Section 4 - Competitive and Concentrated Markets Flashcards
Model of Perfect Competition
>The model of perfect competition is a description of how a market would work if certain conditions were satisfied.
>It is a theoretical market - there are no real markets that work exactly like this.
What conditions are satisfied in a perfectly competitive market - list
- There’s an infinite number of suppliers and consumers.
- Consumers have perfect information - i.e. perfect knowledge of all goods and prices in a market.
- Producers have perfect information - i.e. perfect knowledge of the market and production methods.
- Products are identical (homogeneous).
- There are no barriers to entry and no barriers to exit.
- Firms are profit maximisers.
What conditions are satisfied in a perfectly competitive market - there’s an infinite number of suppliers and consumers
>Each of these suppliers is small enough that no single firm or consumer has ‘market power’ (so all firms have 0% concentration).
>Each firm is a ‘price taker’ - this means they have to buy or sell at the current market price.
What conditions are satisfied in a perfectly competitive market - consumers have perfect information
>Every consumer decision is well-informed - consumers know how much every firm in the market charges for its products, as well as all the details about those products.
What conditions are satisfied in a perfectly competitive market - producers have perfect information
>No firm has any ‘secret’ low-cost production methods, and every firms knows the prices charged by every other firm.
What conditions are satisfied in a perfectly competitive market - products are identical.
>Homogeneous.
>So consumers can always switch between products from different firms (i.e. all the products are perfect substitutes for each other).
>This also means there’s no branding since branding differentiates products.
What conditions are satisfied in a perfectly competitive market - there are no barriers to entry or exit
>New entrants can join the industry very easily.
>Existing firms can leave equally easily.
What conditions are satisfied in a perfectly competitive market - firms are profit maximisers
>So all the decisions that a firm makes are geared towards maximising profit.
>This means that all firms will choose to produce at a level of output where MC=MR.
What does perfect competition usually lead to?
>Allocative Efficiency.
What do the conditions for perfectly competitive market ensure?
>The conditions for a perfectly competitive market ensure that the rationing, signalling and incentive functions of the price mechanism work perfectly. In particular:
- all firms are price-takers (‘the market’ sets the price according to consumers’ preferences, rationing resources and signalling priorities).
- consumers and producers have perfect knowledge for the market, and there are no barriers to entry or exit (so firms can recognise and act on incentives to change their output level of enter/leave a market.)
Supply and demand diagram - perfect competition
>In perfect competition, a market’s demand curve = marginal utility, because consumers demand reflects what that good is worth to them and that decreases as quantity increases due to the law of diminishing marginal utility.
>Also , a market’s supply curve = marginal cost because producers’ marginal costs increase as quantity increase due to the law of diminishing returns.
Perfect competition - allocative efficiency
>Allocative efficiency occurs when a good’s price is equal to what consumers want to pay for it, and this happens in a perfectly competitive market because the price mechanism ensures that producers supply exactly what consumers demand. So, P=MC or P=MU.
>Without perfect competition, a market can’t achieve allocative efficiency.
Demand = Marginal Utility
Supply = Marginal Cost
Where forces of demand and supply determine equilibrium, equilibrium price and quantity will be there MU = MC
If there are externalities, perfect competition may not be allocatively efficient, if the long run equilibrium is price is equal to the marginal private cost.
Allocative efficiency and externalities - perfect competition
>Perfectly competitive markets will achieve allocative efficiency, assuming that there are no externalities.
>Strictly speaking, AE occurs when P=MSC.
>Perfect competition results in a long run equilibrium where P=MPC.
>But if there are negative externalities, say then MPC
Perfect competition - supernormal profits
>In perfect competition, no firm will make supernormal profits in the long run.
>This is because any short-term supernormal profits attract new firms to the market (since there are no barriers to entry). This means supernormal profits are ‘competed away’ in the long term - i.e. firms undercut each other until all firms only make normal profit.
When do firms leave a market?
>A firm will leave a market if it’s unable to make a profit in the long run.
>If the market price (AR) falls below a firm’s average unit-cost (AC), the firm is making less than normal profit (i.e. a loss).
>There are no barriers to exit in a perfectly competitive market so in the long run the firm will just leave the market.
>However in the short run, there are 2 possibilities:
1. If the selling price (AR) is still above the firms average variable costs then the firm may continue to trade temporarily.
2. If the selling price (AR) falls below AVC then the firm will leave the market immediately.
Perfect competition and productive efficiency
>Productive efficiency is about ensuring the costs of production are as low as they can be. This means that prices to consumers can be low as well.
>In perfect competition, productive efficiency comes about as a direct result of all firms trying to maximise their profits.
>At the long run equilibrium of perfect competition, a firm will produce a quantity of goods such that:
-marginal revenue = marginal costs.
-output above this level (MC>MR) reduces profit, so firms wouldn’t produce it.
-output below this level (MR>MC) would mean the firm would earn more revenue from extra output than it would spend in costs - so the firm would expand output as this would increase profit.
>In a PC market, this long run output level is at the bottom of the AC curve - productively efficient.
>Having to compete gives firms a strong incentive to reduce waste and inefficieny i.e. they have to keep they level of ‘x-inefficiency’ as low as possible - if not, they may be forced to leave the market.
X-efficiency
>X-efficiency measures how successfully a firm keeps its costs down.
>X-inefficiency (or ‘organisational slack’) means that production costs could be reduced at that level of production.
Causes of x-inefficiency
- Using factors of production in a wasteful way (e.g. by employing more people than necessary).
- Paying too much for factors of production.
Perfectly competitive markets - why may they not be productively efficient?
>Perfectly competitive markets only achieve productive efficiency if you assume that there are no economies of scale in the industry.
>In a perfectly competitive market, there’s an infinite no. of firms.
>This means that each firm is very small, and so can’t take full advantage of economies of scale.
>If there are economies of scale, then an industry made up of an infinite number of very small firms may be less productively efficient than if there was one very big firm.
Perfect competition - dynamic efficiency
>Dynamic efficiency is about improving efficiency in the long term, so it refers to the willingness and eagerness:
a) to carry out R&D to improve existing products or develop new ones.
b) to invest in new technology or training to improve the production process and reduce production costs.
>However, these strategies involve considerable investment and therefore risk, so they will only take place if there’s adequate reward.
>Firms in a perfectly competitive market earn only normal profit, so there;s no reward for taking risks. This means dynamic efficiencies will not be achieved.
>However, as long as a market is towards the ‘perfect-competition end’ of the spectrum then firms can achieve a degree of dynamic efficiency without becoming too allocatively and productively inefficient. This is why firms do achieve some degree of dynamic efficiency - in real life, no market is perfectly competitive.
perfect competition - static efficiency
>If allocative and productive efficiency are achieved at any particular point in time, this is called static efficiency.
>But static efficiency can’t last forever, since technology and consumer tastes change.
>For example, the methods used to make cars in the 1920s might have been AE and PE at the time, but they’d be hopelessly out of date now.
>To remain in AE and PE, car makers would have needed to invest in new production technology and design new models at some point.
‘Spectrum’ of market structures
>In a perfectly competitive market, all the goods produced are identical, so the only ways for firms to compete is on price.
>In practice, firms usually compete in other ways than on price - e.g. improved products, better quality, wider product range, advertising and promotion, nicer packaging, products that are easier to use.
>In the real world, markets fall somewhere on a ‘spectrum’ of different market structures.
>At one extreme are ‘perfectly competitive markets’, and at the other are ‘pure monopolies’ (where there’s no competition at all).
>Real-life markets lie somewhere between these extremes.
>The close an actual market matches the description of a perfectly competitive market, the more likely it is to behave in the same way.
Competition in markets
>Governments often try to encourage competition in markets.
>perfectly competitive markets lead to efficient long run outcomes in theory.
>By encouraging competition, governments hope to achieve these same kinds of efficiencies in real life. E.g. governments want to make sure firms:
1) are forced to produce efficiently, reducing costs where possible.
2) set prices at a level that’s fair to consumers.
>They also hope competition will encourage firms to innovate, leading firms to create both new products (giving more choice for consumers) and new production processes (allowing firms to reduce their costs further).
What policies can a government introduce to increase competition in the economy?
- Encourage new enterprises with advice and start-up subsidies.
- Increase consumer knowledge by ensuring that comparison information is available.
- Introduce more consumer choice and competition in the public sector. This might involve creating ‘internal markets’ in sectors such as health and schooling, for example.
- Privatise and deregulate large monopolistic nationalised industries.
- Discourage mergers and takeovers which might excessively reduce the number of competing firms.
- Encourage more international competition - e.g. by joining the EU, countries enter into a multinational ‘single market’.
Barrier to entry - definition
>A barrier to entry is any potential difficulty or expense a firm might face if it wants to enter a market.
What do barriers of entry determine?
>The ‘height’ if these barriers determines:
- how long it will take or how expensive it will be for a new entrant to establish itself in a market and increase the amount of competition.
- whether new entrants can successfully join the market at all.
Barriers to entry and firms already in the market
>Barriers to entry allow firms that are already in the market (called ‘incumbent’ firms) to make supernormal profits, before new entrants enter the market and compete these profits away.
>How long incumbent firms can make supernormal profit for depends upon:
-the height of the barriers to entry - i.e. how long the barriers can prevent new firms entering the market.
-the level of supernormal profit being earned - this is because the greater the profits to be made, the more effort new entrants will be willing to make to overcome the barriers.
How do barriers to entry vary between markets?
>perfectly competitive markets have no barriers to entry whatsoever.
>In a pure monopoly market the barriers to entry are total. No new firms can enter, so the monopolist remains the only seller.
How are barriers to entry created?
- The tendency (innocent or deliberate) of incumbent firms to create or build barriers.
- The nature of the industry leading to barriers over which incumbent firms and new entrants have little control.
- The extent of government regulation and licensing.
The overall barrier to entry into a market
>The overall barrier to entry into a market might be made up of a number of individual barriers:
- Barriers to entry due to incumbent firms actions.
- Barriers to entry can be due to the nature of an industry.
- Barriers to entry can be due to government regulations.
Barriers to entry due to incumbent firms’ actions
- An innovative new product or service can give a firm a head start over its rivals which can be difficult for a new entrant to overcome. If the new technology is also patented then other firms can’t simply copy the new design - it’s legally protected.
- Strong branding means that some products are very well known to consumers. The familiarity of the product often makes it a consumer’s first choice, and puts new entrants to a market at a disadvantage.
- A strong brand can be the result of a firm making genuinely better products than the competition, or can be created by effective advertising. The barrier to entry is the expense and difficulty a new entrant to the market would have in attracting customers away from the market leaders.
- Aggressive pricing tactics by incumbent firms can drive new competition out of the market before it becomes established. Incumbent firms may be able to lower prices to a level that a new entrant can’t match (e.g. due to economies of scale) and drive them out of business. This is sometimes called ‘predatory pricing’ (or ‘destroyer pricing’ or ‘limit pricing’).
- Just the threat of a ‘price war’ may be enough to deter new firms from entering a market.
Barriers of entry due to the nature of an industry
- Some ‘capital-intensive’ industries require huge amounts of capital expenditure before a firm receives any revenue (e.g. steel production, aeroplane production - require massive investment in sophisticated manufacturing plants). The cost of entering these markets is huge, so smaller enterprises may not be able to break through.
- If investments can’t be recovered when a firm decides to leave a market, then that may make any attempt to break into a market very risky and unappealing.
- If there’s minimum efficient scale of production then any new firms entering the industry on a smaller scale will be operating at a higher point on the AC curve than than established firms. This means any new entrant has higher production costs per unit, so they’d have to sell the product to consumers at a higher price.
Barriers to entry can be due to government regulations
>If an activity requires a licence, then this restricts the number and speed of entry of new firms coming into a market. E.g. pubs, pharmacists, food outlets, dentists and taxis. Similarly, in a regulated industry (e.g. banking), firms have to be approved by a regulator before they can carry out certain activities.
>New factories may need planning permission before they can be built.
>There will also be regulations regarding health and safety and working conditions for employees that firms will need to keep to.
Advantages of new entrants
>Not all new entrants to a market are small firms trying to compete against established ‘giants’.
>Sometimes the new entrants can be large successful companies that wish to diversify into new markets.
>Their large size means they have greater financial resources, so they may be more successful in breaking into new markets.
>E.g. when Virgin Money entered the banking sector, their large resources meant they could overcome barriers to entry - but they had to invest heavily and advertise extensively.
Pure monopoly - definition
>A monopoly (or ‘pure monopoly’) is a market with only one firm in it (i.e. one firm is the industry).
>A single firm has 100% of the market share.
Monopoly - definition
>In law, a monopoly is when a firm has 25% or more of the market share.
Monopoly power
>Even in markets with more than one seller, firms have monopoly power if they can influence the price of a particular good on their own - i.e. they can act as price makers.
>Even though firms with monopoly power are price makers, consumers can still choose whether or not to buy their products. So demand will still depend on the price - as always, the higher the price, the lower the demand will be.
What causes monopoly power?
>Monopoly power may come about as a result of:
- Barriers to entry preventing new competition entering a market to compete away large profits.
- Advertising and product differentiation - a firm may be able to act as a price maker if consumers think of its products as more desirable than those produced by other firms (e.g. because of a strong brand).
- Few competitors in the market - if a market is dominated by a small number of firms, these are likely to have some price-making power. They’ll also find it easier to differentiate their products.
Monopolists - supernormal profit
>A monopolist makes supernormal profits - even in the long run.
>This diagram shows how a firm behaves in a monopoly market.
1. Assuming that the firm wants to maximise profits, its level of output will be where MC=MR shown by the red dot.
2. If the firm produces a quantity Qm, the demand (AR) curve shows the price the firm can set - Pm.
3. At this output the AC of producing each unit is ACm.
4. The difference between ACm and Pm is the supernormal (excess) profit per unit. So the total supernormal profit is shown by the red area.
5. In a monopoly market, the barriers to entry are total, so no new firms enter the market, and this supernormal profit isn’t competed away.
6. This means the situation remains as it is - this is the long run equilibrium position.
Monopoly vs perfect competition diagram difference
>In perfect competition, a firm’s AR and MR are the same - they both equal the equilibrium price (which is set by the market not the firm).
>In a monopoly market, this isn’t true.
Monopolies - productively efficient
>The above diagram shows that MC isn’t equal to AC at the long-run equilibrium position for a monopoly (i.e. the firm isn’t operating at the lowest point on the AC curve).
>This means that a monopoly isn’t productively efficient.
Monopolies - allocatively efficient
>The diagram shows that the price charged by the firm is greater than MC. This means that a monopoly market is not AE. Producers are being ‘over-rewarded’ for the products they’re providing.
>Because of the restricted supply, the product will also be underconsumed - consumers aren’t getting as much of the product as they want.
>The red area shows how some of the consumer surplus that would have existed at the market equilibirum price Pc is transferred to the producer.
>There’s a DWL too. The grey area shows the potential revenue that the producer isn’t earning on the quantity Qm to Qc of the product that consumers would have been prepared to pay for but which isn’t produced.
Further drawbacks of monopolies
>There’s no need for a monopoly to innovate or to respond to changing consumer preferences in order to make more profit, so they may become complacent.
>Similarly, there’s no need to increase efficiency so x-inefficiency can remain high.
>Consumer choice is restricted since there are no alternative products.
>Monopsonist power may also be used to exploit suppliers.
Natural monopolies - causes
>Industries where there are high fixed costs and/or there are large economies of scale lead to natural monopolies.
>If there was more than one firm in the industry, then they would all have the same high fixed costs. This would lead to higher costs per customer than could be obtained by a single firm.
>In this case, a monopoly might be more efficient than having lots of firms competing .
>For example, the supply of water is a natural monopoly - it makes no sense for competing firms to all lay separate pipes.
Natural monopolies - info
>A natural monopoly will have continuous economies of scale.
>I.e. LRAC always falls as output increases (meaning MC is always below AC).
>A profit maximising natural monopoly will restrict output to where MC=MR.
>A government might be reluctant to break up a natural monopoly as this could reduce efficiency.
>However, it might want to provide subsidies to the natural monopoly so that it increases output to the point where demand (AR) = supply (MC). This reduces price from point of profit maximisation.
Potential benefits of monopolies
>A monopolist’s large size allows it to gain an advantage from economies of scale. If diseconomies of scale are avoided, this means it can keep AC (and perhaps prices) low. A monopolists will produce more than any individual producer in a perfectly competitive market would.
>The security a monopolist has in the market (as well as the supernormal profits) means it can take a long-term view and invest in developing and improving products for the future - this can lead to dynamic efficiency.
>Increased financial security also means that a monopolist can provide stable employment for its workers.
>Intellectual property rights (IPRs) allow a form of legal limited monopoly that can actually be in the consumers’ interests because they’ll benefit from better quality, innovative products.
IPRs
>Intellectual Property Rights.
>There are various types of IPRs, such as copyright and patents. These allow a firm exclusive use of their innovative ideas for a limited time.
>During this time, supernormal profits may be possible, but this is seen as the reward for innovation and creativity.
>Without the protection of IPRs, firms would have little incentive to risk their resources investing in innovative products or processes - other firms would simply be able to copy those ideas (and immediately start to compete away any supernormal profits).
Monopsony - definition
>A market with a single buyer.
>A monopsony is a situation when a single buyer dominates a market.
Monopsony - info
>A monopsonist can act as a price maker, and drive down prices.
>For example, supermarkets are sometimes accused of acting as monopsonists when buying from their suppliers. Some people claim supermarkets unfairly use their market power to force suppliers to sell their products at a price that means those suppliers make a loss.
>This could be seen as a monopsonist exploiting its suppliers. But it could be in the interests of consumers if the supermarkets pass on those low prices (by charging low prices to their customers).
>If a firm is the single buyer of labour in a market, it can exploit its power and lower the wages of its employees.
Price discrimination - definition
>Price discrimination means charging different prices to different customers for exactly the same product.
What conditions need to be satisfied for a firm to make use of price discrimination?
>The seller must have some price-making power (e.g. there might be barriers to entry preventing competition). So monopolies (and oligopolies) can price discriminate. Price-taking firms in a competitive market can’t practise price discrimination.
>The firm must be able to distinguish separate groups of customers who have different price elasticities of demand. In fact, the more groups that the market can be subdivided into, the greater the gains for the seller. And the cost of finding out this info needs to be lower than any potential gains.
>The firm must be able to prevent seepage - it must be able to prevent customers who have bought a product at a low price re-selling it themselves at a higher price to costumers who could have been charged more.
Examples of price discrimination
>Theatres + cinemas offer ‘concession’ prices for certain groups, e.g. students and pensioners.
>Window cleaners could charge more in a smart neighbourhood than in a lower-income area.
>Train tickets at rush hour.
>Pharmaceutical drugs in different countries.
Consumer surplus - definition
>A consumer surplus is the difference between the actual selling price of a product and the price a consumer would have been willing to pay.
Aim of price discrimination
>Price discrimination attempts to turn consumer surplus into additional revenue for the seller.
>Price discrimination transfers consumer surplus from consumer to producer.
Degrees of price-discrimination
>First degree/perfect
>Second degree
>Third degree
First-degree/perfect price discrimination
>First degree price discrimination is where each individual customer is charged the maximum they would be willing to pay.
>This would turn all the consumer surplus into extra revenue for the seller.
>However, the cost of gathering the required info to do this, and the difficulty in preventing seepage, makes this method unlikely to be used in practice.
Second-degree price discrimination
>Second-degree price discrimination is often used in wholesale markets, where lower prices are charged to people who purchase large quantities (i.e. price varies with Qd).
>This turns some of the consumer surplus into revenue for the seller, and encourages larger orders.
Third-degree price discrimination
>Third degree price discrimination is when a firm charges different prices for the same product to different segments of the market.
>E.g. a seller can identify 2 groups of customers with different price elasticities of demand.
>To maximise profit, the seller would set the price for each group at a level where MR=MC. This means:
-it will charge a higher price to the group with a more inelastic PED.
-it will charge a lower price to the group with a more elastic PED.
>The red areas represent the supernormal profit earned from each group. The total supernormal profit is greater than if the same price were charged to everyone.
Examples of different segments of the market in 3rd degree price discrimination
>Different ages - i.e. a leisure centre may have child, adult and pensioner prices.
>Customers who buy at different times.
>Customers in different places.
Pros of price discrimination
>Price discrimination certainly results in increased revenue for the seller.
>Whether this is seen as fair or unfair depends on what happens to that extra revenue.
Price discrimination - fair or unfair
>The use of price discrimination means that some or all of the consumer surplus is converted into revenue for the seller - i.e. the seller increases revenue at the expense of the consumer. However, the extra revenue could be used to improve products, or invested in more efficient production methods which might lead to lower prices.
>In all cases, the AR is greater than MC - so price discrimination doesn’t lead to allocative efficiency, because allocative efficiency occurs when P = MC.
>Consumers aren’t treated equally, but often people who end up paying more have higher income, so are more able to afford those higher prices. Some people see this as fair, especially if the greater profits made from some customers are used to subsidise lower prices paid by other (e.g. train passengers commuting to work pay high fares, and profits from these customers could be used to help support daytime services.)
Concentration ratios
>Some industries are dominated by just a few companies (even though there may be many firms in that industry overall). These are called concentrated markets.
>The level of domination is measured by a concentration ratio:
>n-firm concentration ratio = x/total market revenue x 100.
Oligopolies - intro
>You can define an oligopoly in terms of market structure.
>Or you can define an oligopoly in terms of the conduct of firms.
Oligopolies - market structure definition
>An oligopoly is a market:
- that’s dominated by just a few firms (i.e. a small no. of firms have a high concentration ratio).
- that has high barriers to entry (so new entrants can’t easily compete away supernormal profits).
- in which firms offer differentiated products (i.e. products will be similar but not identical).
Oligopolies - conduct of firms definition
>An oligopoly is a market:
- in which firms are interdependent (i.e. the actions of each firm will have some kind of effect on the others.)
- in which firms use competitive or collusive strategies to make this interdependence work to their advantage.
What can a firm in an oligopoly do?
>Firms in an oligopoly can either compete or collude.
>Unlike with perfectly competitive markets and monopolies, there’s no single strategy that firms in an oligopolistic market should adopt in order to maximise profits.
>Firms in an oligopoly face a choice about what kind of long-term strategy they want to employ, and each company’s decision will be affected by how the other interdependent firms in the market act.
>This means that there are different possible scenarios in an oligopolistic market:
1. Competitive behaviour
2. Collusive behaviour.
>The behaviour that occurs depends on the characteristics of a particular market.
>So 2 different markets may both be oligopolies but the behaviour of the firms involved in the 2 markets could be completely different.
Oligopolies - competitive behaviour
>This is when the various firms don’t cooperate, but compete with each other (especially on price).
>Competitive behaviour is more likely when:
1. One firm has lower costs than others.
2. There’s a relatively large number of big firms in the market (making it harder to know what everyone else is doing).
3. The firms produce products that are very similar.
4. Barriers to entry are relatively low.
Oligopolies - collusive behaviour
>This is when the various firms compete with each other especially over what prices are charged.
>Formal collusion involves an agreement between the firms - i.e. they form a cartel. This is usually illegal. Model of prisoner’s dilemma illustrates why these agreements sometimes break down.
>Informal collusion is tacit - i.e. it happens without any kind of agreement. This happens when each firm knows it’s in their best interests not to compete…as long as all firms do the same.
>Some firms in a collusive oligopoly might still be able to act as price leaders, setting the pattern for others to follow (i.e. if that firm changes its prices, other firms will do the same, so prices remain at similar levels to each other).
When is collusive behaviour more likely?
>Collusive behaviour is more likely when:
- The firms all have similar costs.
- There are relatively few firms in the market (so it’s easier to check what other firms are charging, etc.)
- ‘Brand loyalty’ means customers are less likely to buy from a different firm, even when their prices are lower.
- Barriers to entry are relatively high.
Collusive oligopolies
>Collusive oligopolies can produce results quite similar to those in a monopoly.
>Collusive oligopolies generally lead to there being higher prices and restricted output (and under consumption), as well as allocative and productive inefficiency. Firms in collusive oligopolies often have the resources to invest in more efficient production methods and achieve dynamic efficiency, but there’s not always an incentive for them to do so. So collusive oligopolies can lead to market failure.
>Because the firms in a collusive oligopoly don’t lower prices even though they could, they make supernormal profits at the expense of consumers.
>In the case where colluding firms have an agreement to restrict output to maintain high prices, the firms set a price (Po) and a level of output (Qo) that will maximise profits for the industry. They then agree output quotas - the level of output each of the firms will produce.
>Firms that collude on price may still compete in other ways though, so the firms’ marketing policies are very important.
>Other firms that try to break into the market may face predatory pricing tactics. Even so, if the potential profits are large enough, they may persevere until they eventually establish themselves. However, they may then see that it’s not in their interests to compete further - if so, collusion can re-emerge.
Collusive firms - competing on things other than price
>Firms that collude on price may still compete in other ways though, so the firms’ marketing policies are very important.
>For example, colluding firms may try to differentiate their products from their competitors’ - either by improving them in some way or by trying to create a strong brand to attract and retain customers.
>They could use sales promotions (e.g. ‘loyalty’ rewards for customers who make repeat purchases).
>They may even try to find new export markets.
Collusive oligopolies - pros/cons
>Some argue that collusive oligopolies are either:
1. Not as bad as they’re sometimes made to sound.
2. Unstable - i.e. they’re unlikely to last for long.
3. Both of the above.
>They argue that formal collusion is quite unlikely to occur because it’s usually illegal, and any informal collusion is likely to be temporary, because one firm will soon decide to ‘cheat’, and lower its prices to gain an advantage (called first-mover advantage). This kind of behaviour is likely to trigger a price war (and falling prices).
>Even in a collusive oligopoly:
-if firms aren’t competing on price, then non-price competition might even be stronger, leading to some dynamic efficiency. This would be good for consumers if it led to product innovations and improvements.
-firms are unlikely to raise prices to very high levels. This is because high prices may provide a strong incentive for new entrants to join the market, even if the barriers to entry are high.
>Competitive oligopolies can achieve high levels of efficiency.
Oligopoly - game theory
>In oligopolistic markets, each firm is affected by the behaviour of the others - the firms are interdependent.
>This means that the behaviour of firms in oligopolistic markets can be looked at as a king of mathematical game.
>Game theory is a branch of maths.
>It’s all to do with analysing situations where 2 or more ‘players’ are each trying to work out what to do to further their own interests.
>The fate of each of the players depends on their own decisions, and the decisions of everyone else. So all the players are interdependent. This is why it’s often used to analyse situations in economics.
>Game theory can be used to understand the results of interdependence.
>You can understand some outcomes from certain oligopolistic markets by ‘playing the game’ from each firm’s perspective.
>E.g. the model of the kinked demand curve illustrates why prices are often quite stable, even in some competitive oligopolies.
What shows price stability in oligopolistic markets?
>The kinked demand curve.
Oligopolies - Kinked demand curve - assumptions
>In the kinked demand curve model, there are 2 assumptions:
1. If one firm raises its prices, then the other firms will not raise theirs.
2. If one firm lowers its prices, then the other firms will also lower theirs.
>The result of the above assumptions is the kinked demand curve.
>The outcome is that firms have no incentive to change prices. If they either raise or lower prices, they will lose out as a result.
>The result is price stability for prolonged periods of time.
>Note that the firms are competing here - not colluding. Each firm would reduce prices if that would increase revenue…but it wouldn’t.
Oligopolies - Kinked demand curve - 1st assumption
- If one firm raises its prices, then the other firms will not raise theirs.
>The first assumption means that a firm which raises its prices will see quite a large drop in demand.
>This is because customers are likely to switch to buying their goods from other firms.
>In other words: when price is increased, demand is price elastic.
>So it makes sense for competing firms not to raise their prices because any firms that raise their price will lose out - the fall in demand will more than cancel out the gains from charging a higher price.
Oligopolies - Kinked demand curve - 2nd assumption
- If one firm lowers its prices, then the other firms will also lower theirs.
>The second assumption means that a firm which lowers it prices will not gain any market share (although the overall size of the market may increase slightly, given that all the firms will have lowered their prices).
>In other words: when price is decreased, demand is price inelastic.
>Any competing firms not reducing its prices will lose revenue since customers will buy elsewhere.
>This means any firm that reduces prices will lose out - they won’t gain market share but the average price of their products will have fallen.
Oligopolies - Kinked demand curve - limitations
>The kinked demand curve model shows just one type of interdependence.
>This means that it doesn’t explain the behaviour of firms in every oligopoly.
>The assumptions in the kinked demand curve model may not be appropriate for every oligopoly - and if they are not, the model won’t predict firms’ behaviour at all well.
>Other oligopolistic markets will be better described using different models.
Prisoner’s dilemma model
>The prisoners’ dilemma model can be used to understand how interdependent firms might act in an oligopolistic market.
>Suppose there are just 2 firms, A and B.
>Each firm has to decide what level of output to produce in their oligopolistic market situation.
>For simplicity assume each firm has 2 options:
1. produce high level of output
2. produce low level of output.
>Both firms know the other firm is also trying to decide what level of output to produce.
>And both firms know they are interdependent.
>The results from the firms’ different choices can be summarised using a payoff matrix.
>If firms cooperate and agree to restrict output, then the outcome is better for both firms than if they both output at a high level (they’ll flood the market, driving down price until it’s below the CoP). This works well IF they can both be trusted.
>However, it’s in the interests of each firm to stop cooperating and raise output - as long as they do this before the other firm decides to.
>This is because if one firm decides to ‘cheat’ and increase output to get a higher profit, then it’s actually in the other firms interest to keep producing at a low output level and take the reduced profit instead of raising output and forcing both firms to make a loss for example. This is an illustration of the first-mover advantage.
>The theory of first-mover advantage shows why cartels can be unstable - every firm knows they can get an advantage if they break the agreement because anyone else does.
Cons to first-mover advantage
>Different decisions will make sense in different situations - it all depends on the numbers in the payoff matrix (i.e. the potential profits and losses that each firm could make in various possible scenarios.
>E.g., suppose several firms are all deciding whether to launch a new type of product into the market:
-the ‘first mover’ could make a huge profit by winning a large market share very early.
-however, if they’ve overestimated the demand for the product, they make huge losses.
-also, competitors may be able to use a lot of technology that the first firm has developed, reducing their costs, and allowing them to charge a lower price than the first mover.
Monopolistic competition - intro
>Monopolistic competition (sometimes called imperfect competition) lies part-way along the range of market structures - between perfect competition and oligopolies.
>In monopolist competition, the conditions of perfect competition are ‘relaxed’ slightly.
>These ‘relaxed’ conditions are actually more typical of firms in real life. This means that the behaviour predicted in this model may also be more realistic.
Monopolistic competition - market conditions
>In monopolistic competition, the conditions of perfect competition are ‘relaxed’ slightly and instead become:
- Some product differentiation - either due to advertising or because of real differences between products:
- This means the seller has some degree of price-making power.
- So each seller’s demand curve slopes downwards.
- But the smaller the product differences, the more price elastic the demand for each product will be. - There are either no barriers to entry or only very low barriers to entry:
- This means that if very high supernormal profits are earned, new entrants can join the industry fairly easily.
Monopolistic competition - Short run
>In monopolistic competition, the barriers to entry and/or the product differentiation mean that supernormal profits can be made, but only in the short run.
>MC = MR, supernormal profits.
>Like a monopoly but the demand is likely to be more price elastic because there might be similar (substitute) products available.
Monopolistic competition - long run
>Unlike a monopoly, operating at MR=MC doesn’t last in the long run.
>In monopolistic competition, the barriers to entry are fairly low, so new entrants will join the industry. These new entrants will cause the established firm’s demand curve to shift to the left (since the overall demand is now split between more firms).
>New entrants will continue to join (and the established firm’s demand curve will continue to shift left) until:
-Only normal profit can be earned (P=AR=AC). At this point the slopes of the AC curve and the demand (or AR) curve touch tangentially. At this quantity, MR=MC.
>Since the firm is not producing at the lowest point on the AC curve, this outcome is not productively efficient.
>And since the equilibrium price is greater than MC, this is not allocatively efficient.
>But despite this, a monopolistically competitive market will generally achieve much greater efficiency levels than a monopoly market.
-
Monopolistic competition - transition from supernormal to normal profits
>The short run position of monopolistic competition is basically the same as in a monopoly. However, unlike in a monopoly, new entrants to the market will drive prices down until only normal profit is earned in the long run.
>How long this process takes is important.
>If it takes a very long time, the market will resemble a monopoly.
>But if it all happens relatively quickly, then the market will be more like a perfectly competitive market.
>This is why firms are often willing to spend large amounts of money to try to differentiate their product (e.g. by improving it or by advertising to create a strong brand). The longer a firm can retain its price-making power, the longer it can make supernormal profit.
Perfect vs monopolistic competition
>Unlike in perfect competition, in monopolistic competition the firm isn’t producing at the lowest point on the AC curve.
>These different positions on the AC curve mean that prices in monopolistic competition tend to be higher than in perfect competition.
>This is because in monopolistic competition firms need to spend money on differentiating their product (e.g. by advertising) and creating brand loyalty.
>There’s no need for advertising in perfect competition because consumers already have perfect knowledge and all products are identical so there’s no price differentiation.
>Firms in monopolistic competition have also chosen to restrict output in order to maximise profits. This means they don’t benefit from all the economies of scale that they could.
>Prices lower than monopoly seller generally.
>Works reasonably well in practice.
Monopolistic competition and dynamic efficiency
>The length of time it takes for new entrants to force all firms in monopolistic competition to only make normal profit is the length of time an incumbent firm can make supernormal profits.
>These supernormal profits are reward for risky production investment or product innovation.
>However, the lack of barriers to entry mean that firms are unlikely to invest huge amounts of money on new innovations - so there’s likely to be less dynamic efficiency in a monopolistically competitive market.
>In the long run, the absence of supernormal profit will mean there won’t be much money available for investment.
Contestability - meaning
>Contestability refers to how open a market is to new competition (i.e. potential competition), even if currently there’s little actual competition.
>A contestable market is open to new competitors.
Contestable market - intro
>In a contestable market:
-the barriers to entry and exit are low. So if excess profits are made by incumbent firms, new firms will enter.
-supernormal profits can potentially be made by new firms (at least in the short term).
>These factors mean that incumbent firms always face the threat of increased competition. Increased competition is more likely if the incumbent firms make supernormal profits, as new entrants will want some of those profits.
>This means incumbent firms have an incentive to set prices at a level that won’t generate vast supernormal profit.
Barriers to entry and contestability
>High barriers to entry/exit mean low contestability.
>Low barriers to entry make potential competition a genuine threat to incumbent firms. So anything that makes barriers higher makes a market less contestable.
When are barriers to entry high?
- There are patents on key products or production methods:
- patents give a firm legal protection against other firms copying its products or production methods. - Advertising by incumbent firms has already created strong brand loyalty.
- There’s a threat of limit pricing (i.e. predatory pricing) tactics by the incumbent firms:
- if new entrants fear a ‘price war’, then they may decide not to enter the market.
- this would be particularly difficult for new entrants if the incumbent firms had lower costs as a result of having been in the market for longer. - Trade restrictions are present (e.g. tariffs, quotas) - these don’t allow new foreign entrants to compete in domestic markets on equal terms with the incumbent firms.
- Incumbent firms are vertically integrated:
- this could mean that access to supplies of raw materials or distribution networks is difficult for new firms. - Sunk costs (barrier to exit) are high:
- costs are ‘sunk’ if they can’t be recovered when a firm leaves an industry.
- these costs might include investment in specialised equipment, or expenditure on advertising.
- if these sunk costs are high then the cost of failure is high, and potential new entrants may be deterred from even entering the market.
Contestable markets - tactics
>The low barriers to entry and exit in a contestable market can mean that new entrants will ‘hit and run’.
>Hit and run tactics:
-This means entering a market while supernormal profits are being made and then leaving the market once prices have been driven down to normal-profit levels.
>As long as the profit made while in the market is greater than the entry and exit costs, it’s worthwhile for a firm to compete…even for a short time.
>Firms can reduce sunk costs by leasing equipment rather than buying it.
Contestability and the behaviour of incumbent firms
>In a contestable market, it’s the threat of increased competition (as well as the actual competition from firms already in the market) that affects how incumbent firms behave.
>E.g. incumbent firms will know that high supernormal profits (which will maximise short-term profits) are likely to attract new entrants, and that these new entrants are likely to drive down prices.
>So it might make more sense for the incumbent firms to satisfice some short-term profits, and set lower prices to avoid attracting new entrants. This may be the best way to maximise profit in the long run.
>Incumbent firms have an interest in creating high barriers to entry if they can.
>This could involve heavy spending on advertising or making it clear they would be prepared to engage in predatory pricing if new firms entered the market (although have to be careful not to break law).
>But in the long run, firms in contestable markets will move towards productive and allocative efficiency, because supernormal profit is competed away and firms must settle for normal profit.
Can barriers to entry change
>Barriers to entry to an industry aren’t fixed for all time.
>Technological change can raise or lower barriers to entry.
What are the main differences in market structure?
Number of sellers
Barriers to entry
Types of products sold
How do you go about defining a market structure?
What is the relative market power of firms?
How similar is each firm’s product?
How difficult is it for new firms to enter?
What do firms compete with each other on (price, quality etc)?
What are the different types of market structure?
Monopoly:
One seller with price setting power
Holds all market power
Monopolistic competition:
Many sellers with some price-setting power
Oligopoly:
Few sellers with high price-setting power
Perfect competition:
Many, many sellers with little to no price-setting power.
Do firms always aim to maximise only profit?
Not always, as it is not always possible for a firm to focus primarily on profit maximisation.
When do firms start to maximise profit?
Firms maximise profit when MR = MC
Extra units from here will have a negative impact on revenue.
This is due to diminishing marginal returns. At this point, MC will be higher than marginal revenue past this point.
How can they focus on making a profit in the long run?
Before a firm can do this, they may have to achieve a number of other objectives first.
E.g. survival, market share, gain revenue in short term at the expense of profit.
Amazon has made little profit in the last 10 years as they’ve focused on maximising market share.
What is the opportunity cost of not using profit?
Firms have several options regarding what to do with these funds:
Pay dividends to shareholders
Save money for future
Invest towards future growth (R&D)
With an example, explain why firms might not be able to immediately maximise profit?
This would be because a firm may be suffering from decreasing returns, or they do not have a competitive enough share of the market to survive or grow. Therefore, these options would become more important than trying to increase profit.
To make profit, firms may have to achieve a number of other objectives first.
E.g to gain long run profit, it might be more important to gain revenue and market share in the short term so that economies of scale and price-setting power can be first achieved, even if profit must be sacrificed.
Amazon has made very little profit in the last 10 years and seems to have aimed to maximise market share in the short run. A challenge for Amazon would be how to increase their profit margin (how much is charged to the customer over and above costs) without making itself vulnerable to competition.
Explain these other aims in detail. (Not profit maximisation).
Corporate social responsibility:
To act in a sustainable way whilst making a supernormal profit
This can be beneficial to society
e.g. firm aims to produce its goods whilst keeping carbon emissions low
Revenue maximisation:
maximise revenue
needs to produce where MR = 0
leads to increased size of firm which can be beneficial to managers
Satisficing:
bounded rationality might limit ability to make choices that lead to profit maximisation
Herbert Simon proposed theory of Satisficing (alternative to profit max.)
It means reaching a minimum requirement in a number of areas: setting minimum goal for profit, sales and revenue
⇒ Doing the bare minimum.
Market share:
Firms might try to maximise market share (sales maximisation
A firm would produce where AR = AC
E.g. Tesco, this would allow them to achieve EoS and greater price-setting power in the long run
Beneficial to managers because of prestige and perks.
Not for profits:
Firms that don’t aim to maximise supernormal profits but to social welfare
e.g. a student union
What are examples of companies achieving these other aims?
Amazon
Model is based partly on low margins (profit per good) on large scale
Targets reduced AC through improvements in system of delivering goods, criticised on issues such as working conditions
Focused on revenue growth through boosting advertising
Dividends are paid out of profit so shareholder pressure means they might have to pay more attention to profit maximisation
Supermarkets
Supermarkets are engaged in a fierce price war and those like Tesco have made losses
Arguable that supermarkets target market share and entry of competitors like Aldi and Lidl have made price competition more extreme.
What is a ‘divorce of ownership from control’?
>This occurs when a firm’s owners are no longer in control of the day-to-day running of the firm (e.g. because it’s run by directors).
>This can lead to the principal-agent problem, where those in control act in their own self-interest, rather than the interest of the owners.
What is the ‘principal agent problem’?
If interests are not shared between the managers and shareholders then this will lead to divorce of ownership for control
Managers may look to maximise revenue at the expense of profit (which of course benefits shareholders), yet shareholders cannot directly monitor the behaviour of the managers
>This is where a principal (e.g. shareholders) pays for for an agent (e.g. a managing director) to act in their interests, but instead the agent acts in their own self-interest.
How might shareholders regain control from managers?
Shareholders can hold the managers accountable for the firms performance by adding pressure for them to perform in their interest
Managers might have pay linked to the share price over a number of years
This realigns the goals of both
What are examples of the principal-agent problem?
Managers try to grow the company to boost their own importance and status
The benefit of this is ‘sales’ and ‘revenue’ so they might end up with higher costs
Reduced profits but increased revenue.
Solution to this: aligning interests. Companies like Apple offer their top management shares of options to buy shares. So the management then develop interest in long-term profitability.
Corporate social responsibility
>Many firms are also interested in corporate social responsibility (CSR).
>This involves firms operating in a way that brings benefit to society, as well as trying yo make supernormal profit (unlike ‘not for profit’). For example:
-Try to protect environment by using sustainable resources.
-Support local businesses by using suppliers in the region.
-Choose to pay workers above the standard market rate.
>A firm’s CSR policies can help it increase its profits by encouraging consumers to buy from them.
Why does a firm need normal profit in the long run?
>A firm needs normal profit to keep operating in the long run.
>If a firm can’t make normal profit it will close in the long run, because its revenue isn’t covering all of its costs.
>Even if it’s making a money profit, the FoPs could be used to better effect elsewhere.
>In the long run the firm can be released from its fixed costs (e.g. by no longer renting a factory) and it will shut down.
>If the price falls below the firm’s variable costs it should cease production immediately.
Normal profit and the short-run
>In the short run, a firm has fixed costs that it has to pay, whether or not it produces any output.
>So a loss-making firm may not close immediately - it all depends on how its revenue compares to its variable costs.
>If a firm’s TR is greater than its total variable costs, then it will continue to produce in the short term.
>Any revenue generated above the firm’s variable costs can contribute towards paying its fixed costs. If the firm stops production immediately, it’ll actually be worse off.
>If a firm’s TR is less than its TVCs the it’ll close immediately. If it continues to produce, it’ll actually be worse off.
When are profits maximised?
>When MC = MR.
>This is known as the ‘MC = MR profit-maximising rule/condition’.
Optimum output level to maximise profits
>If MR is greater than MC at a particular level of output, the firm should increase output as the revenue gained by increasing output is greater than the cost of producing it so increasing output adds to profit.
>If MR is less than MC, the firm should decrease output because it’s costing the firm more to produce its last unit of output than it receives in revenue so decreasing output adds to profit.
>This means the profit-maximising output level occurs when MR = MC.
Long run/short run and maximising profit
>Maximising profit in the long run sometimes means sacrificing profit in the short run.
>A firm may try to maximise sales or revenue in the short run, e.g. to increase its market share, or to gain monopoly power so that it can make supernormal profits in the long run. Or high sales might make it easier for the firm to borrow money.
>Some firms may even be willing to operate at a loss in the short run in order to make a profit in the long run:
-A firm may expect revenue to increase in the future, for example, once they’ve been in the market for a while and their brand recognition increases.
-Or a firm might expect to reduce costs when they’re able to output at higher production levels (i.e. experience economies of scale), and so they may keep operating at a loss while they build up the business.
>A firm’s objective may be to simply survive in the short run by achieving normal profit. Then, when its established in a market, it can try to maximise profits.
Alternative firm objectives #2
>Some firms might not aim for something directly related to profit, revenue or sales. But these objectives are usually pursued while also aiming to make at least normal profit.
>‘Not for profit’. (aim to ‘do good’).
>High quality products.
>Gain loyal customers.
>Some may be interested in corporate social responsibility (CSR).
Growing from small to large firm
>In small firms, the owner often manages the company on a day-to-day basis.
>As firms grow, the owners often raise finance by selling shares - the new shareholders become part owners of the firm.
>But the firm will actually be run by directors, who are appointed to control the business in the shareholders’ interests.
>This is known as the ‘divorce of ownership from control’ - the owners are no longer in day-to-day control.
>Directors might have different objectives to the owners and employees and other stakeholders in firms may also have their own objectives and might have some level of control.
Principal-agent problem - example
>E.g. a firm’s shareholders will want a firm to maximise profits to increase the value of its shares. However, if the managing director’s pay or bonus is linked to revenue or sales, then they may choose to maximise those things instead.
>Directors might also be keen to grown some aspect of the firm because they enjoy running a large organisation, or because being in charge of a large firm will further their career.
>Employees (another example of an agent) are likely to aim to increase their own pay or benefits ahead of aiming to make profits for the firm.
Managers or directors control
>How much control the managers or directors of a firm have depend on how accountable they are to the owners. By holding managers or directors accountable, owners can tackle the principle-agent problem.
>Shareholders can remove directors by vote if they’re not happy with them, but they often lack information that might make them do this.
>Accountability means managers and directors having to justify what they’ve done in the past and explain their future plans and intentions.
>Owners might also try to encourage directors to aim for profit maximisation by offering incentives which make this an attractive objective for the directors to pursue.
Stakeholder - definition
>Everyone with an interest in or who is affected by the firm.
Satisficing - definition
>Satisficing means trying to do just enough to satisfy important stakeholders, instead of aiming to maximise a quantity such as profit (or minimise something like costs).
>It’s sometimes described as ‘aiming for an easy life’.
Example of satisficing
>Rather than maximising profit, directors might aim to make ‘enough profit’ to stop shareholders getting too concerned, and paying employees ‘high enough wages’ that they don’t look elsewhere to work or threaten to go on strike (this is another example of the principal-agent problem)
Supernormal profit in perfect competition diagram - explain what happens to profit.
Firms in the short run can make a supernormal profit. The point of profit maximisation is where MC=MR and when AR>AC, there will be abnormal profits made.
The total profit gain is shown by the area of the rectangle (P1-C)xQ1
You’ll find that in perfect competition, supernormal profits are eroded away immediately by the entry of new firms who are incentivised to join the market by the abnormal profits (signalling function) and the low barriers to entry.
Return to equilibrium diagram (erosion of supernormal profits)
Firstly, the entry of new firms (incentivised to join through low barriers to entry and abnormal profits), will shift the supply curve right. (S1 to S2)
This lowers the market price and shifts the equilibrium. Average cost gets lower and all firms return to making normal profits in the long run but at a lower price.
