Theme 3.4 Flashcards
What is efficiency?
Efficiency can be used to judge how well the market allocates resources, and the relationship between scarce inputs and outputs. There are a range of different types of efficiency.
What is allocative efficiency?
This is achieved when resources are used to produce goods and services which consumers want and value most highly and social welfare is maximised. It will occur when the value to society from consumption is equal to the marginal cost of production, where P=MC.
What is productive efficiency?
A firm has productive efficiency when its products are produced at the lowest average cost so the fewest resources are used to produce each product. The minimum resources are used to produce the maximum output. This can only exist if firms produce at the bottom of the AC curve, in the short run this is where MC=AC. It is only possible if there is technical efficiency, where a given output is produced with minimum inputs- but not all technically efficient firms are productively efficient.
What is dynamic efficiency?
This is achieved when resources are allocated efficiently over time. It is concerned with investment, which brings new products and new production techniques. The alternative is static efficiency: efficiency at a set point in time. Allocative and productive efficiency are examples of static efficiency. Dynamic efficiency will be achieved in markets where competition encourages innovation but where there are differences in products and copyright/patent laws. Supernormal profit is required to provide firms with the incentive to invest and the ability to do so.
What is x-inefficiency?
If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is organisational/management slack. This is a specific type of productive inefficiency as it occurs when they fail to minimise their cost for that specific output. It often occurs where there is a lack of competition so firms have little incentive to cut costs, or can also occur because the most efficient capital technologies aren’t being used.
Where does productive efficiency occur?
This occurs where ATC is at its lowest, where MC=ATC.
Where does allocative efficiency occur?
This is where the price (marginal utility) = marginal cost. However, the firms will not necessarily produce at this point if their profits are not maximised at that level of output. This means that there is often an inefficient allocation of resources because the output where the maximum social welfare would be provided isn’t being supplied.
What is perfect competition?
Perfect competition is a market where there is a high degree of competition, but the word ‘perfect’ does not mean it maximises welfare or produces ideal results. There are few industries which fit this type of market structure, one example may be agriculture but government interferences may prevent it from being so. In reality, the assumptions made rarely hold and no market is completely perfectly competitive.
What characteristics must there be for a market to have perfect competition?
-There must be many buyers and sellers
-There must be freedom of entry and exit from the market.
-There must be perfect knowledge of the market.
-The product must be homogenous.
Why must a perfect competition market have many buyers and sellers?
There must be many buyers and sellers. This means that no one firm or customer will be able to influence the market. For example, the decision of one firm to double their output or the decision of one buyer to double their consumption will have no effect. If the firm did manage to have an effect, this would mean the market was no longer perfectly competitive as there would be one large firm and other smaller firms, or one large buyer and other smaller buyers.
Why must a perfect competition markets have freedom of entry and exit from the industry?
This is important as it means that when a business is making profits anyone can enter that market and start producing that product for themselves. As a result, business are unable to make huge profits in the long run and if they are making losses they are able to leave. In the long run, they make normal profits.
Why must there be perfect knowledge for a market to have perfect competition?
This enables firms to know when other firms are making profits which will attract them to join the market. Moreover, all firms have the same costs as they can use the same production techniques. It also means that any attempt to raise prices above the level determined by the market will lead to no sales, as customers will be aware they can buy the same good for a lower price and firms know there is no point lowering the price as they will sell all their goods at the higher price determined by the market.
Why must products be homogenous for a market to have perfect competition?
The product must be homogenous, where they are identical so it is impossible to tell the difference between one make and another e.g. semi-skimmed milk. This is important because it means if a firm raises it price above the competitors’ no one will buy it and they will not gain from lowering their price because they can sell all of your product at the same price as everyone else.
What is the difference between short run and long run for firms in a perfect competition market?
Firms are assumed to short run profit maximise and so the firm will produce at MC=MR. In the short run, it is possible for the firm to make a normal profit, a supernormal profit or a loss. However, firms in perfect competition can only make normal profit in the long run.
Why do all firms in a perfect competition market make normal profit in the long run?
Prices are set by the market at P1, where S1=D1. As a result, the firm faces the demand curve of AR1=MR1 and produce where MC=MR1 at Q1 goods. However, since there is perfect information and ease of entry, the fact they are making supernormal profits will encourage new entrants to the market. This will increase supply from S1 to S2 and lead to a fall in price from P1 to P2. The firm now has the demand curve AR2=MR2 and produces where MC=MR2 at Q2. This is also where AR2=AC and so they are making normal profits. If the firm was making a loss, firms would leave the industry and this would decrease supply, pushing prices up and reverting to the long run equilibrium.
How can you deduce the short-run supply curve from the marginal cost curve?
The short run supply curve will follow the marginal cost curve until you reach the point where AVC>P, as this is the shut-down point and after this there will be no supply as production will stop.
Why is perfect competition static efficient in the long run?
Perfect competition is productively efficient, since they produce where MC=AC. They are also allocative efficient since they produce where P=MC. Thus, they are static efficient.
Why is perfect competition not actually dynamically efficient?
However, they are not dynamic efficient. No single firm will have enough for research and development (as there is no SNP) and small firms struggle to receive finance. The existence of perfect information also means one firms’ invention will be adopted by another firm and so the investment will give the firm no competitive benefit. Governments tend to have to do all the research.
Why may costs be higher in perfect competition than they could otherwise be?
Competition should keep costs, and therefore prices, low. However, firms will be unable to benefit from economies of scale and this may mean costs are higher than they otherwise could be.
Why does perfect competition not occur in reality?
-All firms will actually hold some price-setting power in reality.
-Complex products means that consumers won’t actually have perfect market knowledge
-No goods are completely homogenous, some brands will also hold a better reputation than others.
-Regulation set out by governments as well as fixed costs required for certain capital means that there isn’t actually free entry and exit into a market.
What is monopolistic competition?
Monopolistic competition is a form of imperfect competition, with a downward sloping demand curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely exist in a pure form in real life. Some examples of firms in monopolistic competition are hairdressers, estate agents and restaurants.
What are the characteristics of monopolistic competition?
-There must be a large number of buyers and sellers in the market, each of whom are relatively small and act independently. This means that no one buyer or seller has a large price setting power.
-There are no barriers to entry or exit, allowing new firms to enter when supernormal profits are being made and some to leave in the case of losses. As a result, only normal profits can be made in the long run.
-The difference between monopolistic competition and perfect competition is that in monopolistic competition firms produce differentiated, non-homogenous goods or services. This means that individual firms do have some price setting power, and so the curve is downward sloping.
What is the difference between the available profits in monopolistic competition in the short run vs long run?
In the short run, firms can make supernormal profits, losses or normal profits. However, due to the lack of barriers to entry/exit, firms can only make normal profits in the long run.
Why can supernormal profits not be made in the long run in monopolistic competition?
Firms are assumed to be short run profit maximisers, producing at MC=MR1 in the short run. As a result, they produce Q1 at price P1 and make a supernormal profit of the shaded area. However, in the long run, new firms will enter the industry as they know that supernormal profits are being earnt. This will cause demand for the individual firm to decrease and therefore the AR and MR curves will shift to the lift. The firm will produce where MC=MR2 at P2Q2. At this point, AC=AR2 and so the firm is making normal profits. If the firm was making a loss, firms would leave the industry and thus demand for the individual firm would increase as they had less competition. This would lead to normal profits in the long run.
Will there be allocative or productive efficiency in monopolistic production?
Since they can only make normal profit in the long run, AC=AR and since they profit maximise, MR=MC. Therefore, the firm will not be allocatively or productively efficient, as MR does not equal AR so AC cannot equal MC and AC cannot equal MR.
Will firms in monopolistic competition be dynamically efficient?
They are likely to be dynamically efficient since there are differentiated products and so know that innovative products will give them an edge over their competitors and enable them to make supernormal profits in the short run. However, since the firms are small they may struggle to receive finance or have the retained profits necessary to invest.
What is the difference in pricing between monopolistic markets and perfect competition?
In monopolistic competition compared to perfect competition, less is sold at a higher price and firms may not necessarily be producing at the lowest cost. However, the market will offer greater variety and may be able to enjoy some degree of economies of scale.
What are the limitations of the model of monopolistic competition?
The limitation of this model is that information may be imperfect and so firms will not enter the market as predicted as they are unaware of the existence of abnormal profits. Also, firms are likely to be different in their size and cost structure as well as in their products, which may allow some firms to maintain supernormal profits because firms cannot compete on equal terms.
Will monopolistic markets reach stable equilibrium in reality?
No, it is unlikely that this will happen because of the idea that in monopolistic markets there is some differentiation in products. Therefore, new products will always come and go, and more substitutes will always become available. Therefore, in reality the market is always in a constant state of flux, which is known as the product cycle.
What are some non-price factors which affect monopolistic market competition?
-Innovation
-Branding
-Advertisement
-Quality
-Customer service
-Loyalty schemes
-Delivery/service time
-Post-purchase maintenance offers.
What is an example of monopolistic competition?
-Food outlets (e.g curryhouses or kebab shops)
-Road transport market (different car transporter companies for example)
How can it be argued that advertising is a problem in monopolistic markets?
It could be argued that excessive use of advertising to maintain product differentiation could lead the AC curve to be higher than it needs to be. However, it could also be argued that this spending prevents X-efficiency from monopolists who get complacent.
How could firms not optimising economies if scale be an issue for monopolistic markets?
If the full economies of scale which exists aren’t being exploited, then this will be damaging to societies total welfare. It is suggested that product differentiation is why firms can keep the demand curves downwards sloping, and too many products are actually being produced.
This point can be countered however, by pointing out that consumers may enjoy more freedom of choice, and the fact they’re prepared to pay a premium price for a good shows they have a preference for it.
What is a crucial difference between perfect competition and monopolistic competition?
Under monopolistic competition, firms will always like to sell more of their product at the going price. However, in perfect competition a firm can sell as much as it likes at the going price.
This issue arises because the price in monopolistic competition is set above the marginal cost.
What is a good case study example of monopolistic competition?
The craft beer industry.
-Despite some with high market power (e.g Guinness with 19% UK market share), there is lots of small firms which means the market is generally unaffected by changes in prices.
-Extremely low barriers of entry, it is extremely easy for new firms to create a beer and enter the market.
-There is product differentiation: 0% beer, different flavours and advertising differences.
-Due to new firms entering the market and offering lower prices, brands like Guinness and Madri have to differentiate themselves as a ‘premium’ brand for people to pay the extra.
-Non-price factors such as locally sourced beer, ability to appeal as a ‘refreshing’ drink and brand image can also impact price.
What is an oligopoly?
Oligopoly is where there are a few firms that dominate the market and have the majority of market share, although this does not mean there won’t be other firms in the market.
What are the 4 key characteristics of an oligopoly?
-Products are generally differentiated
-Supply in the industry must be concentrated in the hands of a relatively small number of firms, meaning there is a high concentration ratio
-Firms must be interdependent (so the actions of one firm will directly affect another)
-There are barriers to entry.
What are N-firm concentration ratios?
The concentration of supply in the industry can be indicated by the concentration ratio which measures the percentage of the total market that a particular number of firms have. The 3 firm concentration ratio shows the percentage of the total market held by the three biggest firms, whilst the 4 firm ratio shows the percentage by the four biggest firms and so on.
What is the general rule of thumb for the necessary market share for an oligopoly?
When the top 5 firms make more than 50% of total market sales, there is an oligopoly.
What is an example of a market which has an oligopoly?
The soft drinks industry, where coca-cola and Pepsi hold 72% of the market share. There is product differentiation of different flavours and zero-sugar editions etc. Barriers of entry are high because of drinks regulations and also the extremely high marketing costs needed to compete.
What is strategic interdependency?
This is when one firms output and price decisions are influenced by the likely behaviours of competitors.
What is collusion?
Collusion is when firms make collective agreements that reduce competition. When firms don’t collude, this is a competitive oligopoly. The UK energy market is an oligopoly that is suspected of collusion.
How does collusion work to benefit firms?
● If firms compete, they know lowering prices to gain new customers is likely to cause other firms to lower their prices;. However, if they work together, they could maximise industry profits.
● Collusion reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising, which will reduce industry profits.
Why may some firms decide not to form collusions?
● Despite this, firms may decide to be a non-collusive oligopoly since collusion is illegal and due to the risks of collusion, such as other firms breaking the cartel or prices being set where they don’t want it.
● A firm with a strong business model and something that sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors.
When does collusion work best between firms?
Collusion between firms works best when: there are a few firms which are all well known to each other; the firms are not secretive about costs and production methods and the costs and production methods are similar; they produce similar products; there is a dominant firm which the others are happy to follow; the market is relatively stable; and there are high barriers to entry.
What is an example of a legal collusion?
OPEC
How do collusive oligopolies work?
When firms engage in collusion, they may agree on prices, market share or advertising expenditure. There are two main types of collusion: overt and tacit collusion. Overt collusion is when firms come to a formal agreement whilst tacit collusion means there is no formal agreement.
What is a cartel?
A formal collusive agreement is called a cartel, which is a group of firms who enter into agreement to mutually set prices. The rules will be laid out in a formal document which may be legally enforced and fines will be charged for firms who break these rules.
What are the two ways which a cartel can operate?
-agree on a price for the goods and then compete freely using non-price competition to maximise their market share
-agree to divide up the market according to the present market share of each business.
What are the issues with cartels?
The problem with any cartel is that no firm is likely to set their prices/output at the level they would not ideally choose and there is constant temptation to break the cartel. The more successful the cartel, the greater the incentive to break it; it is important for firms to be the first to break it and not the firm who is left to deal with the after effects.
What often occurs due to explicit collusion being illegal?
Since collusion is illegal, firms may be involved in tacit collusion such as price leadership and barometric firm.
What is price leadership in a collusions?
Price leadership is where one firm has advantages due to its size or costs and becomes the dominant firm. Other firms will tend to follow this firm because they would be fearful of taking on the firm on in any form of price war. As a result, the dominant firm will decide the price and allow the other firms to supply as much as they wish at this price.
What is Barometric firm price leadership in cartels?
Barometric firm price leadership is where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their leader.
Why do companies in oligopolies often want to form collusions?
If the firms are individual, to gain market power they will have to produce at their sales maximising point (rather than profit maximisation point). However, if a collusion is formed and a market price can be agreed, the firms can set this price to the profit maximising price, and then this profit can be divided between the firm’s participating in the collusion.
What is a UK example of illegal price fixing?
The construction industry. Firms participate in an activity known as ‘cover bidding’, where when a new job comes out for a large construction job (e.g new selfridges construction), large firms will work together and one firm will deliberately put in a bid way too high or low to secure the job, essentially sacrificing themselves so that the other firm in the collusion can win the bid. They will then swap roles for a future bid which means the firm which sacrificed last time will secure the next big construction job. £60 million in fines was handed out to major firms, as well as prison sentences for some directors of firms.
What is tacit collusion?
This is a collusion which occurs without any written rules actually being formally agreed between the firms. Instead firms closely monitor each other and set their prices accordingly. A good example of this is in the fuel market between different petrol stations.
How do some brands appear to put consumers first to actually deter lower prices from competitors?
Firms will often tell their customers through advertising that they will price match against the cheapest legitimate substitute good available. Although this appears pro consumer, it can actually be done to prevent competing firms from lowering their prices, as this firm will match it by doing the same meaning all that happens is both firms will lose profits and revenue.
What does the behaviour of firms under non-collusive oligopolies depend on?
The behaviour of a firm under non-collusive oligopoly will depend on how it thinks other firms will react to its policies. Game theory can be used to examine the best strategy a firm can adopt for each assumption about its rivals.
What is game theory?
Game theory explores the reactions of one player to changes in strategy by another player. The aim is to examine the best strategy a firm can adopt for each assumption about its rival’s behaviour and it provides insight into interdependent decision making that occurs in competitive markets. The easiest way of demonstrating this is where duopoly exists in the market, so there are two identical firms.
What two strategies can a firm take in game theory?
There are two strategies the firm could take: a maximin policy or a maximax. The maximin policy involves firms working out the strategy where the worst possible outcome is the least bad. Alternatively, the maximax policy involves firms working out the policy with the best possible outcome.
What is the dominant strategy?
If the maximin and maximax strategies end up with the same solution, this is called the dominant strategy. However, dominant strategies aren’t that common in real life and the best strategy for a firm tends to depend on what the other firm does.
What is a Nash Equilibrium?
In some cases, there is a Nash Equilibrium where neither player is able to improve their position and has optimised their outcome based on the other players expected decision. They have no incentive to change behaviour, unless someone else changes theirs.
What is the prisoner’s dilemma?
In the situation, two people are questioned over their involvement in a crime and are kept apart so they can’t communicate. The dominant strategy in this situation is to confess: it’s the greatest reward (3 months rather than a year) and the least bad (3 years rather than 10 years). However, if the prisoners could collude or had confidence in one another, the best option would be to deny the crime; this is the Nash equilibrium.
How does game theory change when the game is repeated, rather than a one-shot game?
In reality, strategies will actually change more than once as firms assume that they will continue to exist into the future.
Here, firms are more likely to take risks and charge higher prices. However, unless there is a known limited number of price changes, firms are unlikely ‘cheat’ and attempt to undercut their rival with lower prices.
What can often occur in a repeated game theory?
In the real world, firms would compete with each other for years, giving more opportunities to potentially collude. Occasionally, firms will collide but this will usually break down over time, because one firm may decide they want to increase their market share and suddenly lower their prices. The other firm will then respond by also lowering their prices, which will take them back to the original nash equilibrium.
How can collusive behaviour cause damage to consumer welfare?
-Higher prices
-Loss of allocative efficiency
-Impacts lower income families more (regressive)
How is the absence of competition a negative as a result of collusion?
- X-efficiency leads to higher unit costs
- Less incentive to innovate/loss of dynamic efficiency
- Output quotas penalise firms who want to expand
How does collusive behaviour reinforcing cartel’s monopoly power cause collusion to be a negative?
-It makes it harder for new businesses to enter the market, reducing contestability.
What are the potential benefits that can come from a collusion?
-General industry standards can bring social benefits
-Fairer prices for producer cooperatives in lower and middle-income developing countries.
-Profits can be used to drive R&D as well as research and development.
What are three types of price competition?
-Price wars
-Predatory pricing
-Limit pricing
What are price wars?
● These occur in markets where non-price competition is weak; where goods have weak brands and consumers are price conscious. They also occur when it is difficult to collude.
● A price war will drive prices down to levels where firms are frequently making losses. In the short term, firms will continue to produce if their AR is below AVC but in the long run, they will leave the market and prices will have to rise since supply falls.
● It lowers industry profits.
● Supermarkets are one example of an industry using heavy price wars, with firms
desperately trying to offer lower prices than their rivals.
What is predatory pricing?
This occurs when an established firm is threatened by a new entrant or if one firm feels that another is gaining too much market share.
● The established firm will set such a low price that other firms are unable to make a profit and so will be driven out the market. The existing firm is then able to put their price back up.
● This is illegal and only works when one firm is large enough to be able to have low prices and sustain losses.
-High barriers of entry are needed for predatory pricing, and a possible barrier for entry could be a dominant firm having a reputation of cutting prices when they feel threatened by an entrant into the industry.
What is an example of predatory pricing?
This can occur when foreign exporters want to maintain their market share in the US industries, and cut their prices when a domestic US firm tries to enter the market. For example, Indian firms cut the prices of steel nails when US companies tried to start producing.
What is limit pricing?
● In order to prevent new entrants, firms will set prices low (the limit price). The price needs to be high enough for them to make at least normal profit but low enough to discourage any other firm from entering the market.
● The greater the barriers to entry, the higher the limit price. It is mainly used in
contestable markets.
● The drawback of this is that it means firms cannot make profits as high as they would be otherwise be able to.
What factors make a collusion more likely to occur?
-High levels of trust between the firms (e,g if they’re in the same business group)
-Movement of senior managers of chief executives between firms can build trust
-When a small number of firms are involved, as behaviour is easier to manage
-Also more likely to maintain a collusion when the punishments of breaking the collision are severe.
What are the advantages of using game theory?
-A powerful tool to analyse interactions between a large number of firms with a large number of possible strategies
-Dynamic rather than static, as it shows how firms behaviour changes over time
-Reasonably accurate in modelling behaviour of firms in a duopoly.
What are the disadvantages of using game theory?
-In reality, it will be difficult for firms to know what the payoffs may be. Making business predictions are extremely difficult, especially when about other firms!
-People do not usually behave rationally, but game theory assumes they do. In reality, entrepreneurs may be extreme risk takers.
What two market conditions mean firms are unlikely to cheat in a collusion?
-High levels of consumer loyalty to brands
-High levels of consumer inertia
-If the market isn’t performing amazingly, so more profits would be made at the high price than cutting price and gaining market share.
How can the kinked demand curve theory be explained?
In an oligopoly, if a firm raises its price, other firms will not raise theirs as a comparatively lower price makes them more competitive. This will cause the demand curve to be elastic for the firm which increases its price.
However, if the firm reduces its price other firms in the market will follow, as otherwise consumers will follow the cheaper prices. This causes the elasticity of demand for the firm to be inelastic when prices decrease, and every other firm also decreased prices. This results in a kink in the demand curve at the original price point.
What is the issue with the kinked demand theory?
It assumes that there is an initial price set within the market, but doesn’t explain how this price arrived.
Why do oligopolistic markets have lots of non-price competition?
Because they’re relatively stable. Therefore, they spend lots of time and money on advertising and promotions, e.g Tesco club cards.
What are some examples of non-price competition?
-Advertising
-Loyalty cards
-Branding
-Quality
-Customer service
-Product development
There is never a guarantee investing in these non-price factors will result in success for the company.
Are firms in an oligopoly efficient?
They will be statically inefficient, as they aren’t productively or allocative efficient.
They are likely to be dynamically efficient, as SNP allows them funds to invest and competition means that have incentive to invest.
Large companies can also exploit economies of scale, and will want to do so to raise barriers of entry.
What is a pure monopoly?
Pure monopoly exists where one firm is the sole seller of a product in a market. One of the closest examples to a pure monopoly is Google, who have 88% of the market.
What are the characteristics of a monopoly?
- There is a single seller of a good
- There are no substitutes for the good, either actual or potential
- There are barriers of entry into the market.
- The firm aims to maximise profits
What is an example of a local monopoly?
A monopoly will change depending on how you define it. This means the size and shape of the market will change wether a firm is considered to have a monopoly.
For example, stagecoach has a local monopoly in Cambridge, but not in the UK bus travel market.
What does the CMA define as a monopoly?
The CMA defines a monopoly as when a firm has more than 25% of a market share.
When will monopolies be strongest?
When there is an extremely high degree of product differentiation, and when this is matched by high barriers of entry. High barriers of entry could include a patent, gov regulation, high cost of machinery, specialist knowledge/machinery needed, economies of scale needed, or advertising costs and brand loyalty.
How do monopolies cause a deadweight loss to society?
If a firm in perfect competition produces in the long run, there will be be allocative efficiency and consumer surplus will be higher. However, if a monopoly charges higher prices, most of this consumer surplus (and also some producer surplus) will be lost, even through more profit is earned by the monopoly. This loss is known as the deadweight loss of welfare to society.
In perfect competition, there is no deadweight loss.
What is price discrimination?
This is where a business charges different consumers different prices for the same products.
What are the 3 types of price discrimination?
1st degree
2nd degree
3rd degree
What is 1st degree price discrimination?
-This is where the price will change for each individual unit purchased. E.g haggling. Doesn’t occur in the Uk very much, but is more common abroad in markets.
What is 2nd degree price discrimination?
This is when prices vary based on the quantity sold and the time of purchase. (e.g bulk buying or buying at peak times).
What is dynamic pricing?
Where firms will change their prices during different times of day, e.g drinks may be cheaper during ‘happy hour’. Stonegate took the opposite approach, raising prices during the peak times of the weekend and in evenings. The price of a pint went up from £3.40 to £4.20. This was said to be due to raising price to eliminate excess demand, as well as additional variable costs like added security.
Uber is another company who raises prices during peak times.
What are the advantages of 2nd degree price discrimination?
-Increased revenue
-Utilise production capacity
-Cater to consumer preferences
-Promote competition
What are the disadvantages of 2nd degree price determination?
-Increases complexity of price setting
-Can become confusing for customers
-Those who would’ve been willing to pay the higher price now pay less, the firm loses profit.
-Can have negative consumer perceptions
-Can have legal and regulatory issues
Why is 2nd degree price discrimination most effective with economies of scale?
With economies of scale, the average cost of production reduced when output rises, so therefore offering deals which mean they have to produce more (e.g through bulk buying offers), they can gain revenue and profits.
Segmentation is also easy for these firms, as you simply divide the population into those who are willing to bulk buy and those who aren’t.
What is 3rd degree price discrimination?
This is when monopolists charge different prices to different people for the same good or service. There are different examples of where this can occur: different times of the day, for example peak and off-peak train times; different prices in different places, such as between London and smaller towns; and between different incomes, for example discounts for elderly people.
What conditions are necessary for 3rd degree price discrimination?
-The firm must be able to clearly separate the market into groups of buyers
-The customers must have different elasticities of demand (willingness to pay)
-They must be able to control supply and prevent buyers from the expensive market from buying in the cheaper market (limited ability to resell)
-Firms must also have some market power (to set prices)
Why are profits higher when 3rd degree price discrimination is used compared to once price for all?
Look at PMT detailed notes diagram to aid this flashcard
The diagram assumes the industry is a constant cost industry, in order to make it clearer. The firm produces where MC=MR in each market. Therefore, in the inelastic market they produce at Q1P1 and make supernormal profit of the orange area; in the elastic market they produce at Q2P2 and make supernormal profit of the purple area; and in the combined market they produce at Q3P3 and make supernormal profit of the yellow area. This shows that by price discriminating and having two separate markets, the inelastic market and the elastic market, rather than a combined market, the firm can make higher profits. The orange area plus the purple area is larger than the yellow area.
What are the costs and benefits of 3rd degree price discrimination?
● Firms benefit since they are able to increase their profits. This can go into research and development, improving dynamic efficiency.
● Those in the elastic market gain as they are able to pay a lower price than they otherwise would; they benefit from cross subsidisation. These consumers may have been unable to access the good if it were not for the price discrimination and so this may increase equality. .
● Consumers lose some of their consumer surplus to the producers and some consumers have to pay a higher price.
Why may even the inelastic consumers in 3rd degree price discrimination benefit from paying a higher price?
In industries with extremely high costs of production, such as airlines, an airline may not be able to afford to carry out the service of it didn’t gain the revenue of those willing to pay for 1st class tickets farther than economy. This is because in some cases the revenue produces from economy tickets simply may not be enough for the airline to make normal profits.
What will monopolies consider doing for consumers that have a PED<1?
Because of 3rd degree price discrimination, firms will consider raising their prices to extract from the consumer surplus experienced.
What is a natural monopoly?
Some companies are said to be natural monopolies. In these industries, the
economies of scale are so large that even a single producer is not able to fully exploit all of them. These are decreasing cost industries. There are no pure natural monopolies in real life, but some examples include the National Grid, Royal Mail and National Rail.
Why would competition be pointless in fixed cost (natural) monopolies?
It would be pointless to encourage competition since it would raise average costs for the industry. If any new firm enters the market, they will be easily priced out as their costs will be so much higher. This raises questions for competition policy and nationalisation.
What characteristic does a natural monopoly have?
Natural monopolies tend to be found in industries with very high fixed costs, such as railways. In order to run one train you would need to invest billions in track, tunnels, bridges and stations whilst running extra trains represents a much smaller relative increase in costs, meaning average costs will decrease drastically.
These high costs won’t necessarily be for machinery and capital, but could be very high marketing costs needed to even consider competing.
What is the efficiency of natural monopolies?
-These firms are neither allocative nor productively efficient as there is no minimum on the AC curve and at allocative efficiency there would be a loss.
What is the efficiency of monopolies?
-They are neither allocative or productively efficient
-They are x-inefficient
-They are dynamically efficient as they earn SNP, however a lack of competition may reduce their incentive to invest.
What are the benefits of monopolies for the firm?
Monopolists have the potential to make huge profits for their shareholders through profit maximisation.
● The existence of supernormal profits means firms will have finance for investments and will be able to build up reserves to overcome short term difficulties.
● Firms with monopoly power will be able to compete against large overseas organisations.
● Large firms will be able to maximise economies of scale, reducing costs and increasing profit further
What are the costs of monopolies to firms?
However, firms may not always choose to profit maximise because of X-inefficiencies, sales or revenue maximising, profit satisficing or contestability leading to limit pricing. In the long run, the lack of competition may mean that firms become complacent and so they may not make maximum profits.
What are the costs and benefits of monopolies on employees?
Monopolists produce at lower outputs, so will employ fewer workers.
● However, the inefficiency of the monopoly may mean employees receive higher wages, particularly directors and senior managers. Profit satisficing or sales/revenue
maximising may mean output is higher and so more employees are employed.
-Also could be welfare benefits to workers for big companies (e.g having a free gym in the office).
What is the impact of monopolies on suppliers?
For suppliers, the impact of a monopolist will depend on the extent to which the monopolist is also a monopsonist. If the monopolist buys all or most of the suppliers’ goods (so is a monopsonist), it will reduce the suppliers’ profits as the monopolist will decrease prices.
What are the benefits of monopolies for consumers?
With a natural monopoly, consumers tend to be better off than if there was competition.
● When firms enjoy economies of scale, they will be more efficient and customers will enjoy a higher consumer surplus.
● Monopolists may produce an increased range of goods or services due to cross subsidisation.
● The use of price discrimination will allow for survival of a product or service, and benefits some customers (those in the cheap market) whilst is negative for others. For example, it is said that economy class flights are funded by business class flights
What are the costs of monopolies for consumers?
Consumers may pay higher prices and see a poorer quality service, due to a lack of competition.
● There is less choice for consumers, since there is only one firm producing the good.
How could monopolies potentially cause a greater consumer surplus than what would exist in perfect competition?
-A large monopolist may enjoy large economies of scale which allow AC to fall. If these fall by a large enough amount, then consumer surplus will grow larger than would exist in perfect competition.
-Monopolies will have large retained profits and will be able to exploit new products or production techniques without worrying about competitors. This would make them more productively efficient, as costs are lower, more allocative efficient, as there are new products in the market, and dynamically efficient.
-Also, monopolists avoid undesirable duplication of services and prevent a misallocation of resources.
-Cross subsidisation may waste resources since profits from one sector finance losses in another, whilst instead they should just stop production of this good.
Why are monopolies rarely permanent?
There are few permanent monopolies since supernormal profits give an incentive for other firms to break down the monopoly through a process of creative destruction. Some suggest a monopoly, or the possibility of having a monopoly, is good in the short run as it provides incentive to invest and innovate which is good for both the company and the economy. The bad aspects of monopoly are more likely to become true in the long run as firms can simply enjoy the benefits and become complacent. The effects of a monopoly will depend on the industry: in industries with high fixed costs, the gains from economies of scale will be higher.
Why would 3rd degree price discrimination not occur if reselling was an option?
The group of consumers who qualify for the lower price would buy the products and sell these to consumers in other parts of the market who would have to pay a higher price.
What is a contestable market?
A contestable market is one with a high threat of new entrants, which keeps firms producing at a competitive level. Even in a monopoly, a firm may be forced to be efficient due to the potential of new entrants to the market. Any attempt to make a huge profit will mean other businesses will be attracted to the industry.
What are the characteristics of a contestable market?
-There is perfect market knowledge
-Freedom of entry and exit, with relatively low sunk costs
-Firms will have legal access to use the best tech available
-Low product loyalty to original firms in the market
-Assume firms short run profit maximise and do not collude
What is an example of a contestable market?
The taxi industry due to the introduction of Uber, or the hotel market with AirBnB.
When will firms enter a contestable market?
● In a contestable market, firms will enter the market if they see other firms are making huge profits. They will remain in the market until competition prevents them from making a profit. This will take away profit from the original firms, and could even force them out of business. The only way to prevent this is by using limit pricing, which reduces the incentive for firms to enter the market.
● In a perfectly contestable market, firms will only be able to make normal profits and produce where AC=AR because new firms will enter the market if price was any higher and they were making monopoly profits.
Are firms in contestable markets efficient?
Firms are likely to be productive and allocative efficient. If they are not producing at the lowest point on their AC curve (i.e. not productively efficient), new firms can enter the market and undercut them by offering lower prices. Due to this, and the fact they can only make normal profits in the long run, they must also be allocative efficient. Since they can only make normal profits AC=AR, and since they produce at the lowest point on their AC curve AC=MC. Therefore, AC=MC=AR, so the value to society is equal to the cost.
What are innocent entry barriers?
Some barriers are natural barriers, sometimes called innocent entry barriers. These include natural monopolies and high entry/sunk costs.
What barriers of entry can be put in place by firms in the industry?
They include patents and copyrights as well as high levels of advertising and branding. Both the costs to entry and exit must be high for the market to have low contestability, since if entry costs are high but the firm is able to make profit once in business and not lose much of this profit if they leave, then the market is still contestable.
How can legal barriers prevent contestability?
Legal barriers can prevent new firms from entering an industry. Laws are put in place which make it more difficult for firms to enter the market, or explicitly mean they cannot enter. For example, patents and exclusive rights to production (such as with television) mean other firms cannot enter the market. Some industries, such as the taxi industry, gain market licences to operate.
How can marketing barriers prevent contest-ability?
Other firms can put up marketing barriers. High levels of advertising build up consumer loyalty, so demand becomes more price inelastic, and consumers are less likely to try other brands. Sometimes a brand can become associated with a product, such as ‘Hoover’ with vacuum cleaners. New firms entering the industry are unlikely to have the funds to undertake large scale advertising so struggle to compete with the incumbent firms. This may also be a barrier to exit, since losing a brand and consumer loyalty will be a cost of leaving the market.
How can the pricing decisions of incumbent firms be a barrier to entry?
The pricing decisions of incumbent firms can be a barrier to entry. Predatory pricing means prices are so low that firms are driven out of the market, and so it would be extremely difficult for new firms to enter. Limit pricing discourages the entry of other firms as prices are set at a level to prevent new entrants. Some firms might employ anti-competitive practices, such as refusing to supply retailers which stock competitors.
How can economies of scale and capital start up costs reduce contestability?
● Economies of scale mean that new firms are unable to produce on the same AC curve as large, incumbent firms. If they were to enter the industry, their costs would be higher and so prices would be higher and they would be unable to compete.
● Some industries have high capital start up costs, for example buying the machinery necessary to begin production. Sunk costs may also be high.
How can barriers to exit prevent contestable markets?
Barriers to exit prevent firms from leaving a market quickly and cheaply. They include the cost to write off assets, pay leases and make workers redundant.
What is a sunk cost?
A sunk cost is a fixed cost that a business cannot recover if it leaves the industry. It includes property (if the lease is longer than it is actually used for), machinery and equipment that cannot be resold, and advertising.
● All businesses will face sunk costs because even if things are resold it is generally for a lower price.
What is the degree of contestability measured by?
The degree of contestability is measured by the extent to which the gains from market entry for a firm exceed the costs of entering the market. A market with no sunk costs and no barriers to entry and exit is a perfectly contestable market. The more contestable a market, the more unstable it will be as there can be regular hit and run competition.
In reality, no market is likely to be perfectly contestable as there is always likely to be some sunk cost.
What is hit and run entry?
This is where a firm enters a market to take short-run supernormal profits, knowing it can exit without incurring costs.
What is the impact of the internet on contestability?
The internet has made information more freely available, and has given consumers improved knowledge of market conditions, allowing them to find and use the cheapest options. It has also made it easier for new firms to enter the market as they may not necessarily need highstreet presence (e,g travel-agents are now predominantly online).
What are the disadvantages of contestable markets?
1) There is a lack of dynamic efficiency (as there’s no longer SNP)
2) Costs are cut in dangerous areas (e.g wages, safety, environmental safety)
3) Creative distruction (causes job losses)
4) Anti-competitive strategies.
What are the evaluation points for contestable markets?
-Length of contestability (e.g if over time firms can get patents contestability will decrease)
-Role of technology (could reduce contestability through copyright but also gives access to consumer data, allowing for price discrimination)
-Regulation (+ve if it fixes the cons of contestability)
-Lack of dynamic efficiency
Why is the airline industry a good example of a
contestable market?
-Deregulation and privatisation in 1990 led to low cost airlines being developed in Europe.
-Aircrafts, staff and air slots can all be leased short-term, so here are actually fairly low sunk costs meaning low barriers to exit and entry.
-The internet allows for good consumer knowledge of the best prices, so there is little brand loyalty.
However,
-Not all servcies are equally available, e.g Heathrow is very expensive to land at and fly a service from, which could be seen as a barrier to entry.
-High sunk costs may be needed to gain licences to meet flying regulations.
-There are also still aviation laws which prevent foreign companies flying to many destinations in the world.
What is a monopsony?
This is where there is only one buyer in the market, and other than this it has the same basic characteristics as monopoly. They can prevent new firms entering the market and aim to profit maximise.
Do pure monopsonies exist in real life?
In real life, pure monopsonies rarely exist but many firms experience monopsony power, when they buy a large percentage of the market. One example could be the NHS, who pay less for cancer drugs than a number of other high-income countries. Moreover, food retailers have power when purchasing supplies from farmers; farmers can either sell them all their goods at a low price or risk not selling them at all.
What will monopsonies attempt to pay to their suppliers?
They will pay their suppliers the lowest price possible to minimise their costs and make the most of their position as the only buyer. This will enable them to maximise their profit. The value of the goods they buy will depend on how much money they can make with these goods, and this is determined by the demand curve of the goods they make and sell.
What are the costs and benefits of monopsonies to firms?
● The monopsony gains higher profits by being able to buy at lower prices. This increases the funding for research and development and leads to more return for shareholders.
● They achieve purchasing economies of scale, which will lower costs and increase profits.
● The NHS is a monopsonist buyer of pharmaceuticals, and this leads to significantly lower prices. As a result, they can invest more and pay for more treatments.
-If firms force suppliers to cut costs, this may impact the quality of products supplied to the firm as cuts may have to be made to wages given to skilled workers, or the quality of raw materials used in production etc…
What are the costs and benefits of monopsonies to consumers?
● Customers may gain from lower prices as reduced costs are passed on, however prices may not necessarily fall, this is up to the monopsonist’s intentions.
● It could lead to a fall in supply, since the business buys fewer inputs. The extent to which supply to customers will fall will depend on the price elasticity of supply in the market of which the monopsonist is a buyer: if it is inelastic, there will be little fall in supply.
-As output of supply is controlled by the monopsonist, suppliers have little incentive to invest in R&D, and therefore product quality is unlikely to see major developments.
● There may be a fall in quality as prices are driven down.
What are the costs and benefits of monopsonies to employees?
● The supplier will sell less goods and so employ less people, whilst the monopsonist may employ fewer, more or the same amount of people since they have less inputs to use for production but their costs are also lower.
● Monopsonists may pay higher wages as they are making higher profits.
What are the costs of monopsonies to suppliers?
-Suppliers will lose out as they will receive lower prices; less will be supplied leading to some firms leaving the market.
-However, suppliers may also gain because of the fact that they know they will have an assured regular buyer of their products.
What is an oligopsony?
This is a market in which there are few buyers of a good, service, or factor of production.
What is an example of a duopoly?
The aircraft manufacturing industry, where airbus and Boeing own over 90% of the industry’s market share.
What is creative destruction?
This is the dismantling of long-standing practices in order to make way for innovation.
What are three good examples of contestable markets (or markets which have become more contestable over time)?
-The banking industry
-Supermarket retail
-Electricity and gas retail
Nash equilibrium?
This will occur is both parties in game theory have maximised their benefit based off of their assumption of the other firms behaviour, so a long-term equilibrium will be maintained.
What is cross subsidisation?
When a firm will charge very high prices for one product in order to facilitate the ability to change a lower price (essentially subsidise) another product.
