4.1.5 Perfect competition, imperfectly competitive markets and monopoly

Question 1

Explain what the Business Objective of Profit Maximisation is.

Answer 1

MC=MR
Profit Maximisation: Firms seek to attain highest level of profit possible from production of goods + services
In traditional economic theory, always assume main objective of firms is to max profit.

Question 2

Explain why a Firm may have the Objective of Profit Maximisation.

Answer 2

• Re-Investment- if business is making large profits, can re-invest that profit back into business in form of: new capital, upgraded capital, new tech, e.t.c.
• Greater Dividends for Shareholders: reward shareholders (owners) with a greater share of the profits
• Lower Costs + Lower Prices for Consumers- consumers + business benefits; market share increases
• Reward Entrepreneurship- reward for risk-taking activity when business starts up

Question 3

Explain why a Firm may not have the Objective of Profit Maximisation.

Answer 3

• No knowledge of MC + MR
• Avoid scrutiny
• Key stakeholders may be harmed
• Other objectives may be more appropriate

Question 4

Explain what the Business Objective of Profit Satisficing is.

Answer 4

• Sacrificing profit to satisfy as many key stakeholders as possible
• Occurs where firm isn’t operating at its profit maximising level

Question 5

Explain why a Firm may have the Objective of Profit Satisficing.

Answer 5

If stakeholders aren’t happy with the Objective of Profit Maximisation:
- Consumers: If harming consumers, business may gain a bad reputation
- Workers/TU’s: if workers are harmed via profit maximisation- may strike
- Gov: if gov are unhappy, may investigate the business + outcomes may be very anti the business’ interests
- Environmental Groups: May protest if unhappy

Question 6

Explain what the Business Objective of Revenue Maximisation.

Answer 6

MR = 0 (as firms can continuously increase revenues, as they can sell another unit for more than £0)

Question 7

Explain why a Firm may have the Objective of Revenue Maximisation.

Answer 7

• Economies of Scale- Revenue maximisation quantity > profit maximisation quantity. Greater growth, greater economies of scale, lower AC, lower prices for consumers
• Predatory pricing- revenue maximisation pricing < profit max pricing; where a firm under-cuts a rival on purpose, sacrificing profit in order to drive competitors out of the market
• Principle Agent Problem- divorce between ownership + control; those who own don’t control. Managers whom control business may choose to revenue max, to use that as leverage to go to shareholders for greater perks in their job.

Question 8

Explain what the Business Objective of Sales Maximisation is.

Answer 8

AC = AR
- Firms seek to max volume of units sold
- Business wants to become as large as they can be, without making a loss

Question 9

Explain why a Firm may have the Objective of Sales Maximisation.

Answer 9

• To gain economies of scale
• Limit-Pricing- trying to limit competition, by pricing at break-even (normal profit) takes away incentive for new firms to enter market
• Principle Agent Problem- divorce between ownership + control; manager may se growth/sales as leverage when going to shareholders for greater perk in their job
• Flood Market- selling large amount of output, consumers become aware of your product- seeing it everywhere- develop loyalty to brand. Can then change objective to one such as profit max

Question 10

Explain some other Objectives that a Firm might have.

Answer 10

• Survval- short-run objective business may use when entering a hyper-competitive market; aiming to stay in business by covering costs
• Quality- allowing firm to differentiate its product in market meaning it can charge higher prices
• Corporate Social Responsibility (CSR)- giving to charities, producing sustainably, paying workers + suppliers fairly, acting ethically

Question 11

Define a Barrier to Entry.

Answer 11

• Any obstacle that prevents a new firm entering a market

Question 12

State the different types of Barriers to Entry.

Answer 12

• Legal (e.g. patents, licences/permits, red tape (excessive paperwork), standards + regulations, insurance)
• Technical: industry specific barriers (e.g. start-up costs, sunk costs (costs which can’t be recovered when firm leaves market- such as advertising + specialist machinery), economies of scale, natural monopoly)
• Strategic: intimidatory tactics used by firms in the market (e.g. predatory pricing (pricing low purposefully to drive out competition), limit pricing (pricing at normal profit, limits competition + incentive for firms to enter), heavy advertising)
• Brand Loyalty

Question 13

Define a Barrier to Exit.

Answer 13

• Any obstacle that prevents a firm leaving a market

Question 14

State examples of Barriers to Exit.

Answer 14

• Under valuation of assets
• High redundancy costs: costs you have to pay to workers when shutting the business down
• Penalties for leaving contracts early: (e.g. contracts with supply, gas + electric contracts, e.t.c)
• High sunk costs

Question 15

Define Perfect Competition.

Answer 15

• Market structure with numerous buyers + sellers, homogenous products, free entry + exit, perfect information.

Question 16

State + explain the characteristics of a market in Perfect Condition.

Answer 16

• Many buyers + sellers (infinite, extreme competition)
• Firms selling homogenous goods (identical)- therefore firms are price takers (no ability to set price)
• No barriers to entry/exit
• Perfect information of market conditions- consumers know about prices + quality in market, producers know about prices, technology + costs)
• Firms are profit maximisers (MC = MR)

Question 17

Explain why there is only Supernormal Profit in the SR for firms in Perfect Competition.

Answer 17

• This profit attracts new firms into the market- can easily enter as there’s no barrier to entry + perfect information.
* As new firms enter, S shifts right, P falls, until there’s no more incentive for firms to enter the market (i.e. all supernormal profit is taken away + normal profit is what’s left)

Question 18

Explain why there is only Subnormal Profit in the SR for firms in Perfect Competition.

Answer 18

• Firms will be incentivised to leave market + produce their opportunity cost instead.
• Can easily leave market as there are no barriers to exit- as firms leave the market, S shifts left, P will be driven up in the market, until there is no more incentive to leave (i.e. till there’s normal profit left)

Question 19

Analyse + evaluate Perfect Competition using Efficiency.

Answer 19

• Allocative efficiency: see if P is equal to MC, at Q2 in the long-run. Furthermore, if firms are allocatively efficient, it means they’re perfectly following consumer demand, prices low, consumer surplus high, Q high, choice high- consumers are benefiting from resources following their demand in the exact way in which they desire them to.
• Productive efficiency: at Q2, is the firm operating at the lowest point on the AC curve? If so, the firm is productively efficient, means there is full exploitation of any economies of scale.
• X efficiency: is firm producing on their AC curve? If so, firm is X efficient, minimising waste + cost.
• Therefore, in the LR firms in perfect competition are statically efficient.
• Firms cannot be dynamically efficient in the LR, as there’s no supernormal profit, therefore firms don’t have the profit in LR to re-invest back into the company- consumers may not see brand new innovative products over top, producers won’t be able to lower their costs through newer technologies.

Question 20

State + explain the benefits of Competition for the Consumer.

Answer 20

• Lower Prices: increased competition means firms minimise costs + keep prices down to stay in business. No barriers to entry means when firms earn supernormal profits, over time new firms enter + this leads to a shift of the supply curve to the right, leading to a fall in market price.
• Increased Choice: Competition creates an increased range of products; improved allocation of resources, as firms are more likely to produce products that a variety of customers will wish to buy
• Improved quality: to maintain a customer base within a competitive market, firms strive to provide better quality products + customer service

Question 21

Define Monopoly, Pure Monopoly, Legal Monopoly, Dominant Market Position + Monopoly Power.

Answer 21

• Monopoly: One seller dominating the market
• Pure Monopoly: one firm having 100% market share (e.g. National Grid, Water Companies- regional monopoly)
• Legal Monopoly: firm has more than 25% market share (e.g. Tesco, Coca-Cola)
• Dominant Market Position: firm has 40% or more of market share (e.g. Microsoft)
• Monopoly Power: Price setting power- able to raise + maintain prices above the price that would normally be charged in a competitive market.

Question 22

State + explain the characteristics of a market in Monopoly.

Answer 22

• Differentiated Products- monopoly is a price maker.
• High barriers to entry/exit. Therefore, supernormal profits can persist overtime.
• Imperfect Information of market conditions.
• Firm is a profit maximiser- producing when MR = MC.

Question 23

Analyse + evaluate Monopolies using Efficiency.

Answer 23

• Allocative Inefficiency: monopolies aren’t allocatively efficient as they are charging a price which is greater than MC, + in doing so, they are exploiting consumers with high prices, low consumer surplus, + restricting output (so that they can charge higher prices- reduces choices for consumers). Not following consumer demand at all.
• Productive Inefficiency: Not productively efficient, as they are voluntarily foregoing economies of scale, by not producing at the minimum point on their AC curve.
• X-Inefficiency: occurs when monopolies are producing above their AC curve. This happens due to monopolies become complacent with a lack of a competitive drive, also happens because it is difficult to reduce waste/cut down to costs, + if a firm doesn’t need to do so, then they’re not necessarily going to do so.
• Therefore, monopolies are statically inefficient.
• Dynamic Efficiency: potential for monopolies to be dynamically efficient, due to supernormal profits being made, no firms can enter market- due to high barriers to entry + imperfect information. Allows supernormal profits to persist in the LR, therefore the monopoly could re-invest these profits back into the company in the form of new technology, new capital, research + development, e.t.c.

Question 24

State + explain why Monopolies are considered bad for Consumer.

Answer 24

• Monopolies can exploit consumer: charging high prices (even if the quality is poor), because consumers have no alternative.
• Lack of innovation
• Leads to inefficiencies.

Question 25

Explain the conditions in which a Monopoly may be good for Consumers.

Answer 25

• The assurance of a consistent supply of a commodity that is too expensive to provide in a competitive market.
• Monopolies can gain economies of scale, passing this onto consumers via lower prices

Question 26

Explain what Consumer Surplus is.

Answer 26

• Area of the demand curve above the equilibrium point + is the amount of people who are willing to pay more for the particular product.
• Firms would like to extract as much consumer surplus as possible by price discrimination + price skimming.

Question 27

Explain the Significance of Consumer Surplus.

Answer 27

• In competitive markets, firms have to keep prices relatively low, enabling consumers to gain consumer surplus.
• If markets weren’t competitive, consumer surplus would be less + there would be greater inequality.
• A lower consumer surplus leads to higher producer surplus + greater inequality.
• Consumer surplus enables consumers to purchase a wider choice of goods.

Question 28

Explain what Producer Surplus is.

Answer 28

• Area above the supply curve, but below the market equilibrium price.
• The number of firms who are willing to charge less for the product.

Question 29

Define Deadweight Loss.

Answer 29

Also known as a loss of economic efficiency.
* Welfare lost due to inefficient allocation of resources in a market, often caused by monopolies.
* The reduction in consumer + producer surplus when output is restricted to less than the optimal level of output.
* A monopoly causes increased producer surplus, decreased consumer surplus + deadweight loss.

Question 30

Define Price Discrimination.

Answer 30

• Where a firm charges different prices to different consumers for an identical goods/service with no differences in the CoPs.
• Example: airlines- charging different prices for the same ticket, depending on when they buy them/the season the ticket is booked for.

Question 31

State + explain the conditions necessary for Price Discrimination (PD)

Answer 31

• Price making ability: need to be able to set price, in order to do this, firm must have monopoly power
• Information to Separate the Market: separate consumers via PED (e.g. need to identify consumers with price inelastic demand, so that they can charge higher prices, + identify consumers with price elastic demand, so they can charge lower prices, thus maximise profits in the process).
• Prevent Re-sale of Good (Market Seepage): Stop someone buying from where prices are lower + selling where prices are higher.

Question 32

Explain what 1st Degree PD is.

Answer 32

• When each consumer is charged the exact price that they are willing + able to pay for a service
• Therefore eroding all consumer surplus in the market + converting it into producer surplus (i.e. monopolist will receive the entire surplus in each transaction with a consumer)
• Examples: auctioning items, buying houses, selling cars

Question 33

Explain what 2nd Degree PD (Indirect PD) is.

Answer 33

• Charging consumers based on the quantity sold.
• One way to look at this is via excess capacity pricing- firm has fixed capacity + makes no sense to leave any of that capacity idle, as these companies have FC they need to pay (e.g. hotel).
• So firms lower their prices last minute, in order to fill that capacity + contribute towards their FC.
• As long as P > MC, firm can still make a profit
• More you use of a good/service, the less you pay
• Examples: mobile phones, gas, electricity

Question 34

Explain 3rd Degree PD (Direct PD) is.

Answer 34

• Firm is able to segment market into different PEDs (split into groups based on: income, location, time, age)
• Same product/service is sold at different prices to different consumers.
• Examples: train fares, cinema tickets

Question 35

State + explain the disadvantages of PD.

Answer 35

• Allocative Inefficiency: 1st degree + 3rd degree PD (inelastic segment), charging costs way beyond MC, exploiting consumers, bad for consumers.
• Inequalities: 1st degree PD, inelastic segment of 3rd degree PD, who are the consumers?- if they are those on lower incomes, may widen income inequality in society.
• Anti-Competitive Pricing: 3rd degree PD, elastic segment. If prices are driven down, these lower prices could drive out competitors, leaving the firm with pure monopoly market power.

Question 36

State + explain the advantages of PD.

Answer 36

• Dynamic Efficiency: with greater profits, firm could re-invest, comes greater dynamic efficiency benefits.
• Economies of scale: due to greater quantity, 2nd + 3rd degree PD, greater economies of scale benefits, + potentially lower prices for consumers over time.
• Some consumers benefit: in 2nd degree + 3rd degree (elastic segment). However, don’t benefit as much as other consumers lose because of PD.
• Cross Subsidisation: higher profits firms make might be used to cross subsidise loss making goods/services elsewhere in the business

Question 37

Define Monopolistic Competition.

Answer 37

• Market structure with many firms selling differentiated products, leading to some but not perfect competition.
• A competitive market, but with some characteristics of a monopoly.

Question 38

State + explain the characteristics of a market in Monopolistic Competition.

Answer 38

• Many buyers + sellers
• Each firm is selling slightly differentiated goods- firms are price makers (only slightly, as there are similar, but no identical, substitutes), price elastic demand.
• Low barriers to entry/exit
• Good information of market conditions
• Non-Price Competition- as firms can’t raise price significantly to make high supernormal profits + exploit consumers.
• Firms are profit maximisers (producing where MC = MR)

Question 39

State examples of markets in Monopolistic Competition.

Answer 39

• Clothing
• Fast-food
• Resturants
• Hairdressers/salons
• Bars/nightclubs

Question 40

Explain why firms in Monopolistic Competition earn Supernormal Profit in the SR.

Answer 40

• In the SR, firms can exploit their price making power, given the fact they are producing a unique good- as a result can make supernormal profit.
• However, supernormal profit erodes in the LR.

Question 41

Explain why firms in Monopolistic Competition earn Normal Profits in the LR.

Answer 41

• In LR, new firms enter due to supernormal profits- can enter, due to low barriers + good info.
• As new firms enter, demand for individual firms in the market shifts left, until normal profit is made; AC = AR

Question 42

Analyse + evaluate Monopolistic Competition using Efficiency.

Answer 42

• Allocative Inefficiency: P is greater than MC, so allocative efficiency isn’t being achieved in the LR. Therefore, consumers are exploited, output is restricted, choices are restricted. However, there is competition in the market, therefore the price making abilities are lower + price exploitation/loss of consumer surplus is no where near as bad as a monopoly. In comparison, to PC- where there is allocative efficiency- there are homogenous goods- no variety for consumers. Furthermore, consumers may be attracted to pay slightly more for a range of goods in a market with monopolistic competition.
• Productive Inefficiency: none of the minimum points are on the AC curve, therefore firms are voluntarily foregoing economies of scale. In comparison to a monopoly, no where near as bad, as there are good substitutes. Allocative inefficiency in monopolistic completion, may be due to product differentiation demands of consumers.
• Dynamic Inefficiency: no LR supernormal profit being made- not enough profit to re-invest back into the capital. However, in a very competitive market, firms may have dynamic efficiency, via re-investing normal profit.

Question 43

Define Oligopoly.

Answer 43

• Market structure with few large firms who compete or collude with each other.

Question 44

Define Natural Monopoly.

Answer 44

As firm grows (output increases), costs continue to fall- continuous economies of scale
* Example: National Grid

Question 45

State + explain why firms price discriminate.

Answer 45

• Extra revenue + profit: firms make more sales/get more customers then if they charged one price.
• Improved Cashflow: enables firms to bring in cash at times when sales may normally be low (e.g. off peak travel, out of season holidays)
• Uses up spare capacity: brings in additions to revenue that can contribute to covering FC, MC of extra sale is usually low (e.g. last minute airlines seats)

Question 46

Explain why firms charge consumers in the price inelastic demand market a higher price in 3rd degree PD.

Answer 46

• In the price inelastic demand market- higher price (P2 is charged as these consumers have a lower PED + will be more willing to pay higher prices.
  *Firm can earn more TR by charging this group a higher P than other groups.
• Example: adult cinema tickets/rail travel

Question 47

Explain why firms charge consumers in the price elastic demand market a lower price in 3rd degree PD.

Answer 47

• In PED market- lower price (P1) is charged as these consumers have less willingness o pay.
• Firm can earn more rev by charging this group a lower price + increasing its total sales.
• Example: student discounts on cinema tickets or rail travel. Firm can benefit from increased rev but also increase capacity utilisation + better cashflow by selling at a lower price to this group.

Question 48

Evaluate how harmful PD is to consumer welfare.

Answer 48

The extent to which PD is considered harmful to consumer welfare depends on:
* Whether it leads to new consumers being able to buy a good/service that were previously unable to buy. Discounts for lower income groups can increase access to goods + consumer welfare- this group gains consumer surplus.
* Reduces waste by increasing capacity utilisation- better use of resources to sell off tickets at last minute than them not being used.
* Most firms are still monopolies + PD is about maximising profits- if this with very inelastic D are exploited through very targeted PD this likely leads to worse outcomes for consumers overall. Therefore, PD where there’s no choice for consumers (1st + to some extent 3rd) is worse than 2nd where consumers can to some extent choose their options.