Module 7 - Perfect Competition And Monopoly

Question 1

Perfect Competition

Answer 1

A market structure in which there are many firms; where there is freedom of entry to the industry; where all firms produce an identical product; and where all firms are price takers.

Question 2

Monopolistic Competition

Answer 2

A market structure where, like perfect competition, there are many firms and freedom of entry into the industry, but where each firm produces a differentiated product and thus has some control over its price.

Question 3

Oligopoly

Answer 3

A market structure where there are few enough firms to enable barriers to be erected against the entry of new firms.

Question 4

Monopoly

Answer 4

A market structure where there is only one firm in the industry.

Question 5

Imperfect Competition

Answer 5

The collective name for monopolistic competition and oligopoly.

Question 6

Factors that determine the market power of a firm

Answer 6

1. Number of firms in the industry
2. Freedom of entry into and exit from the industry
3. Nature of the product
4. Degree of control the firm has over the price (and the implications of this for the firm’s demand curve)

Question 7

Four assumptions under perfect competition

Answer 7

1. Firms are price takers.
2. There is complete freedom of entry into the industry.
3. Firms produce an identical (homogeneous) product.
4. Producers and consumers have perfect knowledge of the market. (producers are fully aware of prices, costs, technology and market opportunities. consumers are fully aware of price, quality and availability of the prodict.)

Question 8

Short run under perfect competition

Answer 8

The period during which there is too little time for new firms to enter the industry.

Question 9

Long run under perfect competition

Answer 9

The period of time which is long enough for new firms to enter the industry.

Question 10

Economic efficiency

Answer 10

Economic efficiency is achieved when:

• Output is produced at the minimum cost (productive efficiency)
• Consumers get maximum benefit from their income (allocative efficiency)

Question 11

Productive efficiency

Answer 11

A situation where firms are producing the maximum output for a given amount of inputs, or producing a given output at the least cost.

Question 12

Allocative efficiency

Answer 12

A situation where the current combination of goods produced and sold gives the maximum satisfaction for each consumer at their current levels of income.

Question 13

Social optimum

Answer 13

The level of output at which allocative efficiency is achieved.

Question 14

Discuss the extend to which perfect competition is economically efficient

Answer 14

Firms operating under perfect competition must be:

• efficient in order to survive
• ready to respond if competitors:
  
  1. adopt more efficient production methods
  2. develop new products

The consumer benefits from allocative efficiency and to some extend productive efficiency. In addition, in the long run, only normal profits are earned, so prices are reasonable and consumers are not exploited.

Question 15

Describe the main features of a monopoly

Answer 15

In principle, a monopoly is an industry with only one firm. However whether an industry is classed as a monopoly in practice depends on the breadth of the definition of the industry. Since the definition is somewhat arbitrary, the level of monopoly power may be deemed to be more important.

Question 16

Natural monopoly

Answer 16

A situation where long run average costs would be lower if an industry were under monopoly than if it were shared between two or more competitors.

Question 17

Describe the barriers to entry that may exist

Answer 17

Natural barriers to entry:

1. Economies of scale
2. Economies of scope
3. Lower costs for an established firm

Strategic barriers to entry:

1. Product differentiation and brand loyalty
2. Ownership or control over key inputs or outlets
3. Threat or merger / takeover
4. Retained profits and aggressive tactics

Legal production can be classed as natural (licence) or strategic (patent)

Question 18

Explain how monopolists determine price and output

Answer 18

A monopolist:

• is a price maker, i.e it can choose the price it charges
• will set price and output to maximise profits (MR = MC)

Question 19

Discuss how much profit may be made by a monopolist

Answer 19

A monopolist can make supernormal profits in both the short run and the long run because of barrier to entry.

Question 20

Competition for corporate control

Answer 20

The competition for the control of companies through takeover.

Question 21

Network economies

Answer 21

The benefits to consumers of having a network of other people using the same product or service.

Question 22

Compare perfect competition and monopoly in terms of price and output levels

Answer 22

All other things being equal:
1. A monopolist will produce at a lower output and a higher price in the short run - a monopolist will produce at MR = MC, and the price will be AR; firms under perfect competition will set price equal to MC and the industry will produce where MC = AR

2. A monopolist may also produce at a lower output and a higher price in the long run - firms under perfect competition will produce at the bottom of their LRAC curves; a monopolist is not forced to produce at this level.

Question 23

Compare perfect competition and monopoly in terms of economic efficiency

Answer 23

Productive efficiency:
Firms in perfect competition produce at minimum average cost in the long run, whereas monopolist in general do not.
Monopolists have less incentive to be efficient, because they are protected by barriers to entry and will survive even if they are inefficient. However, monopolists may have greater ability to maximise efficiency.

Allocative efficiency:
Under perfect competition, firms produce at the social optimum level. Under monopoly, the firm produces less than the social optimum output level. (A state-owned monopoly may choose to produce at the social optimum)

Question 24

Perfect contestable market

Answer 24

A market where there is free and costless entry and exit.

Question 25

Describe how price and profit are affected in a perfectly contestable market

Answer 25

The moment the possibility of earning supernormal profits occur, new firms will enter, thus driving profits down to a normal level. Therefore this will ensure that the firm already in the market will keep its prices down, so that it just makes normal profits.

Question 26

Describe how efficiency is affected in a perfectly contestable market

Answer 26

The firm already in the market will produce as efficiently as possible, taking advantage of any economies of scale and any new technology. If the existing firm did not do this, entry would take place and potential competition would become actual competition.

Question 27

Distinguish between actual competition and potential competition

Answer 27

The theory of contestable markets argues that what is crucial in determining the price and output is not whether an industry is actually a monopoly or competitive, but whether there is the real threat of competition.

Question 28

State the importance of costless exit in perfectly contestable markets

Answer 28

If the losing firm exits the industry with capital equipment that it cannot use, then it is said to have sunk costs. This may deter the firm from entering in the first place, the market is not perfectly contestable and the established firm can make supernormal profit.

Question 29

Discuss the strengths/limitations of the theory of contestable markets

Answer 29

Simple monopoly theory merely focuses on the existing structure of the industry and makes no allowance for potential competition. The theory of contestable markets, however, goes much further and examines the size of entry barriers and exit costs.
One criticism of the theory is that it does not take sufficient account of the possible reactions of the established firm.
If a monopoly operates in a perfectly contestable market, it might bring the ‘best of both worlds’ for the consumer. Not only will it be able to achieve low costs through economies of scale, but also the potential competition will keep profits and hence prices down.