MICRO - perfect competition ✅ Flashcards
what are the key features of a market structure
- number of firms (scale, extent of foreign competition)
- market share of largest firms
- nature of production costs (potential for firms to exploit economies of scale in long run)
- degree to which industry is vertically integrated (business has strong control over supply chain)
- extent of product differentiation (more differentiated = less competition. perfect competition = homogenous products differentiated by branding, price and quality affecting cross elasticity of demand)
- structure of buyers in industry (possibility of monopsony power)
- turnover of customers (how many prepared to switch supply to rival firm)
- size and strength of barriers to entry
what are the types of entry barriers
STRUCTURAL - due to difrences in production costs
STRATEGIC - where firms use different pricing strategies
STATUTORY - where patents protect a franchise eg TV license
what factors affect cost of supply
Entry costs into a market:
- Capital costs vary dependent on industry
- Eg natural monopoly
Sunk costs/exit costs:
- Costs not recoverable if business leaves
- Eg advertising/marketing
- Depreciation of capital equipment
- High sunk costs = market less contestable
Natural cost advantages:
- Location advantages
- Ownership of important raw materials
Control of supply chain in market through vertical integration
what are the types of product differentiation
HOMOGENOUS = same physical characteristics, perfect competition, different grades available
NON-HOMOGENOUS = products differentiated with competitors so branding/marketing/packaging is key, premium prices charged for brand loyalty, demand becomes less price elastic and YED reduction, high profit margins
how does performance affect market structure
performance can affect market structure as top firms gain market share at expense of rivals giving them more market power with a fine line between market dominance and economic efficiency
how does market conduct affect structure
Market conduct affects structure eg decisions about research and development, strategic behaviour of firms makes it difficult to rely on structure conduct performance model
when does market power occur
MARKET POWER occurs when high proportions of sales aren’t lost when businesses influence market price
how many firms are likely to exist in a constestable market, and what is the nature of the products and any significant barriers to entry for new firms?
NO OF FIRMS = any number
NATURE OF PRODUCT = differentiated
ENTRY BARRIERS = no, low entry and exit costs
how many firms are likely to exist in a monopolistic competition, and what is the nature of the products and any significant barriers to entry for new firms?
NO OF FIRMS = many competing suppliers
NATURE OF PRODUCT = differentiated
ENTRY BARRIERS = no entry barriers
how many firms are likely to exist in a monopoly, and what is the nature of the products and any significant barriers to entry for new firms?
NO OF FIRMS = market dominated by one/a few of them
NATURE OF PRODUCT = branded products
ENTRY BARRIERS = entry barriers important in maintaining monopoly/market power
how many firms are likely to exist in an oligopoly, and what is the nature of the products and any significant barriers to entry for new firms?
NO OF FIRMS = highly concentrated market top five firms have > 60% market share
NATURE OF PRODUCT = branded products
ENTRY BARRIERS = high entry barriers maintain market dominance of leading firms
how many firms are likely to exist in perfect competition, and what is the nature of the products and any significant barriers to entry for new firms?
NO OF FIRMS = many firms, none have significant market share
NATURE OF PRODUCT = homogenous products
ENTRY BARRIERS = no entry barriers
in a contestable market;
1. how strong is the pricing power of individual firms in the market?
2. what is the potential to earn supernormal profits in the long run?
3. what is the likely outcome for allocative efficiency?
4. what is the likely outcome for productive efficiency?
- PRICING POWER = depends on degree of competition and threat of new competition
- SUPERNORMAL PROFITS = low chance if highly contestable, new firms able to enter
- ALLOCATIVE EFFICIENCY = high chance because strength of competition likely to encourage firms to price competitively
- PRODUCTIVE EFFICIENCY = high chance, competitive pressures likely to make firms control costs
in monopolistic competition:
1. how strong is the pricing power of individual firms in the market?
2. what is the potential to earn supernormal profits in the long run?
3. what is the likely outcome for allocative efficiency?
4. what is the likely outcome for productive efficiency?
- PRICING POWER = limited pricing power eg if close substitutes exist
- SUPERNORMAL PROFITS = competed away by the entry of new products
- ALLOCATIVE EFFICIENCY = price > MC so not allocatively efficient
- PRODUCTIVE EFFICIENCY = possible loss of productive efficiency if market is saturated with many products
in a monopoly:
1. how strong is the pricing power of individual firms in the market?
2. what is the potential to earn supernormal profits in the long run?
3. what is the likely outcome for allocative efficiency?
4. what is the likely outcome for productive efficiency?
- PRICING POWER = strong pricing power including option to price discriminate
- SUPERNORMAL PROFITS = competed away by entry of new products
- ALLOCATIVE EFFICIENCY = price > MC so not allocatively efficient
- PRODUCTIVE EFFICIENCY = scope for economies of scale eg in case of natural monopoly
in an oligopoly:
1. how strong is the pricing power of individual firms in the market?
2. what is the potential to earn supernormal profits in the long run?
3. what is the likely outcome for allocative efficiency?
4. what is the likely outcome for productive efficiency?
- PRICING POWER = strong price power
- SUPERNORMAL PROFITS = supernormal profits maintained by entry barriers, regulation may limit monopoly profit
- ALLOCATIVE EFFICIENCY = price > MC so not allocatively efficient and risk of welfare loss from price collusion
- PRODUCTIVE EFFICIENCY = scale economies possible although also a risk of X inefficiency
in perfect competition:
1. how strong is the pricing power of individual firms in the market?
2. what is the potential to earn supernormal profits in the long run?
3. what is the likely outcome for allocative efficiency?
4. what is the likely outcome for productive efficiency?
- PRICING POWER = no one firm has setting power, price takers
- SUPERNORMAL PROFITS = no, normal profits in long run equilibrium
- ALLOCATIVE EFFICIENCY = allocatively efficient as = marginal cost
- PRODUCTIVE EFFICIENCY = limited scale economies but productive efficiency in long run equilibrium
what are characteristics of perfect competition
- many buyers and sellers
- sellers are price takers
- free entry to and exit from the market
- perfect knowledge
- homogeneous goods
- firms are short run profit maximisers
- factors of production are perfectly mobile
how is market price set in perfect competition
- market price set by interaction of supply and demand
- the ruling market price becomes AR and MR curve for firm
- average revenue = marginal revenue at every level of output
- assumption that the aim of each firm is to find profit maximising output
what is involved with long run profit maximisation
- supernormal profits in short run = encourages new firms to enter market with profit incentive
- leads to outward shift in supply = lower prices until price = long run average cost
- ceteris paribus, no incentive for movement in/out of industry and long run equilibrium is established where price = average cost at output where MR = MC
what type of profit is long run profit
each firm is making normal profit where price (AR) = average cost
this is just enough to keep resources in their current use
what is allocative efficiency and how does this relate to perfect competition
in both short/long run, price = marginal cost (P=MC) so allocative efficiency is achieved
what is productive efficiency
when equilibrium profit maximising output supplied at minimum average cost, attained in long run for competitive market
output lowest point of AC and if a firm is producing at lowest point of their lowest average cost curve = firm must be X efficient
what is dynamic efficiency and how does this relate to perfect competition
assuming homogenous products in perfect competition, little room for innovation
means that the lack of supernormal profit suggests firms don’t have funds to reinvest so firms in perfect competition are unlikely to be dynamically efficient
why is competition good for economic efficiency
- lower prices because of competing firms. Cross-price elasticity of demand for one product = high suggesting consumers prepared to switch demand to most competitive products
- low barriers to entry, entry of new firms = competition and low prices
- lower total profits and profit margins than in monopoly
- greater entrepreneurial activity. Needs to be desire from entrepreneurs to innovate and invent new markets to improve competition
- competition ensures firms move towards productive efficiency and avoid X inefficiency
- threat of competition = faster rate of technological diffusion, firms have to be responsive to changing needs of consumers (dynamic efficiency)
evaluation of assumptions in perfect competition model
- most firms have some price-setting power, price makers not takers
- dominance in real world markets of differentiated/branded products
- highly complex products, information gaps facing consumers
- impossible to avoid search costs even with spread of digital/web technology
- patents, control of intellectual property, control of key inputs are all ignored by perfect competition model
- rare for entry and exit in industry to be costless
- model of perfect competition assumes no externalities (positive/negative) when there are often third party effects of every market
PROS of a perfectly competitive market structure
- consumers not exploited by firms (high prices) low price in long run, P = MC so there is allocative efficiency
- products are the same regardless of where you buy them, all consumers buy same product
- no ‘wasted’ costs in terms of advertising
- firms produce at bottom of AC curve = productive efficiency
- supernormal profits produced in short run might increase dynamic efficiency through investment
CONS of perfect competition model
- in long run, dynamic efficiency might be limited due to lack of supernormal profits
- since firms are small, there are few or no economies of scale
- assumptions of model rarely apply in real life. in reality, branding, product differentiation, adverts and positive and negative externalities mean that competition is imperfect
- lack of choice so needs may not be met
what is monopolistic competition
form of IMPERFECT competition found in real world markets eg sandwich stores and coffee shops
similar to perf. comp. but regarded as more realistic because products differentiated
what is product differentiation
means businesses have control over products implying some price setting power
AR curve slopes downwards
assumptions of monopolistic competition
- many buyers and sellers, low industry concentration
- perfect information
- very low barriers to entry/exit, allowing firms to respond to profit signals
- all products in same ‘market’ but slightly differentiated, consumers think there are some ‘non price’ differences between products
- consumers aim to maximise utility whilst firms aim to maximise profits
- firms have little price making power over own brand
what profit is made in the long run
supernormal profit in short run will attract new suppliers offering new products so normal profits are only made in long run equilibrium where AR = AC
(no barriers to exit/entry of firms in long run unlike monopoly)
how does the demand curve move in long run profit maximising equilibrium
- demand curve shifts for existing firm to left when firms enter the market due to alternatives being available
- demand curve moves to left until it is tangential to the AC curve, MR curve will also shift inwards with AR curve
- here, monopolistically competitive firm is at its profit maximising level of output (MR = MC) but only making normal profit (AR = AC)
to what extent does monopolistic competition lead to economically efficient outcomes?
- prices above marginal cost = market equilibrium not allocatively efficient
- saturation of market = businesses unable to exploit fully internal economies of scale = long run average cost is higher = not productively efficient
- critics of heavy spending on marketing/advertising argue this spending is wasteful and inefficient use of scare resources
- debate over social costs of packaging and negative externalities from packaging waste linked to monopolistic competition
- monopolistic competition associated with extensive consumer choice and innovation = good for dynamic efficiency although lower profit margins may reduce the funds available for research and innovation
advantages of monopolistic competition
- firms are allocatively inefficient in short and long run (P>MC)
- firms don’t fully exploit their factors so excess capacity in the market, makes firms productively inefficient (note the firm doesn’t operate at bottom of AC curve) this is in both short and long run
- consumers get wide variety of choice
- model of monopolistic competition more realistic than perfect competition
- supernormal profits produced in the short run might increase dynamic efficiency through investment
disadvantages of monopolistic competition
- in long run, dynamic efficiency might be limited due to lack of supernormal profits
- firms not as efficient as those in perfectly competitive market. in monopolistically competitive market, firms have X inefficiency since they have little incentive to minimise their costs
