Perfect Competition, Imperfectly Competitive Markets and Monopoly Flashcards
The Spectrum of Competition
- Perfect competition
- Monopolistic competition
- Oligopoly
- Monopoly
How to distinguish between different market structure
- Number of farms in the market (competitiveness)
- The degree of product differentiation. (The more differentiated the products,
the less competitive the market) - Ease of entry into the market
- The degree to which perfect knowledge exists in the market
- The degree to which the actions of firms are independent of each other or interdependent
Profit Maximisation
MR=MC
Reasons for the consequences of a divorce of ownership from control
- The principle-agent problem
- When an owner of a firm sells shares, they lose some of the control they had over
the firm - When a manager sells their shares, shareholders gain more control over the
decisions of the firm. This could give rise to ‘shareholder activism’
Other possible objectives of a firm
- Survival (e.g. 2008 financial crisis)
- Growth
- Increasing their market shares
- Quality
- Maximise sale revenue (MR=0)
The Satisficing Principle
a decision-making process in which an individual or organization settles for a satisfactory solution rather than striving for the optimal solution. e.g. enough profit to keep shareholders happy
Perfect competition profit in short/ long run
In the short run, firms can make supernormal profits. In the long run where profits are competed away, only normal profits are made.
Implications for firms and the industry of perfect competition
Large numbers of producers
Identical products
Freedom of entry and exit
Perfect knowledge
Price takers
Firms operating in perfect competition are price…
takers
Efficiency’s Golden Child (Perfect Competition)
Productive Efficiency: Firms operate at the minimum efficient scale, minimizing production costs and ensuring output at lowest per-unit cost.
Allocative Efficiency: The market price equals the marginal cost of production, meaning consumers pay exactly what it costs to produce the last unit, reflecting true social value.
No Deadweight Loss: Efficient allocation minimizes societal waste and maximizes consumer surplus (the difference between what consumers are willing to pay and what they actually pay).
Characteristics of monopolistically competitive markets
Many firms, but not as many as in perfect competition.
Products are similar, but not identical - they have some differentiation, like branding or slight differences in features.
Firms have some control over price, but not as much as in a pure monopoly.
Entry and exit are somewhat easier than in monopolies, but not as easy as in perfect competition.
Monopolistically competitive markets will be subject to…
Non-price competition
Main characteristics of an oligopoly
- Few Dominant Firms
- Interdependent
- Significant barriers to entry
- Non-price competition
Concentration ratio
The concentration ratio of a market is the combined market share of the top few
firms in a market
Collusive oligopoly (cartel)
where firms enter into agreements with each other (collude) in order to reduce the uncertainty that comes from interdependence. The market ends up acting like a pure monopoly (restricting output, raising prices/profits and restricting choice) but without the potential benefits of monopoly such as greater economies of scale or the incentive to be more dynamically efficient.
Non-collusive oligopoly
where firms do not enter into agreements with each other (do not collude)
Difference between cooperation and collusion
Cooperation is allowed in the market, whilst collusion is not. Collusion is usually with
poor intentions, whilst cooperation will be beneficial
A Cartel
is a group of two or more firms which have agreed to control prices, limit
output, or prevent the entrance of new firms into the market. A famous example of
a cartel is OPEC, which fixed their output of oil. This was possible since they
controlled over 70% of the supply of oil in the world.
Price Leadership
when one firm changes their prices, and other firms follow.
This firm is usually the dominant firm in the market. Other firms are often forced
into changing their prices too, otherwise they risk losing their market share.
Price Wars
When firms constantly cutting their prices below that of its competitors
Barrier to Entry
Firms might try to drive competitors out of the industry in order to
increase their own market share. Barriers to entry are designed to prevent new firms
entering the market profitably. This increases producer surplus.
Game theory
(used to illustrate interdependent decision making in oligopolistic markets and the uncertainty that arises from it, the incentive to collude and the incentive to cheat on collusive agreements)
Prisoners Dilemma
a model based around two
prisoners, who have the choice to either confess or deny a crime. The consequences
of the choice depend on what the other prisoner chooses.
The dominant strategy is the option which is best, regardless of what the other
person chooses. This is for both prisoners to confess, since this gives the minimum
number of years that they have to spend in prison. It is the most likely outcome.
This is still higher than if both prisoners deny the crime, however. If collusion is
allowed in this dilemma, then both prisoners would deny. This is the Nash
equilibrium.
Nash equilibrium
a concept in game theory which describes the optimal strategy
for all players, whilst taking into account what opponents have chosen. They cannot
improve their position given the choice of the other.
Advantages of an Oligopoly
- Oligopolies can earn significant
supernormal profits, so they might invest
more in research and development. This
can yield positive externalities, and make
the monopoly more dynamically efficient
in the long run. There could be more
invention and innovation as a result.
Moreover, firms are more likely to
innovate if they can protect their ideas.
This is more likely to happen in a market
where there are high barriers to entry. - Higher profits could be a source of
government revenue. - Industry standards could improve. This is
especially true in the pharmaceutical
industry and for car safety technology.
This is because firms can collaborate on
technology and improve it. It saves on
duplicate research and development. - Since oligopolies are large, they can
exploit economies of scale, so they have
lower average costs of production.
Disadvantages of Oligopoly
- The basic model of oligopoly suggests
that higher prices and profits and
inefficiency may result in a misallocation
of resources compared to the outcome
in a competitive market - If firms collude, there is a loss of
consumer welfare, since prices are raised
and output is reduced. - Collusion could reinforce the monopoly
power of existing firms and makes it
hard for new firms to enter. The absence
of competition means efficiency falls.
This increases the average cost of
production.
Monopoly
when one firm dominates the market with more than 25% market share
Monopoly power is influenced by factors such as…
- High barriers to entry e.g. economies of scale, limit pricing, owning a resource, sunk/ set up costs, brand loyalty
- Number of competitors
- Advertising
- The degree of product differentiation
Advantages of a monopoly
- Monopolies can earn significant
supernormal profits, so they might invest
more in research and development. This
can yield positive externalities, and make
the monopoly more dynamically efficient
in the long run. There could be more
invention and innovation as a result.
Moreover, firms are more likely to
innovate if they can protect their ideas.
This is more likely to happen in a market
where there are high barriers to entry, such as in a monopoly - If there is a natural monopoly, it might be
more efficient for only one firm to
provide the good or service, since having
duplicates of the same infrastructure
might be wasteful. For example, it might
be considered inefficient and wasteful to
have two lots of water suppliers. - Monopolies could generate export
revenue. For example, Microsoft
generates a lot of export revenue for
America. - Since monopolies are large, they can
exploit economies of scale, so they have
lower average costs of production. - High profits could be a source of
government revenue through taxation.
Disadvantages of monopoly
- The basic model of monopoly suggests
that higher prices and profits and
inefficiency may result in a misallocation
of resources compared to the outcome
in a competitive market. - Monopolies could exploit the consumer
by charging them higher prices. This
means the good is under-consumed, so
consumer needs and wants are not fully
met. This loss of allocative efficiency is a
form of market failure. - Monopolies have no incentive to
become more efficient, because they
have few or no competitors, so
production costs are high. - There is a loss of consumer surplus and a
gain of producer surplus. If a monopolist
raises the market price above the
competitive equilibrium level, output will
fall from Q1 to Q2. This leads to gains in
producer surplus. - Consumers do not get as much choice in
a monopoly as they do in a competitive
market.
Price discrimination
occurs in a monopoly, when the monopolist decides to charge different groups of consumers different prices, for the same good or service. This is not for cost reasons
Conditions necessary for price discrimination
- The ability to identify different groups in the market e.g. age, time and geography.
- The ability to keep the different groups separate AT LOW COST
- Differences in price elasticity of demand between markets
Examples of Price Discrimination
- First Degree or Perfect Price Discrimination- when each consumer is charged a different price. For example, a lawyer might charge a high income family
more than a low income family. - Second degree price discrimination- is when prices are different according to
the volume purchased e.g. airline last seats. - Third degree price discrimination- is when different groups of consumers are
charged a different price for the same good or service e.g. children v adults
Consumer welfare impacts from price discrimination
Costs:
-Consumer surplus is reduced for those paying the higher prices, since P>MC loss of allocative efficiency
-It strengthens the monopoly power of firms, which could result in higher prices in the long run for consumers.
Benefits:
-Consumers could benefit from a net welfare gain as a result of cross subsidisation, if they receive a lower price.
-Good examples to use here might include legal and medical services where charges are dependent on income levels. Greater access to these services may yield external benefits (positive externalities) which then have implications for the overall level of social welfare and the equity with which scarce resources are allocated. Educational rates for some products/services would be another good example of this.
The impact of producer welfare impacts from price discrimination
Costs:
-Price discrimination might also be used as a predatory pricing tactic - setting prices below cost to certain customers - to harm competition at the supplier’s level and thereby increase a firm’s market power. This type of anti-competitive practice is difficult to prove, but would certainly come under the scrutiny of the UK and European Union competition authorities.
Benefits:
-A discriminating monopoly is extracting consumer surplus and turning it into extra supernormal profit.
- Make better use of spare capacity
- If more profits are made in one market, a different market which makes losses could be cross subsidised, especially if it yields social benefits. This will limit or prevent job
losses, which might result from the closure of the loss-making market.
Short-run and long-run benefits which are likely to result from
competition
- In the long run, firms are likely to be more productively and allocatively efficient.
This is because they provide the goods and services that consumers want, and
competitive pressure forces them to lower their costs of production. - In the short run, firms might make supernormal profits, which can be reinvested back into the firm. This can increase dynamic efficiency and lower LRAC.
- Consumers get a wide variety of choice due to the number of firms in the market.
Goods and services are likely to be of a higher quality, since firms are trying to gain
consumer loyalty
Firms do not must compete on price. Firms might also aim:
- Improve products/ service(quality)
- Reduce costs
Creative destruction
Schumpeter, an economist, proposed the idea of ‘creative destruction’. This is the
idea that new entrepreneurs are innovative, which challenges existing firms in the market. The more productive firms then grow, whilst the least productive are forced to leave the market. This results in an expansion of the economy’s productive
potential.
Contestable markets
there are no entry or exit barriers, no sunk costs and where both incumbent firms and new entrants have access to the same level of technology
Implications of contestable markets
- More likely to become allocative efficient
- The threat of new entrants affects firms just as much as existing competitors
- There could be supernormal profits in the short run and only normal profits in the
long run
Sunk Costs
They are costs which cannot be recovered one they have been spent e.g. advertising
Hit-and-run competition
when firms enter and exit the market quickly, selling their product for a short period of time and then leaving.
Static efficiency
the level of efficiency at one point in time. Productive and allocative efficiencies are examples of static efficiency.
Dynamic efficiency
is concerned with new technology and increases in productivity, which causes efficiency to increase over a period of time
Conditions required for productive efficiency
Productive efficiency occurs when firms minimise their average total costs.
This is when firms produce at the lowest point on the average cost curve. Since the
MC curve cuts the AC curve at the lowest point, MC = AC is a point of productive
efficiency. All points on the PPF curve are productively efficient.
Conditions required for allocative efficiency
Allocative efficiency occurs when resources are distributed to the goods and services
that consumers want. This maximises utility. It exists at P = MC, which means that
consumers pay for the value of the marginal utility they derive from consuming the good or service. Free markets are considered to be allocatively efficient.
Dynamic efficiency is influenced by
research and development,
investment in human and non-human capital and technological change
Consumer surplus
This is the difference between the price the consumer is willing and able to pay and
the price they actually pay
Producer surplus
This is the difference between the price the producer is willing to charge and the
price they actually charge.
