Market Structures- Theme 3

Question 1

Define allocative efficiency.

Answer 1

Producing at a point where the price of a good is equal to marginal cost of production.

Question 2

Define productive efficiency.

Answer 2

Occurs at the lowest point on the average cost curve. This is where the average cost is at its lowest.

Question 3

Define dynamic efficiency.

Answer 3

Looks at how changes in technology and productive techniques over time will increase the productive potential of a firm.

Question 4

Define X-inefficiency.

Answer 4

Occurs when average cost is higher than the lowest possible average cost: the firm operates above the AC curve

Question 5

What are the characteristics of perfect competition?

Answer 5

• many small firms
• homogeneous products
• perfect knowledge, they have access to rival firms information, including latest technology and techniques and information on who makes supernormal profits
• no barriers to entry/exit
• no price setting powers, take price set by market known as price takers.

Question 6

Perfect competition: profit maximising in the short run

Answer 6

Firm taking industry or market determined price. This is above the firms average cost at the profit maximising output of MC=MR. Therefore firm making supernormal profits.

Question 7

Perfect competition: profit maximising in the long run.

Answer 7

Will always make normal profits only, any supernormal profits having been competed away and the losses removed by firms leaving the industry. This is known as long run equilibrium.

Question 8

What are the characteristics of monopolistic competitive markets?

Answer 8

• many small firms
• similar goods, slightly differentiated possibly through, among other things, quality, branding or advertising
• imperfect knowledge
• low barriers to entry/exit
• firms can set price to an extent because they are producing goods that are slightly different from those of rival firms

Question 9

Monopolistic competition: profit maximising equilibrium in short run.

Answer 9

Can make supernormal profits. They need not operate at the productively efficient or allocatively efficient levels of output.

Question 10

Monopolistic competition: profit maximising equilibrium in long run.

Answer 10

Can’t maintain supernormal profits due to near perfect knowledge that allows firms to identify profits to be made, and low barriers to entry that allow firms to enter market and compete profits away.
Don’t make losses as very low barriers to exit so firms making losses will leave industry rather than try persevere in long run.

Question 11

What are the characteristics of an oligopoly?

Answer 11

• few large firms dominate/ high concentration ratio
• product differentiation, goods with some similar characteristics but brand loyalty tends to be strong
• imperfect knowledge about rival firms price and output decisions
• high barriers to entry/exit
• can set price but may decide to agree price-fixing deals with rivals to avoid price competition

Question 12

Define n-firm concentration ratio.

Answer 12

The market share controlled by the n largest firms.

Question 13

Define collusion.

Answer 13

Firms, often operating under oligopoly conditions, working together to fix prices and avoid price wars.

Question 14

Reasons for collusive behaviour.

Answer 14

• to limit competition and therefore divide market
• set prices or output
• increase welfare gains of the firms concerned to the detriment of other firms and consumers

Question 15

Reasons for non-collusive behaviour.

Answer 15

Most collusion is illegal due to restrictive nature and impact on firms and consumers.

Question 16

Define overt collusion.

Answer 16

Where firms openly fix prices, output, marketing or sharing out of customers. An extreme form of overt collusion is forming a cartel

Question 17

Define cartel.

Answer 17

A formal agreement between firms to act together

Question 18

Define tacit collusion.

Answer 18

Quiet or ‘behind the scenes’. May be implicit co-operation and involve no spoken agreement. Result of tacit collusion is; firms don’t compete with each other or prices are higher than they would otherwise be: that is, there’s price fixing. TC may take form of collection of firms avoiding competition and following actions of market leader, known as price leader

Question 19

What is the prisoners dilemma?

Answer 19

An example of game theory in which explains reaction of 2 prisoners lacking trust and pursuing their own self-interest

Question 20

Define predatory pricing.

Answer 20

Pricing below costs to drive out other firms. In short run firm makes a loss, but as other firms leave, prices are raised to higher level than would’ve been possible with competition.

Question 21

Reasons against predatory pricing.

Answer 21

It’s an anti-competitive practice, can lead to fines being imposed by competitive authorities.

Question 22

Define limit pricing.

Answer 22

Pricing at level low enough to discourage entry of new firms: ensuring the price of good is below that which a new firm entering the industry would be able to sustain.

Question 23

Reasons against limit pricing.

Answer 23

Exploits economies of scale that an incumbent firm has and is not necessarily illegal in UK.

Question 24

Define price wars.

Answer 24

Price wars are often short-lived and intense periods when competing businesses lower their prices in a bid to win extra market share, generate improved cash-flow and perhaps increase total revenues.

Question 25

Types of non-price competition.

Answer 25

• advertising
• increased investment in branding eg increase brand loyalty such as loyalty cards
• packaging eg including free gifts
• product development
• quality and innovation

Question 26

What’s the aim of non-price competition?

Answer 26

To shift AR(demand) curve to the right or to prevent it falling as other firms try to increase their market share.

Question 27

What are the characteristics of a monopoly?

Answer 27

• one firm
• unique products
• imperfect knowledge
• high barriers to entry/ exit
• price maker

Question 28

Monopoly: Profit maximising equilibrium

Answer 28

As result of high barriers to entry, monopolists can set high prices to maximise profits without fear that another firm could enter industry. Therefore many governments intervene to prevent development of monopolies + ensure competition is maintained. Monopolies often accused of being X-in efficiency. Referees to tendency to allow costs to rise when no threat of more efficient firm undercutting prices. May make supernormal profit at expense of consumer surplus and are neither productively or allocatively efficient.

Question 29

Define price discrimination.

Answer 29

The sale of the same good to 2 different markets at different prices. To do this firm must be a monopolist able to identify 2 different groups and keep them separate.

Question 30

What are the 3 conditions for price discrimination?

Answer 30

• high barriers to entry and a degree of monopoly power
• at least 2 separate markets with differing price elasticities of demand
• markets can be kept separate at a cost that’s lower than the gain in profits. This is to prevent resale between markets.

Question 31

Disadvantages of monopoly power.

Answer 31

• supernormal profit means less incentive to be efficient and to develop new products
• monopoly power means higher prices and lower output for domestic consumers
• monopolists don’t produce at most productively efficient point of output
• may lead to misallocation of resources by setting prices above MC

Question 32

Advantages of monopoly power

Answer 32

• supernormal profits means funds for R&D and finance for investment to maintain competitive edge.
• monopoly power means firms will have financial power to match large overseas competitors.
• price discrimination may raise firms total revenue to point that allows survival of product or service.
• take advantage of economies of scale, so AC lower than those of a competitive firm at its most efficient position.

Question 33

Define sunk costs

Answer 33

Costs that a firm cannot recover on exit, such as advertising.

Question 34

Define natural monopoly.

Answer 34

Exists when an industry can support only one firm. Typical of an industry that has high sunk costs and requires large levels of output to exploit economies of scale.

Question 35

What are the characteristics and conditions for a monopsony to operate?

Answer 35

• a monopsony is a single buyer in a market.
• It is assumed that monopsonists are profit maximisers.
• able to negotiate lower prices, because their suppliers have nowhere else to sell to (there is only one buyer).
• Firms with monopsony power are able to set the market price

Question 36

Benefits of a monopsony.

Answer 36

• lower prices passed onto consumers

- better quality

Question 37

Costs of a monopsony.

Answer 37

• Employees are likely to lose out with lower wages.

- workers unmotivated if lower wages.

Question 38

What are the characteristics of a high level of contestability?

Answer 38

• low fixed costs.
• low sunk costs
• weak brand names/ very few patents
• low potential profitability in long run.

Question 39

Explain implications of contestable markets for the behaviour of firms.

Answer 39

New firms can quickly enter industry when they see supernormal profits being made and exploit these before leaving industry again. Referred to as ‘hit and run’ profits.

Question 40

Explain legal barriers to entry and exit of contestability.

Answer 40

Legal barriers can act as a barrier to entry. For example, patents and exclusive rights to production (such as with television) mean other firms cannot enter the market.

Question 41

Explain predatory pricing as a barrier to entry and exit of contestability.

Answer 41

Predatory pricing involves firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses. As firms leave, the remaining firms raise their prices slowly to regain their revenue. They price their goods and services below their average costs. This reduces contestability

Question 42

Explain limit pricing as a barrier to entry and exit of contestability.

Answer 42

Limit pricing discourages the entry of other firms. It ensures the price of a good is below that which a new firm entering the market would be able to sustain. Potential firms are therefore unable to compete with existing firms.

Question 43

What are signs of an uncontestable market?

Answer 43

• strong oligopoly or market power of incumbent firms
• high levels of non-price competition
• investigation by the CMA. Although the competition authorities might not take many actions against some industry, the frequency of their investigation can imply that other firms have found it difficult to compete.