Microeconomics: Perfect competition, imperfectly competitive markets and monopoly

Question 1

What are market structures?

Answer 1

The organisational and other characteristics of a market.

Question 2

What does the spectrum of competition consist of?

Answer 2

1) Perfect competition (only a theory):
large number of buyers and sellers
With perfect market information
Able to buy/sell as much as they wish at the ruling market price
Uniform product
No barriers to entry/exit in the long run
2)Various forms of imperfect competition:
Monopolistic competition- imperfect competition among the many.
Oligopoly- A few mutually interdepend firms, each needing to take account of it’s rivals’ reactions when deciding its own marketing strategy.
Monopoly: 1 firm producing 100% of market output price-maker.

Question 3

What are market entry barriers?

Answer 3

Obstacles that make it difficult for a new firm to enter a market.
e.g. high start-up costs, educational qualifications, legal barriers, space, existing firms in the market (brand loyalty), economies of scale (large firms).

Question 4

What are exit barriers?

Answer 4

Obstacles that make it difficult for an established firm to leave a market.
e.g. selling of assets/machinery, selling land.

Question 5

What are sunk costs?

Answer 5

Costs that cannot be recovered if you leave the market. e.g. advertising, training, technology that is outdated, rent.

Question 6

What is a competitive market?

Answer 6

A market with a large number of buyers and sellers, with low barriers to entry .

Question 7

Why does market supply shift to the right in perfect competition?

Answer 7

Assume a new product is made.
In the short. supernormal profits are made because it is new popular product.
This profit attracts new firms into the market, as they want to earn some too.
This existing firm is unable to prevent them entering the market due to low barriers to entry.
This means the number of firms in the market increases, which is a supply factor and shifts market supply to the right.
This pushes the market price down (as the market is now more competitive and firms need to compete for customers)
This reduces the price level for all firms (as they are price takers) which reduces the amount of profit made by all firms)

Question 8

Why may market supply shift to the left?

Answer 8

If too many firms enter the market, price and therefore AR may fall below a firm’s AC. This means they are longer making normal profit and will exit the market.
This means market supply will shift back to the left, as fewer firms are in the market, causing the price level to rise and eventually settle at a level where all firms are making normal profit.
This is enough to keep them in the market but not sufficient to attract new firms and so this is the long run equilibrium.

Question 9

What is market/monopoly power?

Answer 9

The ability of a business to set prices above a level that would exist in a highly competitive market.
Allows firms to maintain high profits by using barriers to entry.

Question 10

What are natural (innocent) barriers to entry?

Answer 10

Barriers to market entry caused by geography.
e.g. economies of scale, sunk costs (staff wages/salaries)

Question 11

What are artificial (strategic) barriers?

Answer 11

Deliberate barriers to market entry.
e.g. patents/copyrights/trademarks, product differentiation, high levels of expenditure on advertising and marketing, benefiting from “first mover” advantage, limit pricing, predatory pricing.

Question 12

What is limit pricing?

Answer 12

When firms already in the market reduce prices so they only just make normal profit, in order to deter entry of new firms.

Question 13

Why is there a downward-sloping AR+MR curve for monopoly?

Answer 13

It has price-setting or price-making power

Question 14

What are the pros of monopoly power?

Answer 14

Re-invest it back into the business as they can charge higher prices as they are the only firm (supernormal profit).
Achieve economies of scale (could grow too large causing diseconomies of scale but it depends if the firm can prevent it e.g. good manager)
A useful source of finance
Attracting shareholders (raise finance)
Profit can be used to fund extra capital investment and research projects. This increases productivity which lowers AC. However, they are more likely to use profits for dividends.

Question 15

What are the cons of monopoly power?

Answer 15

Less incentive to innovate and improve as there is no competition.
Consumers don’t have a choice as they are the only firm so they can charge higher prices causing less disposable income as they are no substitutes.
Loss of allocative efficiency as prices are higher e.g. royal mail.
Regressive effect on low-income households.
Wasteful marketing spending e.g. royal mail.
Not the only firm in the international market (doesn’t always face global competition e.g. Royal Mail, NHS)

Question 16

How can monopolies be regulated?

Answer 16

Industry regulator acting as a proxy consumer to help them keep prices down and standards of service high.
However it depends on the strength of the regulator, is it likely to happen.

Question 17

What are social tariffs?

Answer 17

Cheaper broadband and phone packages for people claiming universal credit, pension credit, and some other benefits. (not regressive impact since it helps low income people)
They charge higher prices to everyone else which means they will gain a lot of profit. This means that they can afford to give social tariffs.
However, it is now a law for companies to impose social tariffs.

Question 18

What is deadweight loss?

Answer 18

The loss of economic welfare to society when the maximum attainable level of total welfare fails to be achieved.
If p>MC (there isn’t allocative efficiency) then there’s deadweight loss.
But we can get them to lower their price via the government introducing maximum price regulator.

Question 19

What are examples of oligopolies?

Answer 19

Airlines, broadband providers, vehicle manufacturers, pharmaceutical companies, fizzy drinks markers.

Question 20

What is the concentration ratio?

Answer 20

Measures the combined market share of a leading group of businesses in a clearly defined market. Typically, we sum the market share of the leading 3 or 5 firms.
As a rule of thumb, an oligopoly exists when the 5-firm concentration ratio exceeds 60%.
Used to assess the degree of market concentration within a particular industry.
Provides insights into how market power is distributed among firms in an industry and whether it is highly concentrated in a few large firms or more dispersed among many smaller firms.

Question 21

What are the key characteristics of oligopoly?

Answer 21

Few dominant firms- dominated by a small number of large firms.
Interdependence- each firm’s pricing and output decisions directly impact the profits of its rivals. Firms closely monitor and react to each other’s actions. (can create a competitive environment and can make the market less predictable and volatile e.g. supermarkets have to constantly monitor each other such as Clubcard and Nectar card)
Barriers to entry- high barriers to entry make it difficult for new firms to enter and compete e.g. high capital requirements, economies of scale, and brand loyalty.
Non-price competition- advertising, product quality improvement, customer service (Waitrose, John Lewis), product innovation (Microsoft), and sales promotion (Clubcard pricing). Price competition may not be as effective in an oligopoly due to small number of firms and the interdependence between them.

Question 22

What is the kinked demand curve?

Answer 22

Explain price rigidity (sticky) and stability in markets where a small number of dominant firms compete.

Question 23

What are the assumptions of the kinked demand curve?

Answer 23

assumption of price rigidity- assumes that firms in the oligopoly market prefer to maintain stable prices over time rather than engage in price wars or frequent price changes.
assumption of rival response- assumes that competitors in the industry will respond to price changes, but their responses are not symmetric.
rival firms are more likely to price match.

Question 24

What does the kinked demand curve show?

Answer 24

Firms in an oligopoly cannot raise their prices, as they will lose their customers to their competitors because they sell homogenous products therefore customers are happy to switch to alternatives.
If they reduce prices, they may gain customers in the short run however the other firms will follow suit and reduce their prices too to win customers back.
This would leave all firms with their original market share, but less profits as prices are lower.
Therefore prices are “sticky” as it is not sensible for firms to either raise or lower prices.

Question 25

What are the limitations of the kinked demand curve?

Answer 25

It doesn’t explain how the kink is formed in the first place.
It doesn’t provide a clear explanation of why firms in an oligopoly would act in a way that leads to a kinked demand curve.
Doesn’t explain how the demand curve would change if the price or quantity changes.

Question 26

What is collusion?

Answer 26

Occurs when 2 or more firms work together to set prices or output levels.
Anti-competitive behaviour that is illegal in many countries (CMA policing it)
By working together, firms can effectively set higher prices and limit output, which results in higher prices for consumers and reduced competition in the market.

Question 27

How can firms collude?

Answer 27

Through explicit agreements or more subtle means like “tacit collusion” where firms follow the actions of rivals and act accordingly.

Question 28

How can collusion be prevented?

Answer 28

Many countries have antitrust laws with penalties that prohibit firms from engaging in such anticompetitive behaviour.

Question 29

What is the difference between collusion and cooperation?

Answer 29

Cooperation is legal and refers to firms working together to achieve mutual benefits in a way that does not harm consumers by ensuring consistency and compatibility of products while collusion exploits money out of society.

Question 30

What is tacit collusion?

Answer 30

Occurs when firms don’t explicitly agree to collude, but instead, they act in ways that suggest that they are colluding.
This can be done through subtle signals or “winks and nods” that let other firms know what they are doing.
e.g. a firm might raise its price and observe whether the other firms follow suit.
Difficult to prove, but it can have significant negative effects on the market if it goes unchecked.

Question 31

What is price leadership?

Answer 31

A specific type of tacit collusion in which one firm takes the lead in setting prices, and the other firms follow suit.

Question 32

What are the main aims of price fixing?

Answer 32

Increase profits for all firms involved.
Can ensure that they don’t compete on price, which can lead to a more stable and predictable market.
Keep new entrants out of the market, as the low prices associated with competition can be difficult for new firms to match as they are not able to benefit from economies of scale.

Question 33

What is the goal of price-fixing cartels?

Answer 33

Maximise joint profits for all of the firms involved. In economic terms, the cartel is trying is trying to maximise the total profit for the entire industry, rather than maximising individual firms’ profits.
e.g. BA and Virgin colluded over fuel charges added to tickets.

Question 34

What are the arguments against oligopoly?

Answer 34

Cartel behaviour leads to higher prices, causing a loss of allocative efficiency (P>MC) and hurting low-income households (it is regressive). But it’s illegal so it’s unlikely.
A high concentration ratio limits consumer choice (homogenous product) and barriers to entry (Gov. may help) may deter innovative smaller firms from profitable entry. But it could depend on how many other options there are.
Persuasive advertising can manipulate preferences and distort the allocation of the price mechanism. However, not all consumers will be persuaded (rational choice), how many people are going to be manipulated?
Many transnational oligopolies avoid paying taxes through shadow or transfer pricing (looks like they make less) leaving a government with less money to spend. But the government could close loopholes, so they can’t avoid paying tax.

Question 35

What are the advantages of oligopoly?

Answer 35

Competitive oligopoly can lead to price wars which then increases consumer surplus however, they are more likely to compete on non-price factors due to price rigidity.
Constant and fierce battle for market share leads to higher levels of research and development (some innovate e.g. scan as you go, Clubcard, loyalty cards) which can then improve dynamic efficiency.
Dominant firms can exploit internal economies of scale which then leads to lower ACs (but may lead to diseconomies of scale) and lower prices in the long run. But this is unlikely as they want to profit maximise.
High supernormal profits can be taxed- a source of revenue to help fund key public services but it depends whether they are loopholes which is likely).

Question 36

What are the evaluation points on oligopoly?

Answer 36

Collusive behaviour is common, but the CMA has become proactive in investigating cartels and issuing large fines.
Often there is intense competition in oligopoly- especially with a cluster of large, scaled businesses fighting for market share.
Barriers to entry are large- but smaller challenger brands often appear- perhaps using a different business pricing model.
Impacts of an oligopoly on consumer welfare depends on how well-resourced and strong the industry regulator is.

Question 37

What is an example of an organised cartel?

Answer 37

OPEC (oil organisation) between countries.
Nobody can do anything about it.
If oil is cheaper, reduce the supply so they can push prices back up due to less revenue.

Question 38

What is monopolistic competition?

Answer 38

Resembles perfect competition in the following ways:
As in perfect competition, there are a large number of firms in the market.
In the long run, there are no barriers to entry or exit.
As a result, the entry of new firms, attracted by short-run abnormal profits, brings down the price each firm can charge until normal profits are made in the long run.
Also resembles monopoly in the following ways:
Each firm faces a downward-sloping demand curve. This results from the fact that each firm produces a slightly different product- differentiated by such features of modern production and marketing as style, design, packaging, branding, and advertising (non-price competition). The goods produced by the various firms provide partial by not perfect substitutes for each other. ( the demand curve facing the firm is likely to be elastic at the prices each firm may decide to set) The resulting “product differentiation” in the market means that each firm raises its price, it does not lose all its customers because there is brand loyalty.
Each firm’s MR curve is below its AR curve, which is the demand curve for the firm’s output.

Question 39

How can monopolistic competition be evaluated?

Answer 39

In the absence of any economies of scale, monopolistic competition is both allocatively and productively (not producing at the lowest point of AC curve) inefficient in comparison with perfect competition. As in Monopoly, P>MC and the firm is producing above the lowest point on the ATC curve. Consumers don’t mind that they are inefficient as they like differentiation).
In the long run, a firm in monopolistic competition must be producing a level of output less than the output at which ATC reaches its lowest point, the productive inefficiency in monopolistic competition takes the form of excess capacity, measured by the difference between QI (profit maximisation output) and Q2 (the productivity efficient level of output).
However, as in perfect competition, long-run profit maximisation and freedom of entry in monopolistic competition mean that firms are forced to produce on their AC curves. They must eliminate any unnecessary costs; otherwise, they will fail to make normal profits.
At the same time, product differentiation increases the range of choices available to the consumer which improves economic welfare.
Kelvin Lancaster argued that the number of differentiated products increases until the gain to consumers in choice from adding one or more products to the market exactly equals the loss resulting from having to produce less of the existing products at a higher cost.
Therefore monopolistic competition does not necessarily result in economic waste. Consumers may prefer the wider choice available in monopolistic competition to an improvement in productive efficiency that alternative market structures might provide.

Question 40

How does informative advertisement increase competition?

Answer 40

Provides consumers and producers with useful information about goods and services.

Question 41

How does persuasive advertisement reduce competition?

Answer 41

Customers become “captive customers” who are unwilling to pay for a cheaper substitute good.
Little information about the good is provided e.g. price so focus on how ownership or the use of the product will improve the consumer’s feelings of self-worth and/or the image portrayed to other people.
Demand curve is less elastic for a product.

Question 42

What is saturation advertising?

Answer 42

Prevents small firms entering the market because they cannot afford the minimum level of advertising and other forms of promotion for their goods which are necessary to persuade retailers to stock their products.

Question 43

What is mass advertising?

Answer 43

Crowd out newcomers from the market place e.g. supermarkets are often unwilling to stock goods produced by new entrants to the market because their products are insufficiently advertised.

Question 44

What are examples of monopolistic competition?

Answer 44

Clothing shops, restaurants, make-up industry (partial substitutes as they offer different kinds of the same products),

Question 45

What is price discrimination?

Answer 45

When a firm charges different prices to different groups of consumers for an identical good or service, for reasons not associated with costs of supply.
Occurs in all imperfectly competitive markets (monopoly and oligopoly).
Must be able to identify and separate groups of consumers- they will have different PEDs- this enables them to charge higher prices to those with inelastic demand and lower prices to those with elastic demand thereby maintaining revenue. e.g. 5:30 AM-9:30 AM peak time for trains- inelastic demand as consumers going to work and school don’t have a choice.
Markets must be separated to prevent “seepage”.

Question 46

What are examples of price discrimination?

Answer 46

Social tariffs- price discriminating based on their income e.g. BT broadband offers half price to millions.
Prescriptions- free for anyone under 18 or receiving benefits and the rest have to pay.
Bohoo selling the same clothes at different prices
Tesco Clubcard offers special offers

Question 47

What are the main aims of price discrimination?

Answer 47

Increased revenue- extracting consumer surplus and turning it into increased producer surplus for the seller.
Higher profits- total profit will rise providing the marginal profit from selling to extra consumers is positive.
Using spare capacity- more efficient.

Question 48

What is 1st degree price discrimination?

Answer 48

Charge each individual consumer the maximum price that they are willing to pay.
e.g. broadband, builders, plumbers assess your house, international students.

Question 49

What is 2nd degree price discrimination?

Answer 49

Charging different prices depending upon quantity bought, time period, use of coupons.
e.g. supermarkets, free delivery online at 5:00 AM- running out of time- panic buy.

Question 50

What is 3rd degree price discrimination?

Answer 50

Charging different prices to groups of people with a different price elasticity.
e.g. fish and chips, barbers, trains, holiday companies, cinema pricing, student discounts, car insurance.

Question 51

Is engaging in 1st degree price discrimination always easy or a cost-free process?

Answer 51

How do you know what the maximum price all consumers are willing and able to pay (difficult to ascertain)- asymmetric information means the producer doesn’t know how much the consumer is willing to pay.
Negotiation is time-consuming.
How good are the staff to negotiate.
Only works if you prevent consumers from sharing information.

Question 52

Is price discrimination harmful for social welfare?

Answer 52

Bad reputation for the firm.
Extracting all consumer surplus (have to pay the maximum for every product).
Benefits low-income groups (progressive) e.g. social tariffs.
In theory, if firms make more profit they can use it to benefit society e.g. giving to charity.
Profits can be used to improve products which benefits society.
Loss of allocative efficiency (P=MC)
Widespread of AI drives price discrimination leading to certain groups in society consistently paying more.

Question 53

What is consumer surplus?

Answer 53

Difference between the price consumers are willing and able to pay for goods and services and the price they actually pay.
Shown by the area under the demand curve and above the market price.

Question 54

What is producer surplus?

Answer 54

Difference between the price producers are willing and able to supply a good or service for and the price they actually receive.
Shown by the area above the supply curve and below the current market price.

Question 55

What is the consumer and producer surplus in monopoly diagram?

Answer 55

Originally, free market equilibrium at point A where supply=demand, where the output is Q1.
However, monopolies do not supply at the market equilibrium, rather than choosing to produce at the output where MC=MR, to profit maximise, so output is only Q2 and price rises to P2.
We therefore see consumer surplus fall.
The monopolistic gains some of this consumer surplus.
Over and above this transfer from consumer to producer, however, there is an overall net loss of economic welfare caused by the fact that there is an output less than the market equilibrium. (Q1 falls to Q2)
This is known as “deadweight loss”- the less of economic welfare when the maximum attainable level of total welfare fails to be achieved. The loss of consumer and producer surplus shows this. The deadweight loss is evidence of market failure in monopoly.

Question 56

What is a contestable market?

Answer 56

One in which new entrants can easily enter and compete with established firms, even if those firms have significant market share e.g. barbers, fish and chips, and cleaning services.
The threat of new competitors entering the market keeps existing firms on their toes, spurring them to be more efficient and competitive, and ultimately leading to lower prices and better products for consumers.

Question 57

What are the key elements of a contestable market?

Answer 57

Low barriers to entry
Freedom of exit
Perfect information
No sunk costs

Question 58

What is a non-contestable market?

Answer 58

Essentially a monopoly.

Question 59

What is hit and run competition?

Answer 59

When a business enters an industry to take advantage of temporarily high supernormal profits.
Happens in markets with low sunk costs.
Enter the market to make quick profits.
Easily exit
e.g. trendy clothing

Question 60

What are examples of markets that have become more contestable in recent years?

Answer 60

Fast food industry (don’t necessarily need a restaurant to deliver fast food now due to delivery apps).
Hotel/room sharing sector (now book online- easier)
City Transport services (before you had to wait/call for an established taxi now there are Uber and Bolt)
Shaving products (before large established shaving companies sold now boxes can be posted to people which is cheaper)
Bookselling (before you have to get an established publisher to publish and stock your book now you can publish for free online e.g. eBooks)

Question 61

What can help make a market more contestable?

Answer 61

Lowering legal barriers to entry such as reform of patents (legal protection on your intellectual property) allowing more operating licenses. You can do this by weakening it so it’s not as specific or making it last shorter. e.g. UK parcel delivery market (removed legal monopoly on parcel delivery, Monzo bank (online-only bank).
Impact of new technologies (e-commerce) which make it easier for small firms to enter- innovative digital entrants can scale quickly e.g. Etsy, eBay.
Trade agreements (making imports cheaper) make it easier for competition from imports.
Entrepreneurial zeal (enthusiasm) can make a difference e.g. Brewdog- fast becoming a challenger to established industrial firm.

Question 62

What are the key aspects of a contestable market?

Answer 62

It is not the number of firms that is important, but the ease by which new firms can enter the market.
There is always the threat of hit and run entry from a challenger.

Question 63

How might the behaviour of firms be different in a contestable market?

Answer 63

Threat of potential competition
Existing firms might choose limit pricing over profit maximisation
Focus on non-price competition e.g. Waitrose advertise quality. Non entrants might go for sales maximisation growth.

Question 64

To what extent will a highly contestable market lead to economic efficiency?

Answer 64

Lower prices (improve allocative efficiency)
Incentives for firms to cut costs (minimise waste)
Incentives for firms to innovate (dynamic efficiency) but how are they going to innovate if they are only making normal profit?
Scope for economies of scale.