Theme 3: Market Structures

Question 1

Allocative efficiency

Answer 1

When resources are distributed to the goods and services that consumers want. This maximises utility. Where P = MC, which means that consumers pay for the value of the marginal utility they derive from consuming the good or service. Free markets are considered to be allocatively efficient.

Question 2

Productive efficiency definition and draw a diagram.

Answer 2

This is when firms produce at the lowest point on the short run or long run average cost curve. Since the MC curve cuts the AC curve at the lowest point, MC = AC is a point of productive efficiency. All points on the PPF curve are productively efficient.

Question 3

Dynamic efficiency

Answer 3

When all resources are allocated efficiently over time, and the rate of innovation is at the optimum level, which leads to falling in long run average costs. The market is dynamically efficient if consumers need and wants are met as time goes on. Related to the rate of innovation, which might lead to lower costs of production in the future, or the creation of new products.

Question 4

What is dynamic efficiency affected by?

Answer 4

Short run factors such as demand, interest rates and past profitability.

Question 5

X-inefficiency and show on a graph

Answer 5

When costs are higher than they would be with competition in the market.

Question 6

What causes X-inefficiency?

Answer 6

Organisational slack, waste in the production process, poor management, or simply laziness. Often monopolies suffer from X-inefficiencies.

Question 7

What are the characteristics of a perfectly competitive market?

Answer 7

• Many buyers and sellers
• Sellers are price takers
• Free entry to and exit from the market
• Perfect knowledge
• Homogeneous goods
• Firms are short run profit maximisers
• Factors of production are perfectly mobile

Question 8

Draw the short run equilibrium for a perfectly competitive market and explain it

Answer 8

The firm is a price taker, and it accepts the industry price of P1. In the short run, the firm produces an output of Q1. The yellow shaded rectangle shows the area of supernormal profits earned in the short run. It is assumed that firms are short run profit maximisers.

Question 9

Draw and explain a diagram showing the long run equilibrium for a perfectly competitive market.

Answer 9

The supernormal profits made by an existing firm means that new firms have an incentive to enter the industry. As there are no barriers to entry in a perfectly competitive market, new firms are able to enter the industry.

This causes the supply in the market to increase, as shown by the shift in the supply curve from S to S1. The price level in the market falls as a consequence. Since firms are price takers they must accept this new, lower price.

Firms can only make normal profits in the long run.

Question 10

Advantages on a perfectly competitive market

Answer 10

1. In the long run there is a lower price, P=MC, so there is allocative efficiency.
2. Since firms produce at the bottom of the AC curve, there is productive efficiency.
3. The supernormal profits produced in the short run might increase dynamic efficiency through investment.

Question 11

Disadvantages of a perfectly competitive market.

Answer 11

1. In the long run, dynamic efficiency might be limited due to the lack of supernormal profits.
2. Since firms are small there are few or no economies of scale.
3. The assumptions of the model rarely apply in real life. In reality, branding, product differentiation, adverts and positive and negative externalities, mean that competition is imperfect.

Question 12

Draw and explain a profit maximising firm in the short run

Answer 12

In the short run, firms profit maximise at the point MC = MR. The area P1C1AB represents the supernormal profits that firms in a monopolistically competitive market earn in the short run.

Question 13

Draw and explain a profit maximising firm in the long run

Answer 13

In the short run new firms enter the market as they are attracted by the profits that existing firms are making. This makes the demand for the existing firms products more price elastic which shifts the AR curve (demand curve) to the left. Consequently, only normal profits can be made in the long run.

Question 14

Disadvantages of monopolistically competitive markets

Answer 14

1. Firms are allocatively inefficient in the short and long run (P>MC)
2. Since firms do not fully exploit their factors, there is excess capacity in the market. This makes firms productively inefficient.
3. Dynamic efficiency might be limited due to the lack of supernormal profits in the market.
4. Firms are not as efficient as those in a perfectly competitive market. As they have little incentive to minimise their costs.

Question 15

Advantages of monopolistically competitive markets

Answer 15

1. Consumers get a wide variety of choice.
2. The model of monopolistic competition is more realistic than perfect competition.
3. The supernormal profits produced in the short run might increase dynamic efficiency through investment.

Question 16

Characteristics of an Oligopoly

Answer 16

1. High barriers to entry and exit
2. High concentration ratio
3. Interdependence of firms
4. Product differentiation

Question 17

How do you calculate the concentration ratio of a markets top 3 firms?

Answer 17

You add their market share up

Question 18

Reasons for collusive behaviour

Answer 18

• When firms agree to work together on something eg setting a price.
• This leads to a lower consumer surplus, higher prices and greater profits.
• Firms in an oligopoly have a strong incentive to collude.
• More likely when there are only a few firms

Question 19

Costs of collusion

Answer 19

1. Loss of consumer welfare, since prices are raised and output is reduced.
2. Absence of competition means efficiency falls. Increasing the average cost of production.
3. It reinforces the monopoly power of existing firms and makes it harder for new firms to enter.
4. Lower quantity supplied leads to a loss of allocative efficiency.

Question 20

Benefits of collusion

Answer 20

1. Industry standards could improve, as firms can collaborate on technology and improve it.
2. Excess profits could be used for investment, which might improve efficiency in the long run. Alternatively, they might be used on dividends
3. Saves on duplicate research and development.
4. By increasing their size, firms can exploit economies of scale, which lead to lower prices.

Question 21

Game theory

Answer 21

The interdependence between firms in an oligopoly. It is used to predict the outcome of a decision made by one firm, when it has incomplete information about the other firm.

Question 22

Types of price competition

Answer 22

1. Price wars- when firms constantly cut their prices below that of its competitors. Then the competitors lower theirs to match. etc
2. Predatory pricing- Firms setting low prices to drive out firms already in the industry. In the SR they make a loss but in the LR they gain.
3. Limit pricing- Low prices discourage the entry of other firms, so there are low profits. It ensures the price of a good is below that which a new firm entering the market would be able to sustain.

Question 23

Types of non-price competition

Answer 23

1. Increase loyalty
2. Improve quality of customer service
3. Loyalty cards
4. Advertising and marketing
5. Differentiation

Question 24

Characteristics on a monopoly

Answer 24

1. Profit maximisation
2. Sole seller
3. High barriers to entry
4. Price maker
5. Price discrimination

Question 25

What % share does a monopoly need to have to have monopoly power in the UK?

Answer 25

over 25%

Question 26

What is monopoly power influenced by

Answer 26

• Barriers to entry
• Economies of scale
• Limit pricing
• Owning a resource
• Sunk costs
• Brand loyalty
• Set-up costs
• Advertising
• Number of competitors
• Degree of product differentiation

Question 27

Draw a cost revenue diagram showing supernormal profits

Answer 27

Question 28

Third degree price discrimination

Answer 28

Third degree price discrimination is when different groups of consumers are charged a different price for the same good or service. For example, the higher price at peak times on trains is a form of third degree price discrimination.

Question 29

Costs to consumers of monopolies

Answer 29

1. Usually, price discrimination results in a loss of consumer surplus. Since P > MC, there is a loss of allocative efficiency.
2. It strengthens the monopoly power of firms, which could result in higher prices in the long run for consumers.

Question 30

Benefits for consumers of a monopoly

Answer 30

1. Net welfare gain as a result of cross subsidisation, if they receive a lower price.
2. As they can price discriminate they might choose to charge those of a higher income more therefore benefiting those of a lower income.

Question 31

Costs for producers of a monopoly.

Answer 31

1. If use predatory pricing the firm could face investigation.
2. It might cost the firm to divide the market, which could limit the benefits gained.

Question 32

Benefits of monopoly for producers

Answer 32

1. Producers make better use of spare capacity.
2. Higher supernormal profits could help stimulate investment.
3. A different market could be cross subsidised.

Question 33

Natural monopoly

Answer 33

High fixed costs usually in the form of infrastructure. Eg water and gas

Question 34

Monopsony

Answer 34

• Single buyer in a market
• Assumed profit maximisers
• able to negotiate lower prices
• Able to set market price

Question 35

Cost of a monopsony

Answer 35

1. Farmers might be taken advantage of and therefore might lose profits
2. Employees get a lower wage, trade unions counteract this
3. Workers might become unproductive if wages are low

Question 36

Benefits of a monopsony

Answer 36

1. NHS has monopsony power when buying drugs. They are able to negotiate lower prices.
2. Consumers might receive lower prices

Question 37

Characteristics of a contestable market

Answer 37

• Face actual and potential competition.
• Entrants have free access
• no significant entry or exit barriers
• low consumer loyalty
• number of firms varies

Question 38

Implications of contestable markets for the behaviour of firms

Answer 38

• Firms are more likely to be allocatively efficient. Which makes them productively efficient
• Threat of new entrants
• Perfectly competitive markets
• Supernormal profits SR and normal profits LR

Question 39

Types of barriers to entry

Answer 39

1. Economies of scale
2. legal barriers
3. Branding
4. predatory pricing
5. limit pricing
6. anticompetitive pricing
7. vertical intergration
8. brand proliferation

Question 40

Types of barriers to exit

Answer 40

1. Write off assets and pay leases
2. losing a brand
3. the cost of making workers redundant