4.1.5 Perfect competition, imperfectly competitive markets and monopoly Flashcards
Outline the different market structure can be depicted on a spectrum
Perfect competition, Monopolistic competition, Oligopoly, Monopoly
* Perfection and Monopolistic have Lower barriers to entry and are more contestable
* Oligopoly and Monopoly have More market power and less efficiency
Outline how market structures are characterised
- The number of firms in the market. The more firms there are, the more competitive the market is. This also includes the extent of competition from abroad.
- The degree of product differentiation. The more differentiated the products, the less competitive the market. In a perfectly competitive market, products are homogenous. Products can be differentiated using price, branding and quality. This affects cross price elasticity of demand.
- Ease of entry into the market. This is the number and degree of the barriers to entry. Barriers to entry are designed to prevent new firms entering the market profitably. This increases producer surplus. The higher the barriers to entry, the less competitive the market. Examples include:
- Economies of scale.
- Brand loyalty, which makes demand more inelastic. It is hard for new firms to gain consumer loyalty, when one firm’s brand name is already strong.
- Controlling the important technologies in the market.
- Having a strong reputation
Why is profit important for firms
Profit is an important objective of most firms. Models that consider the traditional theory of the firm are based upon the assumption that firms aim to maximise profits.
However, firms can have other objectives which affect how they behave. Profit is the difference between total revenue and total cost. It is the reward that entrepreneurs yield when they take risks
Outline the Profit-maximising rule (MC=MR)
A firm’s profit is the difference between its total revenue (TR) and total costs (TC). A firm profit maximises when they are operating at the price and output which derives
the greatest profit.
Profit maximisation occurs where marginal cost (MC) = marginal revenue (MR). In other words, each extra unit produced gives no extra loss or no extra revenue
Outline a diagram which explain profit maximising rule and explain
Profits increase when MR > MC. Profits decrease when MC > MR.
Some firms choose to profit maximise because:
o It provides greater wages and dividends for entrepreneurs
o Retained profits are a cheap source of finance, which saves paying high interest rates on loans
o In the short run, the interests of the owners or shareholders are most important, since they aim to maximise their gain from the company.
o Some firms might profit maximise in the long run since consumers do not like rapid price changes in the short run, so this will provide a stable price and output.
Outline short run profit maximisation
PLCs are particularly keen to profit maximise, because they could lose their shareholders if they do not receive a high dividend. They are more likely to have short run profit maximisation as an objective, because they need to keep their shareholders happy.
Outline the principal-agent problem
The principal-agent problem can be linked to the theory of asymmetric information.
This is when the agent makes decisions for the principal, but the agent is inclined to
act in their own interests, rather than those of the principal. For example, shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, such as a bonus, rather than maximise the dividends of the shareholders.
Outline the reasons for and the consequences of a divorce of ownership from control
When an owner of a firm sells shares, they lose some of the control they had over the firm. This could result in conflicting objectives between different stakeholders in the firm. If the manager is particularly good, they might require higher wages to keep them in the firm. However, they also need to keep shareholders happy, since
they are an important source of investment. It is not always possible to give both the
manager a high salary and the shareholders large dividends, since funds are limited. When a manager sells their shares, shareholders gain more control over the decisions of the firm. This could give rise to ‘shareholder activism’. This could be to put pressure on the management of the firm or to try and get higher dividends
Outline other possible objective of a firm
Survival: Some firms, particularly new firms entering competitive markets, might aim
to simply survive in the market. This is a short term view. During periods of economic decline such as the 2008 financial crisis, when consumer spending plummets, firms might have survival as their objective, until there is economic growth again. Firms might aim to sell as much as possible to keep their market position, even if it is at a
loss in the short run
Growth: Some firms might aim to increase the size of their firm. This could be to take advantage of economies of scale, such as risk-bearing or technological. This would lower their average costs in the long run, and make them more profitable. Firms might grow by expanding their product range or by merging or taking over existing firms. Large firms are also more able to participate in research and
development, which might make them more competitive and efficient in the long run
Increasing their market share: This helps increase the chance of surviving in the market, and it can be achieved by maximising sales.
Quality: Firms might aim to increase their competitiveness by improving their quality. Firms might consider improving their customer service or the quality of the good they produce. This could be achieved through innovation. If firms can gain a reputation for high quality goods, they could potentially charge higher prices, since
consumers might be willing to pay more for them.
Sales maximisation: This is when the firm aims to sell as much of their goods and
services as possible without making a loss. Not-for-profit organisations might work at
this output and price. On a diagram this is where average costs (AC) = average revenue (AR).
Give a diagram and explain Maximise sales revenue (possible objectives of a firm)
Maximising their sales revenue: Revenue maximisation occurs when MR = 0. In other words, each extra unit sold generates no extra revenue.
Give an example of the diagram below summarises each objective
Outline the Satisficing principle
Another objective a firm might have is satisficing. A firm is profit satisficing when it is
earning just enough profits to keep its shareholders happy.
Shareholders want profits since they earn dividends from them. Managers might not aim for high profits, because their personal reward from them is small compared to shareholders. Therefore, managers might choose to earn enough profits to keep
shareholders happy, whist still meeting their other objectives.
This occurs where there is a divorce of ownership and control.
Outline the characteristics of perfect competition
A perfectly competitive market has the following characteristics:
o Many buyers and sellers
o Sellers are price takers
o Free entry to and exit from the market
o Perfect knowledge
o Homogeneous goods
o Firms are short run profit maximisers
o Factors of production are perfectly mobile
Outline in a market what happens in a perfect competition
In this market, price is determined by the interaction of demand and supply. In a competitive market, profits are likely to be lower than a market with only a few large firms. This is because each firm in a competitive market has a very small market share. Therefore, their market power is very small. If the firms make a profit, new firms will enter the market, due to low barriers to entry, because the market seems profitable. The new firms will increase supply in the market, which lowers the average price. This means that the existing firms’ profits will be competed away.
Outline a diagram and explain Profit Maximising equilibrium in perfect competition in the short run
In the short run, firms can make supernormal profits. In the long run where profits are competed away, only normal profits are made. The diagram below shows the short run equilibrium for a perfectly competitive
market. The firm is a price taker, and it accepts the industry price of P1. In the short run, the firm produces an output of Q1. The yellow shaded rectangle shows the area of supernormal profits earned in the short run. It is assumed that firms are short run profit maximisers.
Outline a diagram and explain Profit Maximising equilibrium in perfect competition in the long run
The diagram below shows the long run equilibrium for a perfectly competitive market. The supernormal profits made by existing firms means that new firms have an incentive to enter the industry. Since there are no barriers to entry in a perfectly competitive market, new firms are able to enter the industry.
This causes the supply in the market to increase, as shown by the shift in the supply
curve from S to S1. The price level in the market falls as a consequence. Since firms
are price takers, they must accept this new, lower price.
In the long run, competitive pressure ensures equilibrium is established. The supernormal profits have been competed away, so firms only make normal profits in the long run. The new equilibrium at P=MC means firms produce at the new output of Q2 in the long run.
Give Advantages and disadvantages of perfectly competitive market
Advantages
* 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 productive efficiency.
* The supernormal profits produced in the short run might increase dynamic efficiency through investment.
Disadvantages
* 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 that competition is imperfect.
Define allocative efficiency
This occurs when there is an optimal distribution of goods and services, taking into account consumer’s preferences. A more precise definition of allocative efficiency is at an output level where the Price equals the Marginal Cost (MC) of production.
Define productive efficiency
Productive efficiency is concerned with producing goods and services with the optimal combination of inputs to produce maximum output for the minimum cost. To be productively efficient means the economy must be producing on its production possibility frontier.
Outline the characteristics of monopolistically competitive markets
A monopolistically competitive market has imperfect competition. Firms are short run profit maximisers.
Firms sell non-homogeneous products due to branding (there is product differentiation). However, there are a lot of relatively close substitutes. This makes the XED of the goods and services sold high.
The model is based on the assumption that there are a large number of buyers and sellers, which are relatively small and act independently. Each seller has the same
degree of market power as other sellers, but their market power is relatively weak.
Firms in a monopolistically competitive market compete using non-price competition. There are no barriers to entry to and exit from the market.
Since firms have a downward sloping demand curve, they can raise their price without losing all of their customers. This is because firms have some degree of price setting power. Buyers and sellers in a monopolistically competitive market have imperfect information.
Give examples of monopolistic competition
Examples of monopolistic competition include hairdressers and regional plumbers.
Outline a diagram of Profit maximising equilibrium in the monopolistic competition in the short run and explain
In the short run, firms profit maximise at the point MC = MR. The area P1C1AB represents the supernormal profits that firms in a monopolistically competitive market earn in the short run.
Outline a diagram of Profit maximising equilibrium in the monopolistic competition in the long run and explain
In the long run, new firms enter the market since they are attracted by the profits that existing firms are making. This makes the demand for the existing firms’ products more price elastic which shifts the AR curve (the demand curve) to the left. Consequently, only normal profits can be made in the long run. The long run equilibrium point is P1Q1. Firms can try and stay in the short run by differentiating their products and innovating.
Outline the advantages and disadvantages of monopolistically competitive markets
Advantages
* Firms are allocatively inefficient in the short and long run (P > MC)
* 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.
Disadvantages
* 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. In a monopolistically competitive market, firms have x-inefficiency, since they have little incentive to minimise their costs.
Outline the Characteristics of an oligopoly
High barriers to entry and exit There are high barriers of entry to and exit from an oligopoly. High barriers to entry make the market less competitive.
High concentration ratio- In an oligopoly, only a few firms supply the majority of the market. For example, in the UK the supermarket industry is an oligopoly. The high concentration ratio makes
the market less competitive.
Interdependence of firms- Firms are interdependent in an oligopoly. This means that the actions of one firm affect another firm’s behaviour.
Product differentiation - Firms differentiate their products from other firms using branding. The degree of
product differentiation can change how far the market is an oligopoly.
Outline Oligopoly as a market structure and a behaviour
Firms can either operate in a market which is oligopolistic, or several firms can display oligopolistic behaviour.
Firms which display oligopolistic behaviour might be interdependent, have stable
prices, collude or have non-price competition
Outline collusive behaviour oligopoly
Collusive behaviour occurs if firms agree to work together on something. Collusion leads to a lower consumer surplus, higher prices and greater profits for the firms colluding. It can allow oligopolists to act as a monopolist and maximise their
joint profits. Firms in an oligopoly have a strong incentive to collude. By making agreements, they
can maximise their own benefits and restrict their output, to cause the market price to increase. This deters new entrants and is anti-competitive.
Collusion is more likely to happen where there are only a few firms, they face similar costs, there are high entry barriers, it is not easy to be caught and there is an ineffective competition policy. Moreover, there should be consumer inertia. All of these factors make the market stable.
Outline non collusive behaviour
Non-collusive behaviour occurs when the firms are competing. This establishes a competitive oligopoly. This is more likely to occur where there are several firms, one firm has a significant cost advantage, products are homogeneous and the market is saturated. Firms grow by taking market share from rivals.
