Micro 19 - Perfect competition and Monopolistic competition Flashcards
What are barriers to entry?
- Barriers to entry are factors that prevent or make it difficult for new firms to enter a market
- The existence of barriers to entry make the market less contestable and less competitive, but can however mean opportunities for greater profits for incumbent firms
What are incumbent firms?
Incumbent firms are firms already in the market
The greater the barriers to entry…
the less competitive the market will be
What are the different types of barriers to entry?
- Set up costs
- Economies of scale
- Sunk costs
- Regulatory / legal barriers
- Brand loyalty through advertising
- Exclusive contracts, patents and licenses
- Predatory or limit pricing
What are sunk costs as a barrier to entry?
Sunk costs are those that cannot be recovered when a firm leaves a market and include training and advertising costs and other fixed costs
What is predatory / limit pricing as a barrier to entry?
The incumbent firm sets a low price so new entrants cannot make a profit at that price. This is best achieved by selling at a price just below the average total costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to make.
Why do barriers to entry matter?
- They affect how many firms will operate in an industry
- They affect how vulnerable incumbent firms are to new entrants
- They influence the power held by suppliers and customers
Define perfect competition
Perfect competition is a market structure where there are many buyers and sellers, where there is freedom of entry and exit to the market, where there is perfect knowledge and where all firms produce a homogenous product
What are the characteristics of a market where there is perfect competition?
1- There are many buyers and sellers
2- No barriers to entry and exit of firms in the long run - the market is open to competition from new entrants. This affects the long run profits made by each firm in the industry meaning supernormal profits can only be made in the short term with firms making only normal profits in the long term
3- Identical output produced by each firm - homogenous products that are perfect substitutes for each other (no branding)
4- Perfect knowledge between producers - each firm has access to the same information including the latest technology and information on who makes supernormal profits
5- Perfect knowledge of prices among producers and consumers - if one firm charges a higher price than the market price the demand for its product will be zero as there are lots of substitutes
6- Due to the above conditions, each firm is a price taker - a firm which has no control over the market price and has to accept the market price if it wants to sell its products
In a perfect competition market why can a business not sell below the market price?
They would make a loss as they are already as efficient as possible
In a perfectly competitive market what is the PED for products from an individual firm?
Perfectly price elastic
What affect does firms being price takers in perfectly competitive markets have on the demand curve and MR curve?
- The demand curve is perfectly elastic (horizontal demand curve)
- The MR curve and AR curve are the same curve (one curve representing both) and is also a horizontal line
What price level will firms in a perfectly competitive market operate at?
Each firm profit maximise and so will operate at MR=MC
Draw a supply and demand diagram for perfectly competitive industry
See page 8 in pack 19
Draw a supply and demand diagram for an individual firm an a perfectly competitive market?
See page 8 in pack 19
Explain briefly how the market price is determined and the types of profit that are made in a perfectly competitive market
- In a perfectly competitive market the industry/market determines the market price by the forces of supply and demand
- The individual firms sells its output at this price as firms are price takers facing perfectly elastic demand from customers due to the many substitutes available
- The firm profit maximises operating where MR=MC
- The firm makes normal profits with average cost being equal to average revenue
Which of the three types of efficiency do firms in a perfectly competitive market meet and don’t meet?
- They are allocatively efficient as P=MC
- They are productively efficient as they are operating at the lowest AC
- They are not dynamically efficient as they don’t have supernormal profits to invest back into the business
Draw a cost and revenue diagram showing the long run equilibrium position of a firm facing short-term losses
See page 10 in pack 19
Draw a supply and demand diagram showing the long run equilibrium position of a firm facing short-term losses
See page 10 in pack 19
Explain the supply and demand diagram showing the long run equilibrium position of a firm facing short-term losses
- The firm makes a loss at P1 Q1
- In the long run all factors of production are variable and so firms can leave the industry as there are not barriers to exit
- Supply shifts left and the market price increases to P2 (rationing effect of price mechanism)
- Perfect competition firms are price takers so price rises from P1 to P2
- Normal profits are made at P2 Q2 so no more firms will leave the market
Do perfectly competitive markets exist?
In reality they are unlikely to exist, however it is useful to use the model of perfect competition as a benchmark so that other market structures can be compared in terms of price, output, profits and efficiency
Define monopolistic competition
Monopolistic competition is a market structure with many firms producing a slightly differentiated product and where there are few barriers to entry and exit
Why is a monopolistic competition market structure called monopolistic competition?
Firms aim to create their own monopolies within the overall market. There is a small degree of monopoly power each firm possesses as a result of a branded product
What are the characteristics of a monopolistic competition market?
- A large number of firms are in the market but none are relatively large in terms of the overall market size
- Low barriers to entry making it easy for firms to enter this market. Barriers to exit are also low as firms can generally recoup their capital spending
- Firms generally aim to maximise profits
- Products are non-homogenous - there is product differentiation
- Each firm is a price maker and therefore has a downward sloping demand (AR) curve
Define product differentiation
Product differentiation occurs either through real differences in products or perceived differences for similar products
What is a price maker
- A price maker is a firm that has the power to be able to set its own prices for its products in a market
- The extent to which they can make their own prices will depend upon price elasticity for their products and how differentiated they are
In monopolistic competition when are supernormal profits possible and not possible?
In monopolistic competition, supernormal profits are possible in the short term but not in the long term
Draw a diagram to show how supernormal profits are possible in the short term in a monopolistic competition diagram and explain it
See page 14 in pack 19
- Firms produce at MR=MC to profit maximise
- Supernormal profits are made as AR is above AC
- The firm is neither productively or allocatively efficient
Draw a diagram to show how supernormal profits are not possible in the long term in a monopolistic competition diagram and explain it
See page 14 in pack 19
- Due to low barriers to entry supernormal profits attract new firms
- New firms take away some demand from existing firms
- The demand curve for each firm shifts to the left and becomes more price elastic as there are now more subsitutes
- Some firms may leave the industry if they are facing losses
- Normal profits are now made (AR=AC)
Which of the three types of efficiency are met by firms in a monopolistic competition market structure?
- Not productively efficient as the firm is not operating at the bottom of the AC curve
- Not allocatively efficient as the price charged is above marginal cost
- Not dynamically efficient due to no supernormal profit being make long term to fund investment programmes
