Micro part 10- price leadership, Concentration Ratios/Contestability

Question 1

When does price leadership occur

Answer 1

1. Occurs when there’s only one dominant firm in industry

Question 2

How does price leadership happen

Answer 2

1. The dominant firm (price leader) sets the price and then allows other firms to sell as much as they want at the given price.
2. They then supply the remaining market demand
3. This acts as an incentive since dominant firm can set price at what they want whilst others can supply as much as they want.
4. This provides stability since firms risk losing market share if they do not follow the dominant firm

Question 3

What is Barometric pricing:

Answer 3

1. occurs when a price change by one firm in an oligopoly (due to change in macroeconomic climate) results in all firms changing price by the same amount
2. more plausible when firms have similar cost structures and homogenous good

Question 4

What is Competitive pricing:

Answer 4

1. limit: changing the highest price compatible with deterring entry.
2. It is set below profit maximising since this is low enough to deter entry
3. predatory: force competition out of the market, when a firm believes it can sustain a low price for a long time

Question 5

What are the advantages of oligopoly

Answer 5

1. in competitive there is more incentive to reduce costs and reduce x-inefficiencies
2. price stability
3. incentive to engage in non-price competition which can lead to dynamic efficiency which is facilitated by the potential for s.r. profits

Question 6

What are the disadvantages of oligopoly

Answer 6

1. if they collude then act like a monopoly which can lead to higher prices due to allocative inefficiencies
2. don’t lower prices even if they could so make ANP at expense of consumer surplus
3. have an agreement to restrict output leading to a higher price which will maximise profits across the industry
4. less competition reduces incentive to keep costs down which creates x-inefficiencies which leads to high costs per unit
5. price leadership

Question 7

What is the meaning of concentration ratios

Answer 7

1. They show competitiveness within an industry
2. A high c.r. (c.r. > 60%) means a high % of the market is controlled by a small number of large firms (less competitive)
3. A low c.r. (c.r. < 40%) means the market is relatively competitive with no firm having large share
4. Measured using the n-firm ratio showing the % of the industry’s output accounted for by N

Question 8

What are the uses of concentration ratios

Answer 8

1. Assess the degree of market power held by larger firms
2. Economic theory suggests that a firm with high market power can charge higher prices and produce lower output, meaning they achieve higher profits
3. Larger firms may dominate markets, restricting competition. A greater likelihood of collusion

Question 9

What are the limitations of concentration ratios

Answer 9

1. It is hard to define what the ‘market’ or ‘industry’ is
   National vs international?
2. A concentrated domestic market may face fierce foreign competition meaning that though the ratio may be large they do not have a high degree of market power
3. There may be a high c.r. but the product may have many close substitutes
4. Doesn’t give an indication of how market power is distributed within the n number of firms
5. Could be due to a firm’s efficiency not barriers to entry

Question 10

What are barriers to entry

Answer 10

1. Barriers to entry – factors making it hard/impossible for firms to enter an existing market and compete with the existing producers

Question 11

What are barriers to exit

Answer 11

1. factors making it hard/impossible for a firm to cease production and leave a market

Question 12

What is the height of barriers determined by

Answer 12

1. how long/expensive it will be for a new entrant to establish themselves in a market
2. whether can join the market at all

Question 13

Barriers allow incumbent firms to ANP depending on

Answer 13

1. height meaning how long they prevent new firms entering the market
2. level of ANP because they higher the ANP the greater incentive to overcome barriers

Question 14

How do incumbent firms’ actions affect barriers

Answer 14

1. strong branding creates consumer loyalty

2. aggressive pricing strategies like limit pricing

Question 15

How does the nature of an industry affect barriers

Answer 15

1. capital intensive industries have high start-up costs
2. high sunk costs make it risky and unappealing
3. if there’s an MES then any new firms entering the industry will be operating at a high point on the LRAC curve = high costs per unit = higher prices = less competitive

Question 16

How do gov. regulations affect barriers

Answer 16

1. new factories require planning permission

2. if licenses are required then this restricts the number and speed of entry

Question 17

Characteristics of perfectly contestable markets

Answer 17

1. Low barriers to entry and exit
2. If ANP is made by incumbent firms the new firms will enter
3. Equal access to available industry tech
4. Consumers are willing to change supplies e.g. low brand loyalty
5. Hit and run – occurs due to low barriers to entry/exit.

Question 18

What is hit and run

Answer 18

1. Firms enter the market whilst ANP can be made and then leave one prices have fallen so only normal profit can be made.
2. As long as profit made is greater than entry/exit costs then worthwhile for a firm to compete

Question 19

How can incumbent firms deter new firms

Answer 19

1. Behaviour of incumbent firms is affected by contestability
2. Threat of entry is just as influential as current competition
3. If a firm knows contestability is high and ANP is high then new firms will enter the market so the incumbent firm may set lower prices and sacrifice s.r. profit to maximise l.r. profit

Question 20

What does sacrificing s.r profits do for incumbent firms

Answer 20

1. . this leads to higher productive efficiency (firms are more incentivised to cut costs, to survive when new firms enter the market) and higher allocative efficiency, as the lower price means that P is closer to MC compared to profit maximisation.
2. if operate at profit maximising then incentivises hit and run which can undercut incumbent firm and lower market prices and profit

Question 21

What else can incumbent firms do to deter

Answer 21

1. May further decrease incentives to product/process innovate, as in this further increases ANP in the SR, increasing the rate of new firms entering the market, which ultimately means that the innovation was wasted as the ANP is erode away
2. They may have an interest in creating high barriers to entry
3. High contestability replicates perfect competition
4. Price is likely to be between profit maximising and normal profit so as to not strongly incentive joining the market

Question 22

What does high contestability mean for firms in an oligopoly

Answer 22

1. In an oligopoly, high contestability means firms are less likely to collude, as this would further increase ANP, meaning the likelihood of a “hit and run” entry are more likely, which leads to lower profits for the industry.
2. However, contestable markets theory may not be particularly useful as there are often large entry/exit costs with entering a market

Question 23

What are advantages of Perfectly Contestable Markets

Answer 23

1. productive efficiency
2. lower prices
3. allocative efficiency
   Disadvantages:

Question 24

What are the disadvantages of Perfectly Contestable Markets

Answer 24

1. no dynamic efficiency

2. firms benefit less from EoS