5 - Perfect Competition, Imperfectly Competitive Markets and Monopoly Flashcards
What does Market Structure mean?
How a market is organised and the characteristics of the market.
What are some key features of a market structure?
- Number of firms in a market
- Market share of largest firms, concentration
- Barriers to entry/exit
- Revenues or cost in a market
- Product differentiation in a market
What are the markets we need to know?
Perfect Competition
Monopolistic competition
Oligopoly
Monopoly
Duopoly.
Rank the markets from most contestable (least barriers to entry) to least contestable.
Contestable:
Perfect Competition
Monopolistic Competition
Oligopoly
Duopoly
Monopoly
Least Competition:
How do the number of firms in the market distinguish between different market structures?
The more firms in a market, the more competitive the market is. Pure monopoly are dominated by one firm, whereas perfect competition has lots of buyers and sellers.
How do the Market Entry Barriers distinguish between different market structures?
Barriers of entry are designed to prevent new firms from entering the markets profitability. The higher the barriers to entry the less competitive a market is. In the short-run, for all markets, firms cannot enter or leave the market as at least one of the factors of production are fixed. But in the long run, when all factors of production are variable, firms can enter and leave COMPETITIVE markets.
How do the Product Differentiation distinguish between different market structures?
The more differentiated the products, the less competitive the market. In.a perfectly competitive market, products are homogenous (same). So products can differentiated through price, branding and quality. Affects price elasticity of demand.
Give some examples of Barriers to Entry.
- Economies of scale, This is because they would produce comparatively
expensively, so they cannot compete. - Brand loyalty, demand more price inelastic and consumers are less likely to try other
brands, when a firms name is strong. - Controlling the important technologies in the market.
- Having strong reputation
- Legal barriers to entry such as patents to protect franchises.
- Backwards vertical integration, controls supply as firms control the price they pay suppliers, which makes it hard for new firms to compete on price.
- Sunk Costs
What is the most important objective of firms?
Profit and we assume in theories that firms are profit maximisers.
How do you calculate profit?
Total Profit = Total Revenue - Total Cost
When does a firm break even?
Total revenue = total costs
Where is profit maximised and what does this mean?
Where MR = MC , Marginal Revenue = Marginal Cost
In other words, each extra unit produced gives no extra loss or no extra revenue.
Draw out a total cost and total revenue diagram for profit.
When will profit increase and decrease with marginal revenue and marginal cost
When output increase.
Profits increase when MR > MC. Profits decrease when MC > MR.
Why would firms want to profit maximise?
- Provides greater wages and dividends for entrepreneurs.
- Retained profits cheap source of finance, saves paying for high interest rates on loans.
- In the short-run the interest of the owners or shareholders are most important, maximes gain from the company.
In long-run firms might profit maximise as consumers don’t like rapid changes in price in the short-run, so will provide a stable price and output.
What does the ‘divorce of ownership from control’ refer to?
The owners and those who control the firm (managers) are different groups with different objectives.
What are the reasons for divorce of ownership from control?
- Principal-Agent problem.
- Owner sells shares.
What are the consequences of a divorces of ownership from control caused by the Principal-Agent problem?
This is when the agent makes the best decision for the own interests instead of principle. For example, Managers and stakeholders holders have different objectives, managers might choose to make personal gain lie, a bonus rather than maximise dividends for the shareholders.
What are the consequences of a divorces of ownership from control caused by owners/managers selling shares?
Owners selling shares means they lose some control. As if a manager is really good he may require a high wage to keep him but they must also keep shareholders happy who are important for investment to the company by giving them large dividends.
More shares being sold, more power to shareholders, could create ‘shareholder activism’. More pressure on the firm to give out higher dividends. Like in 2004 Sainsbury’s chairman 2.3 billion bonus being denied by stake holders.
What are other possible objectives of firms?
- Survival
- Growth
- Increasing their Market Share
- Quality
- Sales Maximisation
How would survival be an object other than profit maximisation?
Usually a short term view
Particularly new firms entering a new competitive, might survive in the market.
During periods of economic decline, 2008 Financial Crisis, survival may of been an objective instead of profit. Aim to sell as much as possible to keep their market position.
How would growth be an object other than profit maximisation?
Firms might aim to increase the size of their firm.
Take advantage of economies of scale, such as risk-bearing or technological. Lower the average cost in the long-run, making more profit.
Merging or taking over existing firms. And larger firms are more able to participate in research/development, more efficient in the long run.
How would increasing their market share be an object other than profit maximisation?
Increase chance of survival in the market, by maximising sales.Example, Amazon sold as many kindles as possible, Loss in short-run but gained customer loyalty and are now made way more profit.
How would quality be an object other than profit maximisation?
Improve competitiveness by improving quality. A more efficient good through innovation. And higher quality/better customer service reputation may lead to higher sales or higher price willing to pay.
How would sales maximisation (increasing market share) be an object other than profit maximisation?
Draw and use diagram.
- Aim to sell as much as possible without making a loss. Not for profit but to gain market share to earn more profits in the long run and keep out competitors e.g. Amazon kindle
On the diagram this is where AC = AR
What does profit satisficing mean?
When a firm is earning just enough profits to keep its share holders happy
Why would firms main objective might be satisficing?
Share holders want profits to earn dividends from them. Managers or owners may want personal rewards instead of profits. So Managers may make enough profits to keep share holders happy and still meet their objectives.
What are the characteristics of a perfectly competitive market?
How is market price determined in a perfect competition market?
Interaction of demand and supply.
Why is profit lower in perfectly competitive markets?
Each firm in the competitive market has a very small market share, therefore market power is very small. If firms are making a profit, new firms will enter the market due to lower barriers to entry. Increasing supply and rationing profit away.
Explain profit for perfect competition in short-run and long-run.
In the short run firms can make super normal profits.
In the long run profits are competed away, only normal profits are made.
Draw the diagram for the Short Run Equilibrium for perfectly competitive markets.
Explain this Short Run Equilibrium in a perfectly competitive market.
- Diagram shows the short run equilibrium for a perfectly competitive market
- MC = MR is profit maximising
- The ruiling market price of P1 becomes the AR curve.
- The total cost is shown by the rectangle under C1 and left of Q1
- The firm is the 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
- Its assumed that firms are short run profit maximisers
Draw the diagram for the Long Run Equilibrium for perfectly competitive markets, when supply shifts to the right.
Explain this Long Run Equilibrium in a perfectly competitive market.
When supply shift to the right.
- Diagram shows the long run equilibrium for a 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
What are the advantages of a perfectly competitive market?
Low prices for consumers and high choice.
Firms will be allocatively efficient P=MC
Firms will be productively efficient. Lowest point on AC curve.
Firms have to remain efficient otherwise they will go out of business. (X-efficiency)
What are the disadvantages of a perfectly competitive market?
What are the characteristics of monopoly?
- 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
When does a firm have monopoly power?
When they have over 25% of market share.
Supermarket example of Monopoly?
Sainsbury’s and Asda stopped mergers as they had over 25% market share combined.
What are the examples of barriers to entry which can maintain monopoly power?
- Economies of Scale - Average cost of production low so have to high cost advantage over other firms, new firms not able to compete.
- Limiting Pricing - Existing firms setting price lower than production costs of new firms.
- Sunk Costs - Unrecoverable costs, deterred from entering as if unable to compete.
- Brand Loyalty - difficult for new firms to gain market share.
- Set-Up costs - to expensive to establish a firm.
- Owning a resources - exp BT own cable network.
What factors are monopoly power influenced by?
- Barriers to entry - higher barriers to entry, easier to maintain monopoly power.
- The Number of Competitors - less competitors easier to gain market share.
- Advertising - creates consumer loyalty, higher barrier.
- The degree of product differentiation - more differentiated product the easier to gain market share, more unique fewer competitors.
What is a monopoly?
One firm only in a market.
Examples of monopoly’s.
Google - 90% search engine market.
Tap Water, Thames Water
Bad Monopoly, Microsoft in 1980s – keeping out competition by pre-installing Microsoft software packages.
Examples of perfect competition markets
- Foreign exchange markets - access to many buyers/sellers and good information about prices easy to compare when buying currency.
- Agricultural markets - many buyers, selling identical goods and easy to compare prices.
- Internet Realted industries - made many markets more perfect compettion as easy to compare prices and low barriers to entry e.g. E-bay.
Draw the diagram for Long Run Equilibrium in a perfectly competitive market.
When DEMAND shift to the right.
Explain this Long Run Equilibrium in a perfectly competitive market.
When DEMAMD shift to the right.
- If there’s an increase in demand there will be an increase in price.
- Therefore the demand curve and hence AR will shift upwards causing firms to make supernormal profits
- This will attract new firms into the market causing price to fall back to the equilibrium Pe
What is the monopoly diagram?
Explain this monopoly diagram.
- A monopolistic earns supernormal profits in both the short run and the long run. As they are protected from high barriers to entry to firms can not enter the market and sharing the abnormal profit.
- The shaded rectangle shows the area of supernormal profits.
- MR=MC is where they maximise profit, so producing Q1. But P1 is the maximum price they can charge with still producing at Q1 (not at the price where MR and MC actually intersect. As AR is the demand curve.
Explain how you work out the supernormal profit in this diagram and what the deadweight welfare loss is.
Qm x (AR - AC)
What are the problems/disadvantages purely on efficiency with monopoly?
- Higher prices. Firms with monopoly power can set higher prices (Pm) than in a competitive market (Pc). (Red area is supernormal profit)
- Allocative inefficiency. A monopoly is allocatively inefficient because in monopoly (at Qm) the price is greater than MC. (P > MC). In a competitive market, the price would be lower and more consumers would benefit from buying the good. A monopoly results in dead-weight welfare loss indicated by the blue triangle. (this is net loss of producer and consumer surplus)
- Productive inefficiency A monopoly is productively inefficient because the output does not occur at the lowest point on the AC curve.
- X-Inefficiency. – It is argued that a monopoly has less incentive to cut costs because it doesn’t face competition from other firms.Therefore the AC curve is higher than it should be.
What are the other problems (not efficiency) with Monopoly?
- Supernormal Profit. A monopolist makes Supernormal Profit Qm * (AR – AC ) leading to an unequal distribution of income in society.
- Higher prices to suppliers – A monopoly may use its market power (monopsony power) and pay lower prices to its suppliers. E.g. supermarkets have been criticised for paying low prices to farmers. This is because farmers have little alternative but to supply supermarkets who have dominant buying power.
- Diseconomies of scale – It is possible that if a monopoly gets too big it may experience dis-economies of scale. – higher average costs because it gets too big and difficult to coordinate.
- Lack of incentives. A monopoly faces a lack of competition, and therefore, it may have less incentive to work at product innovation and develop better products.
- Lack of choice. Consumers in a monopoly market face a lack of choice. In some markets – clothing, choice is as important as price
How is economies of scale an advantage of a monopoly, and draw the graph aswell?
- If there are significant economies of scale, a monopoly can benefit from lower average costs. This can lead to lower prices for consumers
- In the graph it gives the example of if there were 3 firms producing 3,000 units at an average cost of £17, average costs would be higher than a monopoly producing 10,000 units, and an average costs of £9. Therefore, for natural monopolies and industries with significant economies of scale, monopolies can be more efficient
Draw the diagram for Monopolistic Competition in the Short Run.
Explain this Monopolistic Competition short run diagram.
In the short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximises profit where MR=MC. This is at output Q1 and price P1, leading to supernormal profit
Draw the diagram Monopolistic Competition in the Long Run.
Explain the Monopolistic Competition in the Long Run diagram.
- In the long run, new firms enter the market as 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 (demand curve) to the left. Consequently, only normal profits can be made in the long run. The long run equilibrium is P1Q1
- Firms can try and stay in the short run by differentiating their products and innovating
Explain the efficiency in a monopolistic competition in this diagram?
- Allocative inefficient. The above diagrams show a price set above marginal cost
- Productive inefficiency. The above diagram shows a firm not producing on the lowest point of AC curve
- Dynamic efficiency. This is possible as firms have profit to invest in research and development.
- X-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide better products.
What is the advantages of Monopolistic Competitive markets?
The supernormal profits produced in the short run might increase dynamic efficiency investment.
Consumers get a wide variety of choice. Low barriers to entry mean that there is intense competition between firms.
In monopolistic competition, prices are kept closer to marginal cost leading to improved allocative efficiency.
What is the disadvantages of Monopolistic Competitive markets?
In the long run, dynamic efficiency might be limited due to the lack of super normal profits.
Firms are not as efficient as those in a monopolistically competitive market, firms have x-inefficiency, since they have little incentive to minimise their costs.
b) calculate the profit-maximising price of haircuts.
Draw the Kinked Demand Curve for Oligopolies.
Explain this Kinked demand curve for Oligopolies.
The kinked demand curve illustrates the feature of price stability in an oligopoly. It
assumes other firms have an asymmetric reaction to a price change by another firm.
It is an illustration of interdependence between firms.
If price increases from P1 to P2, other firms do not react, so the firm which increases their price loses a significant proportion of market share (Q1 to Q2). By holding steady they will gain the other firms will gain that firms market share and sales. Demand curve elastic as small change price has a huge effect on market share as other supermarkets will hold their price.
If the firm decreases their price from P1 to P3, we expect all of the rivals to immediately follow suit with matching the price cut. Therefore demand curve inelastic as increase in price will only have slight increase in quantity demanded for the firm, as all firms demand will increase from a reduction in price.
The first part of the diagram shows a relatively price elastic demand curve. The second part shows a relatively inelastic demand curve.
When firms deviate from the rigid, equilibrium price and quantity, they enter the different demand elasticities.
Assumes firms are profit maximising as MR = MC, and that why they stay at P1 and Q1.
What are the disadvantages of oligopolies?
If firms collude, there is a loss of consumer welfare, since prices are raised and output is reduced.
Collusion could reinforce the monopoly
power of existing firms and makes it hard for new firms to enter. The absence of competition means efficiency falls. This increases the average cost of
production.
Draw a collusive Oligopoly Diagram and explain it?
In the above example, the industry was initially competitive (Qc and Pc). However, if firms collude, they can agree to restrict industry supply to Q2, and increase the price to P2. This enables the industry to become more profitable. At Qc, firms made normal profit. But, if they can stick to their quotas and keep the price at P2, they make supernormal profit.
Where does X-ineffeciency occur?
A firm is x-inefficient when it is producing within the AC boundary. Costs are higher than they would be with competition in the market.
What is the consumer and producer surplus on this diagram?
Explain how monopoly affect the consumer and prouder surplus using this diagram.
Draw an example of price discrimination diagrams.
Explain this diagram, using a club for the example.
Explain this diagram.
To maximise profits a firm sets output and price where MR=MC. If there are two sub markets with different elasticities of demand. The firm will increase profits by setting different prices depending upon the slope of the demand curve.
WIthout price discrimination, there would just be one price set for the whole market (A+B). There would be a price of P3.
However, price discrimination allows the firm to set different prices for segment A (inelastic demand) and segment B (elastic demand)
Because demand is price inelastic, segment (A) will have a higher profit maximising price (P1)
In segment (B) demand is price elastic, so the profit maximising price is lower.
Draw the consumer surplus on this diagram
Shaded area. Allows firms to increase profit by taking consumer surplus away from consumers and covertijng it into abnormal profit.
Explain this oligopoly diagram, with the assumptions made.
In the kinked demand curve model, the firm maximises profits at Q1, P1 where MR=MC. Thus a change in MC, may not change the market price. It suggests prices will be quite stable.
The kinked demand curve makes certain assumptions:
- Firms are profit maximisers.
- If one firm increases the price, other firms won’t follow suit. Therefore, for a price increase, demand is price elastic.
- If one firm cuts price, other firms will follow suit because they don’t want to lose market share. Therefore, for a price cut, demand is price inelastic.
- This is how we get the ‘kinked demand curve
However, the kinked demand curve has limitations:
- It doesn’t explain how the price was arrived at in the first place.
- Firms may engage in price competition.
