market structures Flashcards
what is a market structure?
the environment in which firms operate
where does perfect competition occur?
in a market where there is a very high degree of competition and allocative and productive efficency are achieved in the long run.
what are the characteristics of perfect competition?
HALFPPPP
Homogenous products (all are perfect substitutes)
All firms have access to FOPs
Large number of buyers and sellers
Free entry and exit to the market (no barriers)
Perfectly elastic demand so D=MR=AR
Perfect knowledge of market conditions
Price taker
Profit max objective
here, a firm can expand or reduce output without influencing price. therefore, the price is determined by the market because the individual firm is too small to influence price.
why is marginal revenue the same as average revenue in perfect competition?
If a firm sells its output at the market price, then this price must be the average price or revenue. In addition, each extra item sold will receive the same price for each additional unit and therefore marginal revenue will be the same as average revenue.
draw a perfect competition diagram and explain it .
The firm operates in a competitive market.
The firm is a price taker as it is not large enough to influence market supply so cannot influence market price. The firm can sell all at once at this price. The firm makes just enough to stay in business in the long run and therefore makes normal profit, as the demand curve is perfectly elastic then the firms sell all units at P1, it does not have to price to sell more, therefore AR=MR.
We assume that firms are profit maximises and therefore choose output level when marginal cost is equal to marginal revenue. Here the firm is making normal profits because that the profit maximising level of output AC is equal to AR.
draw and explain supernormal profits in the short run for a firm in perfect competition.
Average cost will be lower than marginal costs. MC cuts AC at its lowest point. Firms are profit maximises and therefore produce where MC is equal to MR. here supernormal profits are made.
why are supernormal profits only made in the short run for firms in perfect competition?
Other firms would have the incentive to enter the market and could do so easily at zero start-up cost no barriers to entry. The entry of new firms stimulates an increase in supply for the industry which decreases the market price. The firm is the price taker, so take this new price, and this decreases profits from supernormal profit to normal profit.
draw and explain a loss in the short run for firms in perfect competition
The average cost curve is above the marginal revenue curve. Here, costs are greater than revenues. The firm is profit maximising where MR is equal to MC however a loss is made.
why does a loss only occur in the short run for firms in perfect competition?
If a firm is making losses in the long run firms would leave the industry as there are no batteries to exit.As a result total supply falls, supply shifts inwards causing a contraction in demand. This leads to normal profits.
what are the positives of perfect competition in the long run?
- allocative efficiency is achieved as P equals MC. This is because the optimal distribution is achieved when the marginal utility of the good equals the marginal cost. The price that consumers are willing to pay is the same as the marginal utility of consumers.
- productive efficiency is achieved as a produced at the lowest point on AC. Cost are the lowest.
what are the negative of perfect competition in the long run?
- dynamic efficiency is not achieved. This is of course no supernormal profit is made this makes investment in research and development unlikely and so firms may become static and cost do not reduce overtime.
- there is no scope for economies of scale. This is because there are many small firms producing homogenous goods at a relatively small amount so there is no scope for economies of scale therefore if an industry has high fixed costs it is unsuitable for perfect competition.
what is a pure monopoly?
a market with a single seller.
however firms can have monopoly power.
what are the assumptions of the monopoly model?
choses output where mc=mr (prof max)
single seller
high barriers to entry
price maker
no substitutes
what are the examples of barriers to entry?
economies of scale (high fixed costs)
other cost advantages
government legislation
high switching costs
strategic actions
limit pricing
brand loyalty
high sunk costs
network effects
what is productive efficiency?
when a firm is producing at the bottom of the AC curve (the minimum cost that output can be produced).
economies of scale have been fully exploited
consumer: low prices, cons welfare
producer: increased production, profit, market share
what is allocative efficiency?
producing a balance of goods and services that match consumer preferences (Pareto efficiency) where P=MC
consumer: low price, max cons surplus, choice
producer: market share, competitive, profit
what is dynamic efficiency?
reinvestment of supernormal profits to decrease LRAC
consumer: quality, low price in LR
producer: low cost, market share, competitive
what is x-innefficency?
when average costs are higher than they would be with competition. this is because of wastage.
increase in LRAC
draw and explain a monopoly diagram.
Downward sloping demand curve as they are price makers
Steep demand curve as PED inelastic
what happens to prices and output in a monopoly?
higher prices, lower output
what happens to consumer welfare in a monopoly?
decreases ad consumer surplus decreases due to higher prices and lower output. some of this loss is turned to producer welfare, some is deadweight loss. loss in consumer sovereignty as they have less choice .
is allocative efficiency achieved in a monopoly?
no, they earn supernormal profit. price is higher than MC. the needs and wants are not satisfied as this causes under consumption. monopsonies choses what to produce.
is productive efficiency likely to be achieved in a monopoly?
no as it does not produce at the bottom of LRAC.if a monopoly is protected by barriers to entry, the incentive to become productively efficient will be less as they can pass on higher prices
why may there be x-inefficency in a monopoly?
as there is little incentive to control costs due to the absence of competition
why may dynamic efficiency be achieved in a monopoly?
SNP can be used to invest in R&D. this also may cause other industries by leapfrogging technology to destroy the monopoly.
why may a monopoly not be dynamically efficient?
it is a risky activity and may cause them to loose profits.
a lack of competition means no incentive to adapt and change
what happens to the monopoly diagram when fixed costs increase?
AC increases, SNP falls
what happens to the monopoly diagram when demand increases?
increase in AR=D so then MR shifts out, SNP increases
what is price discrimination?
charging different consumers different prices with the price based on different willingness to pay
what is the motive of price discrimination?
reduce consumer surplus and so increase profits
why does price discrimination not happen in perfectly competitive markets?
as you cannot charge consumers higher prices than others if a competitor is willing to supply the good for less
what is first degree price discrimination?
where the monopolist charges each individual customer the maximum price that they are willing to pay, extracting all the consumer surplus
e.g bartering, auctions, car boots
what is second degree price discrimination?
when a firm sells off any excess capacity that it has at lower than the normal published price.
what is third degree price discrimination?
charging different prices for the same product to different groups of consumers in different segments e.g age, gender, income
what are the conditions for price discrimination to work?
1) must be different PED
2) must be able to prevent arbitrage
3) cost of selling to different sub groups just not be prohibitive
4) must have control over price
draw and explain price discrimination diagram
combined market- AR=D is kinked as it represents both sub groups. the monopolist has a prof max objective. p is where price is paid
PED elastic market- at price p, quantity is pb. when mr meets the other mr, take down to quantity for a new output
PED inelastic- at this same price there is a new quantity, take this unto the new price.
why is price discrimination positive for consumers?
- dynamic efficiency from higher profits
- may see a fall in price
- merit good
- less busy and avoid waiting times
- use more profitable service to keep less profitable one going
why is price discrimination negative for consumers?
- unfair
- higher prices, consumer welfare
- prices be more difficult to understand sp may not consume at all
*increased barriers to entry so comp decreases so increase prices - don’t invest higher profits
what is a natural monopoly?
a monopoly that arises in an industry in which there are substantial economies of scale that the more productively efficient market structure would be there to be only 1 firm. this is because LRAC falls continuously over output due to high fixed costs and low marginal. therefore, there is only room for one firm to fully exploit the economies of scale and therefore achieve productive efficiency. One large business can supply the entire market at a lower price than two or more smaller ones.
Competition may actually increase costs and price.
draw and explain a natural monopoly diagram
If the natural monopolist operates at the profit maximising level of output, then the monopolist makes supernormal profit. If they are forced to operate at the allocative efficient level of output where price equals marginal cost then the natural monopolist makes a loss.
what will happen to LRAC in a natural monopoly?
It will fall continuously as production expands of natural monopoly is characterised by increasing returns to scale at all levels of output. There may be room for only one supplier to reach the minimum efficient scale and to achieve productive efficiency
What are the advantages of a natural monopoly?
1) efficiency gains- increase in productive efficiency when one firm operates in the market
2) as production increases price falls increasing consumer surplus as people are priced into the market
3) economies a scale are so large that the natural monopolist can benefit from reduce cost so higher profits to be used in investment
4) dynamic efficiency
5) corporate tax
How and why may a government regulate monopolies?
1) to encourage competition - in a natural monopoly they may split the market E.G into infrastructure versus firm
2) encourage investment or expansion into the market to increase quality. They may do this by decreasing tax while they invest.
3) market regulation
4) insist the parties attend mediation in disputes around pricing to make the monopolist aware of the regulators attention
5) set maximum prices
6) fine the monopoly
3) limit mergers or acquisitions
What are the disadvantages of a natural monopoly?
1) an absence of competition may mean that firms have no scope to be dynamically efficient and invest and also do not need to reduce X inefficiency
2) supply and choice is restricted for the consumer reducing consumer welfare
What are the characteristics of monopolistic competition?
- Downward sloping demand curve - it has some control over price and does not have to accept the market price
- Differentiated but similar products- demand relatively price elastic so shallow AR curve
- freedom of entry due to no or low barriers - can take other firms supernormal profit?
- Many small firms.
- No dominant firm.
what occurs in monopolistic competition in the short run?
In the short run, firms can make supernormal profits where AR>AC. they can charge a higher price and will not lose all customers. The firm will profit maximise and produce where MC equals MR. however there are no barriers to entry to new firms and to the market and consumers switch to the competition so AR equals D moves in words therefore MR moves inwards.
Describe and explain monopolistic competition in the long run.
Other firms see the supernormal profit in the short run and therefore enter the market due to low barriers to entry. The firm produces differentiated product and so the existing firm loses some of its output. The demand of shifts to the left. It may also become more shallow as more substitutes become available becoming more PED elastic. Therefore, the AR curve shift to the left at a point where AR is equal to AC where normal profit is made. When this point is reached there is no longer an incentive for firms to enter the market. This is a new equilibrium position.
what happens in regards to productive and allocative efficency in a monopolistically competitive market?
In both the short one and the long run the firm is not operating at the bottom of the AC curve so the firm is not productively efficient
In the short run and the long run price is not set equal to marginal costs so the firm is not allocative efficient
They may be able to be dynamically efficient in the short run due to supernormal profits
Small firms may have incentive to keep cost low so there may be less wastage however spending on advertising maybe ineffective
What are the advantages for monopolistic competition?
1) there are no significant barriers to entry so markets are relatively contestable. Therefore price decreases and consumers are priced into the market.
2) differentiation creates diversity choice and utility
3) the market is more efficient than a monopoly but less efficient and perfect competition
What are the disadvantages of monopolistic competition?
1) efficiency is not achieved as supply does not equal demand and prices are set above marginal cost
2) product differentiation may lead to waste and higher prices
What is an oligopoly?
A market dominated by a few sellers, each of whom has some control over the market and in which each firm must take account of the behaviour and likely behaviour of rival firms.;
What does interdependence mean in an oligopoly?
Each firm has to act strategically in that they need to take into account the actions and possible future actions of rival firms and respond accordingly. They may choose to behave competitively or choose to cooperate.
What are the characteristics of an oligopoly?
- a few large firms dominate the market
- many firms make up the industry
- a high market concentration ratio
- each firm has branded and differentiated products
- there are significant barriers to entry and exit
- firms are interdependent
What is predatory pricing?
The firm set price below the average variable cost to try and force arrival out of the market.
Consumers faith lower prices in the short run, but the market becomes less competitive in the long run
What is limit pricing?
Pricing by the incumbent firm to deter the entry of new firms or the expansion of firms. This is below the normal profit maximising price but above the competitive level so below MC equals MR
What is nonprice competition?
Away in which firms try to differentiate their product from those of competitors to increase custom loyalty and repeat sales.
This enables the firm to charge higher prices.
For example, innovation quality of service free upgrades, branding and loyalty schemes.
Why may a firm choose non-price competition?
Reducing price can be risky as in the short term it can increase demand for the firms products but then if they competitive to follow suit and low as their price then both firms may sell the amount just at low prices reducing sales revenue. Firms will want to avoid this price war. They don’t need to change price and they do not want to change price.
What is a concentration ratio?
The market share of the top N firms in the industry. This can be 3 to 5 firms.
What will cooperation and non-cooperation lead to?
If firms choose to cooperate with each other, they will tend the market towards the monopoly end of the spectrum whereas non-cooperation will take it towards the competitive end. This independence leads to much uncertainty within the market.
Draw and explain an oligopoly diagram.
At first we are at X with price P1 and output Q1. Above P1 the demand curve is PED elastic below the demand curve is PED in elastic therefore if a firm increases its price then demand falls by a greater percentage this firm has lost market share and sales revenue has fallen. This is because competitors don’t follow suit and don’t increase their prices so consumers switched to competitors as substitutes are relatively cheaper if price falls demand rises by a small percentage this is because other firms will follow suit and also low prices. This is independence lowering prize could lead to prize war reducing total revenue for all firms and also no gain market share. Therefore prices are sticky and firms don’t want to change prices so prices are rigid.
Also if MC rises in the vertical gap in MR then P1 is still at its profit maximising price and Q1 is at its profit maximising output as MC still equals MR so firms don’t need to change price.
Why do firms not need to change price in an oligopoly?
If the firm is a profit maximiser and as long as costs change between the gap in the MR curve, they are going to be charging a price of P1.
What are the limitations of the oligopoly model?
1) often objects of firms is not to maximise profit. Therefore, they may be willing to take part in a price war even if this does lead to lower profits. This may lead them to gain market share in a recession markets are more competitive so firms lower price to keep customers.
2) does not explain how P1 is reached in the first place
3) the model ignores collusion
4) it ignores branding and brand loyalty for example smart phones are expensive at all levels. The brand has made them PED in elastic and there is no kink
What is collusion?
A non-competitive and sometimes illegal agreement between rivals which attempts to destruct the market equilibrium. This involves people or companies which were typically compete against one another but they conspire to work together to gain an unfair market advantage.
What is a cartel/over collusion?
An agreement between firms on price and or output with the intention of maximising their joint profits. Firms agreed to restrict supply and increase price. There is an open agreement.
What are the negatives of over collusion?
- that is a temptation for other firms to cheat by lowering price and sneak some additional market share at the expensive other firms. There is a strong chance that the agreement will collapse.
- They are legal. however they are hard to prove so firms are willing to take the risk.
What are the conditions that reduce the possibility of cheating in a collusion?
- Easily detected.
- Punished by other firms.
- Entry barriers are high so that raise price does not spark new entry.
- Includes all the major firms in the industry.
- Similar costs so there is no incentive to spark a price war
- Firms produce similar goods and firms do not have excess capacity. this does not hold in a recession for example demand for oil falls causing the cartel to breakdown
What is tacit collusion?
When firms refrain from competing on price, but without communication or formal agreements between them come to choose price
What is price leadership?
When firms with lower market shares follow the pricing changes prompted by the firm with the dominant position (most experienced or best knowledge) in the market.
What is barometric price leadership?
When one firm tries out a price increase and then wait to see if other firms follow if they do a new higher price has been reached without the need for overt discussions. If they do not, they will drop back into line or lose market share.
What are strategic alliances?
When firms join together to work on part of their business, perhaps undertaking joint research or technology swaps
What are the advantages of an oligopoly if firms are colluding?
- Firms make supernormal profit which can be used for dynamic efficiency to increase consumer satisfaction.
- Firms use non-competition the consumer may perceive differences in quality and choice.
- Collusion may mean firms face greater price stability which helps firms plan and reduce the risk of failure.
What are the advantages if firms are behaving competitively in an oligopoly?
Lower prices, perhaps due to a price war increase consumer surplus and so consumer welfare.
Inefficient terms or fail releasing scarce resources for more efficient firms.
What are the disadvantages if firms are colluding?
Firms will have little incentive to use supernormal profits to innovate and improve quality.
Collision creates barriers to entry which prevents new firms from entering the market and so increases concentration. This reduces choice so reduces consumer welfare.
Not productively or allocatively efficient.
What is a contestable market?
A market in which the existing firm only makes normal profit as there are no barriers to entry the incumbent firm therefore has to charge a low price to deter entrance into the market.
What are the characteristics of contestable markets?
- No barriers to entry or exit
- no sunk costs
- No competitive disadvantage.
- Access to the same technology.
- Entrance and exit rapid.
Explain explain productive and allocative efficiency in a contestable market.
- firms are more likely to be allocative efficient p=mc
- in the long run firms operate at the bottom of the average cost curve, productive efficiency
- the market is close to perfect competition as the existing firm acts as though there is a lot of competition
- supernormal profits in the short run.
What is hit and run competition?
Due to low barriers to entry which provide easy access to the market firms are wary of new entrance entering the market and taking supernormal profit and then leaving.
Why do contestable markets only make normal profit?
As it cannot set a higher price than average cost without attracting entry owing to the absence of barriers and sunk costs
How can governments or regulators increase contestability?
- removing some of the legal barriers to entry
- use tougher competition policy to prevent monopolies and to stop anti-competitive practices
- use trade policy for example free trade agreements and lowering tariffs and quotas
What are the advantages of a contestable market?
- prices should be lower so increasing consumer welfare
- allocative efficiency is achieved in the long run as scares resources are being used to make the products that consumers want
- productive efficiency should be achieved
- no X inefficiency
What are the disadvantages of contestable markets?
- perfectly contestable markets are rare
- is unlikely that there can be no sunk costs
- how long is the long run? Firms set price above AC in the short run then cut prices when entrance come into the market so consumers don’t benefit in the long run.
What are the market structures?
- Perfect competition.
- Monopoly.
- Natural monopoly
- monopolistic competition
- Oligopoly.
- Contestable market.
