7.6 Different market structures

Question 1

What are the 3 types of maximisation?

Answer 1

Profit maximisation MC = MR
Revenue maximisation MR = 0
Sales maximisation AR = AC

Question 2

What does profit maximising equilibrium look like in the short run and the long run? Look at graph

Answer 2

In the short run, firms profit maximise at MC=MR. P1C1AB represents the supernormal profits that firms in a monopolistically competitive market earn in the short run.

Due to no barriers to entry and exit and perfect info of market conditions
In the long run, SNP can’t be made as new firms enter the market as they are attracted by the profits existing firms are already making. Supply shifts right so price falls which keeps happening until there is no more incentive to enter the market which means there is no SNP profit left and leaves us with normal profits Consequently, only normal profits can be made in the long run. P1Q1

1) Draw AR and MR lines
2) Draw MC
3) Profit max point at MC = MR
4) AC curve will now touch the P1Q1 point and cut MR at AC lowest point

Question 3

Why do we always assume the objective of a firm is Profit maximisation?

What are reasons some firms choose not to profit maximise?

Look at graph

Answer 3

This is as it allows for reinvestment in R&D
It provides dividends for shareholders which keeps owners happy
It will give a lower cost and prices for consumers
It rewards the risk taken by entrepreneurship

Some firms don’t know their MC or MR
You can avoid scrutiny (might be doing something dodgy)
Key stakeholders are harmed
Other objectives could be more important

Question 4

Why are profits likely to be smaller in a competitive market?

Answer 4

This is because each firm will only have a small market share. Thus, their market power is very small. If the firms make a profit, new firms will enter the market due to low barriers of entry. The new firms will increase the supply in the market, which lowers the average price.
This means that the existing firms profits will be competed away

Question 5

What is the long run in normal competition defined as?

Answer 5

It is when normal profit is being made. Any profit outside of it is short run equilibrium competition

Question 6

What is perfect competition? Efficiency analysis of perfect comp?

Answer 6

Many buyers and sellers (infinite)
Homogenous good —–> Sellers are price-takers. If they try raise it above market price they will lose all their demand
No barriers to entry and exit to the market
Perfect knowledge of the market. Prices and quality etc.
Firms are short-run profit maximisers MC = MR

AE - P = MC at Q2 which means it is allocatively efficient. This means resources perfectly following consumer demand.
PE - Firm is producing at their lowest point on the AC curve. This means full exploitation of any economies of scale
X efficiency - if they are PE they must be X efficient which minimises their costs.
ALL 3 STATIC EFFICIENCIES. if firms deviate from these efficiencies they won’t be able to survive in these markets
In the LR there is no SNP so they can’t be dynamically efficient

Question 7

What is profit maximisation in the short run and long run? in a perfectly competitive market

Answer 7

In the short run, firms can make supernormal profits. In the long run where profits are competed away, only normal profits can be made.

The diagram for short-run equilibrium:
For short-run equilibrium in a perfectly competitive market, the firm is a price taker and it accepts the industry price of P1 Q1 or the straight line D = MR = AR. The shaded rectangle P1 C1 shows the area of supernormal profits earned in the short run. AC has to be below AR

The diagram for long-run equilibrium:
For long-run equilibrium in a perfectly competitive market, the supernormal profits are being made by existing firms which gives new firms an incentive to enter the market. Since there are no barriers to entry, new firms can enter the industry.
This causes supply in the market to increase, as shown by the shift in the supply from S to S1. The price level falls as a consequence. Since firms are price takers, they must accept this new lower price. The new equilibrium at P = MC means firms produce at the new output of Q2 in the long run. There will only be normal profits as AC=MR

Question 8

Why will subnormal profit last in the long run in a perfectly competitive market?

Answer 8

This is as firms will be incentivised to leave the market and to produce their opp cost. Why continue if making a loss?
They can leave because of no barriers to exit. Costless t leave market.
Supply shifts left and price is driven up in the market and it will continue until there is normal profit

Question 9

What are the Pros and Cons of a competitive market?

Answer 9

Pros: use same graph as the monopoly comparison with competitive markets but in reverse
1) Allocative efficiency - Firms charge P=MC. This means lower prices for consumers, higher CS higher choice higher quality and quantity. What used o be a DWL of CS is now a gain.
2) Productively efficient - minimise costs and exploit all EoS by being on the lowest point of the AC curve. Pass on lower costs to consumers
3) X efficient - minimise waste and produce on the AC curve
4) Jobs can be created more in competitive markets which links to quality of life and standard of living due to derived demand

Cons:
1) There is no dynamic efficiency due to a lack of SNP in the long run. Thus you don’t see reinvestment in technology, innovation development etc etc
2) Lack of EoS as lots of small firms so you can’t build market share (even if they’re productively efficient, still have lower economies of scale than monopolies due to the sheer size of them - look at the graph)
3) Cost cutting in dangerous areas - wages, environment, health and safety
4) Creative destruction - new firms beat existing firms with lower costs of production or brand-new products. Even if there is unemployment caused, those workers could at least transfer to the new frm that has come in though.

Question 10

What are the evaluation points for Competitive markets?

Answer 10

1) There still might be some dynamic efficiency if they gained just enough SNP in the short run to reinvest.
2) Level of EoS
3) Natural monopoly - don’t want to see competition. Regulated monopoly makes more sense
4) Where is cost-cutting taking place?
5) Role for regulation? Make sure society is protected and to stop firms from taking short cuts in their production
6) Static vs dynamic efficiency - which one is preferred for your market (depends on the type of good or service made)
If it’s a necessity market you don’t want to see concentration or a monopoly there at all. You would rather have the static efficiency benefits of lower price higher CS etc. However in other markets people may be ready to pay higher prices for more innovative products etc.

Question 11

What are the characteristics of a monopoly? And monopoly analysis in relation to efficiency

Answer 11

This is when there is one seller domination the market - pure or monopoly power. Theoretical extreme is one person owns everything or monopoly power is the common one which is when one firm on their own has more than 25% of the market

Profit maximisers - earn supernormal profits in the short run and long run. When MR = MC
High barriers to entry and exit allow SNP to persist over time
Differentiated products which allows them to be a price maker
Imperfect information - keeps firms from entering

AE occurs when P = MC. Not allocatively efficient as they are charging a P> MC. Consumers are getting exploited with higher prices and low consumer surplus. They are also restricting output as quantity should be higher if we see where AE should actually be. Risk quality could also be low due to a lack of other competitots
It is not productively efficiency either. This is as they don’t produce at the lowest point of their lowest cost curve. If monopoly gets too large there will be diseconomies of scale
X inefficient - monopolies become complacent with a lack of competitive drive. Also it is very difficult to reduce waste and cut costs so if it is not necessary, they wont do so.

MONOPOLIES ARE STATICALLY INEFFICIENT

however there is potential for dynamic efficiency. This is as they make SNP in the LR due to high barriers to entry and imperfect info etc. They can reinvest which is in the long run interest of consumers and the business

Question 12

What are the pros and cons of a monopoly?

Answer 12

Pros:
1) Dynamic efficiency - Monopolies can earn significant supernormal profits, so they might invest more in research and development. This gives consumers better products over time. There could be more invention and innovation as a result. Moreover, firms are more likely to innovate if they can protect their ideas through patents and keep earning these profits over time. This is more likely to happen in a market where there are high barriers to entry, such as a monopoly
2) Greater economies of scale purely because of the size. Look at diagram. Can charge lower prices and get a higher quantity than a competitive firm that is trying to be allocatively efficient. Therefore you can argue EOS potential is very large in certain markets like car manufacturing company that even firms being productively efficient could have less gains than them
3) Natural monopoly - regulated natural monopoly gives society desirable outcomes as opposed to where there is competition.
3) Monopolies can cross-subsidise
4) Monopolies could generate a lot of exports for an economy and also generate higher tax revenue for gov

Cons:
1) Allocative inefficiency - They aren’t allocatively efficient as P does not equal MC. Higher prices exploit the consumer reduce consumer surplus and increase producer surplus. Consumers don’t get as much choice. This can be a form of market failure. There can also be quality issues as well. They pass on economies of scale
2) Productively inefficient - They don’t minimise their cost by being on the lowest part of the AC. This means the price is higher as a result, so consumers lose in that way too.
3) X inefficiency - Don’t have the incentive to minimise their results which allows for complacency and higher prices
4) Inequalities in necessity markets - due to higher prices, the poor can suffer the most. You don’t want to see inequality in necessity markets as it can lead to income inequalities.

Question 13

What are the evaluation points of a monopoly?

Answer 13

1) You can critique if dynamic efficiency will even occur, instead you could pay off debts or reward shareholders.
2) EoS or DoS? Depends on size of the firm
3) The objective of the monopoly may not be profit maximisation - could be sales or CSR etc
4) Regulation - can help reduce some inefficiencies
5) Price discrimination can occur
6) Competition? There are rarely pure monopolies so the competition can help keep monopolies honest and reduce major inefficiencies
7) Type of good or service - Necessity or luxury? If luxury we don’t mind price as long as we get constant reinvestment to better the good
8) Natural monopoly

Question 14

What is monopoly power influenced by?

Answer 14

Barriers to entry and exit

Number of competitors - The fewer the number of firms, the higher the barriers to entry, and the harder it is to gain a large market share

Advertising - It can increase consumer loyalty, making demand price inelastic, and creating barriers 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 15

What are examples of barriers of entry?

LTSB - Lloyds TSB

Answer 15

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

Legal barriers such as patents, licenses/permits, red tape and standards and regulations -
Patents mean you have sole ownership over something you’ve created so no other firm can copy you.
Licences and permits are very expensive and difficult to obtain.
Red tape which is excessive paperwork which makes it hard to enter.
Excessive standards and regulations very expensive to reach those standards.
Regulations like pollution or hiring and firing laws.

Technical barriers such as sunk costs, start-up costs, Economies of scale and natural monopolies
Sunk costs are costs that can’t be recovered when a firm leaves the market. Examples of these are advertising and specialist machinery
EOS which means companies already have this which means low average costs which can scare of new firms who can’t get the same EOS straight away
Natural monopoly - makes sense for only 1 firm to run the market

Strategic barriers such as predatory pricing, limit pricing and heavy advertising
Predatory pricing is when you price lower to drive out competition. This could even make a loss for a firm but they do it to drive out competitors
Limit pricing where they price at normal profits or break even to limit competitions to the market which takes away the incentive to enter.
Heavy advertising too

Brand loyalty - If consumers are very loyal to a brand, which can be increased through advertising, it is difficult for new firms to gain market share

Owning a resource: Early entrants to a market can establish their monopoly power by gaining control of a resource

Question 16

What are examples of barriers to exit?

Answer 16

Under valuation of assets - you are getting a much lower price than when u bought the assets
Redundancy costs - laying off workers you might have to pay a lot
Penalties for leaving contracts early - with suppliers, rents, gas electrics this could lead to high penalties
Sunk costs - can’t recover

Question 17

What is a natural monopoly?

Answer 17

This is an industry which is most efficient when only one firm produces the good or service rather than several. For example, it is inefficient to have multiple sets of water pipes or electricity cables

Question 18

What are the characteristics of Natural monopolies?

Answer 18

Huge fixed costs (start up costs)
Enormous potential for economies of scale. Look at the diagram, MES where all EOS are fully exploited occur at a very very high quantity level
Rational for only 1 firm to supply the market - competition is undesirable
Competition would result in a wasteful duplication of resources as the 1st firm in the market has the Economies of scale advantage. The other firms won’t have the same EoS as the first firm so they will be priced out of the market. There would be a wastage of resources and allocative and productive inefficiency

Question 19

What does the graph look like for natural monopolies and what is the reasoning?

Answer 19

Looks like the bottom left of a circle
LRMC LRAC curves and the MR and AR lines
They are downward-sloping cost curves due to huge EoS.

As they are monopolies they want to profit maximise at MR=MC, however that point on the graph is deemed not good enough by regulators as they are charging very high prices for basic needs and essentials. Thus, the regulation point is where P= MC, the allocatively efficient point. However, it leaves no reason for firms to stay in the market as AC > AR which means sub-normal profit is being made. So, often subsidies are given by the regulators to make sure the loss is covered. ab = subsidy. This allows them to make normal profit

Question 20

What are the characteristics of a monopolistically competitive market?

Answer 20

Clothing markets
Taxis
Fast food

Many buyers and sellers - relatively small and act independently
Slightly differentiated goods —> firms are price makers and have price elastic demand. However there are loads of substitutes so firms can’t raise prices too significantly
Low barriers to entry and exit
Good info about market conditions
Non-price competition –> Branding, advertising, quality, service. Firms can’t raise price because of the amount of competition.
Firms are profit maximisers MC = MR

Question 21

What are the Pros and Cons of Monopolistic competition? Analysis relating to efficiency?

Answer 21

Pros:
1) Consumers get a wide variety of choice
2) The model of monopolistic competition is more realistic than perfect competition

Cons:
P does not equal MC. P>MC so it is not allocatively efficient in the LR in monopolistic competition. This means in theory consumers are exploited, output and choice is restricted.
Not productively efficient as it doesn’t produce on the lowest point of the AC - a reason for higher prices
Not dynamically efficient as No long-run SNP to reinvest back into the economy
Have X inefficiency as they have little incentive to minimise their costs as they produce differentiated products

Question 22

What are the Evaluation point of a monopolistically competitive market?

Answer 22

Allocative efficiency?
Price making effect isn’t as bad as pure monopolies as there is a good amount of competition in this market. So the loss of Consumer surplus is nowhere near as bad as a monopoly. The loss of CS is nowhere near as bad
In perfect competition, there are homogenous goods, that is not what consumers desire, thus differentiation in monopolistic comp is good. Consumers will be willing to erode a little bit of CS in order to get differentiated goods. Exploitation isn’t that bad as there are lots of substitutes available. So Allocative inefficiency isn’t that bad for monopolistic markets

Productive efficiency?
The productive inefficiency compared to monopolies are nowhere near as bad as there are good substitutes so firms can’t afford to forgo EOS and charge higher prices
In perfect competition, not much EoS but in monopolistic competition there is which means the price can be lower than in perfect comp. Our desire for variety can make it hard to exploit EoS for perfect comps

Dynamic efficiency?
If short-run SNP are enough to reinvest, then dynamic efficiency could occur
In a very competitive market, dynamic efficiency is still present, even if just normal profits are being reinvested. This is because sometimes it is a requirement in a market - clothing or phones to get ahead of rivals

Question 23

What is the calculation of concentration ratios?

Answer 23

It is the combined market share of the top few firms in a market.

The higher the ratio, the less competitive the market, since fewer firms are supplying the bulk of the market

Question 24

What are the characteristics of an oligopoly?

Answer 24

1) Few firms dominate the market - a high conc ratio of roughly 70% for no more than 7 firms.
2) Product differentiation - firms differentiate their products from other firms using branding. The degree of differentiation can change how far the market is an oligopoly
3) High barriers to entry and exit - start-up costs, sunk costs, EOS brand loyalty etc
4) Non price competition - Branding, advertising, quality of product/service etc
5) Interdependence of firms (defining feature) - Firms make decisions based on the actions and reactions of rival firms ( this leads to a lot of price rigidity)
6) Non price comp
7) Prof max not the sole objective

Examples of Oligopoly are:
Soft drink industry
Car industry
OPEC
UK supermarket, energy, airlines and bus industries

Question 25

What are competitive and collusive oligopolies? Factors? And evaluation?

Answer 25

Factors promoting a competitive oligopoly:
1) Can compete on price or non-price competition
2) Large number of firms (less conc) which means organising collusion is hard
3) Is new market entry possible? if it is collusion isn’t attractive as it encourages new firms to come and compete away the SNP.
4) One firm with a significant cost advantage - makes very difficult to fix a price in collusion and unattractive
5) Homogenous goods - don’t have price-making power to fix prices
6) Saturated market - a lot of price wars and competition, the only way to get ahead is to snatch market share

Factors promoting collusive oligopoly:
1) A small number of firms - much easier to collude
2) Similar costs - easy to collude and fix prices and quantities
3) High entry barriers - SNP can be kept
4) Ineffective competition policy means you’re more likely to get away with it
5) Consumer loyalty and inertia - cheating is less likely to take place if there is consumer loyalty to your rivals. Also, some consumers may just not want to switch.

If you have come to the consensus that the oligopoly is competitive, then you evaluate it as if you are evaluating a competitive market. STATIC efficiency gains and dynamic efficiency and EOS is lost.
If you agree it’s a collusive oligopoly, you go down the monopoly route. Shows all static inefficiencies however such big EOS scale gains and dynamic efficiency gains

Question 26

What are the advantages of an oligopoly?

Answer 26

They can earn significant supernormal profits, so they might invest more in R&D. This can yield + externalities, and make the monopoly more dynamically efficient in the long run. There could be more invention and innovation as a result. Firms are more likely to innovate if they can protect their ideas. More likely to happen in a market with high barriers to entry.

Higher profits could be a source of government revenue

Industry standards could improve. This is as firms can collaborate on technology and improve it. It saves on duplicate research and development

Since oligopolies are large, they can exploit economies of scale, so they have lower average costs of production which can be passed onto consumers

Question 27

What are the disadvantages of an oligopoly?

Answer 27

The basic model of oligopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market

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

Question 28

What is the kinked demand curve?

Answer 28

The first part of the diagram shows a relatively price elastic demand curve. The second part shows a relatively inelastic demand curve

Firms don’t want to change price. Price is settled at P1 and around there there is differing elasticities of demand.

A raise in price means Q decreases proportionally more. This is because of interdependence, other firms won’t follow the price rise (looking to gain market share), so by keeping the price the same they will gain market share. Firms that raise their price will suffer as quantity falls significantly as a result which means their market share and revenue will decrease.

A fall in price means Q increases proportionally less than price. This is as the firm now moves to the inelastic part of the demand curve. This is due to other firms and how they will react. Other firms will decide to follow and protect their market share. Then you eventually get into a price war. Total revenue will decrease and over time there will be no change in the market share

Question 29

What conclusions can you make from the kinked demand curve model?

Answer 29

There could still be price competition as firms may still try to reduce prices to gain market share even if it doesn’t make sense.

There is a lot of non price competition in oligopolies

There is a huge temptation to collude - This is because interdependence is very annoying as firms are always worried about their rivals

Question 30

What is game theory?

Answer 30

It is related to the concept of interdependence between firms in an oligopoly. It is used to predict the outcome of a decision made by one firm when it has incomplete info about the other firm. It can be explained using the prisoners dilemma.

2 prisoners aren’t allowed to communicate but they can consider what the other prisoner is likely to choose. This relates to the characteristic of uncertainty in an oligopoly. The dominant strategy is the option that is best, regardless of what the other person chooses.

A Nash equilibrium is a concept in game theory that describes the optimal strategy for all players, whilst taking into account what opponents have chosen. Something that can last in the long run. They are when both firms are selling the low price.

There is price rigidity at 90p so if they need to compete it will be on non price factors
Nash equilibrium isn’t the best choice though as charging 1 pound they can both earn higher amounts. However there is a danger you get undercut. This shows there is temptation to collude and work together and both firms can be making lovely juicy SNP.
However there is also incentive to cheat on a collusive agreement if you can benefit off it, thus collusion may not last in the long run

Question 31

What is collusion/collusive behaviour?

Answer 31

This occurs if firms agree to work together on something. For example, they might decide to set a price which minimises the competitive pressure they face.

Question 32

What does collusion lead to?

Answer 32

Collusion leads to lower consumer surplus, higher prices and greater profits for the firms colluding. It can allow oligopolists to act like monopolists and maximise their joint profits.

Question 33

Why do firms in an oligopoly collude?

Answer 33

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.

Question 34

When does collusive and non collusive behaviour occur?

Answer 34

Collusion is more likely to happen where there are only a few firms, they face similar costs, and there are high barriers to entry.

Non collusive behaviour is likely to occur when the firms are competing. This establishes a competitive oligopoly. This is more likely to occur when there are several firms, one firm has a significant cost advantage, products are homogenous and the market is saturated. Firms grow by taking market share from rivals

Question 35

What is overt and tacit collusion and price leadership?

Answer 35

This is when a formal agreement is made between firms. It works best when there are only a few dominant firms so one does not refuse. It is illegal in the EU, US and several other countries

Tacit collusion is where informal agreements not to engage in price wars.

Price leadership is where the smaller firms follow the dominating firm

Question 36

What is the difference between cooperation and collusion?

Answer 36

Cooperation is allowed in the market, whilst collusion is not. Collusion is usually with poor intentions, whilst cooperation is beneficial

Collusion generally refers to market variables, such as quantity produced, price per unit and marketing expenditure. Cooperation might refer to how a firm is organised and how production is managed

Question 37

What are the characteristics of a contestable market?

Answer 37

A contestable market is where there is a threat of competition

1) Low barriers to entry or exit
2) Large pool of potential entrants
3) Good information on market conditions - new firms must know about costs and technologies
4) Firms already in the market are subject to hit and run competition (snatch SNP)
6) There is low consumer loyalty

Question 38

How has contestability risen due to better tech?

Answer 38

1)Massively reduced barriers to entry and exit as businesses don’t have to be physical anymore (less start-up and sunk costs). Don’t need to hire as many workers and regulations will be less. EoS is easier and advertising is easier so you can overcome that consumer loyalty easier
2) Increased pool of potential entrants through innovation to disrupt markets. New firms with a new product to come and disrupt markets. Also allows for cheaper ways to be producing things. New firms might have lower cost of production methods
3) increased info - can find out information easier so there’s better competition

Question 39

Are monopolies contestable?

Answer 39

Yes. If barriers of entry and exit are just low enough then it can be a contestable market

They will have to move from earning SNP at MC = MR to the normal profit point of AC = AR. The break-even point. This is called limit pricing. By lowering the profit margins, they are eliminating threats and taking away incentive for firms to enter because as long as monopolies are making SNP there is an incentive to enter. Once it is eliminated, you can go back to making SNP

This will keep them prepared if the threat becomes real

AC=AR is an extreme position (limit price). As long as theres movement towards it in the form of lower prices and higher quantities

Question 40

Pros and cons of contestable markets with evaluation?

Answer 40

Pros:
Static efficiency benefits. Even tho there isnt actual competition we still get the benefits as if there were. There is a movement towards these efficiencies
AE - lower prices higher CS, higher quality quantity and choice
PE - greater exploitation of EOS and lower costs and prices for consumers
X inefficiency - minimise waste so lower costs for consumers
Firms do all this in order to stay ahead of competitors if they were to enter
Higher quantity in the market will mean jobs created

Cons:
Lack of Dynamic efficiency as profits decrease - however if new firms come in with innovative ideas then that in itself is dynamic efficiency
Cost cutting in dangerous areas, wages environmental safety etc
Creative destruction - existing firms destroyed which means job losses
If overall market is greater and new firms are larger in size then those workers who lost jobs can move to newer firms
In short run might be a contestable market but if firms use anti competitive strategies then this threat of contestability won’t last in the long term

EVAL:
Length of contestability - if firms patent and use anti competitive strategies it can’t be contestable over time
Regulation - can minimise effect of cost cutting and anti competitive strategies
Dynamic efficiency

Question 41

What are sunk costs and the degree of contestability?

Answer 41

There are different degrees of contestability across the market. It depends on what kind of costs firms face, and how loyal consumers are. No markets are perfectly contestable.

It is hard to judge the degree, since in reality there will be some costs to entry and exit

Sunk costs are a barrier to contestability as they are costs that can’t be recovered. High sunk costs are likely to push a market towards a price and output similar to a monopoly

Question 42

What is non-price competition?

Answer 42

This aims to increase loyalty to a brand, which makes demand for a good more price inelastic.
Improve the quality of their customer service.
Special offers like buy one get one free or loyalty cards or
Advertising and marketing.
However, for some firms, it might be ineffective as they would have large sunk costs that are unrecoverable