Chapter 4-3: Characteristics of Market Structures & Strategies

Question 1

Characteristics of Perfect Competition

Answer 1

Many Small Firms (Sellers) and Many Consumers (Buyers)
Complete Freedom of Entry & Exit
Homogenous Product
Perfect Knowledge

Question 2

PC - Number and Size of firms

Answer 2

Many Small Firms (Sellers) and Many Consumers (Buyers) - Each firm produces insignificantly small portion of total industry supply, will not affect P
- Price taker, horizontal D curve

Question 3

PC - Freedom of E&E

Answer 3

Complete Freedom of Entry & Exit

• Low start-up cost, little need for technological know-how, no legal constraints e.g. stock market
• Existing firms cannot stop new firms from setting up business
• If existing firms supernormal profit, new firms attracted to each industry, removing any supernormal profit enjoyed by existing firms
• Similarly, when firms are making losses, they will leave the industry
• Firms in PC can only earn normal profits in LR

Question 4

PC - Type of Product

Answer 4

Homogenous Product

• Products sold by all firms are identical, perfect substitutes
• Buyers indifferent to product source, no need for advertisements or branding by any one seller
• E.g. Each individual SIA share is identical to one another

Question 5

PC - Knowledge

Answer 5

Perfect Knowledge

• P&C have perfect knowledge of market
• Producers fully aware of prices, costs, production methods, tech, used by other firms and market opportunities
• Consumers fully aware of P, Q, availability of product

Question 6

SR Price and Output Decision of a PC firm

Answer 6

• Price-taker, unable to influence P, has to accept whatever market P is
• Market P set by interaction (intersection) of market D and S curves
• Can sell as much as it wants without affecting market P as its output is negligible to market supply
• Will produce at PM Output where MR=MC where MC is rising
• Can earn supernormal, normal, and subnormal profit
• Subnormal profit, TR cannot cover TVC, will shut down (0 output) in the SR

Question 7

Why PC firm has perfectly price-elastic demand

Answer 7

Raise price - No one will buy from the firm as customers have perfect knowledge and will turn to other firms selling exact same product at lower P. Qd = 0

No incentive to lower price and earn less revenue since it can sell as many as it wants at market P

Question 8

LR Price and Output Decision of a PC firm

Answer 8

PC firm makes supernormal profits - firms outside industry will join this industry so they can also make profits. New firms enter - S will increase, market P driven down till every firm earns only normal profit

PC firm sustaining losses - firms will not only shut down in SR temporarily but exit industry in LR. As firms leave, market S falls and market P starts to rise until all remaining firms earn normal profit.

Long run equilibrium - Normal profit, producing at LR equilibrium which occurs at Qe - lowest point of LRAC curve - operating at optimum plant size

LR - PC firm charges a price and produces output where it can only make normal profit
D cannot cover AC - shut-down and exit industry permanently - winds up all operations - capital resources thus get freed up for use in another venture

Question 9

Price and Non-price strategies of PC

Answer 9

Homogenous products - No product differentiation and no need for advertisements or branding by any one seller
Choice unimportant to consumer - not “brand-conscious”
PC firms will only have to make sure P is the same as the rest in the market and revenue can cover variable costs to stay in business

Question 10

Allocative Efficiency

Answer 10

Allocation of resources to produce combination of G&S most wanted by society
P (AR curve) = MC

Price of a good generally reflects the value customers place on the good. Amount of money customers are willing and able to pay for last unit consumed, reflecting their marginal benefit.
MC - OC of using resources in terms of next best alternative foregone
At AE output, neither over nor under-allocation of production - no misallocation of resources

Last unit produced valued as much as any other good that could have been produced using the same resources
Not possible to improve situation by reallocating resources

Question 11

Productive Efficiency

Answer 11

Production of G&S at lowest possible average COP

Where LRAC is at minimum (MES) - Firm at optimal size where all possible iEOS have been exploited

Beyond MES - Current size too large, experience iDEoS
Before MES - Not all iEoS are exhausted

Question 12

Dynamic Efficiency (Innovation)

Answer 12

Situation where firms are technologically progressive in order to reduce average COP and/or meet changing needs and wants of consumers over time

Achieved via investing in R&D for purpose of product and process innovation
Firm needs both incentive and financial ability (LR supernormal profits) to do so

Better quality products/ More efficient as same number of inputs leads to larger output/ More efficient production methods
But no guarantee of success

Question 13

Equity

Answer 13

Fairness in Distribution in Income/ Wealth/ Opportunities
Normative - Involves value judgement
E.g. can be interpreted as distribution based on effort, contribution, need
Market structure can deeply affect distribution of wealth, income and opportunities

Question 14

Consumer Welfare

Answer 14

Individual benefits derived from consumption of G&S
P consumers pay for goods will affect amount of CS

Deemed desirable that consumers should be given freedom to choose from a variety of G&S and the freedom to purchase similar G&S from different producers

Question 15

PC - AE and PE

Answer 15

Price-taker, PM output is where MR=MC, and MR=AR=P, P=MC, thus AE achieved

At LR Eqm, PC firm will earn normal profit and produce at min point of LRAC, PE is achieved - For any given technology, the firm in LR will produce at least-cost output
PC market - If a firm becomes less cost efficient - make subnormal profit and be driven out of business
More efficient - will earn supernormal profit until other firms copy its more efficient methods - Competition between firms acts as a spur to efficiency

Question 16

PC - DE

Answer 16

Firms only earn normal profits in LR which are just enough to survive / remain in industry, no supernormal profits which could be used to invest in R&D or fund costly innovation
Perfect info - Innovations are quickly replicated by rival firms/ attract new firms - Discourages R&D since innovating firm will not be able to reap the fruits of its innovations - ‘free-ride’ on other firms’ innovation
No financial ability or incentive to be DE

Question 17

PC - Equity

Answer 17

Dividends will be spread out evenly as there is no one making supernormal/ excessive profits
Income earned from ownership of businesses is “fairly” distributed

Free market has its limitations
No guarantee that goods produced will be distributed to members of society in the fairest proportions
Considerable pre-existing inequality of income which PC does not rectify

Question 18

PC - Consumer Welfare

Answer 18

Competition will drive down P to market P - CS maximised
Consumers’ taste change - Resulting P change will lead firms to respond - Consumer sovereignty - Consumers determine what and how much to be produced
Firms have no power to manipulate market or control price - Only thing they can do to increase profits is become more efficient (shadyyy) and that benefits consumers
Consumers also have a choice of many producers

Undifferentiated products - Lack of variety might be seen as disadvantage to consumers
Compared to monopolistic competition / oligopoly - intense competition over quality and design of product and pressure on firms to improve products - No such pressure under PC

Question 19

Characteristics of a Monopoly

Answer 19

Absence of competition
Single supplier of a product or service for which there are no close substitutes
Firm = Industry

Single seller
Unique product
Imperfect knowledge of product
High barriers to Entry and Exit

Question 20

M - Number of sellers

Answer 20

Single seller supplying whole market
Market demand curve is also the firm’s demand curve - monopolist represents the industry

D - downward sloping
Monopolist must lower price if it wishes to sell at greater Q and vice versa
Cannot increase both price and output at the same time

Has ability to affect either price or output - Price-setter
Firm can raise price and consumers either pay or go without the good as they cannot turn to other alternatives
AR and MR must be downward sloping

Question 21

M - Type of product

Answer 21

Unique Product
No close substitutes
No other firm produces similar products or products that vary only slightly from the monopolist’s
PED very low compared to other market structures

Question 22

M - Knowledge of Product

Answer 22

Consumers and potential competitors are not fully aware of cost and production of product. Monopolist is in position to keep info out of reach to consumers and potential competitors

Question 23

M - Barriers to E&E

Answer 23

High Barriers to E&E

New firms may not be able to enter industry freely even when there are supernormal profits due to high barriers to entry - prevent entry of new firms - firm can maintain monopoly position and retain supernormal profits in LR

• High setup cost in activities such as electricity generation - only very large firms able to fund the necessary investment
• R&D costs will represent high proportion of total costs and will require high sales over a long period of time before the activity becomes profitable

If costs cannot be recovered in case of firm shutting down (resources specialised and not easily transferable to other uses) - regarded as sunk costs and act as barrier to exit from the industry

High cost of both E&E deter potential entrants and allow monopolies to earn supernormal profits in LR

Question 24

Barriers to Entry

Answer 24

Obstacles that prevent new firms from entering a market to compete with existing firms
Start-up costs
Makes it difficult for potential entrants to acquire financial resources to enter the market

Question 25

Barriers to Exit

Answer 25

Sunk costs which are costs that cannot be recovered if firm were to eventually leave the market
Makes it more risky for firms to enter the market due to the large losses it could incur if it were to exit later

Question 26

M - Types of Barriers to Entry

Answer 26

Substantial iEoS
Control of Essential Raw Materials or Wholesale/Retail Outlets
Legal Barriers
Brand Loyalty
Other tactics to Eliminate Competition e.g. predatory pricing

Question 27

M - Substantial iEOS

Answer 27

Natural monopoly is likely to emerge if production involves very high start-up costs and tgt with a small market - one firm is able to satisfy the entire market demand

Firm needs to produce at very large SoP to fully exploit iEoS and stay profitable
LRAC continues to fall as output expands over wide range
Any more than 1 firm in the market would mean losses for both as if each has only half the industry demand, there is no price that would allow them to cover costs at every point AR

Question 28

M - Control of Essential Raw Materials or Wholesale/Retail Outlets

Answer 28

Firm controls the supply of key inputs necessary for production of a product, the firm will be able to prevent other firms from entering the industry
Similarly, if a firm controls the outlets through which a product must be sold, it can prevent potential rivals from gaining access to consumers

Question 29

M - Legal Barriers

Answer 29

Firm’s monopoly position may be protected by law through intellectual property (IP) rights

Patent - Exclusive right to produce or sell an innovative product or process. Granted to encourage technological innovation and reward creative efforts

Copyrights - Part of IP rights that are conferred on the works of writers, software programmers and music consumers. Royalties need to be paid in gaining these copyrights.

Licence - Right to operate or produce certain G&S that are granted by the government

Question 30

M - Brand Loyalty

Answer 30

Strong brand name is a barrier as a new entrant will have difficulties breaking into the market as it is extremely hard to compete against a well-established brand
Brand name is often established by means of product differentiation, aggressive advertising and attractive after-sales service E.g. Apple

Question 31

M - Other tactics to eliminate competition

Answer 31

Monopolist can put in a takeover bid for any new entrant
Mere threat of takeovers may discourage new entrants

Intimidation in the form of harassment, legal or illegal, and aggressive tactics like predatory pricing (selling below MC to drive out competitors) can also be effective barriers

Question 32

Price and Output decision of M

Answer 32

Short-run

• Profit-maximising M also produces at an output level where MR=MC. Can earn SupN, N, or SubN profits
• Will shut-down (0 output) in SR if its AR is unable to cover its AVC

Long-run

• M can retain its supernormal profit in the long run as competitors are prevented from entering industry
• LR - M will remain in business only if can at least make normal profits or break-even
• LR equilibrium is output level where LRMC = MR and TR is at least equal to TC
• Would charge a price and produce output where it can retain its supernormal profit.
• If DD cannot cover its AC, it will shut-down and exit the industry permanently
• When a firm exits, it basically winds up all operations. Capital resources thus get freed up for use in another venture.