we attain normal profits in the long run.
Monopoly Characteristics
- Number and Size of firms that make up the industry- One large dominant firm.
-Control over price or output- Price makers- choose price
-Freedom of entry and exit from the industry- huge barriers, difficult to get in/out
-Nature of the product (degree of homogeneity)- highly differentiated, price inelastic, few substitutes.
-Diogromatic representation- very price inelastic (not perfect)
Pure Monopoly Assumptions
-Single seller of goods/service.
-No substitutes for the good.
-There are barriers to entry into the market.
Pure Monopoly
Where only one producer exists in the industry. In reality, rarely exists - always some form of substitute available.
Monopoly exists therefore where one firm dominates the market.
Firms may be investigated for example of monopoly power when market share exceeds 25%. In 2019, Asda + Sainsburies were going to merge, giving 32% market share, not allowed to happen.
Origins of Monopoly
-Natural Monopoly- usually on a network or grid… wastefull to duplicate.
-Geographical factors - where a country or climate is the only source of supply of a raw material… quite rare. However, consider a single grocery store in an isolated village.
-Government-created monopolies - now sold off
-Through growth of the firm, amalgamation, merger or take over.
-Through acquiring a patent or license
-Through legal means - Royal charter, nationalisation, wholly owned plc.
Monopoly Diagrams
Revenue Maximisation at MR=0.
Abnormal profit at P1abP2
If the market is competitive, then it will be allocatively efficient. Where Demand = Supply. Therefore in a monopoly the consumer faces a higher price (P, rather than P3). The Quantity available to the consumer is lower ( Q* rather than Q1). But because Q restricted to Q* we contract along supply curve to P1.
If the market was competitive we would see P3Q1 therefore consumer surplus of CeP3 and producer surplus of P3eo. At Q* consumer surplus is CaP1 and a consumer loss of consumer surplus of P1aeP3. Original producer surplus of P3eo and new producer surplus of P1afo. Dead weight loss of aef.
Price Discrimination
Price Discrimination occurs when a firm charges a different price to a different group of consumers for an identical good or service, for reasons not associated with the cost of supply.
Price Discrimination occurs in all imperfectly competitive markets.
It is most common in monopolies and oligopoly.
Requires a supplier to have some pricing power.
It has potentially important welfare and distribution effects.
Aims of price discrimination
-Increased Revenue- extracting consumer surplus and turning it into increased producer surplus for the seller.
-Higher profits- Total profit will rise providing the marginal profit from selling to extra consumers is positive.
-Using spare capacity- can help a business make more efficient use of their supply capacity.
3rd Degree Price Discrimination
Charging different prices to groups of people with different price elasticity of demand (PED).
Examples of 3rd Degree price discrimination
-Cinema pricing- Ticket prices vary by age, time of film showing and (in some cases) by location of the cinema.
-Student discount- many venues offer price discounts for students who have a more price-sensitive demand.
-Car insurance- price walking- long-standing customers faced higher prices when renewing their policies.
Conditions for using price discrimination
-Monopolists have “market power” - the ability to set prices without worrying about competition.
-The groups being discriminated between must have a different PED.
-There must be a way of stopping arbitrage opportunities that arise from consumers buying cheap, and selling to those who have been charged a higher price.
Negative effects on consumer welfare of price discrimination
-Higher prices for many people reduces their consumer surplus - an example is “dual pricing” in insurance where loyal customers were charged more than new customers. This form of pricing exploits imperfect information in the market and consumer inertia.
-Price discrimination reinforces monopoly power of firms which can then lead to higher prices in the long run and a loss of allocative efficiency.
-Algorithms increase the potential to discriminate between consumers- there is now widespread use of artificial intelligence-driven price discrimination leading to certain groups in society consistently paying more (such as online hotel bookings).
-Multi-purchase or volume discount purchasing favours higher-income, larger families at the expense of single people. It can encourage food waste, which creates external costs.
Arguments supporting price discrimination
-It makes fuller use of spare capacity leading to less waste. There are potential environmental benefits from this- an example, less food waste.
-Helps generate extra cash flow for businesses which can ensure survival during a recession- this supports jobs and maintains choice for consumers.
-Can fund cross-subsidy of goods and services - premium prices for some can fund discounts for other groups living on lower incomes (consider means-tested college fees). It can allow the continuation of loss-making services such as rural bus & train routes.
-Higher monopoly profits can finance investment & research and development spending which then drives improved dynamic efficiency in the long run.
-Can be seen as a progressive policy - an example, charging different prices for drugs such as vaccines between advanced and developing nations.
Monopolistic Competition
A market that shares the same characteristics of monopoly and some of perfect competition.
There are many firms producing similar, but not identical products.
For example:
-Sandwich bars
-Hairdressers
-Takeaway restraunts
-Care homes
-Taxi companies
Key Characteristics of Monopolistic Competition
-There are many producers and many consumers in a market- the concentration ratio is low and they act independently.
-The barriers to entry and exit into and out of the market are low
-The firms are short run profit maximisers.
-Consumers see that there are non-price differences among the competitors’ products .i.e. there is products differentiation.
-Producers have some control over price- they are ‘price makers’ rather than ‘price takers’.
Concentration Ratios
The n firm concentration ratio is the market share of the n largest firms in the market.
Monopolistic Competition - Graph
Long Run equilibrium diagram for monopolistic competition, profit maximisation at MC = MR, LREQ equals normal profit. AR = AC at Q star. AC is tangential to AR at Q star. AC cutting MC at lowest point
Monopolistic Competition - Productive efficiency
No- Since at Qm rather than Qo, not where MC=AC.
-There is a market shortage
-They are also not maximising their economies of scale
Monopolistic Competition - Allocative efficeincy
-No, since Pm > Mc
-In a truly competitive market, the Po would exist - so there is a misuse of the consumer surplus- consumers are overcharged, and firms produce under their capacity.
Monopolistic Competition - Dynamic efficiency
-There are profits for product development
-There is an incentive for the companies to invest in R&D and new ideas…. As the product is always being developed.
-So yes- there is an incentive to be dynamically efficient.
Oligopoly Characteristics
-Few Firms will dominate the market (fight for market share)
-Interdependent
-High concentration Ratio
-Differentiated goods, so price makers
-High barriers to entry and exit
-Profit maximisation is not the sole objective
Example of Oligopoly
Groceries - top five firms have over 60% of the market share
-Tesco, Sainsbury’s, Asda, Morrisons, Aldi
Assumptions of Oligopoly diagram
-Other firms will not follow the price rise
-Other firms will follow a price fall
Oligopoly - collusion
An Oligopoly can lead to a temptation to collude:
-OPEC (Organisation of the Petroleum Exporting Countries)
-In this type of overt, collusion firms typically agree to limit their output in order to raise prices
-OPEC attempts to manipulate the world price of oil by restricting supply
Two main types of oligopoly
Competitive:
-Engage in price wars or non price competition
-When there are lots of firms in market (low concentration)
-Low barriers so firms attracted to super normal profits
-Offer a range of similar goods
-More like a competitive market
(all relative to oligopoly)
Collusive
-Can be overt (publicly) or tactic (discreetly)
-Fix prices high to reduce competition and maximise profits
-Fit the output to keep supply at a certain level
-Higher barriers to entry
-Ineffective competition policy
-Small number of firms dominating (3-4)
Consumers might still be loyal regardless or they might not know or care.
Collusion Advantages
-Excess profits could be reinvested to improve dynamic efficiency in the long run (or higher dividends)
-Firms can collaborate on technology and improve their goods/services
-Saves on duplicate research
-Increase in size so economies of scale - lower prices
Collusion Disadvantages
-Less consumer welfare as prices are raised and output reduced
-Efficiency falls as less competition which would increase average costs
-Makes it tougher for new firms to enter
Game Theory
Game theory - related to the concept of interdependence between firms in an oligopoly.
Firms will eventually end up at the Nash Equilibrium unless they collude, but there is an incentive to cheat to both get higher profits.
Cartel
A formal agreement between firms to fix prices, output, or other market conditions
Price fixing
An agreement among competitors to set prices at a certain level.
The German Beer Price Fixing Case
In 2014, several major German Breweries were fined by the Federal Cartel Office for price-fixing agreements. This case provides a real-world example of collusion in an oligopolistic market. Four of the country’s largest breweries were fined €106.5m (£89m) for price-fixing. The talks resulted in a Germany-wide rise of €5-€7 per hundred litres for barrelled beer, and €1 per crate of bottled beer. The Cartel Office said the brewer AB InBev, whose brands Beck’s, Franziskaner and Hasseroeder were under particular investigation, and the retailer REWE Zentral escaped fines because they co-operated from early on in the investigation. Linking to the prisoner dilemma, by cooperating.
Game Theory - Prisoner Dilemma
The Prisoner’s Dilemma is a classic game theory scenario that demonstrates how cooperation can be difficult to achieve even when it is in everyone’s best interest.
Oligopoly competition: The Prisoner’s Dilemma can be used to model oligopoly competition, where a small number of firms dominate in a market. In this context, each firm has an incentive to maximize its profits, but if all firms do so, it can lead to a suboptimal outcome for the industry as a whole. The Prisoner’s Dilemma provides a framework for understanding how firms can coordinate their actions perhaps through tacit collusion to achieve a better outcome.
Tactic Collusion
In economics, tacit collusion refers to a situation where firms in an industry coordinate their behavior and set prices at a level that maximizes their joint profits, without any explicit communication or agreement between them.
Unlike explicit collusion, where firms engage in illegal behavior such as price fixing or market allocation, tacit collusion is not illegal and is often difficult to prove. In a tacitly collusive industry, firms may engage in a variety of behaviors that allow them to coordinate their actions without communicating directly with one another. For example, they may adopt similar pricing strategies, match each other’s price changes, or limit their production to avoid price wars.
Tacit collusion is often seen in industries with a small number of large firms, where there are high barriers to entry and the market is not very competitive. In such industries, firms may have an incentive to coordinate their behavior in order to avoid the uncertainty and risk associated with aggressive competition.
The effects of tacit collusion on consumers can be significant, as it can lead to higher prices and reduced choice in the market. Regulators and antitrust authorities may monitor industries for signs of tacit collusion and take action to prevent or punish collusive behavior if it is found to be harming consumers.
