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.
