Section 4 - Market Structures 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 thing - there are no real markets that work quite 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.
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.
Describing diagrams of perfect competition and supernormal profits. See blue book for diagrams
> Suppose there’s high demand for a product across an industry as a whole, leading to a firm making supernormal profits, as shown in red in the diagram.
-The firm’s TR=QxP (red+grey area).
-The firm’s TC=Qxc (grey area).
-Subtract TC from TR to find the firm’s profit.
-Here, TR>TC so this firm is currently making supernormal profit (red area).
In a perfectly competitive market, those supernormal profits mean other firms will now have an incentive to enter the market. And since there are no barriers to entry, they can do this easily.
This results in a shift in the industry supply curve to the right meaning the market price falls until all excess profits have been competed away, and a new long run equilibrium is reached at price P1 (with firm supplying Q1).
The new equilibrium is established at the lowest point on AC curve so firm’s become productively efficient. Diagram also shows P=MC so firms=AE too.
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.
