Theme 3.4: Market structures Flashcards
Oligopoly (said in turkish accent)
When is a firm considered a monopoly
When it owns 25% of the market share
What are the 3 assumptions regarding monopolies?
-Only one firm in a market
-The firm wants to Profit maximise - meaning they produce where marginal cost = marginal revenue
-High barriers to entry
What is a pure monopoly?
A firm with 100% market share
What are the 5 barriers to entry?
Legal barriers
Economies of scale
Sunken costs
Brand loyalty
Anti-competitive practices
Why are sunk costs a barrier to entry?
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.
Why are legal barriers a barrier to entry?
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
Definition of perfect competition
A market where there is a high degree of competition
Characteristics of perfect competition
-Many buyers and sellers
-Low barriers to entry and exit
-Perfect knowledge
-Product must be homogeneous
How does many buyers and sellers in a market cause perfect competition?
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
Define a natural monopoly
When it is most efficient for there to only be one firm in the market e.g. TFL and NHS
Why do natural monopolies exist?
High sunk costs and huge internal economies of scale
EXAM STYLE QUESTION
Explain why TFL is considered a natural monopoly. (4 marks)
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.
Definition of price discrimination
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
3 conditions for price discrimination
- Firm must have large market share
- Information on elasticities of consumers
- Ability to limit reselling
Why must firms have market power in order to price discriminate?
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
Why does a firm need information on consumer’s elasticities in order to price discriminate ?
- 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
Why should a firm limit reselling in order to successfully price discriminate?
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
What is meant by perfect competition and what are the 4 conditions which define perfect competition?
Opposite of a monopoly
-Market with many small buyers and seller
-No barriers to entry
-Homogeneous workers
-Perfect information
Explain how a perfectly competitive market moves to its long run equilibrium (4)
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 can no longer make supernormal profit, so we have reached the long run equillibrium
Explain how a perfectly competitive market, where firms are making a short run loss, moves to its long run equilibrium (4)
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
Explain what happens as a monopolistically competitive market moves into its long run equilibrium (4)
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
In monopolistically competitive markets, in the short run, firms can make…
Supernormal profit but in the long run only normal profit can be made due to competition, so only normal profit can be made
What are the key features of an Oligopoly
-Dominated by few large sellers
-High barriers to entry
-Differentiated goods
-Interdependence
Explain two possible sunk costs involved in entering the fizzy drink market (4)
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
Explain what is meant by interdependence
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
Definition of Collusion
When two firms work together to limit competition
Definition of Overt collusion
When there’s a formal agreement between firms to limit competition.
E.g. a phone call/contract/handshake between firms.
It is ILLEGAL
Definition of Tacit collusion
When there’s an unspoken agreement between firms to limit competition.
It is LEGAL
What is meant by predatory pricing?
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.
Definition of Limit pricing
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.
What is a price war?
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.
What are the 4 factors affecting non-price competition?
Firms compete without changing the price
-Advertising
-Loyalty cards
-Branding
-Quality
Why are sunk costs a barrier to entry?
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.
Explain how vertical integration can be an anti-competitive practice:
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.
Define a contestable market
A market in which there are low barriers to entry and exit, the number of firms in the market doesn’t matter
Outline hit and run competition
-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
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)
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.
Benefit of monopolies to consumers
+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
Benefits of monopolies to firms
+ 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
Disadvantages of monopolies for firms
- 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.
How does dynamic efficiency affect the market position of a monopoly?
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.
Explain why consumers may be better off in a market controlled by a monopoly firm
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.
What process may lead a firm with a strong monopoly position to become vulnerable to competitors?
x inefficiency
Advantages of perfect competition
Firms show static efficiency because they are allocatively and productively efficiently so consumer surplus is maximised, unlike in monopoly markets where the is a deadweight loss of efficiency. This reduces prices for consumers which increases demand, increasing revenue and hence profits increase too. These profits can then be handed out as dividends to shareholders, meaning they make more money and could potentially reinvest this profits into the firm.
Static efficiency definition
When a firm is both allocatively and productively efficient
Disadvantages of perfect competition
- 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.
Benefits of oligopolies to consumers
If firms in an oligopoly compete, then prices for consumers will decrease, the quantity of goods supplied will increase and consumer surplus is maximised.
Consumers are better off in an oligopoly where firms do not…
Collude
What type of efficiencies do firms achieve in perfect competition in the long run?
Allocative/productive
Explain how vertical integration can be an anti-competitive practice
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.
What type of efficiencies do firms achieve in perfect competition in the long run?
Productive efficiency
Why can perfect competition be a good thing for consumers?
Perfectly competitive markets are allocatively efficient; they therefore maximise consumer surplus. In addition, consumers enjoy high quality products, lots of choice and low prices.
What can firms in a perfectly competitive market not achieve or access?
-Dynamic efficiency
Explain whether consumers will benefit or lose out in an oligopoly market
If firms in an oligopoly collude, then consumers will lose out due to higher prices and an exploitation of consumer surplus. However, if firms in an oligopoly compete, then prices will fall and consumer surplus will increase. Therefore, consumers will fare better in an oligopoly that competes than in an oligopoly that colludes.
APPLICATION
Example of a monopoly
-Google has market power in internet search advertising, with 92% market share worldwide in internet searches.
-Google’s dominance has been put down to the quality of its search algorithm early on, network economies of scale and good timing. Network economies of scale mean that the more users a search engine has, the more interest from advertisers and other users. The economies of scale of Google make it a natural monopoly.
-Google and Facebook have been found to charge up to 30% higher for each click through from online advertising (compared to companies like Bing).
-The European Commission fined Google 2.4 billion euros for abusing its dominant position as an internet search provider. Specifically, in giving another of Google’s products, a shopping comparison service, a prominent placement in search results.
APPLICATION
Examples of Oligopolies
-The five largest supermarkets in the UK have a five firm concentration ratio (combined market share) of 66%. However the industry has witnessed the growth of new entrants such as discount chains Aldi and Lidl.
-Some supermarkets were fined a sum of £50 million back in 2011 for fixing dairy prices.
-The CMA has been investigating loyalty schemes, such as Clubcard and Nectar. These schemes allow some customers to access discounts. The CMA suggests this could make it harder for consumers to compare prices between supermarkets and may investigate the fairness of a two-tier pricing system.
APPLICATION
Example of monopolistic competition
-There are 46,000 hair and beauty businesses in the UK in 2021.
-Hairdressing contributes up to £6.6 billion to the UK economy per year.
-Hairdressers sell similar services. But the services may be differentiated e.g. depending on the quality of the haircut, the interior or comfort in the salon or upsells such as a particular shampoo or hair product.
-The UK hairdressing industry has a mix of independent stores, as well as chains such as Toni and Guy
Should hairdressers need a licence to cut customers’ hair? The British Barbers Association states this would improve quality of service. This would also increase barriers to entry.
APPLICATION
Example of perfect competition
-There were 7.5 million sellers on the Etsy online marketplace in 2022.
-While there are no examples of perfectly competitive markets, online platforms like Etsy may be some of the closest.
-Etsy businesses have high start-up and failure rates, with 74% of Etsy shops failing.
-Etsy has low barriers to entry. To set up an Etsy shop, you just need to set up an Etsy account and set up an online shop (including payment methods and product listings).
