Microeconomics part 3- Perfect Competition, Imperfectly Competitive Markets and Monopoly Flashcards
What can market structures be determined by?
- Barriers to entry
- Homogeneity of the good
- Number of firms
- Market share
- Price taker/maker
- Perfect knowledge
What are features of a perfectly competitive market?
- Price taker
- Perfect knowledge
- Homogeneous goods
- Large number of firms and buyers
- No barriers to entry and exit
- Small market share
- Factors of production are completely mobile
What is a real life example of the closest there is to a perfectly competitive market?
- Currency exchange
- Gambling
What does the demand curve look like for a perfectly competitive firm?
Horizontal
What does D equal for a perfectly competitive firm?
D=P=AR=MR
What does the supply and demand diagram look like for the industry in which there are perfectly competitive firms?
Normal S and D
What do we assume about all firms?
They are all short run profit maximisers
Where do we assume firms produce if they are short run profit maximisers?
MC = MR
Why don’t perfectly competitive firms maximise revenue?
Because MR doesn’t equal 0
Do perfectly competitive firms maximise sales?
Yes, because AC = AR
Why don’t perfectly competitive firms innovate?
They have neither the means nor the incentive
What would happen if a short run profit maximiser innovated?
- They would have to have supernormal profits
- This would incentivise other firms to join the industry
- In a perfectly competitive industry, the factors of production are completely mobile, so other firms will join the market
- This causes supply to shift right so price will fall
Where do firms produce to maximise short run profits?
MC=MR
Where do firms produce to maximise sales?
AC=AR
Where do firms produce to maximise revenue?
MR=0
Where do firms produce to achieve allocative efficiency?
P=MC
Static efficiency definition:
Productive efficiency and allocative efficiency
What type of efficient are perfectly competitive firms?
Productively
Allocative efficiency definition:
Occurs when it is impossible to improve overall economic welfare by reallocating resources between markets. In the whole economy, price must equal marginal cost in every market
Why is allocative efficiency at P=MC?
- Before P=MC, P is higher, so it is a signal to the firm that they should produce more as people value the good at more than it costs the firm to make them
- After P=MC, it is a signal to the firm that they are producing too many and a rational firm would use those factors of production to make something else
Dynamic efficiency definition:
Efficiency over time- new products, techniques and processes which increase economic growth
What does dynamic efficiency require?
- Innovation
- R+D
- Technology
- Supernormal profit
Why is there no dynamic efficiency in perfectly competitive markets?
It requires supernormal profit
Why does P not reflect the true price of the good if there is an externality?
It does not take into account the externality so it is too high or too low. This means that the firm is not allocatively efficient because P does not reflect the true price of the good
What do we assume about all firms?
They are short run profit maximisers
Divorce of ownership and control definition:
The owners and those who manage the firm are different groups with different objectives. This only applies to large firms; PLCs
PLC definition:
Public Limited Company. Owned by shareholders who buy stocks on the stock exchange and receive dividends (shares of the profit)
What does the divorce of ownership and control lead to?
The principal agent problem
The principal agent problem definition:
The principal (owner) appoints an agent (director/manager) to perform tasks on his or her behalf, but the incentives of the owner may be different from those of the principal
What are methods of coping with the principal agent problem?
- Employee share-ownership schemes (John Lewis)
- Shareholder activism (Sainsbury’s)
- Delist (Virgin)
Satisficing definition:
Achieving a satisfactory outcome rather than the best possible outcome
Sources of monopoly power:
High barriers to entry:
- Natural barriers to entry:
- Economies of scale
- Natural barriers to entry e.g. high start up costs
- High sunk costs
- Artificial barriers to entry:
- Patents
- Product differentiation
- Advertising and marketing
- First mover advantage
- Limit pricing
- Predatory pricing
Features of a monopoly:
- Only one firm
- Complete barriers prevent the entry and exit of firms
- Short run profit maximiser
- Firm is a price maker
What does the demand curve look like for a monopoly?
Downwards sloping
What does D equal for a monopoly diagram?
D=P=AR
Where does MC go through?
Productive efficiency- the lowest point of AC
Where are supernormal profits on a monopoly diagram?
Above Q, from AC to P and then across to the axis
Why is MR falling in a monopoly diagram?
When the average is falling, the marginal must be below it
How do we know that monopoly firms are not productively efficient?
Q is not where AC is at its lowest point.
Why is a monopoly a short run profit maximiser?
Although it has the means for innovation, it does not have the incentive
How do we know monopoly firms are not allocatively efficient?
At Q, P does not equal MC
Why are monopoly firms not dynamically efficient?
Although they have the means for innovation, they do not have the incentive
Why will a nationalised monopoly produce at Q where P=MC?
This is allocative efficiency and the government will want to meet the needs and wants of the consumer
Where is the loss on a nationalised monopoly diagram?
D=LRMC up to LRAC and across to the axis
What do LRAC and LRMC look like on a nationalised monopoly diagram?
They are both curves that go down
In reality, where would a nationalised monopoly produce?
Somewhere between Q at MC=MR and Q at LRMC=P
This is because the firm will argue they need some supernormal profits for innovation etc
Who regulates how much nationalised monopolies can charge?
Regulatory bodies. This may lead to regulatory capture
Natural monopoly definition:
There is only room in a market for one firm. They never fully exploit economies of scale
What would happen if a monopoly decided to innovate?
- AC and MC would rise
- The new point of output would be to the left of the old one
- Price would be higher
- Supernormal profits would be lower
X-inefficiency definition:
Occurs when a firm lacks the incentive to control cost (Banker’s bonuses). This is an example of the principal agent problem
What is the diagram for x-inefficiency?
The point of output is floating above the AC curve
Advantages of monopolies:
- Benefit from economies of scale
- Can theoretically pass on savings onto consumers
- Means for dynamic efficiency
- Makes sense in the case of natural monopolies so there is no duplication of resources
- Internationally competitive
Disadvantages of monopolies:
- Restrict supply
- Higher prices
- Not productively efficient
- Not allocatively efficient
- No incentive for dynamic efficiency
- Misallocation of resources
- Underconsumption of the good
- Inequality
- Loss of consumer welfare/ surplus
- May satisfice rather than maximise profit
- X-inefficient
- Lack of choice
Consumer surplus definition:
A measure of the economic welfare enjoyed by consumers; surplus utility received over and above the price paid for a good
Producer surplus definition:
A measure of the economic welfare enjoyed by firms or producers; the difference between the price a firm succeeds in charging and the minimum price it would be prepared to accept
How to draw welfare loss/ gain on a diagram:
Draw a line straight up from the equilibrium then make a triangle
Deadweight loss definition:
The name given to the loss of economic welfare when the maximum attainable level of total welfare is not achieved
Price discrimination definition:
Charging different prices to different customers for the same product or service, with prices based on different willingness to pay
Conditions necessary for price discrimination:
- Must be able to identify different groups of customers easily
- Different customers must have different price elasticities of demand
- Markets must be able to prevent resale
- Needs to be a monopoly
Methods of price discrimination:
- Geographical
- Time
- Age of customer
- Quantity bought
First degree/ perfect price discrimination definition:
When the discriminating firm can charge a different price to each individual customer e.g. car insurance
Why is there no consumer surplus for first degree price discrimination?
Everyone is charged the most they are willing to pay
Why is producer surplus maximised for first degree price discrimination?
The firm makes the most profit possible for each customer
What is the diagram for first degree price discrimination??
- 2 diagrams
- Differently sloped demand curves (and MR curves)
- Constant MC
- Same Q so different P
Second degree price discrimination definition:
Charging a different price for different quantities, such as quantity discounts for bulk purchases
What is the amount of producer and consumer surplus for second degree price discrimination:
- More consumer surplus than first degree
- Less producer surplus than first degree
- Trade off between producer and consumer surplus
Diagram for second degree price discrimination:
- Normal demand curve
- Different MC and AC curves at each Q
- The assumption is that bulk purchases generally have lower average costs of production
Third degree price discrimination definition:
When the discriminating firm can charge a separate price to different groups of customers
What is the diagram for third degree price discrimination?
Same as first degree
What is the amount of producer and consumer surplus for third degree price discrimination:
- More consumer surplus than second degree
- Less producer surplus than second degree
- Trade off between producer and consumer surplus
Advantages of price discrimination:
- Producer surplus increases; maximised when first degree
- Could be equitable
- Profit maximising as prices match characteristics of the market
- Can increase sales which may lead to economies of scale
- Lower prices for some consumers
Disadvantages of price discrimination:
- Consumer surplus decreases; disappears when first degree
- Could be unequal (bad for rich)
- May be costly to prevent resale (why firms choose not to do it)
Oligopoly definition:
Where a few large firms have the majority of the market share
Features of an oligopoly:
- Supply in the industry concentrated in the hands of relatively few firms
- Firms must be interdependent
- High barriers to entry
- Non price competition
Concentration ratio definition:
The proportion of the market share held by the dominant firms
What type of prices do oligopolies experience?
Sticky prices/ price rigidity at the kink in the demand curve
Why do oligopoly firms not have a higher output?
They would have to lower their prices by a higher proportion than the revenue gained from extra sales (price inelastic)
Why do oligopolies not increase prices?
All their customers would go to other firms (price elastic
Does an oligopoly maximise revenue (assuming short run profit maximisation)?
No because MR does not equal 0
Why do we not know if an oligopoly minimises costs or maximises sales?
No AC curve
Examples of non-price competition:
- Better quality of service
- Longer opening hours
- Extended warranties
- Discounts on product upgrades
- CSR
- Product differentiation
- USP
Weaknesses with the kinked demand curve:
- Where did the price come from?
- Ignores effects of non-price competition
- Behavioural economics (anchoring, brand loyalty etc.)
- Assumes a particular reaction by other firms to a change in the price of a firm’s product
- Few economists now accept the kinked demnd curve
When is there the means or incentive for innovation in an oligopoly?
- At low MC curves there is the means but not the incentive
- At high MC curves, there is the incentive but not the means
Interdependence definition:
The actions of one firm will have an effect on the sales and revenue of other large firms in the market
Collusion definition:
Where firms cooperate in their pricing, marketing, R&D and/ or output policies. It is an attempt by firms to recognise their interdependence and act together rather than to compete. It is illegal.
Cartel definition:
A collusive, formal, agreement by firms, usually to fix prices. Sometimes there is also an agreement to restrict output and to deter the entry of new firms
Why does collusion hardly ever happen?
Because it doesn’t work because it is inherently unstabe
Price leadership definition:
The setting of prices in a market, usually by a dominant firm, which is then followed by other firms in the same market
Overt collusion definition:
Collusion in full public view that is desirable. For example, R+D by car manufacturers. Individual firms wouldn’t have the money to do that research but it could improve safety so is for the public’s benefit
Types of formal collusion:
- Restrictive agreements (when firms refuse to sell to outlets who sell below the agreed price)
- Price fixing
- Dividing the market by area (e.g. not putting supermarkets close)
- Predatory pricing
- Cartels
Informal collusion types:
- Price leader
- Parallel pricing
- Tacit collusion- an understanding without explicit agreement between firms
Problems facing cartels/ collusion:
- An agreement has to be reached
- Cheating has to be prevented
- Potential competition must be restricted
- Legislation
Advantages of oligopolies:
- Stable prices good for consumers, businesses, inflation
- Market cooperation can lead to improved health and safety, R+D (rare)
- Firms may have means for dynamic efficiency
Disadvantages of oligopolies:
- No sales (reduction of price)
- There could be collusion
- Concentration ratio
- Firms may not have the incentive for dynamic efficiency
- Firms are interdependent. Revenues may rise or fall through no action of their own
What diagram should be drawn if there is collusion?
Monopoly
Monopolistic competition definition:
A market structure in which firms have many competitors, but each one sells a slightly different product
Features of monopolistic competition:
- Large number of buyers and sellers; all act independently, low concentration ratio
- In the long run, there are no/low barriers to entry or exit. (You don’t need the initial design)
- Firms produce differentiated, non-homogeneous goods; competition is strong, plenty of switching takes place
- Producers have some control over price
- Information is widely spread but not perfect
Similarities between monopolistic competition and perfect competition:
- Large number of firms
- In the long run, there are no(/low) barriers to entry
Similarities between monopolistic competition and monopoly:
- Some price making ability, especially in the short run
- Supernormal profit in short run
- Restriction of supply, even in long run
What is the diagram for monopolistic competition like in the short run?
Monopoloy diagram
What happens to the diagram for monopolistic competition like in the long run?
- The demand curve flattens because more firms enter the market
- The lowest point of the AC curve hits the demand curve
What type of profit do monopolistically competitive firms make?
- In the short run they make supernormal profits
- In the long run they just make normal profts
e. g. deliveroo
Efficiencies for monopolistic competition in the long run:
- Not productively efficient
- Not allocatively efficient
- Not dynamically efficient, has the incentive for innovation but not the means
Efficiencies for monopolistic competition in the short run:
Same as monopoly:
- Not productively efficient
- Not allocatively effient
- Means and potentially the incentive for innovation, aware that there is the potential for competition. They want to innovate to maintain monopoly power
When with monopolistic competition might there be the divorce of ownership and control?
The short run. Shareholders will just want them to maximise short run profits and not innovate
What does monopolistically competitive markets having dynamically efficiency depend upon?
The size of the business and whether or not they think they will continue to be the biggest in the market
Where do monopolistically competitive firms produce at in the long run?
At Q where AC=AR, sales maximisation
Advantages of monopolistic competition:
- No significant barriers to entry in the long run, therefore markets are relatively contestable
- High level of promotion, informative, low search costs
- Differentiation creates diversity, choice and utility
Disadvantages of monopolistic competition:
- Some differentiation does not create utility but generates unnecessary waste
- Inefficient, leads to dead weight loss
- Economies of scale not maximised
Contestable market definition:
Where there is free entry and exit of other firms
What is the theory of contestable markets?
That what matters is the absence of barriers to entry and the level of sunk costs
Features of contestable markets:
- Number of firms in the industry varies from few to many, with no single firm having significant market share
- Freedom of entry and exit to the market
- Firms compete with each other and do not collude to fix prices
- Firms may produce homogeneous goods or they may produce branded goods
- There is perfect knowledge in the industry
What happens to encourage contestability?
Barriers to entry are lowered
Ways to encourage contestability?
- Deregulation (e.g. post, taxis)
- Tougher laws against anti competitiveness
- Reduce patents
- Subsidise smaller firms
Evaluation of deregulation of firms
Difficult to deregulate some monopolies e.g. water or gas
Evaluation of laws against anti competitiveness?
Some firms find these laws will restrict their long run success
Evaluation against subsidising smaller firms::
Unpopular
What to do with competition causes markets to become more contestable?
The THREAT of increased competition
What does reducing the barriers to entry do to a firm with monopoly power?
Encourages it to act like it is in a more competitive market. The threat is real as long as the barriers remain low
Hit and run entry definition:
Where new firms enter the industry where barriers to entry are low, gain lots of supernormal profits, and then leave the market
What types of markets can be efficient as long as they are contestable?
All except natural monopolies
What is the diagram for a contestable market and why does a firm produce here?
- Monopoly diagram with output at Q where AC=AR (sales maximisation)
- This is beyond allocative efficiency and there are no supernormal profits to be made
- It produces here because if there are no supernormal profits, it won’t attract other firms into the market
- In reality, it would actually produce somewhere between here and MC=MR (free market), because there would be some level of brand loyalty etc. so it doesn’t need to lose all supernormal profits completely
