Market Structures Flashcards
What are the four types of market structure.
- Perfect competition
- Monopolistic competition
- Oligopoly
- Monopoly
Describe perfect competition.
Many firms
Freedom of entry to the market
Product is homogenous (undifferentiated).
Firm faces a horizontal demand curve as they a price takers (no control over price)
Describe monopolistic competition.
Many or several firms
Freedom of entry to the market
Products are differentiated
Firm faces a downward sloping but elastic demand curve (limited control over price)
Describe oligopoly.
A few firms
Restricted entry to the market
Products can be either differentiated or undifferentiated
Firms faces a downward sloping demand curve that is relatively inelastic (control over price depends on rivals).
Describe monopoly.
One firm
Restricted or blocked entry to the market
Unique product
Firms faces a downward sloping demand curve that is inelastic. (the firm has considerable control over price).
Draw a curve showing the average and marginal costs. Describe why their shape is like that.
- The average cost is U shaped.
- For the first few units of goods, there are higher fixed costs associated hence the higher cost per unit. Eventually, it becomes less efficient to produce more output, so the cost per unit increases again.
- The marginal cost curve is decreasing initially as it becomes cheaper to produce the next good due to the high initial start up costs. Eventually, the marginal returns begin to diminish as it becomes less efficient and more costly to produce more.
- The marginal cost curve always intersects the average cost curve at the lowest point. This is because if the marginal cost < average cost then the average cost will decrease (and the curve will move down). If the marginal cost is > average cost then the average cost will increase (and the curve will move up).
What is an ‘economy of scale’?
When increasing the output of a good reduces the cost per unit
What is the key difference between the ‘short run’ and the ‘long run’ of production?
In the short run, the factors of production are fixed but in the long run anything can be variable.
Show graphically the economies and diseconomies of scale in the long run of production.
Economies of scale is where the LRAC curve is negative, diseconomies of scale is when it is positive.
Show, graphically, how profit is maximised in the short run under perfect competition.
The price is set by the market equilibrium (left), which determines the average revenue per unit to the firm. The profit maximising position is where marginal costs = average revenue (for any goods sold beyond Qe, the firm will lose money).
If the average cost is less than the average revenue, the firm is making supernormal profit.
The difference between average cost and average revenue is the supernormal profit.
Show, graphically, how loss is minimised in the short run under perfect competition.
The price is set by the market equilibrium (left), which determines the average revenue per unit to the firm. The loss minimising position is where marginal costs = average revenue (for any goods sold beyond Qe, the firm will lose money).
Here, the shaded area shows the loss that is less than normal profit.
What is supernormal profit?
Profit that is made that exceeds the profit required to remain in the market.
Why is profit maximising not sustainable in the long run? Demonstrate this graphically.
- If all firms in the industry are making a supernormal profit, there will be an incentive for new firms to join the market.
- As a result, the supply curve will shift right, and there will be a new, lower equilibrium price.
- The price will then decrease, which reduces the amount of supernormal profit as supply increases.
What would happen if too many new firms entered the market?
The new equilibrium price would shift too low, to below average cost. Then, the firms become loss minimising.
What are the advantages of perfect competition?
- The price equals the marginal cost
- Production occurs at a minimum average cost which achieves technical efficiency
- The market is responsive to consumer wishes (consumer sovereignty)
- Competition induces efficiency
What are disadvantages of perfect competition?
- Profits are insufficient to drive investment
- There is a lack of product variety
What is a natural monopoly?
When long run average costs are lower if only one firm supplies the market (e.g. national grid, railway lines, water pipes).
Show graphically why it is more efficient in a natural monopoly to only have one firm.
Here shows two demand curves - D1 for if two firms traded as one and D2 for if each firm traded individually.
At the market price of P1, the long-run average costs are higher when the firm trades as one compared to if the firm trades as two.
Show graphically how a monopoly maximises profit. Show the supernormal profit.
The average revenue curve is the demand curve for the entire industry (because there is only one firm).
Profit will be maximised by producing where marginal profit = marginal costs
The supernormal profit is where average revenue exceeds average costs.
8 reasons
Why may monopolies occur?
- Substantial economies of scale
- Absolute cost advantages (a company can produce a good for far cheaper than any competitors)
- Switching costs for consumers
- Network externalities
- Brand loyalty
- Legal restrictions
- Mergers and takeovers
- Aggressive tactics or intimidation
What happens to supernormal profits in the long run under a monopoly? Why?
Nothing. The firm can continue to produce for the price that returns supernormal profits as there is no ability for other firms to enter the market and compete away the supernormal profit.
What is limit pricing?
When a monopolist deliberately restricts the price to below the profit maximising point in order to limit the supernormal profits so their is no incentives for new firms to attempt to break into the market.
Compare graphically the equilibrium price of a market under a monopoly
Under the monopoly, the price is higher and the quantity supplied is not at the socially optimal point.
Under a perfect competition, the quantity supplied is higher and the price is lower.
Draw the marginal revenue curve and the average revenue curve. What is the (graphical) difference between them?
The marginal revenue curve comes down at half the rate of the slope of the average revenue curve.
What are advantages of a monopoly?
- High profits allow research, development and investment
- Potential for high profits encourages innovation
- In some circumstances, it is more technically efficient to have a monopoly
What are disadvantages of a monopoly?
- There are high prices but low output
- There can be a lack of incentive for innovation as profits are already high
- It is technically inefficient
What literature argues against monopolies in the health industry?
Schmitz and Fettig (2020) argue that monopolies in healthcare ‘inflict harm’ on the poor, and this is disproportionate compared to the harm inflicted on wealthier individuals.
McGraw (2023) also argues that medical monopolies disparately impact lower socioeconomic populations and ethnic minorities, and suggests price ceilings on drugs under patent.
Pogge (2023) also argues that pharmaceutical patents contribute to economic inequalities, and arguably not allowing poorer patients access to drugs by allowing monopolies is violating human rights.
What happens to profits in the short run under a monopolistic competition?
Any supernormal profits are competed away as there are no barriers to entering the market.
Why do firms under a monopolistic competition wish to sell more than the demand at the equilibrium curve.
The demand curve is at tangency to the average cost curve, but not at its minimum point.
Therefore, firms are selling goods for greater than the lowest average cost, where the firm wants to be.
Describe why pharmaceutical companies are an example of a monopolistic competition.
- Many firms in the market
- All firms sell a slightly differentiated product that could be substituted
How do pharmaceutical companies attempt to keep supernormal profits?
They attempt ot maintain the short run.
- Differentiation of the product to extend any patents
- Finding a new use for an existing drug
- Creating brand loyalty so customers and providers choose a particular drug over a generic.
What is distinct about an oligopoly?
As the product is undifferentiated between firms, there is more requirement to consider how rival firms will act - leading to a choice between competition or collusion.
What is collusion?
Where firms within an oligopoly collectively decide to act as a monopoly
Draw the demand curve for an oligopoly. Describe its shape.
A firm in an oligopoly faces a kinked demand curve based on two assumptions about rivals’ activity. If the firm raises prices, then other firms won’t and the demand curve will become more elastic (as demand shifts away from this firm). If the firm lowers prices, then rival firms will follow suit and the demand curve will become less elastic.
What is the profit maximising position for an oligopoly? Show this graphically.
Where marginal costs = marginal revenue.
Due to the kinked demand curve, the marginal revenue curve is discontinuous at the point of the kink.
Therefore, the marginal cost could be anywhere along this vertical section and it would not change the profit maximising price.
Describe graphically how a cartel maximises profit.
By operating as a cartel, the oligopoly’s demand curve is the same as the average revenue for the industry. Therefore, if they set output to be where marginal cost = marginal revenue, the profit will be maximised. This can only be achieved if all firms agree to supply up to a total of Q1.
Show graphically why there is an incentive for members of the cartel to ‘cheat’.
Cheating is when a member of the cartel decides to increase output or undercut the market price.
For Firm A (the cheater) who is only able to supply up to 200 units under the cartel, the marginal cost is far lower than £10 a unit (the fixed cartel price). Therefore, they could feasibly increase output to where marginal costs = cartel price, so long as other members of the cartel stuck to their agreement and the market share would be taken from other members.
What is game theory?
A framework of decision making where alternative strategies can be analysed to determine the best action considering assumptions about rivals’ actions.
Describe the Prisoner’s Dilemma.
In the Prisoner’s Dilemma, two individuals have to decide whether to confess or deny. There are four possible outcomes, dependent on both prisoners’ choice BUT the choice is made simultaneously in a single-move.
The Dilemma arises because if both select the dominant strategy, they get a worse outcome than if they had both decided to choose the dominated strategy. Therefore, there is an incentive to choose the dominated strategy, despite a potential worse outcome overall.
How does the Prisoner’s Dilemma relate to markets?
It can be applied to duopolies, where both firms are looking at setting their price. If one raises and the other doesn’t, the one who doesn’t gets more money than if they both or neither raised.
What is the Nash equilibrium?
This occurs in an oligopoly which is the equilibrium position returned once all firms have made (what they think) is an optimal position based on assumptions about their rival’s decisions.
What is the dominant strategy?
The player’s best strategy, irrespective of others outcomes
How can game theory be used in real life?
Agee & Gates (2012) demonstrated that collaboration between a hospital, a physician group and an insurance company on administration of claims and price determination will increase profits for all parties, which is in line with game theory.
Westhoff et al. (2012) uses the prisoner’s dilemma to describe three case studies of the potential strategies for public health decisions in a duopoly. They demonstrate that successful cooperation will lead to broader coverage of health services, but unsuccessful cooperation (where one side cooperates but the other doesn’t) could lead to worse coverage than if they both competed.
