Theme 3.4: Market structures

Question 1

When is a firm considered a monopoly

Answer 1

When it owns 25% of the market share

Question 2

What are the 3 assumptions regarding monopolies?

Answer 2

-Only one firm in a market
- The firm wants to Profit maximise - meaning they produce where marginal cost = marginal revenue
-High barriers to entry

Question 3

What is a pure monopoly?

Answer 3

A firm with 100% market share

Question 4

What are the 5 barriers to entry?

Answer 4

Legal barriers
Economies of scale
Sunken costs
Brand loyalty
Anti-competitive practices

Question 5

Why are sunk costs a barrier to entry?

Answer 5

Sunk costs are costs that cannot be recovered (e.g. advertising).

High sunk costs are a barrier to entry: they deter new firms from entering because firms know that if they fail, they won’t be able to recover any of their sunk costs.

Question 6

Why are legal barriers a barrier to entry?

Answer 6

Legal barriers are things which stop a new firm from stealing an incumbent firm’s ideas (e.g. Patents, trademarks and copyrights)
this means it is harder for new firms to enter as ideas have already been used before, thus deterring firms to enter the market meaning it is a barrier to entry

Question 7

Definition of perfect competition

Answer 7

A market where there is a high degree of competition, but the word ‘perfect’ does not mean it maximises welfare or produces ideal results

Question 8

Characteristics of perfect competition

Answer 8

-Many buyers and sellers
-Freedom of entry and exit from the industry
-Perfect knowledge
-Product must be homogeneous

Question 9

How does many buyers and sellers in a market cause perfect competition?

Answer 9

No one firm or customer will be able to influence the market. For example, the decision of one firm 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 form and other smaller firms, or one large buyer and other smaller buyers

Question 10

Define a natural monopoly

Answer 10

When it is most efficient for there to only be one firm in the market e.g. TFL and NHS

Question 11

Why do natural monopolies exist?

Answer 11

High sunk costs and huge internal economies of scale

Question 12

EXAM STYLE QUESTION
Explain why TFL is considered a natural monopoly. (4 marks)

Answer 12

Natural monopolies exist for two reasons: high sunk costs and huge economies of scale.

TFL has high sunk costs—such as railways, Oyster card tech development, and training staff—estimated as high as £129 billion. It would be inefficient if a second transport firm entered the market and duplicated this £129 billion cost, so having just one firm, TFL, would be inefficient.

TFL has huge economies of scale like purchasing economies, which it can use to buy fuel in bulk to power its trains and buses at very low long-run average costs. To fully exploit these economies of scale and get to its MES, TFL needs to increase its sales massively - which it can only do if it’s the only seller in the market.

Question 13

Definition of price discrimination

Answer 13

When firms charge different groups of consumers different prices for the same good
E.g.
Adults who are more inelastic are charged higher price train tickets compared to elastic students who are charged lower price train tickets

Question 14

3 conditions for price discrimination

Answer 14

• Firm must have large market share
• Information on elasticities of consumers
• Ability to limit reselling

Question 15

Why must firms have market power in order to price discriminate?

Answer 15

A firm must have enough market share to be able to change prices and not lose all consumers
If a firm cant change prices, it cant increase or decrease prices for different consumer groups so it cant price discriminate

Question 16

Why does a firm need information on consumer’s elasticities in order to price discriminate ?

Answer 16

• Firms can only successfully price discriminate if they know shopping habits, age, gender and incomes of consumers so they can efficiently change prices for different consumer groups

E.g. Amazon

Question 17

Why should a firm limit reselling in order to successfully price discriminate?

Answer 17

Firms could lose out on profit because a consumer group may not pay the full price of what they are meant to pay

E.g. A student sells a train ticket to an adult below the adult price. Adult will buy it because it is cheaper than what they will usually have to pay. Firm loses out on profits

Question 18

What is meant by perfect competition and what are the 4 conditions which define perfect competition?

Answer 18

Opposite of a monopoly

-Market with many small buyers and seller
-No barriers to entry
-Homogeneous workers
-Perfect information

Question 19

Explain how a perfectly competitive market moves to its long run equilibrium (4)

Answer 19

In the long run, perfect information means potential sellers outside the market will see the opportunity to make supernormal profit by entering the market

There are no barriers to entry, so new firms will enter the market, increasing supply and decreasing price until AR touches the bottom of the firm’s AC curve and all the supernormal profit is gone

New firms will no longer enter the market because they an no longer make supernormal profit, so we have reached the long run equillibrium

Question 20

Explain how a perfectly competitive market, where firms are making a short run loss, moves to its long run equilibrium (4)

Answer 20

If firms are making a short run loss, the will leave the market as there are no barriers to entry

As firms leave the market, supply decreases and price will increase back up, until normal profit can be made

At this point, firms will be covering their opportunity cost - so they’ll have no reason to leave the market anymore, which means market has reached long run equilibrium, where firms are making normal profit

Question 21

Explain what happens as a monopolistically competitive market moves into its long run equilibrium (4)

Answer 21

In the short run, if a monopolistically competitive firm is making supernormal profit, it will incentivise new firms to enter the market

There are low barriers to entry, so new firms will enter the market, stealing customers from incumbent firms

This will decrease their demand, shifting AR and MR down, until AR just touches the firm’s AC curve - so only normal profit will be left and all supernormal profit is gone

Potential suppliers outside the market will no longer enter the market because they can no longer make supernormal profit, so the market has reached long run equilibrium

Question 22

In monopolistically competitive markets, in the short run, firms can make…

Answer 22

Supernormal profit but in the long run only normal profit can be made due to competition, so only normal profit can be made

Question 23

What are the key features of an Oligopoly

Answer 23

-Dominated by few large sellers
-High barriers to entry
-Differentiated goods
-Interdependence

Question 24

Explain two possible sunk costs involved in entering the fizzy drink market (4)

Answer 24

Sunk costs are costs that cannot be recovered

Like advertising, Pepsi-Co and Coca Cola spend millions on advertising their fizzy drink, but once paid, they can’t recover the money spend on billboards or TV ads, so advertising is a huge sunk cost

Secondly, Research and development. There’s no way to recover costs of researching and developing a new fizzy drink recipe - so R and D is also a sunk cost

Question 25

Explain what is meant by interdependence

Answer 25

Actions of one firm directly affect another firm

E.g. If coca cola halved their prices, Pepsi-co will freak out as they will lose out on consumers hence coca cola and Pepsi-co are interdependent

Question 26

Definition of Collusion

Answer 26

When two firms work together to limit competition

Question 27

Definition of Overt collusion

Answer 27

When there’s a formal agreement between firms to limit competition.
E.g. a phone call/contract/handshake between firms.
It is ILLEGAL

Question 28

Definition of Tacit collusion

Answer 28

When there’s an unspoken agreement between firms to limit competition.
It is LEGAL

Question 29

What is meant by predatory pricing?

Answer 29

When a firm aggressively cuts its prices below AVC to force out competitors from the market.

Short run: The firm incurs a loss

Long run: The firm forces out its competitors, so they can take over the market.

Question 30

Definition of Limit pricing

Answer 30

When an incumbent firm uses its economies of scale to set a price low enough to limit new firms from entering.

Small new firms, without economies of scale, won’t be able to compete so they’ll stay out of the market.

Limit pricing is a barrier to entry.

Question 31

What is a price war?

Answer 31

When firms try to undercut each other with lower prices, the price is driven down super low and from there, only very little profit can be made.

Question 32

What are the 4 factors affecting non-price competition?

Answer 32

Firms compete without changing the price

-Advertising
-Loyalty cards
-Branding
-Quality

Question 33

Why are sunk costs a barrier to entry?

Answer 33

Sunk costs are costs that cannot be recovered (e.g. advertising).

High sunk costs are a barrier to entry: they deter new firms from entering because firms know that if they fail, they won’t be able to recover any of their sunk costs.

Question 34

Explain how vertical integration can be an anti-competitive practice:

Answer 34

Firms can vertically integrate to take control of scarce resources (like the power grid or the oil extraction firm); and then refuse to let new firms use these scarce resources, stopping them from entering the market.

Question 35

Define a contestable market

Answer 35

A market in which there are low barriers to entry and exit, the number of firms in the market doesn’t matter

Question 36

Outline hit and run competition

Answer 36

-Incumbent firms make supernormal profit
-This incentivises new firms to enter the market and they are able to because there are low barriers to entry
-These new firms undercut the incumbent firm and the incumbent firm has to lower price to keep their consumers
-Stealing the supernormal profit

In order to get rid of new firms from entering the market the incumbent firm sets price = AC, this way only normal profit is made and the new firm cant make any supernormal profit and they leave the market

Question 37

Explain what will happen to an incumbent firm’s short run supernormal profit when we move into the long run. Refer to the concept of “hit and run competition” in your answer. (4 marks)

Answer 37

If an incumbent firm is making supernormal profit in the short run, its price must be above its AC.

This leaves the incumbent firm open to “hit and run competition”.

The supernormal profit will incentivise new firms to enter the industry and because the market is contestable, there are low barriers to entry/exit, so it will be easy for new firms to enter.

New firms will therefore enter (or “hit”) the industry. They’ll undercut the incumbent firm to steal away its consumers and make supernormal profit.

To get rid of the new entrants, the incumbent firm has to set price = AC so only normal profit can be made.

The new firm will then “run”: they will leave the market because all the supernormal profit is gone.

Question 38

Benefit of monopolies to consumers

Answer 38

-Consumers may be better off in monopoly markets because monopolies may be able to produce goods at a lower costs and higher quality

-Monopolies make large supernormal profits which can be reinvested to the business to refine the production process and hire more workers

Question 39

Benefits of monopolies to firms

Answer 39

+ Price makers - They can set prices at Pmax, making large supernormal profits

+ Can keep out competitors - Amazon can improve its dynamic efficient by refining the production process, hiring more workers and buying cost saving technologies, lowering their costs, allowing them to keep competitors out of the market

Question 40

Disadvantages of monopolies for firms

Answer 40

• Monopolies can exploit their position to drive competition out of the market. However, this may lead to complacency and an increase in average costs. As a result, firms’ costs may increase. This in turn could lead to higher prices and the potential of the firm’s monopoly position.

Question 41

How does dynamic efficiency affect the market position of a monopoly?

Answer 41

Dynamic efficiency enables firms to drive down prices and keep new firms from joining the market. As a result, reinvesting large profits can lead to a strengthening of a firm’s monopoly position.

Question 42

Explain why consumers may be better off in a market controlled by a monopoly firm…

Answer 42

Monopolies achieve large supernormal profits. They can use this to invest in their capital and achieve dynamic efficiency, lowering their costs. In addition, monopolies are large enough to access economies of scale. This process will also lower average costs in the long run. Therefore, firms may be able to reduce their prices and provide consumers with lower cost, higher quality products than firms would be able to provide in a competitive market.

Question 43

What process may lead a firm with a strong monopoly position to become vulnerable to competitors?

Answer 43

x inefficiency

Question 44

Advantages of perfect competition

Answer 44

Firms show static efficiency because they are allocatively and productively efficiently so consumer surplus is maximised, unlike in monopoly markets

Question 45

Disadvantages of perfect competition

Answer 45

• In perfectly competitive markets, firms aren’t able to achieve dynamic efficiency. They are also unable to access economies of scale. As a result, they pass on higher prices to consumers in the long run.
• Consumers may also lose out over the quality of goods. As firms compete over price, some may cut corners to lower their cost of production.

Question 46

Benefits of oligopolies to consumers

Answer 46

If firms in an oligopoly compete, then prices for consumers will decrease, the quantity of goods supplied will increase and consumer surplus is maximised.

Question 47

Consumers are better off in an oligopoly where firms do not…

Answer 47

Collude

Question 48

What type of efficiencies do firms achieve in perfect competition in the long run?

Answer 48

Allocative/productive