Market structures

Question 1

Allocative efficiency

Answer 1

● Allocative efficiency: This is achieved when resources are used to produce goods and services which consumers want and value most highly and social welfare is maximised. It will occur when the value to society from consumption is equal to the marginal cost of production, where​ P=MC​.

Question 2

Dynamic efficiency

Answer 2

● Dynamic efficiency: ​This is achieved when resources are allocated efficiently over time. It is concerned with investment, which brings new products and new production techniques. The alternative is static efficiency: efficiency at a set point in time. Allocative and productive efficiency are examples of static efficiency. Dynamic efficiency will be achieved in markets where competition encourages innovation but where there are differences in products and copyright/patent laws. Supernormal profit is required to provide firms with the incentive to invest and the ability to do so.

Question 3

X-inneficiency

Answer 3

● X-inefficiency: ​If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is organisational slack. This is a specific type of productive inefficiency as it occurs when they fail to minimise their cost for that specific output. For example, the minimum point on the AC curve may be at 100 goods at a cost of £5 each. The firm is producing 125 goods and so is not productively efficient. It costs them £8 to produce each good, but they could produce 125 goods at £7. Therefore, they are X-inefficient since they are not producing on the lowest AC curve. It often occurs where there is a lack of competition so firms have little incentive to cut costs.

Question 4

Perfect competition

Answer 4

Perfect competition is a market where there is a high degree of competition, but the word ‘perfect’ does not mean it maximises welfare or produces ideal results. There are few industries which fit this type of market structure, one example may be ​agriculture but government interferences may prevent it from being so. In reality, the assumptions made rarely hold and no market is completely perfectly competitive.

Question 5

Characteristics of perfect competition:

Answer 5

For a market to be perfectly competitive, there must be four key characteristics. These mean that demand for the firm’s goods is perfectly elastic, and prices are solely determined by interaction of demand and supply; the firms are ​price takers​.
● There must be ​many buyers and sellers. ​This means that no one firm or customer will be able to influence the market. For example, the decision of one firm to double their output or the decision of one buyer to double their consumption will have no effect. If the firm did manage to have an effect, this would mean the market was no longer perfectly competitive as there would be one large firm and other smaller firms, or one large buyer and other smaller buyers.
● There must be ​freedom of entry and exit from the industry​. This is important as it means that when a business is making profits anyone can enter that market and start producing that product for themselves. As a result, business are unable to make huge profits in the long run and if they are making losses they are able to leave. In the long run, they make normal profits.
● There must be ​perfect knowledge​. This enables firms to know when other firms are making profits which will attract them to join the market. Moreover, all firms have the same costs as they can use the same production techniques. It also means that any attempt to raise prices above the level determined by the market will lead to no sales, as customers will be aware they can buy the same good for a lower price and firms know there is no point lowering the price as they will sell all their goods at the higher price determined by the market.
● The product must be ​homogenous​, where they are identical so it is impossible to tell the difference between one make and another e.g. semi-skimmed milk. This is important because it means if a firm raises it price above the competitors’ no one will buy it and they will not gain from lowering their price because they can sell all of your product at the same price as everyone else.

Question 6

Profit maximising equilibrium for perfect competition

Answer 6

Firms are assumed to short run profit maximise and so the firm will produce at MC=MR. In the short run, it is possible for the firm to make a normal profit, a supernormal profit or a loss. However, firms in perfect competition can only make ​normal profit in the long run​. This can be seen on the diagram.
In the short run, firms are making the supernormal profit of the shaded area. Prices are set by the market at P1, where S1=D1. As a result, the firm faces the demand curve of AR1=MR1 and produce where MC=MR1 at Q1 goods. However, since there is perfect information and ease of entry, the fact they are making supernormal profits will encourage new entrants to the market. This will increase supply from S1 to S2 and lead to a fall in price from P1 to P2. The firm now has the demand curve AR2=MR2 and produces where MC=MR2 at Q2. This is also where AR2=AC and so they are making normal profits. If the firm was making a loss, firms would leave the industry and this would decrease supply, pushing prices up and reverting to the long run equilibrium.

Question 7

Efficiency for perfect competition

Answer 7

● Perfect competition is ​productively efficient​, since they produce where MC=AC. They are also ​allocative efficient since they produce where P=MC. Thus, they are static efficient​.
● However, they are ​not dynamic efficient​. No single firm will have enough for research and development and small firms struggle to receive finance. The existence of perfect information also means one firms’ invention will be adopted by another firm and so the investment will give the firm no competitive benefit. Governments tend to have to do all the research.
● Competition should keep costs, and therefore prices, low. However, firms will be unable to benefit from economies of scale and this may mean costs are higher than they otherwise could be.

Question 8

Monopolistic competition

Answer 8

Monopolistic competition is a form of imperfect competition, with a downward sloping demand curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely exist in a pure form in real life. Some examples of firms in monopolistic competition are ​hairdressers, estate agents and restaurants.

Question 9

characteristics of monopolistic competition

Answer 9

● There must be a ​large number of buyers and sellers in the market, each of whom are relatively small and act independently. This means that no one buyer or seller has a large price setting power.
● There are ​no barriers to entry or exit​, allowing new firms to enter when supernormal profits are being made and some to leave in the case of losses. As a result, only normal profits can be made in the long run.
● The difference between monopolistic competition and perfect competition is that in monopolistic competition firms produce ​differentiated, non-homogenous goods or services. This means that individual firms do have some price setting power, and so the curve is downward sloping.

Question 10

Profit maximising equilibrium monopolistic competition

Answer 10

In the short run, firms can make supernormal profits, losses or normal profits. However, due to the lack of barriers to entry/exit, firms can only make normal profits in the long run. This is shown by the diagram.Firms are assumed to be short run profit maximisers, producing at MC=MR1 in the short run. As a result, they produce Q1 at price P1 and make a supernormal profit of the shaded area. However, in the long run, new firms will enter the industry as they know that supernormal profits are being earnt. This will cause demand for the individual firm to decrease and therefore the AR and MR curves will shift to the lift. The firm will produce where MC=MR2 at P2Q2. At this point, AC=AR2 and so the firm is making normal profits. If the firm was making a loss, firms would leave the industry and thus demand for the individual firm would increase as they had less competition. This would lead to normal profits in the long run.

The limitation of this model is that information may be imperfect and so firms will not enter the market as predicted as they are unaware of the existence of abnormal profits. Also, firms are likely to be different in their size and cost structure as well as in their products, which may allow some firms to maintain supernormal profits because firms cannot compete on equal terms.

Question 11

Efficiency monopolistic competition

Answer 11

● Since they can only make normal profit in the long run, AC=AR and since they profit maximise, MR=MC. Therefore, the firm will ​not be allocatively or productively efficient, ​as MR does not equal AR so AC cannot equal MC and AC cannot equal MR.
● They are likely to be ​dynamically efficient since there are differentiated products and so know that innovative products will give them an edge over their competitors and enable them to make supernormal profits in the short run. However, since the firms are small they may struggle to receive finance or have the retained profits necessary to invest.
● In monopolistic competition compared to perfect competition, ​less is sold at a higher price and firms may not necessarily be producing at the lowest cost. However, the market will offer ​greater variety and may be able to enjoy some degree of ​economies of scale​.

Question 12

Characteristics of oligopoly

Answer 12

Oligopoly is where there are a few firms that dominate the market and have the majority of market share, although this does not mean there won’t be other firms in the market. There are four key characteristics of oligopoly: products are generally differentiated; supply in the industry must be concentrated in the hands of a relatively small number of firms, meaning there is a high concentration ratio​; firms must be ​interdependent ​(so the actions of one firm will directly affect another); and there are ​barriers to entry.

Question 13

Kinked demand theory

Answer 13

In oligopoly, there is a kinked demand curve. If a firm raises its price, other firms will not follow since they know their comparatively lower price means they are more competitive. On the other hand, if a firm lowers its price, other firms will follow since they want to remain competitive.
Therefore, we assume price starts at P1: above P1 the curve is elastic (since competitors are offering lower prices) and below P1 the curve is inelastic (since other firms lower their prices too so there is a little difference in sales for the original firm). The result is a kink in demand. This kink in demand means that there is a gap in the MR curve and so a rise or fall in costs or demand is likely to have no impact on price or output. Because of this, prices in oligopolistic markets tend to be stable. The problem with the kinked demand curve theory is that it assumes that there is an initial price set within the market and does not explain why this price was set.
However, it does explain why prices tend to be stable

Question 14

N-Firm concentration ratios

Answer 14

● The concentration of supply in the industry can be indicated by the concentration ratio which measures the ​percentage of the total market that a particular number of firms have​. The 3 firm concentration ratio shows the percentage of the total market held by the three biggest firms, whilst the 4 firm ratio shows the percentage by the four biggest firms and so on.
● It is worked out by adding the percentages of market share for the firms or using the formula:
​total sales of n firms​ /total size of market x100

The method used will depend on the information in the question.

Question 15

Oligopoly collusive and non-collusive behaviour

Answer 15

Collusion is when firms make ​collective agreements that reduce competition​. When firms don’t collude, this is a competitive oligopoly. ​The UK energy market is an oligopoly that is suspected of collusion.
● If firms compete, they know lowering prices to gain new customers is likely to cause other firms to lower their prices;. However, if they work together, they could maximise industry profits​.
● Collusion ​reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising, which will reduce industry profits.
● Despite this, firms may decide to be a non-collusive oligopoly since collusion is illegal ​and due to the ​risks of collusion​, such as other firms breaking the cartel or prices being set where they don’t want it.
● A firm with a ​strong business model and something that ​sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors.
● Collusion between firms works best when: there are a few firms which are all well known to each other; the firms are not secretive about costs and production methods and the costs and production methods are similar; they produce similar products; there is a dominant firm which the others are happy to follow; the market is relatively stable; and there are high barriers to entry.

Question 16

collusive oligopoly

Answer 16

● When firms engage in collusion, they may agree on prices, market share or advertising expenditure. There are two main types of collusion: ​overt and tacit collusion​. Overt collusion is when firms come to a formal agreement whilst tacit collusion means there is no formal agreement.
● A formal collusive agreement is called a cartel, ​which is a group of firms who enter into agreement to mutually set prices. The rules will be laid out in a ​formal document which may be legally enforced and fines will be charged for firms who break these rules.
● There are two ways a cartel could operate: ​agree on a price for the goods and then compete freely using non-price competition to maximise their market share; or ​agree to divide up the market ​according to the present market share of each business.
● The problem with any cartel is that no firm is likely to set their prices/output at the level they would not ideally choose and there is ​constant temptation to break the cartel​. The more successful the cartel, the greater the incentive to break it; it is important for firms to be the first to break it and not the firm who is left to deal with the after effects.
● Since collusion is illegal, firms may be involved in tacit collusion such as price leadership and barometric firm.
● Price leadership is where one firm has advantages due to its size or costs and becomes the dominant firm. Other firms will tend to follow this firm because they would be fearful of taking on the firm on in any form of price war. As a result, the dominant firm will decide the price and allow the other firms to supply as much as they wish at this price.
● Barometric firm price leadership is where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their leader.
● Other examples could be unwritten rules about keeping advertising low or not trying to take each other’s customers.

Question 17

non-collusive oligopoly

Answer 17

● The behaviour of a firm under non-collusive oligopoly will depend on how it thinks other firms will react to its policies. ​Game theory ​can be used to examine the best strategy a firm can adopt for each assumption about its rivals.

Question 18

game theory

Answer 18

Game theory explores the ​reactions of one player to changes in strategy by another player. The aim is to examine the best strategy a firm can adopt for each assumption about its rival’s behaviour and it provides insight into interdependent decision making that occurs in competitive markets. The easiest way of demonstrating this is where ​duopoly exists in the market, so there are two identical firms.
● There are two strategies the firm could take: a maximin policy or a maximax. The maximin policy involves firms working out the strategy where the worst possible outcome is the least bad. Alternatively, the ​maximax policy involves firms working out the policy with the best possible outcome.
● If the maximin and maximax strategies end up with the same solution, this is called the ​dominant ​strategy. However, ​dominant strategies aren’t that common in real life​ and the best strategy for a firm tends to depend on what the other firm does.
● In some cases, there is a ​Nash Equilibrium where neither player is able to improve their position and has optimised their outcome based on the other players expected decision. They have no incentive to change behaviour, unless someone else changes theirs.

Game theory is used as an explanation for why firms in oligopoly tend to have ​stable prices​:
● In this case, there is no dominant strategy for X. The maximin strategy will be to keep prices unchanged, as profits will not change, whilst the maximax policy is to raise prices, as they could gain £5m. Most firms will want to reduce risk and so adopt the
maximin strategy; they will keep prices unchanged.
● Firm Y will also choose to leave its prices unchanged if it pursues a maximin strategy:
if they raise price they could lose £5m whilst the worst that could happen if they don’t
change is for profits to remain the same.
● Therefore, both firms will leave their price unchanged and there is a Nash equilibrium
since neither firm is able to improve their position given the position of the other player.
Similar matrices can be drawn to show how firms are likely to undertake large amounts of advertising and research and development.

Question 19

Game theory: Prisoners dilemma

Answer 19

One common example of game theory is the prisoner’s dilemma. In the situation, two people are questioned over their involvement in a crime and are kept apart so they can’t communicate. The dominant strategy in this situation is to confess: it’s the greatest reward (3 months rather than a year) and the least bad (3 years rather than 10 years). However, if the prisoners could collude or had confidence in one another, the best option would be to deny the crime; this is the Nash equilibrium.

Question 20

Types of price competition: Price wars

Answer 20

Prices wars:
● These occur in markets where ​non-price competition is weak​; where goods have weak brands and consumers are price conscious. They also occur when it is ​difficult to collude.
● A price war will drive prices down to ​levels where firms are frequently making losses. In the short term, firms will continue to produce if their AVC is below AR but in the long run, they will ​leave the market and prices will have to rise since supply falls.
● It ​lowers industry profits​.
● Supermarkets are one example of an industry using heavy price wars, with firms desperately trying to offer lower prices than their rivals.

Question 21

Types of price competition: predatory pricing

Answer 21

● This occurs when an ​established firm is threatened by a new entrant or if one firm feels that another is gaining too much market share.
● The established firm will set such a ​low price that other firms are unable to make a profit and so will be ​driven out the market. The existing firm is then able to ​put their price back up.
● This is ​illegal and only works when one firm is large enough to be able to have low prices and ​sustain losses​.

Question 22

Types of price competition:limit pricing

Answer 22

● In order to prevent new entrants​, firms will set prices low (the limit price). The price needs to be high enough for them to make at least normal profit ​but low enough to discourage any other firm from entering the market.
● The greater the barriers to entry, the higher the limit price. It is mainly used in
contestable markets.
● The drawback of this is that it means firms cannot make profits as high as they would be otherwise be able to.

Question 23

Other pricing strategies

Answer 23

• Cost plus pricing: This is where firms simply work out their average costs and add a percentage increase, which determines the level of profit they make. The size of this increase will depend on the level of competition and barriers to entry. The problem is that it does not consider the market.
• Psychological pricing: This is where firms use the non-rounded prices to give an impression that the price is cheaper than it is e.g. 99p or £99. The aim is for consumers to feel they can afford the good and so be encouraged to buy it
• Market-led pricing: Firms can set prices simply by looking at prices charged by competition. They price their good close to other firms, since if it was higher people would not buy it and if it was lower then they could be losing profit. The problem is that there is no consideration of costs.
• Price skimming: When a product is initially launched, firms can set very high prices to cover research and development costs and keep demand at manageable levels. Once the product is no longer the newest or best, the price will be lowered. This is mainly used by technology firms.
• Penetration pricing: When a product is first introduced, the firm will set prices low to encourage people to use it for the first time. Hopefully, people will like the product after they’ve tried it and will continue to buy it even at the higher price. It is the opposite to price skimming.

Question 24

Types of non-price competition

Answer 24

An oligopolistic market tends to have a ​lot of non-price competition due to the fact that prices are relatively stable. They spend a long time and a lot of money on ​advertising and promotions​, for example the ​Tesco club-card or the computers for schools scheme​. ​The soft drink market is one good example of a market with high levels of non-price competition.
● Advertising: ​This creates an awareness of the company/product and can persuade a customer to purchase the product. If advertising is successful, it can increase sales and market share for a business which in the long run can increase profits. Advertising can also make the demand for a product/service more inelastic.
● Loyalty cards: ​These encourage repeat purchases by rewarding customers for their loyalty. They also provide firms with lots of data on consumers’ buying habits, which the firm can use to increase sales.
● Branding: ​A successful brand can help increase loyalty and repeat purchases for a business. People will trust the brand and the quality it represents so will more likely keep buying from them. An established brand should find it easier to release new products.
● Quality: A firm that is known for good quality may be able to charge higher prices, and is likely to have strong brand loyalty. They are likely to have good reputation and benefit from positive recommendations,
● Customer service: This will encourage loyalty amongst customers and give the business a more positive reputation.
● Product development: ​A business that invests in product development will have a competitive advantage over rivals. If they’re the first firm to release a new product, they would see an increase in sales and this is likely to help with branding.

The problem with these methods is that they are often ​expensive ​and so firms need the money before they are able to undertake the competition. Similarly, only large firms will be able to do large scale advertising, research and development etc.. There is ​no guarantee that it will be successful.

Question 25

Oligopoly efficiency

Answer 25

● Firms will be ​statically inefficient​, since they are not productively or allocative
efficient.
● They are likely to be ​dynamically efficient. ​They make supernormal profits, so have the funds to invest, and they have an incentive to invest, due to competition. However, some may just share its profits with its shareholders or decide not to invest. It will depend on the market.
● They will be able to exploit ​economies of scale​, lowering costs.