Micro part 8- Perfect Competition, Monopolies

Question 1

What are the characteristics of perfect competition

Answer 1

1. There are infinite amount of buyers and sellers.
2. This means each firm and consumer is small enough that no one has any market power, making each firm a price taker
3. There is perfect information for consumers and firms
4. All goods are homogenous so consumers can easily switch between which firm they buy from
5. No barriers to entry or exit
6. All firms are profit-maximisers, so all firms produce at an output level where MC=MR

Question 2

How does infinite amount of buyers and sellers occur

Answer 2

1. this occurs because all goods are homogeneous so consumers won’t pay extra for another firm’s good
2. also because there are no barriers to entry it means any abnormal profits are eroded away as more firms enter the market.
3. won’t lower price because they can sell everything they produce at MC=MR, if raise price then no one will buy from them.

Question 3

Short/long run profits- abnormal profit perfect competion

Answer 3

1. In the short run, firms are able to make abnormal profit
2. Cannot make long run abnormal profit
3. This happens due to an absence of barriers to entry/exit.

Question 4

Why are firms not able to make abnormal profit in the long run

Answer 4

1. When one firm starts making ANP this will incentivise new firms to join the market, so they can make ANP
2. This will increase the market supply
3. This will reduce price to a point where no one is making ANP, instead only normal profits
4. Eventually no new firms are incentivised to join the market, so the market is in equilibrium

Question 5

What does perfect competition ensure with allocative efficiency

Answer 5

1. Perfect competition ensures the price mechanism works
2. all firms are price takers (price is set by consumer preferences signalling and meaning resources are rationed)
3. There is perfect information so firms can act on incentives to know whether to leave/enter a market

Question 6

What does perfect competition in terms of allocative efficiency mean for consumer and producer surplus

Answer 6

1. means that price is set to what consumers are willing to pay since the price mechanism ensures firms produce exactly what is demanded, meaning P=MC (allocative efficiency).
2. This occurs because consumers are paying the price equal to the cost to society of producing an additional unit of the good (resources are allocated efficiently)
3. consumer and producer surplus are maximised

Question 7

Why is productive efficiency important in terms of perfect competition

Answer 7

1. Firms will be trying to maximise their profits out of necessity to stay in the market.
2. If they were not then a new entrant would enter the market, produce at the bottom of its AC curve, undercut the price of the original firm and that firm would be forced out of business
3. This means firms will need to produce at the bottom of their AC curve (productively efficient) when in equilibrium.
4. They are producing at an output where LRAC is at a minimum
5. This is because having to compete means there is strong incentive for firms to reduce waste and inefficiencies

Question 8

what effect does productive efficiency have on x-efficiency

Answer 8

1. greater x-efficiency since competition ensures firms make best use of current resources and resources not wasted on things like advertising due to product homogeneity

Question 9

what is dynamic efficiency

Answer 9

1. Dynamic efficiency is about improving efficiency in the long run through research and investment
2. This requires investment and risk

Question 10

What are problems with dynamic efficiency investing perfect comp

Answer 10

1. Due to the lack of supernormal profits in the long run, firms will lack the funds to engage in this R&D.
2. Furthermore there is no reward for this investment, as any new production methods to improve efficiency will be immediately copied by other firms, due to the existence of perfect competition.
3. This is an example of the free rider problem
4. This means efficiency isn’t increased and prices may be higher in the long run

Question 11

Describe perfect competition effect on EOS

Answer 11

1. Due to there being a high number of firms (each on a small scale) there will be no firms achieving economies of scale
2. This is because production on a large scale cannot be done due to each individual firm having output that is small compared to the overall market
3. This means cost of production and prices may be higher than if the market were one/few large firms achieving economies of scale

Question 12

What are problems with Perfect competition theory

Answer 12

1. Assumptions are rarely applicable in real life, extreme end of competitiveness structure
2. There is static efficiency but at the expense of dynamic efficiency
3. But conclusions on prices and economic efficiency may be invalid if at least one of the conditions of PC are not met,
4. Also, competition may be less important on firm’s behaviour than contestability (potential competition)

Question 13

What assumptions of PC are rarely applicable to normal life

Answer 13

1. There is often branding
2. some product differentiation and advertising
3. whilst there is unlikely to be perfect information for both firms and consumers

Question 14

What are the conditions of PC that if are not met can make conclusions on price and economic efficiency invalid

Answer 14

1. firms do not always profit maximise,

2. markets can be dominated by a few sellers, collusion etc.

Question 15

Overall conclusion on PC thoery

Answer 15

1. Overall, PC theory is one of many theories explaining likely behaviours in a range of market structures.
2. The usefulness of theories should be judged on the accuracy of predictions rather than realism of assumptions

Question 16

What are the characteristics of a monopoly

Answer 16

1. There is one seller which is also the industry
2. It produces a unique g/s meaning there are few close substitutes so consumers can only buy from this firm
3. There are complete barriers to entry/exit
4. Is a price maker and can make ANP in l.r.
   - due to the absence of competition from other firms which frees firms from having to adjust prices in response to other firms.
5. There are no substitutes for its good

Question 17

When is a firm a monopoly power

Answer 17

1. Monopoly power – when a firm has more than 25% of market share

Question 18

What are the three sources of monopoly power

Answer 18

1. Barriers to entry – these protect monopolies from new entrants e.g. legal costs, sunk costs or anti-competitive practises. Stronger barriers to entry = strong monopoly power
2. Product differentiation/number of substitutes – can demand higher prices as little alternative. Better differentiation = stronger monopoly power
3. Number of competitors – can more easily differentiate product and higher price making power

Question 19

When does equilibrium of monopoly power occur

Answer 19

1. Assumed the firm is a profit maximiser so operates at a level of output where MC=MR
2. Can make ANP in l.r. shown by shaded region since AR > AC
3. Occurs because there’s complete barriers to entry so ANP is not eroded away
4. Occurs only when barriers to entry are total

Question 20

What are Barriers to entry

Answer 20

1. Prevent firms entering the market
2. Economies of scale
3. Sunk costs
4. If brand loyalty is high for an existing firm then hard to gain market power without significant levels of advertising

Question 21

How does EOS act as a barrier to entry

Answer 21

1. as firm grows larger then AC falls because of EoS.
2. Means existing firms have a cost advantage over new entrants.
3. Deters entry as they cannot compete

Question 22

How does sunk costs act as a barrier to entry

Answer 22

1. when some costs are unrecoverable then are deterred from entering the market.
2. If unable to compete and forced to leave market then cannot recover the costs

Question 23

What is a natural monopoly

Answer 23

1. Natural monopoly – when the min. efficient scale is so large relative to market demand that there is only scope for one firm to exploit all available EoS

Question 24

When do natural monopolies occur

Answer 24

1. Typically occur where there are high fixed costs/large EoS, there are increasing returns to scale at all levels of output so LRAC falls as production increases.
2. MC < AC
3. If there was more than one firm then they would all face the same high fixed costs = higher costs per consumer = higher prices
4. Means a monopoly is likely more productively efficient than many firms

Question 25

Are monopolies allocatively efficient or inefficient

Answer 25

1. Will be allocatively inefficient since P > MC
2. Because monopolies that profit maximise operate at an output where MC = MR
3. This means consumers place greater value on the last unit bought than the cost of producing that unit so the good is under-produced
4. Therefore consumer welfare will be reduced

Question 26

Are monopolies productively efficient or inefficient

Answer 26

1. Will be productively inefficient
2. This is because monopolies restrict output to maximise profit so it operates at an output where AC is not lowest
3. This means consumers take on higher costs creating higher prices

Question 27

Describe the X-inefficiency in a monopoly

Answer 27

1. There is less incentive to invest and innovate creating higher AC
2. Due to lack of competition meaning monopolies do not have to price compete due to high barriers to entry
3. This means they lose incentive to invest in capital since profits can instead go paid as dividends to shareholders
4. X-inefficiency is where firms produce above their LRAC and since firms are not incentivised to minimise costs it can create higher prices for consumers = reduced consumer surplus

Question 28

How is consumer choice affected by a monopoly

Answer 28

1. Can be limited due to the presence of only one product
2. There can also be lower quality goods because of this since firms have less incentive to produce better quality/new goods
3. This is due to the presence of barriers to entry meaning the markets are not competitive
4. This can result in less consumer choice, making it harder for a consumer to maximise their utility so consumer welfare is reduced

Question 29

Describe how dynamic efficiency achieved in a monopoly

Answer 29

1. Achieved since barriers to entry mean firms can maintain ANP into the l.r. as its not eroded away by new entrants
2. Means there are funds available for investment into capital which can lead to a downwards shift in LRAC curve.
3. Firms are also incentivised to do so since they want to maintain the ANP in l.r. and are able to protect any new ideas developed from innovation since there are no other firms in the industry to benefit from them (no free rider problem)
4. Lower costs means lower prices for consumers which can increase demand and increase profits

Question 30

How can a monopoly lead to price discrimination

Answer 30

1. Can benefit a group that may have not originally been able to afford a certain good
2. This occurs because they have a high degree of market power so can control prices as are price makers and if they can segment markets
3. This benefits those in the lower price market and if they could not afford the good before discrimination then there is an increase in social welfare and equity