Theme 3 - market structures Flashcards
what is the shutdown condition, when should firms consider shutting down and why? - perfect competition
If price falls below AVC, each unit produced generates less revenue than the variable cost of making it, meaning the firm loses more money by continuing production than by shutting down → In this case, shutting down minimizes losses, as the firm only has to pay fixed costs rather than both fixed and variable costs.
Example: A small coffee shop that sells coffee at $2 per cup but has an AVC of $2.50 per cup loses $0.50 per cup sold → It should shut down temporarily instead of continuing to operate at a loss.
In the long run, all costs become variable, so if P < ATC for an extended period, the firm should exit the industry permanently → Unlike in the short run, where firms can survive if they cover AVC, in the long run, if they can’t cover all costs, they should shut down and reallocate resources to a more profitable industry.
what is the breakeven condition - perfect competition
when AR = AC (normal profit)
- When AC = AR, the firm is covering all its costs (both fixed and variable) and earning zero economic profit. This means it’s not making a loss, so there is no immediate reason to shut down.
- If market conditions improve (e.g., an increase in demand), the firm could start earning positive profits.
when should firms completely shut down - perfect competition
when AR < AVC
- If AR < AVC, the firm is not even covering its variable costs, meaning it’s losing money on every unit produced.
- Staying open with AR < AVC leads to a negative cash flow, making it unsustainable in the short run as the firm cannot pay for essential inputs like labor and materials.
- By shutting down, the firm avoids additional variable costs, which helps minimize losses to just fixed costs. Continuing production would increase its losses further.
what are characteristics of a perfect competition market
- there are many buyers and sellers
- there are no barriers to entry or exit
- firms sell homogeneous goods, firms are price takers, they cannot set their prices
- there is perfect information between buyers and sellers
- firms are profit maximisers
what is the long run equilibrium in perfect competition
when normal profit is being made. any point more than normal profit is a short run equilibrium
why is supernormal profit only a short run equilibrium in perfect competition
- High profits attract new firms due to low barriers to entry and perfect information,
- New firms entering the market increases the overall supply of goods in the market, shifting the supply curve to the right.
- As supply increases, the market price falls, reducing the supernormal profits that existing firms were initially earning.
- Firms continue to enter until prices fall to the point where only normal profits are made, leaving no incentive for further firms to enter.
- In the long run, all firms earn only normal profits as the market reaches a new equilibrium with no supernormal profits remaining.
in perfect competition, why would firms only be making subnormal profits in the short run
- Firms are incentivized to leave the market to avoid losses and produce elsewhere at their opportunity cost.
- Due to low barriers to exit, firms can easily exit the market, reducing the overall supply.
- As supply shifts left, the market price increases, reducing the losses faced by the remaining firms.
- Firms continue to exit until prices rise to the point where the remaining firms earn normal profits.
- In the long run, only normal profits are earned, and there is no incentive for further firms to leave.
efficiency in a perfectly competitive market
allocative efficiency - SR:yes
LR: yes
productive efficiency - SR:NO LR: yes
X - efficiency is high as they are minimising waste and therefore cost
Dynamic efficiency - SR: yes
LR : no
what are barriers to entry
any obstacle that stops a new firm from entering the market
4 types of barriers to entry
- Legal
- Technical
- Strategic
- Brand loyalty
examples of legal barriers to entry
patents - having sole ownership of something you created, no other firm can copy you, firms may not know how to stand out/compete with other firms and may not join the market
license/permits - Licenses or permits create additional costs for new firms, making it more expensive to enter the market. may be expensive/difficult to obtain, and there are a limited number
red tape - is excessive paperwork slow down the process of entering the market, discouraging potential entrants who face long waiting periods
regulations and standards - Standards and regulations impose compliance costs, requiring firms to invest in meeting specific industry criteria, which raises the cost of entry.
insurance - increase upfront costs, making it more expensive for new firms to enter the market.High premiums or limited availability of insurance can deter smaller firms or startups, reducing competition.
examples of technical barriers to entry
- start up costs - High initial investment requirements (e.g., equipment, infrastructure) make it difficult for new firms to enter the market without significant capital.
- sunk costs - Irrecoverable expenses (e.g., advertising, R&D) deter entry as firms can’t recoup these costs if they fail, raising the risk for new entrants.
- economies of scale - Established firms benefit from lower average costs due to large-scale production, making it hard for new entrants to compete at the same cost level.
- natural monopolies - Markets with high fixed costs and infrastructure requirements (e.g., utilities) tend to be dominated by one large firm, discouraging new entrants due to the sheer scale of investment needed.
what are sunk costs
costs that cannot be recovered if the firm were to leave the market
examples of strategic barriers to entry
- predatory pricing
- temporarily lowering prices LOWER THAN AC to drive competitors out of the market.
- they make it financially unviable for new entrants to compete.
- limit pricing
- Firms can use limit pricing to deter potential entrants by setting prices just low enough to make entry unprofitable.
- By maintaining a price that is lower than the average cost of potential competitors, they eliminate competition
- heavy advertisingg
- Established firms may invest heavily in advertising to create strong brand loyalty and awareness.
- Significant advertising expenditures increase customer recognition and preference for the established brand, making it difficult for new entrants to gain market share.
what is monopolistic competition
a competitive market with some aspects of a monopoly
characteristics of a monopolistic market
- many buyers and sellers
- firms sell slightly differentiated goods
- firms are price makers
- price elastic demand as there are many substitutes
- low barriers to entry/exit
- non - price competition(competition based on branding,advertising etc)
- good information
- firms are profit maximisers(MR=MC)
why, in the short run, can firms in monopolistic competitive markets, make supernormal profits
- Firms in monopolistic competition produce differentiated products, allowing them some control over prices rather than being price-takers.
- This differentiation enables firms to set prices above marginal costs, leading to higher revenues relative to costs.
- In the short run, firms can exploit this pricing power to generate supernormal profits
why, in the long run, will firms not be able to make supernormal profit
- new firms enter the market due to low barriers to entry and good information
-This increases competition, shifting the firm’s demand(AR) curve leftwards - As demand falls, the firm adjusts to a point where its demand(AR) curve becomes tangential to the ATC curve.
- In the long run, the price equals ATC at the profit-maximizing output level (MR = MC), so firms earn just enough to cover their costs, resulting in normal profits only.
comments on efficiency in a monopolistic market
short run - allocative efficiency is not reached as price not equal to MC
long run - allocative efficiency is not reached
long run and short run - productive efficiency is not reached as we are not on the lowest part of AC curve
lpng run - no dynamic efficiency, profits arent being made to reinvest
VERY INEFFICIENT STRUCTURE
evaluation point for the argument that a monopolistic competitive market is inefficient
- There is some competition, which reduces price-setting power.
- With firms facing competition from close substitutes, their ability to raise prices and exploit consumers is limited compared to a monopoly
- The loss in consumer surplus is less severe, meaning consumers still get relatively competitive pricing.
- Perfect competition assumes homogeneous goods, but is that what consumers want?
- In monopolistic competition, product differentiation caters to diverse consumer preferences, offering a variety of choices.
- Consumer satisfaction could be higher, as many prefer differentiated products over identical ones.
- The productive inefficiency in monopolistic competition is less severe than in monopoly.
- With close substitutes and competition, firms can’t afford to fully exploit economies of scale as monopolies do, preventing extreme inefficiency.
- Productive inefficiency exists but is not as pronounced, and prices remain more competitive.
- Economies of scale can be greater than in perfect competition
- Firms in monopolistic competition can reach a size that allows for some economies of scale, unlike perfectly competitive firms, which are usually too small to benefit from these efficiencies.
- This could lead to slightly lower prices and better resource use compared to perfect competition.
- Short-run supernormal profits may encourage reinvestment, leading to dynamic efficiency.
- Firms may use their short-run profits to innovate, improve products, and invest in new technologies, making the market more dynamically efficient.
- This can benefit consumers over time through better products and services, even if there is some inefficiency in the short run.
what is allocative efficiency
- where resources follow consumer demand
- where society surplus is maximised
- where net social benefit is maximised
- on a graph, it’s where D=S and where AR/P = MC
what is productive efficiency
- when a firm is operating at the lowest point on their AC curve
- full exploitation of economies of scale
what is X efficiency
- when a company is minimising their waste, there are no excess costs
- occurs when firm is operating on the AC curve
what is dynamic efficiency
- the reinvestment of long run supernormal profit back into the business
difference between static(allocative/productive/X) and dynamic efficiency
- static efficiency all occur at one specific production point
- dynamic efficiency occurs over time
efficiencies consumer analysis
allocative efficiency
- resources perfectly follow consumer demand
- low prices, higher choice, maximisation of CS, high quality of production
efficiencies consumer analysis
allocative efficiency
- resources perfectly follow consumer demand
- low prices, higher choice, maximisation of CS, high quality of production
productive efficiency
- increased production at lower AC
- higher profits
- lower prices and greater market share
Dynamic efficiency
- new innovative products,lower prices, high CS
X efficiency
- low prices, high Cs
efficiency producer analysis
allocative efficiency
- retained or increased market share, staying ahead of rivals, increased profit
productive efficiency
- more production at lower AC
- higher profit
- increased market share, lower prices
dynamic efficiency
- long run profit maximisation
- lower costs over time
- retained or increased market share
- stay ahead of rivals
X efficiency
- lower costs, higher profit, lower prices and increased market share
efficiency producer analysis
allocative efficiency
- retained or increased market share, staying ahead of rivals, increased profit
Real-Life Examples of Perfectly Competitive Markets
Agricultural Markets: Markets for crops like wheat, corn, and soybeans are often used as examples of near-perfect competition. There are numerous farmers (sellers) providing standardized products, with prices determined largely by market demand rather than individual sellers.
Foreign Exchange Market: - The currency exchange market is often cited as close to perfect competition, with many buyers and sellers trading standardized currencies, freely determined by supply and demand.
Stock Market for Commodities:
- The trading of commodities like gold, silver, and crude oil in stock exchanges also approaches perfect competition due to high standardization and many participants, though slight differences can arise based on contracts.
Real-Life Examples of Monopolistic Competitive Markets
Restaurants and Cafés: The food service industry exemplifies monopolistic competition. Restaurants offer differentiated products through cuisine, ambiance, location, and service, with easy entry and exit and many competitors.
Retail Clothing Stores: The fashion retail market, including both branded stores and generic clothing shops, operates in a monopolistic competitive environment, as brands differentiate themselves through style, quality, and brand image.
Beauty and Personal Care Products: Cosmetics, skincare, and personal care items are highly differentiated by branding, quality, and pricing, making the personal care industry a prime example of monopolistic competition.
Fitness Centers and Gyms: Fitness centers differentiate through facilities, classes, and location, but there are many players with relatively easy entry and exit, fitting the monopolistic competition model.
features of contestable markets
- LOW BARRIERS TO ENTRY/EXIT
- large pool of potential entrants
- good information abt the market
- hit and run profits
what are hit and run profits
when new firms enter the market, snatch supernormal profits, then leave the market before firms and income can react and lower their profit margins
how does technology link/increase contestability
- Lowers Barriers to Entry → More Firms Can Enter the Market → Increased Competition
Technology reduces start-up costs by allowing firms to operate digitally instead of requiring physical infrastructure → This makes it easier for new firms to enter previously monopolized markets, increasing contestability → For example, e-commerce platforms reduce the need for expensive retail space, allowing small businesses to compete with larger firms → More competition forces existing firms to improve efficiency and lower prices, benefiting consumers.
Example: The rise of online banking and fintech companies has challenged traditional banks by offering financial services without the need for physical branches, increasing contestability in the banking sector.
- Reduces the Need for Large Sunk Costs → Firms Can Enter and Exit Markets More Easily → Market Becomes More Contestable
New technology, such as cloud computing and software-as-a-service (SaaS), allows firms to operate without significant upfront investment in physical assets → Lower sunk costs reduce the risk of market entry, making it easier for new competitors to challenge established firms → As a result, incumbent firms face greater competitive pressure and must remain innovative and efficient to retain market share.
Example: The media streaming industry became more contestable as platforms like Spotify and Netflix eliminated the need for costly distribution infrastructure (e.g., physical CDs or DVDs), allowing new entrants to emerge with lower initial investment.
- Enhances Consumer Knowledge → Reduces Asymmetric Information → Encourages New Firms to Compete
Technology improves access to market information, reducing information asymmetry between firms and consumers → Consumers can now compare prices, quality, and reviews easily, forcing firms to compete on price and service quality → New entrants can gain market share more quickly by offering better products or lower prices, making markets more contestable.
Example: Price comparison websites (e.g., Skyscanner, Expedia) allow consumers to compare flights and hotels instantly, forcing firms to offer competitive pricing and reducing the power of previously dominant companies in the travel industry.
- Creates Alternative Distribution Channels → Incumbents Lose Control of Supply Chains → Increases Contestability
Technology enables new distribution models such as direct-to-consumer (D2C) sales, online platforms, and decentralized supply chains, reducing reliance on traditional distribution networks controlled by dominant firms → This allows smaller businesses to bypass intermediaries and reach customers directly, increasing competition in previously concentrated industries.
Example: The rise of online marketplaces like Amazon, Etsy, and Shopify has allowed small businesses to sell products directly to customers, increasing contestability in the retail sector where large brick-and-mortar chains previously dominated.
- Enables Disruptive Innovation → Challenges Existing Market Structures → Forces Incumbents to Adapt or Exit
Technological advancements often lead to disruptive innovation, where new business models challenge traditional firms → This forces existing companies to adapt, lower prices, or risk losing market share → If dominant firms fail to keep up with technological changes, they lose their monopoly power, making the market more contestable.
Example: The gig economy (e.g., Uber, Airbnb, Fiverr) has increased contestability in transportation, accommodation, and freelance work, challenging traditional taxi services, hotels, and employment agencies.
if a monopoly was operating in a contestable market, why would they then produce at AC=AR(breakeven)
In a contestable market, a monopoly may choose to produce at AC = AR (breakeven) to reduce the threat of new entrants.
By setting prices at the point where Average Cost (AC) equals Average Revenue (AR), the monopoly earns zero economic profit. This means that there is no room for new entrants to expect high profits by entering the market. The rationale behind this pricing decision is that in a contestable market, low barriers to entry mean that potential competitors could easily enter if they perceive an opportunity for profit.
The impact of producing at AC = AR is that the monopoly reduces the incentive for other firms to enter the market. By setting prices low enough to just cover costs, the monopoly signals that it has no supernormal profits to attract new firms. This strategy serves to maintain market dominance and prevent competition from undermining its position.
advantages of contestable markets
Allocative Efficiency
- In a contestable market, firms are incentivized to produce at a price where demand equals supply, leading to allocative efficiency.
- This is because if a firm charges above the market equilibrium price, new entrants can enter and undercut the incumbent’s price, thus encouraging the incumbent to set prices that reflect consumer preferences.
- As a result, resources are allocated in a way that maximizes total welfare, ensuring that goods and services are produced at the level that consumers want, and at prices they are willing to pay.
X-efficiency
- In a contestable market, firms are compelled to operate efficiently, minimizing costs, as they know that any inefficiency will attract potential entrants.
- Since firms face the threat of competition, there is a strong incentive to reduce waste and improve operations, thus leading to lower costs and higher efficiency in the market.
- This enhances productive output without unnecessary resource use, benefiting consumers and ensuring firms remain competitive.
Productive Efficiency
- Firms in a contestable market are motivated to produce at the lowest cost possible, utilizing their resources effectively.
- Because they have the potential to face competition at any time, which forces them to minimize costs to maintain a competitive edge.
- As a result, firms are more likely to adopt best practices and new technologies that enhance their efficiency, leading to a reduction in average costs.
Job Creation
- In a contestable market, firms that successfully innovate/ reduce costs often expand their operations, can lead to increased demand for labor.
- The entry of new firms also provides job opportunities, as competition increases and firms grow to meet demand.
- This growth in market activity and employment can increase economic growth and job creation within the economy.
disadvantages of a contestable market
Lack of Dynamic Efficiency
- In a contestable market, firms may have limited incentives to innovate over the long term, as their profits are constantly threatened by the potential entry of new firms.
- Since firms can only expect normal profits, the pressure to invest in long-term research and development or technological advancements is weakened.
- This can result in a lack of dynamic efficiency, where innovation and progress are slowed down, ultimately reducing the overall rate of economic growth.
Cost Cutting in Dangerous Areas
- To stay competitive, firms in a contestable market may cut costs in ways that negatively affect product quality or worker safety.
-For example, reducing spending on safety measures or using cheaper materials to lower production costs may endanger consumers or employees.
- This drive for cost reduction in a highly competitive environment can lead to undesirable side effects, such as the exploitation of workers or a decline in product safety.
Creative Destruction
- Contestable markets may encourage “creative destruction,” where inefficient firms are driven out of business as new, more innovative competitors enter the market.
- While this can lead to improvements in overall market efficiency, it may also cause significant disruption, including job losses and the collapse of long-established businesses.
- Such disruption can harm communities and create short-term economic instability, especially for workers in industries that are unable to adapt to new competition.
Anti-Competitive Strategies
- Even in a contestable market, incumbent firms may engage in anti-competitive strategies to deter potential entrants or maintain market dominance.
- These strategies may include predatory pricing, where firms temporarily lower prices below cost to drive new entrants out of the market, or collusion to prevent market entry.
- These reduce the effectiveness of contestability, potentially leading to monopolistic behavior and reducing the benefits of competition for consumers.
eval points for contestable markets
Length of Contestability
- If the market remains contestable for a long period, it ensures that firms continue to face the threat of competition, which encourages efficiency and lower prices.
- However, if barriers to entry increase over time due to changes in market conditions, such as increasing capital requirements or regulatory hurdles, firms may be able to secure their position and reduce the level of contestability, thus undermining its benefits.
Role of Technology
- Technology plays a significant role in making markets more contestable by reducing entry barriers and enabling firms to operate more efficiently.
- However, technology can also lead to market concentration if larger firms have the resources to dominate the use of advanced technologies, potentially limiting competition in the long run and diminishing contestability.
Regulation
- Regulation can have a significant impact on the contestability of a market. While regulation can reduce barriers to entry by ensuring a level playing field (such as removing anti-competitive practices), excessive regulation can increase entry costs and limit market access for new firms.
- For example, strict licensing requirements or heavy tax burdens can deter new entrants, reducing the overall contestability of a market.
- Therefore, the role of regulation is a delicate balance; too little can lead to anti-competitive behavior, while too much can hinder market entry and reduce contestability.
Dynamic Efficiency
- Dynamic efficiency refers to the ability of firms to innovate and improve their products or services over time.
- While contestable markets generally encourage short-term efficiency through price competition, the pressure to maintain normal profits may limit long-term investments in innovation and technological advancement.
- In some cases, firms in a contestable market may not have sufficient incentives to engage in research and development because of the constant threat of competition, which could reduce dynamic efficiency and limit long-term growth.
in a perfectly competitive market, what does it mean when market price is above firms costs
they are making supernormal profits
why might firms engage in collusion
- Because of high interdependence.
- Collusion, such as price-fixing agreements, reduces uncertainty and intense price competition, allowing firms to maximize profits.
- High concentration ratios and barriers to entry make collusion more feasible.
- For example, firms may form cartels to maintain stable prices and output levels, benefiting all parties involved
what is market power
the ability of a business to set prices above the level that would exist in a highly competitive market
Sunk Costs and the Degree of Contestability
High sunk costs reduce contestability.
- Firms cannot recover these costs upon exit, making it risky for new firms to enter.
- Incumbents can maintain market power and set higher prices.
Low sunk costs increase contestability.
- New firms are willing to enter and test the market, knowing they can exit without significant losses.
- Forces incumbents to maintain competitive pricing and operational efficiency.
- Advertising as a sunk cost.
- Heavily advertised markets (e.g., soft drinks) require significant upfront investment to establish brand recognition.
- Reduces the willingness of new firms to enter, lowering contestability
Implications of Contestable Markets for the Behaviour of Firms
Firms are likely to price close to marginal cost.
- To deter entry, incumbent firms may adopt limit pricing strategies to make the market unprofitable for new entrants.
- This leads to allocative efficiency, benefiting consumers with lower prices.
Increased focus on innovation.
- Firms invest in product and process innovation to maintain a competitive edge and create entry barriers.
- Results in dynamic efficiency and higher-quality products for consumers.
Potential for hit-and-run competition.
- Firms enter the market to exploit short-term profits and exit when conditions become unfavorable.
- Ensures that no single firm can sustain monopoly pricing in the long run.
