Theme 3 CC2 - Efficiency and market structures (P1)

Question 1

What are the market structures in order of competiteveness?

Answer 1

1. Perfect comp
2. Monopolistic comp
3. Oligopoly
4. Monopoly

Question 2

What are the characteristics of perfect competition?
And give 2 examples of markets

Answer 2

1. Many buyers and sellers in the market
2. Buyers and sellers possess perfect knowledge about market
3. Freedom of entry/exit (no Barriers)
4. All firms produce homogeneous goods
5. No transport costs

-Foreign exchange markets
- Agricultural markets

Question 3

What are the assumptions of this model?

Answer 3

1. Firms are price takers - sell goods at market price given
2. Demand is perfectly elastic (horizontal)
3. Firms able to sell as much as they wish

Question 4

How is short run (profit maximising) equilibrium in perfect competition drawn in diagrams?

Answer 4

Two diagrams:
Left: market: S&D equilibrium = P=AR (D) = MR
Right: Individual firm max at mc=mr
Draw AC and AVC

Question 5

What are the three possibilities of profit for firms in perfect competition in SR?

Answer 5

Supernormal AR>AC

Normal AR=AC

Subnormal AR<AC

Question 6

What profit can firms produce in the LR?

Answer 6

Firms can only produce normal profit in the LR.

Question 7

Why can firms only produce normal profit in the LR?

Answer 7

In SR, if firms produce supernormal profit, this creates incentive for new firms to enter industry attracted by the profits. This shifts supply to the right, causing a fall in price for both new and incumbent firms where supernormal profits are competed away.

If firms are making subnormal profits in SR, then they may leave industry as they are not covering their opportunity cost. This will reduce industry supply and shift curve to the left, increasing price for remaining firms such that subnormal profits/losses are eliminated.

Question 8

What is the shut down condition?
SR and LR

Answer 8

In SR: AR(P)<AVC

In LR: AR(P)<AC

Question 9

Explain the shut down condition in SR

Answer 9

In the ST, only variable costs must be covered as it would cost more to shut down with fixed costs. If P>AVC then firm is making a ‘contribution towards its total fixed costs’.
Fixed costs have to be paid out regardless of output

Question 10

Explain shut down condition in the LR

Answer 10

All costs - both variable and fixed - must be covered i.e. P>AC
A rational firm and it’s shareholders would not choose to sustain ‘losses’ long term.

Question 11

Why might loss making firms be able to continue production in the SR?

Answer 11

• Savings/retained profits to fund loss
  -overdraft
  -extend credit terms with suppliers

Question 12

Evaluate Perfect comp with C&B

Answer 12

B:
+ Lower prices for consumers, max consumer surplus, perfect comp is allocatively efficient.
+ Productively efficient (Minimising costs), X efficient (No waste) to stay competitive against other firms.

C:
-Lack of consumer choice (Homogenous goods), may lack quality due to corner cutting as firms minimise costs.
-Very unrealistic, overly-strict assumptions
-Lack of SNP in LR, therefore no reinvestment in R&D, no new/better quality products, no dynamic efficiency. No incentive for new products anyway due to perfect knowledge.

Question 13

Why might loss making firms wish to continue production in SR?

Answer 13

• Future LR profits
• Customer loyalty
• protect jobs and industry
• Lesser of two evils (costs more to shut down)

Question 14

What is allocative efficiency?
When is it achieved?

Answer 14

Occurs when the value that consumers place on a good or service equals the cost of the factor resources used up in production

-Achieved where MC=AR (P) (S=D)- total economic welfare is maximised and consumer surplus is maximised.

Question 15

What is productive efficiency?
When is it achieved?

Answer 15

Maximising output at the lowest possible average cost.

Min of AC or MC=AC

Question 16

What is Dynamic efficiency?
What is the condition?

Answer 16

Reinvesting supernormal profit into innovation, R&D and new technology to lower LRAC

Supernormal profit in the long run
Therefore not applicable to firms in perfect competition.

Question 17

What is X-inefficiency and it’s sources?

X-efficiency?

Answer 17

X-inefficiency occurs when a firm has little incentive to control costs due to large profits and a lack of competition L.
Sources: Organisational ‘slack’ and waste

X-efficiency occurs in perfect competition where firms must operate on potential AC curve to survive as they only make normal profits in LR

Question 18

Define Barriers to entry (BTN)

Answer 18

BTN are factors which make it difficult or impossible for firms to enter an industry and compete with existing producers.

Question 19

Give 4 groups of barriers to entry

Answer 19

LSTB
1) Technical - Innocent barriers e.g. economies of scale, high start up costs
2) Strategic barriers are deliberate e.g. limit/predatory pricing
3)Legal barriers e.g. a government requirement to obtain a licence to operate. Also patents giving firms monopoly power.

Also brand loyalty

Question 20

Define barriers to exit (BTX)

Answer 20

BTX exist when there are obstacles to firms leaving the industry

Question 21

Give 2 barriers to exit

Answer 21

• Sunk costs - costs incurred by a firm that it cannot recover should it leave the market. E.G. capital, useless stock, spending on advertisement and redundancy costs.

• Reputation damage - loss of faith in the brand and the management team

Question 22

Define monopoly

Answer 22

A market structure where one firm supplies all output in the industry without facing competition because of high barriers to entry to the industry.

Question 23

Give 4 characteristics/considerations of a monopoly

Answer 23

-One single firm, profit maximising, able to set prices & control output
- High barriers to entry and exit
-Downward sloping demand curve
- CMA defines Monopoly=25% market share, pure monopoly = 100% market share

Question 24

What is monopoly power?

Answer 24

The ability to influence the market e.g. to some degree able to determine price (price maker)

Question 25

What is a natural monopoly?

Answer 25

Industry where there are substantial economies of scale such that only one firm is viable e.g. utility industry providing water, sewer services and energy distribution

Question 26

Evaluate Monopolies: 3 Costs

Answer 26

1. Loss of economic efficiency
   - Assuming no EOS, monopoly equilibrium is both productively and allocatively inefficient.
   - Likely x-inefficient due to complacency (no competition)
   - May be less dynamically efficient as less incentive to innovate.
2. Welfare loss
   - LRAC/LRMC constant (straight line) assumes no EOS, higher prices and lower output than PC
   - Consumer surplus lost to monopolist as supernormal profit
   - Welfare loss triangle ABC
3. Redistributive effect - Monopoly profit is distributed to shareholders who are likely to be higher income households than consumers - so there could be an inequitable redistribution of income from consumers to shareholders.
4. Less consumer choice, forced to buy from one producer (although not much better in PC)

Question 27

Evaluate Monopolies: 3 benefits

Answer 27

1. Possible improvement in dynamic efficiency - As firms can earn supernormal profit in LR, this can be invested into R&D. There may be a faster rate of technological change - reducing costs and producing better quality goods for consumers.
2. Schumpter and ‘creative destruction’ - monopoly leads to the development of new products as firms need to get round barriers of entry. They create new products to destroy the monopoly position of existing products e.g. Kodak film cameras lost out to digital cameras.
3. Economies of scale - Monopolies able to exploit EOS leading to lower costs than under competitive conditions. Lower MC curve (draw monopoly diagram - no AC drawn) leads to lower price goods and greater output.
4. Cross subsidisation - a decision to fund a loss from one product by raising the price of another.

Question 28

Give 3 characteristics of natural monopoly

Answer 28

• Huge fixed costs therefore may need subsidy (show on diagram AR=MC)
• Enormous EOS
• Competition is undesirable, it is rational fort one firm to supply entire market (show on diagram)

Question 29

Evaluate monopolies for employees

Answer 29

✅ Job security - ‘The quiet life’
❌Few alternative career paths (structural unemployment)

Question 30

Evaluate monopolies for suppliers

Answer 30

✅ Secure contract
❌Significant negotiating power

Question 31

What curves does a change in fixed costs effect?

Answer 31

Just AC curve

Question 32

What curves does a change in variable costs effect?

Answer 32

AC and MC

Question 33

Define price discrimination

Answer 33

-Charging different prices to different consumers for an identical good or service for reasons other than differences in cost.

Question 34

Why are different consumers willing to pay different prices?

Answer 34

Because they have different PEDs depending on their willingness and ability to pay.
- Profit max firms deduce this information and charge accordingly.

Question 35

How does price discrimination effect consumer surplus and what is this an example of?

Answer 35

• Producer attempts to tap into consumer surplus and turn it into additional revenue.

-Example of first degree price discrimination (Not directly examined)

Question 36

Give the 4 conditions of Price discrimination

Answer 36

1. Must have degree of monopoly power (price maker)
2. Identify distinct groups of buyers and be able to prevent market seepage e.g. resale between customers in different market segments.
3. Different demand elasticities for each identified group
4. Low admin costs e.g. cheap to separate markets and implement price discrimination

Question 37

Evaluate Price discrimination with C&B for consumers

Answer 37

Benefits:
- Some consumers able to buy goods at lower prices (in some cases losses are made)
- Additional profit may be reinvested for benefit of consumers e.g. better products
- Cross subsidisation brings social benefits e.g. charging lower prices for goods that cost more to make

Costs:
- Consumers with relatively price inelastic demand pay a higher price and subsidise lower prices for others.
- Overall loss of consumer surplus, meaning welfare loss to consumers and welfare gain to producers. Therefore, exploitation of the consumer as majority pay more than MC.

Question 38

Evaluate Price discrimination with C&B for producers

Answer 38

Benefits:
- Capture of consumer surplus, therefore ^Revenue/profit
- Some consumers may be priced into market if price is reduced (elastic customers that wouldn’t be willing/able to buy before PD.
- Better use of spare capacity - environmental benefits (less waste)
- Reinvest SNP into R&D

Costs:
- Admin cost of keeping different groups of consumers apart (High costs not worth it e.g. labour of ticket checker at cinema)
- Possible risk of investigation of competition authorities
- Reputation may suffer from PD

Question 39

Define Monopsony

Answer 39

• Where one firm has significant buying power (and the ability to exploit suppliers to negotiate lower prices- purchasing EOS)
  -One buyer and many sellers

Question 40

Give example of monopsony

Answer 40

British sugar is an example of a pure monopsony - buys almost the entire sugar beet crop produced in the UK year.

Question 41

Evaluate monopsony for firms

Answer 41

Benefits:

• Monopsony power allows bigger firms to achieve purchasing economies of scale leading to lower long run
  average costs
• Lower purchase costs bring about higher profits and increased returns for shareholders
• The extra profit might be used to fund capital investment or r&d

Costs:
- Loss of reliable suppliers due to unsustainably low prices and falling profits
* Reliable suppliers may decide to serve rival firm if being harshly treated which may give them a competitive advantage

Question 42

Evaluate monopsony for consumers

Answer 42

Benefits:

• Consumers may gain from lower prices e.g supermarkets can negotiate better prices from manufacturers that are then passed on to consumers
• Improved value for money - for example the UK
  National Health Service can use its bargaining power to drive down the prices of routine drugs used in NHS treatments, social welfare benefit
• A monopsonist can act as a useful counter-weight to the selling power of a monopolist helping to protect the interests of consumers

Costs:
-Quality may fall as reliable suppliers are forced out due to unsustainably low prices
* Lack of profits can result in reduced R&D resulting in less innovation and product development long term

Question 43

Evaluate monopsony for employees

Answer 43

Costs:
- As small suppliers forced out of the market, certain product lines could be unviable resulting in redundancies

Benefits:* Dominant market position means greater job security
* Enhanced profits means employees stand to receive higher bonuses/profit share

Question 44

Evaluate monopsony for suppliers

Answer 44

Benefits:
* Dominant market position means greater job security
* Enhanced profits means employees stand to receive higher bonuses/profit share

Costs:
* Dominant market position means secure contract and
certainty of income
* Greater incentive to reinvest and improve efficiency as gate price gradually reduced by monopsonist over time

Question 45

Define monopolostic competition

Answer 45

A large number of small firms produce differentiated products and where there are low barriers to entry or exit.

Question 46

5 characteristics of monopolistic comp

Answer 46

1. Large number of buyers and sellers in market, each of
   which is relatively small and acts independently (firms are
   short run profit maximisers, will produce where MC=MR)
2. Perfect knowledge
3. Low barriers to entry & exit
4. Differentiated (non-homogeneous) products
5. No transport costs

Question 47

What can firms in monopolistic comp achieve in the long run profit wise?

Answer 47

Only Normal profits.
For SR Supernormal profit firms: Barriers to entry are low, supernormal profits are available attracting new firms. Other firms enter – supply in the industry increases. Therefore each incumbent firm loses customers and has a lower level of demand, increasing PED (due to more subs).

For Subnormal profit firms: Forces firms to exit industry, increasing individual firm’s demand and/or reduces PED (fewer subs)